John and Kay, two audit committee members of Companions for the Blind, a charitable nonprofit organization, were making a final review of the proposals for tax work submitted by three public accounting firms. John thought about the presentations that each of the firms made to Companions of the Blind about their expertise in preparing the Form 990. Wayne, a tax partner in one of those firms, made a particularly compelling case for using his firm’s services. Wayne’s presentation included an explanation to the board about why the proper preparation of Form 990 was so important. He also discussed the complexities involved in completing the form and how important it was for the board or its designated committee to review and approve it.
In the meeting, Wayne said, "Over the past decade, there has been significant focus by legislators such as Senator Charles Grassley, watch dog agencies such as Charity Navigator and Board Source, and government agencies such as the IRS on the tax-exempt status of nonprofits. Nonprofits benefit by not having to pay federal income and excise taxes and, in many states, by not having to pay state income, property, and other taxes. Some nonprofits also use their tax-exempt status to issue bonds at lower rates because the interest is not taxable to the bond holders. These benefits can save a nonprofit significant money, which can then be spent on programs that benefit the community. But abuse of tax-exempt status, poor internal controls, and lack of board oversight over the years has caused the IRS to focus more on areas in which issues have occurred. Compensation practices and board governance are of particular interest to them right now, and the information tax return (Form 990), which was redesigned in late 2007* for fiscal years beginning in 2008 (note that most of these fiscal years end in 2009), focuses significant attention on compensation paid to officers, directors, trustees, key employees, and highly compensated individuals, not to mention the dozen or so questions on the organization’s governance practices. The tax-exempt organization is required to answer questions pertaining to its governance practices by checking a box ‘yes’ or ‘no’ and in some instances providing explanations of its policies or procedures. This technique forces the tax-exempt organization to either implement the governance policies and procedures or admit that it doesn’t have them. The IRS is the only organization I know of that has a no cost system of ‘enforcement.’ Each day thousands of people, including contributors, supporters, employees, state attorneys general, watchdogs, newsgroups, data gatherers, and other organizations go to the Guidestar website and other web-based sources to view the Form 990s that are of interest to them. They make funding and other decisions based, in part, on what they see in the form. Therefore, governing boards, whose members are listed in the organization’s Form 990, need to be very concerned about the thoughtfulness and accuracy with which the Form 990 is prepared and review it carefully.
John said to Kay, "Maybe we better look past the fee to the expertise of the firms. What Wayne said made a lot of sense, and I for one do not want my name associated with an organization that does not appear to be concerned with tax compliance. I never knew the thing was so complicated or that it could be seen by so many people." Kay said, "You’re right. It sounds like the IRS is concerned about abuses by tax-exempt organizations, and if it took the effort to redesign the form to gather specific information then there’s probably more to it than we even know."
* The form was redesigned in later 2007 to be used by tax-exempt organizations beginning in 2009.
This chapter is designed to provide board members with an understanding of the issues that nonprofits must consider related to obtaining and maintaining tax-exempt status. Although the chapter discusses the various forms that must be completed by tax-exempt organizations, it is not intended to provide instruction as to how to complete or file the forms. This chapter provides scenarios to illustrate some of the more typical situations that a tax-exempt organization might encounter. Tax regulations are complex, and those related to information tax return Forms 990, 990-EZ, 990-N, 990T, and 990PF are no different. It is always important to obtain and read the instructions for each form before completing it. When in doubt, it is a good idea to consult a tax professional.
The terminology and definitions dealing with concepts related to nonprofit organizations can be confusing. Nonprofit is a type of organization, not-for-profit is a type of activity, and tax exempt is a status granted through sections of the Internal Revenue Code that are then recognized, or not recognized, by the IRS.1
There are many types of tax-exempt organizations. Following are the most prevalent.
|Type||Examples of What They Do||IRC Code Section|
|Charities, educational, religious, scientific, literary, testing for public safety, fostering amateur sports competition, and prevention of cruelty to children or animals||Conduct activities consistent withtheir descriptive class||501(c)(3)|
|Private foundations||Can be either operating or nonoperating. Operating foundations operate their own programs, whereas nonoperating foundations provide funding to charities and other nonprofit organizations and governments for charitable purposes.||501(c)(3)|
|Civic leagues and social welfare organizations||Civic associations, health maintenance organizations and volunteer fire departments||501(c)(4)|
|Labor, agricultural, and horticultural organizations||To improve the conditions of work or to improve products or efficiency||501(c)(5)|
|Business leagues, chambers of commerce, and real estate boards||To improve business||501(c)(6)|
|Social and recreational clubs||For pleasure, recreation, and social activities||501(c)(7)|
|Fraternal beneficiary societies and associations||Payment of life, sickness, accident, or other benefits to members||501(c)(8)|
|Voluntary employees beneficiary associations||Payment of life, sickness, accident, or other benefits to members||501(c)(9)|
|Domestic fraternal societies and associations||Type of lodge that devotes the net earnings to charitable, fraternal, and other purposes. Not permitted to pay life, sickness, or accident benefits to members||501(c)(10)|
|Teacher retirement fund associations||Pay retirement benefits to teachers||501(c)(11)|
|Benevolent life insurance associations, mutual or cooperative telephone companies, and mutual ditch or irrigation companies||Offer benefits to members||501(c)(12)|
|Cemetery companies||Burials and incidental activities||501(c)(13)|
|State chartered credit unions||Offers banking and other financial services to members||501(c)(14)|
More detailed information may be found in section 7.25, Exempt Organizations Determinations Manual, of the IRS’ Internal Revenue Manual in exhibit 7.25.1–1, “Table of Organizations Exempt Under Section 501,” at www.irs.gov/irm/part7/irm_07–025-001.html#d0e331.
Tax-exempt organizations are required to file many forms with the IRS and with state agencies. The forms noted in the next paragraphs will be discussed in this chapter. Appendix B to the chapter identifies other forms that these organizations must file. This information is for returns filed generally in 2018 for tax years beginning in 2017. Churches are not required to file Form 1023 or 990 but many do in order to give comfort to their donors that the organization is tax exempt.
|IRC Code Section||Annual Gross Receipts||Assets||Information Tax Return||Application for Recognition of Tax-Exempt Status|
|501(c)(3)||Normally less than $50,000||Any||990 N||1023 EZ required— see below|
|501(c)(3)||$50,001 to $199,999||And < $500,000||990 EZ||1023 required|
|501(c)(3)||$200,00 0+||Or $500,00 0+||990||1023 required|
|501(c)(3) Private Foundation||Less than $5,000||990 PF||1023 required|
|Other code sections listed in preceding table||Thresholds listed previously apply.||Thresholds listed previously apply.||Types of returns vary by threshold.||1024 recommended|
Form 990-T is also required to be filed when the organization has gross unrelated business income (UBI) (gross receipts before cost of goods sold) of $1,000 or more from a regularly carried on trade or business. Form 990-T is also used for the payment of proxy tax on lobbying expenditures or other taxes. Even organizations that are exempt from filing a Form 990, such as churches, are subject to the same Form 990-T filing requirements.
The information tax returns are required to be filed by the fifteenth day of the fifth month after its fiscal year end. There are two three-month extensions available for those organizations filing the Form 990-EZ, 990, or 990-PF. These returns are posted on the Guidestar website (www.guidestar.org) within approximately two months. There is no penalty for filing the 990 N late. However, if it is not filed for three consecutive years, the organization will lose its tax-exempt status.
|Due date of return||Due date with 1st
|Due date with 2nd
|June 30, 2017||November 15, 2017||February 15, 2018||May 15, 2018|
If the exempt organization has $10 million or more in total assets, and if it files at least 250 returns of any type during the calendar year ending with or within the organization’s tax year, then it will be required to file the Form 990 or 990-EZ electronically. As noted in appendix B, there are many types of returns that the organization will be required to file. These include income, excise, employment tax, and information returns. Note that each W-2 that an organization completes is considered a return.
Private foundations and nonexempt charitable trusts are required to file Form 990-PF electronically, regardless of their asset size, if they file at least 250 returns of any type annually.
