CHAPTER THREE
Tax Exemption: Source and Recognition
- § 3.1 Source of Tax Exemption
- § 3.2 Recognition of Tax Exemption
- § 3.3 Recognition of Public Charity, Private Foundation Status
As subsequent chapters indicate, there are many categories of tax-exempt organizations. Accordingly, the advantages and disadvantages of tax exemption will differ, depending on the particular category.
§ 3.1 SOURCE OF TAX EXEMPTION
Section 61(a) of the Internal Revenue Code provides that “[e]xcept as otherwise provided in this subtitle [Subtitle A—income taxes], gross income means all income from whatever source derived,” including items such as interest, dividends, compensation for services, and receipts derived from business. The Code provides for a variety of deductions, exclusions, and exemptions in computing taxable income. Many of these are contained in Internal Revenue Code Subtitle A, Subchapter B, entitled “Computation of taxable income.” Of pertinence in the tax-exempt organizations context, however, is the body of exemption provisions contained in Subtitle A, Subchapter F, captioned “Exempt organizations.”
Exemption from federal income taxation is derived from a specific provision to that end in the Internal Revenue Code. A federal tax exemption is a privilege (a matter of legislative grace), not an entitlement,1 and—being an exception to the norm of taxation—is often strictly construed.2 (The same principle applies with respect to tax deductions and tax exclusions.3,4) This type of exemption must be by enactment of Congress and will not be granted by implication.5 Two related tax precepts are that a person requesting exemption must demonstrate compliance with the requirements set forth in the statute that grants the exemption,6 and the party claiming the exemption bears the burden of proof of eligibility for the exemption.7 Thus, a court wrote that the federal tax statutory law “generally consists of narrowly defined categories of exemption” and is “replete with rigid requirements which a putatively exempt organization must demonstrate it meets.”8 The IRS and the courts are alert for efforts to gain a tax exemption where the underlying motive is the purpose of “confounding tax collection.”9
Nonetheless, provisions according tax exemption for charitable organizations are usually liberally construed. Thus, a court wrote that the “judiciary will liberally construe, and rightfully so, provisions giving exemptions for charitable, religious, and educational purposes.”10 Another court said that “in view of the fact that bequests for public purposes operate in aid of good government and perform by private means what ultimately would fall upon the public, exemption from taxation is not so much a matter of grace or favor as rather an act of justice.”11 Similarly, the exemption of income devoted to charity by means of the charitable contribution deductions has been held to not be narrowly construed.12 These provisions respecting income destined for charity are accorded favorable construction, since they are “begotten from motives of public policy”13 and any ambiguity therein has been traditionally resolved against taxation.14
The provision in the Internal Revenue Code that is the general source of the federal income tax exemption is IRC § 501(a),15 which states that an “organization described in subsection (c) or (d) or section 401(a) shall be exempt from taxation under this subtitle [Subtitle A—income taxes] unless such exemption is denied under section 501 or 503.”
The U.S. Supreme Court characterized IRC § 501(a) as the “linchpin of the statutory benefit [exemption] system.”16 The Court summarized the exemption provided by IRC § 501(a) as extending “advantageous treatment to several types of nonprofit corporations [and trusts and unincorporated associations], including exemption of their income from taxation and [for those that are also eligible charitable donees] deductibility by benefactors of the amounts of their donations.”17
Most categories of tax exemption are manifested in the list of them that comprises IRC § 501(c). Yet, references to exemption are found elsewhere in the Internal Revenue Code, namely, IRC §§ 501(d), 521, 526–529A, and 664.18
An organization that seeks to obtain tax-exempt status, therefore, bears the burden of proving that it satisfies all the requirements of the exemption statute involved.19
§ 3.2 RECOGNITION OF TAX EXEMPTION
An organization's tax-exempt status may be recognized by the IRS; indeed, the law may mandate this recognition. Recognition of tax exemption is a function of the IRS, which it accomplishes, where the organization qualifies for exemption, by making a written determination20 that the entity constitutes an exempt organization. (The role of the IRS in recognizing the exempt status of organizations is part of its general function of evaluating the tax status of organizations.21) Recognition of exempt status, however, must be contrasted with eligibility for exempt status. Congress, not the IRS, is responsible for granting exempt status.22 Thus, if an organization qualifies for exemption pursuant to the federal tax law, it is exempt—although the law may require a procedural step, such as filing for recognition of exemption by or providing a notice to the IRS.
