Maintaining Your Tax-Exempt Status

You’ve finally done it! You’ve organized your non-profit organization according to the laws of your state, developed a mission, drafted and approved bylaws, and adopted a functioning board structure. You have also completed and submitted the arduous Form 1023 Application for Recognition of Exemption Under Section 501(c)(3). And then you have waited. . . . . . and waited. . . . . and waited. And today it came! The letter from the IRS that you actually want to receive! The letter that states:

We’re pleased to tell you we determined you’re exempt from federal income tax under Internal Revenue Code (IRC) Section 501(c)(3). Donors can deduct contributions they make to you under IRC Section 170. You’re also qualified to receive tax deductible bequests, devises, transfers or gifts under Section 2055, 2106, or 2522. This letter could help resolve questions on your exempt status. Please keep it for your records.

Receiving this letter is cause for excitement! After all, completing the Form 1023 itself is typically 50-100 hours of work (although the Form 1023-EZ form is much shorter). However, obtaining your tax-exempt status is just the beginning. Now, and for the remainder of the organization’s life, you must maintain your tax-exempt status. To do so, there are several activities you MUST perform on an ongoing basis and several activities you MUST avoid. Maintaining tax-exempt status is not difficult, but it is helpful if you are aware of the pitfalls, so as to avoid them.

Activities to regularly PERFORM to maintain your tax-exempt status:

1. Timely file all required filings with the IRS.

While timely completing all required tax filings should be obvious, there are many organizations who have issues in this area. A not-for-profit organization can have many required filings, including quarterly, and annual payroll tax returns; annual 1099 filings, the annual 990 return and, if required, the annual form 990-T, to name a few. Many of these filings are required for all organizations, for-profit and not-for-profit. Therefore, the following paragraphs specifically focus on the 990 Annual Information Return.

Late filing of form 990 is not the end of the world, but it is best avoided as the IRS late filing penalties are draconian. For small organizations (gross receipts up to $1,208,500), the penalty is $20/day up to a maximum of the lesser of $12,000 or 5% of the gross receipts of the organization for the year. For larger organizations (gross receipts over $1,208,500), the penalty is $120/day up to a maximum of $60,000.

The larger danger comes with not filing the form 990 for consecutive years. If an organization fails to file the form for three consecutive years, the IRS will automatically revoke its tax-exempt status. Since the IRS began this automatic revocation program in 2011, it has revoked the status of approximately 500,000 organizations. Of these, approximately 20% have reapplied for exemption and had it reinstated.

The Form 990 is due on the fifteenth day of the fifth month following the organization’s year end (May 15^th for a calendar year organization). An automatic six-month extension can be applied for. Filing of the extension is common and is quite simple to complete.

2. Make certain documents available to the public.

One of the trade-offs of being exempt from income tax is losing some privacy. The IRS requires an organization’s original exemption application (Form 1023), determination letter, and the three most recently filed information returns (including 990-T, if applicable) be made available to the public. Moreover, the organization is prohibited from charging for providing these forms, outside of a minimum reimbursement for the cost of copying.

As a practical matter, many users of this information will go to public sources, such as Guidestar.org, for historical form 990s. However, there is a significant lag between when a return is filed and when it is posted on Guidestar. Therefore, it is common for users to go directly to the organization for the most recently filed return or for a copy of the original exemption application.

As the organization is not required to make its donor records public, it may omit donor name and address information on Schedule B from any copies it provides.

3. Be familiar with the charitable solicitation laws in your state.

Each state requires an organization to register to solicit funds and engage in fundraising activities. The rules for each state are different and have varying levels of compliance. Some simply require a form be filed annually while others may require you to engage a CPA to perform a full audit of the organization’s records. Any exempt organization should be familiar with the rules of its home state as well as those in other states where it solicits funds.

