Know the IRS red flags — and take steps to avoid themWhen your nonprofit obtained tax-exempt status from the IRS, you likely celebrated overcoming a significant hurdle — as well you should! But now you want to do all you can to keep that status. Thankfully, the IRS is quite explicit about the sorts of activities that can jeopardize tax-exempt status. We'll address the main ones here.
Unrelated business activities
IRS red flag: Conducting unrelated business activities that generate substantial revenue.
To be considered an unrelated business activity, the activity must meet all three of the following characteristics:
- It's a trade or business
- It's regularly carried on
- It's not substantially related to furthering your organization's exempt purpose
As you may have guessed from the wording of these guidelines — "regularly" and "substantially" being the biggest hints — you'll need to use your best judgment to determine which business activities fit within the allowed scope. If you do need to report nonexempt income, you'll submit an additional IRS 990 Form (the 990-T) with your annual filing.
It's also worth noting that the IRS provides many exceptions to the unrelated business activities prohibition. For example, the IRS specifically notes an exception for certain bingo games and activities that:
- Raise money for the organization using volunteer labor
- Are primarily for the benefit of members (such as a school cafeteria)
- Involve the selling of used merchandise (such as a thrift store that raises funds for a nonprofit)
IRS red flag: Paying profits to individuals associated with your organization.
Paying profits to any person who has a personal or private interest in your organization will jeopardize your tax-exempt status. As if this isn't a big enough deterrent, this type of activity is also subject to tax penalties for both the beneficiary and the organization making the payment. Maintaining tax-exempt status requires any money you raise beyond operating costs to be devoted exclusively to furthering your organization's mission.
IRS red flag: Spending more time or money than is allowed on lobbying to influence legislation.
There are two distinct ways to lose tax-exempt status that have to do with politics: campaigning for a particular candidate and lobbying with the intent of influencing legislation. The former is fully prohibited while the latter is allowed in a limited capacity.
The IRS is quite plain about political campaigning: don't do it! Voter registration and educational outreach about the electoral process are fine, as long as no individual candidate is promoted over any other.
The rules around lobbying are slightly less draconian. You can do a little lobbying, as long as it doesn't constitute a substantial part of the work you do. What constitutes substantial? The IRS considers two factors: time and financial expenditure. The IRS will look at what percentage of your organization's time was devoted to lobbying by both paid employees and volunteers.
If you're worried about how subjective the term "substantial" might be, consider saving yourself the guesswork by filing IRS Form 5768 — also known as taking the 501(h) election. Doing so provides a specific spending limit based on your organization's annual exempt purpose expenditures. If you're not convinced, remember the stiff penalties for overspending on lobbying: a 25 percent excise tax on the amount you overspent and loss of your exempt status if you're over the limit for four years running. And there's more: you'll have to pay taxes on all income brought in during that period.
If you're still unsure that your lobbying plans are in keeping with the spirit of the law, it's in your best interest to consult an attorney.
Record keeping and filings
In addition to avoiding these prohibited activities, you'll need to keep good records of charitable activities and stay current on your 990 and other relevant tax filings (such as employment and business income tax returns). The IRS publishes a helpful guide outlining which records to keep and other considerations for maintaining tax-exempt status. As with lobbying, however, there's a degree of subjectivity to determining which records to keep and for how long. You may want to consult an attorney who specializes in charity law to get you started (or back) on the right track.
This article draws on the expertise of Grace Davies, a Minneapolis-based attorney with special interest in product liability, medical malpractice and employment discrimination.
Nolo: What is private inurement? by Stephen Fishman (2013)
National Council of Nonprofits: Taking the 501(h) election
IRS: Unrelated business income defined (2016)
IRS: Instructions for Form 990-T (2015)