IRS PROCEDURAL ISSUES

Transcription

1 IRS PROCEDURAL ISSUES I. Introduction A. In general, IRS procedural issues involving organizations that are, are seeking to become, or claim to be exempt from Federal income tax are the same as those for other taxpayers. B. Absent special rules to the contrary, the procedures for the determination, payment, and collection of Federal taxes by exempt organizations follow the rules 1. for the classification of the entity -- corporation, trust, or partnership, and 2. for the type of tax -- income, employment, or excise. C. For example, the procedural rules for information turn reporting on Form 1099, for employment taxes or Forms 941 and 940, or for wage information reporting on Forms W-2 are usually the same for all taxpayers, whether or not exempt from Federal income tax. Similarly, the rate of tax for unrelated business income tax purposes depends on whether the particular exempt organization is a corporation or a trust, and it is taxed accordingly. D. This outline and discussion will only attempt to focus on the procedural rules that are applicable to exempt organizations specially, although those rules are often informed by the general tax rules and procedures. II. Overview A. The categories of procedures applicable to exempt organizations and their matters before the IRS are as follows: 1. Initial qualification 2. Continuing qualification 3. Examination of status and determination of tax liabilities 4. Administrative resolution of controversies and disputes 5. Litigation and judicial resolution B. As a conceptual matter, in understanding the applicable procedures it is helpful to think of an IRS exemption letter as an insurance policy. 1. The insured (and beneficiary) is the organization to which the exemption letter is issued. 2. The insurance company, the IRS, will stand behind that letter and protect the organization from audit and other challenges as long as the material facts and controlling law have not changed. 3. To keep the policy in force, it is the responsibility of the organization, just like any insured, to notify the insurance company, the IRS, of any changes in its activities or its governing instruments. 4. Failure to make these notifications or to follow other prescribed steps, could have the same effect as cancellation of the policy, revocation or modification of the exemption letter. 5. Against this background, each of the procedural categories will be explored. III. Initial Qualification

2 A. The applicable procedures for establishing qualification for exemption from Federal income tax depend on whether the applicant is seeking recognition as a charitable organization under section 501(c)(3) or some other provision of the Code. Two forms are currently prescribed by the IRS. 1. Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. 2. Form 1024, Application for Recognition of Exemption Under Section 501(a) or for Determination Under section 120. B. Procedural checklists are included in each of these forms. Careful attention should be given to all listed items and applicable portions of the application forms. C. A detailed narrative description of the activities of the organization--past, present, and proposed--is required. This, along with the necessary financial information, is the core of the application, and typically provides the basis upon which the IRS makes its initial determination, assuming, of course, that all other relevant parts of the application, particularly the governing instruments are in order. D. The narrative description is also the yardstick by which questions will be resolved regarding what activities of the organization were covered by the exemption letter. It is difficult, if not impossible, for an organization to argue that its exemption letter should not be retroactively revoked because of a problematic activity not disclosed in the original application or by a subsequent update. E. Upon receipt by the IRS by the Key District Office of jurisdiction, it will be screened for completion. The IRS District Office responses include: 1. returning incomplete applications and asking for an entire re-submission 2. retaining the application and requesting more information 3. forwarding the application to the National Office because the case presents novel issues not covered by existing precedent 4. issuing a favorable determination letter 5. issuing an adverse determination letter, with the right to protest and request Appeals Office consideration. F. If an application is referred to the National Office for consideration, and an adverse ruling is issued, the organization will be informed of the basis for the decision and of its right to protest and have a conference in the National Office. G. Before the issuance of a ruling or determination letter, the organization may withdraw its application from further consideration by the IRS. This action could prevent IRS from issuing an adverse determination. However, it will not prevent the IRS from using any information it has received in examining the organization or its managers, or in using that information in the consideration of a later application from the organization or successor group. In this regard, the IRS returns no submissions from the organization, nor does it refund any user fees. H. The effective date of an exemption letter is usually the date of formation of the organization if the purposes and activities were substantially the same upon which the exemption letter was based. If an organization is required to modify its operation or substantially amend its governing instruments, the exemption letter will usually specify the effective date. I. The effective date for the exemption of section 501(c)(3) charitable organizations, and their eligibility to received deductible contributions from donors under section

3 170, is also governed by the rules of section 508(a), the applicable regulations, and Rev. Proc The effect of these rules is to permit a 27-month window from the time a new charity is formed within which to submit a Form 1023 to the IRS and have its status automatically recognized back to the date of its formation. A charity that misses the 27-month deadline may nevertheless request a further discretionary extension under the criteria set out in section of the Income Tax regulations and Rev. Proc J. If a further discretionary extension is not granted, the organization may still seek to qualify for exemption from income tax under section 501(c)(4) as a social welfare organization for the period of the delinquency however, contributions from donors during that period would not be deductible. K. If the IRS issues an adverse notice of final determination of status under section 170(c)(2), 501(c)(3), 509(a), or 4942(j)(3), and all administrative remedies have been exhausted, the organization may file suit for declaratory judgment relief under the provisions of section These suits may be filed in the U.S. District Court for the District of Columbia, the Claims Court, or the Tax Court. L. In certain circumstances, a suit for declaratory judgment may be filed even though the IRS has not issued a final adverse determination. Under section 7428(b)(2), an applicant shall be deemed to have exhausted its administrative remedies with respect to a failure by the Service to have issued the final adverse determination letter at the expiration of 270 days after the date on which the request was made and the organization has taken, in a timely manner, all reasonable steps to secure the determination. M. Non-charities have no judicial remedy for a declaratory judgment regarding their exempt status. Adjudication of their status, however, may be accomplished through the deficiency notice procedures or refund suits. IV. Continuing Qualification A. Mindful of the nature of the exemption letter as an insurance contract, an ongoing obligation on the part of every exempt organization is to notify the IRS Key District Director of any significant changes in activities or in the governing instruments. 1. This action should be taken as soon as feasible after the changes have occurred. 2. The organization should prepare a letter to the Service fully describing the changes, explain why they are in furtherance of exempt purposes (assuming that is the case), and ask for a reply letter informing the organization that the changes described will not adversely affect tax-exempt status. 3. This is a required action to keep the exemption letter in force, and no additional user fee is charged. 4. In most instances, the Key District will acknowledge the request and inform the organization that it continues to be recognized as exempt. 5. Sometimes, the IRS will necessarily ask for more details. Though unpleasant, such an inquiry can result in an early correction, if required. 6. The danger of not complying with this notification requirement is that the insurance policy effect of the original exemption letter can be severely diluted. B. Annually filing a complete and accurate Form 990, Return of Organization Exempt From Income Tax, is the most important step an organization can take to

