You’ve decided to form a nonprofit. Just like forming a for-profit business, you have a lot of decisions to make upfront, many of which will require outside counsel from an accountant, a consultant, or an attorney. Without experienced counsel, your startup will face difficult challenges and could be doomed to failure.

First Step: Create Your Legal Entity.

For the IRS to recognize a nonprofit’s exemption from taxation, it must be organized as a trust, a corporation, or an association. (An unincorporated association can gain recognition as a tax-exempt organization, but this form of organization is not typically recommended for various reasons). Nonprofit incorporation or formation creates your nonprofit entity in your chosen home state. Your Articles of Incorporation/Formation will be required when applying for exempt status. This is also the first place where you will identify your nonprofit’s purpose.

Write Your Bylaws

Bylaws are legal documents, which means there are legal requirements for what should be included. These requirements vary depending on the state in which your nonprofit operates. To ensure your bylaws are in accordance with state laws, get assistance in drafting or amending your bylaws from a qualified professional experienced in nonprofit matters.

Your bylaws are your organization’s operating manual. Typically, they will include:

Size of the board and how it will function

Roles and duties of directors and officers

Rules and procedures for holding meetings, electing directors, and appointing or removing officers

Conflict of interest policies and procedures

Other essential corporate governance matters

As a governing document, your bylaws need to be included in your exemption application. The IRS looks for two key provisions to be included in either your Incorporation/ Formation Document or your bylaws:

A purpose clause: What are you going to do, and who will benefit from what you do? The purpose clause will help the IRS determine your organization’s exact exemption code.

A dissolution clause. How will you “go out of business” if the organization is not sustainable?

If you anticipate filing for 501c3 status, the IRS has specific requirements that apply to your purpose and dissolution clauses.

The bylaws may be quite different depending on the organization. Is the goal to gain status as a public charity, a private foundation, or some other type of exempt organization such as a membership organization?

Even with counsel, it’s still the board’s responsibility to provide input throughout the process and to vote to adopt the final product. Although bylaws are not considered public documents, making them public and easily available increases the organization’s accountability and transparency to donors, beneficiaries, and the general public.

Develop a Business Plan

Every nonprofit seeking tax-exempt status must have an Employer Identification Number (EIN), whether or not it has employees. File a Form SS-4 with the IRS to obtain your EIN.

This is the time for the organization to act like a business and develop its business plan. The business plan should address/include the following:

Past, present, and planned activities and programs

Any planned compensation of directors, officers, trustees, and certain highly paid employees and contractors (“Close Personnel”)

Any planned compensation of Close Personnel from related organizations

Existing or planned sales and/or contracts between the organization and any Close Personnel (including any organizations they have certain affiliations with)

Discussion of family and business relationships among directors, officers, and trustees

Goods, services, and/or funds (grants) to be provided to individuals or organizations

Fundraising programs planned

Conflict of interest policy or explanation of how the organization manages conflicts of interest

Financials (actual and/or projected) for three or four years

Besides being a business best practice, gathering much of this information will be necessary if you are required to complete a full Form 1023 or 1024 for exempt status.

Seek Exempt Status

Incorporating a nonprofit in the state of formation only establishes it as a legal business entity. Creating a nonprofit corporation does not guarantee the organization will be granted tax-exempt status by the Internal Revenue Service (IRS). You must apply for tax-exempt status with the IRS and be approved. There are currently 40 different types of exempt organizations in the Internal Revenue Code. Only organizations that meet the requirements of Internal Revenue Code Section 501(a) are exempt from federal income taxation. And charitable contributions made to some Section 501(a) organizations by individuals and corporations are deductible under Section 170.

Other benefits may include access to certain grant monies and income and property tax exemptions.

Determining the correct exempt status for the organization will depend heavily on who will benefit from the mission or its purpose, whether the assets will be dedicated to the mission, and where funding will come from.

Public Charities and Private Foundations

Every exempt charitable organization is classified as either a public charity or a private foundation. Generally, organizations classified as public charities are:

Churches, hospitals, qualified medical research organizations affiliated with hospitals, schools, colleges, universities, and other organizations that benefit the general public;

Have an active program of fundraising and receive contributions from many sources, including the general public, governmental agencies, corporations, private foundations, and/or other public charities;

Receive income from the conduct of activities in furtherance of the organization’s exempt purposes; or

Actively function in a supporting capacity to one or more existing public charities.

Private foundations usually have a single major source of funding, typically a gift from one family or a corporation, and most have as their primary activity the making of grants to other charitable organizations and individuals rather than the direct operation of charitable programs. Some private foundations, called private operating foundations, do directly operate their own charitable programs.

Political Organizations

A political organization subject to Section 527 is a party, committee, association, fund, or other entity (whether or not incorporated) organized and operated primarily for the purpose of directly or indirectly accepting contributions or making expenditures, or both, for an exempt function.

