By Connie Kent Carhart, CPA
“What’s a 501c3?” “Why do we need one?” “Why, if we never needed this before?”
Do these questions sound familiar? Are members who have been in your organization for some time asking these questions? They have a point.
There was a time when your organization didn’t need to worry about this. But times have changed. Did you know that if you are not a 501c3, donations to your organization are not deductible by the donor? Most grants and other public funding are no longer available unless you have proof that the IRS has acknowledged you as a 501c3 organization. Also, if you are not a 501c3, you are not considered tax-exempt and are subject to income tax liabilities on your profits.
So, what is a 501c3? It’s a reference to a part of the Revenue Code that identifies your organization as a charitable, tax-exempt organization. In order to be classified as such, you need to file an application with the IRS called Form 1023, “Application for Recognition of Exemption under Section 501c3 of the Internal Revenue Code”. We will discuss this process a little later, but first, let me give you a brief history of the “501c3”.
Charitable organizations in our country have histories as far back as the colonial days. But it wasn’t until the Wilson- Gorman Tax Act of 1894 that they were first identified as not having to be taxed. The Revenue Act of 1913 established income tax. And when income tax rates were increasing (to help fund WWI), the Revenue Act of 1917 introduced the idea of allowing individuals to take a deduction for donations made to charities, to encourage continued support for them. This was the beginning of tax- exempt charities as we understand them: not having to pay income taxes and allowing donations to be tax deductible.
The Revenue Code of 1954 established the 501c structure that we still use today to define the different types of charities. The 501c3 is perhaps the most common, but there are also many other types depending on the organization’s purpose. Prior to 1969, you could declare your organization a 501c3 using these definitions, without first receiving recognition by the IRS.
Thus, most of your organizations rightfully considered themselves to be a charitable organization not subject to income tax, and whose donors could have the benefit of deducting their donations to you. And for many, this was the situation for over 100 years.
But things changed in 1969. With the Tax Reform Act of 1969, publicly supported charities were now required to start filing an annual return with the IRS. This annual return is Form 990, “Return of Organization Exempt from Income Tax.” Think of this as the equivalent of our 1040s that we must file each year.
“If you’ve depended on public support for your organization, 501c3 determination from the IRS became extremely important.”
Even with this new requirement, a lot of organizations did not file and were not compliant, yet suffered no consequences. They were essentially “flying under the radar.”
So, what woke the IRS up? The Enron Scandal is said to be one of the major turning points. The government suddenly began to focus more on funds held by public companies. They became aware of the vast amount of assets being held by charitable organizations. The total book value of assets held by charitable organizations in 2004 was $2.5 trillion, an increase of over 222 percent of the amount held in 1985. In addition, in 1985 there were approximately 335,000 active charities classified as 501c3’s. That number almost tripled to 933,000 in 2004.
The Pension Protection Act of 2006 provided that any organization that failed to file their annual return (form 990) within a three-year period would automatically lose its tax-exempt status. In June of 2011, they enforced this by publishing a list of over 275,000 charities who were no longer exempt (thus donations to them were no longer deductible). This got the attention of private foundations that provide grants, as well as private and corporate donors. They could not afford to lose the deductions they were claiming for donations to these charities and began to demand proof of tax-exempt status.
Therefore, if you’ve depended on public support for your organization, 501c3 determination from the IRS became extremely important. Organizations who had not been affected up until this point, suddenly found that not having that IRS determination denied them access to public funds they had been accustomed to receiving.
How to Comply
So where does that leave your organization? In order to have 501c3 status, you must have your determination letter from the IRS.
First, you must be incorporated as a charitable organization. You may already be incorporated – many volunteer fire companies actually incorporated in the early 1900s. But there are key phrases that must be in it to satisfy the IRS qualifications. Choose an attorney who specializes in charitable organizations and they will be able to either file your initial articles of incorporation or amend your original so that it contains the key phrases.
Once you are incorporated as a charitable organization, you’re all set, right? No. That qualifies you as a legal entity. And you do not want to stop here. At this level you are a taxable corporation; your organization will be subject to corporate tax rates and penalties. If you are incorporated, but not a 501c3, the IRS can come in and demand back returns, income taxes and penalties for failure to file Form 1120: “U.S. Corporation Income Tax Return.” You will also be liable for New York State Corporate (referred to as Franchise) income taxes.
Once you are incorporated as a charitable organization, you’re all set, right? No.
You will also want to adopt bylaws, and it is recommended that you adopt a conflict of interest.
To avoid corporate liabilities, you must become a tax-exempt entity. Again, you do this by filing Form 1023 with the IRS. This form is a lengthy “package” that gives detailed insight into how your organization is governed, what your purpose is, programs you provide, what public sector you serve, and details about your finances for the last five years. The IRS estimates that it will take approximately 105 hours to complete.
Once this form is filed, the IRS will review it, and potentially ask additional questions. With the heightened enforcement, the charitable division of the IRS found itself in a bit of a backlog. In the past, It has taken nine to 12 months or more to get final approval. But they have improved the turnaround enough that recent filings have received final determinations within three to four months.
Assuming your application is accepted, you will receive a letter of determination from the IRS, which is the end goal. Most grants and private funding require a copy of this letter as proof that you are an exempt organization in the eyes of the IRS. In addition, IRS Publication 78, the official list of entities qualified to receive tax-exempt donations, will have your entity added to it.
Once you receive your acceptance, things do get simpler. You will need to file the annual return – Form 990 – to remain in compliance. Achieving the 501c3 status may seem like an overwhelming task. But there are tax professionals who can assist with the preparation of the 1023, and the long-term benefits to your organization will make it worthwhile. You will close the door on costly corporate liabilities, have your name appear on public searches of eligible tax-exempt organizations, and open the door to available grants and continued public support.
Connie Kent Carhart, CPA has over 35 years of experience. Her specialty is assisting charitable organizations with their tax needs. Carhart will be participating as a panelist at the FASNY Annual Convention on Friday, August 9, 2019. She can be reached at (585) 746-5023 or firstname.lastname@example.org