Understanding the Form 1023
Forming a nonprofit organization (with 501c3 tax exemption) is a worthy pursuit that might even make the world a better place, but it is important to understand that the process can be legally complex and challenging. A first step is to file the IRS Form 1023, which can feel overwhelming for a person unfamiliar with this tax document. If you are starting a nonprofit organization, consider visiting with the experienced nonprofit attorney Jennifer V. Abelaj at the Jennifer V. Abelaj Law Firm (212-328-9568) in New York. Jennifer V. Abelaj is an experienced nonprofit law attorney who can help you create, structure, and launch the successful nonprofit business of your dreams.
Form 1023 or 1023EZ
The Form 1023 is a complicated document that exceeds 60 pages (including instructions). Some applicants for tax-free status, however, are eligible to file the Form 1023-EZ, which allows a more streamlined process. The Internal Revenue Service provides highly specific eligibility requirements for filing the EZ version of Form 1023. You must be able to answer no to a variety of important questions that include the following in order to proceed with the Form 1023-EZ:
- Do you expect the organization’s gross receipts to exceed $50,000 in any of the next 3 years?
- Have the organization’s gross receipts exceeded $50,000 in any of the past 3 years?
- Does the fair market value of the organization’s total assets exceed $250,000?
- Was the organization formed under another country’s laws?
- Is the organization’s mailing address in a foreign country?
- Is the organization controlled by or is the organization a successor to an entity that was suspended of tax-exempt status as a result of being identified as a terrorist organization?
- Is the organization structured as any kind of entity other than a corporation, an unincorporated association, or a trust?
- Is the organization formed as an entity that is for profit?
- Is the organization a successor of an entity that is for profit?
- Has the organization been previously revoked or is it a successor to a previously revoked organization (other than revocation for failure to file a Form 990-series for three years running)?
- Is the organization currently (or was it previously) recognized as being tax exempt under any other section of IRC 501(a)?
- Is the organization a church that is recognized under the IRS’s understanding of the term?
- Is the organization a school, university, or college as defined by the IRS?
- Is the organization engaged in medical research or is it a hospital as defined by the IRS?
- Is the organization an agricultural research organization as defined by the IRS?
Correctly filing the correct IRS form is paramount, and Jennifer V. Abelaj at the Jennifer V. Abelaj Law Firm (212-328-9568) in New York is a dedicated nonprofit law attorney who has the experience and legal understanding to help you master your Form 1023 – in pursuit of tax-exempt status for your organization.
If You Do Not Qualify to File Form 1023-EZ
If you do not qualify to file Form 1023-EZ, you will need to move forward with the lengthier standard form. The difference between the two include the following requirements for the standard Form 1023:
- You will need to provide a written narrative that describes your organization in detail.
- You will need to provide a detailed description of your organization’s activities.
- You will need to provide more detailed information about your organization’s board of directors.
- You will need to provide more detailed information about your organization’s current, past, and projected financials.
There are also more specific requirements related to your organization’s overall structure that will need to be addressed in the standard Form 1023.
Preparing to File Form 1023
In order to file Form 1023 with the IRS, you will need to engage in a range of preliminary activities that include (as applicable) obtaining a federal employer identification number (EIN), incorporating your organization, drafting your bylaws, and making financial projections. You will also need to include each of the following (as applicable) in your application packet:
- Your Form 1023 checklist
- Your application, which includes Form 1023 and Schedules A through H (as applicable)
- Accurate financial statements (or well-considered projections)
- Your organization’s organizing document (your Articles of Incorporation for example)
- All the amendments to your organization’s organizing document (provided in chronological order)
- A Power of Attorney and Declaration of Representative (as applicable)
- Tax Information Authorization (as applicable)
- Your organization’s bylaws – or other rules of operation – and any amendments thereto
- All other applicable attachments, including financial information, printed materials and publications, necessary explanations, and anything else that applies
It is important to mark each or your packet’s inclusions with your organization’s name and EIN.
