Nonprofit Organizations Spring 2004 Class Six: Overview of Federal Tax Considerations/Income Tax Rules Relating to Tax-Exempt Organizations Michelle Coleman-Johnson Bourland, Wall & Wenzel, P.C

Tax-Exempt Organizations Defined The Internal Revenue Code, in Section 501(c) lists some organizations that are exempt from federal income tax These qualifying organizations do not pay federal income tax on an entity level  because they do not have (and should not have) a profit motive

List of Exempt Orgs – IRC Section 501(c) 501(c)(1) United States instrumentality 501(c)(1) United States instrumentality 501(c)(2) Certain title holding companies 501(c)(2) Certain title holding companies 501(c)(3) Religious, charitable, scientific, etc. 501(c)(3) Religious, charitable, scientific, etc. 501(c)(4) Civic leagues 501(c)(4) Civic leagues 501(c)(5) Labor organizations 501(c)(5) Labor organizations 501(c)(6) Trade associations 501(c)(6) Trade associations

IRC Section 501(c)… 501(c)(7) Social clubs 501(c)(7) Social clubs 501(c)(8) Fraternal societies 501(c)(8) Fraternal societies 501(c)(9) VEBAs 501(c)(9) VEBAs 501(c)(10) Fraternal societies (some distinction from (c)(8) 501(c)(10) Fraternal societies (some distinction from (c)(8) 501(c)(11) Teachers retirement funds 501(c)(11) Teachers retirement funds 501(c)(12) Benevolent life insurance assocs. 501(c)(12) Benevolent life insurance assocs.

IRC Section 501(c)… 501(c)(13) Cemetary Companies 501(c)(13) Cemetary Companies 501(c)(14) Non-Profit Credit Unions 501(c)(14) Non-Profit Credit Unions See 501(c)(15)-(27) for additional listing of tax exempt organizations. See 501(c)(15)-(27) for additional listing of tax exempt organizations. Common Traits: not organized for profit, no earnings should inure to any private person – but activities not recognized as charitable Common Traits: not organized for profit, no earnings should inure to any private person – but activities not recognized as charitable

Tax Exempt vs. Charitable Listed in Section 501(c) – other than (c)(3) Listed in Section 501(c) – other than (c)(3) Exempt from federal income tax Exempt from federal income tax Contributions not income tax deductible to the donor Contributions not income tax deductible to the donor Described in Section 501(c)(3) Described in Section 501(c)(3) Exempt from federal income tax Exempt from federal income tax Contributions tax deductible to the donor Contributions tax deductible to the donor

Section 501(c)(3) Organizations - Purposes Organized and operated exclusively for Organized and operated exclusively for –Religious, charitable, scientific –Testing for public safety –Literary –Educational purposes; or –To foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment); or –Prevention of cruelty to children or animals

501(c)(3) Orgs – Prohibited Activities No part of net earnings may inure to the benefit of any private shareholder or individual No part of net earnings may inure to the benefit of any private shareholder or individual –Private benefit/inurement doctrine No substantial part of activities may be carrying on propaganda, or otherwise attempting, to influence legislation No substantial part of activities may be carrying on propaganda, or otherwise attempting, to influence legislation –Except as provided in (c)(h)

501(c)(3) Organizations – Prohibited Activities May not participate in, or intervene in (including the publishing or distributing of statements) any political campaign on behalf of (or in opposition to) any candidate for public office. May not participate in, or intervene in (including the publishing or distributing of statements) any political campaign on behalf of (or in opposition to) any candidate for public office.

Charitable Contributions Donors are allowed an income tax charitable deduction for contributions to 501(c)(3) organizations Donors are allowed an income tax charitable deduction for contributions to 501(c)(3) organizations –See sections 170(a)(1) and 170(b)(1)(A) –Some organizations are “charitable” by definition or by the activities carried on

Private Foundation – under section 509(a), an organization is presumed to be a private foundation unless it is demonstrated that it fits an exception, and thus is a public charity Private Foundation – under section 509(a), an organization is presumed to be a private foundation unless it is demonstrated that it fits an exception, and thus is a public charity Further Classification - Private Foundation

