It’s easy for a 501(c)(3) organization / Nonprofit to maintain its IRS tax-exempt status – and it can be just as easy to lose it. the IRS recognizes private foundations, churches, educational institutions, hospitals, and many other types of public charities.
501(c)(3) IRS Tax-Exempt Status Is a Privilege
IRS tax exemption is a privilege, and your 501(c)(3) organization can lose it if you’re not careful. There are 6 key areas to stay on the IRS’s good side and keep that tax exemption.
- Private benefit
- Unrelated business income (UBIT)
- Political campaign activity
- Operation in accordance with the stated exempt purpose
- Annual reporting obligation
1. Private Benefit / Private Inurement
If your 501(c)(3) holds an IRS tax exemption, then its activities have to be directed toward an exempt purpose. It should not serve the private interests, or benefit, of any person or organization more than insubstantially.
The concept of inurement states that no part of an organization’s net earnings may inure to the benefit of a private shareholder or individual who, because of the person’s relationship to the organization, has an opportunity to control or influence its activities. Prohibited inurement includes the payment of dividends, the payment of unreasonable compensation to insiders, and the transfer of property to insiders for less than fair market value.
By the same token, nonprofits with tax exemptions can’t have their income or assets benefit insiders. This includes people like board members, officers, directors, and important employees of an organization. If an organization benefits them, the insiders AND the organization could be subject to penalty excise taxes, and the nonprofit could lose its tax-exempt status.
If a 501(c)(3) organization engages in inurement or substantial private benefit, the organization risks losing its exemption. Additionally, insiders guilty of inurement may be subject to excise tax.
Lobbying is when an organization contacts, or asks the public to contact, lawmakers to propose, support, or oppose the legislation. It’s also considered lobbying when the organization directly advocates for or against any legislation. 501(c)(3) organizations are allowed to do some lobbying. However, if lobbying activities are substantial an organization risks losing its tax-exempt status. An organization can elect to have its lobbying activities measured by an “expenditure test” to determine whether or not the activities are substantial. This is known as a 501(h) election, so named for the section of the Internal Revenue Code where the rules for the expenditure test are spelled out.
By making this election, an organization agrees to not spend more than a certain percentage of its total expenses on lobbying activities. The other way to measure lobbying activity is to determine whether, based on all of the pertinent facts and circumstances, an organization’s lobbying comprises a substantial part of its overall activities. This substantial part test is a more subjective method compared to the more mathematical, objective expenditure test.
Organizations must file Form 5768, Election/Revocation of Election by an Eligible Sec. 501(c)(3) Organization to Make Expenditures to Influence Legislation, in advance to be subject to the expenditure test.
3. Political Activity
Nonprofits cannot participate in political campaigns for or against any candidate for public office, at the federal, state or local level. All section 501(c)(3) organizations are prohibited from directly or indirectly participating in, or intervening in, any political campaign on behalf of (or in opposition to) any candidate running for public office. The prohibition applies to all campaigns (federal, state and local level). Political campaign intervention includes any and all activities that favor or oppose one or more candidates for public office. The prohibition extends beyond candidate endorsements. Contributions to political campaign funds or public statements of position (verbal or written) made by or on behalf of an organization in favor of, or in opposition to, any candidate for public office clearly violate the prohibition on political campaign intervention.
Section 501(c)(3) organizations may engage in some activities to promote voter registration, encourage voter participation, and provide voter education, but they can’t engage in activities that favor or oppose any candidate for public office. Whether an activity is a political campaign intervention depends on all the facts and circumstances.
The political campaign intervention prohibition is not intended to restrict free expression on political matters by leaders of organizations speaking for themselves as individuals. Nor are leaders prohibited from speaking about important issues of public policy. However, for their organizations to remain tax-exempt under section 501(c)(3), leaders cannot make partisan comments in official organization publications or at official functions of the organization.
To learn more about political activity and nonprofits, check out Charities, Churches, and Educational Organizations – Political Campaign Intervention.
4. Unrelated Business Income (UBI)
Earning too much income from activities that aren’t related to your exempt purpose can endanger your exempt status. This kind of income comes from a business activity that is not substantially related to the organization’s exempt purpose. This can get murky because there are some modifications, exclusions, and exceptions.
An organization that produces unrelated business income due to its unrelated trade or business may have to pay taxes on that income. The income-producing activity must meet three conditions before the income is potentially taxable.