The Application Process
Applying for tax-exempt status with the Form 1023 is a lengthy process (the IRS estimates that it takes about 100 hours) but failing to do so properly can protract the process further – or can void your application entirely. Working closely with an experienced nonprofit law attorney from the outset is the surest means of expediting the process and helping to ensure that you are successful in your endeavor. Once the IRS makes its decisions regarding your organization’s exemption status, it will inform you with in a Determination Letter.
Discuss Your Organization’s Tax-Exempt Status with an Experienced New York Nonprofit Law Attorney Today
Starting a nonprofit organization can prove exceptionally rewarding, but obtaining tax-exempt status is a challenging process. Forming a tax-exempt organization hinges on your ability to meet the federal government’s requirements and on your ability to successfully file the IRS Form 1023, which is a complicated and lengthy endeavor. Jennifer V. Abelaj at the Jennifer V. Abelaj Law Firm is an accomplished New York nonprofit law attorney who has a wealth of experience successfully supporting clients like you in their quests to create socially aware nonprofit organizations that promote the better good. Your efforts toward this end are admirable and important, and we are here to help you achieve your goals. For more information about what we can do for you, please do not hesitate to reach out by contacting or calling us at 212-328-9568 today.
Does Your Organization Meet The Criteria For An Educational 501(c)(3)?
Section 501(c)(3) is a part of the United States Internal Revenue Code that allows nonprofit organizations to apply for tax exemption if they meet certain requirements. The organization must meet one of the exempt purposes designated by the Internal Revenue Code, including educational purposes. Educational purposes can be defined broadly and may apply to organizations other than traditional schools. In addition, not all educational organizations necessarily qualify for tax-exempt status. For an organization to apply for tax-exempt status based on educational purposes, its leaders should make sure that it meets the criteria for an educational 501(c)(3). While obtaining tax-exempt status for your nonprofit can be complex, an experienced nonprofit lawyer can provide useful guidance throughout the process. If you want to learn more about educational 501(c)(3)s or are ready to file for your nonprofit to receive this status, consider contacting the Jennifer V. Abelaj Law Firm by calling 212-328-9568 to schedule a consultation.
What Qualifies as an Educational Organization?
The term “educational purposes” is not specifically defined in the Internal Revenue Code. Rather, the Internal Revenue Service (IRS) refers to Section 1.501 (3)-1(d)(3)(i) of the Code of Federal Regulations for their definition, according to the United States Government Publishing Office, which states that an organization must meet one of the following two requirements to qualify:
- Provide instruction and training of individuals to improve or develop their capabilities or
- Instruct the public regarding subjects useful to the individual that benefit the community
This idea is further elaborated in the same statute’s definition of “charitable,” which includes advancing education as one qualifier. These broadly defined terms allow some organizations that do not directly work in education to claim tax-exempt status based on educational purposes, such as providing a support service to educational organizations. However, educational organizations and other 501(c)(3) organizations will not qualify for exemption if a substantial part of their activities is related to non-exempt purposes.
IRS Restrictions for All 501(c)(3) Organizations
In addition to meeting the criteria for “educational purposes,” educational 501(c)(3) organizations are required to meet the same requirements, according to the Internal Revenue Service (IRS), as all other types of tax-exempt non-profits, including that:
- The nonprofit may not be organized or operated for the benefit of private interests
- None of the organization’s earnings may be distributed to private shareholders or individuals
- The organization may not dedicate a substantial amount of its activities toward influencing legislation, nor participate in any political campaign activities
In addition to meeting these requirements when applying for tax-exempt status, nonprofit organizations must maintain these standards at all times in order to maintain their status. Those who violate the IRS requirements may have their tax-exempt status revoked and could face serious financial penalties. If you have questions about meeting the criteria for an educational 501(c)(3) organization, an experienced nonprofit lawyer at the Jennifer V. Abelaj Law Firm may be able to help.
Is the Organization a Public Charity or Private Foundation?
