Applying for Tax-Exempt Status

Introduction

Section 501(c)(3) of the Internal Revenue Code exempts qualified organizations from federal income tax. In order for the Internal Revenue Service to recognize an organization as exempt it must submit an application for review. Before submitting an application, an applying organization should be familiar with the basic process and required content of this application. The purpose of this article is to provide an introduction to the process of applying for exempt status and identify some helpful resources for further study.

Application

To apply for exempt status an organization must use the appropriate application form. The correct form for an organization applying for exempt status under Sec. 501(c)(3) is either Form 1023 or Form 1023-EZ.

Forms

On July 1, 2014 the IRS issued Form 1023-EZ. There are two purposes for the form: (1) to allow certain small organizations to apply for tax exempt status without having to complete the 26-page Form 1023; and (2) to allow organizations that have had their tax-exempt status automatically revoked file for reinstatement without having to use Form 1023. An organization may apply using Form 1023-EZ if it meets the 26 criteria on the Form 1023-EZ Eligibility Worksheet. If the organization does not meet the criteria on the Eligibility Worksheet then it must apply using Form 1023. Form 1023-EZ is three pages long and includes four parts also included in Form 1023 (though in slightly truncated form). These parts include: Identification of Applicant, Organizational Structure, Narrative Description of Activities and Private Foundation Classification. Additionally, Form 1023-EZ includes one Part not included in Form 1023 (Reinstatement after Automatic Revocation).

Organizations that cannot apply for exempt status under 501(c)(3) using Form 1023-EZ must use Form 1023. Form 1023 includes eleven Parts followed by eight schedules that may or may not apply to the organization applying for exemption. In order for the application to be accepted it must be substantially completed.

Identification of Applicant

Part I of Form 1023 requests identifying information about the applicant including the organization’s full name, mailing address, Employer Identification Number (EIN), accounting period, primary contact, website and date of formation. An EIN is required before an application for exemption may be submitted. The easiest way to apply for an EIN is online through the IRS website. The EIN is issued immediately once the application information is validated.

In addition, the applicant must answer questions about whether the organization is (1) represented by an authorized representative; (2) formed under the laws of a foreign country; and (3) claiming to be exempt from filing an information return. Finally, one question was added recently in an attempt to catch individuals who are trying to avoid tax through an exempt organization. Question 8 asks whether a person who is not one of the organization’s officers, directors, trustees, employees or authorized representative was paid to help plan, manage or advise the organization. If the organization has paid a consultant to help develop a program to solicit funds or about other organizational, financial or tax matters, then it should answer Question 8 in the affirmative.

Legal Form

For an organization to be tax-exempt it must be organized as a corporation or limited liability company (LLC), an unincorporated association or a trust. Sole proprietorships, partnerships or other affiliations cannot apply for tax-exempt status using Form 1023.

A corporation is established by sending the appropriate documents to the Secretary of State in the state the corporation would like to incorporate. A corporation’s organizing document is typically called the Articles of Incorporation, but has other names depending on the state. A copy of the Articles of Incorporation must be submitted along with the organization’s application for exempt status. If an existing and already exempt charity sets up a single member LLC that is treated as a disregarded entity, then a separate Form 1023 application is not needed for that LLC.

An unincorporated association is formed under state law and must have at least two members who have signed a written document for a specifically defined purpose. The written document is called the articles of organization and it must include the name of the organization, the purpose, the date the document was adopted, and the signatures of at least two individuals.

A trust’s organizing document is a trust agreement, a declaration of trust or a will. The organizing document must be signed and dated. If the trust was created by will, a copy of the death certificate and the relevant portion of the will must be included with the 1023.

Required Provisions in Organizing Documents

An organization applying for exemption under Section 501(c)(3) must be organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, to test for public safety, to foster national or international amateur sports competitions or to prevent cruelty to children or animals (“exempt purposes”). This requirement has caused the Service to create two tests that an applying organization must pass in order to qualify for exempt status: (1) the organizational test; and (2) the operational test.

To pass the organizational test an organization must have the appropriate terms in its organizing document. An organization is organized exclusively for exempt purposes if its organizing document (1) limits the purpose(s) of the organization to one or more exempt purposes stated in Sec. 501(c)(3); and (2) does not empower the organization to engage in activities that are not in furtherance of one or more exempt purposes unless these non-exempt activities make up an insubstantial portion of the organization’s overall activities. The articles may state a purpose as broad or more specific than those specified in Section 501(c)(3). For example, an organizing document could state that the organization is organized for “charitable purposes.” Since the organizational test looks exclusively at the organizing document, the test is not met if the applicant claims that its purpose is limited by other means. For example, the organizational test is not met if an organization limits its purpose in its bylaws, by an officer’s statements that the organization intends to operate for exempt purposes or even by the fact that the organization actually does in practice operate for exempt purposes.

