The IRS reminded organizations of several important considerations for Section 501(c)(3) organizations, whether or not they use the internet to raise funds:

• Deductibility of donations.  An organization that is raising funds, but has not yet received recognition as a tax-exempt organization under Section 501(c)(3), must include a clear and conspicuous statement on its solicitation materials (including its website) stating that it has not received Section 501(c)(3) recognition, and, therefore, donations may not be deductible.
• Professional fundraisers.  An organization should consider whether any fees that a fundraiser or other private party charges could be excessive or whether the fees violate the rules against private benefit or private inurement.
• Quid pro quo contributions.  If an organization provides something of value in exchange for a donation, then the organization must consider whether this arrangement violates the rules against private benefit or private inurement.  The organization must also comply with any substantiation and disclosure requirements for quid pro quo contributions.
• Disclosing fundraising information.  An organization that is applying for recognition of Section 501(c)(3) status must describe its actual and planned fundraising activities and its fundraising expenses on its application for exemption (Form 1023).  Expenses relating to fundraising incurred by an organization must be reported on the organization’s annual information return (Form 990, Form 990-EZ or Form 990PF).

In 2008, the IRS sent a 33 page questionnaire to 400 randomly selected colleges and universities.  In 2010, the IRS released an Interim Report.  Following review of the responses and Forms 990 and 990-T, the IRS selected 34 schools for audit.  The audits were limited to two specific areas, unrelated business income tax (UBIT) and executive compensation.

The Final report was released on April 25, 2013.  The IRS points out that because the 34 organizations that were audited were not randomly selected, the schools do not represent a statistical sample.

UBIT

The IRS found that:

• UBIT was underreported at 90% of the colleges and universities examined.
• The underreported amounts totaled over $90 million.
• The underreported amounts resulted from 30 different types of unrelated business activities, but the majority of adjustments resulted from only these five activities (in order of frequency):
  • Fitness and recreation centers and sports camps;
  • Advertising;
  • Facility rentals;
  • Arenas; and
  • Golf courses
• In total, the IRS disallowed more than $170 million in losses and Net Operating Losses.

The IRS concluded that the underreporting of UBIT stemmed primarily from four practices:

1. Schools claimed losses from activities that did not qualify as a trade or business. The majority of the schools claimed losses from activities where for many years the expenses exceeded income.
2. Sixty percent of the schools misallocated expenses to offset unrelated business income.  Claimed expenses did not have the necessary connection to the unrelated business activity.
3. Many schools incorrectly treated income producing activities as not subject to UBIT.
4. More than a third of the schools reported erroneously calculated or understated Net Operating Losses.

Compensation

IRS experts found that in 20% of the schools, the compensation comparability data was not appropriate data.  The data used was not appropriate because:

1. Information was used from schools that were not similarly situated.
2. The compensation studies did not explain the selection criteria nor how the selected schools were similar.
3. The compensation surveys did not specify whether reported amounts included compensation other than salary.

Not surprisingly, the IRS found that sports coaches and investment managers were the most highly compensated, with an annual average package of almost $900,000.  The average total compensation for top management officials was about $620,000 a year.

The IRS also examined employment taxes and retirement plans for some of the 34 schools.

Employment Taxes – Issues were found in each of the 11 schools examined, resulting in $36 million in increased wages and over $7 million in taxes and penalties.

Retirement Plans – The IRS examined 8 schools and found problems in four, leading to increases in wages of more than $1 million and $200,000 in taxes and penalties.

The IRS plans to look at UBIT reporting more broadly, especially at recurring losses and the allocation of expenses.

On May 1, 2013, Congressman Boustany, chair of the Subcommittee on Oversight of the Committee on Ways and Means announced a hearing set for May 8^th and said:

“Given the importance of nonprofit colleges and universities, it is critical that the Subcommittee continue its review of this segment of the tax-exempt sector. The IRS’s colleges and universities compliance project suggests widespread noncompliance. The Subcommittee has an obligation to explore the root of these alarming findings on the audit of our nation’s higher education providers. This hearing is an excellent opportunity to discuss the results of the compliance project and examine areas for improvement in oversight, with an eye toward comprehensive tax reform.”

