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501(c)(3) Charitable Tax Exempt Status for Nonprofit Organizations

I. A "Charitable" Organization.

A. The term "charitable" is used in its generally accepted legal sense and is not limited by the separate enumeration of tax-exempt purposes. The term includes relief of the poor and distressed or of the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening of the burdens of Government; and promotion of social welfare by organizations designed to accomplish any of the above purposes, or (i) to lessen neighborhood tensions; (ii) to eliminate prejudice and discrimination; (iii) to defend human and civil rights; or (iv) to combat community deterioration and juvenile delinquency. Regs. 1.501(c)(3)-1.

1. Focus of organization’s purpose must be to benefit the community or society as a whole, not just the organization’s members and their families or other select individuals. Enumerated purposes under 501(c)(3) include: religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals.

2. Organizational tests. An organization is organized exclusively for one or more exempt purposes only if its articles of organization:

a. Limit the organization to one or more exempt purposes;

b. Do not expressly empower the organization to engage, except to an insubstantial extent, in activities which in themselves are not in furtherance of one or more exempt purposes; and

c. Provide that the organization’s assets, upon dissolution, would be distributed for exempt purposes to another 501(c)(3) organization, or to the federal, state or local government for a public purpose.

3. Operational tests.

a. An organization will be regarded as operated exclusively for one or more exempt purposes only if it engages primarily in activities which accomplish one or more 501(c)(3) purposes. An organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.

b. The primary activity of organization cannot be to "carry on a business with the general public in a manner similar to organizations which are operated for profit." However, profit-making business may be carried out as an incidental part of the organization’s activities.

c. An organization is not operated exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals.

d. Neither can the organization be operated primarily as "a social club for the benefit, pleasure, or recreation of its members." However, social functions for the benefit of members may be carried out if incidental to the organization’s primary purposes.

B. Private Foundation Classification.

1. All 501(c)(3) organizations are also classified by the IRS as to private foundation status under 509(a).

a. An organization is either a private foundation or it is a public charity. The presumption, unless an organization can show otherwise, favors a finding of private foundation status.

b. Private foundations are subject to a number of special excise taxes on passive income, undistributed income, impermissible expenditures, etc. which generally make private foundation status undesirable.

2. The chief difference between a public charity and a private foundation is the source of financial support. A private foundation derives its financial support from a small number of private sources, while a public charity is primarily supported by the public. There are four ways an organization can demonstrate that it is not a private foundation:

a. Traditional charity status. Certain organizations are presumed to be a public charity, including: churches; schools, certain hospitals and medical research organizations; collegiate support organizations; governmental units; and organizations deriving at least 33% of their support from public contributions and government grants.

b. Service provider organizations. Organizations receiving more than one-third of their support from contributions and revenues from related business enterprises (exclusive of revenues from certain major donors).

c. Support organizations. An organization which is operated to benefit, perform the functions, or carry out the purposes of another public charity which is controlled by the public charity.

d. An organization organized and operated exclusively for testing for public safety.

C. Public Foundation Status.

1. General Definition. A public foundation is a "donative" public charity which should be qualified as an IRC 509(a)(1) and 170(b)(1)(A)(vi) charity and not as a 509(a)(2) "service provider" charity.

a. To qualify as a "charitable" entity, the public foundation must meet the organizational and operational tests described above.

b. A public foundation is not a private foundation. A private foundation derives its financial support from a small number of private sources, while a public foundation is primarily supported by the public.

2. A Publicly Supported "Donative" Charity. A public foundation must meet the one-third public support requirements for a "donative" [i.e., a 509(a)(1) organization] charity, or otherwise be able to demonstrate facts and circumstances in support of its donative status.

a. A public foundation qualifies as a "donative" publicly-supported charity if it attracts, receives, and depends on financial support from members of the general public on a regular, recurring basis.

b. A "donative" charity is distinguished from a "service provider" charity [a 509(a)(2) organization] which receives its primary support from membership fees and receipts from admission, sales of merchandise, performance of services, etc. in a business related to its exempt purposes.

c. A public foundation is not required to engage in periodic community-wide fund raising campaigns.

3. The governing body of a public foundation must:

a. have the power to modify any restriction on the distributions of funds where it is inconsistent with the charitable needs of the community;

b. commit itself to the exercise of its powers in the best interests of the public foundation; and

c. commit itself to seeing that funds are invested pursuant to accepted standards of fiduciary conduct. [Reg. 1.170A-9(e)(11)(v)].

II. Governmental Activities.

A. Lobbying Activities.

1. A 501(c)(3) organization may not devote a substantial part of its activities for lobbying purposes.

a. Lobbying means carrying on propaganda or otherwise attempting to influence legislation.

b. Lobbying also includes urging individuals to contact their legislators to propose, support, or oppose legislation.

2. If substantial lobbying activities exist, tax exempt status is forfeited. Lobbying activities may be found to be substantial in the ten to twenty percent (10-20%) range of total nonprofit activities.

3. Sec. 501(c)(3) organizations other than churches, church auxiliaries, and certain affiliated organizations are permitted to make a special election under 501(h).

a. For electing organizations, lobbying expenses are limited to between five and twenty percent (5-20%) of their annual budget for exempt expenses.

b. A maximum limit on lobbying expenses of $1,500,000 applies, although an additional twenty-five percent (25%) of this amount is allowed for grass roots expenses.