In addition to limiting the organization’s purpose, the organizing document must provide that that upon dissolution the organization’s assets will be distributed for one or more exempt purposes, to a government entity, for a public purpose or by a court to further the purpose for which the organization was originally established.

Finally, Sec. 508(e) requires that a private foundation’s organizing document contain language that prohibits violations of private foundation rules. For an organization applying for exempt status as a private foundation, Form 1023 Part X Question 1b asks if this requirement is met. It is important to note that many states have passed laws that include this provision in a private foundation’s organizing documents by operation of law. So, for a private foundation that is organized in one of these states, it may not be necessary for the provision to be explicitly included in the organizing document. A list of the state laws relating to private foundation dissolution provisions is in Appendix B to the Instructions for Form 1023.

Narrative Description of Activities

The operational test focuses on an applying organization’s activities and finances. Parts IV and V of Form 1023 focus on the operational test. An organization is operated exclusively for exempt purposes if it engages primarily in activities that accomplish one or more exempt purposes.

An organization will not be regarded as operating exclusively for exempt purposes if (1) more than an insubstantial part of its activities is not in furtherance of an exempt purpose; or (2) if its earnings inure in whole or in part to the benefit of private shareholders or individuals. In order to determine whether the applicant meets the operational test, the application requires that the organization fully describe its proposed activities (including fundraising activities) and submit financial statements (or budget proposals).

Part IV of the application focuses on the organization’s activities. It requires that the applying organization describe its past, present and planned activities. This is not a place to simply restate the purposes in the organizing document. Instead, the organization should provide a narrative description of its activities. For each activity, answer the following: (1) What is the activity?; (2) Who conducts the activity?; (3) When is the activity conducted?; (4) Where is the activity conducted?; (5) How does the activity further the organization’s exempt purpose?; (6) What percentage of the organization’s total time is allocated to the activity?; and (7) How is the activity funded? Be sure to attach a paper copy of screenshots from the organization’s website to support the narrative description of activities.

The difficulty of this part is its open-endedness. It may be wise to fill out Part VIII of the application first. That part asks questions concerning the organization’s activities. After filling out Part VIII, it will be easier to come back to Part IV and provide the narrative description. When describing activities be comprehensive and accurate, but also as concise as possible. Describe the organization’s activities and how those relate to the organization’s mission without stating unnecessary information that could cause the IRS to inquire further.

Compensation and Financial Arrangements with Key Personnel

Part V asks nine questions about financial transactions with the organization’s officers, directors and trustees as well as the five highest compensated employees and independent contractors (“key personnel”). The purpose of these questions is to root out any private inurement and self-dealing or transactions with disqualified persons. If a disqualified person will be paid compensation, then information showing that the amount of compensation is reasonable must be attached.

The organization must begin by listing the name, title, mailing address, total annual compensation, average hours worked and duties of all key personnel. In addition, any family or business relationships between the organization’s officers, directors and trustees must be disclosed. Finally, the organization must describe any business relationships it has with the officers, directors or trustees other than their position with the organization. If any key personnel receives compensation from organizations related to the applying organization through common control then they must be identified.

The IRS has seven recommendations as to how organizations should approve and document compensation arrangements. Question 4 asks whether the organization has instituted practices consistent with these recommendations. The purpose of these recommended practices is to keep top officials from receiving excess compensation. Providing documentation that proves compensation is reasonable is important since excessive compensation could result in excise taxes or even loss of exemption.

The organization must confirm whether it has adopted a conflict of interest policy. While the application confirms this is only a recommendation, it is a strong recommendation. A conflict of interest policy will provide evidence that an organization is serious about avoiding excess payments to insiders. There is a Sample Conflict of Interest Policy in Appendix A to the Form 1023 Instructions.

Any key personnel that receive non-fixed payments, such as discretionary bonuses or revenue-based payments, must be named. If the organization will buy or sell goods to its key personnel then it must describe the purchase or sale transaction. Finally, if the organization will enter into agreements with organizations where its key personnel have at least a 35% interest, then those transactions must be described in the application.

Members and Others that Receive Benefits

The organization must determine if it provides goods, services or funds to individuals or organizations. If so, it must describe each program that provides goods, services or funds to individuals or organizations. For example, a charity might provide food to the homeless or grants to other organizations. Further, the organization must determine whether its programs limit the provision of goods, services or funds to members. If membership is required then the applicant must provide (1) a copy of a membership application; (2) a schedule of membership dues; (3) a list of membership levels (if any); and (4) a list of membership benefits. Finally, determine whether the recipients of goods, services or funds have a family or business relationship with the organization’s key personnel. If so, then provide evidence that explains how these related individuals qualify for goods, services or funds.