If an organization must file its return electronically but does not, it is considered to have not filed its return. In addition, late filing can result in substantial monetary penalties and even loss of exempt status.
The fundamental difference between a nonprofit organization and a commercial entity is not the fact that a nonprofit makes no profit and a commercial entity (also referred to as a for-profit entity) was created to make a profit. If profit is defined as the excess of revenues over expenses, all entities that wish to remain viable must make a profit. The phrase “no margin, no mission” is often used in nonprofit organizations to describe the need to have residual earnings.
The distinction between a commercial entity and a nonprofit is that the nonprofit organization is subject to the private inurement doctrine. The IRS discusses avoidance of private inurement in Publication 557, Tax Exempt Status for your Organization, as one of the characteristics that must be upheld by a nonprofit in order to be recognized as tax exempt. It states that “no part of the net earnings of a nonprofit can inure to the benefit of any private shareholder or individual.”2 Basically this means that excess of revenues over expenses of the organization, along with its assets, should be used to conduct the activities of the organizations and not to enrich a private party.
An IRS General Counsel Memorandum (GCM)3 states that private inurement is likely to arise when “the financial benefit represents a transfer of the organization’s financial resources to an individual solely by virtue of the individual’s relationship with the organization and without regard to accomplishing the tax-exempt purpose.” Another GCM4 explains that private inurement is prohibited to prevent anyone in a position to do so from siphoning off any of an exempt organization’s income or assets for personal use.
In order for private inurement to be present, the private party (also known as an insider in federal tax law)5 must have the ability to control or otherwise influence the actions of the charitable organization. For purposes of private inurement, an insider would be an officer, director, trustee or key employee, family members of those individuals, and certain entities that are controlled by them. Private inurement can occur when
- compensation is paid to an individual.
- there is a sale or lease of property between the organization and an individual.
- loans are made to individuals by the organization.
- goods or services or facilities are furnished to the organization by an individual or vice versa.
A Guide to Federal Tax Issues for Colleges and Universities provides several examples of case law in which private inurement was said to have occurred either resulting in failure to recognize the tax-exempt status of the organization or revocation of the organization’s tax-exempt status.
Jeremy is about to be offered a position as the CFO of HIV-Aids Partners, a nonprofit charity. The compensation committee of HIV-Aids Partners is in the process of determining his compensation package. Because he will work for the organization, the payment of compensation is permissible. However, when deemed excessive, it may be considered private inurement because he would be deemed an insider. The committee performed some research into whether the amount it wanted to offer Jeremy as compensation would be considered reasonable. This included not only the cash compensation but also fringe benefits he would receive in the form of insurance, deferred compensation, and retirement benefits.
After a significant amount of deliberation, the board of directors voted to make an emergency loan to the executive director. The loan was to be for a period of 9 months, and the board performed research to determine the market rate of interest commensurate with the risk involved. The board chair had this statement put into the minutes: “We must be very careful to monitor the repayment of this loan and to document all of the consideration we gave to the issue in deciding to make it. We must also not make this a precedent for future actions because it is our policy not to grant loans to those who would be considered insiders. We understand that this loan will be disclosed on the Form 990 and must be prepared for any inquiries from donors or others.”
When an individual receives a benefit in excess of what is provided to the organization, it is considered an excess benefit. If the person is considered a disqualified person, then the IRS can impose intermediate sanctions on him or her.
A disqualified person is defined by the IRS as a person who was in a position to exercise substantial influence over the affairs of the applicable tax-exempt organization at any time during the five-year period before the excess benefit transaction occurred. It is not necessary for the individual to exercise substantial influence for an excess benefit transaction to have occurred. They only have to be in a position to do so.
Examples of a disqualified person6 are as follows:
- A voting member of the governing body
- A person who has responsibility for implementing the decisions of the governing body or for supervising the management, administration, or operation of the organization
- A person who has ultimate responsibility for managing the finances of the organization
- The person who founded the organization
- A substantial contributor to the organization
- A person whose compensation is based primarily on revenues derived from organization activities that the person controls
- A person who has or shares authority to control or determine a substantial portion of the organization’s capital expenditures, operating budget, or compensation for employees
- A person who manages a discrete segment or activity of the organization that represents a substantial portion of its activities, assets, income, or expenses
- A person who owns a controlling interest in a corporation, partnership, or trust that is a disqualified person
- A person who is able to exercise substantial influence over a supporting organization (under Internal Revenue Code section 509(a) (3))
Family members of the disqualified person and entities controlled by the disqualified person are also disqualified persons. In making this determination, control is defined as owning more than 35 percent of the voting power of a corporation, more than 35 percent of the profits interest in a partnership, or more than 35 percent of the beneficial interest in a trust.
The intermediate sanctions are imposed on the disqualified person and not the nonprofit. The disqualified person who received the excess benefit is subject to an initial tax of 25 percent of the amount of the excess benefit. He or she also has to return the excess benefit amount to the organization. If an organization manager knowingly participated in an excess benefit transaction, then that person is subject to an initial tax of 10 percent of the excess benefit. And additional taxes could be levied—equal to 200 percent of the excess benefit—in situations in which corrective action was not made.
Sunshine Home increased the pay of its executive director to $450,000. The board approved the compensation. When Form 990 was prepared, the compensation was properly listed on the form. A reporter from Channel 3, Eye on You News, was working on a story about inappropriate use of charitable assets and pulled the Forms 990 for 25 charities in the area, one of which was Sunshine Home. Based on the research performed by the reporter, executive directors in similar commercial and nonprofit organizations earned as much as $250,000.
If the IRS reviewed the situation and determined that $250,000 was reasonable compensation,* then $200,000 would be considered the excess benefit. The executive director is a disqualified person.
|Compensation paid to disqualified person||
|Compensation held to be reasonable||
|Initial tax to disqualified person (25%)||
|Tax on each board member who signed off on the compensation assuming they knew it was an excess benefit (10%)||
|Payback on part of disqualified person||
|Second tier tax if the situation is not remediated. This is leveled on the disqualified person (200%).||
There is an exception for the first time a payment is made to a disqualified person. The amount must be a fixed payment or calculated using a fixed formula specified in the contract. In addition, the person could not have been a disqualified person prior to entering into the contract.
* Treas. Regs. §53.4958–4(b)(1)(ii) states that the excess benefit is the amount over the value of services that would ordinarily be paid for like services by like enterprises (whether taxable or tax-exempt) under like circumstances (reasonable compensation).
Closely related to private inurement is private benefit. It comes from statutory law that charities must be operated primarily for their tax-exempt purpose.7 This occurs when individuals receiving a benefit are not members of the charitable class and when the benefit is not incidental. For a benefit to be incidental, it must be necessary in that the exempt objectives cannot be achieved without also benefitting private individuals. A charitable organization will not qualify as tax exempt if its primary purpose is to provide a private benefit. The benefit does not need to be provided to insiders to constitute a private benefit.
Helping Hands is a nonprofit, tax-exempt organization that helps lower income patients apply for Medicaid and refers them to physicians who take patients with Medicaid. In doing so, it indirectly provides benefits to physicians, including the physicians who sit on its board. However, because it would be impossible to carry out its tax-exempt purpose without indirectly providing this benefit to physicians, the benefit is deemed to be incidental.
Starving Artists is a charitable organization that promotes the arts by encouraging young artists. It holds monthly functions at which the work of young artists is displayed, allowing the artists to gain exposure and sell their work. Recently, the organization began holding events at which its members could showcase and sell their work. The organization’s tax advisor advised them to stop the practice immediately because the members were not considered to be part of the charitable class. If the members had been willing to donate their work to the organization where it could be sold and the proceeds used for the organization’s programs, this would be a different situation.
Most tax-exempt8 organizations are nonprofits, but not all nonprofits are eligible to be tax exempt. To be tax exempt, the organization must qualify. In order to be tax exempt, the organization needs to meet the statutory requirements that provide for its exempt status. Charities, credit counseling agencies, and certain employee benefit organizations are required to file with the IRS. Social welfare agencies, labor organizations, trade groups, professional associations, and social clubs are not required to file. The filing for charitable organizations is Form 1023. Other organizations file a Form 1024. Some 501 (c) (3) organizations such as churches are not required to file for exemption. However, many do because it gives the donors an additional layer of comfort knowing that their contributions are tax deductible.
