How a Colorado Nonprofit Tax Attorney Can Help You Setup Your Nonprofit and Keep Your Tax-Exempt Status
Within Colorado, there are currently around 20,000 nonprofits, each making valuable contributions to their local communities. Relying on the generosity of fellow Coloradans and tax exemptions from the government, it’s of vital importance that these nonprofits operate on a platform of transparency and accountability. Not only is this imperative in keeping tax-exemption status but also retaining good-standing and trust within their communities.
This guide covers the following topics:
- What is a nonprofit
- The difference between a public charity versus a private foundation
- How to become a nonprofit in Colorado
- How to keep your tax-exempt status
What is a Nonprofit?
As defined by Internal Revenue Code 501(c), a nonprofit (also referred to as a non-governmental organization or NGO) is a public charity that operates for public benefit of a community, and are thus tax-exempt due to their contribution to society. Nonprofits are extremely diverse, their goals and missions encompassing humanitarian, environmental and animal rights issues and causes.
To mirror the diversity of nonprofits, there are 29 different types of organizations recognized under the IRS tax code 501(c). Each with their own rules and regulations to follow. They range from credit unions (c)(14), cemetery companies (c)(13), teacher’s retirement fund associations (c)(11), co-ops (c)(16) and mutual insurance companies (c)(15).
Tax group 501(c)(3) is the most abundant of the 29 distinct types of nonprofits that are recognized by tax law. Uniquely, they are one of the few types of nonprofits where a donation is tax deductible. Roughly 35 percent of these nonprofits are focused on human services, such as feeding the homeless, caring for the elderly and helping battered women. Education groups account for the next largest group at 17 percent, then health services at 13 percent, Civil Rights at 11 percent, religious organizations at 6 percent, environment and animal rights groups at 5 percent and international development at 2 percent.
Public Charity versus Private Foundation
501(c)(3) entities are divided into two categories: private foundations and public charities. Below are some major differences between the two:
|Public Charity||Private Foundation|
|Offer direct, charitable activity||Indirectly support charitable activities, through donations|
|Has board diversity standards||Can be family or corporately run|
|33 percent of revenue must be small donor||Cap on allowed donations per donor|
|3 tax filing options (income dependent)||Only files 990-PF|
Classified as a Public Charity
Most universities, hospitals, churches and medical research facilities are automatically assumed to be a public charity, whereas other nonprofits are assumed to be private foundations unless they can prove otherwise. A nonprofit has 27 months from the start of operation to notify the IRS that it is not a private foundation.
For a new nonprofit wishing to apply for this status, the IRS will grant it if they can prove that they expect to be publicly supported. By supplying the proper financial evidence along with submitting the application Form 1023, the IRS will award the tax-exempt status for five years. On the sixth year, a nonprofit must show that it can withstand the public support test by submitting Schedule A and 990 form (there are three 990 forms which are dependent on revenue) for all five years, detailing information on its sources of financial support. If it passes the test, then the nonprofit will be required to file for each year thereafter.
Classified as a Private Foundation
Private foundations can further be broken down into two categories – operating and nonoperating foundations. In the simplest of terms, an operating foundation distributes its funding to its own charitable activities, while a nonoperating foundation distributes its funding to other nonprofits.
Since private foundations are not required to receive a third of their funding from the public and are controlled by a small group of people, they are seen to be less open to public scrutiny. Because of this lack of involvement and public oversight, private foundations are more easily prone to misuse and wayward activity. The IRS compensates by adding supplementary operational requirements; such as:
- Required to donate 5 percent of income per year
- Cannot do business with contributing businesses
- Subject to “excise tax” up to 2 percent on investment income
- Cap on tax deductible donations at 30 percent of donor’s gross income
- Financially liable for any activates not seen to further charitable activates, or do not adhere to tax law
How to Become a Nonprofit in Colorado
There are many benefits to becoming a 501(c)(3) entity. Not only can an organization become exempt from paying federal taxes but a state may also choose to award the same exemption for state taxes. Nonprofits can save additional money on say postage, as the post office sometimes offers reduced rates to qualified 501(c)(3) nonprofits. Additionally, a nonprofit may see a rise in public participation as this tax status provides incentive for donors to contribute due to their donations being tax deductible.
The first step to becoming a nonprofit is figuring out where your organization will fall under the tax code. There are 29 options to choose from and each has their own rules concerning political contributions, lobbying and deductibility of donations:
Once you know what tax type your organization falls under, then you will begin the application process. There are various forms, depending on which tax exempt status you are applying under.
The main three forms are:
- Form 1023: This is for entities that are applying for the 501(c)(3) status. This can include: 501(e) (co-op hospital services), 501(f) (co-op educational organizations), 501(k) (child care operations), 501(n) (charitable risk pools) and 501(q) (credit counseling providers).
- Form 1023-EZ: This form is for nonprofits looking to apply under 501(c)(3) and make under $50,000 gross annually and have less than $250,000 in assets. It is a streamlined application for smaller organizations.
- Form 1024: This form is for any other nonprofit seeking a tax exemption 501(a). This includes: 501(c)(2) (Title holding corps), (c)(4) Civic/welfare leagues, (c)(5) Labor/agriculture organizations, (c)(6) business leagues, (c)(7) social clubs, (c)(9), employee benefits associations, (c)(10) Fraternal societies, (c)(13) cemetery companies, (c)(19) armed forces organization.
Along with your application form, the following must be included:
- Employer Identification Number (EIN)
- Articles of incorporation
- Bylaws (if created by the nonprofit)
- Description of charitable activities
- Financial data
When submitting any attachments, all must include the nonprofits’ name and EIN number at the top of every page, including a label stating that it is an attachment and what aspect of the application it is supporting. Do not submit any original documents, as these will be kept by the IRS. Only submit certified copies. Be careful; any missing or incomplete information and the IRS will send the application back.
