How to lose IRS tax-exempt status


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Many people think that once they receive a tax-exempt status determination letter from the IRS, they are all set.  Actually, nothing could be farther from the truth.  While attaining federal tax-exempt status for your nonprofit organization is indeed a big milestone, it is only the beginning.  Now you have to keep that status.  Unfortunately, there are many missteps that can cause 501(c)(3) organizations to lose their status.

Here are five common ways to get your organization stripped of its exempt status (accompanied by a plea from me that you not do any of them):

Mistake 1:  Forget to submit a 990 for three years.

This is probably the easiest way to lose exempt status.  If your organization is required to submit a Form 990 series return and you forget about it for three years running, tax-exempt status is automatically revoked by the IRS.  You will then have to apply for reinstatement and pay the application fees again.

It may seem surprising that an organization’s leadership would just forget to submit a return for three years, but it is very common in small nonprofits with working boards.  The treasurer is often a different person every year, and if one person forgets to tell the next person to do it, it just doesn’t get done.  If the organization’s address is not kept updated, notices may be mailed to the wrong place, so no one sees that anything is amiss.  I am often contacted by organizations whose boards only realized that their status had been revoked when a donor discovered that a contribution was not really tax-deductible.

Action Item:  Use the EO Select Check tool on the IRS website to make sure that your organization’s status is current.  Be sure that you know which form to file and when it is due.

Mistake 2:  Campaign for or against a political candidate.

It is easy to understand why a nonprofit might be interested in getting a certain candidate elected.  After all, one candidate’s views may align nicely with those of your organization, while another one may even represent everything your organization combats on a daily basis.  However, nonprofits should in general not do anything that could appear to favor or oppose a particular candidate, as it could cost them their tax-exempt status.  There has been some political interest in permitting religious organizations to engage in candidate support, but that subject remains an ongoing discussion.   Non-partisan activities (such as encouraging people to vote) are typically acceptable, but they should be designed carefully to fit within IRS guidelines.

Action Item:  Examine your organization’s messaging (including social media) and programming to ensure that you are not inadvertently advocating for or against any particular candidate or party.

Mistake 3:  Do a lot of lobbying.

I’ve found that many nonprofit professionals do not understand what lobbying is, and some are even unknowingly engaging in it.  Some people have picked up dramatic stereotypes from television and films, and envision highly-paid political insiders working on shady deals to influence elected officials.

The truth is rather less exciting.  The IRS sees lobbying simply as attempting to influence legislation.   You may not think that you are engaging in lobbying, since you are not meeting directly with legislators and asking them to vote a certain way.  However, if you are urging supporters of your organization to contact their elected representatives with messages asking them to vote a certain way, you may well be engaging in lobbying activities without even thinking about it.  Organizations whose lobbying efforts make up a substantial part of their overall activities risk losing their exempt status.  Because “substantial” is a fuzzy definition, some nonprofits choose to file an additional form with the IRS to be analyzed based on expenditures instead.

Action Item:  Examine your organization’s activities to determine whether you are lobbying, and if so, determine whether the lobbying exceeds the substantial part test.  If you are concerned or unsure, work with an attorney.

Mistake 4:  Make a lot of money from a business unrelated to your organization’s purpose.

A well-run nonprofit should ensure that it brings in revenue from a variety of sources to diversify its funding and manage the risk of a budget shortfall.  This goal can lead organizations to want to generate revenue through a variety of profit-making ventures, but it is important to be very careful that these ventures are not creating excess unrelated business income (UBI), which could endanger an organization’s exempt status.

The definition of UBI can be a bit complex and situation-specific, so I won’t go in-depth on it here, but the IRS describes it generally as “a trade or business” that is “regularly carried on” and “is not substantially related to furthering the exempt purpose of the organization.”  It would of course be unfair competition for a tax-exempt nonprofit to conduct the same business across the street from a for-profit enterprise engaged in the same work, so the nonprofit may end up being taxed on certain types of income.  Use the linked resources here and undertake your own research to make sure you understand what UBI is in the context of your organization and whether you have to file a Form 990-T.

Action Item:  Take the IRS Unrelated Business Income interactive course (yes, really, it’s informative and free) and use what you learn to examine your organization’s income-generating practices.  If you are unsure as to your organization’s income, consult with a qualified accountant or attorney, as applicable under the circumstances.

Mistake 5:  Use your organization to financially benefit insiders.

A nonprofit must exist for the benefit of the public.  It should of course pay its employees a reasonable wage for their work, but tax-exempt organizations may not be operated for the benefit of private individuals.  You may hear terms such as “private inurement” or “self-dealing” associated with this concept, and people sometimes get so bogged down in terminology that they forget the general principle.  The key thing to remember is that in general, neither people associated with an organization nor their family/friends/businesses should reap profits as a result of that association.   Having a diverse board that is careful to disclose any conflicts of interest and to engage in arm’s length transactions is important, and interested directors should recuse themselves from voting on any issues which might benefit them in some way.  In short, you simply may not use the organization to funnel some type of benefit through from a donor to an insider recipient.  Losing tax-exempt status for your organization could be the least of your problems if you engage in the misappropriation of funds.

Action Item:  Make sure you understand what a private benefit means.  Ensure that your organization has an appropriate conflict of interest disclosure, policy, and resolution procedure in place.

Please note:  This blog is intended as general educational information only, and should not be considered legal advice or a substitute for consulting a lawyer.