The IRS classifies each Section 501(c)(3) organization as either a public charity or a private foundation. Educational organizations should be aware of the distinction between these two categories, as each carries its own rules and regulations. The central distinction is the organization’s source of funding. Private foundations are typically under the control of an individual, family, or corporation, and most of their funding comes from a handful of donors and investments. Conversely, public charities generally receive their financial support from a large network of public donators and fundraising.
The vast majority of educational and other Section 501(c)(3) organizations are public charities. Schools automatically qualify as public charities, while certain other types of educational organizations may need to prove that they are publicly supported. In most cases, demonstrating this proof involves showing that at least one third of the organization’s support comes from donations, membership fees, or gross receipts from activities directly related to educational purposes. Those who provide this proof and meet all other criteria may qualify as tax-exempt public charities.
What Types of Educational Organizations Qualify?
Schools are the most obvious example of an educational organization, but there are several types of educational activities that could qualify an organization for tax-exempt status under Section 501(c)(3). To qualify, the organization must serve the public good by providing educational activities related to instruction and training. For example, a coding boot camp would be obligated to help its students acquire new skills and become more proficient at coding. If the camp is operated to educate the community without any focus on private interests and meets all other requirements, it could qualify as an educational 501(c)(3) organization.
There are just a few common examples of nonprofit educational organizations. IRS evaluations of exempt purposes are subjective, but several types of organizations could qualify as long as they are dedicated to providing instruction and training without seeking profits. Some of the other types of nonprofit businesses that could qualify for tax-exempt status under Section 501(c)(3) include:
- Trade schools
- Kindergartens and daycares
- Public and private universities
- Museums
- Planetariums
- Public libraries
- Science centers
Applying for 501(c)(3) Classification as an Educational Nonprofit
Those who are in the beginning stages of forming an educational nonprofit will need to meet several requirements before applying for 501(c)(3) tax-exempt status. Extensive paperwork must be filed to incorporate the organization with federal and state governments, and regulations may vary from state to state. Once incorporated, the organization must meet all requirements for 501(c)(3) and provide thorough documentation proving that it meets these requirements. These documents must be submitted along with the IRS Form 1023-series application.
Contact an Experienced Nonprofit Lawyer To Learn More
Applying for tax-exempt status under Section 501(c)(3) of the Internal Revenue Code is a complicated and lengthy process that requires strict adherence to all guidelines. Filing this application is critical to the formation of nonprofits. While organizations may be able to handle the steps internally, many seek help from experienced nonprofit attorneys who understand what is required to successfully obtain tax-exempt status for their clients. If you have questions regarding the criteria for an educational 501(c)(3) or another nonprofit matter, consider contacting a knowledgeable nonprofit lawyer at the Jennifer V. Abelaj Law Firm by calling 212-328-9568 to schedule a consultation today.
The IRS Now Mandates Electronic Filing For All Non-Profits
Even though the Internal Revenue Service (IRS) has long accepted electronic tax filings, tax-exempt organizations have been able to rely exclusively on paper returns and filings until recently. The IRS now mandates electronic filing for all non-profits. The new mandate is designed to streamline the filing process, modernize technology, and improve tax compliance in the tax-exempt sector. To help your non-profit organization comply with the new mandate, consider contacting the Jennifer V. Abelaj Law Firm at 212-328-9568 before the next tax deadline.
New Requirements for Non-Profit Electronic Filing
In the years prior to 2019, exempt organizations were only required to electronically file returns if they had at least 245 employees or reported assets of $10 million or more. However, on July 1, 2019, President Donald J. Trump signed the Taxpayer First Act into law, requiring all tax-exempt organizations to e-file their returns.
Smaller exempt organizations were initially provided some relief by being allowed to file paper returns if they filed Form 990-EZ, Short Form Return of Organization Exempt for Income Tax. However, the IRS has stopped accepting paper returns even for this purpose as of July 31, 2021. Due to the new IRS update, all exempt organizations, including those that filed Form 990-EZ, must file their returns electronically.