As noted in this chapter, unless the nonprofit is a church and elects not to file Forms 1023 or 1024 for recognition of tax-exempt status. The IRS requires that the form be filed within 27 months of the date that the nonprofit was formed. Along with the form, the organization must attach its Certificate of Incorporation and By-laws. For those entities wishing to obtain tax exemption under section 501(c) (3), there are some important considerations. The organizing documents should clearly show that
- the entity is organized for charitable, educational, or religious purposes or one of the purposes described in the preceding paragraph related to that code section.
- no part of the organization’s net earnings will inure to the benefit of private shareholders or individuals.
- the organization will not substantially attempt to influence legislation and will not participate in any political campaign of candidates for public office.
The third bullet point does not mean that the organization cannot perform lobbying activities. However, they are limited as discussed subsequently in this chapter.
The organizing documents (for example, articles of incorporation) must also limit the purpose of the organization to one of those described in section 501(c) (3). However, it is not enough to say that the purpose is within the code section; the document must state the purpose specifically.
New Horizons was drafting its organizing documents and identified its purpose as “assisting the home-bound elderly with activities of daily living regardless of their ability to pay.”
Also important in the organizing documents is the dissolution clause. If the organization were to be dissolved, the assets must be distributed to another organization for an exempt purpose under section 501(c) (3).
New Horizons was drafting its organizing documents. Management and the board were trying to decide whether it was better to leave the dissolution clause very broad or whether to name a specific organization. Its tax advisors noted that it may be better to leave them broad because the specific organization named would need to be a section 501(c) (3) at the time of dissolution, and so an alternative would also need to be named just in case. New Horizons drafted the language as follows:
Upon the dissolution of New Horizons, its assets shall be distributed to Hope Valley Home for the Aged. If Hope Valley Home for the Aged is not a section 501(c) (3) at the time of New Horizon’s dissolution, then its assets shall be distributed for one or more exempt purposes within the meaning of section 501(c) (3) of the Internal Revenue Code, or corresponding section of any future federal tax code, or shall be distributed to the federal government or a state or local government for a public purpose.
Form 1023 requires the organization provide the following information:
|Description of the organization’s activities||It is important to be sure that the narrative is well thought out. The Form 1023 is open to public inspection. In addition, this information is expected to agree to the information in Form 990.|
|Description of public charity status||
IRC Code Section 509(a) (1) and 170(b) (1) (A) (i)—a church or a convention or association of churches. (Complete and attach Schedule A of Form 1023).
509(a) (1) and 170(b) (1) (A) (ii)—a school. (Complete and attach Schedule B of Form 1023).
509(a) (1) and 170(b) (1) (A) (iii)—a hospital, a cooperative hospital service organization, or a medical research organization operated in conjunction with a hospital. (Complete and attach Schedule C of Form 1023).
509(a) (3)—an organization supporting either one or more organizations or a publicly supported section 501(c) (4), (5), or (6) organization. (Complete and attach Schedule C of Form 1023).
|Compensation and financial arrangements with officers, directors, trustees, employees, and independent contractors||In 2006, the form was revised to add more disclosure on the arrangements with insiders and certain vendors. As noted earlier, the IRS has placed significant focus on private inurement in the interest of good governance. Some of the questions deal with whether the compensation arrangements of the person approving the arrangements are documented; what objective standards were used to determine the reasonableness of the compensation; and whether the organization will have dealings with organizations owned more than 35 percent by an officer, director, or trustee. In case such arrangements exist, how they will be made at arms-length must also be specified.|
|Conflict of interest policy||The organization’s conflict of interest policy must be attached, along with a description of the approval procedures for the policy. Although it is not necessary to have a conflict of interest policy, it is something that the IRS will see as unfavorable if the organization does not because it is an element of good governance.|
|Lobbying||As noted earlier, a charitable organization can only perform limited lobbying activities. The Form 1023 asks if the organization attempts to influence legislation and, if so, whether it has made an election under Section 501(h) to measure its activities by expenditures. There is an additional form that the organization completes if this is the case. The general rules are noted in a subsequent section, but the answer to this question is a tip to the IRS about whether the organization’s tax-exempt status should be recognized. If the election is not made, the organization must attach a description of the activities to Form 1023.|
|Political activities||Charitable organizations cannot participate in partisan political activity.|
|Fundraising||Information on how fund-raising is conducted|
|Other financial information||Balance sheet and projected statement of revenues and expenses. If the organization has been in existence over 1 year and up to __ years, then it will provide up to __ years of statements of revenue and expenses.|
Many 501(c) (3) organizations attempt to influence legislation through lobbying. However, lobbying cannot be a substantial portion of a charitable organization’s activities without jeopardizing its tax-exempt status. But the word substantial is not well defined.
The IRS makes it relatively easy to determine the amount of lobbying that would not be considered substantial by use of an expenditure test. This test is not required, but if the organization elects to use it, this test provides comfort to the organization that the objective results will determine whether its lobbying activities are substantial. Charitable organizations other than churches can lose tax-exempt status if their lobbying activities are substantial. This is defined as more than 150 percent of the lobbying nontaxable amount.
The organization will pay a proxy tax of 25 percent on its excess lobbying expenditures. If the lobbying expenditures are sufficient to cause the organization to lose its tax-exempt status, then it will still pay a tax that is equal to 5 percent on the lobbying expenditures that resulted in the organization being disqualified. It is also possible that the organization manager could be taxed. If the manager agreed to the expenditures knowing that they were likely to result in the loss of tax exemption, then the manager may have to pay a 5 percent tax. The manager will not pay a tax if the action was not willful and it was due to a reasonable cause.
Organizations such as civic leagues, horticultural or agricultural organizations, labor organizations, trade groups, and HMOs that are exempt under other code sections are permitted to make lobbying and political expenditures. However, they need to let the dues paying members know that the portion of the dues that were used for lobbying are not tax deductible. If the organization chooses not to notify the members, then a proxy tax will be paid equal to 35 percent of the lobbying or political expenditures. Form 990-T must be filed when proxy taxes are paid.
Lobbying can be conducted in two ways: grass roots lobbying and direct lobbying. Grass roots lobbying is conducted at the level of the community to try to cause the population’s opinion on issue to be swayed to support the organization’s cause.
An Alzheimer’s association wants to bring an awareness of the seriousness of the disease to the public and inspire them to write to their representatives to obtain more federal or state dollars for Alzheimer’s research. The association sends out materials describing the disease and the devastating effects it can have on the afflicted individuals and their families. The communication also includes a call to action.
Direct lobbying would include any attempt to influence legislation by contacting a member of a legislative body or the member’s staff or any other government official or employee who would participate in drafting or voting on legislation.
A charitable organization concerned about Multiple Sclerosis (MS) sends a person to Washington, D.C., to discuss a bill that would reduce the amount of funding that would be devoted to MS research. The lobbyist makes direct contact with the members of the committee that drafted the legislation.
