The question posed in the title to this post comes up at least once a year in discussions with clients.
They get a plan in mind to start a not-for-profit to shelter income. They usually haven’t thought through the details other than starting a not-for-profit and donating all of their money into it to avoid taxes.
For example, a high-income spouse will suggest having their home-maker spouse start a not-for-profit, and the high-income spouse will “donate” 100% of their salary to the not-for-profit each year, and the not-for-profit will pay a “salary” to the other spouse to live on, which of course will be a fraction of the taxable income the high-income spouse takes home.
Example:
Here’s how clients typically sketch it out: Alex and Angie are married. Alex makes $250,000 per year at a job. Angie is a stay-at-home mom. Alex proposes that Angie start a not-for-profit. Alex will then “donate” all of his salary into the not-for-profit and take a $250,000 deduction, while Angie will draw out a small salary that’s just large enough to pay the bills.
Yes, this seriously does come up at least once a year, sometimes more often, every year.
There are several flaws with this scheme, including the fact that charitable contributions are limited to a percentage of your income (usually 50% of AGI), so in our example above, Alex wouldn’t get a full $250,000 deduction.
Still, as with most tax schemes, there’s a small nugget of truth to the idea. You can indeed start a not-for-profit and put money into it and get a deduction (but only if the not-for-profit is a 501(c)(3)!). You can also put yourself or other family members on payroll within the not-for-profit.
But here’s the biggest flaw with this scheme: your not-for-profit has to actually be organized for charitable purposes and it has to demonstrate that it’s meeting that charitable purpose for the public — shielding your income from taxation is not a charitable purpose!
Here’s what the Treasury Regulations say:
Thus, to meet the requirement of this subdivision, it is necessary for an organization to establish that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests.
Regulation 1.501(c)(3)-1(d)(1)(ii)
And:
An organization is not operated exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals.
Regulation 1.501(c)(3)-1(c)(2)
So if you’re going to start a not-for-profit and pay yourself a salary, you’d have to make sure the not-for-profit was organized for actual charitable purposes for the public, and that it actually carried out that charitable purpose.
Also, you’d have to go through the 501(c)(3) application process, and you likely wouldn’t qualify to use Form 1023-EZ. This means fees and a mountain of paperwork to get the entity started. Plus, filing the annual 990s. And since you’re drawing a salary out of the entity, you’d have to deal with payroll taxes, payroll filings, etc.
In conclusion: there’s a nugget of truth here. You could funnel your income into a not-for-profit and get a deduction, and then draw a salary out of the not-for-profit. It can be done. But in my experience, 100% of the clients who bring this up are not in a position to A) jump through all of the hoops to get it set up, and B) aren’t in a position to actually manage a functioning not-for-profit that actually does real charitable work in the real world.