Short answer: it depends on what you mean by “working.”
Not a very satisfactory answer, is it? As much as I wanted a 10-word blog post, we’ll have to go a bit longer to really answer this question.
The 1023-EZ was introduced a little under 2 years ago to help deal with the tremendous backlog of tax-exemption applications facing the IRS. The idea was that small organizations didn’t really need a full review. Those organizations could fill out a shorter form and get a decision much more quickly. This would free up the IRS’s staff to scrutinize full 1023s more closely.
For what it’s worth, I’m a big fan of the IRS doing some triage here. The IRS was getting crushed by applications in the past, and it makes sense for the IRS to focus its efforts on the biggest organizations. Also, the effort needed to complete a full Form 1023 is a burden on small organizations. The IRS estimates that it takes 15.5 hours to properly prepare the full Form 1023. Form 1023 itself is 12 (fine, 11.5) pages, plus the 8 possible schedules that may also be required. Form 1023 is difficult to prepare well, and it can be tough for a small organization.
What Form 1023-EZ is doing well
Speed of review. The IRS turnaround times for both Form 1023-EZ and Form 1023 applications have dropped considerably. The IRS used to have a webpage showing the average age of its pending applications, but it has retired that, instead asking that you follow-up within 90 days for a 1023-EZ or 180 days for a full 1023. That’s much faster than the turnaround before the 1023-EZ came along. This is great for applicants and the IRS.
Client satisfaction. The Journal of Accountancy reports that overall satisfaction regarding the process was at 87% for 1023-EZ users and 72% for 1023 users. Further, 1023-EZ users reported more significantly more satisfaction with the time and ease of completing the application, the length of the process, and the ease of understanding the application than 1023 users.
What Form 1023-EZ isn’t doing well
Compliance. Organizations currently attest to numerous key things regarding compliance:
- That the organization has the appropriate organizing document for its type of entity (articles of incorporation for a nonprofit corporation, for instance),
- That the organization’s purposes are limited to one or more of the exempt purposes under Section 501(c)(3),
- That the organization is not allowed to engage–except as an insubstantial part of its activities–in activities that do not further one or more of the exempt purposes under Section 501(c)(3),
- That the organization’s organizing document requires that the organization will give its assets to another 501(c)(3) organization or the government upon dissolution,
- That the organization won’t support or oppose candidates for office,
- That the organization’s net earnings won’t be given to the organization’s insiders,
- That the organization will not engage in a trade or business outside of its exempt purposes,
- That if the organization attempts to influence legislation, it will only do so as an insubstantial part of its activities, and
- That the organization will not provide “commercial-type insurance.”
At present, the IRS does not require the submission of organizing documents or corporate by-laws in order to review the organization’s compliance with these requirements. Additionally, some of the language here may by tough for the leadership of a small nonprofit to understand. For instance, what is “an insubstantial part” of an organization’s activities? I have clients ask that question fairly regularly, because it’s a term of art and they aren’t familiar with it.
A “gotcha” approach to compliance. The IRS has said that it will do more audits of organizations in order to check for compliance. I’d prefer the IRS check for compliance at the beginning of the process rather than auditing an organization that filed a 1023-EZ only to find out they are non-compliant. Will such an organization have a chance to become compliant? What will that process look like? What about the organization’s donors? What about back taxes, interest, and penalties for a non-compliant organization?
Uncertainty for organizations. When I work with clients that file a 1023-EZ, one question almost always pops up: what if we go over $50,000 in annual gross receipts? For many small organizations, those initial budgets are made in good faith, but sometimes those budgets are the product of educated guesses. It isn’t clear right now what happens if an organization exceeds the limit–should an organization that grows beyond its projections stifle its growth to avoid trouble with the IRS?
Potential for misuse. The 1023-EZ process involves fairly light oversight, so I’m sure some organizations are tempted to claim 1023-EZ eligibility to take an easier path to exemption. By tightening the oversight of the 1023-EZ process a little bit, the potential for misuse could be reduced.
How could the process be better for Form 1023-EZ users?
My suggestions would probably add some complexity and some additional turnaround time to the Form 1023-EZ process. I’m not sure I’d improve IRS user satisfaction by making these changes! By making the process “better,” I’m suggesting that a process that is still easy for small organizations to manage while allowing the IRS to find compliance problems, letting the organizations correct the problems, and getting the organization started on the right track.
So, what do I have in mind?
Require submission of organizational documents. Rather than requiring attestation to the organization’s purposes and dissolution clauses, require the organization to submit them. The organization already has to create the documents, so there’s no extra time spent for the organization. It is relatively easy to get documents into a PDF format, and reviewing them shouldn’t take that much extra time for the IRS.
Require the submission of a 3-year budget. Again, organizations have to say they don’t expect annual gross receipts of over $50,000 those first 3 years. With that in mind, do their budgets make sense? For instance, an organization that plans to hire a staff member probably can’t have a year with less than $50,000 in gross revenue and hope to survive. The IRS could follow-up on an unrealistic budget and find out if a full 1023 would be more appropriate.
Issue guidance for organizations that exceed the $50,000 limit. I suspect that the IRS is watching 990-EZ filings to see if organizations that applied with Form 1023-EZ exceeded the $50,000 limit. The IRS should do that. But what if an organization exceeds the limit? It’s not clear what would happen. Would the IRS revoke the tax-exempt status of those organizations? Maybe, although I think that’s excessive. I would expect the IRS to require a full 1023 (and the full user fee), but that’s a guess. Until the IRS has guidance, we won’t know for sure.
Form 1023-EZ has unquestionably made application for tax-exempt status more convenient, even for organizations that don’t qualify for it. Still, if we’re willing to sacrifice some of the convenience, we could achieve a more effective review process.