The price of noncompliance: What happens when nonprofits lose tax-exempt status

Nonprofit organizations, such as charities, schools, and religious organizations, are critical 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 fewer resources, the IRS offers a range of benefits to these organizations — including 501(c)(3) status.

501 (c) (3) status is a crucial designation for nonprofits, granted to those that meet specific criteria. This status not only exempts them from federal income taxes but also enables them to receive tax-deductible donations from supporters, making it a significant advantage for these organizations.

While 501(c)(3) status is a great benefit for nonprofits, it isn’t permanent

501(c)(3) status comes with several complicated obligations and restrictions, and strict adherence to these regulations is required. Failure to comply with any requirements can result in the revocation of tax-exempt status and significant fines.

Here are a few reasons why 501(c)(3)s may lose their tax-exempt status :

Failing to file the required forms

Nonprofits must file specific tax forms, including annual returns and exemption applications, to maintain their tax-exempt status. If the nonprofit doesn’t file the proper forms on time, its nonprofit status may be revoked.

Engaging in prohibited activities

Nonprofits are barred from engaging in activities prioritizing 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

Insurance 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 its director an exceptionally high salary compared to their job duties, that can be considered insurance. 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 status or be required to reapply.

What happens when you lose your 501(c)(3) status?

The loss of 501 (c) (3) status can be a significant blow for nonprofits. Donors and supporters prefer to contribute to organizations they trust are benefiting the community. The loss of tax benefits for donors and potential doubts about the organization’s credibility can have a profound impact.

With 501(c)(3) status, the nonprofit can earn grants and gain funding. Many grant opportunities and fundraising initiatives are only available to tax-exempt organizations, so nonprofits with tax-exempt status are eligible 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 specific steps you can take to regain it. The first is to apply for reinstatement with the IRS. While the process may vary based on the reason for your 501(c)(3) revocation, there are some fundamental steps you can expect to complete.

First, complete a 501(c)(3) reinstatement application. Depending on your unique situation, you may be required to supply documentation, financial statements, and additional forms or pay a fee.

Next, you must pay off your tax bill or set up a repayment plan if you owe back taxes. Some 501(c)(3)s must pay taxes on the income earned during the month or years they were deemed to be operating outside 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 restructure into for-profit entities or merge with other tax-exempt organizations. 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 where a percentage of the proceeds support the cause you care about. Sometimes, the most effective help can be time or money toward the cause rather than an organized 501(c)(3).

Nonprofits must understand that sound financial management is not just a good practice, it’s a necessity for maintaining their 501(c)(3) status. This includes implementing effective nonprofit bookkeeping solutions and adhering to fund accounting. Transparent nonprofit financial reporting is crucial, as it ensures donors and supporters trust the organization’s financial practices. Meticulous nonprofit budgeting and forecasting help nonprofits allocate resources effectively, further demonstrating their commitment to their mission.

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.