April 20th, 2022

Your Questions on Tax Exempt Organizations, Answered

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Author: Mark W. Schweighofer, Rebecca A. O'Neill

Help your clients navigate the complex and evolving tax laws and regulations unique to the tax-exempt world so they can avoid jeopardizing their tax-exempt status.

Watch Stein Sperling tax and business attorneys Mark Schweighofer and Becky O’Neill share case law and IRS authority illustrating difficult tax compliance issues, and discuss strategies for avoiding or mitigating them during a recorded webinar, “501(c)(3) Tax Compliance Pitfalls: Cases from the Field,”

Schweighofer and O’Neill share a preview in this Q&A.

Q: What is the difference between a nonprofit and a tax-exempt organization?

A: A non-profit (or non-stock) corporation is a type of corporation formed under state law. Tax-exempt status refers to federal income tax exemption under the Internal Revenue Code. A non-profit corporation is not automatically exempt from federal income tax and must apply with the IRS for tax-exempt status. 

Q: What’s the timeline to for the IRS to approve the application for 501(c)(3) status?

A: The IRS could take 6-9 months to process and approve the application. In addition to that, please note that it can take up to a few months just to finalize the IRS application for submission, depending on the complexity involved and the availability of required information for the application.

Q: During the time between when the IRS application is filed and we hear back, how do we operate?

A: Once the IRS application is filed, the organization can act as a tax-exempt organization unless it receives correspondence from the IRS denying its application for tax-exempt status. However, while the application is pending,  the organization must disclose to the public, especially donors, that its IRS application is still pending. The organization cannot hold itself out to the public as tax-exempt when it is not.

Q: What streams of revenue can a tax-exempt organization have?

A: This depends on facts and circumstances. Aside from charitable donations, generally, a tax-exempt organization may be permitted to earn revenue from activities that are consistent with the organization’s tax-exempt purpose. However, if the revenue is generated from business activities that are unrelated to the organization’s tax-exempt mission, that income is likely to be taxable as “unrelated business taxable income”, or “UBTI” for short, and taxed at the regular corporate income tax rates at both the state and federal levels. Not only is UBTI subject to tax, but too much UBTI can jeopardize an organization’s tax-exempt status.  This is why It’s important to continually analyze all sources of UBTI.

Q: What if we want to employ a family member or other “insider”?

A: “Insiders” such as family members, directors, officers, founders or major contributors can be compensated by a tax-exempt organization for managerial services, however there are rules for both private foundations and public charities that must be followed. Any compensation paid to “insiders”, including fringe benefits, must be reasonable and not excessive, which is a determination requiring a comprehensive analysis.

Q: What if the organization needs to relocate into a different state?

A: Sometimes a non-profit corporation determines it is in its best interest to change its place of incorporation from one state to another. In the past, an organization undergoing such a transition would have to reapply for tax-exempt status all over again as a new organization in the new state.  However, recently the IRS blessed the ability of a tax-exempt organization to carry over its tax-exempt status upon moving from one state to another, so long as certain criteria are met. However, note that each state has different rules on how a non-profit organization can transition out/be domesticated in, so each situation will be different and must be analyzed from all angles to determine the proper steps to follow in both states.  

Q: How do we dissolve a tax-exempt organization?

A: The most important thing to remember is that private individuals cannot benefit from the dissolution of a 501(c)(3) public charity or private foundation, so the assets must be dealt with appropriately. If the organization is a public charity, per IRS rules, upon dissolution, the remaining assets must be transferred to another public charity or to a governmental unit.  By contrast, if the organization is a private foundation, it can either transfer all of its remaining assets to a public charity, or it can convert to a public charity and continue operating as such for at least 5 years. In some cases, a private foundation may be able to merge into an existing private foundation. Note that regardless of the termination method chosen by a private foundation, there are specific IRS rules that must be strictly adhered to, or there will be adverse tax consequences to the private foundation and its founders.