Guidelines to Help Protect Your 501(c)(3) Tax Exempt Status
Whether your organization is seeking exemption from federal income tax under Section 501(c)(3) of the Internal Revenue Code (IRC) or you have been exempt for years, you’re going to want to do everything you can to protect and preserve that status.
For most organizations, staying exempt is a matter of good governance, sound financial management, ongoing compliance, and the ability to meet certain organizational and operational tests. These are basically the same tests that allowed your organization to secure exempt status in the first place. Consistently applying them to your operations, performing regular check-ups, and regularly reviewing your organizational documents will help you stay off the IRS’s radar.
The operational test asks: what is your purpose?
An organization only qualifies for exemption under Section 501(c)(3) “if it engages primarily in activities which accomplish one or more of such exempt purposes.” Qualifying exempt purposes include:
- Charity (generally defined as helping those less fortunate and those in need)
- Education (includes private schools at all levels)
- Religious (congregations of all faiths and organizations focusing on religious practices and issues)
- Scientific (medical, scientific, and technical research are prime examples)
- Literary purposes (groups promoting reading, literacy, English as a second language)
- Testing for public safety (everything from electrical appliances to elevators and vehicles)
- Amateur athletic activities (all levels of athletics and local youth sports organizations)
- Prevention of cruelty to children and animals (animal shelters, child abuse prevention)
It’s possible to qualify under more than one purpose. For example, you may be a private college (education) operated by a religious institution such as the Catholic Church. Any group that doesn’t pass muster here may be able to obtain exemption under another section of the IRC. Social clubs, business leagues, fraternal societies, veteran’s groups, and political organizations are all covered elsewhere in Section 501, and each of these classifications has its own requirements.
The organizational test can be met with documentation
For your nonprofit to pass the IRS’s organizational test, properly drafted organizing documents ― prepared at the inception of the group and periodically reviewed to maintain currency — should include the following:
- A purposes clause, which limits the purpose(s) of the organization to one or more of the exempt purposes described above
- A powers clause, which limits the organization's activities to those that further its exempt purpose(s)
- A provision prohibiting private inurement and limiting private benefit (explained below)
- A dissolution clause, which dedicates the organization's assets solely to exempt purposes and ensures that, on dissolution of the organization, any remaining assets will be distributed for one or more exempt purposes, to one or more Section 501(c)(3) exempt organizations, or to the federal or state government
- A provision prohibiting participation or intervention in political campaigns
- A provision limiting lobbying activity
The threat of private benefit and inurement
Your organization must operate for the benefit of the public. Period. If an individual connected to the organization receives a private benefit, you could lose your exempt status and face other penalties. The IRC’s threshold for judging the significance of a private benefit is somewhat vague; it says that exemption can be denied if the benefit to a private person is more than “insubstantial.” Furthermore, the private person or persons do not have to be those with substantial influence or control over the organizations, such as the CEO, the president, or the treasurer.
Section 501(c)(3) provides that an organization can lose its exemption if part or all of its net earnings inure to (benefit) any private shareholder or individual, which it defines as “persons having a personal and private interest in the activities of the organization.”
As you can see, the private benefit limitation applies more broadly than does the inurement prohibition. Limits on private benefit, in contrast to the prohibition on inurement, are not absolute.
Sanctions and penalties for excess benefit transactions
Since the IRS’s only recourse when private benefit and private inurement surface is to terminate the organization’s exempt status, it created another means of dealing with some of these instances. These are called excess benefit transactions. There are two types:
- Any transaction in which an economic benefit is provided to a disqualified person (i.e., any individual, corporation, or other entity that is in a position to exercise substantial influence over the affairs of the organization in the preceding five-years). This includes officers and members of the board of directors.
- Any transaction in which the amount of an economic benefit provided to or for the use of a disqualified person is determined by the revenue of activities of the organization, but only if the transaction results in inurement.
Examples of excess benefit transactions might include higher-than-market compensation, low interest loans to a board member or executive, buying property from the organization at less-than-market value, selling property to the organization at above-market value, or payment of below-market rent.
If the IRS determines that an excess benefit transaction has occurred, there can be significant consequences for the organization and the individuals involved. The person who received the excess benefit must immediately repay the amount to the organization. The exempt organization and anyone in the organization that was involved in the transaction can also face penalties. Known as intermediate sanctions, these penalties allow the organization to correct the error without losing its 501(c)(3) status.
Sometimes the damage to an organization’s reputation can last longer and be felt more keenly than the financial consequences. In fact, there may be wide-ranging fallout with volunteers, donors, the public, and the management team. Climbing back from such a serious blow can take years and the besmirched reputation of individuals and organizations may never be the same again.
How we can help
CLA’s experienced nonprofit professionals can provide a thorough examination of your group’s organizing documents, help you revise language if needed (with the assistance of your legal counsel), and suggest amendments that can help you align with IRS requirements. Of course, we would not want to see your organization receive an IRS notice questioning its status, but if one does arrive, we can help you make the changes necessary to preserve your 501(c)(3) exemption.