Final Internal Revenue Code Section 403(b) regulations which became effective January 1, 2009 require that plan sponsors adopt written 403(b) Plan documents.  A 403(b) Plan is a form of defined contribution retirement plan that may only be offered by employers that are tax-exempt entities under Section 501(c)(3) of the Internal Revenue Code or that are public educational organizations and for the benefit of certain clergy members.  If a 403(b) Plan sponsor did not adopt a written plan document by December 31, 2009, the sponsor’s 403(b) plan is technically no longer considered to be a qualified tax-deferred retirement plan as of January 1, 2009.  The benefit of correcting the written document failure is that all money that has been contributed to the 403(b) Plan will remain tax-deferred and that all investments under the 403(b) Plan will retain their tax-favored status.

To help 403(b) Plan sponsors voluntarily correct any plan document errors, the IRS recently updated its Employee Plans Compliance Resolutions System (referred to as EPCRS).  Plan document errors are cured through the voluntary correction program (referred to as VCP) by having the 403(b) Plan sponsor adopt a written plan document that complies with the final regulations, make a VCP submission, and pay a compliance fee based on the number of employees eligible to participate in the 403(b) Plan.  To simplify this procedure, the IRS has made available a 403(b) VCP Submission Kit, and to encourage 403(b) Plan sponsors to take advantage of this program, the IRS has reduced the compliance fee by 50% if the VCP filing is made by December 31, 2013.

Correction Due to Loss of Tax-Exempt Status

What happens if a tax-exempt organization becomes ineligible to sponsor a Section 403(b) Plan because it loses its exempt status under Internal Revenue Code Section 501(c)(3)?  As an example, loss of tax-exempt status may occur automatically if the organization fails to file an annual Form 990 information return for three consecutive years.  It may also lose its exempt status if the IRS revokes or terminates exempt status for other reasons.

To fix that problem, an organization may apply to the IRS for a reinstatement of its tax-exempt status; however, this only works if tax-exempt status was automatically revoked due to failure to file Forms 990.  In that case, the IRS may reinstate tax-exempt status retroactively, or it may only reinstate tax-exempt status prospectively.

If an organization loses its tax-exempt status, it must immediately stop making contributions to its 403(b) Plan because it is no longer considered an eligible employer.  If, however, contributions were made to the organization’s 403(b) Plan after loss of tax-exempt status and tax–exempt status is not reinstated or is only reinstated prospectively, the 403(b) Plan sponsor may voluntarily correct the eligibility failure through the IRS’s Employee Plans Compliance Resolutions System (EPCRS).  The benefit of correcting the employer eligibility failure is that all money that was contributed to the 403(b) Plan while the employer was ineligible to maintain the 403(b) Plan will retain its tax-favored status, all contributions may remain in the applicable annuity contracts and custodial accounts and the organization may avoid potential penalties.

To participate in this voluntary correction program (VCP), the organization must make a VCP submission to the IRS and pay a compliance fee based on the number of employees that were eligible to participate in the 403(b) Plan.  To be eligible to correct an employer eligibility failure under VCP, the organization or the 403(b) Plan cannot be under audit by the IRS, all contributions to the 403(b) Plan must have ceased (except where tax-exempt status has already been prospectively reinstated), the 403(b) Plan must have complied with all applicable requirements under the final Section 403(b) regulations and must continue to comply with the distribution rules applicable to 403(b) Plans.

IRS Establishes Pre-Approved Plan Program for 403(b) Plans

On March 28, 2013, the IRS issued Revenue Procedure 2013-22 which establishes a program for the IRS to accept applications for opinion and advisory letters for 403(b) prototype plans and 403(b) volume submitter plans, respectively, starting June 28, 2013.  The new program is similar to the pre-approved plan program maintained by the IRS for tax-qualified plans with one significant difference – an employer who adopts a pre-approved 403(b) plan will not be able to apply for an individual determination letter for the 403(b) plan.  In addition, the IRS has stated that it is not establishing a determination letter program for individually designed 403(b) plans at this time.  Although many large employers will likely continue to use individually-designed 403(b) plans, the program offers employers an alternative to adopting an individually-designed plan to satisfy the written plan requirement under the final regulations issued under Section 403(b) of the Internal Revenue Code.

The IRS has also issued an information package containing samples of 403(b) plan provisions to assist sponsors who are drafting 403(b) prototype plans and 403(b) volume submitter plans with the goal of accelerating the review and approval of these plans.  Some of the notes included in the information package reflect requirements that are not included in the final Section 403(b) regulations and have raised questions concerning 403(b) plan administration and compliance.  In addition, the information package does not include sample provisions for mandatory employee contributions as a condition of employment, a common feature in many 403(b) plans.