Forms to Be Electronically Filed
Since the IRS now mandates electronic filing for all non-profits, the following Form 990 series must be electronically filed:
- Form 990, Return of Organization Exempt from Income Tax
- Form 990-EZ, Return of Organization Exempt from Income Tax (Short Form)
- Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Trust Treated as Private Foundation
- Form 990-N, Electronic Notice
- Form 990-T, Exempt Organization Business Income Tax Return
Additionally, tax-exempt organizations that file any of the following forms must now file them electronically:
- Form 8872, Political Organization Report of Contributions and Expenditures
- Form 1120-POL, United States Income Tax Return for Certain Political Organizations
- Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code
- Form 1065, United States Return of Partnership Income
About Form 990
The IRS Form 990 series provides transparency and accountability for the non-profit sector. These forms can generally be viewed and inspected by the public and are the primary source for basic information about the non-profit organization. However, the filing of paper returns often created a lag between the time when the non-profit organization submitted its required forms and when the public had access to view the contents. That made it difficult for the public to have accurate and timely information about many organizations in the non-profit sector. The new mandate is expected to provide more timely data for donors, regulators, and other stakeholders.
The IRS does not require certain non-profit organizations to file Form 990 or even Form 990-EZ. These include:
- Certain religious organizations
- Certain government organizations
- Certain political organizations
- Organizations with gross receipts less than $50,000 (although they must file Form 990-N)
- Certain organizations that file different kinds of annual information returns, such as private charitable entities exempt under section 501(c)(3) and described in section 509(a), private charitable entities terminating their status by becoming a public charity, religious or apostolic organizations described in section 501(d), and stock bonus, pension, or profit-sharing trusts that qualify under section 401.
E-Filing Deadline
The electronic filing deadline for non-profit organizations is July 31. Although smaller exempt organizations were provided with transitional relief to give them more time to switch over from filing paper returns to electronic filing, all tax-exempt organizations except those with a specific exemption must now prepare electronic filings. All entities, including the ones that previously used Form 990-EZ, were required to electronically file forms 990 and 990-EZ with tax years ending July 31, 2021, and later.
How to Comply with the New Mandate
Organizations that previously filed paper tax forms were sent a letter from the IRS notifying them that the IRS now mandates electronic filing for all non-profits. If organizations filed a paper return after the applicable deadline, the IRS might have responded by saying that they needed to redo the return electronically. The IRS might have flagged the return as late when providing this notification. To abide by the new tax law, exempt organizations can engage the services of an outside tax professional or use one of the IRS’s pre-approved software providers to prepare their electronic return.
Because tax-exempt organizations may have complex reporting requirements that are substantially different than for regular taxpayers, they may wish to work with a tax consultant or legal professional who has more experience with the system. The Jennifer V. Abelaj Law Firm works closely with non-profit organizations and is well-versed in the laws and regulations that affect them. Consider contacting the office for help with tax filings and answers to any questions you have.
Contact a Non-Profit Lawyer for Help
If you are uncertain about how to comply with the current requirements for tax filings since the IRS now mandates electronic filings for all non-profits, you might consider reaching out to a lawyer who focuses in this area of the law. The Jennifer V. Abelaj Law Firm has years of experience working with various non-profit organizations, including public charities, private foundations, social welfare organizations, business associations, and more. We also assist with estate planning so that your non-profit organization can benefit from legacy gifts. Numerous charities and non-profit organizations depend on us for help with their creation, governance, transaction assistance, advocacy, tax compliance, and dissolution. We are also prepared to handle any potential legal issues that arise during tax filing season. Because we know all about the new mandate, we can help to ensure compliance and help you achieve your non-profit’s objectives by explaining whether the new mandate applies to your organization, how to transition from paper returns to electronic returns, and how to electronically file a return. Consider contacting the Jennifer V. Abelaj Law Firm at 212-328-9568 to discuss your non-profit organization’s current challenges, tax filing status, and goals.
Non-Profits and Automatic Revocation of Tax-Exempt Status for Failure to File Tax Return
Non-profit organizations must comply with many tax laws to maintain their tax-exempt status. One of the easiest compliance requirements which is sometimes overlooked is filing annual tax returns. If a non-profit fails to file a tax return for three consecutive years, the IRS automatically revokes its tax-exempt status.
