Tax Exempt Organizations

In the 1800s, Congress decided that the work of certain organizations were so important that it would be beneficial to society if they could keep their funds in order to carry on their works. Rather than paying part of these funds to the federal government as income taxes, Congress chose to exempt these organizations from business income. However, there has been certain limitations established by Congress over the last 100 years. The most popular and largest categories of these organizations are 501(c)(3) organizations. The 501(c)(3) organizations are charitable, educational, and religious organizations. However, there are several other categories of organizations that are exempt from federal income taxes. There are 28 different types of

organizations that are exempted from income taxation under Internal Revenue Code Section 501. The numbers of organizations have grown considerably; the revenue reported to the IRS states that such organizations have increased $0.3 trillion in 1975 to about $1.2 trillion in 2001.
Tax-exempt status does not mean that the organization is exempt from all taxes.

Nevertheless, tax-exempt status does mean that an organization does not have to pay corporate federal income tax on income. Furthermore, this income must be from activities that are substantially related to the purpose for which the organization was given exempt status. In addition, the organization does pay tax on income that is unrelated to the purpose of the organization called unrelated business income. There are several reasons Congress decided to tax unrelated business income. First, Congress did not think it would be fair for businesses that pay tax Secondly, instead of Congress prohibiting tax-exempt organizations from having any type of business functions, Congress chose to permit unrelated business activities, but the income would be taxed just like for profit business. Lastly, the imposition of a tax on unrelated business income was the best evidence that tax-exempt organizations can engage in business

activities.
The unrelated business income tax (UBIT) has become a major issue. There are several questions that need to be answered in order for a tax-exempt organization to keep its status. A tax-exempt status is not easy to obtain, even if an organization does have a charitable purpose. An organization's application for tax-exempt status must be properly formatted and include all the necessary information. Furthermore, just because an organization is tax-exempt, does not mean that it will remain indefinitely. This paper will discuss the history of tax-exempt organizations, how to become a tax-exempt organization, the limitations and issues these organizations face, and what is the best course of action not to lose exemption status. With continuous changes within the Internal Revenue Code (IRC), the most effective way to retain exempt status is for a non-profit organization to use a related entity to carry on unrelated business activities. Furthermore, if the organization decides to be the sole owner of the related entity, a Limited Liability Company (LLC) would be the most efficient entity.

II. The History of Tax Exempt Organizations

A. Overview of 501(c)(3) Organizations

What are the implications of a 501(c)(3) organization?

Charitable organizations described in section 501(c)(3) comprise of about two-thirds of all exempt organizations. In 2001, the total revenue of charitable organizations was about 9.3 percent of gross domestic product. The largest categories of charitable organizations were hospitals and post-secondary educational organizations. In 2001, hospitals made up about 42 percent of total revenues in the charitable sector. In addition, there has been substantial growth in charitable organizations within the last 50 years. In 1976 there were 259,523 charitable organizations, which increased to 1,010,365 in 2004. There was an increase of 289 percent between this time and a revenue increase from $155 billion to about $942 billion.
In order for an organization to become exempt under section 501(c)(3) the organization must be “(1) organized and operated exclusively for a certain purpose; (2) there can be no private inurement within the organization; (3) there must be more than an incidental private benefit to private persons who are not organization insiders; (4) lobbying cannot be a substantial part of the organization’s activities; and (5) the organization may not participate or intervene in political activities.” If an organization fails to meet any of these requirements, the organization cannot become an exempt organization under section 501(c)(3), or will result in a loss of the organization’s exempt status. After an organization meets all the requirements, there must be a determination of if the organization is a private foundation or public charity. The difference between a private foundation and public charity is the level of public support the organization receives. If an organization receives support from donors, then it is a private foundation. Furthermore, private foundations are subjected to more restrictions of their activities than public charities.
The requirements for exempt organizations are broken down into three categories: “(1) whether the organization and operation of the organization are exclusively for exempt purposes; (2) whether the organization’s assets benefit private parties; and (3) whether there are political related activities of lobbying and electoral activity.” In addition to meeting the requirements, an organization must not engage in public policy. Furthermore, the organized and operational requirement looks to what extent does an organization’s activities advance the organization’s exempt purpose.

Organizational test

An organization can only become an exempt organization if it is organized and operated exclusively for exempt purposes. In order to meet the organizational test the organization must adopt certain formal requirements in the founding documents of the organization. Joint Committee states, “an organization must limit its purpose to one or more exempt purposes and must not be permitted to engaged in activities that do not further exempt purposes.” Additionally, the founding documents must prohibit violation of lobbying and must prove that the organization’s assets are committed to the exempt purpose of that organization. An organization fails the organizational test if its article of incorporation requires the organization to engage in activities that make it an “action organization.” An action organization is an organization that substantial attempts to influence legislation.