Other Organizations

Organizations that meet certain requirements may qualify for exemption under subsections other than 501(c)(3). These include social welfare organizations, civic leagues, social clubs, labor organizations, and business leagues.

Application for Exemption

Certain types of organizations are automatically considered exempt without actually filing an application with the IRS, most notably, churches, their integrated auxiliaries, and conventions or associations of churches. Others must file either Form 1023, 1023-EZ, 1024, or 1024-A with the IRS seeking status. All applications are now filed online.

Organizations seeking status under 501c(3) apply using a 1023 or 1023-EZ form. Others seek status by filing Form 1024 or 1024-A.

When filing for a 501c3 determination, smaller organizations may file the simpler EZ Form— Streamlined Application, 1023-EZ. These applications are much easier and take less time complete, and the filing fee is smaller. Larger organizations will file full 1023 or 1024 forms and require much of the information in your “business plan.”

To get the most out of your tax-exempt status, file your Application Form within 27 months of the date you file your nonprofit Articles of Incorporation. If you file within this time period, your nonprofit’s tax exemption when granted takes effect on the date you filed your Articles of Incorporation, and all donations received from the point of incorporation forward will be tax-deductible. If you file later and can’t show “reasonable cause” for your delay, your tax-exempt status will begin as of the date on your IRS Application.

Once You File

Once you submit your application, you will receive an acknowledgment notice from the IRS confirming receipt of your application. If the IRS needs more information, an Exempt Organization specialist may request further information and will contact you and/or your power of attorney. If you have counsel or another representative assisting you with your application, contact them immediately regarding the additional information being requested. Do not try to answer their questions without their assistance.

Once the IRS completes its review of the exempt application, they will send you a determination letter, which will either grant your federal tax exemption or issue a proposed adverse determination, a denial of tax exemption that becomes effective 30 days from the date of issuance. If you receive a proposed denial of tax-exempt status, you have the right to appeal and should seek expert advice immediately. Do not delay; waiting to reply will risk the denial of your exemption.

The IRS review process typically takes several months or longer. Be prepared to wait. The IRS is currently processing 95,000 applications annually. Applicants can review current wait times by going to the IRS website: https://www.irs.gov/charities-non-profits/charitableorganizations/wheres-my-application-for-tax-exempt-status. You can also contact the IRS by phone at 877-829-5500; by fax at 855-204-6184; or by regular mail at:

Internal Revenue Service

EO Determinations; Attn: Manager, EO Correspondence;

P.O. Box 2508; Room 6-403; Cincinnati, OH 45202.

Compliance Begins Immediately

Unless you qualify for an exception from the requirement to file an annual return or notice, your filing obligations begin as soon as you are formed. If you have an annual information return or tax return due while your application is pending, complete the return by checking the “Application Pending” box in the heading Item B, and submit the return as indicated in those instructions. You should also determine when you are required to begin your state’s compliance filings, as each state has its own set of requirements.

Setting up an exempt organization can be confusing, to say the least. The HBK Nonprofit Solutions team is here to help.

Read the full Fall issue of Insights, the HBK Nonprofit Solutions quarterly newsletter.

In order to qualify for tax-exempt status, charitable organizations must comply with very stringent rules related to the activities they are allowed to carry out. In general, these rules require that a charitable organization’s activities be directly related to the organization’s tax-exempt purpose. However, in most instances, a charitable organization is allowed to invest in or engage in a trade or business that is considered unrelated to the exempt purpose. So long as the charitable organization follows the rules, and pays the tax, they will continue to maintain their exempt status. This article addresses what activities are considered an unrelated trade or business under these rules, and how a charitable organization can comply with the reporting requirements related to these activities.

Definition of Unrelated Trade or Business

An unrelated trade or business is generally defined as an activity that is regularly carried on and unrelated to a charitable organization’s exempt purpose. This determination is made by looking at the actual activity – not what the organization does with the revenue generated from the activity. While this definition may seem straight forward, many activities would appear to be unrelated, but qualify for an exception. And many activities perhaps should be considered related, but are not.

For instance, some income from investment activities – interest, dividends, capital gains, and rental income – would appear to be unrelated to an organization’s exempt purpose, but these items of income are specifically excluded from the definition of an unrelated trade or business for most charitable organizations. In contrast, revenue generated from advertising in a newsletter that a charitable organization publishes in furtherance of their exempt purpose is generally considered unrelated to the organization’s exempt purpose because it is commercial in nature.