Filing Requirement
All non-profit organizations are required to file annual income tax returns. The type of return required depends on the organization’s tax classification. Non-profits with annual gross receipts of less than $50,000 must file a Form 990-N on the IRS’s website (sometimes called a “postcard 990”). This is an online filing and can easily be done by the organization without the assistance of an attorney or accountant.
An organization with annual gross receipts greater than $50,000 must file a full Form 990. This is best prepared by a Certified Public Accountant.
All private foundations must file Form 990-PF.
Small Organizations Must Remain Vigilant to File Timely
An organization may request an extension of time to file their income tax returns. This allows an additional 6 months to prepare and file the appropriate tax return.
If an organization forgets or fails to file a return in one year, it can “catch up” in the following year by filing both years.
This is particularly the case for small organizations that must annually file the postcard Form 990-N. The due date for a 990-N is 4 months and 15 days after the organization’s year-end. If it fails to file by the due date, the IRS closes the system for that particular year and the organization must wait until the portal re-opens for filing in the following tax year. At that time, the organization can file the current 990-N, as well as up to 2 prior years that were not filed without losing tax-exempt status.
Failure to File for 3 Years Results in Automatic Revocation of Tax-Exempt Status
If any organization fails to file or request extension of time to file for 3 consecutive years, the IRS automatically revokes the organization’s tax-exempt status.
The result is that the organization will be taxed as a corporation (or as a trust if applicable) and be required to file a Form 1120 and pay tax at the corporate rate.
The organization will also appear on the IRS’s website as having lost its tax-exempt status.
In addition, donations to the organization are no longer tax-deductible to the donor. This can have a significant impact on fundraising efforts.
What to Do if Your Non-Profit’s Tax-Exempt Status is Automatically Revoked
The IRS provides information on how to reinstate tax-exempt status due to automatic revocation. The date of the organization’s reinstatement as tax-exempt may be retroactive to the creation date OR to the date of revocation notice. This is critical to note because reinstatement to the date of creation provides tax-exempt status, including tax-deductible donations, for the non-compliant three years. By comparison, reinstatement to the date of the revocation notice will result in the organization loses tax-exempt status for the non-compliant three years and any donations made in that time will not be tax-deductible to the donor.
The IRS provides a “Streamlined” reinstatement process for organizations that were eligible to file a Form 990-EZ or 990-N for the three years that they failed to file a return (and which caused the revocation). Organizations that were required to file a Form 990 or 990-PF are not eligible for a streamlined process and must provide additional information.
Don’t Delay in Taking Action if your Non-Profit Organization Loses its Tax-Exempt Status
It is very important for a non-profit organization to timely file its tax returns. If its tax-exempt status is automatically revoked due to failure to file for three years, it must act promptly to obtain reinstatement.
Depending on the complexity of your non-profit organization, it may require representation by an attorney and tax preparation by an accountant.
If your organization has received notice of automatic revocation of tax-exempt status, do not hesitate to contact our Firm. We have years of experience assisting non-profits in tax and corporate governance and compliance.
Ongoing Tax and Governance Compliance for Tax-Exempt Organizations
Existing not-for-profit organizations (“NPO”) must ensure that they annually comply with corporate and tax laws. The failure to do so may impact the NPO is minor ways or in significant ways.
Tax Compliance
Annual Tax Return Filing (Form 990)
An existing NPO must file a Return of Organization Exempt from Income Tax (Form 990) as soon as it completes its first fiscal year of existence. Occasionally, the NPO may still be awaiting a determination letter from the IRS approving its tax-exempt status. However, the NPO must file the appropriate Form 990 based on the activities and gross receipts within the first year.
An amended return can be filed if the IRS determines that the NPO is tax-exempt under a tax section which differs from the application request. For example, an NPO may apply for exemption as a public charity. However, the IRS may approve the application as a private foundation. In such a case, the organization would be able to file an amended Form 990-PF for the year in question.