There are certain activities that would not constitute lobbying:
- Sending a nonpartisan research report out to interested parties
- Evaluating social issues such as teen pregnancy or violence against women
- Defending the organization against a threat to its tax-exempt status, deductibility of contributions, or other such issues at a hearing or meeting with a legislative body
- Communicating with legislatures on nonlobbying related matters
- Providing information or technical advice or answering questions to a legislator or member of his or her staff
Your Sight, a charitable organization, participates in both grass roots and direct lobbying. The organization’s exempt purpose expenditures were $5,384,504. Of those expenditures, $567,500 were spent on lobbying. Of the $567,500, $25,000 was spent on grassroots lobbying. The organization elected to use the objective measure under section 501 (h). In its first year, Your Sight made the following evaluation of its lobbying expenditures. The evaluation resulted in the organization paying a proxy tax of $37,069.
|Objective Test for Lobbying Activities|
|Evaluation of Lobbying Expenditures|
|How much was spent on grassroots lobbying?||
|How much was spent on lobbying, including grassroots lobbying?||
|Calculation for Nontaxable Lobbying Expenditures|
|Amount of exempt purpose expenditures (do not include amounts paid or incurred for a separate fund-raising unit or other organization or amounts to organizations if primarily paid for fundraising, but do include lobbying expenditures)||
|Are the exempt purpose expenditures < $500,000?|
|Multiply the amount of expenditures by 20%.||
|This is the lobbying nontaxable amount.|
|If NO, then|
|Are the exempt purpose expenditures between $500,000 and $1,000,000?||
|Multiply the amount over $500,000 by 15%.|
|Add $100,000 to compute lobbying nontaxable amount.|
|If NO, then|
|Are the exempt purpose expenditures > $1,000,000 but not over $1,5000,000?||
|Multiply the amount over $1,000,000 by 10%.|
|Add $175,000 to compute lobbying nontaxable amount.|
|If NO, then|
|Are the exempt purpose expenditures > $1,5000,000?|
|Multiply the amount over $1,500,000 by 5%.||
|Add $225,000 to compute lobbying nontaxable amount.|
|Calculation for Nontaxable Grassroots Lobbying Expenditures|
|Calculate the grassroots nontaxable amount (multiply lobbying taxable amount by 25%)||
|How much of the amount spent on grassroots lobbying is > the nontaxable amount?||
|How much of the amount spent on lobbying is > the lobbying nontaxable amount?||
|If the organization spent more on lobbying than the grassroots or lobbying nontaxable, multiply that amount by 25%.||
Form 1023 asks whether the organization is a public charity or a private foundation. A public charity receives a substantial amount of its support from the public, including funding from governmental units. There are three main types of public charities:
- Publicly supported organizations
- Those organizations that support publicly supported organizations (referred to as supporting organizations)
- Organizations that operate exclusively for public safety testing, such as SBCCI Public Safety Testing and Evaluation Services that tests building products
A supporting organization is one that is organized and operated exclusively to benefit or perform certain functions for a publicly supported charitable organization. It must also be operated, supervised, or controlled by or in connection with a publicly supported charitable organization.
New Trends, a private school, wanted to raise money for expansion. To do this, it created New Trends Foundation to benefit only the school, to raise money for it, and to manage the money. The private school qualified as a public charity. Therefore, New Trends Foundation is a supporting organization.
A charitable organization, unless it is a church, educational institution, hospital or a medical research organization operated in conjunction with a hospital, endowment fund operated for the benefit of state and municipal colleges and universities, or governmental unit, has to meet certain tests to determine if it is publicly supported. Otherwise it could be classified as a private foundation. A private foundation is often funded by few sources and often by an individual, family, or company. The expenditures of a private foundation are funded generally from the earnings on the assets contributed by those sources. There are operating foundations that conduct their own programs (operating foundations), but more often the foundation gives to other charities. The IRS imposes additional requirements on private foundations:
- Private foundations are subject to a tax on the net investment income. This can be either 1 percent or 2 percent depending on the foundation’s operations.
- The foundation must document its grant making procedures on Schedule H of Form 1023 and have them approved in advance.
- Private nonoperating foundations are required to annually spend at least 5 percent of the net fair market value of noncharitable-use assets on qualified distributions for charitable purposes. If they fail to do so, a 30 percent penalty is imposed. For those that do not remediate the situation, an additional 100 percent penalty is imposed on the shortfall. Qualifying distributions can be made to public charities, private operating foundations, or governments to be used for charitable purposes. These are typically referred to as grants. Grants cannot be made to organizations that are related to or controlled by the private foundation.
- The private foundation files information tax return 990-PF instead of Form 990
Donors will generally prefer to give to public charities and private operating foundations because the deduction for individual contributions is limited to 50 percent of the donor’s adjusted gross income. Donations to nonoperating foundations are more limited. Depending on the type of contribution, the maximum is either 20 percent or 30 percent of the donor’s adjusted gross income.
Before September 9, 2008, the IRS had an advance ruling process. After that date, the IRS automatically classifies a new 501(c) (3) organization as a public charity as long as the financial information provided in the Form 1023 shows that it could reasonably expect to be publicly supported. During the first five years of the charity’s life, the IRS reviews the results of the support test described in the next section. After the charity’s first five years, if it fails the test in two consecutive Form 990 s, it will be classified as a private foundation. There is no retroactive assessment of private foundation taxes on the organization.
A public charitable organization has several opportunities to meet the public support test. Based on the types of support and revenue the organization receives and earns, it will elect Test 1 or Test 2. Test 1 was constructed for those organizations that receive a large amount of contributions and do not provide services for which they charge a fee. Test 2 was constructed for those organizations that derive a significant amount of their revenue by charging fees for services. However, there are limitations, as discussed in the next section.
The public support tests are made over a five-year period including the current year. After deducting amounts from a substantial contributor at start up (unusual gifts), public support will equal the sum of
1. the remaining gifts, grants, contributions, and membership fees received (contributions of services are not included unless they are furnished by a governmental unit, as noted subsequently in this chapter),
2. tax revenues levied for the organization’s benefit and either paid to or expended on its behalf, and
3. value of services or facilities furnished by a governmental unit to the organization without charge,
4. Less those gifts and contributions from an individual or organization that equal more than 2 percent of total support for the five-year computation period. Note that the total support must be computed first to determine the amount to subtract from public support.
This amount is divided by total support, which represents list items 1–3 plus gross income from interest, dividends, payments received on securities loans, rents, royalties and income from those types of sources, net income from unrelated business activities even if it is not regularly carried on, and other income. Capital gains, contributions of services, and unusual grants are excluded from the denominator. Fees for services that are related to the tax-exempt function are not included in total support.
If the organization has been in existence for six years, it will compute the public support percentage for the current year and also document the public support percentage computed in the prior year. If the organization’s public support percentage is not 331/3 percent or more, then it has the opportunity for another test. This is called the facts and circumstances test. In this test, the organization could still be considered a publicly supported charity if meets 10 percent of the support requirement and if it shows attraction of public support. Attraction of public support means that it is organized and operated in such a way that it will attract new support from the public or the government on a continuous basis. It will need to have a fundraising program.
If the organization has not been in existence five years, then it will end the test because it has five years to meet the requirements. It is presumed to be a public charity until five years have passed and it has failed both of the public support tests discussed in the preceding paragraph for two years in a row. If it fails the test two years in a row, then it is considered to be a private foundation.
Julia, the CFO of Westchester’s Mental Health Outreach Association (WMHOA), was making an evaluation of the organization’s charitable status. She believed the organization would qualify under 509(a) (1) because of the amount of donations the organization received from various sources. WMHOA also charged fees for its services on a sliding scale. And because of an endowment, WMHOA had a significant amount of interest income.
During the 5 years covered by the 2010 Form 990, the organization had the following:
|Contributions from the public||
|Net income from unrelated business activities||
|Income from seeing clients (tax-exempt purpose)||
|Total support and revenue||
|Evaluation of public charity status:|
|Donations that were over 2% of total support coming from individuals and foundations||
|Public support (less amounts excluded because of 2% large donation requirement)||
Julia was very happy to see that the organization met the test. For the past several years, it had received very large contributions from individuals and foundations that were over 2 percent of the organization’s total support over the five-year period, which were deducted from public support. Although the organization met the 10 percent facts and circumstances test, they worked diligently to increase the number of donors, and, over the last two years, the number of donors had increased. This year, they met the test.
This test includes the elements discussed in the preceding paragraphs with the following additions or changes:
- Gross receipts from activities that are related to the tax-exempt mission are added into the calculation of public support.
- The 2 percent disallowance described in the preceding section is replaced with the following. Amounts of gross receipts from the organization’s exempt purpose activities that are received from any one payor (which represent greater than $5,000 or 1 percent of the organization’s total support for any of the five taxable years, including the current year) are not included in the computation of public support. This does not include amounts from disqualified persons.
- The organization also has to meet an investment income test, so the investment income is included in total support but not public support. It may not have an investment income that is greater than 331/3 percent of total support.
- There is not a 10 percent facts and circumstances test.
As with Test 1, capital gains are excluded from the calculation as are contributions of services in Test 2. The calculation considers five years including the current year. If the organization has not been a 501(c) organization for five years, it does not need to evaluate the public support percentage. And, also like Test 1, it takes two years of failing the test to be classified as a private foundation.
