It is essential that all public charities understand the basic rules surrounding their exemption. Indeed, achieving tax-exempt status is only half the battle – once an organization has established that it is tax-exempt, it must set up the proper checks to ensure that it meets ongoing compliance obligations. Plainly, certain activities can jeopardize an organization’s tax-exempt status or subject it to penalties. Because the IRS revised its Compliance Guide for Public Charities and we are in such a highly regulatory environment, we thought it would be helpful to discuss some of the basic rules surrounding tax exemption.
Certain activities are completely off-limits to non-profits, while others must be undertaken after research and sometimes consultation with business or legal advisors. The following list contains rules with which public charities must comply in order to maintain their tax exempt status:
- No Private Benefit and Inurement. Individuals and organizations may not obtain more than an incidental benefit from a public charity. Additionally, any person with a private or personal interest in the activities of an organization may not be compensated unreasonably by the organization. If any person in a position to exercise substantial influence over the affairs of an organization receives an economic benefit from it (in excess of the goods or services that the person has provided), the charity must report the transaction to the IRS as an “excess benefit transaction.”
- Political Campaign Intervention. Public charities may not directly or indirectly participate or intervene in any political campaign – whether on behalf of or in opposition to any candidate for public office. Public charities may engage in general “get out the vote” drives, as long as they are non-partisan. Organization leaders can make political comments only if they clearly indicate they are speaking in a non-official capacity. This absolute bar on political activity extends to issue advocacy as well – public charities cannot advocate for any issue that essentially functions as political campaign intervention. The IRS has also issued detailed guidelines about when it is appropriate for candidates to speak at functions sponsored by a public charity. Ultimately, failure to heed the restrictions against engaging in political activity can have severe effects on a public charity, ranging from the imposition of an excise tax to loss of tax-exempt status.
- Lobbying. Public charities may not try to influence legislation through substantial lobbying activities. Whether an organization’s legislative activity is considered substantial enough to risk loss of tax-exempt status or imposition of an excise tax is determined by one of two tests. The substantial part test looks at a number of factors to determine whether lobbying activity is substantial, while the expenditure test looks at how much an organization spent on lobbying activities compared to a set amount specified in the Internal Revenue Code.
- Form 990. Annually, public charities must file some version of the IRS Form 990 (Form 990-EZ, Form 990-N). The penalties for failure to file or late filings vary, and are based on an organization’s annual gross receipts (but may range from $20 per day to $100 per day). An organization that is delinquent in filing the appropriate form for three consecutive years may have its tax-exempt status revoked.
- Employment Tax Returns. All public charities that pay wages to employees must withhold, deposit, and pay employment tax (including federal income tax withholding, Social Security and Medicare taxes). Public charities should have a Form W-4 on file for each of their employees to determine how much income tax to withhold. Public charities must also report employment taxes on Form 941 (quarterly) or Form 944 (annually).
- Recordkeeping. Public charities should maintain books and records to demonstrate that they are in compliance with tax rules, and keep all documents that indicate the sources of their receipts and expenditures reported on the Form 990. Generally, charities should keep records that support an item of income or deduction on a return until the statute of limitations for that return runs. Failure to provide back-up documentation when requested by the IRS may result in a loss of tax-exempt status. Additionally, charities should maintain records generally as a means to evaluate their programming, identify their donors over time, and monitor their financial health. In addition, charities sometimes must prepare accurate and timely annual financial statements (per state law) and maintain adequate records and case summaries of grant-making activities. An organization’s record-keeping system should include a summary of transactions (including gross receipts, purchases, other expenses, employment taxes, and assets) and all documentation supporting these entries (such as grant applications and awards, donor correspondence, sales slips, paid bills, invoices, receipts, deposit slips, and canceled checks).
- Governance. As we have mentioned in previous blog posts, public charities should develop and adopt sound governance policies and practices. At a minimum, public charities should adopt a mission statement, establish an active and engaged governing board, and implement policies relating to executive compensation, conflicts of interest, investments, fundraising, document retention, and whistleblower claims. Also, a charity should document important governance decisions made by the board or other governing body.
For additional issues that exempt organizations should consider in this new regulatory environment, please see our May 19, 2010 entry.