The Basics of Establishing and Operating a Charitable Organization—Part 1

This article discusses the basic considerations which must be addressed in forming and operating a tax code Section 501(c)(3) organization, primarily from a federal income tax perspective. Section 501 and accompanying Treasury Regulations provide for the creation and operation of “charitable” organizations, sometimes referred to as “non-profits.” The use of the terms “charity” and “non-profit” can be misleading, as not all Section 501(c) organizations are in fact “charities” in the commonly-used sense of the word, and Section 501(c) organizations—including those which are of the charitable variety—can be operated at a profit.

Section 501(a) provides generally that those organizations identified in Section 501(c) are exempt from federal income taxation. Section 501(c) identifies 25 distinct types of organizations which are exempt from paying income tax to the federal government. Perhaps the most familiar of these are those organizations identified in Section 501(c)(3)—the so-called charitable organizations. A closely-related, but nonetheless distinct, type of tax-exempt organization is the Section 501(c)(4) “social welfare” organization. Section 501(c)(3) and Section 501(c)(4) organizations share the common function of having been organized to serve the public at large. By contrast, most other Section 501(c) organizations are organized to serve a much narrower constituency—generally consisting of their own members. Examples of such “mutual benefit” organizations include Section 501(c)(5)s (labor organizations), Section 501(c)(6)s (business leagues), and Section 501(c)(7)s (recreational clubs).

While all Section 501(c) organizations enjoy tax-exempt status (provided that they are organized and operated in compliance with the tax code and the Treasury Regulations), certain Section 501(c)(3) organizations enjoy a special benefit that most other Section 501(c) organizations do not. Section 170 provides that contributions made to certain, but not all, Section 501(c)(3) organizations are deductible by the donors of such contributions. Individuals making charitable contributions of cash to such Section 501(c)(3)s are entitled to deduct their contributions to the extent that their aggregate contributions do not exceed 50% of their “contribution base” (i.e., their adjusted gross income) for the taxable year. The existence of this charitable deduction gives these Section 501(c)(3)s a distinct advantage in fundraising over other types of non-profits, at least to the extent donors’ contributions are motivated by the tax benefits derived from charitable giving.

THE REQUIREMENTS OF SECTION 501(c)(3)

Section 501(c)(3) provides that corporations and certain other types of entities which are “organized and operated exclusively” for certain enumerated purposes are exempt from paying federal income tax. The statutory purposes which qualify such an organization for tax-exempt status are as follows:
(1) religious,
(2) charitable,
(3) scientific,
(4) testing for public safety,
(5) literary,
(6) educational,
(7) fostering of national or international sports competition, and
(8) preventing cruelty to children or animals.

In order for any of these organizations to enjoy tax-exempt status, no part of any such organization’s net earnings may “inure to the benefit of any private shareholder or individual.” Moreover, “no substantial part” of the activities of any such organization may consist of “propaganda, or otherwise attempting, to influence legislation,” except as otherwise provided in Section 501(h). Finally, no such organization is permitted to participate or intervene in any “political campaign” on behalf or, or in opposition to, any candidate for public office.

The Organization Requirement

As an initial matter, an organization must be organized exclusively for one or more tax-exempt purposes in order to enjoy tax-exempt status. This is generally the least problematic requirement to meet, and is largely a procedural matter. The regulations provide that an organization is “organized exclusively” for one or more exempt purposes only if its articles of organization (1) limit its purposes to one or more exempt purposes, and (2) do not expressly empower the organization to engage in activities which are not in furtherance of one or more exempt purposes (except to an insubstantial degree). The purposes set forth in the articles may be as broad as, or more specific than, those statutorily-sanctioned purposes, but they cannot be broader. The articles should not empower the organization to engage in any political campaign activity or anything more than an insubstantial amount of lobbying. In order for an organization to be deemed to be organized exclusively for one or more exempt purposes, the organization’s assets must, upon dissolution, be distributed for one or more exempt purposes (or to the federal, state, or local government for a public purpose). This distribution-upon-dissolution requirement may be satisfied either through the articles themselves or under state law governing the organization.

In order to obtain Section 501(c)(3) tax-exempt status, most organizations must notify the IRS that they are applying for such status and receive a favorable determination from the IRS. This notice requirement is satisfied by submitting a completed Form 1023 with the IRS. Certain organizations, such as churches and organizations other than private foundations whose gross receipts are not normally more than $5,000 for any taxable year, are exempted from this notice requirement. Certain “small” organizations which expect to have less than $50,000 in annual gross receipts for their first three years and which have assets valued at less than $250,000 may apply for tax-exempt status on an IRS Form 1023-EZ, which provides a more streamlined and simple application process than the IRS Form 1023.

