The IRS, Tax Exemption and Patience

Sign in front of IRS

Backlog at the IRS

Where is my exemption application and when will the IRS rule on it? I get those questions a lot from clients. This post will examine the current backlog problems at the IRS and offer a few planning options.

With very limited exceptions for churches, church-related organizations, and very small organizations (those with gross receipts normally not more than $5,000 per year), to be entitled to tax-exempt status under Section 501(c)(3) of the Internal Revenue Code an organization must obtain recognition of that status by filing Form 1023 (Application for Recognition of Exemption) with the IRS and receiving a determination letter. I receive many calls from individuals wishing to create a new 501(c)(3) organization and expecting that the process will be relatively quick. In fact, that is typically not the case.

Form 1023 is filed with the Determinations Office of the IRS. According to the IRS website, upon receipt applications that are accompanied by the required user fee are initially separated into four categories including those that can be approved immediately, those that may need minor additional information to be resolved, those that are incomplete, and those that require further development. Again, according to the IRS website, the first three categories result in the organization receiving a determination letter or a request for additional information within approximately 90 days of the date the application was submitted. The fourth category—those requiring further developments—must be assigned to an Exempt Organizations agent. While the IRS reports that approximately 30% of the applications submitted fall into this fourth category, my experience shows a much higher percentage. Given, this may be because the applications that I handle are typically not very basic or plain vanilla applications. Likewise, it may be because an inordinate percentage falls into the third category (incomplete applications) and once that issue has been resolved, the application falls into the fourth category. The IRS does not provide what percentage of applications are resolved within the initial 90 to 120 days. What is clear though is that the backlog is growing.

According to a Bloomberg BNA Daily Tax Report, National Taxpayer Advocate Nina Olson has said that the inventory of open applications increased from 15,570 in fiscal year 2010 to 33,505 in fiscal year 2012. If the IRS receives (as is reported) approximately 60,000 new applications a year and at least 30% of those require further development, the problem of the backlog is clear.

The issue with the backlog is that the applications are essentially in limbo during this wait. The applications have not been assigned to an Exempt Organizations agent and thus the organization has no contact person at the IRS. According to its website, the IRS is currently assigning the applications received in April 2012—17 months prior to this post being authored. The backlog increases month by month.

In light of this concern I am often asked what options exist. First, it should be noted that so long as the organization has filed its Form 1023 within 27 months from the time it was created (for nonprofit corporations, the time period when it filed its governing document with the Secretary of State), once exemption is granted (whenever that may be) it is retroactive back to the date of filing its initial governing document. While the organization cannot hold itself out as a Section 501(c)(3) tax-exempt organization during this interim time period, it can raise funds (though it cannot tell donors that those funds will be deductible) and it can operate. Oftentimes, this is not feasible as donors want the determination letter as evidence of the exemption. While the IRS does have procedures in place for expediting an exemption application, those procedures are narrowly drawn and require exceptional circumstances. If an organization believes they qualify for expedited handling, it is advisable to seek professional assistance in making that request.

The second option for organizations during this interim period is the use of a fiscal sponsor. A fiscal sponsorship arrangement is created between the organization with the pending application and an organization that has already been determined by the IRS to be a 501(c)(3) organization. The sponsor receives the funds with full discretion and control over the funds and uses the funds to support the pending organization’s project(s) in a way that furthers the sponsor’s tax-exempt purposes. There are various models of fiscal sponsorship and an organization considering entering into such a relationship needs to seek professional guidance to protect its assets, as well as its tax status and that of the sponsor organization. More information about fiscal sponsorship can be found from the National Network of Fiscal Sponsors.

Finally, an organization that has had its application pending for more than 270 days is authorized by Section 7428 of the Internal Revenue Code to seek a declaratory judgment that it is qualified under Section 501(c)(3). This requires a petition for declaratory relief to be filed in the United States Tax Court, the United States District Court for the District of Columbia, or the United States Court of Federal Claims (all of concurrent jurisdiction in such cases). This action requires a determination on the part of the board of directors that the expenditure of additional funds for the handling of this litigation is justified, in order to push through an exemption application.

It is well-known that the IRS is currently under fire and that the focus is specifically on Exempt Organizations. There has been significant turnover in management as a result of the inquiries and investigation concerning the handling of conservative groups’ 501(c)(4) applications. This has only served to exacerbate the backlog. That backlog is likely to continue to grow and thus an organization should understand its options for handling this interim period.