4 make sure that its exemption letter remains in force. Form 990 is a road map that contains important checks on an organization's exemption requirements. requirements. These checks include: 1. current reporting of an organization's revenues, expenditures, assets, and liabilities 2. updated statement of program service accomplishments 3. an analysis of income-producing activities, and a determination on the need to file Form 990-T, Exempt Organization Business Income Tax Return 4. information regarding taxable subsidiaries and joint ventures and 5. compliance with the public inspection requirements for returns and exemption applications. C. Charitable organizations filing Schedule A of Form 990 have additional checks. These include: 1. reporting on lobbying activity 2. financial transactions with officers, directors, trustees, key employees, their family members and affiliated entities 3. ongoing compliance with public charity financial support tests and 4. transfers to and transactions and relationships with noncharitable exempt organizations. V. Examination of Status and Determination of Tax Liability A. As the agency responsible for administering the Internal Revenue Code, the IRS has ongoing examination programs to determine compliance with the tax laws, identify abuses, and make findings regarding the correct amount of tax owing by particular taxpayers. B. The investigative authority of the IRS is very broad, and it has relatively significant resources to carry out its mission. C. At the same time, taxpayers have many rights to ensure that they will be treated fairly and even-handedly in the case of an audit. Every taxpayer has the right to expect that any audit will be conducted impartially, and that the examining officer will be guided by the material facts and relevant law. D. The results of an IRS examination include these results: 1. the issuance of a no-charge letter 2. the issuance of a warning attached to a no-change letter, advising that certain activities, if enlarged, could jeopardize tax-exempt status 3. the assertion of additional liability for unrelated business income tax, employment tax, or other Federal tax, with no-change to exempt status 4. the assertion of additional income tax to officers, directors, or employees, or contributors because of findings made during the course of the organization, but with no-change to its exempt status. 5. mofification of exempt status, but with no apparent income tax consequence 6. prospective revocation of exempt status, with only apparent future tax consequences 7. retroactive revocation of exempt status, with potential, but typically undetermined, liability for past Federal income taxes (the IRS expects the taxpayer to prepare and file the requested returns although sometimes a substitute for return is sometimes

5 prepared by the examining agent.) VI. Administrative Resolution of Controversies and Disputes A. With the exemption of those rare controversies that involve a pure legal question, it is almost always in the best interests of the taxpayer and the IRS to resolve a dispute at the lowest possible level at the earliest opportunity. B. Should that not be possible, organizations usually have the administrative right receive a 30-day letter, with the opportunity of a protest to the Appeals Office. Sometimes consents on Form 872 to extend the statute of limitations on assessment and collection will be required in order to preserve this administrative right. C. If an exemption finding questions a prior National Office ruling or technical advice, the taxpayer has right of appeal to the National Office. D. In addition, an organization seeking to have its case heard in the National Office, may initiate a request for technical advice either at the examination or Appeals stage. Such a request will not ordinarily be granted unless the organization can show the issue presented is on that is not covered by exiting precedent or is one on which district offices have taken inconsistent positions. E. Moreover, any case requesting non-retroactive relief under the authority of section 7805(b) must be forwarded to the National Office for consideration. F. Warning letters are special problems as they are not directly appealable. If an organization disputes either the conclusion or implication of a warning, it should take steps to document its objections, and, if feasible, consider initiating a request for technical advice. G. Administrative resolutions include: 1. appeals office resolution 2. technical advice being issued or 3. closing agreement being entered into. VII. Litigation and Judicial Resolution A. Should an administrative resolution prove not to be feasible, remedies are available through 1. the declaratory judgment process, and 2. deficiency or refund suits. B. In evaluating whether or not to litigate, an organization should take note of the high success rate of the government, particularly at the Supreme Court level. VIII. Summary and Conclusion A. The best procedures for dealing with real and potential IRS inquiries is planning ahead for them, anticipating areas of concern, and learning to communicate successfully with the IRS. B. The IRS procedures for establishing and maintaining tax-exempt status are designed to be fair and are sufficiently flexible to allow most organizations to demonstrate their compliance, resolve differences, and receive a fair hearing. C. Current pending legislation in connection with proposals for intermediate sanctions place considerable emphasis on the decision-making process by charities, particularly as regards compensation questions. Regardless of the outcome of that

6 legislative debate, public charities ought now consider what measures can be instituted to demonstrate their satisfaction with the underlying exemption requirements.