Nonprofits: Are You at Risk of Losing Your Tax-Exempt Status?

AuthorGina M. Lavarda
Pages04

Page 1475

I Introduction

Throughout the 2008 presidential election, the media coverage focused on prohibited political-campaign activity by nonprofit organizations.1 For example, various sources accused the United Church of Christ of engaging in prohibited political-campaign activity that could jeopardize its § 501(c)(3) tax-exempt status.2 In one such instance, the church held a national convention in June of 2007 at which then-Senator Barack Obama mentioned his candidacy for President and his platform in front of 10,000 church members and at which volunteers promoted Obama's campaign by staffing campaign tables directly outside the convention complex.3 In other instances, the church's Reverend Jeremiah Wright Jr., Obama's widely publicized former pastor and spiritual mentor, delivered fiery sermons from his church pulpit in which he compared Obama to Jesus Christ and criticized Obama's election opponents.4 The IRS determined that, even though the church and its leaders may have appeared to endorse Obama's candidacy through political-advocacy speech, the church did not run afoul of federal tax law and would not lose its § 501(c) (3) tax-exempt status.5

Federal tax law strictly prohibits § 501(c)(3) organizations from engaging in political-campaign activity.6 Nonprofit organizations risk losing Page 1476 their tax-exempt status or subjecting themselves to a penalty tax if they campaign in violation of this restriction.7 Complicating this issue is the difficulty nonprofit organizations have in attempting to classify political-campaign activity and specifically whether the actions of individual organizational leaders should be attributed to the organization for the purposes of determining whether the organization has violated the political-campaign prohibition. 8

Copmlaints of overreaching by § 501(c)(3) organizations are not new. During the 2004 presidential campaign period, for example, numerous watchdog groups wrote letters to the IRS accusing various § 501(c)(3) organizations of participating in political-campaign activity.9 In response to these allegations, the IRS organized The Political Activity Compliance Initiative ("PACI") to investigate allegations of political-campaign activity by § 501(c)(3) organizations.10 The IRS found that seventy-five percent of the Page 1477 orgianzations investigated had been violating the campaign prohibition. 11interestingly, however, these violations were often innocent. in fact, many of the infringing organizations did not understand that the Internal Revenue Code ("IRC") defines the political-campaign prohibition broadly and that it includes more than a mere prohibition on expressly endorsing or opposing political candidates. 12

Through PACI, the IRS learned that it needed to educate § 501(c) (3) organizations on the broad scope of the prohibition against political campaigning.13 This Note seeks to assist in educating organizations by clarifying the specific requirements and broad restrictions that federal tax law imposes on § 501 (c) (3) organizations. Instead of focusing on the entire range of prohibited conduct however, this Note specifically seeks to define more clearly the political-campaign prohibition and how that prohibition interacts with the actions of organizational leaders. This is because one of the problems that PACI identified was that leaders of nonprofit organizations sometimes spoke on behalf of their organizations rather than as individuals, who are protected when exercising their First Amendment right to free speech.14 Because of this particular problem, this Note proposes a test to assist courts and organizations in determining whether the leaders of an organization are acting or speaking as individuals or as representatives of their organization, or in other words, whether the organization is violating the restrictions that its tax-exempt status places on its activity by way of its organizational leaders.

Prior to developing this test, however, Part II of this Note provides background information about § 501(c) (3) organizations to help place the ultimate test in context.15 Part III reviews the statutory and case-law requirements that organizations must satisfy to qualify for tax-exempt status.16 It also reviews the findings of PACI, which the IRS organized and conducted to address and study political-campaign violations by § 501(c)(3) organizations.17 Next, Part IV discusses the apposite case law upholding the prohibition on political campaigning as constitutional and clarifies that Congress wrote the provision as an absolute prohibition on political campaigning and not as a substantial prohibition on political campaigning.18Part V discusses the sanctions the IRS or courts may impose against tax-exempt organizations that violate any of the discussed statutory or case-law Page 1478 reqruiements or restrictions.19 Part VI examines the problems that § 501(c)(3) organizational leaders face by highlighting two examples in the media of when an organization's leader violated the political-campaign prohibition. 20

In light of the problems highlighted in this Note, Part VII proposes a test to help courts determine whether organizations' leaders are speaking on behalf of their organizations or individually exercising their personal rights to free speech.21 Not only will this test allow courts to properly adjudicate whether an organization should have its tax-exempt status revoked, but with proper application of this test, organizations' leaders will be more informed about how to exercise their constitutional rights to free speech without causing their § 501(c)(3) organizations to lose their tax-exempt status. In essence, it will provide organizations with a guideline by which their leaders are able to engage in public life without placing their organizations at risk.

II background: basic definition of a § 501(c)(3) Organization

In 2006, 1,064,191 organizations classified themselves as § 501(c)(3) organizations.22 Although § 501(c)(3) organizations are often charitable organizations,23 they may also be educational institutions, churches, or other nonprofit organizations.24 The factor that distinguishes § 501(c)(3) organizations from other organizations is that § 501(c)(3) organizations are organized and operated primarily for a purpose that qualifies for tax-exempt status under § 501(c)(3).25 Page 1479

Orgianzations seek § 501(c)(3) status for two reasons. First, § 501(c)(3) organizations are exempt from federal income taxes.26 Second, pursuant to 26 U.S.C. § 170(a)(1), taxpayer contributions to § 501(c)(3) organizations are tax deductible on the taxpayer's federal income-tax return.27 These advantages result in more revenue-raising opportunities for § 501(c)(3) organizations than would otherwise exist.

III Statutory and Case-law Requirements and PACI's Findings

To qualify for tax-exempt status, an organization must satisfy four conditions under § 501(c)(3) and two conditions created by case law.28 In 2004, the IRS studied § 501(c)(3) organizations that had been accused of violating the third statutory condition, the political-campaign prohibition, and learned that many of those organizations underestimated the breadth of that condition.

A Statutory Requirements Placed On § 501(C)(3) Organizations
1. Organize and Operate for a Purpose that Qualifies for Tax-Exempt Status

First, an organization must organize itself and operate "exclusively" for a tax-exempt purpose that is enumerated in § 501(c)(3) of the IRC.29Treasury regulations provide that "exclusively" in this statute means "primarily" or "substantially."30 Section 501(c)(3) and the Treasury regulations lay out the purposes that qualify for tax-exempt status, including activities that are "for religious, charitable, scientific, literary, or educational purposes, . . . or for the prevention of cruelty to children or animals."31 Page 1480 Therefore, to acquire and maintain tax-exempt status, an organization must organize itself and operate at least primarily or substantially for any purpose that qualifies under § 501(c)(3).32

The Treasury regulations provide an organizational test and an operational test to determine whether an organization organizes itself and operates substantially for a tax-exempt purpose. 33 An organization must satisfy both tests to qualify as tax-exempt.34

a Organizational Test

The organizational test examines the organization's purpose as stated in the organization's founding document.35 To satisfy the organizational test, the founding document must state: (1) the purposes of the organization that comport with one or more purposes enumerated in § 501(c)(3);36 (2) that the organization will perform activities in furtherance of these purposes, and any activities not in furtherance of these purposes will be to an insubstantial degree;37 and (3) that it will dedicate the organization's assets...

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