B. Political Campaigning Activities.

1. A 501(c)(3) organization is absolutely prohibited from engaging in any political campaigning activities whatsoever, or else it will forfeit its tax exempt status.

a. Campaign activity includes participation or intervention in any political campaign on behalf of, or in opposition to, any candidate for public office. A candidate is any contestant for elective office.

b. Political campaign activities relate to individual candidates, whereas lobbying activities relate to social issues and laws.

c. Participation in a campaign includes publishing or distributing statements made either by a candidate or by someone else directed at a candidate.

C. Prohibited Political Activities.

1. The endorsement of candidates.

2. Making donations to a candidate’s campaign.

3. Engaging in fund raising on behalf of a candidate.

4. Distributing statements supporting or opposing a political candidate.

5. Becoming involved in any other activities that may be beneficial or detrimental to any candidate.

III. Unrelated business activities

A. Any organization exempt from tax under 501(a) must nonetheless pay income tax on its unrelated business income. This refers to income derived from any unrelated trade or business regularly carried on.

1. An "unrelated" trade or business is one which is not substantially related to fulfilling the organization’s exempt purposes, aside from the need for funds. A trade or business is "related" if the activity is: a) causally connected to achieving an important exempt purpose of the organization; and b) the causal connection is "substantial."

2. A "trade or business" includes any activity carried on for the production of income from the sale of goods or the performance of services. Key factors in determining whether an activity is a trade or business include:

a. Whether a profit motive is evident.

b. Whether the activity is normally conducted by commercial enterprises, or is viewed as competitive to commercial businesses.

3. Whether any activity is "regularly carried on" depends on the frequency and continuity of the activity.

B. Exceptions to UBTI.

1. UBTI does not include income from any trade or business:

a. In which substantially all the work is performed for the organization without compensation.

b. Which is carried on by a 501(c)(3) charity or a state college or university primarily for the convenience of its members, students, employees, or officers.

c. Carried on by certain local associations of employees.

2. UBTI does not include, for organizations exempt under 501 and contributions to which are deductible under 170(c)(2) or (3);

a. Income from exchanging or renting membership or donor lists to or with another similarly exempt organization. But, watch out if the other organization is not similarly exempt!

b. Activities related to distributing "low cost articles" incidental to the solicitation of donations.

(1) A "low cost article" is one which costs the organization no more than $6.70 in 1996 (indexed for inflation).

(2) The low cost articles must be distributed without being requested or consented to by the donor.

(3) The articles must be accompanied by a solicitation for donations and a statement that the article may be kept regardless of whether a donation is made.

3. UBTI generally does not include income from "passive" sources, such as dividends, interest and royalties, or rental of real estate.

a. However, such income will be taxable if: a) derived from a controlled organization; or b) derived from debt-financed property.

b. Note: rental of personal property or intangible property is generally taxable as UBTI. Thus, Payments received by a nonprofit for the use of its name and logo, together with an exclusive active endorsement of a certain product (such as long-distance telephone services), are viewed by IRS as rental income, not royalties. This case involved Disabled American Veterans.

C. Other Considerations Regarding Unrelated Activities.

1. If a nonprofit accepts paid advertising, the advertising fees may be unrelated business taxable income. The act of selling advertising is not in itself a tax exempt activity, but is a sale of a business service that is taxed like a business is taxed.

2. However, advertising can be related to an exempt purpose if:

a. The organization coordinates the content of the advertisements with the editorial content of the publication; or

b. Published advertisements reflect new developments in the fields promoted by the organization as part of its exempt purposes.

3. If unrelated activities become substantial, a nonprofit organization may lose its tax-exempt status. Although there is no "bright line" test under federal tax law, an activity generally becomes "substantial" somewhere between 10% and 20% of gross revenues or gross expenditures.

4. An organization’s unrelated business activities are generally not exempt from state sales taxes and other state taxes.

IV. Reporting Requirements.

A. Form 990. Form 990 is required to be filed by nearly all exempt organizations. Among other things, Form 990 now requires disclosure of:

1. Unrelated business taxable income;

2. Allocation of revenues and expenses between fundraising, program activities and administration;

3. Disclosure of excise taxes paid by reason of improper lobbying or political activities; and

4. Disclosure of excise taxes paid by reason of excess benefit transactions.

B. Public Inspection File. [IRC 6104]

1. Application for Exemption (Form 1023 or 1024). The full application, together with all papers submitted in support and the determination letter issued by the IRS, must be available for public inspection.

2. Annual Returns (Forms 990). Annual returns must be made available for public inspection for 3 years after filing with the IRS.

3. When and How. Inspection files must be maintained at the organization’s principal office and at any other regularly maintained office having 3 or more employees.

a. Anyone may request a copy of such documents - and only a reasonable copying charge (and mailing cost, if applicable) can be collected.

b. Written requests must be complied with in 30 days. In person requests must be satisfied immediately.

4. Penalties.

a. IRC 6652. A willful failure to comply with IRC 6104 is subject to a penalty of $5,000.

b. IRC 6685. Organizations which fail to timely file Form 990 are subject to a penalty of $20/day up to the lesser of $10,000 or 5% of its gross receipts. For organizations with gross revenues exceeding $1,000,000 annually, the penalty is $100/day up to the lesser of $50,000 or 5% of its gross receipts.

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