Following receipt of the determination letter, and assuming the NPO agrees with the IRS’s determination, the NPO must file an annual Form 990. In some cases, it may be as simple as the online filing of Form 990-N for organizations with gross receipts of less than $50,000 in the taxable year (and less than $250,000 in assets). An NPO that requires a full Form 990 must ensure that they provide their CPA with annual financials necessary for timely and complete preparation.
Failure to file a Form 990 for three consecutive years automatically revokes the organization’s tax-exempt status. The process to reinstate tax-exempt status requires the assistance of your attorney and accountant.
Estimated Tax Payments on Unrelated Business Income
If an NPO has unrelated business income in excess of $500 a year, it is required to pay quarterly taxes on Form 990-W. Unrelated business income is a complex area and beyond the scope of this article, but it is generally an investment by the NPO that is not related to its charitable activities in which it expects to receive an income. The IRS allows an NPO to receive UBI without losing its tax-exempt status if the UBI is not significant. The challenge is that there is no formula to determine the amount is not significant.
Failure to monitor UBI could place the organization in jeopardy of losing its tax-exempt status.
Tax Payments on Net Investment Income for Private Foundations
A private foundation must pay taxes on its annual net investment income. The payment may be done at the time of filing the tax return (Form 990-PF) or in quarterly estimated payments.
Governance Compliance
Registration and Filing with the Office of Attorney General
NPOs that fundraise within New York State must register with the Charities Bureau of the New York State Office of Attorney General (“Charities Bureau”). The initial registration is completed contemporaneously with filing of the Application for Tax-Exempt status or shortly following receipt of the IRS determination letter.
An NPO must file an annual report with the Charities Bureau, along with a copy of their Form 990. A filing fee may be required as determined by the NPO’s annual gross receipts. The annual filing, including the Form 990, is publicly available on the Charities Bureau’s website. Religious organizations are not required to register or to submit an annual filing.
Annual Meetings
New York State requires that an NPO hold a membership meeting at least once each year. NPC-L 603(b). The membership meeting generally includes voting of directors or officers, discussion of the Board’s annual activities and financial reports, and ratification of certain actions, such as changes in the Bylaws.
Although the NPO does not require an annual meeting of directors, it is likely that the NPO’s Bylaws mandate an annual Board meeting. Discussions include long-term strategy for the NPO, goals on how to effectuate the NPO’s charitable purposes, financial and tax considerations, and building a team of advisors and support for the Board.
Annual Compliance Makes NPO Management Easier in the Long Run
Taking small steps each year to maintain compliance with the tax and governance laws applicable to your NPO has a big impact for the success of the organization. Regular communication with your Board, members and advisors ensures that the NPO is proactively managing its activities to avoid potential troubles.
If you have questions about ongoing governance or tax compliance, please contact us to discuss how we can assist your organization.
Substantial Contributors to Public Charities: With Reward comes Some Risk
Charitable organizations are created and operated for a public good and not for purposes of making a profit for investors. But there is a cost to operating and carrying out a charity’s goals. The cost is covered by a portion of the contributions received by the charity.
It’s great when a charity is the potential recipient of an unusually large contribution. It will help the charity carry out its objectives and pay the expenses necessary to do so. But such a large gift may place the organization in jeopardy of losing its tax-exempt status, as described in this article.
Impact of Substantial Contributor on Governance and Taxation
If a donor makes a large contribution to an organization, the donor may be classified as a “substantial contributor” to the charity. A substantial contributor impacts the charity in two important ways: (i) determining whether the substantial contributor is a disqualified person, and (ii) determining whether the charity meets the public support test for IRS purposes. The tentacles of a substantial contributor classification reach very long lengths.
Identifying a Substantial Contributor
A substantial contributor is any person or entity (other than a 501(c)(3) pubic charity or government entity) who contributes or bequeaths a total amount of more than $5,000 to the charity if the amount is more than 2% of the total contributions and bequests received prior to the end of the year. Substantial Contributor Private Foundation | Internal Revenue Service (irs.gov).
