Federal Tax Law
Who must a 501(c)(3) organization serve?
A 501(c)(3) organization must serve a charitable class of beneficiaries and not just a selected individual or a narrowly defined small group of identifiable individuals (e.g., the 5 people hurt in a fire at 123 Main St.). A charitable class must be large enough or sufficiently indefinite that the community as a whole, rather than a pre-selected group of people, benefits when the charitable organization provides assistance.
What does it mean to have a charitable purpose?
According to the Treasury Regulations, the term charitable is to be interpreted in its generally accepted legal sense and includes, but is not limited to:
- Relief of the poor, distressed or underprivileged;
- Advancement of religion, education, or science;
- Erection or maintenance of public buildings, monuments, or works; and
- Lessening of the burdens of government.
The promotion of social welfare can also be charitable when conducted by an organization designed to accomplish one of the enumerated charitable examples listed above or to:
- Lessen neighborhood tensions;
- Eliminate prejudice and discrimination;
- Defend human and civil rights secured by law; or
- Combat community deterioration and juvenile delinquency.
What does it mean to have an educational purpose?
According to the Treasury Regulations, the term educational relates to:
- The instruction or training of the individual for the purpose of improving or developing his capabilities; or
- The instruction of the public on subjects useful to the individual and beneficial to the community.
An organization may be educational even though it advocates a particular position or viewpoint so long as it presents a sufficiently full and fair exposition of the pertinent facts as to permit an individual or the public to form an independent opinion or conclusion. On the other hand, an organization is not educational if its principal function is the mere presentation of unsupported opinion.
What does it mean to have a religious purpose?
Unlike the case with the terms charitable and educational, the term religious is not defined in the Treasury Regulations, in large part due to Constitutional issues. Religious organizations include, but are not limited to, churches (broadly defined under common law to include various houses of worship, including temples, mosques, and synagogues). Churches that meet the requirements of Section 501(c)(3) are automatically considered tax exempt and are not required to apply for and obtain recognition of tax-exempt status from the IRS.
See Starting a Nonprofit: What is “Religious” under 501(c)(3)?; IRS Publication 1828 (last revised August 2015), Tax Guide for Churches and Religious Organizations.
What is the difference between a private foundation and a public charity?
501(c)(3) organizations are classified into two broad categories: private foundations and public charities. To be classified as a public charity, a 501(c)(3) organization must fall within one of the exceptions described in Section 509(a)(1), (2), (3), or (4) of the Internal Revenue Code. Section 509(a)(1) and (2) each require passing a public support test. Section 509(a)(3) describes supporting organizations. And Section 509(a)(4) describes public safety organizations, which are not eligible to receive deductible charitable contributions. Private foundations are subject to an additional regime of laws (colloquially referred to as private foundation laws) which include a minimum distribution requirement; restrictions against self-dealing, excess business holdings, jeopardizing investments, and taxable expenditures (including any expenditures on lobbying); and an excise tax on investment income. Consequently, the public charity classification is generally far more preferable to the extent an organization can reasonably qualify as such.
See EO Operational Requirements: Private Foundations and Public Charities; Public Charity: Public Support Tests Part I: 509(a)(1); Public Charity: Public Support Tests Part II: 509(a)(2); Supporting Organizations – Requirements and Types; Private Foundation Rules.
What is an example of a prohibited transaction benefiting a director under 501(c)(3)?
A director (board member) of a 501(c)(3) organization may not be unjustly enriched by the organization at the organization’s expense, but it’s not unjust enrichment where the benefit they receive is not preferentially directed to them as a member of the organization’s charitable class of recipients. If a director is unjustly enriched through a prohibited private benefit transaction, the transaction may be considered (1) private inurement, which could cause the organization to lose its 501(c)(3) status; and/or (2)(a) an excess benefit transaction (applicable to public charities) or (b) self-dealing (applicable to private foundations), either of which could result in penalties to the director who received the benefits of the transaction and, in egregious cases, to the directors who approved the transaction.
What are examples of prohibited benefits provided by a 501(c)(3) organization?
