One of the Greatest Misnomers of the Tax Code: Tax Exempt Entities
We generally refer to them as “nonprofits” but IRS calls them tax-exempt. And let’s just get this out of the way- nothing is really and truly outside the purview of the IRS. This post is just to give you a basic understanding of what it takes to be a “nonprofit” for federal income tax purposes.
What it Means to be Tax Exempt
You know that nonprofits are entities that do good things; they help people and they don’t pay taxes, or something like that. We have this general idea but there is a lot more to it and this is as good a time as any to get into the details.
The title, “nonprofit” actually comes from state law but state level nonprofit status does not mean that the entity has tax exempt status on the federal level. These businesses have received tax exempt status, generally because they have a charitable purpose. They are businesses and they certainly can and do bring in money; they can be profitable. We will revisit some of the details of that in a bit.
Becoming Exempt
Nonprofits form an entity, generally a corporation; then they will apply for tax-exempt status with IRS. SEED is always here to help you with this but IRS provides some guidance on the application process.
While there are others options, 501(c)(3) tax-exempt status is the most common tax-exempt status and it provides an exemption from paying federal income tax if the entity is organized and operated exclusively for a charitable purpose.
Charitable Purpose
These entities are organized with public benefit as their priority rather than being operating for profitability. They are referred to as a 501(c)(3) nonprofits because that is the section of the Internal Revenue Code where the specific purposes for operation are detailed as follows:
· Religious;
· Charitable;
· Scientific;
· Testing for public safety;
· Literary;
· Educational;
· Foster national or international amateur sports competition; or
· For the prevention of cruelty to children or animals
If an entity has one these charitable purposes, it must also adhere to some very specific prohibitions. No part of the net earnings can go to benefit a person or private shareholder. Additionally, no substantial part of the activities can involve attempting to influence legislation and does not intervene in/on behalf of any political campaign for public office. If you think your tax-exempt entity may be involved in any of those activities you will want to seek advice on how to avoid running afoul of those regulations. Once you have organized an entity and see that you will comply with the requirements, you can use IRS Form 1023 or 1023 EZ to apply for exempt status.
Public Benefit
The idea that nonprofits are operating for the public benefit is that they are set up with a purpose of helping a group of people or section of the public and not a specific person or family. Additionally, the funds raised by the organization are spent on that purpose. To illustrate, this rule would be violated if an organization was created with the purpose to help people with a certain kind of cancer but instead, all of the funds raised and work performed were really on behalf of a single individual suffering from that disease.
Private Inurement
This may be the provision that most distinguishes exempt entities from other businesses. IRS prohibits income received by tax exempt entities inuring to a private shareholder or individual. The idea is that money that goes into the business can only go to support the charitable purposes of the entity and cannot go to any individual. Further, none of the earnings of the business can go to benefit a person with a personal or private interest (called an insider), key employee, or a family member of an insider. This does not mean that an individual working as an employee cannot be paid a reasonable salary but they could not be paid an unreasonably high salary or receive other economic benefits. The IRS does not want an insider or any party that has substantial influence over the organization to be receiving a financial benefit exceeding the value of goods or services provided. Doing so would be considered an excess benefit transaction and would risk revocation of the tax exempt status.
Politics
As a tax-exempt entity, there are also restrictions related to political campaign activity and legislative advocacy. Exempt entities cannot directly, or indirectly intervene or participate in political campaigns on behalf of or opposing a candidate for public office. They also cannot contribute to political campaign funds or make any statements supporting or opposing candidates. Violations of these rules could cause a revocation of the tax-exempt status and may result in assessment of additional tax liability. This is not intended to be a limitation on freedom of speech; nonpartisan voter education activities are okay, and exempt entities can take a position on some policy issues but must do so cautiously to not be indirect participation in a political campaign.
Tax-exempt entities cannot engage in lobbying or substantial legislative activities either. Attempting to influence legislation includes contacting or encouraging the public to contact legislators with a specific position, or advocating or rejecting certain legislation. Substantial participation in these activities would result in the organization failing to be operating for its charitable purpose, risking its exempt status.
Keep in mind, this is a summary and there is a lot more to know if you are considering doing any work that might touch into the areas of lobbying or politics.
Unrelated Business Income Tax
So you have your exempt status and you get a great new idea that will bring a new revenue stream that could help fund your organization. If you have income that is not substantially related to that charitable purpose, it is considered unrelated business income (UBIT) and it is taxable. If the amount is $1000 or more, the organization will need to file a Form 990-T to report that income and calculate the income tax owed. This may also cause you to need to make estimated tax payments throughout the year.
Trade or business activities not substantially and importantly related to the charitable purpose could be taxable if they are conducted regularly. What is substantially and importantly related can be unclear. Additionally, the activity must be conducted regularly, so a one time event or short term offering would not necessarily cause the entity to owe tax on this income.
As an example, say your nonprofit works to increase literacy for children. You decide to sell t-shirts to earn some extra money. Money from that on-going activity is UBIT and taxable. Say then, you see an opportunity to rent parking during sporting events at a neighboring complex. If you do this year round on a regular and continuous basis, income generated from that would likely be taxable. Let’s say that you only do it twice during particularly large events; that would probably not rise to the standard of continuous activity and would probably not be taxable. This is a brief summary on what can be a more complex issue as evidenced by the fact that IRS has 23 page Publication describing the topic (IRS Pub. 598).
Estimated Tax Payments
If an exempt organization does expect that it will owe $500 or more in tax, generally on unrelated business income, it must make quarterly estimated tax payments. You can use IRS Form 990-W to calculate what the organization’s estimated tax amount would be.
This article is an overview of legal considerations and does not cover every legal right or obligation, consideration, exception, or restriction. Every business decision should be well researched and discussed with a professional before being made.
To schedule a consultation with a SEED Law attorney, you can give us a call at (816)945–4249 or schedule your consultation here.
