fbpx

TCP CPA Exam: Understanding the Events That Would Cause an Entity to Lose Its Tax-Exempt Status

Understanding the Events That Would Cause an Entity to Lose Its Tax-Exempt Status

Share This...

Introduction

Purpose of the Article

In this article, we’ll cover understanding the events that would cause an entity to lose its tax-exempt status. Understanding the events that can lead to the loss of tax-exempt status is crucial for both tax-exempt organizations and professionals preparing for the TCP CPA exam. Tax-exempt entities, often categorized under Internal Revenue Code (IRC) Section 501(c), benefit from significant advantages, such as exemption from federal income tax and eligibility to receive tax-deductible contributions. However, these advantages come with strict compliance obligations, and failure to adhere to them can result in the revocation of the organization’s tax-exempt status.

For professionals studying for the TCP CPA exam, it is essential to understand these rules because advising tax-exempt organizations on maintaining their status or recognizing when it may be at risk is a critical component of tax planning and compliance. Missteps can lead to serious consequences, including tax liabilities, penalties, and damage to an organization’s reputation. The knowledge gained through this topic prepares future CPAs to provide informed guidance and mitigate risks for their clients.

Overview of Tax-Exempt Status

Tax-exempt status refers to an organization’s exemption from federal income tax, granted by the Internal Revenue Service (IRS) under IRC Section 501(c). To qualify, an entity must be organized and operated exclusively for exempt purposes, such as charitable, religious, educational, or scientific activities. While there are multiple categories of tax-exempt organizations under IRC Section 501(c), the most common is the 501(c)(3) designation for charitable organizations.

Organizations under 501(c)(3) are expected to operate for public benefit rather than for the personal benefit of individuals or shareholders. They must adhere to specific rules governing their operations, including restrictions on political activities, lobbying, and the use of their resources. In addition to charitable organizations, other types of tax-exempt entities include social welfare organizations under 501(c)(4), labor organizations under 501(c)(5), and business leagues under 501(c)(6).

Maintaining tax-exempt status requires ongoing compliance with both operational and reporting requirements set forth by the IRS. Failure to comply with these obligations can lead to the revocation of tax-exempt status, resulting in significant financial and operational consequences for the entity involved. Understanding what activities can trigger the loss of tax-exempt status is key to ensuring that organizations maintain their eligibility and continue to benefit from the tax advantages of their designation.

Overview of the Criteria for Maintaining Tax-Exempt Status

Qualifying as a Tax-Exempt Entity

To qualify for tax-exempt status, an entity must meet specific organizational and operational requirements established by the IRS under IRC Section 501(c). Primarily, the organization must be formed as a nonprofit, meaning that its primary purpose is not to generate profits for private individuals or shareholders but to further a recognized public or social good. The entity’s formation documents—such as its articles of incorporation or bylaws—must explicitly state its exempt purpose, and it must operate exclusively to advance that purpose.

Additionally, the entity must not engage in activities that violate the restrictions placed on tax-exempt organizations. For instance, it cannot participate in political campaigns, engage in excessive lobbying, or allow its earnings to benefit private individuals (a concept known as “private inurement”). These restrictions ensure that the entity’s focus remains on benefiting the public or a specific charitable cause rather than private interests.

The IRS also requires entities to apply for tax-exempt status by filing Form 1023 (for 501(c)(3) organizations) or Form 1024 (for other types of exempt organizations). This application process involves submitting detailed information about the organization’s structure, activities, and financials to prove that it meets the legal criteria for tax-exempt status.

IRC Section 501(c) Provisions

IRC Section 501(c) contains several subsections that describe the different types of organizations eligible for tax-exempt status. While there are various categories, the most common include:

  • 501(c)(3) Charitable Organizations: These entities must operate exclusively for charitable, religious, educational, scientific, literary, or public safety purposes. They may not support political candidates or devote substantial resources to lobbying activities. Donations made to 501(c)(3) organizations are tax-deductible for the donors.
  • 501(c)(4) Social Welfare Organizations: These entities focus on promoting the common good and general welfare of the community. Unlike 501(c)(3) organizations, they are allowed to engage in lobbying as a significant part of their activities, and they can participate in some political activities, although contributions to them are not tax-deductible.
  • 501(c)(5) Labor and Agricultural Organizations: These entities exist to support the interests of labor unions or agricultural organizations. They may engage in lobbying activities, but like 501(c)(4) organizations, contributions to them are not tax-deductible.
  • 501(c)(6) Business Leagues and Trade Associations: These organizations promote the common interests of their members, which typically consist of professionals or business owners. They can lobby on behalf of their members but cannot participate in political campaigns.

Each type of organization under IRC Section 501(c) must adhere to specific rules that govern their activities, especially concerning political involvement, lobbying, and the distribution of profits.

Ongoing Compliance

Maintaining tax-exempt status is not a one-time process. Organizations must comply with IRS regulations on an ongoing basis to retain their status. Key compliance obligations include:

  1. Adhering to Operational Restrictions: The organization must continue to operate within the scope of its exempt purpose as stated in its governing documents. Any deviation from this purpose, such as engaging in substantial unrelated business activities, could jeopardize the organization’s tax-exempt status.
  2. Avoiding Prohibited Activities: Tax-exempt organizations, especially 501(c)(3) entities, are strictly prohibited from engaging in political campaign activities and must limit their lobbying efforts. Violations of these rules can trigger penalties and the potential loss of exemption.
  3. Preventing Private Inurement and Private Benefit: No part of a tax-exempt organization’s earnings may inure to the benefit of private individuals, and its activities must serve the public interest. Transactions that unfairly benefit insiders, such as excessive compensation or private use of the organization’s assets, can lead to revocation of tax-exempt status.
  4. Filing Annual Returns: Most tax-exempt organizations are required to file Form 990 annually, which provides detailed information on their finances, governance, and activities. Failing to file for three consecutive years results in automatic revocation of tax-exempt status.