Determining whether an activity is an unrelated trade or business depends on the facts and circumstances of any given situation, and therefore the best guidance available comes from court cases, revenue rulings, and other guidance that the Internal Revenue Service provides. Here are some examples of activities that are unrelated and therefore subject to tax:

• The leasing activity of an exempt organization is considered an unrelated trade or business where the building that is being leased is subject to a mortgage, but only the rental income that relates to the mortgaged portion is subject to tax since it is financed by debt and not eligible for exclusion.
• The sale of scientific books and city souvenir items by an art museum is unrelated to the art museum’s exempt purpose because these items have no causal relationship to art or artistic endeavors.
• Income from pet boarding fees and grooming services for the general public that is received by an organization that advocates for the prevention of cruelty to animals is considered unrelated to the organization’s exempt purpose because the activities do not contribute to the purpose of preventing cruelty to animals.

On the other hand, these activities were found to be related to a charitable organization’s exempt purpose:

• A museum’s operation of eating facilities, which help attract visitors and allow them to spend more time viewing the museum’s exhibits, is related to the museum’s exempt purpose because it contributes to the museum’s accomplishment of its exempt purpose.
• A gift shop operated by an exempt hospital is substantially related to the hospital’s exempt purpose because it allows visitors to make purchases for patients and employees.
• The operation of a furniture shop by an exempt halfway house that provides full-time employment for the residents is related to the exempt purpose because it aids the residents in their transition from treatment to a normal and productive life.

Reporting Unrelated Trade or Business Income

Once a charitable organization determines that an activity is an unrelated trade or business, the organization must then account for the revenue and expenses related to that activity and then determine whether it is required to file Form 990-T to report the net income. A Form 990-T is required if gross income exceeds $1,000 during the tax year. If the organization is not required to file, it may still benefit from filing if there are losses that may carry forward to offset income in future years.

If an organization has more than one unrelated trade or business, these activities will generally need to be accounted for and reported separately, and tax must be calculated separately on each activity. This separate treatment is a relatively new reporting requirement, imposed by the Tax Cuts and Jobs Act (TCJA) of 2017. The Treasury Department recently issued regulations providing some relief to this requirement, and allowing organizations to aggregate some investment income received from partnerships and other entities that the organization may invest in.

Form 990-T is due on the 15th day of the fifth month after the end of the organization’s tax year. An organization that has a year-end of December 31st will therefore need to file Form 990-T by May 15th of the following year. The organization may also apply for a six-month extension to a filing by submitting a request on Form 8868 on or before the original due date. Note that this extension is separate from an extension to file the organization’s Form 990, 990-EZ, 990-N, or 990-PF. In addition, any taxes that may be owed must be paid by the original due date of the return. Payments are made electronically using the Electronic Federal Tax Payment System (EFTPS). Late payment and late filing penalties may apply if the organization misses these deadlines.

Conclusion

The rules governing unrelated trades and businesses that are carried out by charitable organizations are complicated. Having an experienced nonprofit specialist is critical to ensuring that an organization is in compliance with these rules and is not potentially subjecting the organization to unnecessary penalties. If you operate or are involved in the operation of, a charitable organization, we encourage you to reach out to the HBK Non-Profit Solutions Group to assist you in understanding and complying with the unrelated trade or business rules.

The IRS announced on Thursday that it had sent premature notices to nonprofits indicating that their tax-exempt status had been revoked, citing their inability to change the due date within their systems. The tax-exempt status of nonprofit organizations is automatically revoked if the organization does not file a tax return (Form 990 series) for three consecutive years. This year, some organizations received this notice after they failed to file a tax return by the filing deadline of May 15, 2020, even though an extension to July 15, 2020, had been granted due to the pandemic.

The IRS indicated that it is working with organizations that received premature notices, and it has established a dedicated fax number, 855-247-6123, to receive filings from tax-exempt organizations. The IRS is also processing returns that were paper filed by the extended due date.

Please contact your HBK tax advisor if your organization received a notice that the tax-exempt status has been revoked, or if you have any questions or concerns.

The Taxpayers First Act of 2019 has two provisions that relate specifically to tax-exempt organizations; a mandate for electronic filing, and reform to IRS notice requirements related to failure to file.

Before the Act was in place only tax-exempt organizations meeting certain thresholds were required to electronically file their return, while all others had the option to paper-file. The following tax-exempt returns and their related forms are now required to be filed electronically:

• Form 990: Return of Organization Exempt from Income Tax
• Form 990-PF: Return of Private Foundation or Section 497(a)(1) Trust Treated as Private Foundation
• Form 8872: Political Organization Report of Contributions and Expenditures
• Form 1065: U.S. Return of Partnership Income (if filed by a Section 501(d) apostolic organization)

 

For those organizations that file Form 990 or 990-PF, this mandate is applicable to tax years ending July 31, 2020, and later. Form 8872 will no longer be accepted by the IRS if paper filed for periods after 2019. The mandate includes transition relief for small tax-exempt organizations who file Form 990-EZ, where the IRS will accept either paper or electronic filings for tax years ending before July 31, 2021. Certain forms are not yet available for electronic filing by the IRS, including Forms 990-T and 4720. The IRS is working to convert these forms into electronic format and plans to have these forms available for e-filing in 2021.

