IRS Compliance for Nonprofits: Critical and Often Complex

IRS Compliance Mission Counsel Kansas Missouri

Let's suppose that you have your nonprofit up and running. You've received approval from the IRS and are ready to begin your mission. But how do you maintain your nonprofit's status? The IRS has imposed special requirements on 501(c)(3) or 501(c)(4) organizations for IRS compliance. If your nonprofit doesn't meet those requirements, it can lose its nonprofit status.

Mission Counsel can help your nonprofit remain compliant. We are a modern, client-centered law firm with deep experience in the nonprofit sector. We serve nonprofit organizations of all sizes throughout Missouri and Kansas. Our goal is to end the access to justice gap nonprofit organizations face by providing the same world-class legal counsel that traditional big law firms provide to large charities.

Toward that end, we've summarized the five most important areas of IRS compliance on this page. And of course, we are always ready to help.

Annual Form 990 Series Filings

Each year, a 501(c)(3) or 501(c)(4) nonprofit must make a filing with the IRS. The Form 990 and its variations are simply informational returns to keep your nonprofit's public information updated. This filing is the most fundamental step to maintaining IRS compliance. If your nonprofit fails to file for three consecutive years, the IRS will automatically revoke its nonprofit status.

There are four varieties of 990 filings, depending on how much your nonprofit's gross receipts normally are, how much its assets are worth and what kind of nonprofit it is:

Form 990-N

Gross receipts normally ≤ $50,000. No asset test.

Form 990-EZ

Gross receipts < $200,000 and total assets < $500,000

Form 990

Gross receipts ≥ $200,000 or total assets ≥ $500,000

Form 990-PF

If your organization is a private foundation, regardless of income or assets

As of tax year 2020, the IRS requires that nonprofits file these returns electronically.

Avoid Mission Creep for IRS Compliance

Another problem associated with IRS compliance is “mission creep.” Per Merriam-Webster, mission creep is “the gradual broadening of the original objectives of a mission or organization.” Mission creep usually occurs unintentionally; organizations tend to evolve. But you must beware of mission creep because it could cost your organization its nonprofit status.

When you organized your nonprofit, you filed Articles of Incorporation with your state. In those articles, your organization stated the charitable or social welfare issues it wanted to focus on. When you applied to the IRS for nonprofit status, you had to identify the purpose of your organization by selecting one of the National Taxonomy of Exempt Entities (NTEE) Codes. If your organization expands or changes its mission, you might be required to notify the IRS for IRS compliance purposes.

Watch Out for Excess Benefit Transactions

The IRS forbids a nonprofit from engaging in an excess benefit transaction. It defines excess benefit transactions as those in which

  • an economic benefit is provided by an applicable tax-exempt organization, directly or indirectly, to or for the use of a disqualified person, and
  • the value of the economic benefit provided by the organization exceeds the value of the consideration received by the organization.

Excess benefit transactions can happen in many ways. But a simple example conveys the point. Suppose the president of a nonprofit caused the nonprofit to convey real estate worth $250,000 to one of its board members for $150,000. In that event, the board member would receive an excess benefit of $100,000. A nonprofit that engages in an excess benefit transaction is out of IRS compliance.

Penalties on Disqualified Persons

The IRS imposes heavy penalties when a nonprofit fails to follow the IRS compliance rules on excess benefit transactions: The disqualified person – here, the board member – must pay an excise tax equal to 25% of the amount of the excess benefit. In our example, the tax would equal $25,000. But if the disqualified person does not pay the tax, the amount of the tax increases to 200% of the excess benefit, or $200,000 in our example. The disqualified person has ninety days within which to pay the 25% tax. The 200% tax kicks in if the disqualified person fails to pay.

Penalties on Charity's Manager

The IRS also may impose an excise tax equal to 10% of the excess benefit – in our example, $10,000 – on an organization's manager. The law makes the tax payable if the manager “knowingly participated in the transaction, and the manager's participation was willful and not due to reasonable cause.” Although the nonprofit's president might be required to pay the 10% in this example, the actual amount of the tax is the lesser of 10% of the excess benefit and $20,000.

Preparing for IRS Compliance

If the IRS accuses a disqualified person of engaging in an excess benefit transaction, the disqualified person has the burden of showing that there was no excess benefit. But that burden can be flipped when the nonprofit takes these steps:

  • An authorized body of the nonprofit with no conflicts of interest approved the transaction;
  • The authorized body obtained and relied upon appropriate data as to comparability prior to making its determination; and
  • The authorized body adequately documented the basis for its determination concurrently with making that determination.

