Tag Archives: revocation of tax-exempt status

What is Unrelated Business Income?

One of the big traps that can tangle up an organization is engaging in some sort of fundraising activity that generates what the government calls “unrelated business income,” which can cause an organization to have to pay taxes or, in extreme cases, even forfeit the 501(c)(3) tax exemption altogether.

Some sources of income are automatically excluded from UBI (and I’ll give you some other exceptions near the end), like dividends and interest, some types of investment income, royalties, some types of rental income, and some capital gains.

If you do have unrelated business income of $1,000 or more, you must file Form 990-T for the tax year involved. If you expect to have more than $500 in UBI during a particular year, your organization must pay estimated tax.

What is Unrelated Business Income?

Unrelated business income is money earned by an organization that meets three requirements:

  • It’s earned from activities that constitute a “trade or business.”
  • The activity is “regularly carried on.”
  • The activity does not further the organization’s exempt purpose.

For something to count as UBI, it must meet all these requirements; if one is missing, it’s not UBI. Let’s talk about each of these requirements in more detail.

What is a “trade or business?”

Here’s how I think about this requirement: is the money-making activity something that a for-profit business would engage in to make money? If you’re exchanging a good or service for money, you’re probably engaging in a trade or business. Car washes, bake sales, and selling advertising in programs, for instance, have obvious for-profit equivalents: the commercial car wash, the local bakery, and newspapers and magazines that sell ad space do the same thing. Each of those would qualify as a trade or business.

Of course, not every activity that raises funds is a trade or business. Receiving donations is not a trade or business–there’s no exchange taking place. Likewise, applying for grants from other organizations or charitable trusts isn’t a trade or business; it’s a donation.

What does it mean to be “regularly carried on?”

Generally, an activity is “regularly carried on” if it occurs roughly as often as it would for a for-profit business engaged in the activity. If a for-profit business does the activity year-round, and you’re only doing the activity every now and then, it probably won’t be considered regularly carried on.

For example, imagine that your organization operates a sandwich stand for a couple of weeks out of a year. Most for-profit sandwich sellers operate year-round, and a couple of weeks isn’t going to be frequent enough to be regularly carried on (that example is from Treasury Regulation 1.513–1(c)(2)(i), if you want to see it for yourself). On the other hand, the regulations also say that if you were to run that same sandwich stand one day each week throughout the year, that would be sufficient for the activity to be regularly carried on. Also, if a for-profit business would operate the activity on a seasonal basis, a couple of weeks of that activity within the same season might be enough.

The closer your activity is to a comparable for-profit business in terms of how frequently you’re open for business, the more likely your activity will be “regularly carried on” for UBI purposes.

What do you mean, the activity doesn’t further an exempt purpose?

This criterion often surprises people. To be “substantially related to an exempt purpose,” the activity itself has to help achieve the exempt purpose. The classic example is tuition for an educational institution. Education is one of the 501(c)(3) exempt purposes, so students enrolling and taking classes directly furthers the school’s purpose.

Here’s what gets people: fundraising activities do not “further an exempt purpose” even if all the money you raise is going to an exempt purpose. Let’s go back to the car wash example. Washing cars is not an exempt purpose. So, if you have a car wash fundraiser, that doesn’t “further an exempt purpose” even if every cent you raise goes to fund your organization’s exempt purposes.

Again, don’t forget that for the organization’s income to count as unrelated business income, it must meet all 3 of these requirements. And even then, there are exceptions.

Exceptions to Unrelated Business Income

So, let’s say that your organization does engage in some sort of money-making activity that meets all three requirements for unrelated business income. We’re not done yet! There might be an exception available. There are four big exceptions:

  • Volunteer labor: Your activity is run entirely by unpaid volunteers
  • Convenience of members: Your activity is carried on primarily for your members, students, patients, or employees–(examples from the regulations: leasing dormitory apartments to students of a college, school or hospital cafeterias, or hospital parking lot all fall under this exception)
  • Selling donated merchandise: Your activity involves selling merchandise which was donated or gifted to your organization
  • Bingo: Bingo should probably get its own post, but the exception applies in bingo games where you complete a pre-selected pattern on a card (5 in a row is most common) to determine a winner, and wagers are made, winners are determined, and prizes are awarded simultaneously.

