Not-for-profit organizations with 501(c)(3) status are exempt from federal income taxes. However, this exemption is a privilege rather than a right, and the Internal Revenue Service (“IRS”) may ultimately revoke a nonprofit’s federal income tax status under certain circumstances. The IRS giveth, the IRS taketh away. Additionally, as tax exemption is a privilege, the IRS does not violate constitutionally protected rights, such as the Free Exercise clause, when revoking an exemption.
Here are the top five stipulations that 501(c)(3) not-for-profits must adhere to in order to avoid losing their federal tax exemption:
1. Stay Aligned with Not-for-Profit Purpose
One of the most important distinguishing factors between a not-for-profit and for-profit is the nonprofit’s purpose. Most exempt nonprofits qualify under 501(c)(3) of the Internal Revenue Code, which is the most sought after exempt classification primarily for donors’ ability to deduct contributions. 501(c)(3) requires organizations to be “organized and operated” primarily for their statutorily-approved purposes, such as religious, charitable, educational, among others. The IRS may impose excise taxes or revoke exempt status as a result of the not-for-profit’s failure to properly follow these unique requirements. Not-for-profits must be organized for a proper purpose to initially receive 501(c)(3) tax exempt status, satisfying the “organized” factor in “organized and operated.”
Furthermore, not-for-profits must also maintain their activities in conformity with their stated purpose. Although a for-profit company is allowed to conduct its activities in whatever legal way it chooses, nonprofits do not have such flexibility. In short, it is of primary importance that not-for-profits maintain their organizational activities in conformity with their original purposes. The not-for-profit’s charitable purpose should be clearly understood by all employees through a transparent mission statement and board members should regularly evaluate whether the organization’s activities serve its 501(c)(3) purpose.
2. Be Careful about Lobbying
The tax code requires that "no substantial part of an organization's activities should be carrying on propaganda or otherwise attempting to influence legislation. Therefore, not-for-profits have a strict limit on lobbying, which is considered any activity that is meant to influence action by congress, state legislatures, local governing bodies, or public referendum, usually through a politician or public official. The most common form of nonprofits, 501(c)(3) organizations, are allowed to conduct an insubstantial amount of lobbying, but such a test is fairly ambiguous and is difficult for organizations to conform to. Thus, if a 501(c)(3) organization wants to influence legislation, keeping such lobbying expenditures under 5% of its total budget will likely avoid the substantial threshold. However, if a nonprofit wants to dedicate more than 5% of its budget to lobbying efforts, it can opt into 501(h) to avoid the no-substantial test for a clearer quantification test that allows between 5% to 20% of the budget to be spent on lobbying, depending on the size of the budget.
3. Keep Away from Political Campaigning Altogether
Unlike lobbying, political campaigning, which is any activity meant to influence voters relating to candidates for public office, is completely prohibited for all 501(c)(3) organizations. Although donating to political candidates who support the not-for-profit's purpose may appear to conform to the IRS' "organized and operated" test, that activity is also not allowed.
4. Avoid Private Inurement and Excess Benefits
The principle behind all 501(c)(3) organizations is that they must be organized and operated to serve the public rather than private interests. This means they must not unduly benefit people who have a close relationship to the organization or provide excess benefits to its insiders, known as inurement. Any private inurement may result in the revocation of the organization's tax-exempt status.
Excess benefits is another mechanism that is designed to prevent private inurement without the consequence of revocation, but comes with an excise tax penalty between the exempt organization and a disqualified person. An excess benefit transaction typically involves a transaction in which one party is the organization and the other party is an insider of the organization.
Generally, an insider receiving benefit from the organization must be a disqualified person defined as any person who was, at any time during the five-year period preceding the excess benefit transaction, in a position to exercise substantial influence over the affairs of the organization. This typically includes directors, trustees, officers, and their close relatives, also known as disqualified persons.
Disqualified persons are allowed to receive benefits from the nonprofit organization as long as the benefit is proportional and appropriate for the value provided to the organization by the disqualified person. However, when the benefit exceeds fair market value consideration for the value provided to the organization, the benefit is considered an excess benefit. For example, if one of the organization’s directors owns commercial real estate and leases the space to the organization for more than fair market value, then the IRS may consider that an excess benefit.
There are four steps the disqualified person and the organization may take to create a rebuttable presumption that the benefit is permissible: (1) The disqualified person discloses the conflict to the organization; (2) the disqualified person recuses himself or herself from decision-making and voting relating to the transaction; (3) the board performs due diligence to ensure that the organization gets a fair deal; and (4) the organization contemporaneously records its procedures approving the transaction. If these steps are followed, then the burden is on the IRS to prove inurement.
5. Pay Attention to Private Benefits to Non-Insiders
Impermissible private benefits are found when non-insiders receive more than an incidental private benefit. 501(c)(3) organizations are supposed to be organized and operated exclusively for its exempt purpose. To determine if a private benefit is permissible (an incidental quid pro transaction) or impermissible (an excess benefit transaction) the IRS applies the Qualitative and Quantitative tests. The transaction must satisfy both tests for the expenditure to be permissible. The Qualitative test looks to whether the expenditure advances the exempt purpose. If either test fails, then the expenditure is an impermissible excess benefit transaction. The Quantitative test looks to whether the private benefit is proportional to the public benefit. For this test, the IRS looks at whether the price paid for the t-shirts is reasonable.
This article is for general purposes only and not as legal advice. A tailored review and analysis by an attorney is strongly recommended for any business or organization. It is advisable that an organization consult an attorney if they are unsure about anything relating to their tax exempt status. You can contact a Mauck & Baker attorney at (312) 726-1243.