About 8,400 Washington-area nonprofits lost their tax-exempt status this year because they failed to file necessary annual returns. Nationwide, the figure topped 275,000. The revocations are part of the Internal Revenue Service’s renewed commitment to ensuring that nonprofits comply with the rules and regulations that govern their valuable tax-exempt status.
This latest crackdown by the IRS is related to penalties set forth in the Pension Protection Act, which was passed by Congress in 2006. This year the IRS ended a three-year review period for which organizations that did not file the necessary returns for all three years had their tax-exempt status revoked.
Even if Washington-area nonprofits escaped this round, there are many other ways nonprofits can come under IRS scrutiny. Here are some potential pitfalls they should avoid:
Engaging in excess benefit transactions
IRS-determined 501(c)(3) and 501(c)(4) organizations are prohibited from entering into “excess benefit transactions” with “disqualified persons.” The goal is to prevent leaders of the organization from using the nonprofit to enrich themselves.
An “excess benefit” occurs when the value of the benefit provided by the organization exceeds the value of what the disqualified person provides to the organization in return. A “disqualified person” is defined as a person who is, or in the past five years prior to the transaction has been, in a position to exercise substantial influence over the organization’s affairs. One example might be an organization that pays excessive consulting fees to a board member’s marketing firm. The IRS is also examining compensation arrangements to determine if executive compensation represents an unreasonable (read “above-market”) compensation arrangement between the organization and its executive staff.
Lobbying
A 501(c)(3) organization can lose its tax-exempt status because of lobbying activities, or participation or intervention in a political campaign on behalf of or in opposition to a candidate for public office. Such 501(c)(3) organizations operating as public charities (other than a church or church-related entities) can elect to file Form 5768 in order to make expenditures to influence legislation, subject to certain limits set forth by the IRS, but they cannot directly support or oppose candidates for public office without endangering their tax-exempt status.
Deviation from exempt purpose/excessive unrelated business income
If an organization begins operating in a manner materially different from the exempt purpose that was originally represented to the IRS, then the organization risks losing its tax-exempt status beginning on the date that the departure took place. An organization also risks losing its tax-exempt status by generating excessive unrelated business income.
If a nonprofit’s unrelated business income becomes a significant part of the organization in terms of revenue generation and resource deployment, then the IRS may deem that it is operating as a for-profit organization and revoke its tax-exempt status.
It is the duty of every officer, director, board member and employee of a nonprofit to be aware of any filing requirements and prohibited activities that could result in the loss of the organization’s tax-exempt status, and to insure that the organization is in full compliance with those requirements at all times.
Chris Rauch is a senior manager at Veris Consulting in Reston and provides outsourced accounting and consulting services to tax-exempt organizations.
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