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The price of noncompliance: What happens when nonprofits lose tax-exempt status
Posted by Grace Townsley
March 23, 2023
Nonprofit organizations, like charities, schools and religious organizations, play a critical role in caring for local communities. From providing housing and shelter to those in need, to raising awareness for environmental issues, nonprofits work tirelessly to improve conditions and protect the planet.
To empower nonprofits to do more good work with less resources, the IRS offers a range of benefits to these organizations — including 501(c)(3) status.
This special tax status is given to nonprofits that meet a particular set of criteria, like operating exclusively for charity work and maintaining transparent financial records. It gives them an exemption from federal income taxes and allows these organizations to receive tax-deductible donations from supporters.
While 501(c)(3) status is a great benefit for nonprofits, it isn’t permanent
501(c)(3) status comes with a number of complicated obligations and restrictions, and strict adherence to these regulations is required. Failure to comply with any requirements can result in not just the revocation of tax-exempt status, but significant fines.
Nonprofits are required to file a specific set of tax forms to maintain their tax-exempt status, including annual information returns and exemption applications. If the nonprofit doesn’t file the right forms on time, they may have their nonprofit status revoked.
Engaging in prohibited activities
Nonprofits are barred from engaging in activities that prioritize private interests over community-based ones. Any 501(c)(3) organization caught engaging in partisan political activities, lobbying for legislative changes, or benefiting a particular person can lose its tax-exempt status.
Private benefit or inurement
Inurement refers to a situation where one individual or a private entity (like a business) receives an excessive benefit from a nonprofit. For example, if a nonprofit pays their director an exceptionally high salary compared to their job duties, that can be considered inurement. And the IRS frowns on any 501(c)(3) using tax-free donations to benefit private interests, like political agendas.
Changes in organizational structure or activities
When nonprofits initially apply for tax-exempt status, they must describe the activities they’ll be engaging in. If they start operating outside those parameters, or change their organizational structure significantly, they may lose their tax-exempt status, or be required to re-apply.
For nonprofits, losing tax-exempt status is a serious setback. Donors and supporters want to support organizations they trust are benefitting the community, and receiving a tax deduction to go along with it is a nice benefit to donating towards the causes you care about. If a nonprofit no longer has 501(c)(3) status, its donors lose the tax benefit and may doubt the trustworthiness of the organization.
Without 501(c)(3) status, the nonprofit will also struggle to earn grants and gain funding. Many grant opportunities and fundraising initiatives are only available to tax-exempt organizations, so nonprofits without tax-exempt status will find themselves ineligible for most of these opportunities.
If you’ve lost (or are at risk of losing) your 501(c)(3) status, you may be able to get it back — if you act quickly
If your nonprofit has lost its tax-exempt status, there are a few ways to get it back. The first is to apply for reinstatement with the IRS. While the process of reinstatement varies based on the reason for your 501(c)(3) revocation, there are a few basic steps you can expect to complete.
The first is to fill out a 501(c)(3) reinstatement application. You may be required to supply documentation, financial statements, additional forms, or pay a fee, depending on your unique situation.
Next, if you owe any back taxes, you’ll be required to pay off your tax bill or setup a repayment plan. Some 501(c)(3)s are required to pay taxes on the income they earned during the month or years they were deemed to be operating outside of their tax-exempt status requirements.
Once your forms are in and your fees are covered, all you can do is wait. The reinstatement process can take anywhere from a few weeks to several months, depending on the complexity of your situation.
If your nonprofit is unable to regain its tax-exempt status, there are other solutions available
Some nonprofits choose to restructure their organization into a for-profit entity, or merge with another tax-exempt organization. While this option may not be feasible or desirable for all nonprofits, it may allow your organization to continue operating smoothly.
Another option is to close your existing nonprofit and launch a traditional company in which a percentage of the proceeds support the cause you care about. Sometimes the most effective help can be time or money put toward the cause, rather than an organized 501(c)(3).
Want more? Escalon has helped thousands of startups and nonprofits maximize their potential with our back-office solutions for accounting, HR, payroll, insurance, and recruiting and taxes — and we can help yours too. Talk to an expert today.
This material has been prepared for informational purposes only. Escalon and its affiliates are not providing tax, legal or accounting advice in this article. If you would like to engage with Escalon, please contact us here.