The Operation Requirement

In General

Whichever of the specifically-enumerated statutory purposes for which an organization is formed, it must be organized and operated to serve “a public rather than private interest” in order to be entitled to tax-exempt status. While Section 501(c)(3) provides that an organization must be operated “exclusively” for one or more tax-exempt purposes, the regulations provide that an organization meets this test if it is operated “primarily” for one or more tax-exempt purposes. As provided by the regulations, an organization may qualify for tax-exempt status if it “engages primarily in activities which accomplish one or more of [its] exempt purposes,” but will not qualify for tax-exempt status “if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.” Thus, the regulations leave room for an organization to engage in some activities which are not in furtherance of its exempt purposes, provided that these activities are no more than an insubstantial part of its overall activities.

Commercial Activities

The requirement that an organization be operated primarily in furtherance of its tax-exempt purposes does not mean that an organization may not engage in commercial activities. An organization will qualify for tax-exempt status even if it operates a trade or business as a substantial part of its activities provided that “such trade or business is in furtherance of the organization’s exempt purpose or purposes,” and provided that the organization is not organized or operated for the primary purpose of carrying on a trade or business unrelated to its exempt purpose or purposes. Factors relevant in making this determination include the size and extent of the organization’s activities which are in furtherance or its exempt purposes and the size and extent of the subject trade or business.

To the extent that an organization does engage in activities which are not related to its exempt purposes, and provided that those unrelated activities do not rise to the level of being so “substantial” as to disqualify the organization from tax-exempt status, the organization is subject to a tax on the income it derives from such unrelated activities known as “unrelated business taxable income,” or UBTI. An organization’s UBTI is its gross income derived from an unrelated trade or business regularly carried on by it, less deductions directly connected with such unrelated trade or business. Certain categories of income are excluded from the calculation of an organization’s UBTI. Such excluded income includes income of a passive nature, such as dividends, interest, royalties, and certain rents. Also excluded from UBTI is income derived from certain activities which are not considered to be an “unrelated trade or business,” including a trade or business:

(1) in which all of the work is performed by the organization without compensation;

(2) which is carried on by the organization primarily for the convenience of its members, students, patients, officers or employees; or

(3) which consists of the selling of merchandise, substantially all of which has been received by the organization as a gift or contribution.

The Prohibition on Inurement

In General

Section 501(c)(3) provides that “no part of the net earnings of” a Section 501(c)(3) organization may “inure to the benefit of any private shareholder or individual.” This prohibition against inurement is the fundamental distinguishing feature between “non-profit” corporations and “for-profit” corporations. The term “net earnings” has been broadly construed to exclude from its ambit only those ordinary expenses necessary to the operation of any organization. The terms “private shareholder or individual” include any person “having a personal and private interest in the activities of the organization,” and generally consist of “insiders” such as an organization’s creator or his or her family, an organization’s shareholders, or persons controlled directly or indirectly by such private interests. The policy behind this prohibition against inurement has been stated as follows: “The government leaves funds in the hands of charitable organizations rather than taxing them and spending the funds on public projects. Implicit in this purpose is that charities must promote the public good to qualify for tax exemption.”

A related concept is that of the prohibition against a Section 501(c)(3) organization providing a private benefit. Whereas the prohibition against inurement is directed towards those who control, or otherwise have a close affiliation with the organization, the prohibition against private benefit is directed not only towards insiders but also those who are not in a position to exert influence over the organization’s activities. Underlying both concepts is the notion that a Section 501(c)(3) organization should be operated for the benefit of the public as opposed to the benefit of a select few.

Excess Benefit Transactions

Historically, the penalty for violation of the inurement prohibition was the “death penalty”— revocation of a Section 501(c)(3)’s tax-exempt status. Amid concerns that such a penalty may be disproportionate to the offense in certain cases, in 1996 Congress enacted Section 4958, providing for a regime of “intermediate” sanctions for violations not rising to the level which would justify revocation of tax-exempt status. This tax code section addresses “excess benefit transactions,” which are defined as any transaction 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” if the value of such economic benefit is greater than the value of the consideration received by the organization in return. “

Applicable tax-exempt organizations“ include Section 501(c)(3) and Section 501(c)(4) organizations other than those which are private foundations. The statutory definition of a ”disqualified person“ consists of several classes of persons, including among others:

(1) any person who was, within the five years ending on the date of the subject transaction, in a position to exercise ”substantial influence“ over the affairs of the organization;

(2) a family member of any such person; and

(3) a corporation, partnership, trust or estate in which any of the foregoing own more than a 35% interest.

