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

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

Published in the April issue of TaxStringer, part 1 of this series provided a beginning overview of the basics of tax exemption. This article will continue that discussion, focusing especially on tax exemption with respect to jeopardizing tax-exempt status, lobbying, the Form 990 series, and state laws.

Jeopardizing Tax-Exempt Status

To qualify for exemption under IRC section 501(c)(3), an organization must serve a public interest. If the organization serves both public and private interests, the private benefit must be incidental to the public benefit.

There are certain limitations on the activities of IRC section 501(c)(3) organizations. An IRC section 501(c)(3)
organization—

  • may not be used for the private benefit of any individual nor may its earnings inure to the benefit of insiders,
  • may engage in legislative activities only to a limited extent,
  • is forbidden to engage in political activities, and
  • will lose its exempt status if it operates for the primary purpose of carrying on an unrelated trade or business.

Inurement

No part of an IRC section 501(c)(3) organization’s net earnings may inure to the benefit of an insider (such as officers, directors, or key employees). Examples of prohibited inurement include unreasonable compensation and the transfer of property for less than fair market value. The prohibition on inurement is absolute. Any amount of inurement is grounds for loss of tax-exempt status. Prohibited inurement does not include reasonable payments for services rendered or payments made for the fair value of real or personal property.

Excess Benefit Transactions

An excess benefit transaction is any transaction between an IRC section 501(c)(3) or IRC section 501(c)(4) organization and a disqualified person, in which the economic benefit is greater than the value of the consideration provided for the benefit (such as unreasonable compensation for services or a non–fair market value transaction). A disqualified person is anyone who is or was in a position to exercise substantial influence over the organization’s affairs. The IRS may impose an excise tax on a person who benefits from an excess benefit transaction, as well as any organization manager who knowingly participates in the transaction. The regulations do not prescribe a specific dollar amount above which constitutes an excess benefit.

Payments under a compensation arrangement are presumed to be reasonable if the following three conditions are met:

  • The transaction is approved by an authorized body of the organization that is composed of individuals who do not have a conflict of interest concerning the transaction.
  • Before making its determination, the authorized body obtained and relied upon appropriate data as to comparability.
  • The authorized body adequately documents the basis for its determination concurrently with making the determination.

It is very important that the governing board establish this rebuttable presumption of reasonableness prior to finalizing any compensation arrangement for highly compensated individuals.

Lobbying

An IRC section 501(c)(3) organization may conduct lobbying activities provided that they are insubstantial in relation to their exempt-purpose activities. Lobbying is defined as an attempt to influence legislation—that is, contacting (lobbying) or urging the public to contact (grassroots lobbying) members or employees of a legislative body for the purposes of proposing, supporting, or opposing legislation.

Organizations may engage in public policy issues without the activity being considered lobbying, including conducting educational meetings or preparing and distributing educational materials. In addition, it will not be considered lobbying if an organization communicates with a legislative body about a matter currently before the body that could impact the organization’s existence, its powers or duties, its tax-exempt status, or the deductibility of contributions to it.

If lobbying activities are substantial, an IRC section 501(c)(3) organization risks losing its tax-exempt status. Substantiality is measured by one of two tests: the substantial part test or the expenditure test.

Substantial part test

The substantial part test determines substantiality on the basis of all the pertinent facts and circumstances in each case. The IRS considers many factors, including the time devoted by both compensated workers and volunteers and the expenditures devoted to the activity. Under the substantial part test, an organization that conducts excessive lobbying in any tax year may lose its tax-exempt status. The organization may also be subject to an excise tax.

Expenditure test

Public charities may elect to use the expenditure test under IRC section 501(h), which is an objective mathematical test. IRC section 501(h) establishes a sliding scale of permissible lobbying nontaxable amounts for both total lobbying and grassroots lobbying. Expenditures in excess of either amount in any tax year (excess lobbying expenditures) are subject to an excise tax. In addition, an organization may lose its tax-exempt status if it spends more than 150% of its lobbying nontaxable amount over a four-year period.

Churches and church-related organizations may not use the expenditure test. Organizations electing to use the expenditure test must file Form 5768 at any time during the tax year for which it is to be effective. The election remains in effect until it is revoked by the organization.

Lobbying by IRC Section 501(c)(4), (5), and (6) Organizations

Under the IRC, such organizations may lobby; however, a tax deduction is not allowed for donations and membership dues used for lobbying. These organizations must notify their members that a portion of contributions and/or dues is not deductible because it was used for lobbying activities. If notifications are not sent to members, the organization must pay a proxy tax on lobbying expenditures at the corporate tax rate (currently 21%). The tax is paid with Form 990-T.

Political Campaign Activity

IRC section 501(c)(3) organizations are prohibited from intervening, directly or indirectly, in any political campaign, on behalf of or in opposition to, any candidate for elective public office. This includes contributions to political campaigns or public statements (oral or written) made on behalf of the organization in favor of or in opposition to any candidate. It also includes inviting only one major party candidate to speak in a public forum. (Note: The political campaign activity prohibition is not intended to restrict free expression on political matters by leaders of organizations speaking for themselves as private individuals.)