Noncompliance with these IRS rules and regulations can trigger revocation proceedings, in which the IRS reviews whether the organization continues to meet the criteria for tax exemption. If an organization is found to be noncompliant, its tax-exempt status may be revoked, exposing it to federal income taxes and other penalties. Therefore, continuous monitoring of the organization’s activities and adherence to IRS requirements is critical for maintaining its tax-exempt status.

Key Events That Can Lead to the Loss of Tax-Exempt Status

Engaging in Political Campaign Activity (Prohibited Political Activity)

Explanation

One of the strictest prohibitions for 501(c)(3) tax-exempt organizations is the rule against engaging in political campaign activities. The IRS explicitly states that these organizations may not participate in, or intervene in, any political campaign on behalf of—or in opposition to—any candidate for public office. This prohibition applies to all types of political campaigns, from federal elections to local races.

Activities considered political intervention include endorsing or opposing candidates, making financial contributions to political campaigns, distributing statements or publications favoring one candidate over another, and even allowing the organization’s facilities or resources to be used for political purposes. The IRS also takes a broad view of what constitutes political involvement, meaning that even indirect support or opposition, such as through public statements or social media endorsements, could be seen as a violation of this rule.

The rationale behind this prohibition is that tax-exempt organizations, particularly those classified under 501(c)(3), are supposed to serve public interests, not political interests. Engaging in political activities undermines this purpose and can lead to the organization being perceived as a tool for private or partisan gain rather than public benefit.

Case Studies

Several organizations have lost their tax-exempt status due to political involvement, serving as cautionary tales for others:

  1. The Church at Pierce Creek (1995)
    In this landmark case, the Church at Pierce Creek, a 501(c)(3) organization, lost its tax-exempt status after it ran full-page advertisements in national newspapers opposing then-presidential candidate Bill Clinton. The ads explicitly called on Christians not to vote for Clinton, citing his stance on issues such as abortion and homosexuality. Despite disclaimers that the church was not endorsing any particular candidate, the IRS determined that the ads clearly violated the prohibition on political campaign activity. As a result, the IRS revoked the church’s tax-exempt status.
  2. Branch Ministries, Inc. v. Rossotti (2000)
    In another significant case, Branch Ministries, Inc., which operated the Church at Pierce Creek, challenged the IRS’s revocation of its tax-exempt status, claiming it was unconstitutional. However, the U.S. Court of Appeals upheld the IRS’s decision, reinforcing that 501(c)(3) organizations are prohibited from political involvement. This case highlights the IRS’s strict enforcement of the no-political-activity rule and the limited recourse available for organizations that violate it.

These cases demonstrate the importance of adhering to the IRS’s restrictions on political campaign activity. Even seemingly indirect or issue-focused communications can be interpreted as political intervention if they appear to support or oppose a candidate. As a result, tax-exempt organizations must exercise extreme caution when engaging in activities that could be construed as political to avoid jeopardizing their exempt status.

Excessive Lobbying Activities

Explanation

Lobbying, while closely related to political activity, is distinct and involves efforts to influence legislation, either directly by communicating with legislators or indirectly by mobilizing the public. For 501(c)(3) organizations, some lobbying is permissible, but it is subject to strict limitations imposed by the IRS. Unlike the outright ban on political campaign activity, 501(c)(3) organizations may engage in lobbying, but only to the extent that it does not constitute a “substantial part” of the organization’s activities.

The IRS applies two tests to assess whether lobbying activities are substantial:

  1. Substantial Part Test: This is the default test used by the IRS and is somewhat subjective. It examines the organization’s overall lobbying efforts relative to its other activities. If a substantial part of the organization’s resources, including time and money, are devoted to lobbying, the IRS may deem it excessive, potentially jeopardizing the organization’s tax-exempt status.
  2. Expenditure Test (Section 501(h) Election): Organizations can choose to be evaluated under the expenditure test by filing Form 5768 with the IRS. This test provides clearer limits by setting defined dollar thresholds based on the organization’s annual expenditures. Under this framework, lobbying expenditures are capped based on the organization’s size, and exceeding the cap results in penalties and potential revocation of tax-exempt status.

The critical distinction between lobbying and political activity is that lobbying seeks to influence specific legislation, while political activity involves supporting or opposing candidates for public office. For instance, advocating for or against a bill in Congress is considered lobbying, whereas endorsing a political candidate is political activity. Although limited lobbying is allowed, the IRS ensures that tax-exempt organizations remain primarily focused on their exempt purposes, rather than legislative advocacy.

Consequences

Engaging in excessive lobbying can lead to severe consequences for 501(c)(3) organizations. If lobbying activities are determined to be a substantial part of the organization’s operations, the IRS can revoke the organization’s tax-exempt status. This means the organization would be subject to federal income tax and would lose the ability to receive tax-deductible donations, which could severely impact its ability to raise funds.