Activities to constantly AVOID to maintain your tax-exempt status:

1. Having too much Unrelated Business Income (UBI)

While an in-depth review of UBI is beyond the scope of this article, put simply, an organization must pay tax on trade or business income generated from activities that are regularly carried on, for the purpose of generating a profit and not substantially related to the exempt purpose of the organization. So, if you are a Habitat for Humanity and begin a lawn care business for the purpose of funding housing, that lawn care business would be UBI. There are many other activities the IRS considers UBI. Three of the most common are selling advertising space in publications, investment in certain types of entities, and renting debt financed property.

Many not-for-profit organizations are concerned about the possibility they may have to pay tax on their UBI. After all, they are tax-exempt, why should they be paying taxes? And they do their best to avoid it. However, tax on an organization’s unrelated business activity is not necessarily a bad thing. It means that activity is generating a profit which could be beneficial to the Organization’s mission.

The pitfall would be having too much in UBI, which can jeopardize an organization’s tax-exempt status. There is no hard line as to what constitutes too much UBI. Moreover, the IRS has given conflicting guidance; once stating that UBI must be an “insubstantial part” of a non-profit’s activities, and later stating the UBI can be substantial so long as it is not the organization’s “primary purpose.” As a general rule, the Organization should consider where its primary focus lies. If the primary focus of the board and management is on the mission and programs which fulfill that mission, it is probably fine, even if UBI activities are significant. However, if the organization finds most of the time spent by management and the board is on operating unrelated businesses, there could be cause for concern.

2. Avoiding prohibited political activities

Before delving into this topic, a distinction must be made between lobbying and political campaign intervention. Although these terms sound similar, they are different. An organization is allowed to do a certain amount of lobbying while it is completely prohibited from political campaign intervention.

Lobbying is defined as “any activity designed to influence legislation.” Using our earlier example of Habitat for Humanity, this type of organization would be allowed to promote or discourage a bill related to low-income housing as that legislation has a direct impact on its mission. The amount of lobbying an organization can undertake is defined and is based on the amount of exempt purpose expenditures. See the instructions for Form 990 for details.

Political campaign intervention is defined as “Participating in any political campaign on behalf of or in opposition to any candidate for public office,” and public charities are completely prohibited from this activity. This prohibition applies to all campaigns at the federal, state, and local levels.

A good memory tool for making this distinction is to remember the three Ls and the three Ps. Lobbying deals with Legislation and is Limited in the amount of activity that can be undertaken. Political campaign intervention deals with People and is completely Prohibited.

3. Avoid Private Benefit and Inurement

These two items are similar but distinct. Private Benefit includes any activity that substantially benefits the private interest of an individual or organization. This does not mean that management, governance, or employees cannot be compensated for services performed. Rather, any compensation received must be commensurate with the value of the services performed.

Inurement is allowing income or assets to accrue for the benefit of insiders. Insiders are those who have personal or private interests in the activities of the organization, such as officers, directors, or key employees. Inurement is most easily understood by comparing a non-profit organization with a for-profit business entity. In a for-profit business, investors expect a return on their investment. Accordingly, they would expect dividends or distributions of earnings based on the performance of the business. Senior managers in a for-profit business might receive large bonuses that are contingent on reaching certain performance indicators or income levels. Compensation based on the profitability of the organization is strictly prohibited for public charities. Other examples of inurement include unreasonable compensation or transferring property at less than fair market value.

Neither private benefit nor inurement is allowed. Unless clearly egregious, engaging in private benefit activities typically results in the imposition of severe penalties. However, engaging in inurement activities is grounds for immediate revocation of the organization’s tax-exempt status.

Summary and Conclusion

As mentioned above, maintaining your tax-exempt status is not hard, but does need to be an area of constant focus. There are very few activities an organization is completely prohibited from engaging in. The key is not to let them overtake the organization’s focus. If I had to summarize this entire article in one sentence, it would be, “Keep your eye on the mission.” Do that, and you should not have any problems with compliance.

For more information on this topic, the IRS has excellent resources on its website: www.stayexempt.irs.gov.