Problem: A nonprofit organization fails to file Form 1023 with the IRS to request recognition of its tax-exempt status within the 27 month window AND it does not file a Form 990 for three consecutive years. Sometime beyond 27 months after formation it files its application for exempt status. Instead of receiving an approval, it receives notice of revocation. Why is this happening? How can the IRS revoke the exempt status even before it “approves” the exempt status?
Understanding this issue requires some understanding of the law.
The Law of Federal Tax Exemption under Section 501
Internal Revenue Code Section 501(c) sets out the conditions under which a nonprofit organization may qualify as exempt from federal income taxes. For instance, section 501(c)(3) defines the qualifications for a charitable nonprofit. 501(c)(4) defines the qualifications for a social welfare organization.
It is important to understand that the IRS does not “grant” tax-exempt status. The status occurs by operation of law. If the organization meets the organizational and operational requirements, it is, by definition, tax-exempt under the relevant paragraph of section 501(c). The IRS simply “recognizes” an organization’s exempt status if the organization applies. With one common exception, no application need be made to the IRS.
Section 508 Notice Requirement
The exception referred to above relates to 501(c)(3) charitable organizations. Congress has mandated via section 508, that in order to qualify under 501(c)(3), an organization must “give notice” to the IRS that it is claiming to be exempt under that code section. It does this by filing Form 1023. It has 27 months from the date of formation to do so. This notice requirement does not apply to most other non-charitable organizations.
The Old Law
Before enactment of section 6033(j) mandating revocation for failure to file a return for three consecutive years, an organization that failed to apply for recognition within the 27 month window AND which failed to file Form 990, could simply file Form 1023 late, offer the “reasonable cause” explanation that it filed before being notified by the IRS that it had failed to file Form 1023 on time, file the delinquent returns, and request recognition of tax-exempt status retroactive to the date it came into existence. On several occasions I’ve seen organizations that were more than 5 years late filing Form 1023 receive recognition of their tax exempt status retroactive to the beginning of their existence. They also received late-filing penalties for the delinquent Form 990’s, but those were forgiven upon showing of reasonable cause.
Organizations that did not qualify for retroactive recognition of charitable status had the option of being treated as a 501(c)(4) social welfare organization from the beginning of their existence until the date they filed Form 1023. They could then be recognized as a 501(c)(3) starting on the day the 1023 was filed with the IRS. While not a perfect solution, this option at least avoided the undesirable situation of being treated as a taxable entity during years before the 1023 was filed.
Organizations are responsible for filing their Form 990 even if their Form 1023 is still “pending” approval.
The New Law
For taxable years beginning in 2007, section 6033(j) mandates that an organization will lose its tax-exemption if it fails to file its Form 990 for three consecutive years. The new law mandates that ALL tax-exempt organizations (except churches) file some type of Form 990. Small organizations that fell under the filing threshold for the 990-EZ could submit an electronic postcard to meet their filing requirement. When applied on top of the 27 month window for filing Form 1023, the new law has created some confusion. This confusion seems to stem from the fact that once the 3 consecutive filings have been delinquent, the option to be treated as a (c)(4) is no longer available to a charitable [(c)(3)] entity. Instead, revocation is automatic.
The Results of the New Law as Applied to 501(c)(3)
A 501(c)(3) organization that fails to file Form 1023 within the 27 month period AND which fails to file a Form 990 for three consecutive years may find itself in a predicament. There are two “windows” to be aware of. This is best explained by an example. I’ll make it as simple as possible:
ABC Charity incorporates on January 1, 2010 and uses a December 31 year end.
ABC Charity has 27 months beginning January 1, 2010 to file Form 1023. This means the 1023 must be filed on or before March 31, 2012. This is the first “window.”
Under the new law, it is required to file some form of 990 return for each year. The due dates of the first three returns are as follows:
- May 15, 2011
- May 15, 2012
- May 15, 2013
If it has not filed any of the three returns by May 15, 2013, it automatically has its tax-exempt status revoked on May 15, 2013. This is the second “window.” It does not have the option of being treated as a 501(c)(4) social welfare organization for the preceding years. It will be treated as a taxable business.
If ABC files Form 1023 within the 27 month window, it will be tax-exempt beginning 1/1/2010. As long as it files its Form 990 each year it is in good standing. If it then fails to file any of the required returns before 5/15/2013, it will lose its tax-exemption on 5/15/2013 and will have to file Form 1023 again. Assume it files Form 1023 on 12/31/2013 to apply for reinstatement. If approved, it will be reinstated as of the date the IRS receives the application (probably mid-January 2014). This creates a period between 5/15/2013 and January 2013 when ABC will be considered a taxable corporation. Whether the IRS will pursue corporate tax return filings is currently unknown.
If ABC files Form 1023 AFTER the 27 month window, but BEFORE 5/15/2013 (assumes no Form 990’s have been filed), it can request that the IRS accept the late-filed 1023 because it was filed before being notified by the IRS that it had not been filed (reasonable cause), and can request recognition of exempt status effective 1/1/2010. If granted, the organization will be treated as tax-exempt until it fails to file any of the returns by the 5/15/2013 due date. If it files any of the returns before the 2013 due date, its exempt status will not be in jeopardy, but it will be subject to late filing penalties where applicable. If it fails to file any of the returns by 5/15/2013, its exempt status will be revoked as of that date. You can see where the confusion can come into play with various documents being filed in close proximity to the various windows and due dates.
Finally, if ABC lets 5/15/2013 pass without filing either the 1023 or any of the 990’s, its exempt status will be automatically (by operation of law) be revoked on 5/15/2013. ABC will have to re-apply with a new Form 1023 which can only be effective as of the date it is received by the IRS. Yes, I know the IRS has said that upon showing reasonable cause the organization’s exempt status can be retroactively reinstated, but in practice this is pie-in-the-sky. It rarely happens. This means that ABC will be considered a taxable entity from 5/15/2013 until the date the IRS received the Form 1023. If that happens to be a 5 or 10 year period, you can see the possibility of a large tax liability accruing for some types of organizations. There is no provision for the organization to request that it be treated as a 501(c)(4) social welfare organization during the period that its exemption was revoked.
Applying the new law to organizations that are tax exempt under some other paragraph, such as 501(c)(4) or (6) or (7), is similar to the above examples, except that the 27 month window does not apply to those organizations. They are not required to file Form 1024, though many do so. Generally, once a non-charitable entity reaches the filing threshold of Form 990-EZ it will need to file Form 1024 or the IRS will not accept the 990-EZ or Form 990 filing. The IRS may accept a Form 990-N even though no 1024 is filed, but you’ll need to call them first to let them know you’ll be submitting a 990-N.
There is some question as to whether the IRS will accept as valid a timely filed extension for the third year return. See my discussion of the law and guidance on this issue.
Reference: IRS Revenue Procedure 2013-9, section 11