Jared, the CFO of Hawthorne Health Clinic, was making an evaluation of the organization’s charitable status. He knew that Julia was evaluating public support under 509(a) (1), but he knew that his organization had substantially more fee-for-service income and many fewer donations. He thought he would qualify under 509(a) (2). He was not concerned because he had few large payments and because the investment income was only about 5 percent of total support. He made the following evaluation.
During the 5 years covered by the 2010 Form 990, the organization had the following:
|Contributions from the public||
|Income from seeing clients (tax-exempt purpose)||
|Total support and revenue||
|Evaluation of public charity status:|
|Payments that were over $5,000 or 1% of total support except amounts from disqualified persons for any of the years||
|Public support (less amounts excluded because of 1% large payment requirement)||
|Investment income percentage||
As noted, supporting organizations may qualify for public charity status. There are three types of supporting organizations, and they are referred to as Type I, Type II, and Type III. The important aspect of the supporting organization is that the charitable organization must maintain control of the supporting organization. In effect, the charitable organization is sharing its tax-exempt status with the organization that supports it.
A supporting organization cannot be controlled directly or indirectly by disqualified persons other than foundation managers. These might be contributors to the foundation or a family member, owners of more than 20 percent of the combined voting power of a corporation that is a substantial contributor to the foundation, a beneficial interest of a trust or unincorporated business that is a substantial contributor, a corporation, partnership, trust, or estate of which more than 35 percent of the interest is owned by any of the mentioned persons. A foundation manager and family members are also disqualified persons. However, the foundation manager is not included in the prohibition against disqualified persons.
Type I and Type II organizations differ only in that Type I organizations are operated, supervised, or controlled by one or more publicly supported organizations. The officers, directors, or trustees of a Type I supporting organization must be selected by the supported organization’s governing board, officers, or membership. Type II organizations are supervised or controlled in connection with one or more publicly supported organizations. The same persons would supervise or control the supporting and supported organization. Both Type I and Type II organizations need to meet two tests:
1. Organizational Test. The Articles of Organization must limit the purposes of the supporting organization to the one that is being supported.
2. Operational Test. The supporting organization would be recognized as one that supports one or more publicly supported organizations if its activities are limited to those that provide support to the supported organization(s). The supporting organization is not required to pay out all of its income to the supported organization, but it must ensure that its income carries on some activity or program that benefits the supported organization.
A Type III supporting organization needs to meet a test that shows that it is operated in connection with the publicly supported charitable organization:
- Organizational Test. The Articles of Organization must limit the purposes of the supporting organization to the one that is being supported. And the supported organization must be specified by name. If the organization chooses, it can also designate a class or purpose of organization that would be a substitute if the named organization was dissolved or lost its tax-exempt status. There also needs to be a historic relationship between the two organizations.
- Responsiveness Test. The supporting organization must be responsive to the needs of the supported organization. The supported organization must elect, appoint, or maintain a close and continuous working relationship with the officers, directors, or trustees of the supporting organization. This helps to ensure that the officers, directors, and trustees of the supported organization have a voice. All IRS-required information must be provided to the supported organization.
- Integral Part Test. The supporting organization must maintain involvement in the operations of the supported organization because the supported organization needs to be dependent on the supporting organization. In other words, the supporting organization is an integral part of the supported organization. There are two ways to satisfy this test:
1. The activities carried on by the supporting organization are ones that “but for” the supporting organization the supported organization would need to perform them.
2. The supporting organization makes payments of substantially all of its income to or for the use of the supported organization. The amount received has to be large enough to ensure that the publicly supported organization is attentive to the activities of the supporting organization.
- Operational Test. If the supporting organization meets the integral part test, the only thing that it can do to fail this test is to conduct activities of its own that would not meet the “but for” test.
Genessee Foundation was formed to support the activities of Genessee Shelter, a 501(c)(3) organization. Its organizing documents state that it was created solely to manage the property of Genessee Shelter and to raise funds for and manage its endowment. When it raises money for the shelter, it recognizes contribution revenue. All of the revenue is used on services to support the foundation or is distributed to the organization. The shelter’s board selects a majority of the supporting organization’s officers, directors, or trustees. The foundation is a Type I supporting organization.
Creative Solutions was formed to provide record keeping and other administrative services to five small tax-exempt organizations. It charges lower fees to these organizations than they would otherwise pay to commercial organizations. The nonprofits would have to perform these services “but for” the fact that Creative Solutions performs them. Each of the five tax-exempt organizations has representation on Creative Solutions’ board. Creative Solutions is considered functionally integrated because it operates as a part of each of the five tax-exempt organizations it serves. It is a Type III supporting organization.
Donors give to charitable organizations because they care about the cause. But in return, most are also very interested in the tax deduction they get for their donations. To qualify as a donation, the gift must be given voluntary and without the expectation of receiving any benefits from the charitable organization, such as services or property of equal value. This is called donative intent. The organization to which the contribution is given must be considered qualified in order for it to be tax deductible to the donor.
One of the reasons to ensure that the Form 1023 is properly filed and that the organization passes the charitable support tests is so that the organization will be qualified. Generally, only organizations that are organized under U.S. tax laws are qualified. Exceptions are certain charities that are organized under the laws of Mexico or Canada that fall under a treaty with the United States.
Churches and religious institutions such as associations of churches or integrated auxiliaries of a church (such as a men’s or women’s organization, religious schools, mission societies, or youth groups) are automatically qualified, but donors need to know that some entities that call themselves “religious organizations” may not meet the definition for IRS purposes. For that reason, it is probably a good idea for a religious organization to apply for recognition of tax-exempt status. A donor can go online to search for charities, schools, hospitals, religious organizations, and other 501(c) (3) organizations that have been recognized as tax exempt at www.irs.gov/app/pub-78/.
Contributions can be cash, securities, or other property. Donors are responsible for identifying the fair value of their donations. The IRS has an excellent publication that can be accessed online at www.irs.gov/publications/p561 /ar02.html that will help donors determine the fair value of their gifts. Donors often provide services to a 501(c) (3) organization, but these are not tax deductible. Only the mileage and out of pocket expenses are deductible. The IRS rate for mileage that can be deducted for each mile driven in service of charitable organization for 2011 is 14 cents.
Although it is the donor’s responsibility to obtain one, nonprofits should expect to provide an acknowledgement for charitable donations they receive. The IRS does not require a standard acknowledgement, but the donor needs the following in order to substantiate his or her contribution.
|Contribution that is $250 or more||
|Payroll deduction for a single contribution of $250 or more||
|Payroll deduction for a single contribution <$250||
When the donor receives goods or services for making the donation, the nonprofit will need to provide an acknowledgement to them. The term contemporaneous refers to the timing of the written acknowledgement. An acknowledgement is considered contemporaneous when it is received by the earlier of the date on which the donor filed his or her tax return or the extended due date of the return.
Form 1771 (www.irs.gov/pub/irs-pdf/p1771.pdf) contains sample acknowledgements for a nonprofit to use. The required content of the acknowledgement is as listed:
- The name of the qualified organization.
- The amount of the contribution for those that are cash.
- A description of the property (note that it is the donor’s responsibility to value the property for his or her deduction). The nonprofit also has a valuation issue that is related to recording the donation at the fair value at the date of donation. This was discussed in chapter 5.
- The amount, if any, of goods or services provided to the donor by the nonprofit. This is referred to as a quid pro quo contribution. The rules associated with these goods or services and the responsibility to the donor are discussed in the next few paragraphs.
Nonprofit organizations will often offer premiums to donors in a pledge campaign. When this happens and the donors accept the goods or services offered by the nonprofit, an acknowledgement must be provided if the quid pro quo donation is $75 or more. The requirements of the acknowledgement are
- the amount of the contribution that is deductible and
- an estimate of the fair value of the goods or services.
When the benefits that are provided in exchange for a contribution are of intangible religious benefit that are not sold, such as attendance at a religious ceremony or free religious education that does not lead to a degree, then the acknowledgement should state this.