(a) General Rules
As a general rule, recognition of tax exemption by the IRS is not required in connection with most categories of exempt organizations. (The IRS informally refers to these types of entities as self-declarers.) Frequently there is confusion on this point, because there is no rule of statutory law that affirmatively so provides. Rather, this conclusion has to be reached by implication, as a matter of statutory construction, in that the federal tax law requires certain types of organizations to secure recognition of exemption to be exempt; thus, the other types of entities need not make the filing.23 That is, in order for an organization to be exempt as a charitable entity (with exceptions), a credit counseling organization that desires exemption as a social welfare entity, a nonprofit health insurance issuer, or an employee benefit entity, it must file an application for recognition of exemption with the IRS and receive a favorable determination.24 Nonetheless, an organization that is not obligated to seek recognition of exemption may voluntarily do so.25
(By contrast, for an organization to be regarded as a tax-exempt social welfare entity,26 it must give notice to the IRS.27 The same is the case with respect to exempt political organizations.28)
There is little formal evidence of this distinction in the law between organizations that are required to file for recognition of tax exemption and those that do not have to file. The distinction is somewhat reflected in an IRS revenue ruling,29 which is predicated on the rule that an organization that desires tax exemption as a charitable entity from the outset of its existence must file for recognition of exemption within a threshold period; if it does so, the recognition of exemption is effective as of the date the entity was formed (that is, the recognition is retroactive).30 The point of this ruling is that an organization that qualifies for exemption both as a charitable entity and as a social welfare entity,31 and that filed for recognition of exemption after expiration of this threshold period and thus cannot qualify as a charitable entity from its beginning, can qualify as an exempt social welfare entity during the period starting with the date of its formation and ending on the date the exempt charitable entity status commences—the underlying concept being that social welfare organizations are not required to file for recognition of exemption to be exempt. This ruling is somewhat confusing and misleading, however, in that it states that an organization in this circumstance “may” file an application for recognition of exemption as a social welfare organization during the initial period, implying to some that it must file an application. In fact, an organization of this nature (that is, an entity that is not a charity credit counseling/social welfare organization, nonprofit health insurance issuer, or employee benefit fund) can achieve the same result without filing for recognition of social welfare organization status merely by operating as such an organization.
This dichotomy is also reflected in the application for recognition of exemption filed by organizations seeking tax exemption as charitable entities.32 If the applicant organization is submitting the application more than 27 months after the end of the month in which it was formed,33 it may be eligible for exemption only from the date the application was sent to the IRS.34 Nonetheless, the IRS observes that the organization may be eligible for exemption as a social welfare organization from the date of its formation to the postmark date of the application. A box on the application is to be checked if the organization wants the IRS to regard the submission as a request for exemption as a social welfare organization during this initial period. Then the IRS requires the organization to attach page 1 of the application that is filed by social welfare organizations.35 Once again, this is somewhat misleading, because the applicant organization could qualify as an exempt social welfare organization during the interim period without making any submission to the IRS—because social welfare organizations (like most other categories of exempt entities) do not have to file for recognition of exemption with the IRS to be exempt.
Subject only to the authority of the IRS to revoke a determination letter or ruling for good cause (a material change in the facts or a revision of law), an organization, the tax exemption of which has been recognized by the IRS, can rely on that determination as long as there are no substantial changes in the entity's character, purposes, or methods of operation.36 Should one of these changes occur, the organization is expected to notify the IRS to accord the agency the opportunity to reevaluate the entity's exempt status.
(b) Concept of Recognition
Thus, rather than grant tax-exempt status, the IRS's function is to recognize exempt status (assuming the organization so qualifies). The concept of recognition is based on the fact that the tax exemption exists before the IRS commences its review of the applicant organization. The IRS thereafter recognized the fact of exemption, by agreeing with the applicant that it is an exempt entity, as manifested by the issuance of a favorable determination letter.37
This distinction is reflected in the IRS's instructions that accompany Form 1023. It is there stated that, in connection with the categories of entities that are “eligible” for tax-exempt status, “[o]rganizations organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals are eligible to file Form 1023 to obtain recognition of exemption from federal income tax under section 501(c)(3) of the Internal Revenue Code.”38 In explaining that certain organizations are not required to file this application to be tax-exempt (such as churches39), the IRS stated that “these organizations may choose to file Form 1023 in order to receive a determination letter that recognizes their section 501(c)(3) status.”40
This distinction is also reflected in a publication the IRS prepared on the subject of tax exemption. This document, the IRS stated, “explains the procedures [an applicant organization] must follow to obtain an appropriate determination letter recognizing [the] organization's exemption.”41 The IRS added: “To qualify for exemption under the Code, [the] organization must be organized for one or more of the purposes specifically designated in the Code.”42 In other words, if an organization satisfies the requirements of the federal tax law for exemption, it qualifies for exemption, but it may have to have that qualification recognized by the IRS to actually achieve exemption.
§ 3.3 RECOGNITION OF PUBLIC CHARITY, PRIVATE FOUNDATION STATUS
The IRS expanded this concept of recognition to include recognition of changes in public charity status;43 although an organization is not required to obtain a determination letter44 to qualify for a new public charity classification, in order for the IRS's records to recognize a change in public charity status45 an organization must obtain a new determination of this status.46 Likewise, a private foundation47 may qualify as a private operating foundation48 without an IRS determination letter, but the IRS will not recognize the status in its records without a determination.49 An organization claiming to be an exempt operating foundation50 must obtain an IRS determination letter recognizing that status to be exempt from the tax on its net investment income.51