In addition to losing its tax-exempt status, an organization that exceeds its allowable lobbying limits under the expenditure test can face stiff financial penalties. The IRS may impose excise taxes on the excessive lobbying expenditures, further straining the organization’s financial resources.

While tax-exempt organizations can engage in some lobbying, they must carefully monitor and limit these activities to avoid surpassing the IRS’s thresholds. Excessive lobbying can not only lead to the loss of tax-exempt status but can also harm the organization’s finances and reputation. Organizations that wish to be involved in legislative advocacy should consider filing the 501(h) election to gain more clarity on permissible lobbying limits and reduce the risk of violating IRS rules.

Private Inurement or Private Benefit

Explanation

Private inurement and private benefit are key concepts that the IRS uses to ensure that tax-exempt organizations operate for public, rather than private, interests. Both violations occur when individuals or insiders within an organization benefit unfairly from the organization’s earnings, assets, or activities, which contradicts the fundamental purpose of tax-exempt entities—to serve the public good.

  • Private Inurement: Private inurement specifically refers to situations where an insider—such as a director, officer, or key employee—receives an excessive or undue benefit from the organization’s resources. This can include receiving unreasonably high compensation, loans at below-market rates, or using the organization’s property for personal purposes. The IRS strictly prohibits private inurement in 501(c)(3) organizations, as these entities must ensure that no part of their earnings benefit any private individual.
  • Private Benefit: Private benefit is a broader concept that refers to the organization conferring benefits on any individual or group, not just insiders. While some private benefits are allowable if they are incidental to achieving the organization’s exempt purposes, they must be both quantitatively and qualitatively incidental. This means the benefit should be insignificant relative to the overall activities of the organization and essential to furthering the organization’s mission. For instance, a charity providing services to the general public that also indirectly benefits a private individual (such as a board member) must ensure that the private benefit is incidental to the public good being served.

In short, any time an exempt organization prioritizes private gain—whether through excessive insider compensation or indirectly benefiting private interests—it risks violating the private inurement and private benefit prohibitions. These violations threaten the organization’s tax-exempt status, as the IRS requires that exempt entities operate exclusively for public, charitable, or educational purposes.

Examples of Violations

There have been several high-profile cases where tax-exempt organizations engaged in private inurement or private benefit, leading to severe consequences, including the revocation of their tax-exempt status:

  1. Excessive Executive Compensation at United Cancer Council (1999)
    In this case, the IRS revoked the United Cancer Council’s 501(c)(3) tax-exempt status after it was discovered that the organization had entered into a fundraising contract that resulted in the charity’s primary fundraiser taking the vast majority of donations—while the charity itself received only a small fraction. The IRS argued that this arrangement conferred an excessive private benefit on the fundraiser, which constituted private inurement. The charity lost its tax-exempt status as a result.
  2. GCM Grosvenor (2020)
    GCM Grosvenor, a private equity firm, faced penalties when it was revealed that one of its tax-exempt subsidiaries had used its assets to benefit private individuals. Specifically, the IRS found that certain transactions resulted in significant private inurement to individuals within the organization. While Grosvenor ultimately paid financial penalties, the case serves as a reminder of the high cost of violating the private inurement rules.
  3. Private Benefit in the Case of Credit Counseling Organizations (2003)
    In the early 2000s, several credit counseling organizations lost their tax-exempt status due to violations of the private benefit prohibition. These organizations, which were set up to provide credit counseling services, were found to be primarily benefiting private for-profit companies that they had close business relationships with. Instead of operating solely for charitable purposes, these credit counseling agencies funneled clients to affiliated businesses, resulting in the IRS revoking their tax-exempt status.

These examples illustrate how organizations can lose their tax-exempt status when they fail to adhere to the rules prohibiting private inurement and private benefit. The consequences of such violations include not only revocation of tax-exempt status but also potential penalties, loss of public trust, and long-term damage to the organization’s reputation. To maintain their status, organizations must carefully manage their operations and ensure that their resources are used to further their exempt purposes, not to enrich private individuals or insiders.

Operating for Non-Exempt Purposes

Explanation

One of the fundamental requirements for maintaining tax-exempt status under IRC Section 501(c) is that an organization must operate exclusively for the purposes outlined in its tax-exempt application. For example, a 501(c)(3) organization must be dedicated to charitable, religious, educational, scientific, or similar purposes that serve the public interest. When an organization shifts its focus away from these exempt purposes or begins to engage in activities that primarily benefit private interests, it risks losing its tax-exempt status.

Operating for non-exempt purposes generally occurs when the organization’s activities no longer align with the mission for which it was granted exemption, or when it serves private rather than public interests. The IRS views this as a violation of the organization’s tax-exempt status because the entity is no longer functioning in a way that justifies its exemption from paying federal income tax. For instance, an organization whose primary activities become commercial in nature, such as operating a for-profit business, or whose resources are directed toward benefiting specific individuals or private interests, is no longer fulfilling its public service role.

When the IRS determines that a substantial part of an organization’s activities are for non-exempt purposes, it can revoke the entity’s tax-exempt status. This revocation has significant consequences, including the organization’s income becoming taxable and the potential loss of donor support, as donations to non-exempt entities are no longer tax-deductible.

