With all the legal hoops involved, it can be difficult for a not-for-profit to secure its tax-exempt status. The last thing you want after gaining this critical designation is to lose it. In the current political climate, it may be easier than ever to forfeit your status. So if you lead a 501(c)(3) organization, be sure to familiarize yourself with the IRS’s tax-exempt rules. In particular, watch out for the following prohibited activities:
- Political campaigning. 501(c)(3) nonprofits are banned from participating or intervening — either directly or indirectly — in any political campaign for or against any candidate running for public office. This prohibition applies to political campaigns on all levels, including federal, state and local elections.
The rule is designed to discourage nonprofits from meddling in elections. Therefore, your organization will be in violation of the rule if it makes contributions to political campaign funds or issues public statements favoring or opposing a candidate for public office. However, your nonprofit is allowed to engage in certain activities promoting voter registration and participation. It can also provide voter information, so long as it doesn’t take a side.
- Lobbying. Similar to political campaigning, lobbying is usually off-limits for not-for-profits. However, the rules allow a little more leeway here.
Lobbying is defined as attempting to persuade members of a legislative body to propose, support, oppose, amend or repeal legislation. For these purposes, “legislation” is considered broadly. Essentially, your organization can’t try to convince a legislator to vote a certain way.
But as long as lobbying doesn’t represent a “substantial part” of your nonprofit’s overall activities, doing it generally won’t harm your tax-exempt status. Of course, “substantial” can be interpreted subjectively. What you consider insubstantial may be different from what the IRS considers insubstantial. One remedy for such uncertainty is to elect the “expenditure test” to measure lobbying costs. So long as your organization spends less than a certain percentage of its total expenses on lobbying, its tax-exempt status is safe. Your tax advisor can provide further details.
- Private benefit inurement. No part of a 501(c)(3) organization’s net earnings may inure to the benefit of a private shareholder or individual who has the opportunity to benefit. This prohibition is aimed at preventing insiders from profiting from their charitable services.
Board members, officers, directors and other key employees all qualify as insiders. The ban against private inurement includes payment of dividends, unreasonable executive compensation arrangements and transfers of property to insiders for no or below-market value.
- Unrelated business income.Obviously, nonprofits are fundamentally different from for-profit businesses in that they’re not designed to make money. That’s not to say that your organization can’t earn income. The income just has to further your tax-exempt mission and meet several other legal tests.
A nonprofit’s unrelated business income is taxed at the same tax rate as corporate income. This tax is commonly known as the unrelated business income tax (UBIT) and is triggered when an organization’s annual income exceeds $1,000. You can’t engage in more than an insubstantial amount of unrelated business activity without risking the loss of your tax-exempt status. Keep in mind that “unrelated business” is regularly carried out and generally isn’t related to an organization’s tax-exempt purpose. So take care to generate only income that supports your nonprofit’s tax-exempt function.
- Annual reporting. Unfortunately, you can’t simply apply for and receive a tax-exempt status and then forget about it. Your organization also must satisfy regular reporting obligations (with certain exceptions for most faith-based organizations).
Generally, your not-for-profit is required to do one of the following annually:
- File Form 990, Return of Organization Exempt from Income Tax,
- File Form 990-EZ, Short Form Return of Organization Exempt from Income Tax, or
- Submit online Form 990-N, Electronic Notice (e-Postcard) for Tax-Exempt Organizations Not Required to File Form 990 or 990-EZ.
The option chosen typically depends on the size of the organization. Nonprofits may file Form 990-EZ if their gross receipts are less than $200,000 and total assets are less than $500,000 at year end. Otherwise, they must file Form 990. Organizations with annual gross receipts of $50,000 or less can submit the new Form 990-N.
- Stated purpose. Finally, your tax status may be jeopardized if you stop operating in accordance with your stated tax-exempt function. This is harder for the IRS to monitor. In general, the tax agency only acts when a nonprofit admits it’s no longer following its own mandate. For example, an organization may come under scrutiny for failing to file annual reports and the IRS investigation may subsequently indicate that its exempt function has changed.
These are only six of the most common ways your nonprofit can put its tax-exempt status in jeopardy. To ensure you aren’t inadvertently courting risk with other activities, discuss them with a tax advisor who specializes in nonprofits.