 

 

 

The Fiduciary Duty of Care

In a previous post I described the three basic fiduciary duties owed by officers and directors of nonprofit organizations — the duties of care, loyalty, and obedience. This post will focus on the duty of care.

Designing football play on chalkboard

One of my law partners likes to say the duty of care is the duty to show up, to suit up and to speak up (or to get out). He talks like that because he’s a former athlete (which he’s happy to talk about — he even has old footballs and pictures from his playing days’ in the 60s all over his office). But he’s right. If you’re not willing to be all in participating as a part of the team, you don’t need to be on the team. Let someone else who is willing to be fully engaged serve that part. It’s a good short-hand way to remember what’s required by the duty of care, but I’ll try to flesh it out a bit.

The duty of care most simplified is a duty to stay informed and exercise ordinary care and prudence in management of the organization. With respect to nonprofit corporate directors and officers, the duty of care under Texas law (where I practice) mandates that the decision maker act (1) in good faith, (2) with ordinary care, and (3) in a manner he or she reasonably believes to be in the best interest of the corporation. This standard developed at common law but has actually been codified as a part of the Texas Business Organizations Code.

Good faith

Texas law doesn’t define “good faith” in the context of fiduciaries. Broadly, the term describes “that state of mind denoting honesty of purpose, freedom from intention to defraud, and, generally speaking, means being faithful to one’s duty or obligation.” BLACK’S LAW DICTIONARY 693 (6th ed. 1990). Whether a director acted in good faith is measured objectively based on objective facts. “Good faith” can be contrasted with “bad faith” which usually means being motivated by self-gain.

Ordinary care

“Ordinary care” requires the director to exercise the degree of care that a person of ordinary prudence would exercise in the same or similar circumstances. If a person has a special expertise (e.g., accounting expertise, legal expertise, etc.), ordinary care means that degree of care that a person with the same expertise would exercise in the same or similar circumstances.

Best interest of the corporation

Finally, decision makers must make decisions they reasonably believe to be in the best interest of the organization. Reasonableness is based on the objective facts available to the decision maker. Determining whether a proposed action is in the best interest of the organization requires weighing varied factors including the short-term interests, the long- term interests, the costs, the benefits, etc.

Business Judgment Rule

Under Texas law decision makers of nonprofit corporations are not insurers and thus are not liable so long as those persons exercise their business judgment in making decisions on behalf of the organization. The Texas Business Organizations Code says a decision maker will not be liable for errors or mistakes in judgment if she acted in good faith with reasonable skill and prudence in a manner she reasonably believed to be in the best interest of the corporation. This is obviously a restatement of the duty of care, but the courts have generally refused to impose liability upon a disinterested director absent a challenged action being ultra vires, tainted by fraud or grossly negligent.

Satisfying the duty of care

To satisfy the duty of care, the director should be reasonably informed with respect to the decisions she is required to make. This means the decision maker must understand the purposes of the organization (i.e. she has to read and have familiarity with the organization’s governing documents) and make decisions in line with those purposes. The same is true for management of the organization, policies of the organization, and any financial data relevant to the decisions she is making. Having this type of familiarity and knowledge requires the director to attend board meetings and actively seek the information necessary to make an informed and independent decision regarding which course of action is in the corporation’s best interest. A director should be careful to personally weigh the benefits and detriments of the course of action to the corporation rather than simply voting with the majority. While a director may rely on the counsel of advisers, the director must nevertheless exercise her own independent judgment in making decisions as to what is in the corporation’s best interests.

Duty of Care Checklist

Decision makers of nonprofit corporations that engage in ongoing operations should understand that their duty of care goes beyond financial or business decisions to reach all decisions made in the course and scope of their duties as directors. The following checklist is provided to aid decision makers in satisfying the duty of care.

