Christina K. Patten, EA
Tax-exempt status with the Internal Revenue Service (IRS) has its perks, the most beneficial being exemption from paying federal income taxes, allowing the net income of an organization to be used in furtherance of its tax-exempt purpose. Other beneficial perks include allowing the organization to receive charitable contributions and, if qualified, government funding.
Once an organization is established as tax-exempt under Internal Revenue Code (IRC) section 501(c)(3), the organization’s governing board members and officers must ensure that the organization maintains its tax-exempt status and meets its ongoing compliance responsibilities. A governing board should be composed of persons who are informed and active in overseeing the organization’s operations and finances, and ensure the organization’s tax-exempt status is properly maintained.
The following are a few ways a tax-exempt organization can maintain its exemption and public charity status:
Comply with Federal Tax Law
IRC section 501(c)(3) requires tax-exempt organizations to comply with federal tax law to maintain their tax-exempt status and avoid penalties. Under IRC section 501(c)(3), an organization must not be organized or operated for the benefit of private interests, and no part of the net earnings may inure to the benefit of any private shareholder or individual. If the organization engages in an excess benefit transaction with a person having substantial influence over the organization, an excise tax may be imposed on the person and any organization managers who knowingly participated in the transaction. Additionally, the organization may not attempt to influence legislation as a substantial part of its activities and it may not participate in any political campaign activity for or against political candidates.
Pay Employment Taxes
Although a tax-exempt organization is exempt from federal, state or local income taxes, it is responsible for employment taxes. The tax-exempt organization must withhold, deposit and pay employment tax, including federal income tax withholding and Social Security and Medicare (FICA) taxes. IRC section 501(c) (3) organizations do not pay federal unemployment (FUTA) tax. Employment taxes are reported on Form 941, Employer’s Quarterly Federal Tax Return. The organization is subject to penalties if it fails to withhold and pay employment tax.
The organization is responsible for determining whether individuals providing services are employees or independent contractors. The organization can be held liable for employment taxes, plus interest and penalties, if a worker is incorrectly classified as an independent contractor. Generally, the organization does not have to withhold or pay employment tax on payments to independent contractors but may have to file a Form 1099.
Be Aware of Unrelated Business Income Tax
Unrelated Business Income (UBI) is income from a trade or business, regularly carried on that is not substantially related to an organization’s exempt purpose. If an organization has $1,000 or more of UBI during a tax year, Form 990-T must be filed. Excessive UBI, which the IRS has not specifically quantified, may result in the IRS taking the position that the organization is not operated exclusively for exempt purposes, thereby jeopardizing it tax-exempt status.
Pass the Public Support Test
Most organizations exempt under IRC section 501(c)(3) are required to pass an annual public support test in order to maintain their tax-exempt status. If the organization cannot meet the public support test for two consecutive years, it may be reclassified as a private foundation as of the start of the second consecutive year. Certain types of organizations are exempt from this test such as churches, schools and colleges, hospitals and supporting organizations.
An organization’s annual public support test is reported on its Federal Form 990, Schedule A, Part II or Part III. Part II applies to organizations that are described in IRC section 170(b)(1)(iv) and 509(a)(1) which normally receive a substantial part of support from a governmental unit or from the general public, in general, one third. Part III applies to organizations described in IRC section 509(a)(2) which normally receive (1) more than one-third of their support from contributions, membership fees and gross receipts related to exempt functions, and (2) no more than one-third of their support from gross investment income and unrelated business income. Each of the tests looks at the cumulative support for the year being reported plus the prior four years, so any one year is not definitive in terms of passing or failing the public support test.
Should an organization under IRC section 509(a)(1) receive less than one-third but more than 10 percent of its support from the general public or a governmental unit, it can qualify as a public charity if it can establish that, under a “facts and circumstances test,” it normally receives a substantial part of its support from the general public or a governmental unit. The “facts and circumstances test” is not available for organizations under IRC section 509(a)(2). The organization must establish on Federal Form 990, Schedule A, Part IV how the organization meets the “facts and circumstances test” in accordance with the criteria found in IRS Regulations section 1.170A-9(f)(3).
Newly formed organizations that would otherwise be subject to the annual support test are treated as meeting the test during their initial five years. After their first five years, they must meet the public support test, which is based on a five-year computation period that consists of the current year and the four years immediately preceding the current year.
When completing the annual public support test, either on Part II or III of Schedule A, unusual grants are excluded. Unusual grants are grants and bequests from disinterested persons or organizations that are (1) attracted because of the organization’s publicly supported nature, (2) unusual and unexpected because of the amount, and (3) large enough to endanger the organization’s status with regard to meeting the one-third public support test or the 10 percent facts and circumstances test. The most common unusual grants are typically large bequests from estates or large one-time “startup” grants received early in an organization’s life.
The organization should pay attention if public support percentages are decreasing and should consider ways to gain more public support in order to avoid ultimately failing the test. Projections can be made for future years to determine approximately what is going to be required to pass the test.
File Annual Form 990
Tax-exempt organizations that are required to file annually must file IRS Form 990-N, 990-EZ or 990 depending on the organization’s total annual receipts and total assets. Please be aware that supporting organizations, regardless of threshold amounts, are not allowed to file Form 990-N. Failure to file for three consecutive years results in automatic revocation of tax-exempt status (IRC section 6033(j)). The list of organizations whose tax-exempt status has been automatically revoked is available to the public on the IRS website. This Auto-Revocation List can be viewed and searched on Exempt Organizations Select Check.
This article originally appeared in BDO USA, LLP’s “Nonprofit Standard Newsletter” (Winter, 2017). Copyright© 2017 BDO USA, LLP. All rights reserved. www.bdo.com