One more thing about bingo: don’t forget that bingo games may be regulated by your state or local government! You may need to apply for permits or register–or you might not be able to do it at all.

In addition to those exceptions,

Unrelated business income is an easy issue to miss–every time you consider a new fundraising activity, you should always take a moment to consider if this activity will create UBI for your organization.

Tea Party Class Action Wins in Federal Appellate Court

Last week, the U.S. Court of Appeals, Sixth Circuit (which covers Michigan, Ohio, Kentucky, and Tennessee) ordered the IRS to produce discovery (the pre-trial exchange of information between the parties in a lawsuit) required by the trial court in an ongoing legal battle with a class of conservative and “Tea Party”-related organizations.

If you’re new to this story–or if you’ve forgotten about it, because it’s been off the radar for a while–Forbes contributor Kelly Phillips Erb (or “taxgirl,” as she’s often known) has a pretty good timeline here. The short version is that after the Citizens United decision, there was a dramatic increase in applications for tax-exemption under Section 501(c)(4) of the Internal Revenue Code. That’s because Citizens United held that the government cannot prevent a nonprofit corporation, for-profit corporation, or a labor union from making “independent political expenditures,” which are expenditures on statements supporting or opposing a political candidate but is made independently of any candidate’s control or cooperation. (Note: That’s not the same as requiring the government to subsidize that speech with a tax exemption, though, which is why 501(c)(3) organizations can lose their tax-exempt status for political speech. Even with 501(c)(4) organizations, political activities must be an insignificant part of their activities.)

These organizations allege that the IRS treated applications from conservative groups unfairly. The IRS specifically looked for applications with terms such as “Tea Party,” “9/12,” and “Patriots,” as well as those advocating positions on taxes and government spending. Those applications were either delayed or subject to pretty heavy requests for information from the IRS. Indeed, the Treasury Inspector General for Tax Administration found that the criteria used were inappropriate. As the Sixth Circuit points out, charges that the government has targeted its own citizens for mistreatment based upon those citizens’ political viewpoints are a serious matter.

As part of the discovery process, the plaintiffs (the organizations alleging mistreatment) wanted to find out what organizations were screened out by the IRS’s “Be On The Lookout” lists, which the IRS has, up to this point, resisted turning over. The Sixth Circuit rejected the IRS’s request to avoid turning over this information in clear terms:

“The lawyers in the Department of Justice have a long and storied tradition of defending the nation’s interests and enforcing its laws—all of them, not just selective ones—in a manner worthy of the Department’s name. The conduct of the IRS’s attorneys in the district court falls outside that tradition. We expect that the IRS will do better going forward. And we order that the IRS comply with the district court’s discovery orders of April 1 and June 16, 2015—without redactions, and without further delay.”

As Nonprofit Quarterly explains, this most likely opens the door for depositions of IRS officials involved in this matter, and depending on the facts that come out of those depositions, this controversy may find its way back into the limelight.

Photo credit, Siyan Ren, via Unsplash.com, licensed under CC-0

Should Non-Profit Boards Get Paid?

A couple of weeks ago, the board of the Tampa General Hospital voted to take compensation for their board service, between $15,000 and $30,000 per year. Because nonprofit board positions are frequently unpaid, this raised a number of eyebrows and got a number of people talking and thinking about the issue (this article, by Monica Oss, was among my favorites). One board member resigned over the decision, and the board has since rescinded their decision.

