There are several reasons for which a public charity can loss its tax-exempt status – and the most common is also the most easily avoidable. Each year thousands of nonprofits loss their tax-exempt status for failure to fulfill annual filing requirements. More specifically, they fail to file the Form 990, Return of Organization Exempt From Income Tax.
If an organization fails to file the Form 990 for three consecutive years, their nonprofit status is automatically revoked. Even if an organization has no financial activity, it is still required to file the Return of Organization Exempt From Income Tax. However, the IRS has made it fairly easy for organizations without activity to stay in compliance with filing requirements. If gross receipts are under $50,000, the 990N, Electronic Notice (e-Postcard) for Tax-Exempt Organizations Not Required to File Form 990 or Form 990-EZ, can be filed. The only information needed for a 990N is the EIN, name and address, principal officer information and confirmation that gross receipts are under $50,000. For organizations with gross receipts between $50,000 and $200,000 Form 990EZ is available, and for organizations with gross receipts over $200,000 the full Form 990 must be submitted.
The Form 990 is not the only filing required for a nonprofit to stay in good graces with the IRS. Payroll tax reporting must also be in good standing and compliance with state filing requirements is also required. Typically, state requirements would include the filing of a corporate annual report, a charitable solicitation registration and if applicable, sales tax reporting.
Other items that can jeopardize a tax-exempt status relate to proper governance or engagement in activities that preclude an organization for operating for the public good. These activities can include private benefit/inurement, substantial efforts to influence legislation, substantial unrelated business income, operating outside its exempt purpose and improper recordkeeping.
A nonprofit organization may not be organized or operated for the benefit of private interest, and no part of an organization’s earnings may inure to the benefit of individuals. This restriction is to ensure that nonprofits service the public interest, not a private interest. Individuals related to the organization should not receive excessive compensation or payments, nor receive excessive benefit from the activities of a charity.
Lobbying or political campaign activities
A public charity cannot engage in substantial activities to influence legislation, nor can it participate in any campaign activity for or against political candidates. This does not mean that lobbying is completely disallowed. It is fine to have lobbying activity as long as it is not substantial.
Substantial unrelated business income (UBI)
UBI is income from routine trade or business activity that is not related to the exempt purpose of the charitable organization. Income is designated as UBI if 1) the trade or business competes with other business and it is conducted in a commercial manner 2) the trade or business is regularly carried on and 3) the trade or business is not substantially related to the exempt purpose of the organization. If a nonprofit organization generated more than $1,000 in gross income from an unrelated activity, if has to file a Form 990-T and pay tax on this income. But keep in mind, having UBI does not automatically place a nonprofit in jeopardy. The risk for losing exempt status only occurs if UBI becomes a significant revenue stream.
No longer operating for exempt purpose
A public charity typically relies on donor and government funding to operate. If donor or government funds are misused, the IRS can take away the organization’s exempt status. Examples of misuse include the use of funds for illegal activities, or using funds that were restricted for an unintended purpose.
Just like any business entity, proper recordkeeping is required to mitigate misuse of funds or even fraud. Tax-exempt organizations are required to maintain proper accounting and other records necessary to justify their claim for exemption in the event of an audit. Organizations should establish and document internal control policies that include segregation of duties, disclosure of conflict of interest, internal audit and monitoring. In addition, the organization should maintain accurate meeting minutes, donor receipts, and executive compensation policies.
The effect of losing a tax-exempt status can be detrimental to a nonprofit. If status is revoked, the organization will need to pay corporate income tax on annual revenues going forward, and there may be state tax liability as well. Depending on the nature of the revocation, the organization may also be subject to back taxes. And, donors are no longer be able to receive a tax deduction for contributions.
However, if an organization’s tax-exempt status was revoked for failure to file the required Form 990, there is hope. The organization can apply for retroactive reinstatement. How is this done? It’s back to the drawing board. If you’re lucky enough to have retained your original application for recognition of exemption – take it out and dust it off. You need to start the process all over again, but at least this time you have a sample to work from.