Maintaining Tax Exempt Status in a Nonprofit

Maintaining Tax Exempt Status in a Nonprofit

by Jane Haskins, Esq., March 2015

Getting approved for tax exempt status is a major milestone for any nonprofit corporation.

But nonprofit status isn’t always permanent: you can lose it if you don’t comply with corporate formalities, file tax returns, and restrict your involvement in certain activities. A tax exempt nonprofit that doesn’t follow the rules can also be subject to special excise taxes.

Here are five steps to follow to protect your nonprofit’s tax exemptions.

1. Pay Attention to Corporate Formalities

Like all other corporations, a nonprofit corporation must have officers and a board of directors. Unlike for-profit companies, however, tax exempt organizations do not have shareholders who receive dividends. Some nonprofits choose to have members who participate in making decisions for the nonprofit. But many nonprofits forego the membership structure in favor of simply having major decisions made by the board of directors.

Your board of directors should meet on a regular basis. Important decisions should be formalized with a resolution, and your corporate secretary should maintain a minute book.

You should also be sure that you are operating within the purpose for which you obtained a tax exemption. If you set up a nonprofit to operate a dog park, you can’t change your mind and open a drug rehab center instead.

2. Don’t Get Political

Nonprofit 501(c)(3) corporations are not allowed to donate to candidates for political office or make any statements that take a position on political candidates. If they do, the IRS can revoke the tax exempt status and assess excise taxes.

Although nonprofits can take part in lobbying activities, there are strict limits: lobbying either can’t exceed a designated percentage of your nonprofit’s income, or it can’t be a substantial part of your nonprofit’s activities.

3. Properly Account for Unrelated Income

Nonprofits frequently have what’s known as “unrelated income,” which is income from activities that don’t directly relate to the nonprofit’s core mission. Examples include income from gift shops, consulting fees or the sales of merchandise, ads or publications.

Unrelated income of more than $1000 is taxable and must be reported on your nonprofit’s tax return. You risk your nonprofit status if you generate substantial income from these unrelated activities. Because the issues can be complicated, it’s best to consult with a nonprofit lawyer or accountant if you think your nonprofit may have unrelated income.

4. Keep Good Books

Nonprofits with annual gross receipts over $50,000 are required to file an annual tax return using IRS form 990 or 990EZ. Those with receipts of $50,000 or less must file tax exempt form 990N. Failure to file can result in financial penalties and, eventually, revocation of tax exempt status.

Nonprofits must keep financial records to back up the information provided on the tax return. If you don’t have good financial records, you can lose your tax exempt status or be reclassified as a private foundation. Consider hiring a bookkeeper or using bookkeeping software to help you stay organized.

5. Watch Out for Transactions That Benefit an Officer, Director or Key Employees

A nonprofit’s income must be used for a charitable purpose and not for anyone’s personal benefit. It’s fine to pay nonprofit employees a salary, but the salary must be reasonable. Salaries should always be approved by the board of directors.

Similarly, if your nonprofit organization is considering doing business with an officer, director, key employee or with a business owned by one of these people, the person’s interest must be disclosed to the board of directors and the board must approve any transaction. Compensation cannot exceed the reasonable value of the goods or services provided.

Finally, nonprofits cannot pay dividends or transfer money or property to any individual. If the nonprofit decides to dissolve, any remaining money or property must be donated to another nonprofit.

If your nonprofit violates any of these rules, it has engaged in something the IRS calls an “excess benefit transaction.” These transactions must be reported to the IRS, which will levy an excise tax on both the benefited person and any nonprofit manager who knowingly approved the transaction. If you have concerns about excess benefit transactions, it’s important to consult a tax advisor so you can handle the situation properly.

In most cases, maintaining nonprofit tax exemptions is simply a matter of keeping good records, filing tax returns on time, and following 501(c)(3) compliance rules for lobbying and political activity. However, it’s a good idea to seek professional advice if your corporation has unrelated income or has concerns about making payments to officers, directors or key employees.

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