But I think it’s still a question worth answering. There is some case to be made for compensation: as Ms. Oss points out, for-profit board members are compensated, often quite handsomely. And there’s certainly a time commitment involved with being a board member–in the Tampa General Hospital example, 6 meetings per year, plus committee meetings and retreats with hospital staff. Further, board members are expected to give their expertise, and as you can imagine, hospitals require a lot of specialized knowledge. If that knowledge has value (it does), isn’t it worth paying for?

Even with those arguments in mind, I’d still say that generally speaking, compensating board members is probably a bad idea.

First, compensating board members is a drain on resources. Not to pick on Tampa General Hospital, but to use them as an example, there are 15 board members, and each could have taken somewhere between $15,000 and $30,000. There were some board members who planned to decline the compensation, but assuming each board member took $15,000, that’s $225,000 being paid out in board compensation each year. I don’t know the hospital’s budget (it’s probably pretty big), but that’s quite a bit of money that could go to other projects in the organization.

Second, it may damage your relationship with the public. As a 501(c)(3) organization, your financials are available to the public through your tax returns. The public is generally wary and suspicious of nonprofits–if they’re going to give, they want to know that it’s going to help somebody. It doesn’t seem to please the media either; look at the first Tampa Bay Times article I linked above–in those first few paragraphs, it’s pretty clear the reporter does not approve. When you’re paying the board, that increases overhead and that can damage your relationship with the public.

Third, because paying directors is unusual, board members generally aren’t expecting, much less demanding, to be paid. Most directors understand that board service is a volunteer arrangement–and in some organizations, even an arrangement that requires the board member to give to the organization. In the Tampa example, one board member quit over the compensation arrangement, and others declined to take any compensation. Making board service more like a part-time job rather than a volunteer service opportunity might even turn some people off from the position.

And then there’s the legal stuff. Paying your board runs the risk of creating “inurement” to the directors. As it’s said in the regulations, the net earnings of the organization may not “inure in whole or in part to the benefit of private individuals.” By the way, don’t get too hung up on “net earnings,” as the Tax Court has said, any “unjust enrichment” counts (even a really small amount), whether its from the gross earnings or net earnings or whatever. If there is inurement, the organization’s tax-exemption can be revoked. Additionally, an insider that receives such a benefit gets hit with a 25% tax, and if the organization is not made whole, the insider gets hit with another 200% tax on the transaction. Additionally, any board member that approves such a transaction gets hit with a 10% tax. To sum up, this is a big deal.

Of course, often organizations will provide private benefits to individuals, and it’s not a problem. For instance, a food pantry provides food to people. A library lets people check out its books and CDs and whatnot. That’s not an unjust benefit, that’s just serving your charitable class as part of your exempt purpose. Using Tampa General Hospital as an example, a board member could be admitted to the hospital just like anyone else.

So what’s actually a problem? When you’re dealing with insiders of the organization (and board members are definitely insiders), those insiders cannot get the better of a transaction with the organization. It’s perfectly okay for an organization to do business with its insiders, but the terms have to be fair–if anyone is to be favored, it’s the organization. Also, any transactions between the organization and an insider are best done “at arm’s length,” meaning that the insider doesn’t have any special influence over the organization. Often, nonprofits have conflict of interest policies that require board members who stand to benefit from a transaction to disclose their interest and possibly recuse themselves from the discussion and decision. By the way, conflict of interest policies are a good idea.

Would this be private inurement? It’s hard to say (this is all very case-by-case), but here are the questions we need to ask:

First, is the compensation fair and reasonable? What are the skills the board members are providing? How much time do the board members spend on their duties? I’d suggest that an organization that compensated its directors get crystal clear on the time spent and the value provided by the directors. Also, the fact that other boards are usually uncompensated is a problem, although in the Tampa case, the board suggested a growing trend of paying directors a stipend. Again, this is all going to be largely determined by the facts of a particular case.