Because there are still a number of unanswered questions and issues that need to be refined, we expect that the IRS will continue to provide guidance concerning the program and the sample provisions.

The questionnaire contains questions about the organization generally, its activities and related organizations, revenue and expenses, and compensation of directors, officers, trustees and key employees.  While the range of questions is broad, there is a particular focus on political activity, like political campaign intervention.  While 501(c)(4) organizations are allowed to engage in some political activity, it must not be their primary purpose.  In recent years, the IRS, members of Congress, and advocacy groups have been concerned that 501(c)(4) organizations are engaging in political activity beyond what is permitted by law.  In fact, this initiative was anticipated in the IRS Exempt Organizations FY 2013 work plan.  The questionnaire also has a number of questions about whether the organization received professional advice in determining its tax status and whether activities constituted an unrelated trade or business.

Only the organization that receives the letter may complete the questionnaire.  Although the questionnaire is a voluntary compliance instrument, the IRS may refer the organization for examination if the organization does not complete the questionnaire.  The IRS has not indicated when results from the survey will be analyzed and made available to the public, but this usually takes a year or two.

Attorneys can reap enormous rewards by serving on nonprofit boards.  Lawyers derive tremendous personal satisfaction in governing an organization that is meaningful to them.  They can do the public good by participating in a charity that feeds the poor, heals the sick, enlightens through culture and education, or preserves the environment.

Nonprofit board service is prestigious, and invaluable for professional networking.  It is also a great remedy for the ennui that sometimes sets in when lawyers work inside big law firms, corporate departments or government agencies, and a cure for the isolation of solo or small-firm practice.  A lawyer who serves as a nonprofit trustee is likely to quickly become a trusted and valued member of the team, whose individual contributions markedly enhance a worthwhile enterprise.

Board service may lead to (or in some locales even qualify as) pro bono work.  Suitable pro bono opportunities are sometimes hard to find, particularly for corporate or transactional lawyers.  Most important is the opportunity to serve the public interest in a meaningful way, to bring professional skills to bear in a collegial context that is different from an otherwise adversarial professional realm.

Why Nonprofit Boards Want Attorneys

For their part, organizations wish to recruit lawyers to their boards for a variety of reasons:  legal expertise and perspectives, stature, good judgment, negotiating skills, and of course financial contributions.  The fiduciary duty of care requires that board members attend meetings and pay attention to the governance of the organization, overseeing management in fulfillment of mission. In addition, most nonprofit board memberships come with a (stated or tacit) expectation that each member will donate or solicit funds on behalf of the organization.  Some organizations have a stated amount, others simply ask that each board member give an amount that is meaningful to him or her.

In addition to governing and personal giving, board members may be expected to serve in an external relations role, advocating for the organization and introducing it to new sources of funding such as private philanthropists, donor advised funds, government funders, corporations and foundations.

Apt Roles for Lawyers on Boards

By their training and professional expertise, lawyers may be particularly suited to fulfill certain roles on boards, for example:

• Legal Committee
• Governance committee
• Audit committee
• Public affairs/government relations committee
• Corporate secretary role
• Ad hoc committee to review and update by-laws
• Development (fundraising) committee
• Grants committee (for grantmaking organizations)

In many nonprofits, particularly those with larger boards, much of the work of the board is carried out through committees, whose activities and recommendations are memorialized in minutes and regularly reported out to the board for discussion, refinement and ratification. Attorneys may be particularly well-suited for the minute-taking role as well as for keeping track of the organization’s adherence to its policies and by-laws.

Some Cautionary Notes

Lawyers joining nonprofit boards would do well to observe some cautions.  Many nonprofits, particularly smaller or less-sophisticated organizations, may erroneously believe that having a lawyer on the board is the same thing as having a lawyer.  They may not recognize that the establishment of an attorney-client relationship is a formal matter, with an engagement letter (legally required in some states) and stated professional understandings as to scope of the representation, fees/fee waivers, and expenses.  For their part, the lawyers may not be in a position to deliver legal services to the client for any number of reasons: core competency, time and availability, conflict of interest, lack of malpractice insurance, lack of bar admission in that state, or otherwise.

