Tax Exemption: What Nonprofit Executives, Board Members, and Auditors Need to Know (Part 1 of 2)

By:
Allen L. Fetterman, CPA, MBA
Published Date:
Apr 1, 2020

Many nonprofit executives, board members, and their auditors are familiar with Form 990—some auditors might even prepare it. Yet many of these professionals don’t know enough about what needs to be done to obtain and maintain tax-exempt status, and they’re not aware of actions that could jeopardize that status. For that reason, this discussion provides a beginning overview of the basics of tax exemption—and will be continued in an upcoming article in next month’s TaxStringer.

Obtaining Tax-Exempt Status

There are a few steps that nonprofits must take prior to applying for tax exemption. The organization must be established as a not-for-profit corporation or a trust and must draft organizing documents (laws and requirements vary from state to state). It should also obtain a taxpayer identification number.

Not all not-for-profit organizations will qualify for tax exemption. To be tax exempt, the organization must be described in IRC section 501(c) and apply for recognition of exemption by filing one of three forms: Form 1023 for exempt status under IRC section 501(c)(3), Form 1024-A for exempt status under IRC section 501(c)(4), or Form 1024 for exempt status under all other IRC section 501(c) subsections. In 2017 there were approximately 1.8 million tax-exempt organizations registered in the United States, according to the IRS; of these, approximately 90% were public charities and private foundations exempt under IRC section 501(c)(3). Given that fact, this article will concentrate on IRC 501(c)(3) organizations.

There are several benefits to a tax-exempt status:

  • Exemption from federal income tax on income related to its exempt purpose.
  • IRC section 501(c)(3) organizations and certain other IRC section 501(c) organizations are able to receive tax-deductible contributions.
  • IRC section 501(c)(3) organizations are exempt from federal unemployment taxes.
  • Possible exemption from state income, sales, and property taxes.
  • Tax-exempt educational, charitable, or religious organizations may provide benefits for employees through an IRC section 403(b) tax-sheltered annuity.
  • Reduced postal rates for bulk mailings.

Qualifying for IRC Section 501(c)(3)

In order to qualify for exemption under IRC section 501(c)(3), an organization must be organized and operated exclusively for one or more of the following exempt purposes:

  • Charitable.
  • Educational.
  • Religious.
  • Scientific.
  • Literary.
  • Fostering national or international amateur sports competition.
  • Preventing cruelty to children or animals.
  • Testing for public safety.

Form 1023

Form 1023 is the application filed to obtain tax exemption under IRC section 501(c)(3). The organization’s certificate of incorporation or other organizing documents and its bylaws must be attached. The organizing documents must contain provisions for:

  • Dissolution: upon dissolution, all remaining assets must, after any necessary expenses, be distributed for one or more exempt purposes to another IRC section 501(c)(3) organization or to the federal or state or local government.
  • Noninurement: no part of the organization’s net earnings shall inure to the benefit of any member, trustee, director, or officer of the organization, nor to any private individual.
  • Influence limitation: an organization cannot devote more than an insubstantial part of its activities to attempting to influence legislation nor directly or indirectly participate or intervene in any political campaign on behalf of, or in opposition to, any candidate for public office.
  • Restrictive purposes or activities: the organization is organized exclusively for one or more of the purposes detailed above.

The Form must include a detailed description of the organization’s exempt activities. Too broad of a description could result in the IRS  denying the organization’s application; too narrow, and it could restrict expansion of the organization’s activities in future years.

The application for exemption also must include financial statements reflecting receipts and expenditures for the current year, along with a balance sheet at the end of the year and for the three preceding years (or for the nonprofit’s entire history, if less than four years). There must be a description of the sources of its receipts and the nature of its expenditures. If the organization has operated for less than one year, there must be a proposed budget for two years and a balance sheet at the end of the two years.

If Form 1023 is filed within 27 months after the end of the month in which the organization was legally formed and the IRS approves the application, the legal date of formation will be the effective date of tax-exempt status. If Form 1023 is not filed within 27 months of formation, tax-exempt status will not apply before the date on which the IRS receives the application.

Religious Organizations

Churches are not required to file an application for exemption. But keep in mind that not all religious organizations are churches—the term “church,” as used in the IRC, includes all denominations of churches, synagogues, temples, mosques, and more. Other religious organizations that do not meet the criteria of a church (such as mission organizations and nondenominational ministries must apply for tax exemption by filing Form 1023.