Operational test

The operational test requires that an organization’s operations are consistent with the requirements of the Code. One requirement that the operational test enforces would be operating exclusively for exempt purposes. An organization will be held as operating exclusively for an exempt purpose, “only if it engages primarily in activities which accomplish exempt purposes.” The Code allows a charitable organization to have activities that do not further its exempt purpose; however the activities cannot be substantial. The Court decision in Better v. United States held:
The presence of a single nonexempt purpose, if substantial in nature, will destroy the exemption regardless of the number or important of the exempt purpose. An organization with an important nonexempt purpose was subjected to tax. Thus, under the regulation, insubstantial nonexempt activities are consistent with exempt status, and nonsubstantial nonexempt purposes are consistent with exempt status.
There is nothing within the Code or regulations that gives a standard in determining what is a substantial nonexempt purpose. The Tax Court has applied a fact and circumstances test to solve this issue. The Tax Court held, “factors such as the particular manner in which an organization’s activities are conducted, the commercial hue of those activities, and the existence and amount of annual or accumulated profits are relevant evidence of a forbidden predominant purpose.” The primary purpose test looks at the purpose towards which an organization’s activities are directed, instead of the activities themselves. Thus, an organization can have a trade or business as it primary activity and be a charitable organization as long as the trade and business activities will furtherance the exempt purpose.

Private inurement and private benefit

In order for an organization to become exempt under section 501(c)(3), the organization cannot be a private benefit or a private inurement within the organization. A private benefit is when an organization’s assets or revenues are used to benefit an individual. In addition, inurement occurs when a person in a decision making position within the organization receives benefits from the organization that are unreasonable to their contribution. The court in American Campaign Academy v. Commissioner held that even though private benefit and private inurement are similar in many ways, the two are distinct requirements that must be satisfied independently. Furthermore, the court stated that private inurement violates both prohibitions. However, the absence of private inurement does not mean that there is an absence of a private benefit.
Throughout history Congress has expressed that an exempt organization shall not be organized nor operated for personal gain of stockholders or investors. In addition, there can be no economic benefit of any individual. However, that individual may receive economic benefit through the proper performance of functions. Within the Corporation Excise Tax Act of 1909 the private inurement clause of section 501(c)(3) was established. The private inurement clause provided a safeguard that the “exemption for charities was limited only to those institutions that have no element of personal gain and that are exclusively devoted to exempt purposes.” Additionally, the private benefit doctrine was established as part of the requirement that an organization operate exclusively for an exempt purpose. If an organization operates for the benefit of private interest, it does not meet the requirement of operating exclusively for an exempt purpose.
The inurement prohibition applies to an organization’s charitable assets and is not limited to profits shown on the books. In addition, inurement does not always have to occur through the distribution of dividends. Inurement may be found even if the amounts involved are small. However, the payment of reasonable compensation to officers or employees is permitted. In the past, the only sanction for a private inurement violation was the withdrawal of the organization’s tax-exempt status. However, the sanction rules of 1996 provided a sanction that did not require the withdrawal of an organization’s tax-exempt status. The sanction rule of 1996 allows the IRS to impose a tax on insiders who wrongly benefited from transactions with charitable organizations.
Even though there is absolute prohibition against private inurement, a private benefit that is minimum is permitted. If a private benefit exists, it must be qualitative and quantitative. In order for a private benefit to be qualitatively incidental, a private benefit must occur as a “necessary concomitant of the activity that benefits the public at large; in other words, the benefit to the public cannot be achieved without necessarily benefiting private individuals.” To be quantitatively incidental, the benefit must be insubstantial in relation to the public benefit resulted from the activity.

Political and lobbying activities

A charitable organization cannot engage in political activity and is limited on the amount of lobbying activity.

The statutory rules regarding political activity and lobbying were enacted in 1934 and 1954. The Revenue Act of 1934 required that no substantial part of an organization’s activities be lobbying. Furthermore, the Revenue Code of 1954 added the requirement that charitable organization cannot participate in political campaign activities. On the other hand, under present law, an organization will not be tax-exempt as a charitable organization unless “no substantial part” of its activities are attempting to influence legislation. Also, Public charities may engage in limited lobbying activities if these activities are not substantial. In contrast, public foundations are restricted from lobbying activities, even if they are insubstantial. In order to determine if a public charity’s lobbying activities are substantial, a public charity can elect to choose the “substantial part” test or the “expenditure”

test.
The substantial part test uses a fact and circumstance approach to measure the level of lobbying activities. There are no statutory guidelines for this test; therefore it is not clear if the levels of lobbying activities are measured by an organization’s activities or its expenditures. If an organization exceeds the substantial part test, it risks losing its tax exemption. In addition, the organization may be taxed due to its substantial lobbying activities. The next test that an organization could elect to use would be the expenditure test. The expenditure test sets a dollar limit on the amount a charity may spend to influence legislation. There are two expenditure limits; the first limit restricts grassroots lobbying expenditures and the second expenditure limit restricts the total amount of lobbying expenditures the public charity can make. A charity that does not file an election will be subjected to the substantial part test.