On Saturday, February 13, 2016, I presented a session called Selected Pitfalls in the Life Cycle of a Charity at the People’s Law School at Baylor Law School. As I mentioned in my session, I was originally asked to speak on “pitfalls for nonprofits,” which seemed awfully broad. If we are looking at pitfalls for nonprofits, we would need to decide whether we were talking about the nonprofit universe (which includes both taxable and tax-exempt nonprofits) and, if we are talking about the tax-exempt sector, whether we are talking about charitable organizations or all tax-exempt organizations, etc. To narrow the focus, I chose to speak on certain pitfalls for charitable organizations and to organize my talk around the lifecycle of a public charity. Keep in mind that many of the pitfalls for charitable organizations are no different than pitfalls for any other organization. Specifically, employment issues trip up employers whether they are taxable or tax-exempt, as do many liability issues. As a result, I chose to focus on issues that are specific to charitable organizations, including satisfying the organization and operational tests, applying for 501(c)(3) status, proper governance and the attorney general’s oversight in relation to governance, the handling of restricted gifts, and like issues. It is a broad overview, as any of those topics could be presented as a standalone. For those interested, the paper is available here and the PowerPoint is available here.
On January 25, 2014 I had the pleasure of presenting an overview of the planning opportunities with public charities and private foundations to the Southwest Regional Education Conference of the American Association of Attorney-Certified Public Accountants at Texas A&M Law School in Fort Worth. It was an early Saturday morning (after having 16 6th graders from my son’s church youth group spend the night!) but a good discussion. I appreciated the opportunity. The presentation materials can be found at the following links.
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.