Second, is the compensation negotiated at arm’s length? Probably not. The problem is that there’s going to be a conflict of interest–the board members are voting on their own compensation. That’s a real problem with board compensation. One way to deal with that might be a “27th Amendment” solution–the 27th Amendment to the U.S. Constitution requires that no law changing the pay for a representative or a senator can take effect until the next Congress, so all the representatives and one-third of the senators have to survive an election to experience the change in pay. Perhaps something like that–where no board compensation changes could take effect until after the next board election–would make board compensation more palatable from a conflict-of-interest perspective. To my knowledge, that theory is untested.

Because paying directors is an unusual practice, an organization that decides to do it can expect to be scrutinized thoroughly–from the IRS, the media, and the public. Between the risks of the IRS finding inurement, the potential for public relations damage, and the possible better uses for the funds, I’d generally advise against paying board members.

Form 1023-EZ: Is It Working?

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.

Photo credit: Helloquence, via unsplash.com, licensed under CC0

Form 990 Deadline Looms for Calendar-Year Organizations

For organizations that use the calendar year as its fiscal year, the deadline for filing your annual information return (on Form 990, or some variant of it) is fast approaching: May 16, 2016. Let’s look at some of the basics of annual information return reporting for 501(c)(3) organizations:

 Which version of Form 990 do I file?

There are three main variants for Form 990:

  • Form 990, for most organizations with gross receipts of $200,000 or more OR total assets of $500,000 or more;
  • Form 990-EZ, for most organizations with gross receipts of less than $200,000 AND total assets of less than $500,000;
  • Form 990-N (e-Postcard), for most organizations with gross receipts under $50,000.

Private foundations have their own 990, the 990-PF, and black lung trusts also have their own variant, the 990-BL.

Don’t forget that your filing may be more than just the form itself–you may have additional schedules to fill out as well. If you’re working on these forms, be careful; make sure you get all the schedules you need as well–and you may want to have a professional work on it anyway.

If you qualify for 990-N (e-Postcard) filing, there is no paper form; the form is submitted electronically through the IRS website. If you’ve filed a 990-N before, that’s a new thing–the IRS had accepted them through the Urban Institute, but that changed at the end of February 2016.

There are still some organizations that are exempt from filing Form 990, and the IRS has a list of those exceptions. If your organization is of a type on that list, make sure you review the list closely to ensure that you don’t have to file something else instead. For instance, the list includes stock bonus, pension, or profit-sharing trusts that qualify under section 401 of the Internal Revenue Code. However, that entry also indicates that those trusts should file Form 5500, so be careful to make sure you don’t have some other reporting requirement.

When do I have to file?

Form 990 is due by the 15th day of the 5th month following the close of your fiscal year. If your organization’s fiscal year is the calendar year, that usually means May 15 of the following year. This year, May 15, 2016 happens to fall on a Sunday, so the deadline falls on the following Monday, May 16. If you have a different fiscal year, you’ll need to calculate it from the end of your fiscal year.

What if I miss required filings?

If you don’t file for 3 consecutive years, the IRS will automatically revoke your organization’s tax-exempt status. If that happens, the organization will no longer be tax-exempt starting from the due date of the third missed return. If the organization was a 501(c)(3) organization prior to revocation, any contributions you receive after revocation will no longer be tax-deductible for your donors, which can be a very big mess.

If your organization is automatically revoked, it is significant work to have the tax-exempt status reinstated. If this happens, you have to file an application to have your organization’s tax-exempt status reinstated. Depending on the circumstances, this can be a lot of work–in one case, I had an organization that had to file a new 1023, 990-EZs for each of the missing years, and a statement explaining why the failures occurred and how the failures would be prevented in the future. Short version: make sure the return gets filed each year!

If your organization needs an extension, it can apply for one using Form 8868.

Remember, Form 990 is a public document, and it tells the public a lot about your finances. It should be completed carefully and accurately. However, it also gives you some opportunity to brag about the projects you’ve completed, so you really can use it as an opportunity to show off your organization’s work.

Note: a version of this post originally appeared on my firm’s website, attorneykevinkelly.com, and has been updated for publication here.

Photo credit: Mari Helin-Tuominen, via unsplash.com, licensed under CC0