All decision makers should know the following:

  • Legal form of the organization
  • Mission of the organization
  • Provisions of Articles of Incorporation/Certificate of Formation
  • Provisions of Bylaws
  • Any policies affecting decision makers (e.g. Conflict of Interest Policy)
  • Financial Picture (budget and financials)
  • Most recent 990
  • Existence/operations of related entities
  • Where the organization is conducting activities
  • Tax status and applicable legal requirements of the organization
  • Activities being conducted by the organization
  • Management structure
  • Key employees
  • Committee Structure
  • How directors and officers are selected

A director should seek to do the following:

  • Faithfully attend meetings
  • Read materials and prepare for meetings
  • Ask questions before, during and after meetings
  • Exercise independent judgment
  • Rely on appropriate sources of information
  • Review minutes of the board
  • Seek to stay informed as to legal obligations and good governance
  • With other members of the Board, develop schedules for review and approval of the strategic direction of the organization, executive compensation, legal compliance, and budget

How to Set Up a Disaster Relief Charity

West

When tragedy strikes as it did in different ways last week in Boston and West one thing is a constant, the desire of Americans to help their neighbors. That help comes in many forms as people seek to meet the physical, emotional, spiritual and even financial needs of those affected. Sometimes to meet those needs individuals and businesses decide to set up new charitable organizations. This post will teach you how to set up a new charity (one that follows the IRS rules) to provide aid following a disaster.

There are many ways to help our neighbors in need. We give blood, give to established charities like the Red Cross and Salvation Army, donate clothes, food, and blankets, and join together to pray and show support. After the most immediate needs have been met in the aftermath of tragedy, the focus turns to what we can do longer term. Sometimes a decision is made to establish a fund to help those affected. While not mandated, often the decision is made to seek tax exempt status. Trying to meet the needs we see while also navigating the various rules that regulate this type of good is an admirable goal but not one without challenges.

The key to establishing a tax-compliant charity to provide for disaster assistance is defining the persons eligible for aid. This requires two answering two questions: (1) what class of persons is eligible for assistance, and (2) which of the persons in that class are needy or distressed.

To qualify for tax exempt status under Section 501(c)(3) an organization must serve public purposes, not private purposes. In the context of disaster relief this means defining the class broadly so as to benefit a “charitable class” as opposed to a narrower subset of individuals. Stated differently, the class must be sufficiently large or indefinite as opposed to closed and definite. For example, an organization established to provide assistance to families of the first responders who lost their lives in West, Texas would fail to qualify as a Section 501(c)(3) organization the class is closed and defined (i.e. a specific group that would qualify and no one else). However, an organization established to provide assistance to families of West, Texas first responders who lose their lives in the line of duty, both those from last week’s fertilizer plant explosion and those who may lose their lives in the future, would qualify the class is open and indefinite (the criteria may apply to any number of people in the future). As a side note, there is no bright line on what class is “sufficiently large” so as to qualify as a charitable class. While a class like the first responders killed during the event would be too small, a class of families of those killed or injured (more than 170) could arguably be large enough.  For example, One Fund Boston, according to news reports, has been established specifically to assist families of those killed or injured in the Boston bombing. It will be interesting to see if that class is sufficiently large so as to be charitable.

After ensuring the assistance is available for a charitable class, the organization providing disaster relief must also ensure the specific persons receiving aid are proper recipients of charity. The IRS has acknowledged that both individuals and businesses may be appropriate recipients of charity. Further, charitable aid may be provided on an emergency basis, a short-term basis (e.g. 3-6 months) or a long-term basis. With respect to emergency aid (such as blankets, hot meals, clothing), it is sufficient that the persons receiving aid were victims of the disaster no showing of financial need is required. However, for assistance beyond immediate emergency assistance, the organization must conduct an assessment to ensure the recipient of aid meets the test of being in need and qualifying for charitable aid, namely lacking the resources to obtain basic necessities.

At that point, the type of aid that is appropriate depends on the recipient’s needs and resources. For example, while all victims in the immediate area of the Boston Marathon bombing may qualify for immediate crisis counseling, whether long(er) term counseling may be given by a charitable organization depends on the needs and resources of the individual.

It is critical for the organization dispensing aid to document the assessment it performs so that it will have records to show that its funds were spent for charitable purposes. More information on documentation and reporting can be found in the IRS’s helpful publication on disaster relief, Publication 3833.

Aside from the issues in this post specific to disaster relief, to create a disaster relief charity, the founders must follow state law to create the organization and file Form 1023 to obtain recognition of tax exempt status from the IRS. Here is a link to a paper that I wrote in 2004 and updated in 2011 regarding the basic set-up of a 501(c)(3) organization discussing these concepts: Setting Up Your 501(c)(3) Nonprofit Organization.