Conference Speaker: If You Want to Keep Your Tax-Exempt Status, Don't Do These Things

Chris Gaetano
Published Date:
Dec 15, 2020

If a tax-exempt organization wishes to remain that way, it will need to be careful about a number of things, ranging from what it pays to what it says, according to Allen L. Fetterman, a prolific lecturer on nonprofit matters who spoke at the Foundation for Accounting Education's Exempt Organizations Conference on Tuesday.

Fetterman said there are four main ways a 501(c)(3) organization can lose its tax-exempt status: inurement, lobbying, political activity and being reckless with unrelated business income.

The prohibition on inurement, he said, means that insiders, officers, directors, key employees or other major figures with the organization (including major donors) cannot derive a private benefit from the organization's activities. This could include unreasonably high compensation or transferring real or personal property for less than fair market value.

"It doesn't mean an organization cannot sell property at less than fair market value; it just cannot do so to an insider," he said, though he added that the organization will still need to document the reasons for selling something at less than fair market value.

He said this prohibition against a private benefit for insiders is "absolute," as "any amount is grounds for loss of tax-exempt status." He noted that "grounds for" does not mean it's guaranteed, but the IRS does have the right to revoke status in such situations, and so Fetterman advised against doing this.

If a disqualified person does receive a private benefit considered to be an inurement, there is an initial 25 percent tax on the excess benefit transaction. If the situation is not corrected within that taxable period, then a further 200 percent excise tax is leveled against the person. Fetterman noted that he has seen this happen, most recently with the CEO of a large health organization, so, he cautioned, don't think the IRS won't do it.

To avoid such an outcome, the transaction must be approved by an authorized body of the entity, such as its board or a committee, composed of people who have no conflict of interest regarding the transaction. The board or committee should obtain and rely on appropriate data as to comparability, and it must also adequately document the basis for its determination concurrent with making the determination.

"You could write this as one sentence: The board shall approve this [after looking at comparable data] and document it. Should the board do this, they create a rebuttable presumption of reasonableness," he said. This means that the burden is on the IRS to prove tha tthe compensation was unreasonable; without this process, the burden falls on the organization to prove that it was reasonable.

Lobbying, the second way an organization can lose tax-exempt status, is defined as attempting to influence legislation, either by directly appealing to lawmakers or via grassroots efforts that exhort the public to appeal to lawmakers instead. What's safe from this definition, said Fetterman, are activities such as nonpartisan analysis and research, public meetings with educational materials and provisioning advice to a government body at its request. Another exception is communications between the organization and its members, unless the organization specifically tells its members to lobby. The third exception is called self-defense lobbying, which occurs when there is legislation proposed that would impact the organization's tax-exempt status.

"I would believe, for example, when the [Tax Cuts and Jobs Act] was proposed a few years ago, it was going to impact negatively on the tax-exempt world. I think if an organization were to go out and communicate with legislators about that type of proposed legislation, it would not have been considered lobbying," he said.

He noted that foundations cannot engage in any type of lobbying at all.

The third prohibited area is political activities, namely supporting or opposing a candidate for office. This means that an organization cannot donate to a candidate, endorse a candidate, or even rate a candidate, no matter how objective its scale may be. But beyond that, an organization cannot use office resources to engage in political campaign activity, and if it holds a public forum, it cannot exclude any candidates.

"That's a big one: They invite major candidates but leave one out. That is political activity," he said.

Excluded from this prohibition are generally nonpartisan activities such as voter education, registering people to vote (unless the organization encourages them to register or vote for a particular candidates), or holding nonpartisan public forums. Also excluded are the statements of people within the organization, so long as they make it clear they are speaking only in their own capacity and not as representatives of their organization.

"Like [if] the CEO of a 501(c)(3) at a private party says, 'I'll vote or so and so—I think he's the best for our community.' People are allowed to say that. But if a minister says this in church, to the congregation, that would constitute political activity," he said.

The fourth prohibited area is unrelated business income, which is subject to taxation. Only income that advances the purpose of the organization, even in the form of a trade or business, is tax exempt. This is the case even if the activity provides funds toward the exempt organization's purpose. If an activity constitutes a trade or business, if that trade or business is regularly carried on, and if it's not substantially related to the exercise or performance of the organization's exempt purpose, then it's likely that the net income from it counts as unrelated business income and therefore is taxable.

He offered the example of a hospital that, as a fundraiser, sets up a sandwich stand at a county fair; this won't fall under the category of unrelated business income because the fair is going to end in a few weeks and won't be competing with more established sandwich shops. If, on the other hand, that same hospital operated a commercial parking lot every single Saturday, then it would fall under the category.

Fetterman said that arrangements that might seem casual could count as unrelated business income if not approached with care. He talked about how he used to be the treasurer for his synagogue and, at one point, it rented property to an itinerant church. He calculated what percentage of the building's square footage the synagogue used and what percent of the time the building was available for its use. It came down to less than 15 percent of the property. This was important, as one of the conditions was that the activity must be substantial. Since 85 percent of the building was still devoted to its original purpose, the rental income did not count as unrelated business income.

"Make sure you keep your work papers in case the IRS ever challenges that calculation," he said.

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