A tax primer for CPAs volunteering at nonprofit organizations.

• Author: Cowan, Mark J.
• Position: Certified public accountants

EXECUTIVE SUMMARY

* Prior to taking office at a See. 501(c)(3) organization, a CPA should assess its records and operations, to ensure that it has properly established (and is continuing to maintain) Sec. 501(c)(3) status.

* Insiders may be subject to excise tax sanctions if any part of the net earnings of the organization inure to the benefit of private shareholders or individuals.

* CPAs should be familiar with a number of other issues, including lobbying and political campaign restrictions, reporting requirements and UBIT.

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CPAs working with charitable organizations should be aware of the Code's rules governing nonprofit organization behavior, to avoid liability and maintain the entity's Sec. 501(c)(3) status. This article provides a general overview of the tax risks and issues facing nonprofits.

Because of their expertise and standing in the community, CPAs are often asked to serve as board members or officers of local churches, charities and other small- to medium-sized nonprofit organizations. While such service can be personally rewarding, it may come with unexpected risk. Many CPAs tapped for nonprofit service have strong tax and business experience, yet may be unfamiliar with the tax rules governing nonprofit organizations. Understanding these tax rules is critical, however, because the Federal government uses the Code to regulate nonprofit behavior. CPAs may well find themselves working with a nonprofit that has unwittingly run afoul of the Code, subjecting officers and board members to possible penalties or even putting the organization's Federal tax exemption in jeopardy.

The nonprofit provisions of the Pension Protection Act of 2006 (PPA '06), coupled with an already complex array of nonprofit rules, make it all the more important for CPAs to understand the Code's rules as they assume key roles in local nonprofit organizations. This article highlights some of the important tax issues that a CPA officer/director (1) of a local nonprofit may encounter, suggests questions he or she may want to research and provides examples of potentially problematic situations.

Qualifying for and Maintaining Exempt Status

Sec. 501(c) lists the various types of nonprofit organizations that may qualify for exemption from Federal income tax. The most important type are organizations that qualify under Sec. 501(c)(3). (2) Such organizations are not only eligible for Federal tax-exempt status, but in most cases are also eligible to receive tax-deductible contributions under Sec. 170(c)(2)(B). Sec. 501(c)(3) organizations include educational institutions (including private schools and museums), religious organizations (including churches and synagogues), certain organizations that foster amateur sports competitions, and a variety of other, more specialized organizations. They do not include social clubs, homeowners' associations or business leagues (including chambers of commerce).

For most nonprofits, maintaining Sec. 501(c)(3) status is paramount. (3) If lost, the nonprofit's income (if any) would become subject to Federal income tax, donors would be unable to deduct their contributions (making fundraising difficult) and valuable state and local tax exemptions (such as property tax exemptions) might be lost. Also, loss of the Federal government's tax-exempt "stamp of approval" would be embarrassing to the organization and its managers.

Prior to taking office at a Sec. 501(c)(3) organization, a CPA should assess the organization's records and operations to ensure that it has properly established, and is continuing to maintain, Sec. 501(c)(3) status. First, he or she should look at the organizing documents (articles of incorporation, bylaws and other governing instruments) and check that the entity has met the "organizational test" necessary for treatment as a Sec. 501(c)(3) organization.

Organizational Test

Under Regs. Sec. 1.501(c)(3)-1(b), the nonprofit's articles of organization must limit the entity's activities to exempt purposes (as enumerated in Sec. 501(c)(3)) and cannot empower the entity to carry out any substantial, nonexempt activities. Specifically, under Regs. Sec. 1.501(c)(3)-1(b)(4), the entity's articles of incorporation must require that the organization's assets be remitted to another charitable organization or the government on dissolution; distribution to the organization's members or shareholders must be prohibited.

Example 1: Gymnastics Club of Idaho, Inc. (B) is a parent-controlled athletic booster club established several years ago as a nonprofit corporation under Idaho laws. Parents of gymnasts become members of B by paying a $25 annual fee. Once they become members, parents are expected to participate in various B fundraising activities. B's articles of incorporation state that its purpose is "to further the competitive experience of amateur youth gymnasts, by providing additional opportunity for training and education, encouraging active participation in national gymnastic competition by the parents and guardians of the gymnasts, and promoting fundraising projects to assist gymnasts with the costs of competing, including, but not limited to, transportation, housing, equipment, uniforms, and meet fees." Further, the articles of incorporation note that in the event of dissolution, all of B's assets will be transferred to another local Sec. 501(c)(3) entity.

B meets the organizational test, because its organizational documents indicate that (1) its primary activities are exempt purposes under Sec. 501(c)(3)--education and the support of amateur athletics (4) and (2) all of B's assets would be remitted to another Sec. 501(c)(3) entity on dissolution.

Determination letter: Once the CPA has reviewed the Sec. 501(c)(3) organization's documents, he or she should find out if the organization applied for exempt status with the IRS. This is generally done on Form 1023, Application for Recognition Under Section 501(c)(3) of the Internal Revenue Code. (5) Some organizations are exempt from completing the application because of their activities or size. Under Sec. 508(c)(1), very small nonprofits (generally, those with $5,000 or less in annual gross receipts) and churches (regardless of receipts) are not required to file Form 1023 to attain Sec. 501(c)(3) status. (6)

Form 1023 asks a number of questions designed to inform the Service whether the organization's activities will meet Sec. 501(c)(3)'s numerous requirements (discussed below). It also clarifies whether the organization is a public charity or private foundation. (7) The submitted Form 1023 is open for public inspection, under Sec. 6104. If the Service approves it, the organization will receive a determination letter and be listed in IRS Pub. 78, which contains the names of organizations eligible to receive deductible contributions. (8)

The CPA should also review the determination letter, as it will indicate whether the organization is a public charity or a private foundation. In many situations, the Service will grant public charity status under an advance ruling. The organization will be deemed to be a public charity for five years. At the end of the five-year ruling period, the organization will need to show the IRS that it is truly publicly supported. The CPA will want to determine if the organization satisfied the five-year advance-ruling-period requirements.

Once the CPA has determined that the organization has been properly organized and properly attained Sec. 501(c)(3) status, he or she must also ensure that it is continuing to maintain such status. The following paragraphs summarize these requirements.

Operational Test

It is not enough that the organization's articles and Form 1023 be in order. Sec. 501(c)(3) also requires that the organization be operated in accordance with those documents. Specifically, the entity must operate "exclusively" for a nonprofit purpose: charitable, educational, religious or another of the categories enumerated in Sec. 501(c)(3). Regs. Sec. 1.501(c)(3)-1(c) makes it clear that "exclusively" really means "primarily."...