Violation of this prohibition may result in loss of tax-exempt status and the imposition of an excise tax on the political expenditures. An excise tax may also be imposed on organization managers who agreed to the expenditures knowing that they were political.

IRC section 501(c)(4) and IRC section 501(c)(6) organizations are allowed to be involved in campaign activity so long as it is not their primary purpose.

Unrelated Business Income Tax

An IRC section 501(c)(3) organization may engage in income-producing activities unrelated to its tax-exempt purposes so long as the unrelated activities are not a substantial part of the organization’s overall activities. Net income from such activities will be subject to unrelated business income tax (UBIT) if three conditions are met:

  • The activity constitutes a trade or business.
  • The trade or business is regularly carried on.
  • The trade or business is not substantially related to the exercise or performance of the organization’s exempt purpose.

The term “trade or business” includes any activity carried on for the production of income from selling goods or services. Business activities are considered regularly carried on if they show frequency and continuity and are pursued in a manner similar to commercial activities of nonexempt organizations. An activity is not substantially related to an organization’s exempt purpose if it does not contribute importantly to accomplishing that purpose (other than through the production of income).

Examples of unrelated business activities include—

  • advertising,
  • gaming—but bingo does not generate unrelate business income for IRC section 501(c)(3) organizations,
  • sales of merchandise and publications,
  • parking lots, and
  • debt-management plan services.

Generally, income derived from the rental of real property (and incidental personal property) is excluded from unrelated business income. Rental income may be unrelated business taxable income if an organization rents property on which there is debt outstanding (unrelated debt-financed income) or personal services are rendered in connection with the rental.

There are certain exceptions to unrelated business income, including—

  • activities conducted substantially by volunteers,
  • activities conducted for the convenience of members, students, patients, or employees,
  • sales of donated merchandise,
  • distributions of low-cost articles incidental to the solicitation of contributions, and
  • convention and trade show activity.

Interest, dividends, royalties, rents, and gains from the sale of property are generally excluded from unrelated business income. Organizations may deduct from gross unrelated business income trade or business expenses, interest expense, losses, charitable contributions, and a $1,000 specific deduction.

An organization must file Form 990-T if it has gross unrelated business income of $1,000 or more, even if the Form reflects a net operating loss and thus no tax is due. The tax rates are the same as for C corporations. The tax return is due on the 15th day of the fifth month following the end of the tax year. The organization may request an automatic six-month extension of time to file by using Form 8868. (For further information on UBIT, see IRS Publication 598.)

Form 990 Series

Most tax-exempt organizations file an annual information return in the Form 990 series; churches, however, are exempt. Form 990 is filed by organizations with gross receipts during the tax year that are greater than or equal to $200,000 or total assets at the end of the year greater than or equal to $500,000. Form 990-EZ is filed by organizations with gross receipts that are less than $200,000 and total assets at the end of the year less than $500,000. Form 990-N (sometimes referred to as the “e-postcard”) is filed by organizations that normally have gross receipts of $50,000 or less. Form 990-PF is filed by private foundations.

These forms are due on the 15th day of the fifth month following the end of the tax year. An organization may request an automatic six-month extension of time to file by using Form 8868. There are penalties for late filing or for filing an incomplete or inaccurate return.

Currently, organizations with $10 million or more in total assets that file at least 250 returns during the year (including income, excise, employment tax, and information returns) are required to file Form 990 electronically. The Taxpayer First Act (TFA) requires all organizations to file the Form 990 and the Form 990-PF electronically, effective for tax years beginning after Jul. 1, 2019; however, Form 990-EZ and Form 990-T filers have an additional year before it takes effect.

Tax-exempt status is automatically revoked if an organization fails to file a Form 990 series form for three consecutive years. TFA requires the IRS to notify an organization, after the second consecutive failure to file a return, that revocation of tax-exempt status will take place if the organization fails to file in the following year.

Tax-exempt organizations are required to make available their Form 990 and all attachments and schedules to anyone who requests it. (A reasonable charge may be made for copying.) Donor information on Schedule B, “Schedule of Contributors,” is confidential and may be redacted, except for private foundations and political organizations.

State Laws

The criteria used by states to grant tax exemption vary from state to state. Many states have regulatory bodies that oversee nonprofit entities and can revoke their state tax-exempt status without regard to federal tax-exempt status.

Many states require nonprofits to register and submit annual filings if the nonprofit solicits funds within the state, holds property in the state, or does business in the state. Many states have statutory regulation of charitable solicitation conducted within their borders, and many require registration and reporting by charitable organizations, professional fund raisers, professional fund-raising counsels, and commercial co-venturers.

A website maintained by the National Association of State Charity Officials and the National Association of Attorneys General provides information with regard to individual state registration and reporting requirements.

Takeaway

The laws and regulations surrounding federal tax exemption are complicated. It is important that nonprofit executives and board members have a basic understanding of these laws. It is also vital that auditors of nonprofit organizations have a good working knowledge of these laws in order to better serve their nonprofit clients.


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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