There are exceptions to the quid pro quo rule for low cost items. If the goods or services did not exceed (1) 2 percent of the payment or (2) $96, then no disclosure statement is necessary. Also, (1) if the payment by the donor is at least $48,9 and (2) the only items provided were items bearing the organization’s name such as mugs or pens or address labels, and (3) the cost is $9.60 or less, then no disclosure statement is necessary.
Another exception is the membership benefits exception. A member benefit would be considered insubstantial when the annual payment is $75 or less and the privileges are items that may or may not be used, such as free or discounted admissions to the facilities (such as a museum), discounts on purchases, or free or reduced rate parking. If the event is a members-only event, then the “per person” cost to the organization, not including overhead, is within the limitations mentioned for low cost items.
If the nonprofit is going to solicit quid pro quo donations, then a disclosure statement needs to be included in such a way that it will be apparent to the donor and not buried in small print.
Jack, the development director of Save the Barred Owl, a 501(C) (3) organization, was drafting acknowledgement letters to send to donors. Two examples follow.
Letter to Mrs. Aurora for her contribution of goods—no goods or services received by donor
Thank you for your donation of three pairs of Bushnell PowerView 20 x 50 Super High-Powered Surveillance Binoculars on January 15, 2011. We appreciate your support of Save the Barred Owl. No goods or services were provided in connection with this donation.
Letter to Mr. Walker for his contribution of cash—goods or services received by donor
Thank you for your $2,000 donation on January 15, 2011. We appreciate your responsiveness to our pledge drive and your support of Save the Barred Owl. In appreciation for your gift, we are sending you a CD featuring natural bird sounds called Bird Song Ear Training Guide that is valued at $12.
Nonprofits need to ensure that acknowledgements are provided and that they meet the requirements mentioned. The penalty for noncompliance is $10 per contribution, not to exceed $5,000 per fundraising event or mailing. This can only be abated if the charitable organization shows that the failure to meet the requirement was due to a reasonable cause.
Filling out the Form 990, the information tax return, is a time-consuming process, but it is critically important that the tax-exempt organization devote sufficient resources to preparing and reviewing it. As discussed in this and preceding chapters, the form was revised to include a significant section related to governance. The sections of the form related to governance will be heavily scrutinized by the IRS and watchdog agencies, not to mention funding sources. See appendix C for a handy checklist of those items.
The Form 990 consists of a core form with 11 parts and 16 schedules. Not all of the schedules will be required of each organization.
|Elements of the IRS Form 990 Core Form|
|Part I||Summary (mission and significant activities and summary information about the revenues, expenses, and net assets of the organization)|
|Part II||Signature Block|
|Part III||Statement of Program Service Accomplishments (program services and accomplishments, changes in programs and services, and three largest programs by expenses)|
|Part IV||Checklist of Required Schedules|
|Part V||Statements Regarding Other IRS Filings and Tax Compliance|
|Part VI||Governance, Management, and Disclosure (including a section on policies) (see Appendix C for a list of the policies referred to in Form 990 and its schedules.)|
|Part VII||Compensation of Officers, Directors, Trustees, Key Employees, Highest Compensated Employees, and Independent Contractors|
|Part VIII||Statement of Revenue|
|Part IX||Statement of Functional Expenses|
|Part X||Balance Sheet|
|Part XI||Reconciliation of Net Assets|
|Part XII||Financial Statements and Reporting|
|Form 990 Schedules|
|Schedule A||Public Charity Status and Public Support||Public support tests|
|Schedule B||Schedule of Contributors||Requires contributions to be identified in detail if they are 2% of contributions or $5,000 if the organization is a 501(c) (3). The threshold for all others is $5,000.|
|Schedule C||Political Campaign and Lobbying Activities||Questions related to involvement in political activities and calculation of excess lobbying expenditures|
|Schedule D||Supplemental Financial Statements||Information about donor advised funds, conservation easements, collections of art and historical treasures, trust, escrow and custodial arrangements, endowment funds, land, buildings and equipment, securities, program related investments, other assets and other liabilities, request for text of the Uncertain Tax Position footnote, reconciliation of change in net assets from Form 990 to financial statements, reconciliation of revenue per the audited financial statements with revenue per return, and reconciliation of expenses per audited financial statements with expenses per the return|
|Schedule E||Schools||Questions about schools related to racial discrimination and financial aid from governmental agencies|
|Schedule F||Statement of Activities Outside the United States||Questions about grants made to individuals and organizations as well as activities conducted outside the United States|
|Schedule G||Supplemental Information Regarding Fundraising or Gaming Activities||Questions about fund-raising activities, fund-raising events, and gaming activities|
|Schedule H||Hospitals||Includes information about the organization and its charity care, bad debts, joint ventures and management companies, and information about the community benefit it provides|
|Schedule I||Grants and Other Assistance to Organizations, Governments, and Individuals in the United States||Information on grants and assistance provided to those inside the United States|
|Schedule J||Compensation Information||Although certain questions on compensation exist in the core form, Schedule J requires more information about compensation for certain parties at certain levels. Included here are benefits, such as first-class air travel, club dues, use of personal residence, along with retirement and other benefits.|
|Schedule K||Supplemental Information on Tax-Exempt Bonds||Bond issues, proceeds, and private business use|
|Schedule L||Transactions With Interested Persons||This schedule will help the IRS pay closer attention to those that might have excess benefit transactions. The items covered in this schedule are loans, grants, or assistance to interested persons.|
|Schedule M||Noncash Contributions||Types of property; donated services are not included.|
|Schedule N||Liquidation, Termination, Dissolution, or Significant Disposition of Assets||To be completed when the organization is terminating|
|Schedule O||Supplemental Information to Form 990 or 990-EZ||To be completed with explanatory information when necessary|
|Schedule P||Related Organizations and Unrelated Partnerships||Provides information about related organizations|
See appendix A for a checklist that could be used for the board’s review of Form 990.
Organizations that are exempt under section 501(C) (3) are subject to tax on UBI. The tax applied is at the regular corporate rate. As noted, organizations that have gross income from businesses unrelated to their tax-exempt mission of $1,000 or more are required to file Form 990-T. If the organization believes that it will have net UBI of $500 or more, then it should be making estimated payments every quarter. Estimated payments are due by the 15th day of the 4th, 6th, 9th, and 12th months of the tax year.
UBI is the income from a trade or business that is carried on regularly by an exempt organization when the purpose of the activity is not substantially related to its tax-exempt purpose. The purpose of this requirement is to ensure that tax-exempt organizations do not compete unfairly with commercial enterprises. Even if the net proceeds from the trade or business will be used to further the organization’s tax-exempt mission, it is still UBI.
Saint Francis, a nonprofit school, holds a Halloween Carnival each year. Although this activity may compete with commercial carnivals, it is an activity that happens once a year. To qualify as UBI, the business activities must be carried on regularly, which would generally mean throughout the year. Therefore, the carnival would not give rise to UBI.
Durham Rehabilitation Center provides overnight accommodations for those individuals trying to improve their lives who currently are homeless. In addition, the center provides a handyperson service that employs the current residents of the center for a period of up to six months. The profits from this business are used to finance activities of the center. Although the center’s handyperson service is a business that is regularly carried out, the income is not UBI because the business contributes to the organization’s mission to help rehabilitate homeless individuals.
There are several activities excluded from the definition of UBI. Some of the most common are as follows:
- Volunteer work force. If the activity is conducted with a volunteer work force, then the income is not UBI even if the business is regularly carried on and not related to the organization’s tax-exempt purpose. Examples are a thrift store and dances at which the workers are volunteers.
CAUTION: Nonprofits should be careful. There have been cases in which the volunteers were given free meals and, in some cases, tips. This can negate the exclusion.
- Convenience of members. If the activity is operated for the convenience of members, students, patients, officers, or employees, then it would be exempt from UBI. Examples are a cafeteria in a school and a pharmacy in a hospital.
CAUTION: In some cases, in which others are using the services, the services may not be considered “for the convenience” services. For example, if a nonprofit hospital has a pharmacy that is in the hospital, then it is not likely that anyone other than the patients would use it. But if it were free standing in a shopping center with easy access to the public, people who are not patients might use it.
