Keeping Your Tax-Exempt Status is Almost as Easy as Losing It.

Non-Profit

Keeping Your Tax-Exempt Status is Almost as Easy as Losing It.

Posted 06/8/2023

Every year, thousands of nonprofits lose their tax-exempt status.

Sometimes, it’s because they plainly broke the rules. Maybe they paid out funds to private individuals or threw their weight into a political campaign.

But it’s often more subtle than that. Organizations can be penalized simply because they failed to submit the proper forms. Or their mission crept beyond its original tax-exempt purposes. Or their fundraising methods generated Unrelated Business Income. Or, as is often the case, they were guilty of doing literally nothing (more on that Kafkaesque statement later).

There are many reasons why organizations lose their tax-exempt status. However, most of them boil down to failing the IRS’ 501(c)(3) exams: the Organizational and Operational Tests.

Let’s talk about what these tests are, why some nonprofits fail them, and how you can ensure your organization passes.

What Are the Organizational and Operational Tests?

If every business could exempt themselves from income taxes, they would. That’s why the IRS created the Organizational and Operational Tests, a pair of annual exams that monitor 501(c)(3) organizations and ensure they are playing by the rules.

To maintain tax-exempt status, your organization must pass both tests.

The Organizational Test

As the name suggests, the Organizational Test examines a corporation’s organizational structure to determine whether it is properly designed for legitimate tax-exempt purposes. During the exam, the IRS reviews its governing documents (charter, articles of incorporation, etc.) to ensure they meet three criteria.

The governing documents must limit the organization’s mission to one or more charitable purposes. “Charitable purposes” can include anything from religious and educational causes to amateur sports, science, and literacy. Documents must explicitly define the organization’s purpose or purposes, and all purposes must be charitable. A single noncharitable purpose, such as raising money for a private shareholder, will disqualify an organization.
They must prohibit the organization from engaging in noncharitable activities. It’s not enough to leave noncharitable purposes off your governing documents. You must also explicitly prohibit noncharitable activities, even if you believe that those activities – such as certain fundraising methods – ultimately further your charitable purposes.
They must permanently dedicate the organization’s assets to charitable purposes. Your documents must make it clear that, even if your organization dissolves, all assets will be used to further your stated charitable purposes. Include a contingency plan explaining how funds will be used in the event of dissolution.

As long as your governing documents meet the requirements above, your organization should have no trouble passing the Organizational Test.

Unfortunately, this isn’t the final exam.

The Operational Test

The second and more challenging of the two annual IRS exams is the Operational Test.

While the Organizational Test looks at how your corporation identifies itself, the Operational examines what it has actually done. This exam aims to determine whether your organization engages primarily in its explicitly stated exempt purposes.

During the Operational Test, the IRS considers three questions:

Is your organization actively engaged in its charitable purposes? This one sounds pretty simple: Are you pursuing your mission or not? However, as organizations grow and leadership changes hands, many nonprofits experience “mission creep”. Practices expand beyond their original purpose, sometimes into noncharitable territory and other times into charitable purposes not defined in governing documents.And that’s a problem. As a 501(c)(3), your organization must pursue the tax-exempt purposes explicitly defined in its governing documents. That means a youth sports league must operate primarily as a youth sports league, a church must be a church, and a school must be a school. A social club disguised as a soup kitchen won’t cut it.On the opposite end of the spectrum are those organizations that cease operating altogether. Odd as it sounds, thousands of nonprofits lose their tax-exempt status every year because they are inactive. The IRS considers inactivity a failure to pursue tax-exempt purposes and grounds for disqualification.

Does your organization engage in substantial noncharitable activity? This sounds nefarious, but it often happens when a well-meaning organization uses business activities to generate substantial revenue.For example, a nonprofit may use gaming (raffles, poker, etc.) to raise funds. Gaming is valid under certain circumstances, but the funds raised from it can sometimes be classified as Unrelated Business Income (UBI). UBI is taxed as corporate income and, if substantial, can cause a 501(c)(3) to lose its status.Beyond fundraising activities, organizations can be penalized for engaging in other noncharitable work, such as funding political campaigns.
Has your organization distributed net earnings to private shareholders or individuals? This happens more than you might think. What starts as a legitimate nonprofit becomes a business disguised as one, or else a nonprofit dissolves and its funds are distributed to shareholders. Either one may be grounds for serious penalties.

How to Pass Your Tests and Stay Compliant

Sometimes, nonprofits fail the Organizational or Operational Tests because of serious violations. But more often than not, they struggle due to technical issues and simple errors. Here are a few tips to prevent the former and avoid the latter:

Submit the proper forms. The most common reason why smaller organizations lose their tax-exempt status is because they don’t submit their paperwork. Fail to submit your Form 990 three consecutive years, and the IRS will automatically revoke your status.

Watch out for mission creep. Organizations should regularly review their fundraising and mission-focused activities to ensure that the vast majority are aligned with their specific tax-exempt purposes.

Strengthen your controls. Improving your organization’s controls can help ensure that you pass the Organizational Test while minimizing the risk of failing future Operational Tests.

Don’t do nothing. As we discussed above, many organizations fail the Operational Test simply because they have been inactive for too long. Periods of inactivity are common in the nonprofit sector, where organizations often face funding issues.

Some nonprofits maintain their status by carrying on with low-level activity, such as occasional fundraising letters or leadership meetings. Others simply dissolve their corporation and start fresh later.