Additionally, the Taxpayers First Act now requires the IRS to send a notice to organizations who have not filed their annual Form 990-series return or postcard for two consecutive years and are therefore at risk of losing their tax-exempt status. This requirement will provide an organization the time needed to file the required annual returns. An organization’s tax-exempt status will be revoked should they fail to file their annual information return for three consecutive years. Previously, the IRS had the ability to automatically revoke an organization’s tax-exempt status after three years of non-filing without sending a notice to the organization. Any organization who loses their status due to failure to file must reapply for tax-exempt status with the IRS.

Employers have provided employees with parking at the workplace for many years without a tax cost. It has been considered a non-taxable fringe benefit and rightly so. Now under recent IRS guidance in Notice 2018-99, most every employer, including tax-exempt organizations, will have tax consequences to consider related to providing employee parking.

The 2017 Tax Cuts and Jobs Act changed the law related to employee parking, but most thought this would be an issue if an employer was paying a third-party for employee parking. Under the new law, effective for parking expenses paid or incurred after December 31, 2017, a for-profit employer is not allowed to deduct expenses related to providing employee parking and tax-exempt organization employers must treat the amount paid for employee parking expenses as unrelated business taxable income (UBTI) and will pay an income tax if the amount of employee parking expenses exceeds $1,000.

Fiscal year for for-profit filers for tax returns filed for years ending in 2018 should consider the amount of employee parking expenses paid or incurred after 12/31/2017. Tax-exempt filers for years ending in 2018 should consider the amount of parking expenses paid or incurred after 12/31/2017 as unrelated business income.

There are two notable exceptions to the disallowance rule. The first is if the parking benefit is included in the taxable wages of the employees. The second is if that parking is primarily for the general public and not primarily for employees.

There is an ongoing effort to repeal this tax provision, but passage of repeal faces a number of political hurdles.

What is considered parking expenses?
Parking expenses are not just what is paid to a third party for parking spaces, but expenses an employer incurs for a parking lot owned by an employer or leased by an employer. Parking expenses included a portion of rent or lease payments allocated to parking if not broken out separately, repairs, real estate taxes, insurance among other expenses.

Other expenses related to parking are also to be considered, but depreciation of any costs related to the parking lot or facility is not to be considered.

After identifying all parking expenses, an allocation of those expenses to employee parking must be determined. Typically, an employer will designate parking spaces for visitors and certain others that effect the determination of the amount that is not deductible or is to be considered UBTI by a tax-exempt organization. Additionally, reserved spaces for employees have expenses allocated in a manner different than general parking for employees. Lastly, if parking is primarily used by the general public, rather than employees, then these rules do not apply at all.

The IRS also issued Notice 2018-100, which provides for a waiver of penalties, in certain circumstances, for the failure by tax-exempt employers to make quarterly estimated income tax payments otherwise required to be made on or before December 17, 2018. The penalty relief is available only to tax-exempt employers that were not previously required to file Form 990-T and that underpaid their estimated income tax due to the parking expenses being included in UBTI.

This penalty relief applies only in case of underpayment of quarterly estimates. Tax-exempt employers that fail to timely file Form 990-T or that fail to pay taxes by the original due date are not eligible for the relief. To claim the waiver, the tax-exempt organization must write ‘Notice 2018-100’ on the top of its Form 990-T.

Employer who pays a third party for parking spots.
If an employer pays a third party an amount so that its employees may park at the third party’s parking lot or garage, the disallowance generally is calculated as the employer’s total annual cost of employee parking paid to the third party. However, if the amount the taxpayer pays to a third party for an employee’s parking exceeds a monthly limitation, which for 2018 is $260 per employee, that excess amount must be treated by the taxpayer as compensation and wages to the employee.

Employer who owns or leases all or a portion of a parking lot or facility.
Until further guidance is issued, if a taxpayer owns or leases all or a portion of one or more parking lots or facilities where its employees park, the deduction disallowance and UBTI amount may be calculated using any reasonable method.

Using the “value” of employee parking, rather than an allocation of actual parking expenses, to determine expenses allocable to employee parking in a parking lot or facility owned or leased by the taxpayer is not considered a reasonable method. The IRS guidance provides the following four step methodology that is deemed to be a reasonable method.

1. Calculate the disallowance for reserved employee spots.
2. Determine the primary use of the remaining spots (for the general public (over 50 percent) or for employees).
3. Calculate the allowance for reserved nonemployee spots.
4. Determine the remaining use and allocable expenses.

Please contact us about your specific situation so we can assist you to comply with these requirements. We have developed an approach to determine what a reasonable approach to allocate expenses to employee parking. We will keep you informed of possible changes to this parking tax.