Charitable organizations continue to be subjected to increasing scrutiny by the public and by the Internal Revenue Service (“IRS”). In recent speeches, the IRS Exempt Organizations Director has reported that IRS priorities include improving data analysis capabilities for analyzing Form 990. The IRS plans to use the data to identify patterns and trends in reporting that are indicative of non-compliance. How will your Form 990 stack up?
The 990 is the single most important tool that a nonprofit organization has to protect and preserve its tax-exempt status. This favored tax status is granted to organizations that meet key principles.
When it comes to addressing these key principles, it is important for nonprofit organization stakeholders to understand actions that can potentially jeopardize an organization’s exempt status. Understanding the requirements for reporting and disclosing information on Form 990 is crucial to maintaining tax-exempt public charity status.
1. Safeguard the charitable purpose
Detailed explanations of program service accomplishments are reported on Part III of Form 990 after a brief description of the organization’s mission. If the organization engaged in new program services not previously reported or made significant changes in how it conducts any program service, these new services or changes must be described on Schedule O.
Exempt status can be revoked because of a material change in the character, purpose or method of operation of the organization that is inconsistent with its exempt purpose. Before an organization takes any steps to implement or change program services, an oversight process is essential to ensure that programming changes will not adversely affect the tax-exempt status.
The IRS has revoked the tax-exempt status of organizations where it found the organization failed to operate primarily for exempt purposes.
2. Be vigilant to prevent private benefit
The design of Form 990 includes several sections and schedules to provide transparency so that organizations violating this principle will be exposed. On Part VII of Form 990 compensation paid to officers, board members, key employees and highest compensated employees is reported and includes compensation and non-taxable benefits from related organizations. Aggregate compensation that the IRS rules is excessive can result in intermediate sanctions. Intermediate sanctions impose an excise tax on any transaction that provides excess economic benefits to a person who is in a position to exercise substantial influence over the affairs of the exempt organization. The excise tax is 25% of the excess benefit. There is an additional tax of 200% of the excess benefit if the transaction is not corrected within a time frame determined by the IRS.
Business transactions and independence
All board members, trustees and directors who served at any time during the organization’s fiscal year are also listed on Part VII. If a board member is engaged in a business transaction that is reportable on Schedule L they are not independent.
Business transactions with board members which are reportable on Schedule L include loans of any amount to/from the organization, contracts of sale, leases, licenses, insurance and performance of services.
The IRS has ruled in a number of cases that a small board, a board with too many related board members, and a board with too few persons with control over the organization is an automatic private benefit.
A well written conflict of interest policy that is monitored and enforced is essential to identifying reportable transactions.
3. Prevent the use of exempt assets for non-exempt purposes
Revocation of tax-exempt status can result from the use of exempt purpose assets for non-exempt purposes, such as:
– Conducting a significant unrelated trade or business.
– Lending without the receipt of adequate security and a reasonable rate of interest.
– Paying unreasonable compensation.
– Providing services on a preferential basis.
– Paying more than fair market value for property or securities.
– Selling any substantial part of investments or other property for less than an adequate consideration.
– Engaging in any other transaction which results in a substantial diversion of income or corpus.
Even in cases where loans to insiders, management and other disqualified persons are repaid, loans without arm’s length terms are considered to be promoting a private interest rather than a charitable purpose, thereby jeopardizing tax-exempt status.
4. Monitor your public charity status
Public charities must pass a test (reported on Schedule A of Form 990) to demonstrate that they attract broad public support. At least 33-1/3% of contributions received (on average over a rolling 5-year period) must come from the general public. Donors giving more than 2% of total contributions are defined as substantial contributors and the excess over 2% of total contributions is excluded from public support. Accordingly, organizations that rely on a limited pool of major donors run the risk of falling below the 33-1/3% minimum required to maintain public charity status.
An organization that fails the public support test will not lose its tax-exempt status, but it will be reclassified as a private foundation, which receives less favorable tax treatment. The private foundation is subject to excise tax on investment income and its charitable activities may be limited.
5. Comply with the annual return filing requirement
The Pension Protection Act of 2006 includes a provision requiring all tax-exempt organizations to file annually for taxable years beginning in 2007. Failure to file information returns under IRC Section 6033 for three consecutive years is basis for automatic revocation of tax-exempt status.
To protect your organization’s exempt status, be sure to have your annual Form 990 reviewed by a professional who can provide guidance on these fundamental reporting issues.