First, the activity must be a trade or business. Second, the trade or business must be regularly carried on. Third, the business activity is not substantially related to an organization’s exempt purpose. In other words, the activity itself does not contribute to accomplishing the exempt purpose for which the non-profit had been set up, other than through the production of funds.
Some of the most common UBI-generating activities include the sale of advertising space in weekly bulletins, magazines, journals, or on the organization’s website; sale of merchandise and publications when those items being sold do not have a substantial relationship to the exempt purpose of the organization; provision of management or other similar services to other organizations; and, even some types of fundraising activities. Generally, organizations that generate unrelated business income should file Form 990-T, Exempt Organization Business Income Tax Return, and pay tax on the income.
Any non-profit generating money in activities that do not further its specific exempt purposes should be very careful in continuing to do so. In addition to paying taxes on the income from unrelated activities, if those activities are substantial in relation to the exempt purpose activities, the non-profit may be putting its exempt status in jeopardy.
For more information about what is considered UBI and how it’s taxed, see Publication 598, Tax on Unrelated Business Income of Exempt Organizations.
5. Annual Reporting Requirements
Public charities are exempt from federal income tax, yes. But, the Internal Revenue Code requires most of these organizations to report information every year by filing Form 990. The 990 verifies that the nonprofit still qualify for tax exemption. It’s a public record, and it helps inform the public about the organization’s programs and operations. In addition, the non-profit may also be liable for unrelated business income tax as discussed above, employment tax, excise taxes, and certain state and local taxes.
Public charities generally file either Form 990, Return of Organization Exempt from Income Tax, Form 990- EZ, Short Form Return of Organization Exempt from Income Tax or submit online Form 990-N, Electronic Notice (e-Postcard) for Tax-Exempt Organizations not Required To File Form 990 or 990-EZ.
The type of form or notice required to be filed by the non-profit is determined by its gross receipts and the value of its assets. An organization may file Form 990-EZ if its gross receipts are normally less than $200,000 and if its total assets are less than $500,000 at the end of the year. If the organization’s gross receipts are $200,000 or greater, or if its assets at the end of the tax year are $500,000 or more, the organization generally must file Form 990. If the organization’s annual gross receipts are generally $50,000 or less, the organization may in lieu of Form 990 or 990-EZ submit online new Form 990-N, Electronic Notice (e-Postcard) for Tax-Exempt Organizations not Required to File Form 990 or 990-EZ.
There are some public charities that are not required to file Forms 990 or 990-EZ, including churches and certain church-affiliated organizations. In general, the organizations that do not need to file a Form 990 are:
- Branches of other nonprofits: Subsidiaries of larger nonprofit organizations may be covered under a general return filed by the parent nonprofit organization.
- Many government corporations.
- State organizations that provide essential services.
- Smaller nonprofit organizations: Those with annual incomes of $25,000 or less do not need to file.
- Nonprofit organizations not yet in the system: Organizations that have not yet applied for exemption from federal income tax are not required to file a Form 990 as the IRS would not yet have the organization’s information.
- State institutions: Organizations that provide essential services, such as universities, do not need to file a Form 990.
- Churches and other faith-based organizations.
The Pension Protection Act of 2006 provides for the automatic revocation of an organization’s tax-exempt status if it fails to file a required annual information return for three consecutive years. In June 2011, the IRS enforced this provision for the first time by publishing a list of about 275,000 organizations that lost their tax-exempt status for failing to meet their annual filing obligations for three consecutive taxable years.
If an organization finds that its exempt status has been automatically revoked due to non-filing and it wants its tax-exempt status reinstated, it will need to reapply and pay the appropriate user fee. Get started today to get the help you need in reinstating the tax-exempt status of your non-profit.
You can learn more about filing requirements, including new requirements applicable to supporting organizations, at IRS Nonprofits and Charities.
6. Not Operating Within Your Exempt Purpose Endangers Your 501(c)(3) IRS Tax-Exempt Status
This can be really troublesome. A 501(c)(3) with the IRS tax exemption received it because it promised to fulfill a charitable mission or purpose. Day to day it must pursue the exempt activities it promised in its IRS application for exemption. If an organization’s activities go toward something other than its original purposes, it must inform the IRS to prevent future problems. If you’re unsure whether a deviation is significant enough to report, contact a nonprofit attorney.
Non-profit organizations must adhere to the guidelines inherent in these six areas. If they continue to do this, they will maintain their tax-exempt status and enjoy its benefits.
Questions about 501(c)(3) IRS Tax-Exempt Status?
If you have questions about your 501(c)(3) IRS tax-exempt status, schedule your consultation with NexGen Taxes now.