How to Maintain Your Nonprofit’s Tax-Exempt Status

Navigating the world of nonprofits can be both rewarding and complex, particularly when it comes to maintaining a tax-exempt status. For many organizations, this status is crucial for operations, allowing them to channel more resources towards their mission. However, with the privilege of tax exemption comes a responsibility to adhere to certain regulations and standards. Here we explore the intricacies of maintaining your nonprofit’s tax-exempt status, shedding light on best practices, avoiding pitfalls, and ensuring continued compliance.

Understanding Tax-Exempt Qualifications

Before diving deep into the practical steps for maintaining your nonprofit’s tax-exempt status, it’s crucial to have a foundational understanding of the qualifications that paved the way for that status in the first place. The Internal Revenue Service (IRS) has set specific criteria under Section 501(c)(3) to define which organizations are eligible. By grasping these essential qualifications, you not only begin the journey of compliance but also ensure the longevity and impact of your organization.

Overview of IRS Section 501(c)(3)

Section 501(c)(3) is a portion of the U.S. Internal Revenue Code that stipulates which organizations may be eligible for tax-exempt status. Organizations that typically fall under this code include charitable, religious, educational, scientific, and literary groups, among others. The benefits of this classification are manifold: not only are such organizations exempt from paying federal income tax, but contributions made to these organizations by donors are often tax-deductible, providing an added incentive for support.

Eligibility Criteria

For an organization to qualify under Section 501(c)(3), it must satisfy specific criteria. These benchmarks are generally categorized under the organizational and operational tests, ensuring that the nonprofit’s structure and activities align with the IRS’s definitions of a tax-exempt entity.

Organizational Test

The organizational test revolves around the very structure of your nonprofit. This means that your organization’s articles of incorporation must limit its purposes to those described in Section 501(c)(3). Additionally, the articles must not empower the organization to engage in activities that don’t further its exempt purposes, or that would result in benefiting private interests.

Operational Test

The operational test, as its name suggests, looks at how the organization functions. Simply put, it must be primarily engaged in activities that further its exempt purposes as stated in its articles of incorporation. For example, if your nonprofit claims to serve an educational purpose, the bulk of its activities should be geared towards education. Additionally, the organization should ensure it does not partake in excessive lobbying, political campaign activities, or generate income that benefits private shareholders or individuals [1].

Types of Tax-Exempt Organizations

While Section 501(c)(3) is the most commonly referenced section when talking about tax-exempt nonprofits, the IRS recognizes several other categories under the broader umbrella of Section 501(c). These range from business leagues (501(c)(6)) to social clubs (501(c)(7)) and labor organizations (501(c)(5)). Each category has its own set of guidelines and requirements. However, for the purposes of this guide, our focus remains on 501(c)(3) organizations, as they are the predominant entities that seek to maintain tax-exempt status for charitable, religious, and educational endeavors.

Essential Practices for Maintaining Nonprofit Status

Acquiring tax-exempt status is a significant achievement for any nonprofit, but the real challenge lies in preserving that status over time. The IRS expects organizations to uphold the principles and operations that initially qualified them for the exemption. Staying compliant requires an ongoing commitment to best practices and a proactive approach.

Regularly Review and Update Governing Documents

Every nonprofit operates based on a set of governing documents. These could be bylaws, articles of incorporation, or other foundational guidelines. They form the backbone of how the organization functions and the principles it upholds.

Stay Current

With time, the objectives or practices of an organization might evolve. Regularly reviewing your governing documents ensures they remain aligned with your current operations and the latest legal requirements.

Make Necessary Amendments

If any discrepancies arise or changes are needed, it’s crucial to follow the proper procedure for amending these documents. This might involve board meetings, voting, and documentation of the changes.

Document and Report

Always keep a record of updates made and, where required, inform the appropriate state and federal agencies about significant changes to your organization’s structure or mission.

Ensure Nonprofit Purpose is Consistently Met

Your organization’s tax-exempt status is closely tied to its mission. Activities and initiatives should consistently align with the purpose stated in your governing documents.

Monitor Activities

Regularly assess projects, programs, and initiatives to ensure they fit within the organization’s mission and the criteria set by the IRS for tax exemption.

Diversification with Caution

While evolving and diversifying the activities is a natural progression for many organizations, it’s essential to ensure that any new endeavor still falls within the boundaries of your tax-exempt purpose [2].