Red Flags

Several activities could signal to the IRS that an organization is no longer operating for its stated exempt purposes. Here are some red flags that might indicate a shift towards non-exempt operations:

  1. Commercial Business Activities:
    If an organization devotes a significant portion of its resources to unrelated commercial ventures rather than its core exempt purpose, this may indicate it is operating for non-exempt purposes. For example, if a charity begins running a large-scale business that is unrelated to its mission (such as a retail store not connected to its charitable activities), the IRS may view this as operating for non-exempt purposes.
    Example: In one case, a tax-exempt arts organization that was originally formed to promote public art exhibitions shifted its focus to selling art through commercial galleries. The IRS determined that the organization’s activities were no longer primarily educational or charitable and revoked its tax-exempt status.
  2. Benefiting Private Interests:
    When an organization’s activities or resources are used to benefit private individuals or entities, rather than the public, it raises concerns about private benefit or inurement. For instance, a nonprofit that funnels its income to a for-profit company owned by insiders or provides significant services that benefit a specific person or business would be operating for non-exempt purposes.
    Example: A nonprofit healthcare organization that provides exclusive medical services to a single corporate client, without offering similar services to the general public, may be considered as benefiting private interests and therefore lose its tax-exempt status.
  3. Failure to Engage in Charitable Activities:
    If an organization stops actively conducting the charitable or public-benefit activities it was established for, it may no longer be fulfilling its exempt purpose. For example, a nonprofit established to provide free legal services to underserved communities that stops providing those services and focuses only on fundraising without actual program delivery would be flagged by the IRS.
  4. Excessive Focus on Fundraising:
    While fundraising is essential for most tax-exempt organizations, it should not become the sole focus of the entity. If an organization spends an excessive amount of time and resources on fundraising or generates substantial income through commercial activities, without reinvesting those resources into its exempt purpose, it could face IRS scrutiny.
    Example: A charity that spends most of its resources running frequent high-end fundraising events, but little on the charitable activities it is supposed to support, could be deemed to have strayed from its exempt purpose.

Operating for non-exempt purposes can be a gradual process where the organization’s focus shifts away from serving the public good and towards benefiting private interests or engaging in unrelated commercial activities. When the IRS identifies these red flags, it may begin an audit or investigation to determine whether the organization should lose its tax-exempt status. Organizations must regularly review their operations to ensure they are in line with their exempt purposes and take corrective action if necessary to avoid the risk of losing their exemption.

Significant Unrelated Business Income (UBI)

Explanation

Unrelated business income (UBI) refers to income generated by a tax-exempt organization from activities that are not substantially related to its exempt purpose. While tax-exempt organizations are allowed to engage in some level of unrelated business activity, the IRS requires that the organization’s primary focus remains on its exempt functions, such as charitable, educational, religious, or scientific work. UBI arises when an organization regularly carries on a trade or business that is not directly connected to its tax-exempt mission.

For example, if a 501(c)(3) charity operates a gift shop selling merchandise that is unrelated to its charitable purpose, the income generated from these sales could be considered UBI. The IRS allows organizations to earn some UBI, but it imposes taxes on this income through the Unrelated Business Income Tax (UBIT). The rationale behind this rule is to prevent tax-exempt organizations from gaining an unfair competitive advantage over for-profit businesses by engaging in commercial activities while being exempt from income taxes.

The real danger comes when an organization conducts too much unrelated business activity. If the IRS determines that an organization’s unrelated business activities are substantial in relation to its exempt activities, it could revoke the organization’s tax-exempt status. This is because the organization would no longer be primarily serving its tax-exempt purpose, but rather functioning more like a for-profit business.

Threshold for UBI

The IRS provides guidelines for determining when unrelated business income becomes problematic. While there is no exact threshold percentage for UBI relative to total income that will automatically trigger the loss of tax-exempt status, the IRS evaluates UBI in proportion to the organization’s overall activities. If UBI becomes a “substantial” part of the organization’s operations, the organization risks losing its exemption.

There are certain exceptions and exclusions to UBI. For example:

  • Volunteer Labor: Income from activities where substantially all the work is performed by volunteers is excluded from UBI.
  • Convenience of Members: Income from activities conducted primarily for the convenience of the organization’s members, such as a school cafeteria for students, is not considered UBI.
  • Sale of Donated Goods: Proceeds from the sale of goods that were donated to the organization, such as items sold in a thrift store, are generally excluded from UBI.

Despite these exceptions, organizations must carefully track and report their unrelated business activities on Form 990-T. Failure to properly report UBI, or conducting too much of it, can result in penalties or the revocation of tax-exempt status.

Examples of Entities Losing Their Exemption Due to Significant UBI

  1. Sierra Club (1986)
    The Sierra Club, a prominent environmental nonprofit, lost its 501(c)(3) tax-exempt status due to excessive unrelated business income. The IRS determined that the organization had generated significant income from advertising in its magazine, which was unrelated to its core environmental advocacy mission. The magnitude of this unrelated business activity was deemed substantial, leading to the revocation of the Sierra Club’s tax-exempt status. Although the organization later restructured and regained its exemption, this case highlights the risks of generating too much UBI.
  2. The University of Phoenix Settlement (2004)
    In this case, the University of Phoenix, a for-profit educational institution, was involved in a complex legal matter where it was initially categorized as a tax-exempt entity. The IRS scrutinized its income sources and found that the university’s substantial income from student tuition and commercial activities constituted UBI. While the university settled with the IRS and did not lose its exemption immediately, the case underscored the fine line between exempt educational activities and unrelated business ventures.
  3. A Museum’s Gift Shop and Restaurant
    A museum with 501(c)(3) tax-exempt status faced scrutiny when it significantly expanded its gift shop and opened a full-service restaurant that catered primarily to tourists, rather than museum visitors. The IRS found that these commercial ventures were unrelated to the museum’s core educational purpose. Because the museum was generating a large portion of its income from these unrelated activities, the IRS revoked its tax-exempt status.