Form 1023-EZ

Some organizations may simplify the application process by filing Form 1023-EZ, which is a much shorter form (three pages, as opposed to 26). To determine if an organization is eligible to file Form 1023-EZ, it should complete the 26-question eligibility worksheet in the instructions. The financial requirements are that annual gross receipts cannot exceed $50,000 in any of the next three years nor have exceeded $50,000 in any of the past three years, and total assets cannot exceed $250,000. Churches, hospitals, schools, colleges, and universities may not file Form 1023-EZ; they must file Form 1023.

Public Charity versus Private Foundation

Every organization that qualifies as tax exempt under IRC section 501(c)(3) is classified as either a public charity or a private foundation. The IRS uses Form 1023 to make this determination. A public charity typically has a broad base of public support, whereas a private foundation is supported by a few individuals, such as members of a family, or by a corporation.

There are two types of private foundations:

  • Private operating foundation, which devotes most of its resources to the active conduct of its exempt activities (similar to a public charity).
  • Private nonoperating foundation, which makes grants to public charities and private operating foundations (sometimes referred to as a “grant-making foundation”).

It is more advantageous to be classified as a public charity or as a private operating foundation for the following reasons:

  • Private foundations are subject to an excise tax on net investment income.
  • Individual contributions to public charities and private operating foundations are limited to 60% of adjusted gross income (AGI), while contributions to private nonoperating foundations are limited to either 30% or 20% of AGI.
  • Private nonoperating foundations must meet a minimum qualifying distribution test, subject to penalties.

Public charities

An organization will meet the definition of a public charity under IRC section 509(a) if it is one of the following:

  • A church, school, or hospital.
  • An organization that receives a substantial part of its support in the form of contributions from publicly supported organizations, governmental units, and/or the general public [IRC section 509(a)(1)].
  • An organization that normally receives not more than one-third of its support from gross investment income and after-tax unrelated business income and more than one-third of its support from gifts, grants, contributions or membership fees and gross receipts from activities related to its exempt functions [IRC section 509(a)(2)].
  • An organization that supports one or more of the organizations described in the preceding two paragraphs and has a governance relationship with those organizations (supporting organizations) [IRC section 509(a)(3)].
  • An organization that is organized and operated exclusively for testing for public safety [IRC section 509(a)(4)].

Public Support Tests

To be classified as a public charity solely on the basis of public support, an organization must meet one of the public support tests. An organization’s level of public support is calculated on the basis of a five-year moving average, which includes the current tax year and the four preceding tax years.

A new IRC section 501(c)(3) organization will be classified as a public charity for its first five years if the organization shows, on Form 1023, that it can reasonably expect to be publicly supported. The IRS will monitor an organization’s public charity status after the first five years based on the public support information reported annually on Form 990, Schedule A. Beginning with the organization’s sixth year, if it shows it meets a public support test, it will remain a public charity.

Public support test under IRC section 509(a)(1)

In general, in order to meet the public support test under IRC section 509(a)(1), the organization must receive a substantial part of its support from the general public or from governmental units. Substantial public support is defined as one-third of total support. If the organization meets the one-third support test based on the aggregate support provided for the last five years, including the current tax year, it remains a public charity for the current tax year and the subsequent tax year. Thus, if an organization fails to meet the one-third support test for one tax year, it still remains a public charity for the subsequent tax year. If, however, it fails the one-third support test for two consecutive tax years, there is a fallback position—the facts and circumstances test. If the organization can show that it meets a 10% support test and the attraction of public support requirement by describing how it is actually publicly supported, it will remain a public charity for the current tax year and the subsequent tax year.

Public support under IRC section 509(a)(1) includes gifts, grants, contributions, and membership fees treated as contributions. Public support does not include the following:

  • Revenues received from activities related to its tax-exempt purpose (also excluded from total support).
  • Capital gains (also excluded from total support).
  • Contributions from each person (other than a governmental unit or publicly supported organization) in excess of 2% of the organization’s total support over the five-year period, though there is an exception for unusual grants.

Public support test under IRC section 509(a)(2)

An organization that does not meet the public support test under IRC section 509(a)(1) for two consecutive years may try to meet a public support test under IRC section 509(a)(2). This section contains a broader definition of public support than section 501(a)(1): it includes revenues received from activities related to its tax-exempt purposes (such as program service revenues and special events revenues). Public support under IRC section 509(a)(2) does not include exempt purpose revenues received from one payer greater than $5,000 or 1% of the organization’s total support for the five-year period. An organization using the IRC section 509(a)(2) public support test also must not receive more than one-third of its total support from gross investment income.