When attorneys do agree to represent the organization as well as serve on its board, they should be mindful of the following risks:

• Document the inception, scope and terms of the attorney/client relationship.  Some states’ professional responsibility rules require a written engagement letter setting forth these matters.
• Avoid private inurement – nonprofit resources being used improperly to enrich the attorney or the law firm.  The actuality or appearance of a prohibited private inurement relationship between the organization and the attorney can avoided by providing services pro bono.  If the engagement is on a fee-bearing basis, the attorney should be sure to follow the organization’s conflict-of-interest policies and, once the relationship is cleared by independent directors, the attorney should be sure to follow requirements for ongoing disclosure of fees.
• Privilege waiver can occur if the attorney/director fails to flag when she is taking off her director hat in the board room and commencing the rendering of legal advice as counsel.  See, e.g., Deutsch v. Cogan, 580 A.2d 100 (Del. Ch. 1990) (holding that lawyer’s communications with other board members or management were while she was wearing her “director hat” and not her “lawyer hat,” and that the communications are discoverable in litigation); see generally Model Rule of Professional Conduct 1.6.
• Conflicts of interest can arise, for example, if the lawyer is asked to give a legal opinion on board actions in which the lawyer participated.  Another example: if the organization is party to a litigation, the lawyer may be unable to try the case on behalf of the client, especially where he may be a witness.
• Gaps in liability coverage: Some legal malpractice insurance underwriters will not cover either the lawyer or her firm if one of its lawyers serves on the board of the client; other policies will provide coverage only where the lawyer was acting as a lawyer but not as a director.  This can lead to disputes between the D&O carrier and the malpractice carrier about whether the lawyer was acting as a lawyer or as a director, and ultimately can lead to a lack of adequate coverage altogether.
• Higher standard/greater liability:  will a director who is also a lawyer be held to a higher standard in what they know or should know about company matters?  This question has been litigated and answered in the affirmative in a number of states in the for-profit context.  Query whether courts would apply a heightened standard to a lawyer acting as a director of a charity.

The opportunities and pleasures of serving on a nonprofit board are manifold.  Lawyers should embrace the chance to lead, learn and grow.  At the same time they should be mindful of the potential pitfalls of undertaking a dual role, and take appropriate steps to mitigate the risks.

To locate board member opportunities in New York City visit BoardServeNYC.

Lesley Rosenthal is Vice President, General Counsel and Secretary, Lincoln Center for the Performing Arts and author of the bestselling Good Counsel:  Meeting the Legal Needs of Nonprofits (John Wiley & Sons 2012)

• Key Provisions of the Affordable Care Act
• Cybersecurity Threats and Identity Theft
• Lawyers as Nonprofit Directors

Here are some take-away points from each presentation:

 Key Provisions of the Affordable Care Act

 Peter J. Marathas, Jr. reviewed some of the key provisions of the Affordable Care Act (“Act”), reminding those attending that many of the Act’s requirements are already in effect, and many more are set to go into effect in 2013 and 2014.  Mr. Marathas specifically addressed the “counting rules” under the Act, which will be used to determine whether an employer employs 50 or more full time equivalent employees and is therefore subject to the 2014 “play or pay penalties,” and the number of full-time employees employed by an employer for purposes of determining the extent to which a penalty may apply.  Mr. Marathas also discussed issues related to so-called “variable hour employees,” those who work on an as-needed or similar basis, and how they are counted for purposes of the Act.  He reminded employers that implementation of the Act continues in full force, with the federal agencies releasing important guidance.  Working closely with knowledgeable counsel and other advisors is therefore essential.  For additional information on the Affordable Care Act click here.

 Cybersecurity Threats and Identity Theft

Kristen Mathews discussed cybersecurity threats and online identity theft. Ms. Mathews emphasized that cybersecurity risks for not-for-profit organizations are similar to those to profit-making enterprises, as they collect and maintain personal, health and financial information of employees, donors and customers.  Not-for-profit entities also have the same or similar legal obligations with respect to those types of information.  Common data security threats were highlighted, including politically motivated hacking, data theft for profit, and employee negligence.  As a case in point, Ms. Mathews recounted a recent incident in which a journalist’s online accounts, computer and mobile device were accessed and controlled and his personal data destroyed by hackers who used social engineering techniques to exploit flaws in the account security procedures of major online service providers.  She followed up with recommendations for improved online account security practices for individuals as well as service providers.  For identity theft prevention tips click here.

