Obtaining tax-exempt status requires an organization to apply to the IRS and ensure it will follow the appropriate rules. If an organization becomes complacent once exempt status has been obtained, it may not realize their tax-exempt status can be lost without even trying. Exempt organizations should be aware of and understand IRS regulations and potential tax risk areas to avoid a worst-case scenario.
The requirements for tax-exempt status vary depending on the type of exemption obtained. For example, 501(c)(3) is much more restrictive than other types of exemptions and as such there are more potential pitfalls. Regardless of the type of exemption your organization has, there are several potential tax risks that need to be monitored to ensure your organization does not risk loss of exempt status or subject the organization to penalties or taxes. Organizations that understand and follow the rules affecting common risk areas take large steps toward maintaining their tax-exempt status; organizations that ignore or fail to monitor these tax risks may find themselves subject to IRS review and scrutiny.
Here are a few common risk areas in relation to tax-exempt status.
Tax Risk #1 – Annual Reporting Obligations
In general, most tax-exempt organizations are required to file an annual information return with the IRS via Form 990, 990-EZ or 990-PF. Smaller organizations with annual gross receipts of $50,000 or less may be eligible to electronically submit Form 990-N e-Postcard. A few very limited types of organizations may be excepted from filing altogether. An organization that fails to file an annual federal information return for three years is subject to automatic revocation under IRC Section 6033(j). While new requirements under the Taxpayer First Act formally require the IRS to provide notice after two years of non-compliance, this remains a very real tax risk and is one of the most common causes of the revocation of exempt status.
Tax Risk #2 – Following Your Tax-Exempt Purpose
Organizations that have been recognized as exempt by the IRS must follow specific rules regarding the requirements to maintain tax-exempt status. These rules vary by organization type, so organization managers need to be aware of the specific requirements. All organizations must operate consistent with the purpose for which they obtained exemption. Conducting activities that are outside of its tax-exempt purposes results in a risk of revocation. For example, social clubs exempt under 501(c)(7) may only receive a small portion of their revenues from non-members without jeopardizing exemption.
501(c)(3) organizations must also be organized exclusively for charitable purposes. The organizing documents must expressly limit its purposes to those listed under Section 501(c)(3) of the IRS Code. The documents must also contain a dissolution clause that permanently allocates all the assets of the organization to charitable purposes. In addition, the organizing documents must address both the lobbying and political restrictions on the organization.
Tax Risk #3 – Private Benefit and Inurement
To be recognized as tax-exempt under 501(c)(3) or 501(c)(4), the net earnings of the organization may not inure to the benefit of any private individual and the organization must not be operated for private benefit. The private benefit rules prohibit benefits to individuals that are not “incidental to the accomplishment of exempt purposes.” These rules apply to both individuals within and outside of the organization. The private benefit doctrine focuses on whether the primary activities are charitable and whether they appropriately benefit a large enough charitable class of individuals. An organization can have some private benefit without impacting tax-exempt status.
The inurement doctrine prohibits benefits to insiders of the organization in excess of consideration received. The consequence of private inurement is loss of exempt status. However, to limit the impact of loss of exempt status to extreme situations, the IRS has implemented intermediate sanction provisions which impose an excise tax on the insider who benefited from the transaction. These sanctions are applied in situations where “excess benefits” are received and can be applied in addition to loss of exempt status or in place of loss of exempt status. Primary examples of inurement or excess benefits occur in the context of excessive compensation, non-fair market value transactions or transactions with taxable entities owned by insiders.
Tax Risk #4 – Lobbying Activities
The level of lobbying activities an exempt organization can engage in varies significantly by type of exemption. Lobbying occurs when an organization attempts to influence legislation by contacting or urging the public to contact members or employees of a legislative body regarding specific pieces of legislation. Simply conducting educational meetings, preparing and distributing materials or providing information on issues of public policy in an educational manner is not considered lobbying. Organizations other than those exempt under 501(c)(3) are not restricted on the amount of lobbying they do, however there are rules on what type of reporting is required. Organizations exempt from tax under 501(c)(3) can engage in lobbying only if it is insubstantially related to their overall activities (based on time and/or expenditures). All organizations should track and routinely review lobbying activities and expenditures to assess potential restrictions and exposure.
Tax Risk #5 – Political Campaign Activities
Political campaign activities are specifically prohibited for 501(c)(3) organizations, and participation—whether direct or indirect—can result in loss of exemption. Prohibited political activities include participating in or intervening in a political campaign on behalf of or in opposition of any candidate for public office. Contributions to political campaign funds or public statements of position made on behalf of the organization are violations of the rules. 501(c)(3) organizations can participate in certain voter education activities, voter registrations or get-out-to-vote drives as long as they are conducted in a non-partisan manner. Other types of exempt organizations are not specifically prohibited from conducting political activities but may be subject to additional reporting requirements or limitations.
Tax Risk #6 – Unrelated Business Income
Unrelated business income (UBI) is created from activities the organization regularly carries on with a profit motive that are not substantially related to its exempt purpose. All organizations that identify UBI report activity via the Form 990-T and pay tax at either the corporate or trust rates on net income. There are many exceptions, nuances and rules to UBI and requires review and annual due diligence. In general, these unrelated business activities must constitute an insignificant portion of the activities otherwise, the organization may risk its tax-exempt status. There is no bright line test in determining what is substantial, all facts and circumstances must be considered. If an unrelated activity becomes substantial, restructuring opportunities are available to minimize risk to the exempt status.
A critical component to consider in exempt organizations are exam issues. Learn more about what to look for.
Tax Risk #7 – Other Areas of Tax Risk
In addition to the risks discussed above that can jeopardize tax-exempt status of an organization, there are many other tax risks that may result in other penalties or exposure from the IRS or other regulatory bodies. Exempt organizations should always follow applicable guidance for state and local taxes including sales and use tax compliance, property tax payments, unclaimed property reporting, and charitable solicitation registration (for 501(c)(3) organizations). Laws and registration requirements are complex and vary from state to state. In addition, organizations that invest in alternative investments may have foreign reporting requirements which can carry significant penalties if not properly completed. All organizations that have employees should also ensure they are properly following all payroll tax reporting.
Exempt organizations should have an awareness around these potential tax risks and should develop processes to regularly assess exposure. Working with a tax professional can help clarify the complexities surrounding tax-exempt status so that you can focus on your mission.
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