Types of Public Charities –“traditional” public charities such as churches, colleges and universities, hospitals and medical research facilities and governmental units (section 509(a)(1); 170(b)(1)(A)(i)-(v) –“donative” publicly supported charities (section 509(a)(1);170(b)(1)(A)(vi) –“service provider” publicly supported charities (section 509(a)(2)) –Supporting organizations (section 509(a)(3)) –Organizations organized and operated exclusively to test for public safety (509(a)(4))

Examples of Public Charities Community Foundation (donative public charity) Community Foundation (donative public charity) Boy Scouts/Girl Scouts (typically a service provider public charity) Boy Scouts/Girl Scouts (typically a service provider public charity) Baylor University (educational institution – not required to meet support test) Baylor University (educational institution – not required to meet support test)

What’s the difference? Private Foundation/Public Charity Lower Income tax deduction for donor Lower Income tax deduction for donor –30% AGI limit for cash gifts –20% AGI limit for gifts of appreciated property Prohibited transactions and excise taxes Prohibited transactions and excise taxes Can be controlled by an individual or family Can be controlled by an individual or family Higher Income tax deduction for donor Higher Income tax deduction for donor –50% AGI limit for cash gifts –30% AGI limit for gifts of appreciated property Intermediate sanctions excise taxes Intermediate sanctions excise taxes More accountability to the public More accountability to the public

Recognition of Tax Exempt Status 1. Organize for state law purposes in Texas, can be unincorporated association, trust or non-profit corporationin Texas, can be unincorporated association, trust or non-profit corporation 2. File IRS Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code If seeking exemption under another section, file Form 1024 If seeking exemption under another section, file Form 1024

Form 1023 Filed within 15 months from the end of the month of organization (date of formation or incorporation) Filed within 15 months from the end of the month of organization (date of formation or incorporation) –Automatic 12 month extension – to 27 months from formation –Additional extension may be granted for good cause

Effect of Timely and Complete Filing of 1023 Once approved, IRS will issue either a determination letter or an advance ruling, depending on the type of organization Once approved, IRS will issue either a determination letter or an advance ruling, depending on the type of organization –Determination letter – evidence of an organization’s exempt status –Advance ruling – for public charities subject to a support test, a preliminary ruling that will be again examined after an initial five year period

Substantiation Rules Substantiation documentation for donations Substantiation documentation for donations –A charitable organization must issue substantiation letters to its donors where the donation has a value of $250 or more –Must be in writing and state whether goods or services were provided in return –If gift of appreciated property is received and sold within 2 years of acquisition, the charity must prepare and file Form 8282 –See Publication 1771 for further guidance

Common Issues: Unrelated Business Taxable Income (UBTI) Income from an unrelated trade or business Income from an unrelated trade or business –Taxed at highest corporate rate –Could result in loss of exemption if substantial –Theory: tax exempt organizations should not be in competition with for-profit businesses

UBTI Defined Income from any regularly conducted trade or business which is not substantially related to the performance of the organization’s exempt function Income from any regularly conducted trade or business which is not substantially related to the performance of the organization’s exempt function

UBTI Exclusions Passive income such as dividends and interest, rents, royalties, certain gains or losses from sale, exchange or other disposition of property Passive income such as dividends and interest, rents, royalties, certain gains or losses from sale, exchange or other disposition of property Income from some research (Section 512(b)) Income from some research (Section 512(b))

UBTI Exceptions Volunteer exception Volunteer exception –Where substanitally all the work in carrying on the trade or business is performed for the exempt organization without compensation Convenience exception Convenience exception –Governmental college or university, primarily for the convenience of its members, students, patients, officers or employees (dining hall) Selling of donated merchandise (ex: thrift store) Selling of donated merchandise (ex: thrift store)

UBTI – Debt Financed Property Income incurred with respect to debt- financed property Income incurred with respect to debt- financed property –Any property held to produce income and with respect to which there is acquisition indebtedness –Acquisition indebtedness – debt incurred in connection with acquisition or improvement of property Exclusions: See Section 514 – beyond scope of class

Future Classes Private Foundations Private Foundations - prohibited transactions - excise taxes Public Charities Public Charities - intermediate sanctions - support tests