Whether a large established charity, a small not-for-profit private foundation, a school club, or anything in between, there are many ways for not-for-profit organizations to run afoul of IRS rules and regulations. A simple misstep in management can change the organization from a tax-exempt entity to a taxpaying entity and result in substantial taxes on the organization’s management. This article addresses a few of the critical issues facing not-for-profits who wish to remain tax exempt.
What to File and When
Most not-for-profit organizations’ only interaction with the IRS involves the submission of an annual information report, Form 990, at the end of the year. This imposing form requires detailed reporting of revenue, expense items, and balance sheets. The most intimidating facet, however, is Form 990’s required nonfinancial disclosures. Over 100 questions await the Form 990 preparer, covering topics such as officer and director compensation, governance, programming, lobbying, and political activity. Up to 16 additional schedules may also be required depending on the organization’s operations, such as Schedule A for public charities, Schedule B for a list of contributors, and Schedule C for political and lobbying activities. Form 990 is due by the 15th day of the fifth month after the not-for-profit’s year-end. An automatic three-month extension is available to not-for-profit filers who file Form 8868, and a second, nonautomatic three-month extension may also be requested.
Some degree of relief is available to smaller organizations. Many not-for-profits with gross receipts less than $200,000 and total assets less than $50,000 at year-end can file Form 990-EZ, which requires roughly half the information reported in Form 990. Form 990-EZ is also due by the 15th day of the fifth month after year-end, and automatic and nonautomatic extensions of time are also available. Form 990-N is available to many not-for-profits whose annual revenues are $50,000 or less. Known as the e-Postcard, this form is filed online and requires answering eight basic questions. It is also due by the 15th day of the fifth month after year-end, but no extension is available.
There are several key issues that should be reviewed and addressed by board members, management, donors, and accountants prior to an annual Form 990 filing. Lack of attention to these topics could, in some cases, lead to substantial excise taxes and the possible loss of not-for-profit status.
Paramount among these issues is the determination of reasonable compensation paid by the entity; no other single item on Form 990 requires such an extensive level of reporting. This is not unfair; donors and other sources of funding rightfully have an expectation that their support is being prudently used and not improperly enriching employees. Not-for-profits are required to report individual compensation information for officers, directors, trustees, key employees, highly compensated employees, and independent contractors on Form 990. A determination by the IRS of excess benefits, including compensation, paid to these parties will result in an excise tax of 25% imposed on the recipient and potentially an excise tax of 10% on the organization’s manager. The size, scope, number of excess transactions, safeguards, and corrections of past transactions may also lead the IRS to revoke an organization’s not-for-profit status.
The IRS defines reasonable compensation as the value that would ordinarily be paid for like services by like enterprises under like circumstances. There is a rebuttable assumption of reasonableness if the following three conditions are met:
The transaction is approved by an authorized body of the organization (or an entity it controls) composed of individuals who do not have a conflict of interest concerning the transaction;
Before making its determination, the authorized body obtained and relied upon appropriate data as to comparability; and
The authorized body adequately documents the basis for its determination concurrent with that determination.
Adherence to this process is the linchpin to avoiding the taxes associated with a finding of unreasonable compensation.
Not-for-profit entities are allowed to spend money to influence legislation. Approximately 2.5% of not-for-profit organizations reported lobbying in 2013, with an average lobbying expenditure of $100,513. In general, entities considered not-for-profit via sections 501(c)(4) (social welfare organizations), 501(c)(5) (agricultural and horticultural organizations), and 501(c)(6) (business leagues, chambers of commerce, boards of trade, and similar organizations) of the IRC have substantial freedom to lobby, but offer no tax deduction to contributors for donations used in lobbying. Specific rules, however, limit the amount of lobbying allowed by section 501(c)(3) entities (public charities and private foundations). In general, an organization may not qualify for section 501(c)(3) status if attempting to influence legislation makes up a “substantial part” of its activities. The term “substantial part” may be determined one of two ways:
The substantial part test.
The IRS makes a determination based on the basis of all the pertinent facts and circumstances in each case. The IRS considers a variety of factors, including the time and expenditures devoted by both compensated and volunteer workers to lobbying, when determining whether such activity is substantial.
The expenditure test.
Organizations other than churches and private foundations may elect the expenditure test as an alternative method for evaluating lobbying activity; once this election has been made, it remains in effect for all future years until revoked. Under the expenditure test, the extent of an organization’s lobbying activity will not jeopardize its tax-exempt status, provided the expenditures related to such activity do not normally exceed an amount calculated using the table in Exhibit 1. This limit is generally based upon the size of the organization and may not exceed $1 million. Attempts to influence the general public on legislative matters, or grassroots lobbying, are also limited to 25% of this total. Should an organization exceed its lobbying expenditure dollar limit in a particular year, it must pay an excise tax equal to 25% of the excess. In addition, if the organization’s average annual total lobbying or grassroots lobbying expenditures over a four-year period are more than 150% of its dollar limits, the organization will lose its exempt status, making all of its income for that period subject to tax.