These examples demonstrate that organizations must be vigilant in limiting their unrelated business activities. If UBI becomes a significant part of their operations, they risk the IRS reclassifying them as a for-profit business, which leads to the loss of their tax-exempt status and the imposition of taxes on their income. Organizations must regularly review their activities to ensure that they remain compliant with IRS rules regarding UBI.

Failure to File Required IRS Forms

Explanation

One of the essential requirements for maintaining tax-exempt status is complying with the IRS’s annual reporting obligations, particularly through the timely filing of Form 990. Form 990 is an information return that tax-exempt organizations must file annually to provide the IRS with detailed information about their financials, governance, and operations. The form serves as a transparency tool, allowing the IRS, as well as the public, to assess whether the organization continues to operate in line with its exempt purposes and complies with tax laws.

There are three variations of Form 990 based on the size and type of the organization:

  • Form 990-N (e-Postcard): For small organizations with gross receipts of $50,000 or less.
  • Form 990-EZ: For organizations with gross receipts less than $200,000 and total assets less than $500,000.
  • Form 990: For larger organizations with gross receipts exceeding $200,000 or total assets exceeding $500,000.

Failure to file Form 990, or the appropriate version of it, for three consecutive years results in automatic revocation of the organization’s tax-exempt status. This rule was introduced under the Pension Protection Act of 2006 and applies to nearly all tax-exempt organizations, including charities and nonprofit groups. Once an organization’s status is revoked, it must pay federal income tax and can no longer receive tax-deductible donations. The organization’s name is also added to the IRS’s Auto-Revocation List, which publicly identifies organizations that have lost their exempt status.

For instance, many small organizations or groups that rely on volunteer staff may inadvertently miss filing deadlines, especially if they do not have dedicated accounting personnel. However, regardless of the size of the organization, the IRS imposes strict consequences for failure to file. Regaining tax-exempt status after automatic revocation requires reapplying for exemption and paying any applicable fees, which can be a burdensome process for many organizations.

Prevention

To avoid the risk of losing tax-exempt status due to failure to file, organizations should implement best practices that ensure compliance with IRS filing requirements:

  1. Set Annual Reminders: Establish a system to track filing deadlines. Organizations should mark their calendars for the due date of Form 990, which is the 15th day of the 5th month after the close of the organization’s fiscal year. Having automated reminders, along with staff accountability, can help ensure timely filing.
  2. Delegate Responsibility: Assign the responsibility of preparing and submitting Form 990 to a specific staff member or board member, or hire an accountant to handle the filing process. Ensuring that one person or department is in charge of this task helps avoid oversight.
  3. Review Filing Requirements Annually: As the organization grows, its required version of Form 990 may change. For example, an organization that starts small and files Form 990-N may need to file Form 990-EZ or the full Form 990 as its revenue increases. It’s important to review the organization’s financial position annually and confirm which version of the form is required.
  4. Consider Filing Extensions: If the organization is not ready to file by the due date, it can request an extension by filing Form 8868. This extension gives an additional six months to complete the Form 990 without incurring penalties or risking revocation.
  5. Consult a Tax Professional: For organizations unfamiliar with tax filings or those with complex financial operations, it is beneficial to consult with a CPA or tax advisor. They can help ensure compliance, accuracy, and timeliness in reporting.
  6. Monitor IRS Correspondence: Organizations should regularly review any communication from the IRS. Notices about missed filings or other compliance issues should be addressed immediately to prevent escalation into more severe consequences, such as revocation.
  7. Reinstate Status Promptly After Revocation: If an organization’s status is revoked, it should act quickly to apply for reinstatement. The IRS allows organizations to apply for retroactive reinstatement, meaning the organization can regain its tax-exempt status as if it were never revoked, but this must be done within 15 months of the revocation notice.

By taking these proactive steps, tax-exempt organizations can significantly reduce the risk of missing filing deadlines and, ultimately, the risk of losing their tax-exempt status due to non-compliance.

Excessive Compensation or Benefits to Insiders

Explanation

One of the key principles that tax-exempt organizations must follow is ensuring that no part of their earnings unjustly benefits private individuals, a concept known as private inurement. This rule is particularly important when it comes to compensating insiders, such as board members, executives, and key employees. If an organization pays unreasonable or excessive compensation to these individuals, it risks violating the private inurement rule, which can ultimately result in the loss of its tax-exempt status.

The IRS defines insiders as individuals who are in a position to exert significant control or influence over the organization, such as directors, officers, trustees, or substantial contributors. These individuals must be compensated reasonably for the services they provide to the organization, and their compensation must align with the market value of similar services in comparable organizations. Paying insiders more than what is considered fair market value could be viewed as an improper distribution of the organization’s assets for personal gain, which runs contrary to the public-interest purpose that tax-exempt entities must serve.

In addition to direct compensation, excessive fringe benefits provided to insiders, such as luxury travel, personal use of the organization’s assets, or generous retirement packages, can also trigger IRS scrutiny. The IRS closely monitors these arrangements to ensure that they are necessary for carrying out the organization’s exempt purposes and are not simply a way to funnel financial benefits to insiders at the expense of the public or charitable mission of the organization.

