Maintaining 501(c)(3) Tax-Exempt Status: Key Rules and Tips

Charitable organizations can take advantage of provisions in the tax code that exempt them from federal income tax and other types of tax obligations.

This leaves charitable organizations free to pursue their missions without worrying about tax liability. That said, gaining a tax exemption from the IRS does not free an organization from all federal tax compliance. It must still take steps to maintain its tax-exempt status.

This includes filing annual returns and refraining from activities that do not fall under the categories outlined in the Internal Revenue Code (IRC).

What Is a 501(c)(3) Organization?

The 501(c)(3) designation is named for the section of the IRC that defines what types of organizations may be tax-exempt. To qualify for a 501(c)(3) tax exemption, an organization must meet the following criteria under the statute:

• Its founding documents state that it will be used exclusively for certain approved purposes, including “religious, charitable, scientific, testing for public safety, literary, or educational purposes.”
• None of the organization’s earnings “inure" to the benefit of any private shareholder or individual.”
• Its activities do not substantially include “carrying on propaganda,” lobbying or “influence[ing] legislation” or participating in or influencing election campaigns for public office.

IRS regulations spell these requirements out in far greater detail. When applying for 501(c)(3) status, an organization must demonstrate that it meets each element of the statute.

What Can 501(c)(3) Organizations Do (and Not Do)?

A 501(c)(3) organization can engage in almost any activity that does not violate the abovementioned requirements. This might include:

• Raising money to support scientific or medical research in specific areas.

• Providing services to at-need communities like education, legal representation, medical care or food.

• Promoting the arts, such as film, theater, visual arts or literature.

• Educating the public about issues like animal welfare or environmental threats.

• Maintaining monuments or other structures; or

• Providing religious ministries and related services.

As for what 501(c)(3) organizations cannot do, the statute provides a list, which the IRS has supplemented:

• Inurement: A 501(c)(3) organization’s income and assets may not benefit insiders, such as employees, officers or board members. Income must go toward the organization’s mission. It may not be used to pay dividends or similar benefits.

• Private benefit: An organization’s activities must be directed toward an exempt purpose provided in the statute or IRS regulations. The organization cannot direct activities to private interests or benefits, except in a minimal way.

• Lobbying: 501(c)(3) organizations may engage in a small amount of lobbying, which means interacting with legislators, or encouraging the public to interact with legislators, in order to advocate for or against legislation. Lobbying may not be more than an “insubstantial” part of an organization’s activities.

• Political Campaigning: 501(c)(3) organizations may not engage in campaigning for or against candidates for public office. This applies to elections at all levels of government, from the municipal to the federal level.
  
  

How Can an Organization Lose Its Tax-Exempt Status?

There are three main ways that a 501(c)(3) organization can lose its tax-exempt status:

• Engaging in prohibited activities: The IRS can revoke the tax-exempt status of an organization that engages in prohibited activities like political campaigning, or inurement.

• Deviation from exempt purpose: An organization must pursue the purpose or purposes stated in its founding documents and its application for tax exemption. It must notify the IRS if its operations shift from its original purpose or purposes. The IRS may revoke its tax exemption if it does not receive notice.
• Failing to meet annual reporting requirements: 501(c)(3) organizations do not have to pay taxes on most income, but they do have to file an annual Form 990 with the IRS. Failure to file this form for three consecutive years results in automatic revocation of tax-exempt status.
  
  

What Do Organizations Need to Do to Maintain Their Tax-Exempt Status?

Maintaining an organization’s tax-exempt status does not need to be onerous. It is mainly a matter of consistently meeting the annual filing requirements and refraining from prohibited activities. The following tactics may help organizations keep their tax exemptions:

• Be aware of the IRS regulations governing tax-exempt status for 501(c)(3) organizations.
• Appoint someone responsible for annual Form 990 filings and be sure they have access to all needed information.
• Conduct regular reviews of an organization’s operations to determine whether any activities could violate the 501(c)(3) rules.

How Can an Organization Restore Its Tax-Exempt Status?

An organization that loses its tax-exempt status can apply for reinstatement. The IRS will make reinstatement retroactive to the date of revocation if the organization demonstrates that its compliance efforts used “ordinary business care and prudence"

As of today, it takes the IRS on average six months to process reinstatement requests (without expedition), and depending on the reason for revocation additional documentation, such as the past-due returns, may be required as well.

LGT prides itself on keeping your nonprofit charitable. We make the effort to alert you of any potential shortcomings or issues your nonprofit may face and can even assist with the reinstatement process.

To learn more about LGT and how we can serve you, contact us here.