Avoid Unrelated Business Income

While nonprofits can engage in business activities, these activities shouldn’t become their primary focus. Income generated from unrelated business activities could jeopardize tax-exempt status if not managed correctly.

Identify Unrelated Activities

Any activity that doesn’t directly support the nonprofit’s mission and is a regular trade or business can be considered unrelated.

Manage Income Sources

If a significant portion of your organization’s revenue starts coming from unrelated business activities, it’s a red flag. Consider strategies to either integrate these activities more closely with your mission or limit their scale.

Pay Relevant Taxes

Income from unrelated business activities might be subject to unrelated business income tax (UBIT). Ensure that these taxes are filed and paid appropriately.

Manage and Monitor Finances

Financial transparency and accountability are paramount for any nonprofit aiming to maintain its tax-exempt status. Properly managing funds not only helps in compliance but also builds trust with donors and stakeholders.

Proper Allocation of Funds

Allocate funds primarily towards activities that support the organization’s mission. Regular audits and budget reviews can ensure that funds are not being misused or diverted.

Avoiding Excess Benefit Transactions

Transactions that provide an excessive benefit to private individuals or parties, especially those in positions of power like board members, can endanger your tax-exempt status. Always conduct transactions at fair market value and avoid deals that disproportionately benefit insiders.

Ongoing Nonprofit Compliance with Reporting and Disclosure

One of the most common misconceptions about tax-exempt organizations is that their exemption absolves them from all reporting responsibilities. In reality, maintaining tax-exempt status requires regular communication with the IRS and possibly other state agencies. This ongoing dialogue ensures transparency, maintains public trust, and upholds the integrity of the nonprofit sector.

Filing Annual Returns (Form 990 Series)

Every tax-exempt organization, unless specifically excluded, is required to file an annual return. This is where the Form 990 series comes into play.

Determine the Right Form

The type of Form 990 to file often depends on the organization’s financial activity during the year. Larger nonprofits typically file Form 990 or 990-EZ, while smaller ones might be eligible for Form 990-N (e-Postcard). Churches and certain church-related organizations are generally excluded [3].

Timely Submissions

Annual returns are typically due on the 15th day of the fifth month after the end of the organization’s fiscal year. Delays or repeated failures to file can result in penalties and even loss of tax-exempt status.

Content of the Return

The form captures detailed information about the organization’s activities, governance, revenue, and expenses. This comprehensive document serves as a snapshot of the organization’s financial health and operational focus.

Public Disclosure Requirements

Tax-exempt organizations have a responsibility to maintain public trust, and transparency plays a crucial role in achieving this trust.

Availability of Documents

Nonprofits must provide copies of their three most recent Forms 990 or 990-EZ, 990-T (if they file this form), and their application for tax exemption upon request.

Immediate Access

If the request is made in person, these documents should generally be provided immediately. For written requests, the organization typically has 30 days.

Charges

While you can charge a fee for reproduction and mailing costs, it’s often advisable (and seen in positive light) to provide these digitally at no cost when possible.

Record-Keeping Best Practices

Beyond annual returns and public disclosures, an effective record-keeping system is fundamental to ensure all necessary information is at your fingertips when needed.

Duration

As a rule of thumb, keep all records that support an item of income or deduction on a return until the statute of limitations for that return runs out. This is generally three to seven years, depending on the situation.

Organization

Regularly updating and categorizing records makes the filing process smoother. Digital backups, when possible, are also beneficial.

Details to Maintain

Ensure you have detailed records of income, expenses, employment taxes, assets, and any communications with the IRS. Also, maintain copies of filed returns, which can serve as a reference for future filings.

Avoiding Nonprofit Prohibited Activities

While the nonprofit sector offers organizations a wide latitude in terms of mission and operation, there are clear boundaries set by the IRS that must not be crossed. Engaging in prohibited activities can jeopardize the tax-exempt status of an organization, potentially undoing years of hard work and dedication. To ensure the longevity of your nonprofit and its mission, it’s vital to be aware of these limitations and actively ensure that all organizational activities fall within the allowed spectrum.

Political Campaign Activities

The relationship between nonprofits and politics is a nuanced one, and organizations must tread carefully.

Absolute Prohibition

501(c)(3) organizations are completely prohibited from directly or indirectly participating in, or intervening in, any political campaign on behalf of or in opposition to any candidate for elective public office. This includes contributions to political campaign funds or public statements made on behalf of the organization [4].

