I had the good fortune to be at KPMG—then Peat, Marwick—when the Tax Reform Act of 1969 created private foundations and significantly revised the tax code pertaining to nonprofit organizations. I essentially had a blank slate with which to begin to develop practice aids, client checklists, and educational materials for use by directors, trustees, and fellow accountants and lawyers to advise clients and prepare or review the annually expanding Form 990 and 990-PF. My experiences and associations during my years of performing services for nonprofit organizations have been and continue to be enriching.

An important goal in writing this book is to remind the nonprofit community that tax-exempt organizations really are taxpayers. Although tax privileges are afforded to organizations determined to be exempt under Internal Revenue Code (IRC) §501(c), the tax code imposes a wide variety of income and excise taxes and penalties for late filings and noncompliance when the rules are broken. As with most tax provisions, the rules are often gray and the impact based upon the particular facts and circumstances of the particular organization in question.

To compound the wealth of information necessary to comply with the rules, Congress, the courts, and the IRS regularly reform the rules now-repealed to exempt organizations. The important 2017–19 tax legislation, including the “parking tax” and “silo” isolation for net losses are presented, along with many new private letter rulings.

It is amazing how new developments have expanded the girth of this book each year as the annual supplements are prepared. This expansion has resulted in fragmentation of the materials. The process began in 2001 with the publication of the 990 Handbook: A Line-by-Line Approach, which evolved somewhat into the Revised Form 990 book coauthored with Amanda Adams in 2009 that is now somewhat out of date.

I encourage creativity in studying and applying the tax code. For example, I have often heard a private foundation say it is not allowed to make a grant to an individual without prior IRS approval. Chapter 17 addresses the meaning of grants for “study, travel, and similar purposes” which do require that approval, and additionally shares standards for grants-in-aid for other purposes.

When Form 1023 was substantially revised in 2004, the IRS Form 1023 Preparation Guide was written to serve as a step-by-step guide for gaining recognition of exemption. Thus, that portion of Chapter 18 has been abbreviated. As this book is being prepared, the IRS announced that effective May 1, 2020, the form must be filed through Pay.gov: in other words, mandating electronic filing. The discussion of the questions in the prior book are still helpful in understanding the import of a response.

It is important to remind readers that the Forms 990-EZ, 990, 990-PF, and Form 1023 or 1024 should be prepared carefully. If you, your clients, your board, or anybody else is questioning why a nonprofit organization should give top priority to the correct completion of these forms, be aware that the forms must be made available to anyone who asks to see them. A copy to take home can be requested if the requester is willing to pay a modest fee. For many §501(c) organizations, the form is also posted on the Internet at www.guidestar.org. An organization's public reporting responsibilities have a broad dimension and deserve careful attention. Chapter 18 describes the IRS organizational structure and changes and summarizes the filing requirements of an exempt organization from its birth to its demise.

Part I: Qualifications of Tax-Exempt Organizations

Starting with Chapter 1, this book describes the characteristics of tax-exempt organizations and distinguishes them from for-profit organizations. Checklists designed to gauge the suitability of a project for tax-exempt status, along with other start-up tax and financial considerations, are provided—types of organizations that can qualify are compared to those that cannot. The characteristics distinguishing programs that qualify from those that do not are presented. Throughout these chapters, I explain the rationale underlying the distinctions.

Chapter 2 deserves study by anyone working with an organization that seeks to obtain and maintain exemption as a charity under IRC §501(c)(3). The standards for serving a charitable class, for meeting the (some say outdated) IRS commensurate test (devoting enough money to charitable programs), for being educational (versus action-oriented), for conducting activities on the Internet, and other issues should be carefully studied. An understanding of the vague and sometimes contradictory meaning of these tests is very useful in applying the rules.

Chapters 3 through 10 provide a framework for determining an organization's qualification for exempt status. Churches, schools, civic associations, social clubs, business leagues, labor unions, governmental affiliates, and title-holding companies are compared and the particular requirements of each of the major §501(c) exemption sections are fleshed out. Lists of the revenue rulings and procedures that contain the standards and definitions applicable to the many different types of organizations within each category allow one to discern a project's qualification for exemption. Readers may be amazed by the seemingly outdated footnotes from the 1960s and 1970s, yet they still serve as the primary guidance. Between 1974 and 1990, more than 400 revenue rulings concerning exempt organizations were issued; precious few were issued between 1991 and 2011. Private letter rulings (PLRs) are often the only source of IRS thinking on an issue. Even though they cannot be relied upon as precedential, they are discussed throughout the text when they might provide a reasonable basis for decision making.