Limits on Lobbying Expenditures under the Expenditure Test
If the amount of exempt purpose expenditures is:; The lobbying nontaxable amount is:
$500,000; 20% of the exempt purpose expenditures
> $500,00 but ≤ $1,000,000; $100,000 plus 15% of the excess of exempt purpose expenditures over $500,000
> $1,000,000 but ≤ $1,500,000; $175,000 plus 10% of the excess of exempt purpose expenditures over $1 million
> $1,500,000; $225,000 plus 5% of the exempt purpose expenditures over $1,500,000
Not-for-profit organizations must make their three most recent information returns available for the public to review.
Regardless of the test being used, it is imperative for section 501(c)(3) entities to maintain lobbying expenditures within either the limits set by the expenditure test, if elected, or within the more ambiguous limitations of the substantial part test.
The rules governing not-for-profit organizations’ political contributions are similar to the rules for lobbying expenditures. In general, section 501(c)(4), 501(c)(5) and 501(c)(6) entities may make political contributions through use of their own funds or by setting up a separate segregated fund under section 527(f)(3). As with lobbying expenditures, there is no tax deduction for donations used for funding political contributions. Section 501(c)(3) entities are strictly prohibited from participating directly or indirectly in political campaigns, including financial contributions and the making of written or verbal statements in support of or against particular candidates. Section 501(c)(3) entities are allowed to participate in certain nonpartisan voter education activities, such as the publishing of voter education guides. They may also be allowed to participate in nonpartisan activities that encourage individuals to vote, such as voter registration drives.
There is an excise tax on section 501(c)(3) entities that participate in political campaigns of 10% of the amount spent, as well as a 2.5% excise tax on the organization manager who agreed to the expenditure. The latter tax is limited to $5,000 per expenditure. There are additional second-tier taxes on both the not-for-profit and the manager, assessed if the political expenditure is not corrected within a taxable period. “Corrected” means recovery of part or all of the expenditure (to the extent recovery is possible), establishment of safeguards to prevent future political expenditures, and where full recovery is not possible, such additional corrective action as prescribed by IRS regulations. The “taxable period” begins on the day the expenditure is made and ends on the earlier of the mailing for the initial 10% excise tax or the assessment of the initial 10% excise tax. The second-tier tax on the not-for-profit entity is 100% of the expenditure made, and the second-tier tax on the manager is 50%. The IRS may abate these excise taxes in situations where the tax in question was due to reasonable cause, not willful neglect, and the expenditure was properly corrected.
Unrelated business income.
In general, not-for-profit entities do not pay income taxes. If a not-for-profit has “unrelated business income” in excess of $1,000 in a given year, however, it must pay unrelated business income tax and file Form 990-T. For a not-for-profit organization, “unrelated business income” is net income 1) from a trade or business 2) that is regularly conducted by the not-for-profit entity and 3) that is not substantially related to the exempt purpose or function of the organization. Net income not meeting all three of these criteria, such as passive income, is not subject to the tax. The IRC and various regulations provide additional details as to this three-part test, as well as codified exceptions for certain entities.
Unrelated business income tax is calculated using regular corporation tax rates. Form 990-T is due by the 15th day of the fifth month after the not-for-profit’s year-end. For not-for-profit trusts subject to unrelated business income tax, the tax is calculated using regular trust tax rates, and Form 990-T is due by the 15th day of the fourth month after year-end. As with regular income tax, quarterly estimated unrelated business income tax payments are required.
Failure to file Form 990.
Not-for-profit entities with gross receipts of $1 million or less are assessed a penalty of $20 per day after the filing deadline, up to a maximum of the lesser of $10,000 or 5% of the entity’s gross receipts. Late-filing not-for-profit entities with gross receipts greater than $1 million are assessed a penalty of $100 per day, with a maximum of the lesser of $50,000 or 5% of gross receipts. Not-for-profit managers are also subject to assessment of a $10-per-day penalty, with a maximum of $5,000. There is no penalty for late filing of a Form 990-N.
In addition, not-for-profit organizations must make their three most recent information returns available for the public to review. Entities that do not file their annual information return for three years will have their federal taxexempt status automatically revoked. Following loss of not-for-profit status, entities may request reinstatement by filing an application for exemption and paying a fee. If upon reviewing such a request, the IRS determines the entity meets the requirements for not-for-profit status, it will issue a new determination letter to the not-for-profit.
Compliance Is Critical
Not-for-profits enjoy many tax-exempt privileges, but these privileges are subject to stringent requirements. CPAs with not-for-profit clients must stay aware of these requirements, educate their clients about them, and ensure that they are followed to the letter at all times.
Jim Martin, CPA, MPA is the Henrietta and G.W. Snyder Jr. Professor in Business, at Washburn University in Topeka, Kans.
Barbara Scofield, PhD, CPA is a professor of accounting, at Washburn University in Topeka, Kans.