When excessive compensation or benefits are identified, the IRS may impose intermediate sanctions, such as excise taxes on the individuals involved. However, if the violations are severe or ongoing, the IRS can revoke the organization’s tax-exempt status entirely, leading to significant financial consequences, including taxation of the organization’s income and loss of donor support due to the inability to provide tax-deductible donations.

To avoid these risks, tax-exempt organizations must carefully document how they determine compensation levels for their executives and other insiders. They must ensure that these decisions are made by independent boards or compensation committees using objective, verifiable data such as salary surveys or compensation studies. By doing so, the organization can demonstrate that the compensation is reasonable and does not violate IRS rules governing private inurement.

Process of Losing Tax-Exempt Status

IRS Audits and Investigations

The IRS can initiate audits and investigations of tax-exempt organizations to ensure compliance with the rules governing tax-exempt status. These audits are often triggered by specific events or red flags, such as:

  • Failure to File Required Forms: Not filing Form 990 or other required IRS forms for three consecutive years automatically triggers an IRS review.
  • Excessive Unrelated Business Income (UBI): When an organization reports substantial unrelated business income, the IRS may investigate to determine if the organization is focusing too much on commercial activities.
  • Complaints or Whistleblower Reports: The IRS may receive complaints from the public, donors, or even insiders about misconduct or violations, leading to an audit.
  • Significant Changes in Financial Statements: Large fluctuations in income, expenses, or assets reported on Form 990 may raise red flags for the IRS.
  • Failure to Comply with Prohibited Activities: Engaging in political activities, excessive lobbying, or private inurement can also prompt an IRS investigation.

The IRS audits aim to assess whether the organization continues to operate in compliance with its exempt purpose. During an audit, the IRS will review the organization’s financial records, operations, and governance practices. If violations are identified, the IRS will take corrective actions, including revoking the tax-exempt status if necessary.

Revocation Procedure

The process by which the IRS revokes tax-exempt status involves several steps, giving the organization an opportunity to correct its course or provide justification for its actions before the status is formally revoked:

  1. Initial Audit and Warning: During an audit, if the IRS discovers that an organization is not compliant with the rules governing tax-exempt entities, the organization will typically receive a warning. This could be in the form of a written notice identifying the issues and giving the organization an opportunity to respond or correct the violations.
  2. Proposed Revocation Letter: If the organization fails to address the issues or the IRS determines that the violations are serious, the IRS will issue a proposed revocation letter. This letter details the findings of the audit, explains the violations, and notifies the organization of the intent to revoke its tax-exempt status. The organization has a chance to respond and provide further information to dispute the findings.
  3. Final Revocation Notice: If the organization is unable to rectify the situation or provide sufficient justification, the IRS will issue a final revocation notice. At this point, the organization’s tax-exempt status is officially revoked, and it must begin paying federal income taxes on all income generated moving forward. The organization is also added to the IRS’s list of auto-revoked tax-exempt entities, which is made available to the public.

Organizations that receive a final revocation notice face significant challenges, including the loss of federal tax exemptions, potential state tax liabilities, and the inability to offer tax-deductible donations to supporters. Furthermore, the organization’s reputation may suffer as donors, partners, and the public become aware of the loss of exemption.

Appeals Process

If an organization disagrees with the IRS’s decision to revoke its tax-exempt status, it has the right to appeal. The appeals process involves several steps:

  1. Administrative Appeal: Before the revocation is finalized, the organization can file an appeal with the IRS Office of Appeals. This is an internal IRS process that allows the organization to present additional evidence or arguments supporting its continued tax-exempt status. The organization typically has 30 days from the date of the proposed revocation letter to file this appeal.
  2. Appeal Timelines: The IRS Office of Appeals will review the case and make a determination. The appeal process can take several months, depending on the complexity of the issues and the amount of supporting documentation provided. During this time, the organization may continue to operate as tax-exempt while the appeal is pending.
  3. Litigation in Tax Court: If the administrative appeal is denied, the organization may choose to take the case to U.S. Tax Court. This is a more formal legal process where the organization presents its case before a judge. While this process provides an additional layer of review, it can be costly and time-consuming. Organizations must weigh the costs of litigation against the potential benefits of reinstating their tax-exempt status.
  4. Reinstatement: If the organization successfully appeals the revocation, its tax-exempt status is reinstated, and it may return to operating without federal income tax liability. However, if the revocation is upheld, the organization must comply with the tax obligations of a for-profit entity and may need to reapply for tax-exempt status if it seeks to regain its exemption in the future.

The appeals process is critical for organizations that believe their revocation was issued in error or can provide new evidence to counter the IRS’s claims. However, careful compliance with IRS regulations can often prevent the need for such appeals in the first place.

Consequences of Losing Tax-Exempt Status

Impact on Donors

One of the most immediate and significant consequences of losing tax-exempt status is the effect it has on donors. When an organization loses its tax-exempt status, contributions made to the organization are no longer tax-deductible for donors. This can severely impact fundraising efforts, as many individuals and businesses are incentivized to give to tax-exempt entities in part because of the tax benefits they receive. Without the ability to offer tax-deductible donations, organizations may find it more difficult to attract donors, especially large contributors who rely on the charitable deduction to reduce their taxable income.