Civic associations, unions, and business leagues operate to serve the common interests of their members, but may not function to serve the private interests of the members. Examples are provided to compare and contrast services and programs that can be conducted versus those that represent unrelated activity. Section 501(c)(4), (5), and (6) organizations must calculate the portion of the dues they spend on lobbying activities. That portion of member dues spent on lobbying is not tax deductible for members unless the league chooses to pay a proxy tax on such expenditures. Making this important choice involves following intricate rules discussed in Chapter 6. The IRS's battle to tax certain associate members' dues for labor unions is chronicled in Chapter 7. The somewhat different criteria for identifying members of business leagues and the impact on revenues collected for rendering member services are reviewed and updated in Chapter 8.

The very different standards applied to social clubs are found in Chapter 9. Importantly, a qualifying social club can receive only a limited amount of revenue from nonmembers. Title-holding companies, used by a nonprofit organization to shield properties from liabilities, are considered in Chapter 10. The important distinction between a municipal-type program that qualifies as a governmental unit and a government-affiliated entity that can seek §501(c)(3) status is also outlined in that chapter.

How a charitable organization can qualify for and maintain status as a public charity is presented in Chapter 11. The impact of the distinctions between public and private tax-exempt organizations is discussed, along with a presentation comparing and contrasting the various types of public charities. You will discover how the IRS distinguishes government grants treated as donations from grants considered to be fees for services, how a membership fee is classified, and the kinds of donations that are not counted as public support. Support organizations and the labyrinth of tests that apply to them are discussed, including the several Type III categories. Retention of public status is vitally important to those charities that seek funding from foundations and certain public sources.

Part II: Standards for Private Foundations

Privately funded charities are subject to complex sanctions imposed by Congress in 1969 when it set out to discourage the formation of private foundations and to strictly curtail their activities. Despite the absolute tone of the sanctions, many exceptions apply. The dizzying array of excise taxes, definitions, and applicability can be simplified by following the discussion, checklists, and examples in Chapters 12 through 17.

Techniques for calculating the excise tax that private foundations and certain private colleges pay on investment income are presented in Chapter 13. The self-dealing rules outlined in Chapter 14 sound absolutely draconian—and they are. Essentially, the intention is that no money be paid to a disqualified person by a private foundation. Through the years, however, the rules have evolved as the IRS has followed a very practical approach to permit transactions that benefit the foundation. Applicable exceptions are presented by type of financial transaction: sales or leases of property, loans, compensation, payments on behalf of officers and directors, and nonmonetary payments. A private foundation must make “minimum distributions,” or pay out a percentage of certain assets annually, and Chapter 15 discusses which assets are included in the formula and various methods of valuation. Restraints are placed on business ownership by a private foundation with the prohibition on “excess business holdings.” Chapter 16 presents the permitted holdings and disposition periods for excesses received as gifts, along with a discussion of the types of speculative investments considered to be jeopardizing for a foundation. Additionally, permissible investments that accomplish a charitable purpose, called program-related, are considered.

Chapter 17 discusses the “taxable expenditure” rules that govern how a private foundation must spend its money. This chapter shows that a foundation's spending parameters can be broad if enhanced documentation is maintained. When charitable purposes are served, a private charity can conduct a breadth of direct charitable activity in addition to simply granting funds to a public charity.

Part III: Obtaining and Maintaining Tax-Exempt Status

The task of communicating successfully with the IRS to achieve recognition of exempt status is outlined in Chapter 18. The requirements for seeking recognition of exemption are explored along with filing and timing issues. Which tax-exempt organizations must file which Form 990 and why is outlined, along with other important filing issues such as changes in fiscal year or accounting methods, group exemptions, reporting changes in public charity status, and amended returns. The IRS process for examination of returns, along with suggestions for achieving a good answer, can be found here. The various reasons why an exempt organization might report back to or might hear from the IRS after initial notification of qualification for exempt status are outlined.

It has been my experience that the IRS EO Branch is staffed with folks who mirror those working in the nonprofit community. They view their job as facilitating projects of publicly spirited citizens wishing to benefit society.

Marcus Owens, then-chief of the IRS EO Division, in 1997 at an American Bar Association meeting said, “Absence of documentation is at the heart of just about every inurement and private benefit case that is pending in my division now and is a problem we constantly see with unrelated business income (UBI) cases.” This refrain formed the structure of the published guidance on incentive compensation paid by hospitals reported in Chapter 4 and regulations on intermediate sanctions discussed in Chapter 20. Organizations that conduct activities like those performed by commercial companies, such as health-care providers, consulting or referral services, and research programs, present a challenge for professionals representing them. Particularly for those entities, Marcus's words are still valid years later: the contemporaneous documentation of the process used to determine the tax-exempt purposes served by activities is crucial.

After securing initial IRS approval, annual compliance measures assure ongoing exemption and can aid in accumulating appropriate documentation of process. Chapter 19 contains checklists for use by both public and private charities and for non-(c)(3) organizations. I recommend the use of these checklists for annual review of a client's local, state, and federal filing matters, evaluation of reporting and documentation requirements, and for early detection of any troublesome activity.