Lawyers as Nonprofit Directors

Lesley Rosenthal, Vice President, General Counsel and Secretary, Lincoln Center for the Performing Arts, discussed the role of lawyers serving on nonprofit boards.  Scott Harshbarger facilitated the discussion.  Ms. Rosenthal pointed out that both the lawyers and nonprofit organizations can benefit from a lawyer serving on the board.  Ms. Rosenthal also addressed certain pitfalls which can result from the dual roles of lawyer and board member and how to avoid them.  A forthcoming blog post will discuss Ms. Rosenthal’s presentation in further detail.

2012 Highlights:

• Exchange of Information with States.  EO continued to see an increase in the number of referrals from state charity regulators and tax agencies regarding potential exempt organization tax law violations.  In FY 2011, EO received 104 referrals from 19 different states.  Some of the most common issues that are referred to the IRS from the charity regulators involve private benefits and inurement, nonfilers, political activities by § 501(c)(3) organizations, employment tax issues and organizations not operated as required by their exempt status.  Conversely, under recently expanded authority, the IRS is allowed to disclose to certain state charity regulators significantly more information about exempt organizations, including proposed and final revocations of tax exemption for § 501(c)(3) organizations, proposed and final notices of deficiency for Chapter 42 excise taxes, § 501(c)(3) exempt organizations applications in process and proposed or final denials of these applications.  At present, only eight state tax and charity agencies in seven states have met the requirements to receive these disclosures; nonetheless, these agencies received approximately 27,000 disclosures in FY 2011.
• Hospital Community Benefit Reviews.  As we have previously noted, EO is required under the Affordable Care Act to review the community benefit activities of all tax-exempt hospitals every three years.  This work continued in the past year.  EO will use the information from the reviews for research, reporting and compliance purposes, as well as to identify areas where additional guidance, education or Form 990 changes are needed.
• Governance and Compliance.  EO recently completed a study of the impact of exempt organizations’ governance practices on compliance.  Preliminary findings indicate that the presence of the following factors was associated with compliance: having a written mission statement; always using comparability data when making compensation decisions; having controls in place to ensure the proper use of charitable assets; and providing for Form 990 review by the entire board of directors before filing.  The preliminary findings also suggest that having control of the organization concentrated in one individual, or in a small, select group of individuals, was associated with noncompliance.  EO will continue this review and will look at whether other factors or practices are relevant.
• Community Foundations.  In response to the significant increase in the number, size and complexity of community foundations over the past decade, EO sent questionnaires to 3,700 organizations asking for information on demographics, revenues, assets, investments, grantmaking and relationships.  Using the responses from the questionnaire and information from the Form 990, EO selected certain community foundations for examination, particularly those organizations where donors appeared to exercise significant control over investments and grantmaking decisions.  The IRS found that some of the organizations were mischaracterizing fees earned from providing administrative, clerical or grant-related services to unrelated organizations as related income.
• Private Foundations.  EO continued an ongoing project to determine levels of tax compliance by large private foundations.  Many of the entities selected for examination had foreign investments or made grants overseas.  Nearly half of the examinations that closed resulted in additional taxes or penalties, including excise taxes on net investment income, taxes on unrelated business income, taxes on certain expenditures that are taxable when made by private foundations and employment taxes.  EO will complete the examination of the remaining returns in 2013.