The public nature of tax-exempt status revocation can also hurt the organization’s reputation. Donors and grant-making institutions, especially those who depend on due diligence to ensure their funds are being used for charitable purposes, may become reluctant to support an organization that has had its tax-exempt status revoked. Additionally, many institutional donors, such as foundations, are legally required to make grants only to tax-exempt entities, meaning the loss of status could make the organization ineligible for certain types of funding.

Tax Implications

Losing tax-exempt status has profound tax implications for the organization itself. Once the status is revoked, the organization is treated as a taxable entity and is required to file regular corporate tax returns (Form 1120) and pay federal income taxes on its net income. This includes not only income from unrelated business activities but also income that was previously exempt from tax, such as donations, grants, and other revenue generated through the organization’s exempt purpose.

In addition to federal income tax, the organization may also face state and local tax liabilities, depending on the jurisdiction. Some states offer additional tax benefits to tax-exempt organizations, such as exemptions from property taxes or sales taxes. When federal tax-exempt status is revoked, these state and local benefits may also be lost, further increasing the financial burden on the organization.

Moreover, any accumulated earnings that were previously untaxed may become subject to taxation, and the organization could face penalties for failing to file appropriate tax returns during the period when its exempt status was under review.

Reinstatement of Status

Organizations that have had their tax-exempt status revoked can apply for reinstatement, but the process can be complex and may involve penalties. The IRS provides several avenues for reinstating tax-exempt status, depending on the circumstances surrounding the revocation:

  1. Retroactive Reinstatement:
    If the organization applies for reinstatement within 15 months of the revocation, it may qualify for retroactive reinstatement of its tax-exempt status. To do this, the organization must file a new application for exemption (Form 1023 or Form 1024, depending on the type of organization), along with a written explanation detailing why it failed to comply with its obligations. The IRS will review this explanation and determine whether the organization qualifies for retroactive reinstatement, which would restore its status as if the revocation had never occurred.
  2. Streamlined Retroactive Reinstatement:
    Small organizations that had their tax-exempt status automatically revoked for failure to file Form 990 for three consecutive years may be eligible for streamlined retroactive reinstatement. These organizations must file Form 1023 or Form 1024 and pay the appropriate user fee, but they do not need to provide a detailed explanation of their failure to file. This process is available to organizations with gross receipts of $50,000 or less in each of the previous three years and total assets of $250,000 or less.
  3. Postmark Reinstatement:
    If the organization applies for reinstatement more than 15 months after revocation, it can request reinstatement from the postmark date of the application. This means the organization’s tax-exempt status would be reinstated as of the date the IRS receives the application, but it would not be retroactive to the date of revocation.
  4. Reinstatement with Reasonable Cause:
    In cases where the organization’s failure to comply with IRS requirements was due to a reasonable cause, the organization may request retroactive reinstatement by providing a detailed explanation of the circumstances that led to noncompliance. The IRS will consider whether the organization took steps to avoid the failure and whether it acted quickly to remedy the issue once it became aware of the noncompliance. If the IRS finds that reasonable cause exists, the organization may be granted retroactive reinstatement beyond the 15-month window.

In addition to filing the appropriate forms, organizations seeking reinstatement must pay a user fee, which varies based on the size of the organization and the type of application being filed. Larger organizations may also be subject to penalties and interest for taxes owed during the period when their tax-exempt status was revoked.

While reinstatement is possible, the process can be costly and time-consuming. Organizations should take preventive steps to avoid revocation in the first place by maintaining compliance with IRS filing requirements and operating in accordance with their exempt purposes. However, for those that do lose their tax-exempt status, timely action is essential to regain their standing and minimize financial and reputational damage.

Preventive Measures

Best Practices for Maintaining Compliance

To avoid the risk of losing tax-exempt status, organizations must adopt proactive strategies to ensure compliance with IRS regulations. Here are some practical tips that can help tax-exempt entities stay compliant and maintain their exempt status:

  1. Timely Filing of Required Forms:
    Ensure that Form 990 (or the appropriate version) is filed annually by the due date. Setting up automated reminders or a filing schedule can help organizations stay on track. In cases where the organization is not ready to file, submitting Form 8868 for an extension is a simple way to avoid penalties.
  2. Limit Unrelated Business Income (UBI):
    Regularly review all sources of income to ensure that unrelated business income (UBI) remains a small part of the organization’s overall activities. Organizations should familiarize themselves with IRS rules on UBI and consider whether income-generating activities are aligned with their exempt purpose.
  3. Avoid Prohibited Political Activity:
    Stay aware of the IRS rules prohibiting political campaign activity, particularly for 501(c)(3) organizations. Clear guidelines and internal policies should be established to prevent staff or volunteers from inadvertently engaging in political activities that could jeopardize the organization’s tax-exempt status.
  4. Monitor Lobbying Activities:
    Organizations that engage in lobbying should track the extent of these activities to ensure compliance with IRS limitations. Filing Form 5768 (the 501(h) election) can provide more precise guidance on allowable lobbying expenditures and reduce the risk of noncompliance.
  5. Reasonable Compensation Practices:
    Review compensation levels for executives and other insiders to ensure they are reasonable and justifiable. Organizations should use salary surveys or compensation studies to determine fair market value and document how compensation decisions are made.
  6. Document and Disclose Conflicts of Interest:
    Implement a conflict-of-interest policy and require board members and key employees to disclose any potential conflicts. Regularly reviewing and addressing conflicts of interest can prevent private inurement and ensure the organization is serving the public interest.
  7. Keep Records Organized and Up to Date:
    Proper record-keeping is essential for demonstrating compliance with IRS rules. Organizations should maintain detailed financial records, meeting minutes, and documentation of all major decisions, especially those related to compensation, unrelated business income, and charitable activities.

