Income Tax Issues Affecting Small Nonprofit Organizations
Introduction | Top
Income tax laws and regulations are often confusing and sometimes even frightening. Indeed, tackling the Internal Revenue Code may seem to be a task not for the faint of heart. This guide is intended to present some basic information to volunteer treasurers, directors and board members of nonprofit organizations (NPO) to help them obtain, maintain and understand exemption from income taxation and possibly relieve some of the confusion and fear.
As is the case with most tax law, there are exceptions to every rule. The information presented in this guide is general, and will not be applicable to every specific situation encountered by a NPO. Furthermore, because of the intricacies of the Internal Revenue Code, it would be impossible for this guide to address all aspects of taxation of NPOs.
We hope the information contained herein will prove valuable and informative. However, should any of the topics covered in the following pages raise questions as to how the law pertains to your specific organization, we urge you to consult with your certified public accountant. The Virginia Society of CPAs sponsors a volunteer program and maintains a pool of highly trained tax experts throughout the state who have offered their time and expertise to non-professionally managed NPOs in need of help. Please avail yourself of this program if there is a need within your organization.
Throughout this guide, we will use as our example ”Goodworks, Inc.,” a hypothetical company organized for the purpose of soliciting contributions from the general public and using the funds to help runaway teenagers. We will discuss how Goodworks would obtain exemption from taxation, the various Internal Revenue Code sections that would affect Goodworks’ exemption, filing of the necessary returns with the IRS and other tax-related topics.
Internal Revenue Code Section 501(c) | Top
The various types of organizations that qualify for exemption from income taxes in general are enumerated in Section 501(c) of the Internal Revenue Code. There are 23 subsections under Section 501(c) that deal with a wide array of potential NPOs. Since our example company, Goodworks, Inc., intends to operate as a charitable organization, its activities would fall under Section 501(c)(3). Other types of NPOs would be classified under other subsections; for instance, civic leagues would be exempt under 501(c) (4), while social and recreational clubs would meet the criteria of 501(c)(7).
Obtaining Tax Exemption | Top
Exemption from income taxes is not automatic. Regardless of an organization’s charitable or benevolent intent, tax exemption must be granted by the IRS. Generally, one of two forms must be filed by an aspiring NPO to obtain an exemption from the IRS. An organization like Goodworks’ which feels its activities would qualify it for exemption under Section 501(c)(3) would file Form 1023 with the IRS. Most other NPOs that would fall under other subsections of 501(c) should file Form 1024. A user fee must be included with the application for tax-exempt status; the fee is $750 in most circumstances.
The NPO must have an acceptable legal form. Complete financial information is required with the application. It is important to note that, in general, in order for a NPO to be recognized as exempt by the IRS from its inception, it must apply for exemption within 15 months of the end of the month in which it is organized.
In most instances, the initial exempt determination by the IRS is temporary, and is based on what the NPO states in Form 1023 or 1024 as their functions.
Several years after issuance of this temporary exemption, the IRS will ask for information about the actual operations of the NPO since its inception, and at that time will make a final exemption determination. If the NPO is performing the exempt functions as outlined in its initial application, the final determination generally is made without difficulty. Once a final determination has been made, it remains in effect as long as the operations of the NPO do not change significantly.
Public Charity Versus Private Foundation | Top
All organizations exempt under Section 501(c) (3) are, by definition, either public charities or private foundations. The IRS states that a 501(c) (3) NPO automatically will be considered a private foundation unIess it is one of the following types of organizations:
- Church, convention of churches or association of churches
- School
- Hospital or cooperative hospital service organization
- Federal, state or local government or governmental unit
- Medical research organization in conjunction with a hospital
- NPO operated for the benefit of a college or university
- NPO that receives a substantial part of its support from a governmental unit or from the general public
- NPO that receives more than one-third of its support from membership fees and gross receipts from activities related to its charitable functions, and less than one-third from investment income
- NPO whose primary purpose is to support another NPO described above
Classification as a private foundation has certain disadvantages. These NPOs are subject to a 1 to 2 percent income tax on their net investment income (interest, dividends, etc.). Moreover, private foundations also are required to distribute a certain percentage of their assets each year for exempt purposes, and if these distributions are not made, a second tax ranging from 30 to 100 percent is imposed on undistributed amounts. Goodworks should not be classified as a private foundation by the IRS, since it will receive most of its support from the general public in the form of contributions. It is important to remember that regular large grants from one source could change the status of the nonprofit.
Filing Form 990 | Top
In general, all NPOs except churches are required to file an annual information return with the IRS. Most NPOs (including Goodworks) must file Form 990 by the 15th day of the fifth month after their year end, unless gross receipts are generally less than $25,000 per year. Those with contributions under $25,000 must file an annual statement with the IRS. Private foundations and certain other NPOs must file forms other than 990. Form 990 essentially requires the NPO to report to the IRS its income statement and balance sheet in a prescribed format, and extensive questions concerning the operations of the NPO must be answered.
In addition to Form 990, all 501(c)(3) organizations must file a Form 990 Schedule A. This schedule requires the NPO to report to the IRS information concerning its highest-paid employees and highest-paid outside professionals (management agents, accountants, attorneys, etc.). The form also asks for information concerning any activities the NPO may have had with any other NPOs not exempt under 501(c)(3).
