5 Ways Nonprofits Can Lose Their Tax-Exempt Status

The line between maintaining and losing tax-exempt status is finer than many realize. For organizations dedicated to public good, this status is essential for their existence. However, complexities abound, and even the most diligent nonprofits can inadvertently cross into precarious territory.

Let’s explore five critical areas where nonprofits, if not vigilant, can unwittingly compromise their status, as well as practical and actionable strategies for imbuing a culture of compliance throughout an organization. For leaders and managers in the nonprofit sector, understanding these risks is paramount to safeguarding your organization’s future.

1. Engaging in For-Profit Activities

The foundational rule drawing the line between charitable activities and for-profit ventures is straightforward: A nonprofit must primarily engage in activities that further its exempt purpose. However, venturing into for-profit activities — even unintentionally — can be a slippery slope.

The IRS stipulates that nonprofits must not be organized or operated for the benefit of private interests. Any profits generated should support the organization's exempt purposes. The challenge arises when nonprofits, perhaps in a bid to diversify funding sources or expand their impact, undertake activities that resemble commercial enterprises. 

Such ventures, if not carefully managed, can lead to the unrelated business income tax liabilities, and in some cases, the loss of nonprofit status. Under current rules, a nonprofit that has $1,000 or more of gross income from an unrelated business must file Form 990-T, and must pay estimated tax if it expects its tax for the year to be $500 or more.

Knowing whether a particular activity will be viewed as “for profit” is not always black and white — there’s often a gray area. For instance, a nonprofit educational organization selling books could be seen as furthering its mission. However, if the scale of this operation shifts focus from its primary educational purpose, it risks scrutiny. The key is maintaining a balance — ensuring that any income-generating activities are incidental and directly connected to the core mission.

Practical Strategies for Compliance

• Mission alignment check. Regularly review all activities for alignment with your nonprofit's mission.
• Documentation and reporting. Maintain clear records and report income activities accurately to avoid any misconception of for-profit ventures.
• Seek expert advice. When in doubt, consult with legal or financial experts specializing in nonprofit law to navigate complex situations.

2. Political Campaign Involvement

Stringent laws meant to preserve the public trust and the non-partisan nature of nonprofits govern the intersection of nonprofit operations and political activities. Under the Internal Revenue Code, 501(c)(3) organizations are explicitly prohibited from directly or indirectly participating in any political campaign on behalf of or in opposition to any candidate for public office. This applies to all campaigns at the federal, state and local levels.

Here’s the rationale: Nonprofits are granted tax-exempt status on the basis of their charitable, educational or religious purposes — not to serve as vehicles for political agendas. Engaging in political campaigns can not only lead to penalties, including hefty fines, but can also result in the loss of tax-exempt status.

Navigating these issues requires another balancing act. Nonprofits can engage in advocacy or issue-based education, but must steer clear of partisan activities. This includes endorsing candidates, making donations to political campaigns or using resources to influence elections. The key is to remain strictly non-partisan in all activities.

Practical Strategies for Compliance

• Clear policies. Establish and enforce strict internal policies to prevent any form of involvement in political campaigns.
• Training and awareness. Regularly train staff and volunteers on what constitutes political campaign activity and the importance of avoiding it.
• Constant vigilance. Monitor all organizational communications, including social media, to ensure no inadvertent political endorsements or activities occur.

3. Failure to Comply With Reporting Obligations

For nonprofits, transparency is not just a best practice, but a legal requirement. Regular and accurate reporting is essential to comply with state and federal laws. This includes filing the necessary financial statements, tax returns (like Form 990) and other required documents.

Failure to meet these reporting obligations can lead to serious consequences. At the federal level, the IRS requires nonprofits to submit annual returns, and failure to file for three consecutive years results in automatic revocation of tax-exempt status. The IRS takes this obligation seriously. In June 2011, it enforced the “failure to file for three consecutive years” rule for the first time by publishing a list of approximately 275,000 organizations that lost their tax-exempt status for failing to meet their annual filing obligations.

At the state level, requirements vary, but non-compliance can lead to penalties, fines and even dissolution of the nonprofit.

Practical Strategies for Compliance

• Establish robust internal systems. Implement strong internal controls and record-keeping systems to ensure all financial and operational data is accurately captured.
• Regular reviews and audits. Conduct regular reviews and audits of financial statements and reports for accuracy and completeness.
• Timely filing. Adhere to a strict schedule for filing all required reports and returns to avoid missing deadlines.

4. Inappropriate Benefit to Insiders

At the heart of a nonprofit's existence is the principle that its assets and income should be devoted to its mission, not to personal gain. This principle is jeopardized when insiders, such as board members, officers or their family members, receive benefits that are not justifiable within the framework of the organization’s purpose. For example, if a nonprofit board member's family business was contracted for services at rates significantly above market value, that could be considered an inappropriate benefit to an insider.

The IRS and other regulatory bodies view any form of personal enrichment (often referred to as “private inurement”) through nonprofit resources as a serious violation. This includes excessive compensation, providing goods or services to insiders on favorable terms, or engaging in transactions that benefit an insider's personal interests. Such activities can lead to penalties, including the imposition of excise taxes on the individuals involved, and in severe cases, can result in the revocation of the nonprofit's tax-exempt status.

Practical Strategies for Compliance

• Implement conflict-of-interest policies. Establish clear policies that define conflicts of interest and outline procedures for disclosure and resolution.
• Regular training and education. Ensure that board members and key employees are educated about these policies and the importance of avoiding conflicts of interest.
• Transparent decision-making. Foster an organizational culture of transparency, particularly in financial decisions and dealings with insiders.

5. Failure to Operate Exclusively for Exempt Purposes

The fundamental criterion for a nonprofit's tax-exempt status is its commitment to operate exclusively for one or more exempt purposes, such as charitable, religious, educational or scientific endeavors. Straying from these purposes can not only undermine the organization’s mission but also threaten its tax-exempt status.

Regulatory bodies, particularly the IRS, closely scrutinize nonprofits to ensure that their activities align with their stated exempt purposes. Significant deviations, known as "mission creep," can lead to serious consequences, including allegations of private benefit if activities serve private interests rather than the exempt purposes.

To illustrate what mission creep looks like, consider a hypothetical nonprofit focused on sports education for underprivileged youth that expands into for-profit adult sports leagues. This move draws focus and resources away from the organization’s primary mission. This type of mission creep could prompt a review and require a realignment to their original exempt purpose to maintain its tax-exempt status.

Practical Strategies for Compliance

• Regular mission review. Consistently revisit and reassess the organization's activities to ensure they align with its exempt purposes.
• Avoiding mission creep. Guard against mission creep — the gradual shift away from the original exempt purposes, often in pursuit of new funding opportunities or initiatives.
• Board oversight and governance. Ensure that the board of directors exercises strong governance and oversight to maintain focus on the organization's exempt purposes.

In the nonprofit realm, success is less about the grandeur of a mission and more about the quiet diligence in its execution. It's a balancing act — your cause drives you forward, but it's the meticulous adherence to rules that sustains your journey. The greatest impact often comes from not just doing good, but doing it right.

The preceding post was provided by an individual unaffiliated with NonProfit PRO. The views expressed within do not directly reflect the thoughts or opinions of NonProfit PRO.