A prohibited benefit might be provided by a 501(c)(3) organization to a director or any person or entity if not related to the furthering of the 501(c)(3) purposes of the organization and where inadequate value (consideration) is provided back to the organization in return. This might take several forms, including:
- Excessive compensation
- Contracting preferences
- Provision of goods, services (including advertising and promotion), or facilities on more favorable terms than available to the general public
What is an unrelated business?
An unrelated business is one that is not substantially related to the organization’s exempt purpose. More specifically, it is one that does not contribute importantly to the accomplishment or furtherance of the organization’s exempt purpose. And the use by the organization of the profits derived from the business are not considered in this analysis. See, e.g., Unrelated Business Income Tax Explained; Unrelated Business Taxable Income – What Doesn’t Count?
How much unrelated business activity can a 501(c)3) engage in without jeopardizing its tax-exempt status?
Under the 501(c)(3) Operational Test, an organization must not engage in more than an insubstantial part of its activities that does not further an exempt purpose. This might suggest that a 501(c)(3) organization should only engage in unrelated business activities that cumulatively would be insubstantial in relation to its exempt activities. However, some guidance from the IRS suggests that an unrelated business activity could further an exempt purpose (e.g., by producing income to fund charitable programs) and that so long as operating the unrelated business isn’t the organization’s primary purpose, it could be a substantial activity without threatening the organization’s 501(c)(3) status.
There also remains the issue of what “insubstantial” means in the context of the Operational Test and how much nonexempt activity is permissible. Substantiality is based on a facts-and-circumstances test. For such test, it’s more important to examine what percentage of an organization’s resources are deployed on nonexempt activities than what percentage of revenues are from unrelated business activities.
Can 501(c)(3) organizations engage in joint ventures with for-profit organizations?
A 501(c)(3) organization may engage in a joint venture with a for-profit organization (“JV”) subject to certain requirements and limitations. Where the organization invests more than an insubstantial amount of its resources in a JV, the 501(c)(3) organization’s participation and investment in the JV must further its charitable purpose. In addition, the arrangement must permit the nonprofit to control the JV’s charitable activities and ensure that the nonprofit acts exclusively in furtherance of its charitable purpose and only incidentally for the benefit of its for-profit partner. See Nonprofit Joint Venture Basics.
How is a 501(c)(3) organization different from a 501(c)(4) organization?
Colloquially, 501(c)(3) organizations are called charitable organizations and 501(c)(4) organizations are called social welfare organizations. But the differences between charitable and social welfare purposes and activities are often unclear. Charitable organizations must benefit a charitable class. Social welfare organizations must in some way promote the common good and general welfare of the community. One way to consider the differences is to understand that the IRS is less likely to question whether an organization’s exempt purpose is the promotion of social welfare. Social welfare is broader concept than charity primarily because 501(c)(4) organizations, unlike 501(c)(3) organizations, are not eligible to receive deductible charitable contributions.
In exchange for the right to receive deductible charitable contributions, 501(c)(3) organizations are also subject to additional restrictions, including limitations on lobbying and a strict prohibition against political campaign intervention. 501(c)(4) organizations are able to lobby in furtherance of their social welfare purposes without limitation and can engage in political campaign intervention so long as it is not their primary activity. See, e.g., Comparing 501(c)(3) vs. 501(c)(4) for Nonprofit Startups; 501(c)(4) Social Welfare Organizations.
What happens if a nonprofit corporation operates inconsistent with its articles of incorporation or bylaws?
This may be an example of an ultra vires act – an action outside of the corporation’s authority. Such an act often occurs where a nonprofit corporation’s original stated purposes in the articles or bylaws have evolved over time, but the governing documents were not appropriately amended. Depending on the significance of the change and on any claims of misrepresentation, this may or may not lead to serious legal consequences. Nevertheless, there may be issues that arise regarding fiduciary duties, breach of charitable trust, and unrelated business income tax. If a nonprofit discovers this problem, it would be wise for its leaders to confer with an attorney.
Are the terms board member and director synonymous?