By adopting these best practices, tax-exempt organizations can minimize the risk of noncompliance and protect their tax-exempt status.

Governance and Monitoring

Good governance practices are critical in ensuring that tax-exempt organizations comply with IRS regulations and avoid activities that could lead to the loss of their tax-exempt status. Strong governance promotes accountability, transparency, and ethical decision-making, all of which are essential for maintaining public trust and staying compliant with legal obligations.

  1. Establish a Competent Board of Directors:
    The board of directors plays a vital role in overseeing the organization’s operations and ensuring that it adheres to its exempt purpose. A well-informed, diverse, and engaged board can help monitor the organization’s activities and ensure compliance with IRS regulations.
  2. Implement Internal Controls:
    Effective internal controls are essential for preventing fraud, mismanagement, and noncompliance. Internal controls can include processes for approving expenditures, monitoring financial performance, and regularly reviewing compensation decisions. These controls help ensure that the organization’s resources are used for their intended exempt purposes.
  3. Conduct Regular Compliance Audits:
    Periodic internal or external compliance audits can help identify any areas of risk or potential noncompliance. An audit can provide an opportunity to review financial records, operational practices, and governance policies to ensure they align with IRS rules and best practices for tax-exempt organizations.
  4. Training and Education:
    Ongoing education and training for board members, staff, and volunteers on legal and regulatory requirements are essential. Training can help individuals understand their roles in maintaining compliance and avoiding activities that could jeopardize the organization’s exempt status.
  5. Monitor Activities and Programs:
    Ensure that the organization’s activities and programs are aligned with its exempt purposes. The board and management should regularly review the organization’s activities to ensure they are advancing its charitable mission and that resources are being used effectively.
  6. Establish Clear Policies and Procedures:
    Develop and enforce clear policies on governance, conflict of interest, compensation, political activities, and lobbying. These policies should be reviewed and updated regularly to reflect changes in IRS rules or the organization’s operations.

By fostering a strong governance structure and maintaining effective internal controls, tax-exempt organizations can safeguard their compliance with tax laws and continue to serve their charitable or public purposes without risking their tax-exempt status. Regular monitoring and evaluation of governance practices ensure that the organization operates transparently, ethically, and in accordance with the public interest.

Conclusion

Recap of Key Points

In this article, we explored the critical events that can lead to the loss of tax-exempt status for organizations. These key risks include:

  • Engaging in Political Campaign Activity: Tax-exempt organizations, particularly those under 501(c)(3), are strictly prohibited from participating in or supporting political campaigns. Violations of this rule can lead to immediate IRS scrutiny and loss of tax-exempt status.
  • Excessive Lobbying Activities: While limited lobbying is allowed, excessive lobbying activities that go beyond IRS limits can jeopardize an organization’s exempt status, especially if lobbying becomes a substantial part of its operations.
  • Private Inurement or Private Benefit: If insiders, such as directors or executives, receive excessive compensation or other personal benefits, the IRS considers this private inurement, which is grounds for revocation of tax-exempt status.
  • Operating for Non-Exempt Purposes: Organizations must remain focused on their exempt purposes. Engaging in activities that primarily benefit private interests or unrelated commercial ventures can trigger IRS investigations and revocation.
  • Significant Unrelated Business Income (UBI): While tax-exempt organizations can engage in some business activities, conducting too much unrelated business activity without adhering to IRS limits can lead to loss of tax-exempt status.
  • Failure to File Required IRS Forms: Not filing Form 990 or similar IRS forms for three consecutive years results in automatic revocation of tax-exempt status. Staying compliant with filing requirements is essential.
  • Excessive Compensation or Benefits to Insiders: Unreasonably high compensation or excessive benefits provided to key individuals within the organization can be seen as misusing tax-exempt resources, leading to revocation.

In addition to these key events, we also discussed the IRS’s process for revoking tax-exempt status, the appeals process, and the importance of reinstating status if revoked. Preventive measures such as good governance practices, internal controls, and compliance audits can help organizations avoid these pitfalls.

Final Thoughts for TCP CPA Candidates

For TCP CPA candidates, understanding the events that can lead to the loss of tax-exempt status is crucial. As future tax professionals, you may be tasked with advising nonprofit organizations on maintaining their exempt status, ensuring compliance with IRS rules, and navigating the complex tax landscape. By mastering these concepts, you will be well-equipped to provide guidance that helps organizations preserve their tax-exempt benefits and continue to serve the public interest.

Tax-exempt organizations operate under unique rules and regulations, and missteps can have severe financial and operational consequences. As a CPA, your role in educating and advising these organizations can be instrumental in preventing violations and helping them thrive within the bounds of the law. With a clear understanding of these key risk areas, you will be prepared to guide your clients or employers through the intricacies of tax-exempt compliance, ensuring their long-term success and contribution to the community.

Other Posts You'll Like...

Want to Pass as Fast as Possible?

(and avoid failing sections?)

Watch one of our free "Study Hacks" trainings for a free walkthrough of the SuperfastCPA study methods that have helped so many candidates pass their sections faster and avoid failing scores...