- Sponsorship payments. When a nonprofit receives a payment from a sponsor and the only benefit the sponsor derives is the inclusion of his or her company’s name or logo or use of products, this is a qualified sponsorship payment, and there is no UBI. An example is a fundraising event like a golf tournament at which sponsors names are displayed on banners.
CAUTION: If the sponsor is sponsoring a trade show or convention, this may be UBI.
- Selling donated merchandise. When substantially all of the merchandise being sold in a business activity is donated, it does not result in UBI. Examples are a thrift store and used book store.
CAUTION: Nonprofits sometimes find opportunities to buy merchandise at deeply discounted prices. If a used book store, for example, decides to sell both donated and purchased merchandise UBI could result.
- Pole rental. Pole rentals are not considered unrelated trade or business when rented by a mutual or cooperative telephone or electric company described in section 501(c) (12).
What may not be considered UBI in one setting may be considered UBI in another setting.
Asparagus Fern Science Center has an auditorium where it shows films related to natural science to schools and other groups. It charges a small fee on top of the entrance fee for admission. In addition, to bring in more money when the science center is closed, the theater shows movies that are 40 to 50 years old to the public. They found that many people appreciate seeing movies from the 60s and 70s on a big screen. The science center does not have UBI when it shows the scientific films during normal operating hours, but it does have UBI when it shows the old movies after hours.
More examples can be found in the IRS publication 598, “Tax on Unrelated Business Income of Exempt Organizations,” which can be accessed at www.irs.gov/pub/irs-pdf/p598.pdf.
There are also several types of income that are excluded from UBI:
- Dividends, interest, annuities, and other investment income
- Income from lending securities
- Rents (there are certain exceptions)
- Income from research
- Gain or loss on disposition of property
- Income from services provided under federal license
- Member income of mutual or cooperative electric companies
Income that is derived from debt-financed property is considered UBI even though it might otherwise be excluded. There are exceptions to this as well. If the property is substantially related (85 percent or more) to the tax-exempt purpose, then the property is not treated as debt-financed property. Other exceptions are if the property is leased to a medical clinic and the lease is primarily for purposes related to the lessor’s exercise of its tax-exempt mission, and the property is used in research activities. Nonprofits should read IRS Publication 598 to ensure that they are aware of all the exceptions.
Where there is a business there are also costs of conducting the business. Nonprofits should keep good records of all the possible expenses that could be deducted against UBI including overhead.
There are many issues that could trigger an IRS audit. The IRS can make office and correspondence examinations, field examinations, and team examinations, all of which tie up the nonprofit’s resources, including valuable time. Recently, the primary issues appear to be
- Tax-exempt status
- Public charity or private foundation classification
- Excessive advocacy activities
- Payroll tax related issues
- Involvement in conservation easements, donor advised funds, and joint ventures
- UBI issues
- Political campaign activities
- Executive compensation
- Community benefit for hospitals
- Excess benefits
- Fundraising costs
- Tax-exempt bond recordkeeping
- Charitable giving scams
The best thing a board can do related to tax issues is to ensure that management is well versed in these issues and complies with all laws and regulations. In organizations in which the staff is not sufficiently knowledgeable, there is no substitute for a tax professional who has a deep understanding of the issues affecting tax-exempt organizations. A tax professional maintains current knowledge and has resources at his or her fingertips to help the organization protect and, if necessary, defend its tax-exempt status.
Board members need an understanding of the issues that nonprofits must consider related to obtaining and maintaining tax-exempt status in order to perform important monitoring activities. Although this chapter provides the board member with an overview of the most important aspects related to an exempt organization’s tax status, it is no substitute for the assistance and advice of a tax professional who specializes in the area. Tax regulations are voluminous and complex, and they are subject to change. A tax professional keeps abreast of not only the issues but also the IRS hot buttons that will be areas of risk to the tax-exempt organization. Nonprofit board members and executives can use the information in this chapter to participate intelligently in a board in review of the Form 990 and to know when additional consultation with a tax professional is necessary.
|Part||Description||Important Questions for Board’s Review|
|Part I||Summary (mission and significant activities and summary information about the revenues, expenses, and net assets of the organization)||
1. Is the mission described accurately?
2. Would the description attract potential donors?
3. Does it agree to the Form 1023/1024?
4. Are the data comparable with the prior year? If not, why not? Is it favorable or unfavorable?
|Part II||Signature Block||N/A|
|Part III||Statement of Program Service Accomplishments (program services and accomplishments, changes in programs and services, and three largest programs by expenses)||
1. Is the description of the program services consistent with its mission, the Form 1023/1024, and the website?
2. Are the services described in enough detail to assist the user in understanding them?
Checklist of Required
1. Is the organization engaged in some activity, such as conservation easements, donor advised funds, gaming, or other types of activities, that are the subject of additional scrutiny by the IRS?
2. Did the organization answer "yes" to lines 25a, 25b, 26, or 27 relating to excess benefit transactions and loans, grants or assistance to officers, directors, key employees, or substantial donors? If so, should policies be examined?
|Part V||Statements Regarding Other IRS Filings and Tax Compliance||
1. Has the organization followed the IRS rules related to classification of personnel as employees versus independent contractors?
2. Have all the payroll taxes been deposited on a timely basis with the IRS?
3. Were any other required filings made on a timely basis (also see Appendix B)? If not, this could indicate poor internal controls.
4. Were the rules related to donor acknowledgement followed, and were acknowledgements provided on a timely basis so that donors could substantiate their deductions?
5. Is there a likelihood that the organization is subject to interest and penalties? Examine lines 3b, 6b, 7h (should be answered yes) and 5a, 5b, 8, 9a, and 9b (should be answered no).
|Part VI||Governance, Management, and Disclosure (including a section on policies) (see Appendix C for a list of the policies referred to in Form 990 and its schedules.)||
1. Are the written policies and procedures covered in this section adopted by the organization, and is the board certain that the documentation is available?
2. Is the organization conducting activities in multiple states, and, if so, has it been registered?
|Part VII||Compensation of Officers, Directors, Trustees, Key Employees, Highest Compensated Employees, and Independent Contractors||Consider the compensation of the persons listed on the form and evaluate whether the compensation appears reasonable. Is there documentation available to support it? How would a member of the donor community, or the organizations potential donors and funding sources, view the compensation related to that of other organizations of similar size?|
|Part VIII||Statement of Revenue||Examine the sources of revenue to ensure that the organization is appropriately diversified. Are there actions that should be taken to cushion the risk to the organization?|
|Part IX||Statement of Functional Expenses||
1. Consider the expenditures in terms of how the resources are being expended. Evaluate in the light of prior years.
2. How large a percentage is compensation and benefits?
3. Has the board specified a procedure for approval of nonroutine and nonfixed expenditures in excess of a certain amount?
4. Consider the propriety of amounts spent for outside management services, legal and accounting, investment management fees, advertising, travel, rent, lobbying, and professional fundraising services.
5. How would a donor or funding source view the percentage of expenditures spent on management in general and fundraising?
|Part X||Balance Sheet||
1. Is there excess cash, and is it in an interest-bearing vehicle?
2. Are there significant related party loans? Is there adequate oversight?
3. Are receivables being monitored for collectability?
4. Are liabilities being held too long due to cash flow issues?
5. Are restrictions on net assets being met?
|Part XI||Reconciliation of Net Assets||Was a reconciliation of net assets performed?|
|Part XII||Financial Statements and Reporting||
1. Should the organization consider an independent audit if it doesn’t presently have one?
2. Do the auditors report to the audit committee or to the governing board?
3. Does each member of the governing board or group overseeing the audit receive a copy of the letter(s), including significant deficiencies, material weaknesses, or constructive service comments?
|Schedule A||Public Charity Status and Public Support||
1. Is the organization in danger of becoming a private foundation?
2. What could it do to increase the amount of public support?
|Schedule C||Political Campaign and Lobbying Activities||
1. Is the organization in danger of too much lobbying? What steps could it take to reduce the amount and still be effective?
