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Conference Speakers: Lack of Care in Tax-Exempt Orgs Means They Won't Be Tax Exempt for Long

Chris Gaetano
Published Date:
Jan 14, 2022
GettyImages-989124584 Tax Exempt Organizations Exemption

Tax-exempt status is not a one-and-done process, but rather an ongoing status that an organization must maintain. Unfortunately, according to a pair of speakers at the Foundation for Accounting Education's 44th Annual Nonprofit Conference on Jan. 13,, there are numerous possible mistakes an organization could make that would result in loss of that status.

Garrett Higgins, partner-in-charge of the Exempt Organization Tax and Advisory Services Group for PKF O'Connor Davies, noted that tax exemption is not a right but a privilege, and one that can be revoked if an organization isn't careful. He said that the two most common reasons for revocation of this status are noncompliance with filing activities and engaging in certain activities that nonprofits are not supposed to. 

Such activities include performing actions for private benefit, or inurement; certain lobbying activities; certain political campaign activities; operations not in accord with the stated tax-exempt purpose; and generating substantial amounts of unrelated business income. 

The other speaker, Eva Mruk, a partner in PFK O'Connor Davies' Exempt Organization Tax and Advisory Services Group, noted that many of these rules may seem simple at first, but they have many nuances that can catch organizations unaware. 

"It may seem straightforward and obvious, but the rules can be quite complex and oftentimes misapplied and oftentimes misunderstood," she said. 

Getting specific, Mruk said that private inurement occurs when at least part of the net earnings of a 501(c)(3) organization are inured (basically, siphoned off) by a private shareholder or individual with significant influence over the organization, also known as a "disqualified person." 

"Private inurement is not an absolute term; there is no de minimis restriction," she said. 

Private benefit, Mruk said, is a little more narrow. She said that a nonprofit organization must not serve a private interest more than incidentally. Overall, an organization needs to serve a broad charitable class, rather than private persons, as part of its public welfare mission. 

Political activity could also jeopardize a nonprofit's tax-exempt status. She said that lobbying, which is a political activity, should not be confused with advocacy, which is perfectly within the realm of acceptability. Advocacy, indeed, can be an important part of the organization's mission; the government does not want to discourage people from speaking out on important matters. So long as this advocacy does not involve specific political campaigns or candidates or specific legislation, and generally does not have a call to action, an organization will not run afoul of the IRS.

On the other hand, the IRS defines lobbying as contacting or urging the public to contact members or employees of a legislative body for the purpose of proposing, supporting or opposing legislation or advocating for the adoption or rejection of legislation. (For the purpose of nonprofit organizations, Mruk noted that different laws have different definitions.) She reiterated, though, that while advocacy might resemble lobbying in many ways, the former is more aligned with conducting educational meetings or materials to discuss public policy issues important to the nonprofit's mission. It is important to understand the difference between the two. 

"Advocacy is telling your story to a possible funder, or educating policymakers about your work. So while all lobbying is advocacy, not all advocacy is lobbying," she said. 

The law does tolerate some degree of outright lobbying from nonprofits, but very little, Mruk said. The IRS has two tests to determine if the activity crosses a line. One is looking at how much time is spent by employees and volunteers on it, and while there is not a bright-line test for how much is too much, the IRS has historically benchmarked it at 5 percent. The IRS could also, as an alternative, look at how much money an organization has spent, with a general limit being around $1 million. 

Where the IRS does not tolerate any activity is in political campaigns. The IRS enforces an absolute prohibition on political campaign intervention, generally defined as activities for or against candidates for elective office. Any activity taken in this vein must be nonpartisan. 

"Voter education is allowed, so long as it is conducted on a fair and equal nonpartisan basis, like holding a candidate forum," she said, "[where] there's discussion on a wide variety of issues with no bias.". 

Garrett added that another major risk concerns activities that are outside the scope of the organization's mission, especially if they generate unrelated business income (UBI), even more so if, through this activity, the organization directly competes with for-profit entities in a way that leverages its tax-exempt status to undercut them. 

UBI is generally thought of as income from a trade or business  that is regularly carried on and is not substantially related to the charitable, educational or other purpose that is the basis of the organization's exemption. For example, if a tax-exempt youth organization ran a mini-golf course open to the general public where admission fees charged are comparable to fees of commercial facilities and are designed to return a profit, revenue from this course would likely be seen as UBI, as the operation of the miniature golf course in a commercial manner does not contribute importantly to the accomplishment of the organization's exempt purpose and, therefore, is an unrelated business. Higgins said that the IRS generally uses either time devoted to the activity or money spent on it as factors in determining whether it is excessive. 

"[One is where] the IRS looks at too much time, not necessarily revenue devoted to it [but whether] you not accomplishing your mission," Higgins said. "The other is to look at the pure numbers behind it; is there too much unrelated business income generated compared to all income? But there's no fixed percentage. The IRS takes a fact and circumstances [approach.]."

He noted that, under current rules, UBI is considered in each separate revenue stream, so if streams one and two have losses but stream three has gains, the income from the third stream can no longer be offset by losses in the other two. He said the government imposed this rule after finding that universities were using separate revenue streams to offset each other and therefore cancel out UBI. 

He added, however, that there are numerous exceptions. They can include passive income, such as interest or royalties; rental of real property; capital gains from disposition of property; or debt-financed property if more than 85 percent of it is used for the mission. He noted that there are also a number of industry-specific exceptions, such as summer camps that allow for the use of certain university personnel, research projects and lab services for scientists, or, in the case of hospitals, pharmaceutical sales to nonpatients. 

"So you have to know the industry you're dealing with and what the focus area is," Higgins said. "It's advisable for all tax-exempt organizations ... to really look and see what activities are happening here; are they related, unrelated, and if unrelated is there too much."

Mruk noted that one of the most common reasons why organizations lose their tax-exempt status is simply going too long without filing. All tax-exempt organizations need to file a Form 990; any that go more than three years without doing so will get their status revoked. 

Higgins noted that, regardless of how it happens, once an organization loses its tax- exempt status, its income will be subject to taxation, donations to it will no longer be tax deductible and it will be subject to a degree of public scrutiny that could damage relationships with grant organizations and other funders. 

He said that organizations, overall, should consider public relations and public reporting on  their Forms 990; examine their revenue streams for unrelated business activity and possibly restructure them; review executive compensation policies for reasonableness; evaluate employee and independent contractor issues; review any legislative activity undertaken; maintain adequate board minutes; implement policies on conflict of interest, personnel, and the board; undertake good faith actions by board and management; conduct self-audits; and consult with legal and tax advisers. Taking these steps, he said, can go far in building goodwill with the IRS. 

"Make sure you're conducting above board, and make self corrections as necessary," he said. "When the IRS comes in and says, 'You didn't do this right this year,' it's nice to say, 'We corrected it.' versus putting your head in the sand and saying  your board members are not active and engaged."

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