We generally use the terms synonymously because “director” is used in typical nonprofit statutes and regulations as a member of the board with a right to vote on matters before the board. However, people may also refer to directors in the context of other positions such as executive director and program director. So, you’ll want to be clear when looking to identify the board members of a nonprofit corporation. It’s also important to recognize that officers are not necessarily board members unless they have been separately selected to serve as a board member or they are an ex officio director by virtue of their officer position.
How are board members elected?
Most commonly, board members are elected by the board (in such circumstance, sometimes called a self-perpetuating board). But nonprofit corporations may instead have one or more voting members (referred to in the law simply as “members’) that elect the board members. This tends to be more common in noncharitable mutual benefit corporations and in private foundations where a family or company is seeking to maintain control over the corporation’s governance. Nonprofit corporations may also have certain persons called designators with the right to designate (appoint) one or more board members and ex officio directors, who are board members by virtue of serving in some particular other position (e.g., president of a parent corporation).
How are board members removed?
Board members generally can be removed by the person, group, or entity that selected them as board members. Members who collectively elect board members can typically remove such elected board members without cause. Under the laws of certain states (including California), the same holds true for designators. However, it may be less clear whether board-elected directors can be removed by the board without cause
What are the typical functions of a nonprofit board?
A nonprofit corporation’s board has the ultimate responsibility for the affairs of the corporation. In practical terms, this typically translates to:
- selecting, evaluating, and (if necessary) terminating the executive and other officers;
- setting the direction of the nonprofit – including through the mission, vision, values, plans, and budgets, and with an eye on the broader evolving ecosystem in which the nonprofit and its intended beneficiaries exist;
- overseeing the performance of the nonprofit in all relevant areas – including finances, programmatic impact, fundraising, public relations, governance, and legal compliance;
- protecting the charitable assets – including financial investments, real property, tangible assets, intangible assets like intellectual property and reputation/goodwill, critical relationships, important documents, and the nonprofit’s human resources.
What are ways nonprofit boards may get in trouble?
Nonprofit boards can get in trouble when their members fail to exercise reasonable care in their oversight of the organization and when they allow one or more of their members to unjustly enrich themselves at the expense of the organization.
Individual board members of public charities may be hit with a penalty tax for engaging in an excess benefit transaction or knowingly approving an excess benefit transaction. Individual board members of private foundations may face penalty taxes for engaging in self-dealing or for knowingly participating in a self-dealing transaction, the making of a jeopardizing investment, the making of a taxable expenditure.
With respect to getting in trouble, nonprofit boards may be most concerned with avoiding personal liability and assuring their organizations don’t lose their 501(c)(3) status or get hit with a severe penalty for a compliance issue. But nonprofit board members should also be aware of and take steps to mitigate other risks, including the loss of personal reputation, damage to the organization’s reputation, and harms caused by the organization’s actions or omissions (even if not related to a legal compliance issue).
What prevents a board member from breaching their fiduciary duties?
Their passion for the organization, its mission, and its work? Their sense of personal responsibility? Those are certainly some of the reasons why many board members are diligent in meeting their fiduciary duties. But there are also possible negative consequences that may serve as motivation. For example, board members could face penalty taxes for violating certain laws (some of which are described above); and civil penalties where harm results to a third party due in part to board members’ failure to meet their fiduciary duties.
What does it mean if a charitable nonprofit is not registered with a state charity regulator?
The consequences of failing to register with a state charity regulator will differ depending on the activities the charitable organization carries on in the state, how long the charitable organization has been carrying on those activities, and the level of regulation and enforcement in the particular state. In some cases, particularly for a foreign state nonprofit with very limited activity in the state in question, noncompliance may not be detected or determined to be an enforcement priority. In other cases, where the charitable organization has substantial fundraising activities targeting many individual residents of a state along with some complaints about their solicitations and representations, noncompliance could lead a state charity regulator to suspend the charitable organization’s right to fundraise in the state. More egregious and unlawful activities (e.g., fraudulent misrepresentations, embezzlement) could result in the state charity regulator to remove board members and take other steps within their regulatory authority.