2. Is the organization participating in activities that could jeopardize its tax-exempt status?
|Schedule D||Supplemental Financial Statements||Are there activities under IRS scrutiny in which the organization should review the adequacy of its internal controls and documentation?|
|Schedule E||Schools||Does the school have the appropriate controls in place to prevent discrimination?|
|Schedule G||Supplemental Information Regarding Fundraising or Gaming Activities||
1. Are there any activities, such as those with professional fundraisers, that need additional evaluation?
2. Does the board approve contracts with professional fundraisers?
3. Do the gaming activities constitute unrelated business income because of indirect compensation of volunteers?
|Schedule H||Hospitals||Is the hospital collecting the appropriate information? Is any valuable information being missed? Is the hospital in danger of not meeting the community benefit standard?|
|Schedule J||Compensation Information||
1. If any of the boxes on line 1a are checked, is the benefit really warranted?
2. Is there strict accountability for expense reimbursement?
3. Does the organization set compensation with an appropriate method?
|Schedule L||Transactions With Interested Persons||Has the organization disclosed all the direct or indirect transactions or relationships required?|
|Schedule O||Supplemental Information to Form 990 or 990-EZ||
1. Has Schedule O been used to its best advantage by providing explanatory material to "no" answers?
2. If any fraud was detected in the organization, was it described?
3. Was the way information is made public disclosed on Schedule O?
4. Are transactions with interested persons disclosed?
5. Does the schedule describe the Form 990 board review process?
|Schedule R||Related Organizations and Unrelated Partnerships||Are all required relationships disclosed?|
|Independent Contractors and Lessors|
|Return or Form||To Report or Pay||Frequency||When Due|
|1096||Transmittal form for 1099s||Annual||AnnFeb 28|
|1099-INT||Report payments of interest to unincorporated entities of $10 or more in a calendar year||Annual||Payee: Jan 31
IRS: Feb 28
|1099-MISC||Report payments of $600 or more to unincorporated entities for the following:
||Annual||Payee: Jan 31
IRS: Feb 28
|Return or Form||To Report or Pay||Frequency||When Due|
|940, 940-EZ||Employer’s federal unemployment tax||Annual||Jan 31|
|941||To report employer social security taxes and income and social security taxes withheld from employees||Quarterly||Apr 30, Jul 31, Oct 31, Jan 31|
|943||Farm worker wages and withheld payroll taxes||Annual||Jan 31 (Feb 10 if timely deposits)|
|1099-R||Distributions from retirement or profit sharing plans, IRAs, simplified employee pensions, insurance contracts||Annual||Payee: Jan 31
IRS: Feb 28
|5500, 5500-C/R||Employer-maintained employee benefit plan information report||Annual||Jul 31 (or last day of 7th month after end of plan year if fiscal year)|
|W-2||Report wages, other compensation, withheld and employer-paid payroll taxes (income, social security, Medicare)||Annual||Payee: Jan 31
Administration: Feb 28
|W-3||Transmittal form forW-2s||Annual||Feb 28|
|Other Tax Returns|
|Return or Form||To Report or Pay||Frequency||When Due|
|720||Various federal excise taxes||Quarterly||Apr 30, Jul 31, Oct 31, Jan 31|
|990-T||Unrelated business taxable income (if gross income $1,000 or more), or Internal Revenue Code (IRC) Section 6033(e)(2) proxy tax||Annual||15th day of 5th month after tax year-end|
|990-W||Calculate estimated tax payments on unrelated business income and private foundation net investment income||Quarterly||Payments: 15th day of 4th, 6th, 9th, 12th month of tax year Form: Retained by taxpayer|
|1041||Filed by Sec. 4947(a)(1) charitable trusts if any taxable income or gross receipts $600 or more||Annual||15th day of 4th month after tax year-end|
|1120||Filed by 501(c) organization if not a political organization and has Sec. 527(f)(1) political organization taxable income||Annual||15th day of 3rd month after tax year-end|
|1120-POL||Filed by Sec. 527 political organizations if political organization taxable income over $100 OR gross receipts over $25,000||Annual||
15th day of 3rd month
after tax year-end
|4720||By Sec. 501(c)(3) organizations, managers, tax related to the following:
Also by private foundations for certain excise taxes
15th day of 5th month
after tax year-end
|Return or Form||To Report or Pay||Frequency||When Due|
|945||Report nonpayroll income tax withholding||Annual||Jan 31 (Feb 10 if timely deposits)|
|1098||Report mortgage interest received in a trade or business from an individual or sole proprietor if $600 or more||Annual||Payee: Jan 31
IRS: Feb 28
|1098-C||Report contribution of a qualified vehicle over $500. Copy B to donor to attach to income tax return||Annual||IRS: Feb 28 As acknowledgment to donor, 30 days after arms-length sale or if to be improved, used, or sold cheaply to needy individual, then 30 days after contribution|
|1098-E||Report $600 or more of student loan interest from an individual in the course of a trade or business||Annual||Payee: Jan 31
IRS: Feb 28
|1098-T||Eligible educational institutions: Report tuition for each student with a reportable transaction||Annual||Payee: Jan 31
IRS: Feb 28
|1099-B||Broker or barter exchange: Report certain transactions||Annual||Payee: Jan 31
IRS: Feb 28
|1099-C||Organizations in the trade or business of lending money: Report $600 or more of debt cancellation||Annual||Payee: Jan 31
IRS: Feb 28
|3115||Apply for a change in accounting method||N/A||With Form 990 or Form 990-EZ, AND on or after 1st day of year of change but not later than when tax return filed|
|3800||Claim certain tax credits||Annual||With Form 990-T|
|4562||Report depreciation and amortization||Annual||With Form 990-T|
|8275, 8275-R||Disclose positions taken in Form 990-T contrary to Treasury regulations||Annual||With Form 990-T|
|8282||Report disposition of donated property valued over $5,000 and held less than three years||N/A||125 days after disposition|
|8283||Report noncash charitable contributions||Annual||With Form 990-T|
|8300||Report receipt of cash in trade or business (except charitable contributions) of $10,000 or more||N/A||15th day after receipt of cash|
|8868||Request extension of time to file Forms 990, 990-EZ, or 990-PF||N/A||By 15th day of 5th month after tax year-end (initial)|
|Other Tax Returns|
|Return or Form||To Report or Pay||Frequency||When Due|
|8870||Information report on certain personal benefit contracts||Annual||Charitable remainder trust: Apr 15
Others: 15th day of 5th month after tax year-end
|8886-T||Report participation in a prohibited tax shelter transaction||Various||Various|
|8899||Charitable donee: Report net income from qualified intellectual property to its donor and IRS||Various||Last day of 1st month after donee’s tax year-end|
|SS-4||Organization’s application for employer identification number||N/A||No deadline, but the sooner the better|
|W-2G||Report charitable fundraising event prizes of $600 or more each||Annual||Following year— To winner: Jan 31 To IRS: Feb 28|
|W-9||Request tax ID number of winner of prize of $600 or more||N/A||Before prize awarded|
|TD F 90–22.1||Report financial interest in, or signature or other authority over, a foreign financial account if aggregate value over $10,000 at any time during the calendar year||Annual||June 30|
|Does the organization have this policy or procedure?||Yes||No||If no, why not?||Where documented?|
|Meetings of the governing board and committees that represent those charged with governance|
|Adequate Form 990 review process|
|Conflict of interest monitoring policy|
|Public disclosure of documents policy|
|Endowment spending and accumulation practices|
|Appropriate footnote for uncertain tax positions attached to Form 990|
|Financial statements compiled, reviewed, or audited|
|Policy against discrimination (schools)|
|Charity care policy for hospitals|
|Bad debt policy for hospitals|
|Thorough disclosure of community benefit activities for hospitals|
|Collection practices for patients known to qualify for charity care or financial assistance|
|Gift acceptance policy|
|Did the organization have this issue?||Yes||No||N/A||What controls will be put in place to remediate the deficiency?|
|A material diversion of assets|
|Inadequate policies over donor advised funds|
|Inadequate policies over conservation easements|
|Failure to require substantiation of expenses|
|Inadequate level of documentation for compensation decisions|
|Inadequate documentation for transactions with related organization or interested parties|