History

First, the organization must answer whether it is a successor to any other organization. If so, it must complete Schedule G. Schedule G asks questions about the relationship between the successor and terminated organizations. Additionally, it asks about assumption of debt and the terms of succession.

Second, this part asks whether the application will be completed more than 27 months after the end of the month in which the organization was legally formed. If so, then the applicant must complete Schedule E. In general, if applications for exempt status filed within 27 months of entity formation receive a positive determination, then the organization’s exempt status is retroactive to the date of entity formation. If the application is not filed within 27 months of formation then a positive determination will result in exempt status retroactive to the postmark date of the application. The 27-month period will be extended only in specific circumstances.

Specific Activities

The application asks questions about 22 different types of activities including political activities, fundraising activities and government affiliation. If an organization operates in one of these areas then it will need to answer the questions asked by providing an attachment detailing its answer. It is important that the applicant’s answer includes information about past, present and planned activities. If the organization does not currently engage in a stated activity, but may engage in the activity in the future, then it should acknowledge this in its answer. This article is a general overview of the application process and so will not delve into a deep discussion of each of the activities in Part VIII. However, a general overview of some of the main questions will be discussed.

Questions 1 and 2 ask about prohibited political activities. Specifically, these questions relate to whether the applying organization supports or opposes candidates in political campaigns or attempts to influence legislation in any way. The prohibition regarding a tax-exempt organization engaging in political activities is stated explicitly in the language of Section 501(c)(3). Carrying on propaganda, otherwise attempting to influence legislation or participating in any candidate’s political campaign for public office must not constitute a substantial part of an exempt organization’s activities. The language prohibiting political activities is broad and includes activities such as directly contacting or asking that the public contact members of a legislative body in support or opposition to legislation. However, nonpartisan voter education is permitted. If an organization engages in prohibited political activities it will not qualify for exemption under Section 501(c)(3).

Question 4 asks whether the applicant will undertake fundraising activities. The applicant should identify and describe the types of fundraising programs it will have, whether it will contract with entities or individuals to fundraise on its behalf, whether it will engage in fundraising for other organizations, where it will fundraise and whether any contributor will have the right to advise on the distribution of funds.

Question 12 asks whether the organization operates in a foreign country. If so, then one of the items that should be provided is a description of the procedures the organization will put in place to ensure its programs do not support terrorists. The Treasury Department has suggested financial guidelines that U.S.-based charities operating in foreign countries can put in place.

Question 13 asks about making grants to other organizations. The question asks about procedures that the organization has in place for the selection and oversight of grant recipients. The organization should include attachments of items such as grant application forms or proposals, the criteria for selection, an overview of the evaluation process and any follow-up reports required by the grantee.

Question 15 asks about close connections with any other organizations. The term “close connection” is defined in detail in the Instructions to Form 1023. However, the main concept is that two organizations are closely connected if one controls another, they were created concurrently or they share facilities. Having a close connection with another organization does not necessarily hinder exemption. A supporting organization has a close connection to the supported organization but may be exempt.

Questions 16-21 ask whether an organization is applying for exemption as a particular type of organization. These organizations include a cooperative service organization, a charitable risk pool, a school, a hospital or low-income or disabled housing. Further discussion of these organizations may be found in the Instructions to Form 1023 or IRS Publication 557.

Financial Data

If the applying organization has been in existence for four or more tax years, then it must provide a statement of revenue and expenses for the current tax year and the preceding three tax years. If the applicant has been in operation for more than one year but less than four years, then it must provide a statement of revenue and expenses for each year it has been in existence and projections for future years so that it has a total of three years of statements. The IRS acknowledges that the organization’s actual results may differ from its projections. New activities or other changes should be mentioned in future annual reports. If the organization has been in operation for less than one year then it must provide projections of its likely revenue and expenses for the current year as well as two years into the future so that it has a total of three years of statements. The applicant should prepare the statement using the same method of accounting it uses in keeping its books and attach a statement explaining the method used.

There are many revenue and expense categories that are not specifically asked for in the worksheet provided. However, the applicant should provide information about all revenue and expense categories or the IRS will likely ask for more information. This information can be provided by attachment.

A complete fiscal year should be represented in each column of the statement of revenue and expenses worksheet. The applying organization should make sure that the financial information that it provides makes sense when viewed in light of information it has provided in other parts of the application (especially Parts V, VI and VIII). For example, Part VIII, Question 4 asks about fundraising while Question 1 of the Statement and Expenses worksheet asks about contributions received.

