Six Ways to Avoid Losing Tax-Exempt Status - Ottosen DiNolfo Hasenbalg & Castaldo, Ltd

by Ryan R. Morton

Among the many advantages of forming a 501(c)(3) not-for-profit organization is the freedom to collect income without paying federal or state taxes. That tax-exempt status is not guaranteed, however. Not-for-Profits (NFPs) must be wary of certain activities that could result in losing that financially beneficial status.

Private Benefit

Since the 501(c)(3) designation often attaches to churches, schools, hospitals, and public charities, it stands to reason that income received by the NFP should benefit those public causes. If an organization’s activities—money or services—are being provided to help private interests instead, then that could cost the NFP its tax-exempt status.

Relatedly, the board members, officers, and other people of importance within an NFP must not personally benefit, or inure, from the assets of the charity. Benefits paid to these insiders could result in excise taxes on top of losing tax-exempt status.

Lobbying

A key phrase throughout this article is “substantial.” For instance, private causes can receive some benefit from an NFP, as long as it is not substantial. Similarly, while 501(c)(3) organizations are allowed to lobby legislators (or encourage the public to do so), that activity must be an insubstantial part of their operation. If a charity happens to have an idea for a new law that would benefit its public interests, that is fine. The problem arises when that lobbying effort becomes a significant percentage of what the charity does, rather than directly serving the public.

Political Activity

Since 1954 when then-Senator Lyndon Johnson proposed an amendment to the U.S. Tax Code, 501(c)(3) organizations have been prohibited from engaging in any political campaign activity. Even if their causes tend to align with one side of the aisle more than the other, tax-exempt status can be preserved as long as the charity is not supporting or targeting a particular candidate for office. The prohibition does not prevent charities from advocating for certain issues during a campaign, as long as they are not connected to a candidate.

Unrelated Business Income

Some NFPs conduct business that is not directly related to the organization’s charitable purpose. For instance, a charity designed to help the homeless might operate a bakery. If the income from that bakery is used to fund the NFP’s services, then the “private interest” problem above does not arise. However, the Internal Revenue Service (IRS) still has a problem with NFPs regularly carrying on trades or businesses not substantially related to the charity, even if the income is used for the charity. A bakery is not substantially related to helping the homeless, unless all the food was being baked for those people. However, if the NFP holds an annual bake sale, that would not jeopardize its tax-exempt status, because the profit-making activity is not regularly conducted.

Annual Reporting

Begin tax-exempt does not relieve NFPs from the obligation to file information with the IRS each year to verify that status is still appropriate. The series of tax documents (Form 990) serves a dual purpose. It assures the IRS that there is no substantial activity that would cost the NFP its tax-exempt status. It also provides information to the public about what the charity does. Failing to file this documentation for three consecutive years results in automatic revocation of tax-exempt status.

Changing Purposes

The annual reporting provides an opportunity for NFPs to redefine themselves if necessary. NFPs are only allowed to remain tax-exempt if they are working toward their stated charitable or educational purposes. Deviating from those exempt activities will create problems in future reports unless the appropriate documents are amended with the IRS.

Losing tax-exempt status is no minor concern for NFPs. Beyond having to pay future and past taxes on the organization’s income, the loss of the federal tax exemption could jeopardize state exemptions and prevent donors from claiming tax deductions. These potential pitfalls are relatively simple to avoid as long as your charitable organization knows what to look for and closely monitors its activities. When in doubt, run your questions by an attorney. The impact of losing that tax-exempt status is too significant to leave to uncertainty.