The regulations provide for detailed guidance as to persons who are and who are not deemed to hold ”substantial influence,“ as well as factors which are and are not indicative of ”substantial influence.“

Significantly, reasonable compensation paid for services provided by a disqualified person will not constitute an excess benefit. Compensation is reasonable if it is in an amount that would ordinarily be paid for similar services by similar enterprises, whether taxable or tax-exempt, under similar circumstances. Compensation generally includes all forms of compensation and benefits provided other than certain enumerated disregarded benefits. In order to prevent disguised compensation, an economic benefit will not be treated as compensation for services provided unless the organization clearly indicates in writing its intent to treat the benefit as compensation for services when it is paid. An organization may satisfy this requirement by identifying the compensation in an information return (such as a W-2 or 1099) filed with the IRS, or in an appropriate written employment agreement executed on or before the date of the transfer of the benefit. Under a helpful safe harbor, the regulations provide that a compensation arrangement will enjoy a rebuttable presumption of reasonableness if the following 3-part test is satisfied:

(1) the compensation arrangement is approved in advance by an authorized body of the organization which is composed entirely of individuals who do not have a conflict of interest in the arrangement;

(2) the authorized body obtained and relied upon appropriate comparability data prior to making its determination about the compensation arrangement; and

(3) the authorized body adequately documented the basis for its determination at the time it made such determination.

In the event a compensation arrangement is found to constitute an excess benefit transaction, two levels of tax may be imposed on both the disqualified person receiving the excess benefit, and one on the organization managers who authorized the excess benefit. Notably, no tax is imposed on the organization itself. Initially, the disqualified person is subject to a tax equal to 25% of the excess benefit, and the organization managers participating in the authorization of the excess benefit are subject to a tax equal to 10% of the excess benefit (subject to a $20,000 cap) if their participation was knowing, willful, and not due to reasonable cause.

The excess benefit taxed is the amount by which the value of the benefit provided by the organization to the disqualified person exceeds the value of the services provided by the disqualified person to the organization. Organization managers can usually establish that their participation in the excess benefit transaction was not “knowing” if, having disclosed all relevant facts to an appropriate professional advisor such as an attorney, accountant, or valuation expert, they have relied on a “reasoned opinion” of such an advisor that the transaction is not an excess benefit transaction. In the event the excess benefit is not “corrected”—i.e., repaid along with accrued interest—within a statutorily-prescribed period of time, the disqualified person is subject to an additional tax equal to 200% of the excess benefit.

Limitation on Lobbying Activities

In General

Unless a Section 501(h) election is made, “no substantial part” of an organization’s activities may consist of “propaganda, or otherwise attempting, to influence legislation,” i.e., lobbying. In general, lobbying consists of either (1) contacting, or urging the public to contact, members of a legislative body for the purpose of proposing, supporting, or opposing legislation; or (2) advocating the adoption or rejection of legislation. Legislation includes action by the federal, state, or local legislative body, or by the public in relation to a referendum, constitutional amendment, or other similar procedure. The following activities do not constitute lobbying on the part of an organization: (1) presenting nonpartisan analysis, study or research to a legislative body; and (2) providing expert testimony or technical assistance in response to a request by a legislative body.

Of note is that the restriction on lobbying activities is not absolute, and an organization may engage in lobbying activities provided that they constitute only an “insubstantial” part of its overall activities. When lobbying activities cross the threshold from insubstantial to substantial is not well-defined, and is subject to a vague test dependent upon the facts and circumstances. Relevant factors include the relative amount of money and time the organization has spent on lobbying activities as compared to its exempt purpose activities, the nature and purpose of the organization, and the importance of lobbying activities in attaining the organization’s goals.