To qualify for and maintain its status as a tax-exempt organization, one must operate to benefit one's exempt constituency, not one's creators, directors, or other self-interested persons. Chapter 20 defines impermissible private inurement or benefit. The application of these tax doctrines is discussed with an explanation of how the rules apply to different types of financial transactions. Yes, a salary can be paid to a member of the board of directors or their child, but only to the extent such compensation is reasonable and the work genuinely dedicated to exempt purposes. Factors that determine when other financial transactions—loans, asset sales and purchases, or joint ventures, for example—are appropriate are outlined. Factors to consider in a conversion of a for-profit organization into a nonprofit and vice versa and other financial arrangements are discussed. The intermediate sanction rules applicable to public charities and civic associations that can cause a manager to repay that portion of his or her salary deemed to represent “excess benefits” (plus a penalty) are presented.

As a source of funding, many exempt organizations charge for services they provide or goods they produce—students pay tuition and opera goers pay admission. Tax-exempt organizations are not necessarily prohibited from conducting such income-producing activity, particularly if the revenue stems from an activity that accomplishes its exempt purposes. When an activity is unrelated to the mission, however, income tax may be due on the profits. The IRS applies a commerciality test to decide when the level of income-producing activity is like that of a commercial business, thereby indicating that the organization's underlying exempt status could be challenged. Chapter 21 describes the unrelated business income tax and its endless exceptions and modifications. Due to the convoluted nature of the relevant code sections and the number of conflicting guidelines, it behooves organizations and their advisors to continually seek up-to-date information on this subject and to pay attention to potential legislation on the potential. The small business lobby continues to make suggestions in this regard, as when they asked for enhanced requirements for travel tours. Exclusive marketing agreements and management service agreements have been the subject of IRS initiatives.

Creation of an affiliated organization of another exemption category, spin-off of an activity into a for-profit subsidiary organization, hiring a manager under a profit-sharing agreement, and forming a joint venture with a business organization are astute survival methods an organization might need to take. These important options are available to exempts seeking enhanced efficiency and economies of scale. Forms 990 now request “Information Regarding Transfers, Transactions, and Relationships with Other Organizations” to enable the IRS to scrutinize such relationships. Chapter 22 addresses the issues involved when a tax-exempt organization has such relationships and helps one understand why the form asks such questions.

To accomplish their goals, many nonprofit organizations engage in lobbying or otherwise attempt to influence the making of laws. Participation in the election of the lawmakers—political intervention—is allowed for certain types of exempt organizations and strictly prohibited for others. The restraints on lobbying and electioneering are discussed in Chapter 23 and must be carefully studied before an organization contemplates such actions. Charitable organizations other than private foundations can spend an insubstantial part of their resources on attempts to influence elected officials to change the laws of the land. The permissible amount of such a lobbying effort is, however, limited by one of two very different tests. The pros and cons of making the IRC §501(h) election and the fate of an organization whose purposes can only be accomplished through the passage of legislation (cannot qualify for charitable exemption) must be studied.

Back in 1988, the IRS conducted an Exempt Organization Charitable Solicitations Compliance Improvement Program which emphasized the fact that the tax deduction for a donation to charity had to be reduced by the value of any tangible goods and services received by the donor in connection with the gift. First, the IRS examined fund-raising programs in which premiums, free admissions, dinners, raffles, and other benefits were used to entice donors. Once the list of such events was compiled from the charity's records, the IRS examined the donors to find out whether the tax deduction was overstated. The results were poor. Congress eventually enacted strict disclosure requirements that cause charities to value and report benefits provided to those who sponsor them and support their charitable events. No income tax deduction is allowed without proper documentation to evidence this information. The now-familiar substantiation requirements and suggestions for their implementation can be found in Chapter 24.

Prior to the 1990s, IRS exempt organization examiners did not review payroll tax matters. When they began to look, the results of their examinations caused concern; they found too many employees classified as independent contractors. Millions of dollars of taxes were assessed when the IRS examined colleges and hospitals during the 1990s. For any size organization, payroll taxes and associated employee benefit costs represent a significant cost and thus provide a significant temptation to treat workers as nonemployees. Chapter 25 outlines the issues and reporting requirements on this important matter.

Significant organizational changes, such as a merger or other combination with another nonprofit, bankruptcy, or termination, are not anticipated in the heyday of an organization's formation, and are uncommon for most tax-exempt organizations. Nevertheless, such changes may be necessary—the unexpected does happen. Chapter 26 reviews the tax consequences and filing requirements during such life changes for an exempt organization and considers the consequences, for both the organization and its contributors, when an EO loses its exempt status.

I hope readers will find this new edition useful in working with nonprofits throughout their tax-exempt life. I welcome this opportunity to contribute to our great nonprofit sector.

Jody Blazek
Houston, Texas
February 3, 2020