The NPO also is required to list its principal sources of revenue so the IRS can be sure its operations have not changed significantly. Most such changes require a reevaluation of the exempt status, as mentioned previously. The IRS has issued a simpler 990 called Form 990EZ. This form may be used if the NPO has gross receipts for the year of less than $100,000 and total assets at the end of the year of less than $250,000.
Any changes in a NPO’s organizational documents (bylaws, articles of incorporation, etc.) must be reported to the IRS by attaching a copy of the changes to the Form 990 filed in the year of the changes.
Forms 990, 990EZ and 990PF are considered public information, except for the schedule of contributors. Copies of the forms are available to the general public from the IRS or from the exempt organization. The NPO must make available to the public its 990 forms and its application for exemption for various periods of time as specified in the IRS instructions. The NPO’s schedule of contributors is not considered public information and may be withheld from the general public.
It is also important to mention that at the time of publication of this guide, the Internal Revenue Service through IR-2007-117, dated June 14, 2007, announced "The Internal Revenue Service today released for comment and discussion a draft Form 990, the annual return required to be filed by tax-exempt organizations to report information about their operations. The IRS hopes to have the form ready for use for the 2008 filing year (returns filed in 2009)". Final comments were submitted by September 14, 2007 and the revisions will be substantial.
Unrelated Business Taxable Income | Top
If it is recognized as a NPO by the IRS, Goodworks may receive an unlimited amount of income that is “substantially related to the pursuit of its exempt purpose” and, in general, would be subject to no income taxes. However, a NPO that regularly engages in business activities not related to its exempt function is subject to tax on the net income from these activities. And, if this unrelated business taxable income (UBTI) becomes “substantial” (a term not defined by the IRS), the NPO could even lose its exempt status.
In order for income from an activity to be considered UBTI, each of the following criteria must be met:
- The activity producing the income must be a ”trade or business,” which means any activity carried on for the production of income from the sale of goods or the performance of services.
- The activity must be ”regularly carried on,” which is defined as an activity that shows frequency and continuity and is pursued in a manner similar to comparable commercial activities conducted by for-profit entities.
- The activity must not be substantially related to the NPO’s exempt purpose. Just because an activity raises needed funds for the NPO does not mean, in the eyes of the IRS, that the activity is related to its exempt function. The activity itself must bear a direct relation to the NPO’s exempt purpose.
Several types of income are specifically excluded by the IRS from classification as UBTI. Types of income that are excluded from taxation for NPOs exempt under Section 501(c)(3) include:
- Income generated substantially by unpaid volunteers
- Income from the sale of merchandise donated to the NPO
- Dividend, interest and royalty income and gains from the sale of property
- Rental income from real property (unless the property is debt-financed)
Some of these types of income may be taxable for NPOs exempt under other subsections of 501(c). For example, interest and dividend income is taxable for organizations exempt under Section 501(c)(7).
Some examples of income that could be taxed as UBTI include:
- Operating a mailing service for other NPOs
- Most advertising in exempt organization periodicals
- Publication of a magazine for distribution to the public
- Sale of membership mailing lists on a commercial basis
Examples of income types that may be excluded from taxation include:
- Tournaments held by an organization formed to promote such events
- Operation of a cafeteria, coffee shop, gift shop and parking lots by a hospital
- Sale by a museum and its gift shop of greeting cards reproducing art works
A NPO's first $1,000 of net UBTI is exempt from taxation. Any amounts in excess of $1,000 are taxed at the same rates as for-profit corporations. NPOs receiving more than $1,000 in gross UBTI in any year are required to file form 990T. UBTI is an area of the tax law with many gray areas, and this discussion covers only the basics. UBTI recently has become a “hot item” with the IRS, and sources of UBTI will be a major focus of their audits. Accordingly, if a NPO has a potential UBTI problem, it should consult with a tax advisor.
Penalties | Top
The IRS has a variety of penalties available to enforce compliance with its filing and taxation regulations. This publication cannot detail these penalties, but the NPO should be aware that they exist. The cost of these punitive provisions can be significant to the small NPO. The most common penalties are outlined in the instructions to the Form 990 and address such areas as failure to file on a timely basis, failure to allow public inspection and inadequate prepayment of estimated income taxes. If a NPO suspects that it may be subject to these or other penalties, it should seek advice from a tax advisor.
Other Provisions | Top
In order to claim a tax deduction for contributions of cash, checks, or other monetary gifts (regardless of amount), the donor must have a bank record or a written communication from the NPO showing the name of the NPO, the date of the contribution, and the amount of the contribution. A taxpayer making a non-cash contribution must have a receipt from the NPO. A contribution in excess of $250 requires a written acknowledgement from the NPO.
Conclusion | Top
The material presented herein is designed to provide basic information concerning income tax issues affecting small nonprofit organizations. If an organization feels it needs assistance with obtaining exemption, filing Form 990 or determining whether it has a problem with UBTI, it should seek the help of a CPA.
This guide was last updated in September 2007. Permission to duplicate this guide may be obtained from the Virginia Society of CPAs, P.O. Box 4620, Glen Allen, VA 23058-4620, (804) 270-5344 or communications@vscpa.com.
Brought to you by the Virginia Society of CPAs.
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