6 Common Pitfalls That Put Nonprofits’ Tax-Exempt Status at Risk
A nonprofit organization’s 501(c)(3) status is about as important as it gets. This designation allows donors to give with confidence, grants to flow and the organization’s mission to move forward without the drag of income tax.
While it’s pretty easy to keep that status, there are ways that organizations can lose it. When that happens, it’s almost always traceable to a handful of avoidable missteps rather than some sudden, unforeseeable event.
Understanding where the risks lie (and building simple safeguards around them) can mean the difference between decades of steady growth and a costly, public unraveling.
6 Common Risks to Nonprofits’ Tax-Exempt Status
Organizations such as public charities, private foundations, educational institutions, churches, hospitals and more are covered under section 501(c)(3) of the Internal Revenue Code. Specifically, they enjoy exemption from federal income tax so long as they meet certain requirements, make specific filings and follow the rules.
Those rules mainly revolve around six areas:
1. Annual Reporting Obligation
Most 501(c)(3) organizations must file one of the IRS Form 990s each year (990, 990-EZ, 990-N or 990-PF) to verify continued eligibility for exemption.
Under the Pension Protection Act of 2006, failing to file for three consecutive years triggers automatic revocation … no warning letter required. This provision isn’t theoretical: the IRS publishes a list of organizations that have lost their status this way.
Failure to file remains one of the most common and most preventable causes of lost exemption.
2. Lobbying
Lobbying occurs when an organization contacts, or urges the public to contact, legislators or relevant executive branch officials to support or oppose specific legislation.
Some lobbying is permitted, but it cannot make up more than an insubstantial part of the organization’s overall activities. Organizations that lobby regularly should track that activity closely. “Insubstantial” is judged in relation to the organization’s total efforts; it’s not a fixed dollar figure.
3. Operating in Accord with Stated Exempt Purpose
An organization is expected to carry out the exempt activities described in its original IRS application. If its programs have shifted meaningfully from that stated purpose, the organization needs to notify the IRS rather than let the drift go unaddressed.
Left unreported, a substantial change in mission or activities can call the original exemption into question.
4. Political Activity
Unlike lobbying, political campaign activity carries an absolute prohibition. A 501(c)(3) cannot, whether directly or indirectly, participate or intervene in any political campaign on behalf of or in opposition to a candidate for public office. That’s not just at the federal level, but the state and even local levels, too.
This rule applies to statements made in the organization’s name, financial contributions and any activity that could reasonably be seen as favoring one candidate over another.
Voter education efforts are permissible, but only when conducted in a strictly nonpartisan way.
5. Private Benefit and Inurement
A 501(c)(3) organization’s activities need to serve its exempt purpose, not the private interests of any individual or outside organization beyond an insubstantial degree.
Inurement is a related but stricter concept. It prohibits an organization’s income or assets from benefiting insiders such as board members, officers, directors and other key employees. This could be an executive drawing a salary well above market rate, a board member’s company receiving no-bid contracts or organizational assets used for personal purposes.
Violations here can result in penalty excise taxes against the insiders involved. In serious cases, it can cost the organization its exemption.
6. Unrelated Business Income (UBI)
Unrelated business income, or UBI, is revenue from a regularly conducted trade or business that isn’t substantially related to an organization’s exempt purpose. Earning too much relative to the organization’s overall activity can put its tax-exempt status at risk.
However, the IRS doesn’t draw a clear line in the sand. Broadly speaking, nonprofit experts tend to suggest limiting UBI to no more than 20% of income, though less than 10% would appear safer. Also, if your organization earns more than $1,000 in UBI, it will need to file Form 990-T.
Practical Safeguards Worth Building In
A few habits go a long way toward keeping an organization clear of these pitfalls:
- Establish a written conflict-of-interest policy.
- Require annual disclosures from board members and key staff.
- Track lobbying and political activity carefully, even informally, so leadership always has a clear picture of where the organization stands relative to IRS limits.
- Review contracts and compensation arrangements involving insiders on a regular cycle. (Ideally, this should occur with input from someone outside the immediate leadership circle.)
- Monitor revenue sources. Flag any activity that isn’t clearly tied to the organization’s stated exempt purpose.
None of these measures require a large compliance department. They just require consistency and a willingness to document decisions as they’re made, rather than reconstructing the reasoning after the fact.
Need a Second Set of Eyes? Talk to Us.
Protecting tax-exempt status isn’t a one-time compliance checkbox. It’s an ongoing discipline that touches governance, finance and day-to-day operations alike. And if you want to get it right, you should have someone outside your organization periodically review how decisions are documented and whether internal safeguards are up to snuff.
McManamon & Co. is an accounting, tax, fraud, forensic and consulting firm that serves not just small and midsize businesses, but nonprofit organizations, too. We’ve developed a custom suite of services to optimize your nonprofit’s performance, attain compliance, mitigate risk and reduce operating costs. So our team can help review your governance practices, evaluate potential UBI exposure and make sure your filings stay on track so your organization can focus on its mission with confidence.
Call us at 440.892.8900 or contact us online to learn how we can help protect your organization’s tax-exempt status.
Tags: compliance, McManamon, nonprofit, taxes | Posted in McManamon & Co., nonprofit, nonprofit taxes