How to Keep your Tax Exempt Status: Pt. 1

Here we discuss important issues for those about to start and run a nonprofit organization. If you plan to start an organization that creates a social impact or has a charitable purpose, you can likely form that organization as a nonprofit. An organization formed as a nonprofit enjoys many benefits, one of the biggest being tax-exempt status. However, it is important to remember that tax-exemption comes with regulations. This article will be part one of a two-part series where we examine some of the regulations a nonprofit must comply with in order to keep its tax-exempt status.

Private Inurement Prohibition

Nonprofit organizations enjoy tax-exempt status because they serve the public and thus, do not provide profit to private individuals. As such, a nonprofit will lose its tax-exempt status and the IRS may impose other sanctions on an organization that pays benefits to private individuals, this is known as the “private inurement prohibition.” An organization that runs afoul this prohibition typically does so when it uses its funds to reward insiders such as board members, trustees, officers, key employees, or anyone else who may greatly influence and operate the organization.

A nonprofit can use its funds to benefit private individuals both directly and indirectly. The most common example of private inurement is when the organization pays insiders an unreasonable compensation. However, a nonprofit can provide private gains beyond mere compensation, it may do so when it sells, buys, lends, gives, or enters into an unreasonable deal with insiders.

Despite this restriction, an organization can still pay and engage in business with insiders. In order to do so, however, it must keep two important guidelines in mind— first, compensation must be reasonable; second, business transactions must be done at arms length.

Reasonable Compensation

“Reasonable compensation” cannot be clearly defined or clearly calculated, but as a general rule of thumb an insider’s compensation should directly relate to the amount of services he or she has provided, and should also be an amount consistent with the going rate for workers in the same position in the geographic area. The organization must demonstrate insiders’ compensation reflects a reasonable and justified rate, should a concern ever arise with the IRS or Attorney General. Thus, all nonprofits should keep detailed notes, time cards, and job descriptions in order to prove the reasonability of these wages.

Business Dealings

An issue can also occur when the nonprofit deals in business with insiders, for example when it lends or sells to them. As a rule of thumb for these business transactions, nonprofits must conduct these deals at arms-length. In other words, an organization can buy assets from or sell assets to an insider, as long as it pays the fair market value. Red flags are raised whenever these deals are substantially over or under fair market value. An unfair business transaction also substantially risks the organization losing its tax-exempt status.

Unrelated Business Income Tax (“UBIT”)

A nonprofit may earn profits from business activities that are not substantially related to its charitable purpose. However, these profits are likely subject to UBIT, a tax imposed by the IRS. An organization with unrelated business profits must report these profits on tax returns, which generally are taxed at the corporate tax rate.

Take, for example, a nonprofit that defined its charitable purpose as an effort to stimulate and foster public interest in the fine arts by promoting art exhibits, sponsoring cultural events, and supplying information about fine arts to the public. This organization also conducted business activities in which it leased studio apartments to artist tenants and ran a dining hall for these tenants. The leasing and dining hall activities were not substantially related to the charitable purpose of fostering public interest in the fine arts, and were thus subject to UBIT.

When forming a nonprofit, articulate a clear charitable purpose, and ensure the primary activities of the nonprofit serve that purpose. If there is any doubt about whether the nonprofit is generating profits from business activities that are “unrelated” to the purpose of the nonprofit, consult an attorney to confirm compliance with any federal tax requirements.

What Does All This Mean For Your Nonprofit?

When managing your nonprofit, make every decision with a focus on the charitable purpose of your organization. Any compensation agreement for a member of your nonprofit must be made with an awareness that the organization, its employees, and members work to benefit the public. When organizing business activities for your nonprofit, you must consider whether the activities fall within the scope of your charitable purpose. It is always wise to consult with an attorney regarding these issues and to keep detailed records regarding employment duties and history, as well as records regarding your organization’s activities.

Part two to this article discusses the need to create and act within the scope of your nonprofit’s charitable purpose by exploring the political and lobbying restrictions imposed on nonprofits.

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