How to Avoid Ten IRS Land Mines for Nonprofit Charities

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1 How to Avoid Ten IRS Land Mines for Nonprofit Charities The drive to increase revenue leads many nonprofit organizations to start up business activities. Easy profits are expected, but tax traps waiting to spring could result in hefty taxes even for a tax-exempt organization. Business activities of organizations bring other problems along as well, such as new administrative burdens and reporting requirements. Some activities can also create the possibility of taxable income even though the organization is otherwise tax exempt. Still other activities can remove the deductibility of certain contributions or even jeopardize the entire organization's tax exempt status. Keep an eye on the tax laws, and watch out for the IRS land mines! 1. Avoid engaging in unrelated business activities. Sometimes exempt organizations engage in business activities which help them fulfill some organization purpose. These business activities are known as related business activities because they advance an exempt purpose of the organization. It is permissible for an exempt organization to have related business activities from an IRS perspective. The net income from such activities is not taxable. On the other hand, unrelated business activities are activities which do not help fulfill any tax-exempt purpose of an organization. Unrelated business activities are never necessary for nonprofit organization - that is what makes them unrelated. Therefore, an exempt organization needs to report unrelated activities to the IRS. Every nonprofit organization having unrelated business activities must file an IRS Form 990-T for income received from unrelated business activity. This includes organizations which are exempt from filing an IRS Form 990. The organization will also incur extra administrative and reporting expenses because of its activities. Further, it will need to make disclosure of things it would not otherwise need to tell the IRS. Of course, the nonprofit organization must pay any applicable tax on the unrelated business income. This also adds to the administrative burden, since costs must now be allocated between taxable and exempt activities. If unrelated activities become substantial compared to total activities, the nonprofit organization may even lose its tax exempt status. Further, it is not unusual for sales tax and other state tax exemptions to be made expressly inapplicable to an organization's unrelated business activities. 2. Avoid the sale of advertising to outside companies. Many organizations publish their own newsletters, magazines and catalogs designed to promote the mission of the organization. If these publications promote

2 only the products and services of the publishing organization there is little to be concerned about. However, if the organization accepts paid advertising from other organizations, the advertising fees will normally be unrelated business taxable income. Whether taxes will actually be payable depends on the extent of offsetting deductions available. The reason this tax potential exists is that advertising is usually not related to any charitable or other exempt purpose. It does not matter if the publication is related solely to charitable causes, the publisher is a charitable organization, and the advertiser is a charitable organization. Even when this is the case, the act of selling advertising is not itself a charitable or exempt activity. Rather, it is a sale of a business service (advertising) which is taxed like a business is taxed. This is the general rule, to which there are some extremely limited exceptions. Consult your organization's tax professional for specific tax advice. 3. Avoid non-cash donations which are debt-financed property. An organization need not engage in any actual business activities to be liable for federal income taxes. Non-cash property which is "debt-financed property" may result in liability for income taxes when the property is sold. Generally speaking, debt-financed property is any non-cash property acquired subject to "acquisition indebtedness." Debt-financed property includes real estate subject to debt at the time of organization acquisition, even if the organization has not agreed to pay it. The income realized from the sale of debt-financed property is called unrelated debt-financed income. This is true even if the non-cash property was acquired by the organization as a donation. The debt-financed property rule is another reason to avoid accepting some noncash donations subject to a debt. However, this tax can be avoided if the debt is over five years old when the organization receives the property. The tax also does not apply if the property is put to an exempt use by the organization within a certain time after acquisition. There are other limitations and variations to the debt-financed property rule which management should discuss with the organization's tax advisor. In any case, it is advisable to have written guidelines prepared for considering non-cash donations to flag potential tax problems. 4. Avoid dealing with related organizations except at arms length. Some nonprofit organizations divide their operations among multiple corporations. There are a variety of reasons for doing this. A related organization may carry out unrelated business activities. Or, it may be useful for borrowing large amounts of money. Other organizations may engage in political activities. Some operations may be state licensed or government funded and best kept separate from the main

3 organization. However, organizations often view all related organizations as being under a single organization umbrella for fundraising or administrative purposes. Separate organizations may all be housed in the same building. Legal distinctions often are ignored in the day to day management of the overall organization. This can result in dealings between organizations which are not at arms length. That is, they do not deal with each other the same way they would with outside vendors or other disinterested third parties. An organization may lend money to a related organization at an interest rate below the normal market rate. This could result in additional taxable interest income being imputed to the organization. This is especially likely where the related organization is a profit corporation controlled by an exempt organization. Favorable loan terms extended by the organization could also be private inurement if the borrowing organization has any outside stockholders. 5. Avoid assignment of income problems. It is not uncommon for nonprofit leaders to write books or create other works of authorship in their own names which produce royalty income. Sometimes these authors wish to assign all or part of the royalty rights, but not the underlying copyright, to the nonprofit organization with which they are affiliated. They usually intend to avoid having to pay income taxes on that money personally. However, unless the assignment is made correctly, the author will remain personally liable for income taxes on the royalties paid to the organization. An effective assignment must be both permanent (irrevocable) and a transfer of the author's entire interest in the underlying work to the organization. A similar situation arises when an organization assigns a portion of its income to a subsidiary corporation. Suppose an organization forms a related organization solely to report unrelated business taxable income generated by the activities of the parent organization. Unless the related organization owns the assets and proprietary rights of the business, the assignment of income will not shift any tax liability. To shift taxable income away from the parent organization the related organization must be able to conduct the business activity in its own right. 6. Avoid excessive lobbying activities. Most tax exempt nonprofit organizations are not permitted to devote a substantial part of their activities for lobbying purposes. Lobbying means carrying on propaganda or otherwise attempting to influence legislation. Lobbying is not limited to advocating the adoption or rejection of actual legislation. It also includes urging individuals to contact their legislators to propose, support or oppose legislation. If substantial lobbying activities exist, tax exempt status is