The applicant must also provide a balance sheet for its most recently completed tax year. If it has not completed a tax year then the applicant should provide the most current information available. A new organization may not have any assets. If that is the case then it can simply say so on the application. Assets of unrelated business activity should be combined with investment assets (as is typical for the purpose of financial reporting). The application asks that the applying organization attach an itemized list of the assets owned by the organization in certain categories. For stock, it must list both the book value and fair market value for each holding. Again, make sure that the balance sheet information provided coordinates with other information provided in the application.

NOTE: If an annual information return is due while Form 1023 is pending, then complete the return, mark it as “Application Pending” in the heading and submit it to the place indicated in the instructions.

Public Charity Status

Part X of Form 1023 is designed to help an organization identify whether it is a private foundation or a public charity. Form 1023-EZ includes a part entitled “Private Foundation Classification” that is similar. In order to make this determination the applicant must apply the various tests discussed below. Once the organization has determined that it is a private foundation or a public charity then a further classification must be made. If the applicant is a private foundation it must determine whether or not it is a private operating foundation. If it is a public charity it must indicate whether it is a 509(a)(1), 509(a)(2), 509(a)(3) or 509(a)(4) organization.

Whether a charity is a private foundation or public charity is an important distinction because public charities are not subject to the private foundation rules and donors to public charities receive greater benefits than donors to private foundations. For example, public charities are not subject to the excise taxes set forth in Internal Revenue Code Sections 4940-4945. In addition, donors that make contributions to private foundations may only deduct up to 30% of AGI for cash gifts and up to 20% of AGI for appreciated property gifts. On the other hand, donors that make contributions to public charities may deduct up to 50% and 30% of their AGI for cash and appreciated property gifts, respectively.

An organization is a private foundation unless: (1) it is a church, school, hospital, governmental unit or entity that tests for public safety; (2) it has broad financial support from the general public; or (3) it supports a public charity. Unless the applicant is a supporting organization or one of the entities listed in (1) above then it will have to apply one of the public support tests or the facts and circumstances test to determine whether it is a public charity. If an organization meets any one of the following three tests then it is considered a public charity and not a private foundation.

Public Support Test and Facts and Circumstances Test

An organization has “broad financial support” if it receives at least one-third of its total support from governmental agencies, the general public and other public charities, or if it receives at least 10% from these sources and passes the facts and circumstances test. Under the facts and circumstances test the organization must be organized and operated to continually attract new public support and have the characteristics of a publicly supported organization.

The Not-More-Than-One-Third Investment Income and Net UBI Test

If an organization does not have “broad financial support” under the public support test or the facts and circumstances test then there is a third test that may be applied. An organization has “broad financial support” if it normally receives: (1) more than one-third of its support from contributions from the general public and gross receipts from activities related to its exempt purposes; and (2) not more than one-third of its support from gross investment income and net unrelated business income. If an organization selects this public charity status, then it must request either an advanced ruling or a definitive ruling.

Private Foundation Status

An organization that is not a public charity is a private foundation. A private foundation will be subject to the private foundation rules and deduction limitations. If the organization is a private foundation it must further determine whether it is a private operating foundation. A private foundation is a private operating foundation if it meets the requirements of 26 U.S.C. 4942(j)(a) and (b). If these requirements are met, then the organization must attach financial information showing that it in fact does meet these requirements. Additionally, the applicant must provide either an opinion of counsel or a narrative statement that demonstrates it satisfies the requirements of a private operating foundation.

Signatures

The application must be signed by an officer, director, trustee or other official authorized to sign the application. The authorized officer, director or trustee must also provide his or her title and the date.

Schedules

As noted earlier, Form 1023 includes eight schedules that may or may not apply to the applicant. Five of the schedules apply to certain types of organizations: (1) Churches (Schedule A); (2) Schools (Schedule B); (3) Hospitals (Schedule C); (4) Supporting organizations (Schedule D); and (5) Homes for the Elderly, Handicapped or Low-Income Persons (Schedule F). Three of the Schedules apply in specific circumstances: (1) when the applicant is not filing the application within 27 months of formation (Schedule E); (2) when the applicant is a successor to another organization (Schedule G); and (3) when the applicant is an organization providing scholarships or educational grants to individuals or private foundations requesting advanced approval of grant procedures (Schedule H).

It is beyond the purpose of this article to discuss in detail the specific requirements of each schedule. If an organization needs further information, the Instructions for Form 1023 give a detailed explanation of the required content of each schedule.

Conclusion

This has been an overview of the process and content of an application for tax-exempt status under Section 501(c)(3). The specific content of each application will change depending on the form and purpose of the applying organization. Therefore, it is advisable to contact a competent tax-exempt organizations advisor to help complete the application process. In addition, organizations can contact the Exempt Organization Customer Account Services at 1 (877) 829-5500 or visit the Exempt Organizations page on the IRS website (www.irs.gov/eo) for more information.