There are multiple ways that nonprofit organizations can lose their tax-exempt status, and it’s important for directors, employees, and volunteers to stay informed about what actions could potentially jeopardize the status. With a bit of increased awareness and employee training, it is easy for organizations to remain compliant.
For-Profit Activities/Generating UBTI
Under IRS rules, a nonprofit that generates $1,000 or more in unrelated business income must file a 990-T and pay tax on the income (UBTI or unrelated business tax income). This income comes from a regularly carried-on trade or business not substantially related to the organization’s exempt purpose. However, there are some modifications, exclusions, and exceptions. Selling food and beverages to nonmembers, advertising income, and selling timber cut from the organization’s land are all examples of UBTI-generating activities.
Tax-exempt public charities under the 501c3 classification with dividends, interest, certain other investment income, certain income from research activities, and gains or losses from the disposition of property do not need to have the same worries; these activities are all excluded. Other types of tax-exempt organizations, such as social clubs under the 501c7 classification, do not have this exemption.
Rental income can fall into either category, though it is usually exempt. The IRS lists the reasons rental income will be considered unrelated business income as: “If substantial personal services are provided to lessees, if more than 50% of the rent is for the use of personal property, if the property is debt-financed income or leased to a controlled entity, or if the organization is exempt under Sections 501(c)(7), 501(c)(9) or IRS 501(c)(17)”.
Failure to Comply with Annual Reporting Requirements
Nonprofits must keep up to date with their required filings, including financial statements, form 990, and other required documents. Failure to submit a Form 990 for three consecutive reporting periods automatically causes nonprofits to lose their tax-exempt status, per IRS rules.
For the organization’s state returns, penalties and eventual dissolution of the nonprofit are likely to result if they are not filed on time.
Failure to Operate Exclusively for Exempt Purposes
The purpose of the tax-exempt status is to support organizations with missions motivated by charitable, educational, religious, or scientific pursuits. Any form of profit-generating activity defeats the purpose of the tax-exempt status and could result in an IRS determination to take it away.
Organizations should be mindful of “mission creep,” or when their activities drift away from their stated mission towards direct or indirect involvement with for-profit organizations or activities. Though direct instances of engaging in such activities may be more obvious, subtler instances include shifting the organization’s mission for the sake of receiving a particular grant, shifting to a different geographical location or demographic of people than stated in the company’s mission, or taking on too many activities at once to be able to retain a clear focus.
Private Inurement/Benefits to Insiders
The IRS considers any form of personal enrichment through nonprofit resources as a violation of the organization’s responsibility to use its assets and income solely to support its mission. This can include contracts to board members or family members of the board at higher than market prices, excessive compensation for officers, or engaging in any activity that disproportionately serves the interests of an inside member.
Political Activity
Nonprofits are prohibited from any direct or indirect involvement in support or opposition to a candidate in a political campaign at all levels: federal, state, and local. Endorsing candidates, campaign donations, or any use of the organization’s resources towards influencing the outcome of an election are included in the definition of support. In addition to the loss of tax-exempt status, fines and penalties can result.
In addition to political campaign involvement, any form of lobbying is limited. While a 501(c)(3) organization is allowed to do some lobbying, too much can hurt its tax-exempt status. Its lobbying activities cannot be more than an insubstantial part of its overall activities.
If you have questions about activities your organization is considering launching or is currently involved in, please contact Sciarabba Walker.
By Will Sheavly