4 forfeited. Lobbying activities may be found to be substantial in the 10%-20% range of total organization activities. Charitable organizations other than churches, church auxiliaries and certain affiliated organizations are permitted to make a special election. For electing organizations, lobbying expenses will be insubstantial if they are below certain limits based on the organization's annual budget. Lobbying expenses are limited to between 5% and 20% of an electing organization's annual budget for exempt expenses. A maximum limit on lobbying expenses of $1,500,000 applies in any event. An additional 25% of this amount is allowed for grass roots expenses, defined as trying to influence legislation by affecting public opinion. If these limits are exceeded, an electing organization may forfeit its tax exempt status. 7. Avoid sending earmarked donations to non-controlled foreign organizations. Contributions by individuals to any exempt charitable organization formed in the United States are normally deductible. Contributions to organizations which are not organized in the United States are not deductible. Most other countries have a similar rule, that is, donations to a U.S. organization are not deductible in that country. Thus, contributions by a U.S. donor to a U.S. organization which conducts operations in various other countries will be deductible. There is no limit on where a U.S. organization may use its funds for exempt purposes. However, if the U.S. organization separately incorporates its foreign operations to allow its foreign donors to get a deduction in their own country, it may create a problem for U.S. donors. Suppose a U.S. organization solicits contributions from U.S. donors earmarked for its work in another country. If these operations have been separately incorporated in that other country, a U.S. tax deduction may be unavailable. This is particularly true when the foreign organization works cooperatively with the U.S organization but is not controlled by it. The same result is reached when the foreign organization controls the U.S. organization instead of the other way around. In these cases, the U.S. organization must tell its donors that donations earmarked for foreign operations are not deductible. It is possible to arrange organization relationships to avoid this problem, though. Organizations which operate through multiple entities worldwide need to be extra careful in their tax planning. 8. Avoid any political campaign activity. Political campaign activity, unlike lobbying activities and expenses, is not governed by the rule of insubstantiality. Any amount of political campaign activity completely disqualifies a charitable organization from tax exempt status. This is

5 true no matter how insignificant or insubstantial the campaign activity is compared to total organization activities. There are no special elections available to be made, nor any exemptions from this rule. For organizations exempt under section 501(c)(3) of the tax code, political campaign activity is absolutely prohibited, and that is all. Campaign activity includes participation or intervention in any political campaign on behalf of, or in opposition to, any candidate for public office. Although lobbying activities relate to social issues and laws, campaign activities relate to individual candidates. A candidate is any contestant for elective office at the federal, state or local level. Participation in a campaign includes publishing or distributing statements made either by a candidate or by someone else directed at a candidate. Rating candidates to influence how people may vote also is regarded as campaign activity. 9. Avoid distributing profits to insiders. Another requirement of tax exemption is that no part of the net earnings of an exempt organization may benefit any private person. For this purpose, net earnings are not limited to profit realized from business activities. Net earnings also include the gross donation receipts or net assets of an exempt organization. This rule against private inurement, like the rule against campaign activity, is an absolute prohibition. Any amount of private inurement, no matter how insubstantial, generally disqualifies an organization from tax exempt status. (A limited exception exists for Excess Benefit Transactions.) Private inurement takes many forms, but almost always involves an organization insider. An organization insider is anyone having a personal interest in the activities of the organization, such as an officer, director, trustee, or key employee. Private inurement results when a person who has some control over an aspect of organization operations uses the organization to gain a personal advantage. Forms of private inurement include unreasonably high salaries and salaries based on a percentage of donations or fees. Unsecured loans made to the relatives of organization insiders also are a form of inurement. Other forms of private benefit include payment of all personal living expenses of organization insiders and making charitable distributions solely to organization members. 10. Avoid lending employees to non-exempt organizations. It is common for nonprofit organizations to loan their employees to another organization on a temporary basis to accomplish some specific purpose. Yet, a nonprofit organization should loan its employees on the same basis it spends its money. The purchase of goods or services furthers a business purpose of the

6 organization. The accomplishment of nonprofit activities furthers an exempt purpose of the organization. All expenses should further one of these two purposes. However, an employee loan does not serve a business purpose unless the organization is paid for the use of its employee. An employee loan serves an exempt purpose only if the receiving organization is either tax exempt in the same classification as the lending organization, or uses the employee on a project serving the exempt purposes of the lending organization (something which is difficult to monitor and prove). Further, the employee must be used for a purpose which is within the exempt purposes for both the lending and the receiving organizations (i.e., it isn't enough for the loaned employee to serve the lending organization's purposes - they must also serve the receiving organization's exempt purposes). If an employee loan fails to serve either an exempt purpose or business purpose of the employer, it is a diversion of assets to a non-exempt purpose. Depending on the situation, such a loan could be a form of private inurement.