Most businesses and individuals are subject to federal taxation, but the tax code allows for the existence of tax-exempt entities. The reasoning behind providing tax-exempt status to some entities is that the work done by private organizations relieves the government of paying for some of these services, and private organizations may increase the general welfare and provide other charitable benefits to some groups that would otherwise be neglected by the government. As such, these institutions are nonprofit organizations, where profit is used to further the interests of the organization rather than for enriching individuals.
Tax-exempt status is provided under Subchapter F (Exempt Organizations), §§501-529 of the Internal Revenue Code (IRC). The IRS classifies tax-exempt entities as either public charities or private foundations. Public charities have broad support, which is in contrast to private foundations, which are often funded by major donors and usually have a narrower purpose. The IRS assumes that an entity that is tax exempt under §501(c)(3) is a private foundation, with certain exceptions, unless the tax-exempt entity files Form 1023, Application for Recognition of Exemption to be recognized as a public charity. Most of the exceptions, listed in §509(a)(1-4), are obvious public charities, such as churches, educational institutions, and hospitals.
There is a new shorter application form that small charities can use to receive tax-exempt status. According to the IRS, up to 70% of all applicants will qualify to use the new streamlined form. The new Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code must be filed online, and the $400 user fee must be paid through Pay.gov. The primary requirements that organizations must satisfy is that their gross receipts cannot exceed $50,000 and their assets cannot exceed $250,000.
To limit abuse, there are 2 restrictions on the tax exemption:
- the nature or scope of the organization may qualify it for only partial exemption,
- certain activities may be subject to special taxation.
Many people have attempted to gain tax-exempt status by trying to pass itself off as a tax-exempt entity, such as a church. However, in most of these instances, it was obvious that individuals were actually being enriched by the earnings of the organization, whereas a tax-exempt organization must serve a public rather than a private purpose. No net earnings can be used for the benefit of an individual.
Most of the organizations that qualify for tax exemption are categorized in §501(c). Generally, the tax-exempt entity must serve the commonweal; it must be a not-for-profit entity; net earnings cannot benefit organizational members; nor can the organization attempt to influence politics. For many tax-exempt organizations, the net earnings must be devoted to religious, charitable, scientific, literary, educational, or fraternal purposes.
General Tax Consequences of Exempt Status
Besides the federal income tax, tax-exempt entities may also be exempt from state income tax, state franchise tax, sales tax, or property tax; the organization may receive discounts on postage rates; donors to the exempt organization may qualify for the charitable contribution deduction on both federal and state income tax returns. Some exempt organizations, however, do not qualify for the charitable contribution deduction, such as contributions to the National Football League or the PGA Tour.
If an organization engages in a prohibited transaction, then:
- part or all the organization's income may be subject to federal income tax;
- the exempt status may be revoked;
- intermediate sanctions may also be imposed on insiders.
For instance, tax-exempt entities cannot generally lobby or engage in political campaigns, except to a limited extent and only by a 501(c)(3)organization. The organization must elect to participate in lobbying activities, but will be limited by a ceiling, that if exceeded, could cause the organization to lose its exempt status. A tax may also be imposed on the excess lobbying expenditures.
There are 2 types of permitted lobbying expenses: lobbying expenditures and grassroots expenditures. Lobbying expenditures includes spending money trying to influence the public or communicating with legislators or their staff members or other government officials to influence legislation. Grassroots expenditures, on the other hand, attempt to influence legislation by influencing public opinion. A 25% tax may be assessed on any excess lobbying expenditures.
Intermediate sanctions can also be imposed on insiders of public charities who personally benefit from the exempt organization by receiving excess benefits and where the managers who participate in such transactions know that it is improper. Excess benefit transactions include receiving property for less than fair market value or receiving unreasonable compensation. A first-level excise tax penalty, equal to 25% of the excess benefit, may be imposed. A second-level tax of 200% of the excess benefit may also be imposed if the excess benefit transaction is not corrected within the taxable period.
A feeder organization, which operates a business for the benefit of a tax-exempt entity, is taxed on its income even if it pays all its profit to the tax-exempt entity, unless the feeder organization uses volunteers for its services or it sells merchandise received as gifts or contributions.
Private foundations are tax-exempt organizations providing charity or benefits to a narrowly defined group. A purpose not broadly supported generally caters to the private interests of a few donors rather than to interests supported by the public. Consequently, there are several tax disadvantages to being a private foundation rather than a public charity, including taxes on the organization itself and a lower contribution deduction by contributors.
There are 2 types of tests that are used to distinguish a broadly supported charity from one that is not. The external support test requires that more than 1/3 of the organization's support normally comes from either contributions from the public or sales to the public that is not from an unrelated trade or business, such as gifts, grants, contributions, membership fees, or from admissions, merchandise sales, the performance of services, or from rental facilities that would not be classified as an unrelated trade or business. Thus, an organization that receives support from only a few individuals may qualify as a private foundation, but not as a public charity. If the tax-exempt entity was only recently started, then the external support test can still be met if there is a reasonable expectation that the test will be satisfied during the 1st 5 years of operation based on current or proposed programs and activities, and organizational structure. If the external support test is actually satisfied during the 5-year test period, then the tax-exempt entity will qualify as a public charity.