If an officer or director’s family member makes a substantial contribution, that officer or director is considered to be a disqualified person.
A corporation or partnership is a disqualified person if a substantial contributor has a 35% interest in the corporation (i.e., total voting power) or partnership (i.e., ownership of profit interest in partnership). In addition, if a corporation/partnership is a substantial contributor, then any person who has an interest of 20% or more therein is also a disqualified person. This includes employees of the substantial contributor.
Once a person meets substantial contributor status, she remains a substantial contributor for 10 years, even if she does not meet substantial contributor status in subsequent years.
(i) Disqualified Person
Most charities understand that a director of officer has a special relationship with the organization and are aware to avoid any conflicts of interest. In the IRS’s view, these persons are considered “disqualified persons,” such that they must recuse themselves from certain actions or decisions that may create a conflict of interest.
The IRS also considers a substantial contributor to be a disqualified person.
A substantial contributor may be on a charity’s Board, but too many substantial contributors may place the charity’s tax-exempt status in jeopardy. The voting power of a disqualified person (whether as a substantial contributor, director, officer or key person) must be a MINORITY (i.e., specifically 49% or less, of the board’s total voting power). Further, the combination of the voting power of multiple disqualified persons must be 49% or less.
Any disqualified person is deemed to have control over the Board if her voting power, in combination with the voting power of another disqualified person, exceeds the 49% rule.
This is a big deal when you combine it with the 10-year rule mentioned above.
(ii) Public Support Test
A charitable organization, unlike a private foundation, must be publicly supported. Although there are various formulas to satisfy the public support test, a commonly used formula is that at least 1/3 of annual contributions received are received from the general public.
In determining the contributions that are counted toward the 1/3 calculation, contributions received from disqualified persons is excluded. This may impact the organization’s ability to satisfy the public support test and be treated as a private foundation for tax purposes.
Consider the following simple examples for a charity that has annual contributions of $100,000.
Example 1. Satisfies Public Support Test. Of the $100,000 received, a contribution of $10,000 was from one disqualified person (i.e., a director, officer, or family member), which is 10% of the total contributions received. A portion of the contribution must be excluded from the total support test because it is greater than $5,000 and the amount is more than 2% of the total support received (i.e., $2,000). The amount excluded from the total support test is $8,000, which is the contribution in excess of 2% of total contributions ($2,000) (i.e., $10,000 minus $2,000). Total support for the 1/3 test is $92,000 (i.e., $100,000 minus $8,000). The charity satisfies the public support test because 92% of its contributions are from the general public.
Example 2. Fails Public Support Test. Of the $100,000 received, a contribution of $10,000 was from one disqualified person (i.e., a director, officer, or family member), $15,000 was from a partnership in which an officer’s family member has at least 35% income interest, and various $50,000 substantial contributions carried over from the prior 5-year period. A portion of all these contributions must be excluded from the total support test because they are more than 2% of the total support received for the year ($2,000). The amount excluded is approximately $69,000 ($10,000 minus $2,000 = $8,000; $15,000 minus $2000 = $13,000; $50,000 minus $2000 = $48,000). Total support for the 1/3 test is $31,000 (i.e, $100,000 minus $69,000). The charity fails the public support test because 31% of its contributions are from the general public.
2-Year Rule for Failure to Satisfy Test
Although it is beyond the scope of this article, the IRS provides that a public charity fails to meet the public support test for 2 consecutive years loses its public charity status and must file as a private foundation. This is important to note in order to forecast when and what amount of substantial contributors a charity can receive to safeguard its charitable tax status. 26 CFR § 1.509(a)-3(c)(1)(i).
Final Thoughts
An excise tax may be imposed for a charity that fails the public support test after two consecutive years. It is advisable for a charity to take note of who is a disqualified person and whether any substantial contributor rules may impact the charity’s fundraising effort.
A charity should work closely with their CPA to monitor the organization’s finances and charitable tax calculations.