IRC section 509(a)(3) and section 509(a)(4)

An organization will qualify as a public charity under IRC section 509(a)(3) if it meets three tests:

  • Organization test: it is organized for the benefit of specific IRC section 509(a)(1) or section 509(a)(2) organizations.
  • Operational test: the organization is operated, supervised or controlled by a publicly supported organization; supervised or controlled in connection with a public supported organization; or operated in connection with one or more publicly supported organizations.
  • Control test: the organization must not be controlled by a disqualified person.

An organization will qualify as a public charity under IRC section 509(a)(4) if it is organized and operated exclusively for testing products for public safety. (For additional information on tax-exempt status, see IRS Publication 557.)

Charitable Contributions

Tax-deductible charitable contributions may be in the form of cash or property. Out-of-pocket expenses incurred by volunteers, including mileage, are tax deductible. Donated services are not tax deductible.

Written acknowledgement

A donor may not claim a tax deduction for any single contribution of $250 or more unless the donor obtains a contemporaneous written acknowledgement of the contribution from the recipient organization. An organization has no disclosure requirements for contributions for which the organization provides no goods or services in return. It is the donor’s responsibility to obtain the written acknowledgement. The acknowledgement must be received by the donor at the earlier of the date the tax return is filed or the due date (including extensions) of the tax return. The written statement should contain the following information:

  • Name of organization.
  • Amount of cash contribution.
  • Description (but not the value) of noncash contribution.
  • Statement that no goods or services were provided by the organization in return for the contribution, if that was the case.
  • Description and good-faith estimate of the value of goods or services, if any, that the organization provided in return for the contribution (insubstantial goods and services do not have to be described in the acknowledgement).
  • Statement that goods or services consisted entirely of intangible religious benefits, if that was the case.
  • Quid pro quo contributions

    A quid pro quo contribution may be deducted only to the extent that the contribution exceeds the fair market value of the goods or services the donor receives in return for the contribution—for example, monies paid for admission to a fundraising dinner or charitable golf outing or to support public television in return for a boxed set of DVDs.

    If an organization receives a quid pro quo contribution in excess of $75, the organization must provide a written statement informing the donor of the rule on deductibility and providing the donor with a good-faith estimate of the fair market value of the goods or services provided to the donor. There are penalties for not meeting the written disclosure requirement for quid pro quo contributions.

    Contributions of property

    If a donor contributes property (other than publicly traded securities) valued in excess of $5,000 and the organization sells, exchanges, or otherwise disposes of the property within three years, the organization must file Form 8282 with the IRS and provide a copy to the donor. If a donor contributes a motor vehicle, boat, or airplane with a claimed value of more than $500, the organization must furnish a written acknowledgement of the contribution using Form 1098-C.

    Charity raffles and auctions

    The IRS considers amounts paid for raffles not deductible, even if the taxpayer did not win, because the chance of winning equals the amount paid for the raffle. Thus, a purchase of a raffle is considered a reciprocal transaction—that is, the donor has received value equal to what they paid.

    Also, the IRS considers that the winner of an auction receives an item equal in value to the amount paid. Thus, there is no tax-deductible contribution for the winner of an auction, even if the payment is made to a charity. There is an exception to this rule, however. In order for a winner to take a tax deduction for part of the amount paid for the auctioned item, the winner must establish that the fair market value of the item won is less than the amount of the winning bid. Moreover, the fair market value must be posted in advance of the auction. (For additional information on charitable contributions, see IRS Publication 526.)

    Religious Organizations: Parsonage

    IRC section 107(1) grants ministers (i.e., all clergypersons, such as ministers, priests, reverends, rabbis, cantors, and more) an income tax exclusion from gross income for the rental value of a residence they receive from an employer. IRC section 107(2) excludes from a minister’s gross income any allowance that was paid to the minister for housing (“parsonage allowance”); the minister may claim items like interest on a housing loan and real estate taxes as itemized deductions on Form 1040. The amount of the parsonage allowance is determined by the minister and must be approved by the governing board prior to the beginning of each calendar year. The allowance may not exceed the fair rental value of the home. The minister excludes from gross income the lesser of the parsonage allowance and the amounts actually spent on housing, which includes real estate taxes, interest on a housing loan, and maintenance and other costs specifically to maintain the home.


    Allen L. Fetterman, CPA, MBA, has been active in the nonprofit sector for over 52 years, as a practitioner, lecturer, author, and board member. He lectures throughout the country on nonprofit accounting, auditing, single audits, tax exemption, and governance. He received his BBA from The City College of New York in 1968 and his MBA from The Bernard M. Baruch College in 1972. He received his CPA certificate in 1973. He retired from Loeb & Troper in 2003.

     
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