Educational Activities

It’s crucial to distinguish between political campaign activities and non-partisan educational activities. Nonprofits can hold public forums, publish voter education guides, or conduct voter registration drives, as long as they remain non-partisan.

Personal Expressions

Leaders or members of nonprofits are allowed their personal political views. However, they must ensure that their comments are not perceived as representative of the organization.

Excessive Lobbying Activities

While nonprofits can advocate for their cause, excessive lobbying can threaten their tax-exempt status.

Definition

Lobbying typically refers to activities that advocate for or against legislation. It’s essential to distinguish between lobbying and general advocacy or education on issues.

Limits

Some lobbying activities are permitted, but they must remain an insubstantial part of the organization’s overall actions. The IRS doesn’t specify an exact percentage for “insubstantial,” but a safe rule of thumb is to ensure that most resources and efforts are directed towards the primary exempt purpose.

Electing the 501(h) Expenditure Test

Organizations can choose to be measured based on the 501(h) expenditure test, which provides clearer monetary thresholds for lobbying activities. This might be beneficial for organizations that anticipate regular lobbying.

Benefit to Private Interests

A cardinal rule for 501(c)(3) organizations is that their activities should not unduly benefit private interests.

Avoiding Inurement

No part of the net earnings of a 501(c)(3) organization can inure to the benefit of any private shareholder or individual. This ensures that the organization’s resources are used for the public good and not personal gain [5].

Handling Transactions

All transactions between a nonprofit and its insiders (like board members or key employees) should be conducted at arm’s length. Fair market values should guide such transactions, and any potential conflict of interest should be disclosed and managed appropriately.

Penalties for Excess Benefits

Transactions that provide excessive benefits to individuals at the expense of the nonprofit can lead to stiff penalties, both for the individual receiving the benefit and the organizational leaders who approved it.

Handling Donations and Fundraising for a Nonprofit

Financial sustenance is the lifeblood of most nonprofits, and for many, this comes in the form of donations and fundraising efforts. While these activities are integral to the operations of a nonprofit, they also come with their own set of guidelines and stipulations. Adhering to these ensures that trust is maintained with donors, and more importantly, that the organization remains compliant with tax regulations.

Acknowledging and Documenting Donations

Proper acknowledgment and documentation of donations not only builds trust with donors but also ensures that the organization meets IRS requirements.

Written Acknowledgment

For individual donations exceeding $250, the IRS requires nonprofits to provide a written acknowledgment. This document should indicate the donation amount, date, and if any goods or services were provided in exchange.

Quid Pro Quo Contributions

If a donor receives something in return for their donation (like a meal or merchandise), the acknowledgment should state the value of what they received. This helps donors determine the deductible portion of their gift.

Non-Cash Donations

For non-cash gifts or in-kind donations, it’s wise to provide a description of the gift, though the organization is generally not required to establish its monetary value.

Charitable Solicitation Compliance

As nonprofits expand their fundraising efforts across state lines, they might encounter various state-specific regulations.

Registration Requirements

Many states require nonprofits to register before soliciting donations from their residents. It’s crucial to understand and comply with these registration requirements to avoid legal complications.

Online Fundraising

Digital fundraising campaigns often reach a broad audience. Nonprofits should ensure they meet the charitable solicitation requirements of all states where their online donors reside.

Renewal and Reporting

After initial registration, many states require periodic renewals and detailed reporting about the fundraising activities and financial health of the organization.

Fundraising Ethics and Best Practices

Maintaining a sterling reputation is key for any nonprofit, and ethical fundraising is a cornerstone of this endeavor.

Transparency with Donors

Always be clear about how funds will be used. If a donation is for a specific project or cause, ensure that those funds are earmarked appropriately.

Protect Donor Privacy

Respect the wishes of donors who choose to remain anonymous. Furthermore, unless given explicit permission, avoid sharing donor information with third parties.

Collaborations and Partnerships

If partnering with businesses or other organizations for fundraising, ensure that the terms are clear, ethical, and in line with the nonprofit’s mission.

Avoid High-Pressure Tactics

While enthusiasm is great, it’s essential to avoid pressuring potential donors. An ethical approach respects a person’s choice to donate or decline.

References

[1] How to lose your 501(c)(3) tax-exempt status (without really trying)
[2] Protect your nonprofit’s tax-exempt status
[3] Maintaining a 501(c)(3)
[4] Understanding Nonprofit Status and Tax Exemption
[5] 7 Tips for Maintaining Your Tax Exempt Status