However, the external support test can still be met if the external support is at least 10% of the entity's funding and it satisfies the facts and circumstances test:
- it continually attempts to attract public support;
- the public support that it does receive is broadly based, not limited to members of a family or group;
- the entity has a representative governing body that is representative of the community that it serves;
- The entity supplies a public facility or provides public services, such as a museum or library or an orchestra that gives public performances;
- and if the entity is a membership organization, are the membership requirements minimal, so that it will have broad appeal.
The internal support test requires that no more than 1/3 of the organization's support comes from either gross investment income or from unrelated business taxable income.
Additional taxes and penalties that are imposed on private foundations, but not public charities, include:
- investment income tax;
- tax on the failure to distribute income;
- excess business holdings;
- taxable expenditures;
- tax on self-dealing; and
- tax on investments that may jeopardize charitable purposes.
Except for taxes on investment income, there are generally 2 levels of taxes. The first-level tax, or the initial tax, is assessed on prohibited transactions. A second-level tax will also be imposed if the prohibited transaction is not corrected within a certain time. For instance, an excise tax on excess business holdings would be assessed on a private foundation that is used to gain control of unrelated businesses.
Unrelated Business Taxable Income
The unrelated business taxable income (UBTI) is a tax imposed on businesses owned by tax-exempt organizations that are not related to the tax-exempt purpose, in which case, it is taxed like a corporation. According to the IRS, slightly less than ½ of tax-exempt entities reported unrelated business income. Without a tax on unrelated business income (UBI), the tax-exempt organization would gain an unfair advantage over for-profit business entities. The UBTI applies to all 501(c) organizations, except federal agencies, but only if income exceeds $1000. The business must be regularly conducted by the organization. If the business is only done occasionally, then it will not be subject to the UBTI. For example, a church that rents its parking spaces during an annual fair would not have unrelated business income, but one that rented parking space every Saturday for a farmer's market would have unrelated business income.
However, an organization that conducts a business may be exempt from the UBTI if any of the following are true:
- volunteers perform most of the work;
- sales of merchandise is of property received as gifts or contributions, such as thrift shops;
- the business is conducted primarily for the organization's members, officers, employees, students, or patients, such as the many businesses operated by colleges and universities for their students; or
- where employee unions sell to their members work-related clothing and equipment or food items such as snacks.
To be related to the exempt purpose, the business activities must be causally related and make a major contribution to the exempt purpose. Generally determining whether causality exists and the degree of the importance of the contribution is determined by the individual facts and circumstances. For instance, if a charity is involved in teaching how to make something and the constructed products are sold, then that would be substantially related to the exempt purpose.
There is a special exemption for corporate sponsorship payments, in which an unrelated business makes a payment to a tax-exempt organization for using its name, logo, or to show that its products are used by the exempt organization. To qualify, there can be no expectation that the business will receive any other benefit other than the promotion of its business; there's no advertisement of the products or services; and the payment is not contingent on public exposure, such as the number of people attending an event.
Bingo games can be conducted without being subject to UBTI if they are legal under both state and local law and if commercial bingo games are not permitted in the jurisdiction.
There are also exceptions for the distribution of low-cost articles, such as pens, stationery, and address labels, and also for the rental or exchange of membership lists if it is with other exempt organizations. The cost of a low-cost article to the organization distributing it must be less than an inflation-adjusted limit, which, for 2019, was $11.10. (Although the low-cost article cost is adjusted annually for inflation, it does not change much from year to year, usually less than $1 in 5 years, but the current value can be found in the What's New section at the beginning of Publication 598, Tax on Unrelated Business Income of Exempt Organizations | Internal Revenue Service, published in February.)
Unrelated Business Income
Whether a tax-exempt entity has unrelated business income depends on whether the business is regularly conducted, if it has continuity, and how the business is conducted.
Gross Unrelated Business Income – Deductions = Net Unrelated Business Income + Positive Adjustments – Negative Adjustments = Unrelated Business Taxable Income
A major positive adjustment is unrelated debt-financed income, which is income from property bought with borrowed funds (acquisition indebtedness), but which is not used for the exempt purpose. If at least 85% of the property is used for the exempt purpose, then it is not considered unrelated debt-financed income; otherwise, the percentage not used for the exempt purpose is considered unrelated debt-financed income, which is taxable.
Acquisition indebtedness is debt incurred acquiring or improving property, and also includes any debt incurred either before or after the acquisition that would not have been incurred if the property was not acquired.
Organizations with more than 1 unrelated trade or business must compute UBTI, including to determine any net operating loss deduction, separately for each trade or business. (More: Notice 2018-67)
Most exempt organizations require IRS approval for their exempt status, especially organizations listed in sections 3, 9, and 20 of §501(c).
Tax-exempt organizations are generally required to file Form 990, Return of Organization Exempt from Income Tax, except for federal agencies, churches, organizations with gross receipts not exceeding $25,000,and private foundations, which, instead, must file Form 990-PF, Return of a Private Foundation. The report must be filed by the 15th day of the 5th month after the taxable year. Organizations subject to UBTI may also be required to file Form 990-T, Exempt Organization Business Income Tax Return.
Tax-exempt organizations must make copies of their 3 most recent returns of Form 990, Form 1023, Application for Recognition of Exemption, or Form 1024, Application for Recognition of Exemption under Section 501(a) available to the public.