If the nonprofit takes these steps, there is a presumption of reasonableness that the IRS must rebut to impose a penalty on the disqualified person.

Advocacy, Lobbying and IRS Compliance

The IRS compliance rules allow all 501(c)(3) organizations to engage in advocacy activities. Public charities also may engage in an “insubstantial amount” of lobbying (private foundations are generally prohibited from any lobbying).

Lobbying includes activities that attempt to influence specific legislation, whether in favor of or against it. Specific legislation can be either legislation that has been introduced in a “legislative body” or a specific legislative proposal the charity supports or opposes. The law does not consider judicial, executive, and administrative bodies to be legislative bodies.

There are two tests to determine IRS compliance. They are the “substantial part” test and the “expenditure test.”

Substantial Part Test for IRS Compliance

Section 501(c)(3) of the Internal Revenue Code requires that “no substantial part [of a charity's activities may be] carrying on propaganda or otherwise attempting to influence legislation.” The IRS also calls this “excessive lobbying.” To determine whether there has been IRS compliance, the IRS looks at the facts and circumstances of each case. It wants to know how much money the charity spent on lobbying. But it also considers factors such as how much time both paid and volunteer workers spent lobbying. If the charity exceeds this vague threshold, it can lose its 501(c)(3) status altogether.

Expenditure Test for IRS Compliance

Under the expenditure test, IRS compliance is measured simply by expenditures that the charity makes for lobbying activities. A charity may elect for the IRS to use this test instead of the substantial part test. A statute sets a specific percentage of overall annual exempt purpose expenditures, but in no circumstance may a charity's lobbying expenditures exceed $1,000,000.

Exempt Purpose Expenditures

Lobbying Nontaxable Amount

≤ $500,000

20% of the exempt purpose expenditures

> $500,000 but ≤ $1,000,000

$100,000, plus 15% of the exempt purpose expenditures over $500,000

> $1,000,000 but ≤ $1,500,000

$175,000 plus 10% of the exempt purpose expenditures over $1,000,000

> $1,500,000

$225,000 plus 5% of the exempt purpose

expenditures over $1,500,000

The law makes a further distinction between direct and “grass roots” lobbying. Direct lobbying occurs when one expresses a view to a legislator about specific legislation. Grass roots lobbying consists of requesting others to contact legislators about specific legislation. A 501(c)(3) organization that elects the expenditure test may spend no more than 25% of its total nontaxable lobbying amount on grass roots lobbying.

Quid Pro Quo Contributions

The IRS defines a quid pro quo contribution as a donation to a charity in exchange for goods or services. The donor must subtract the fair market value of the goods and services the donor received from the charity. For IRS compliance, consider this example: At a charity's annual gala, a person places the winning bid of $150 for a pair of concert tickets valued at $100. The winner may deduct only $50 as a charitable contribution.

When the amount the donor gives exceeds $75, the charity must give the donor a written disclosure statement. Note that the $75 is the amount of the donation without any offset for what the charity gave the donor in return. Thus, in the example above, the charity must make a written disclosure to the winning bidder because the amount of the winning bid exceeded $75.

The disclosure must:

  • inform the donor that the amount of the contribution that is deductible for federal income tax purposes is limited to the excess of money contributed by the donor over the value of goods or services provided by the organization; and
  • provide the donor with a good-faith estimate of the fair market value of the goods and services.
  • If the charity fails to provide a written disclosure, the penalty is $10 per contribution, not to exceed $5,000 per fundraising event or solicitation.
In Conclusion

These five common issues show how important IRS compliance is. The law imposes financial penalties for most violations, and the IRS can yank an organization's nonprofit status for some of them. Fortunately, with a little knowledge, most problems are avoidable. Mission Counsel stands ready to help you and your organization with IRS compliance. Our firm also helps both charities and donors if they run afoul of these rules. Feel free to reach out to us by email at [email protected] or call us at (816) 368-1181. Or schedule a free 15-minute Mission Discovery Session with us to see how we may be able to help.

At Mission Counsel, let us help you solve problems so that you can focus on your mission.

Our desire is for our clients to see our services as an added value to their organization. We want to get to know not merely the legal needs of our clients, but also their missions, their visions and their values. We want to come alongside our clients and help them achieve their highest purposes.
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