Keeping Your Tax-exempt Status
IRS tax code outlines what you can and cannot do as a certain type of nonprofit organization. If you fail to follow these guidelines, you risk losing your status as a tax-exempt entity. For example, a 501(c)(3) religious organization has different restrictions than a 501(c)(4) social club. There many things that can cause a nonprofit to lose its status, such as participating in substantial lobbying, misuse of donated funds, failing to file the 990 forms, etc. The biggest worry and one that often trips up most nonprofits is making sure that no funding goes to the benefit of any employed or private individual.
Things to Not Do:
- Refrain from contributing in any way to local, state and federal political campaigns
- Restrict lobbying activities
- Make sure earnings do not inure (profit) anyone individual or shareholder
- Activities must not violate public policy
- Forget to file annual 990 form
- Must not operate for the benefit of private interests (including employees)
If a nonprofit fails to comply with IRS regulations, whether consciously or not, the IRS has legal authority to strip them of their tax-exempt status and penalize them with further excise taxes. As each 501(c) organization has its own unique rules to follow, the below guidelines are best practices that any nonprofit (but especially 501(c)(3) charities) should abide by.
#1. Do not sponsor any political campaigns
This is an “absolute” rule for 501(c)(3) charities. This includes monetary donations, endorsements or opposition of anyone running for local, state or federal office. However, 501(c)(4) organizations can dabble in politics, so long that it is limited and is not the organization’s sole goal. For example, the National Rifle Association (NRA) falls under the (c)(4) category of a social welfare organization, which does participate in politically oriented activities but also offers social services to gun owners.
Important Update: President Trump signs executive order impacting 501(c)(3) religious organizations. The order, signed May 4, 2017, takes aim at the Johnson Amendment, which prohibits tax-exempt religious intuitions from engaging in political speech and activities. The order seeks to “promote free speech and religious liberty” by directing the IRS to exercise “maximum discretion” in targeting churches that support political candidates. While some praise the order in providing regulatory relief, other legal experts claim that the order doesn’t change existing law (something only an act of Congress can do) and does little to affect current policy.
#2. Some lobbying is OK
A 501(c)(3) nonprofit is allowed limited lobbying efforts, so long as those efforts do not exceed 20 percent of its operating budget. However, most nonprofits tend to spend well under 20 percent, closer to 2 percent of their operating budget to be safe. As an example, a nonprofit may engage in voter education about an issue, so long that it abides by nonpartisanship rules and all points of view are represented. Additionally, a nonprofit may also try to persuade elected officials to vote in a certain way. There are additional rules depending on which state you live in and what tax group you fall into, so it’s advised that a nonprofit heavily regulate its lobbying activities.
#3. Keep good records
Accurate and complete record keeping is a must for every nonprofit, as most of these documents are used to support your annual filing of the 990 tax form, or as evidence of financial records for audits. Keep all items associated with revenue such as gross receipts and donations, and accurate expense sheet related to all purchases. Additionally, nonprofits that fund grants to other nonprofits should keep a record of the grantee, how the grantee was chosen and the grantee’s relationship to the nonprofit. This will help demonstrate that grants were made for charitable purposes.
#4. Pay Taxes on Unrelated Business Income
In order to keep their status as a nonprofit, all 501(c)(3) organizations must pay taxes on unrelated business income. Code §512(a)(1) defines unrelated business income as gross income that is derived from trade or business which is not distinctly related to its charitable activity. Income associated with the sales from volunteers or donated merchandise, as well as royalties and rental properties are excluded from this definition. When the IRS determines whether income is related or not, it looks for a “causal relationship,” meaning that it significantly contributed to charitable activity. Due to this subjectivity, all instances are dealt with on a case-by-case basis and nonprofits should seek legal advice if they are unsure. Should an organization have unrelated income in excess of $1000, then they will need to file form 990-T at the end of the year.
#5. File your 990 form every year
Failure to file your yearly 990 tax form could result in the IRS revoking exemption status.
#6. Heed instances of personal benefit
Otherwise known as inurement, this is another hard rule for nonprofits. Exorbitant salaries, selling property that is under or over its fair market value and offering free services to members of the board are to be strictly prohibited. Additionally, hiring family members or other disqualified persons, is seen as “self-dealing” and these conflicts of interest are prohibited by the IRS. A disqualified person is someone who has a particular relationship with the nonprofit, such as a family member, a substantial donor and persons with high standing within a nonprofit (managers, officers, directors etc.). This issue is what most often trips up nonprofits, so it is pertinent to exercise caution and educate your employees.
When in Doubt Seek Legal Advice
Understanding the federal tax code and local regulations can be very overwhelming. It’s always a good idea to seek legal help, it’s not worth the risk of losing your tax status or racking up hefty fines.
Staying mindful can be an effective way for nonprofits to avoid getting in trouble with the IRS. However, with current regulations being influenced by new case laws and the subjectivity that surrounds IRS rules, after reading this article, you may feel like you now know less than before; asking questions like:
- What qualifies as substantial lobbying?
- Has my unrelated business income contribute significantly enough to my charitable activity?
- Is this business venture free from self-dealing and conflict of interest?
- Failing to file a nonprofit or charitable Form 990 tax return
For most, nonprofit tax law is a complicated matter, usually operating on a case-by-case basis. If you find yourself asking any of the above questions, our tax attorneys at Robinson & Henry are apt at advising Colorado nonprofits on their unique circumstance. Please call us for an assessment at 303-688-0944