When a substantial part of a Section 501(c)(3) organization’s activities consist of lobbying, it no longer meets the definition of a Section 501(c)(3) organization and is at risk of having its tax-exempt status revoked. In addition, it is subject to an excise tax equal to 5% of all of its lobbying expenditures for the taxable year in which its tax-exempt status is lost. Further still, the organization’s managers who agreed to the lobbying expenditures, knowing that they were likely to constitute a substantial part of the organization’s activities, are subject to an excise tax equal to 5% of all of the organization’s lobbying expenditures for the taxable year in which the organization’s tax-exempt status is lost, unless their agreement was not willful and was due to reasonable cause. Once a Section 501(c)(3) loses its tax-exempt status as a result of such excessive lobbying activities, it is not eligible to convert to a Section 501(c)(4) organization, which may generally engage in lobbying activities without limitation.

The Section 501(h) Election

In light of the vagueness of the “substantial part” test described above, Section 501(h) allows most Section 501(c)(3) organizations which are not private foundations to make an election to opt out of the “substantial part” test and have their lobbying activities be tested under the more mechanical and certain, albeit more complex, test of Section 501(h) instead. Among Section 501(c)(3) organizations, only churches and their related organizations are not permitted to make the Section 501(h) election. Perhaps due to the complexity of the rules surrounding Section 501(h) elections, most Section 501(c)(3) organizations have not elected to have their lobbying expenditures tested under Section 501(h).

In order to understand the Section 501(h) test, it is important to grasp the interplay between Section 501(h) and Section 4911. This latter section, and the regulations promulgated thereunder, contain several key definitions and concepts. Lobbying may consist of direct lobbying, which generally includes attempts to influence legislation through communications with legislators, their staff, or other government employees participating in the formulation of legislation. In order to constitute direct lobbying, such communications must refer to specific legislation and reflect the organization’s view on such legislation.

Lobbying may also consist of grassroots lobbying, which generally includes attempts to influence legislation by way of influencing the opinions of the general public or any segment thereof. In order to constitute grassroots lobbying, such communications must refer to specific legislation, reflect the organization’s view on such legislation, and encourage the recipient of the communication to take action with regard to the legislation.

Excepted from the definition of lobbying are the following types of communications:

(1) making available the results of nonpartisan analysis, study or research,

(2) providing technical advice or assistance to a government body in response to a written request by such body;

(3) certain so-called “self-defense” communications before a legislative body on issues affecting the existence, powers, tax-exempt status, or deductibility of contributions of the organization;

(4) certain types of communications between the organization and its bona fide members with respect to legislation of mutual interest; and

(5) communications between the organization and non-legislative government officials and employees, unless the principal purpose of the communication is to influence legislation.

Section 4911 provides for an excise tax on an organization’s lobbying expenditures which are in excess of a certain amount the organization may spend on lobbying without incurring any such tax. It does so by defining an organization’s “exempt purposes expenditures” (EPE) as the total amount of the organization’s expenses for a taxable year, including its general administrative expenses and lobbying expenses, but excluding its capital expenditures and the expenses of a separate fundraising unit. An organization’s “lobbying nontaxable amount” (LNTA) is the amount an organization may spend on both direct and grassroots lobbying efforts in a taxable year without being subjected to an excise tax, and is calculated as a scheduled percentage of the organization’s EPE for the taxable year (with the percentage depending on the total amount of the organization’s EPE), subject to a $1 million cap.

An organization’s “grassroots nontaxable amount” (GNTA) is the amount an organization may spend on grassroots lobbying efforts in a taxable year without being subjected to an excise tax, and is calculated as 25% of the organization’s LNTA for the taxable year. An organization is subject to a tax equal to 25% of its “excess lobbying expenditures” for a taxable year, which is defined as the greater of: (1) the amount by which its total lobbying expenditures for the taxable year exceed its LNTA for the taxable year; or (2) the amount by which its grassroots lobbying expenditures for the taxable year exceed its GNTA for the taxable year.

Organizations may, however, lose their tax-exempt status if they “normally” make either: (1) lobbying expenditures in excess of the “lobbying ceiling amount,” or (2) grassroots lobbying expenditures in excess of the “grassroots ceiling amount.” An organization’s “lobbying ceiling amount” for a taxable year is equal to 150% of its LNTA for such taxable year, and an organization’s “grassroots ceiling amount” is equal to 150% of its GNTA for such taxable year. Whether an organization “normally” has lobbying expenditures in excess of these ceilings is determined by aggregating the organization’s lobbying expenditures over the four year period ending with the year in question.

