The Requirements for Obtaining a Not-for-Profit Income Tax Exemption
An organization normally is subject to federal income taxation unless it obtains a formal exemption from the Internal Revenue Service. The exemption is granted only to qualified entities that endure a rigorous application and review process. For an organization to obtain an income tax exemption under Section 501(c)(3) of the Internal Revenue Code, the organization first and foremost must be organized and operated on a not-for-profit basis. In addition, its purposes must be exclusively for charitable, religious, scientific, testing for public safety, literary, or educational purposes, fostering national or international amateur sports competition or for the prevention of cruelty to children or animals. All of these undertakings are “exempt purposes,” and an exempt organization must limit its activities to one or more of these exempt purposes.
Eligibility for Tax-Exempt Status
Eligible organizations can be corporations, limited liability companies, trusts or unincorporated associations, but their organizing documents (e.g., articles of incorporation in the case of a corporation) must strictly limit their purposes to the furtherance of exempt activities only. Furthermore, the exempt organization is prohibited from participating in certain activities that are regarded as inconsistent with the designated exempt purposes, such as (i) participating in political campaigns, (ii) permitting the organization’s assets to be used to enrich members of the organization’s board of directors, officers, senior managers or other insiders, (iii) furthering the private interests of others, (iv) operating primarily as a trade or business or (v) engaging in activities that are illegal or that public policy.
In order for the IRS to make a determination that an applicant satisfies these criteria, the organization must submit an IRS Form 1023 application, an often daunting and always laborious undertaking. The applicant must provide enough information about its activities and finances to fully satisfy the IRS that the organization is deserving of tax exempt status and other benefits that flow from such a designation (such as deductibility for donations made to the organization). The organization must submit copies of its corporate charter and bylaws to insure that it has limited itself to exempt purposes and is organized in such a fashion that private parties will not profit from its operations. The charter also must provide that in the event the organization were to be dissolved and liquidated, its assets thereafter would not benefit any private parties, but instead would be transferred to other exempt organizations.
Information Required by the IRS
The IRS is very thorough in the information it requires, including (a) a detailed narrative history of the organization and a description of its future plans, (b) the contact information and qualifications of the current officers, directors and senior managers of the organization and (c) information about all contracts and other business arrangements between the organization and such individuals. Organizations in which insiders have an interest as well as a business relationship with the applicant also must be disclosed, together with copies of any written agreements. Certain contracts with independent contractors also are subject to disclosure, as are employment agreements with senior managers that are in excess of $50,000 per year. Questions are posed regarding the organization’s fundraising activities, how it compensates its senior staff, how it determines that its senior staff is not paid more than what is reasonable and whether the organization has a written conflict of interest policy. Financial disclosures include balance sheet information and sources of income and expenses for both past years and projections into the future. The information is required in order to prove that the applicant is not a vehicle used improperly for the private inurement of other parties.
Once filed with the IRS, the application is reviewed by an IRS agent, who often requests additional information and clarifications. The review process normally takes six to nine months. After the IRS makes a determination that an organization qualifies for exemption from income tax under 501(c)(3), the IRS determines whether the applicant is a private foundation or a public charity.
All organizations that are not public charities are designated as private foundations, and additional, less favorable tax consequences apply if the organization in unable to qualify as a public charity. Organizations can qualify as public charities under Section 509(a)(1) if they are a church, a school or a hospital, or if they receive a substantial portion of their income from publicly supported organizations, from a governmental unit, or from the general public. An organization can qualify as a public charity under Section 509(a)(2) if it normally receives not more than one-third of its financial support from gross investment income and also receives more than one-third of its financial support from contributions, membership fees, and gross receipts from activities related to its exempt functions (subject to certain exceptions). Other organizations can qualify as public charities under Section 509(a)(3) as “supporting organizations,” because their activities support the exempt purposes of other 509(a)(1) and 509(a)(2) organizations, or organizations that qualify for tax exemption under certain other sections of the IRS Code, such as chambers of commerce and business leagues.
Applying for tax exemption normally requires the guidance of a knowledgeable professional to ensure that the application and the organization’s documents are complete and that the organization’s staff thoroughly understands the bases of its exemption, as well as its ongoing obligations and reporting requirements to maintain its status as an exempt organization.
Ted Goldstock is a business attorney who advises exempt organizations and who has assisted many clients through the IRS application process. He also serves as general counsel to several local not-for-profit organizations. For more information about obtaining a not-for-profit tax exemption, contact Ted at (301) 347-1274 or firstname.lastname@example.org.