Tax-Exempt Hurdles: Common Reasons Why Applicants Withdraw
Two issues nonprofits should assess before filing for tax-exempt statusBy Doug Mentes, Esq. | Reviewed by Canaan Suitt, J.D. | Last updated on November 10, 2023 Featuring practical insights from contributing attorney Gene Takagi
Use these links to jump to different sections:
- What Are Common Reasons for Applicants Withdrawing?
- 1. Are Business Activities Consistent With the Exempt Purpose?
- 2. Is the Organization Benefitting Insiders?
- Issues to Watch Out For: Compensation and Board Members
- Find a Lawyer Experienced with Nonprofit Organizations
Nonprofit organizations that apply to the Internal Revenue Service (IRS) for tax-exempt status are not guaranteed approval.
Gene Takagi, a California attorney who has spent many years advising and representing nonprofit organizations, says the “IRS does reject applications, but not a huge percentage. A larger percentage are never completed because the IRS has some questions or thinks changes need to be made, and the applicant decides to drop the application instead.”
Based on some “rough guesses from past information,” Takagi believes approximately 1 percent of applications receive actual denials of tax-exempt status versus close to 15 percent of applicants who withdraw their application. “A large number of those may be for organizations that decide they can’t comply with the requirements to get the exemption,” he says.
What Are Common Reasons for Applicants Withdrawing?
Takagi notes there are two common IRS concerns that often cause applicants to decide to withdraw from completing their application for federal tax exemption:
- Whether the organization’s activities are consistent with its exempt purpose; and
- Whether possible insider transactions might defeat the 501(c)(3) purpose.
1. Are Business Activities Consistent With the Exempt Purpose?
Takagi says this is a controversial question: “It’s a significant issue, whether founders’ or their founding groups’ business plan really is in furtherance of a tax-exempt purpose.”
Types of organizations that are considered to have exempt purposes under the Internal Revenue Code (IRC) include charitable organizations, religious organizations, and educational organizations.
For example, Takagi says, look at a bookstore. “If somebody wants to sell books, they can say that’s for educational purposes, right? But is being a bookstore enough to say you are a charity and don’t have to pay taxes? If it is, then you would see a rapid change in business models of a lot of business organizations—just starting to become charities that don’t have to pay taxes.”
Takagi cautions potential tax-exempt organizations that an inquiry is a bit more detailed than an organization simply saying they’re charitable because they benefit the public. “Whether the business plan is consistent with furthering a tax-exempt purpose is actually one of the big inquiries that a lawyer that knows this space will want to work with their clients on,” he says.
2. Is the Organization Benefitting Insiders?
Takagi provides an example of what benefitting an insider might look like: Say an organization, such as a private foundation, wants to hire a board member’s spouse to provide consulting to the organization but pay the spouse double what someone with similar qualifications would earn. According to Takagi, that could be called an excess benefit transaction, which could subject the organization to taxes on the excess amount—and require a return of the excess amount to the organization.
“Figure out in advance whether the organization is at risk of insider compensation or insider transactions, with any insider, like a board member,” says Takagi. “Federal tax laws are usually imposed if the board member or insider gets more than reasonable compensation.”
Issues to Watch Out For: Compensation and Board Members
Takagi warns organizations to be careful in situations where either:
- The founder is interested in being employed by the organization; or
- There is only one board member on the board of directors.
The first step is to identify any issues that may give rise to a conflict, and the second is to determine if the issue will be problematic. “Sometimes it’s OK, sometimes it’s not. Trying to figure that out can be difficult,” says Takagi.
The organization will further want to determine whether any board members or founders intend to be compensated by the organization, either directly as employees or contractors or indirectly. You should also find out whether any insiders plan to do business with the organization through a company they’re affiliated with.
Also, with only one board member, Takagi says, “there seems to be a higher risk that organization is going to be operated for that member’s private interest.” This may raise some red flags with the IRS.
Find a Lawyer Experienced with Nonprofit Organizations
Because of a lack of resources, the IRS often does not detect issues with tax-exempt applicants for federal tax-exempt status. “Once the IRS does detect an issue, they can be pretty serious in terms of determining whether the organization should be penalized or not,” says Takagi, “with the ultimate sanction being loss of tax-exempt status.”
With that level of risk on the line, an organization should consult with an experienced nonprofit attorney before filing its application form for recognition of exemption.
For additional information on this area, see our business organizations overview.
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