Prohibition on Political Campaign Activities

A Section 501(c)(3) organization may not participate or intervene in any political campaign on behalf or, or in opposition to, any candidate for public office. Unlike the restriction on lobbying activity, this prohibition is absolute and does not provide for an allowance for “insubstantial” campaign activities. Candidates for public office generally include those running for an elected position within the federal, state, or local government. What constitutes participation or intervention in a political campaign is highly fact-specific. However, it may generally be said that activities which are partisan in nature, or which tend to favor one candidate over others, are more likely to be considered prohibited intervention than activities which are neutral, and which do not tend to favor one candidate over another. In Revenue Ruling 2007-41, the IRS published helpful guidelines to assist organizations in determining whether their activities cross the line into prohibited conduct in several different contexts, including:
(1) voter education, voter registration, and “get out the vote” drives;
(2) activities by an organization’s leaders;
(3) candidate appearances at organization events;
(4) an organization’s advocacy of issues;
(5) an organization’s conduct of business; and
(6) an organization’s maintenance of its website.

By way of illustration, the revenue ruling notes that, while leaders of tax-exempt organizations are not prohibited from speaking on issues of public policy that may be at issue in a political campaign, they may not do so at official organization meetings, may not use to the organization’s assets or publications to do so, and may not purport to speak on behalf of the organization in doing so. When an organization invites a candidate to speak at an organization event, factors to be considered in determining whether the organization has intervened in a political campaign include whether:

(1) the organization provides an equal opportunity for other candidates seeking the same office to participate;

(2) the organization indicates that it supports or opposes the candidate; and

(3) any political fundraising occurs.

When an organization invites several candidates to speak at an organization event, some of the factors to be considered in determining whether the organization has intervened in a political campaign include whether:

(1) questions for the candidates are prepared and presented by an independent and nonpartisan panel;

(2) the candidates are given an equal opportunity to present their views on the issues discussed;

(3) the candidates are asked whether they agree or disagree with positions taken by the organization; and

(4) a moderator suggests approval or disapproval of a candidate’s positions.

When an organization takes a position on an issue of public policy, factors to consider in determining whether the communication results in prohibited intervention in a political campaign include whether:

(1) the communication identifies one or more candidates for public office or expresses approval or disapproval with one or more candidates’ positions;

(2) the communication is close in time to an election or makes reference to the election;

(3) the communication is part of an ongoing series of communications made by the organization independent of an election; and

(4) the issue addressed in the communication is one distinguishing the candidates for a public office.

Organizations that engage in prohibited political campaign activity are subject to loss of their tax-exempt status, as well as certain excise taxes. The organization is subject to an excise tax equal to 10% of the amount of each political expenditure. Moreover, the organization’s managers who agreed to the political expenditures, knowing that they were such, are subject to an excise tax equal to 2.5% of such political expenditures (subject to a $5,000 cap on each political expenditure), unless their agreement was not willful and was due to reasonable cause.

In the event payment of the political expenditure is not “corrected” within a statutorily-prescribed period of time, the organization is subject to an excise tax equal to 100% of the political expenditure, and the organization’s managers who refused to agree to the correction are subject to an excise tax equal to 50% of the political expenditure (subject to a $10,000 cap on each political expenditure). Correction consists of recovering the political expenditure to the extent possible, establishing safeguards to prevent future political expenditures, and, where full recovery is not possible, such other corrective action as the IRS may prescribe. In the event payment of the political expenditure is corrected within the statutory period and the IRS is satisfied the payment was not willful and flagrant, the IRS may waive the first level excise tax.

Other Requirements

As noted, imposed upon all tax-exempt organizations, irrespective of the specific purpose for which they have been formed, is the requirement that they be operated to serve a public interest. Another requirement imposed upon all tax-exempt organizations is that they act in accordance with the law and not engage in activities which violate “fundamental public policy.” For instance, the U.S. Supreme Court held that a private university was not eligible to retain its tax-exempt status when certain of its policies were found to violate laws prohibiting racial segregation and discrimination. In a revenue ruling, the IRS found that an organization organized to promote world peace by, among other means, committing acts of civil disobedience failed to qualify for tax-exempt status because it encouraged illegal activity.

Jim Standard serves as a trusted advisor to his clients, assisting them in achieving their business goals. Mr. Standard applies his diverse background in law, business, finance, and tax to provide a unique and perceptive approach to representing his clients. He handles a variety of business transactions, including mergers and acquisitions, stock purchases, asset purchases, and other buy-sell transactions.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Jim Standard is a partner at Taylor, English, Duma LLP in Atlanta. He handles a variety of business transactions, including mergers and acquisitions, stock purchases, asset purchases and other buy-sell transactions.

Copyright © 2020 James Standard