2013 Priorities and Goals:

• Asset Diversions and Governance.  For several years, the Form 990 completed by exempt organizations has included a question about whether the organization experienced a significant diversion of assets.  EO has identified 285 organizations that reported such a diversion on their 2009 Forms 990, and in the coming year, EO will conduct examinations to learn more about whether and how governance practices may contribute to or prevent diversions.
• Section 512(b)(13) Study.  In response to a provision in the Pension Protection Act of 2006 directing the Secretary of Treasury to report on the administration of § 512(b)(13) (originally due by January 1, 2009), EO developed a § 512(b)(13) checksheet to be used in examinations in order to gather basic data related to the tax treatment of payments between controlled entities and their parent exempt organizations.  EO has just begun to analyze the 3,000 checksheets they received during the last two years.
• Employment Taxes.  2013 is the third and final year of the IRS-wide research project on employment tax compliance. EO revenue agents have closed approximately 6,500 returns from almost 2,000 organizations and individuals from tax years 2008, 2009 and 2010.  In 2013, EO will complete approximately 2,500 remaining returns and provide the data to the IRS-wide National Research Program project for further processing.
• Foreign Activities.  In 2012, EO completed examinations of a sample of organizations that reported a foreign bank account on their Form 990s.  The results showed that there is often a failure to file required reports of foreign bank accounts, inadequate recordkeeping, lack of discretion and control over funds sent abroad (as required for deductibility of contributions) and failure to file employment tax returns.  In 2013, EO is shifting its focus to examinations of organizations with high amounts of foreign grant expenditures.
• Group Rulings.  Last year EO developed a Group Rulings Questionnaire in response to a 2011 report on group exemptions by the IRS Advisory Committee on Tax-Exempt Organizations and the large number of subordinates whose exemption was automatically revoked for failing to file a Form 990-series return for three consecutive years.  Last fall, EO mailed the questionnaire to over 2,000 randomly selected central organizations in group rulings.
• Self-Declared Exempt Organizations.  Last year EO developed a project focusing on § 501(c)(4), (5) and (6) organizations to determine whether the organizations, which are not required to obtain a determination of exemption from the IRS, have classified themselves correctly and are complying with applicable rules.  In 2013, EO will send a questionnaire to organizations that “self-declared” to examine these questions.
• Colleges and Universities.  EO launched a compliance project for colleges and universities several years ago and conducted some follow-up examinations.  In 2013, EO expects to complete the final report on this project.
• Level of Charitable Activity.  EO is continuing a long-range study that focuses on the sources and uses of funds in the charitable sector and their relationship to charitable accomplishments.  EO selected about 170 small organizations that reported high expenses on their Forms 990.  After examination, some of the apparent high expense ratios turned out to be lower in actuality after a full review of the books and records was completed.  EO did revoke the exempt status of four organizations due to either very little or no charitable activity or inurement to an officer.  EO will complete the remainder of the examinations this year.
• Compensation Transparency.  Continuing its ongoing focus on compensation, EO will begin conducting examinations this year of a random sample of 200 organizations.  The organizations selected will be ones reporting high annual gross receipts with very low total compensation to all officers, directors, trustees and other key employees. EO hopes to determine whether some organizations may be circumventing the goal of transparency by not fully reporting compensation.
• Political Activity.  Using Form 990 data, EO has developed indicators of potential noncompliance in the political activity arena.  These indicators are now and will continue to be tested this year.  The potential indicators have been used to identify organizations engaging in impermissible campaign intervention.  Along with testing these indicators, EO will also determine whether exempt organizations have political activities and are required to file Form 1120-POL under § 527(f) (in addition to Form 990), and if so, whether they have filed.
• UBI.  Last year EO completed compliance checks of 400 organizations that had reported taxable unrelated business income (UBI) on their Forms 990 but had not filed Form 990-T, the return used to report and pay tax on UBI.  The checks resulted in more than $260,000 in tax payments.  In a quarter of the cases, inaccurate reporting on their returns resulted in the organizations being examined for UBI issues.  EO stated that if the organizations had reported correctly, they would likely not have been examined.  This year, EO will examine organizations that report substantial gross UBI for three consecutive tax years but reported no income tax due for those years.  EO is concerned that these organizations may be understating net income by not be correctly allocating and deducting expenses associated with their UBI.

In June of 2011, the IRS completed the process of identifying organizations in its exempt organizations database that failed to file during the three years following the PPA effective date and therefore were subject to automatic revocation.  Since then, the IRS has been identifying organizations subject to automatic revocation on an ongoing basis and has made this information available to the public on its website.  The IRS is now taking the next step: ensuring that past non-filers subject to automatic revocation don’t get retroactive exemption determinations (and, accordingly, cannot have their tax-exempt status retroactively reinstated unless they establish reasonable cause for the failure to file).

In this year’s annual update (Rev. Proc. 2013-9) of the revenue procedure establishing procedures for granting exemption determination letters, the IRS explains that only a few types of exempt organizations, such as Section 501(c)(3) organizations, have a deadline for filing an exemption application.  This is because many other types of exempt organizations are not actually required to apply to the IRS for recognition of exempt status, although they may voluntarily do so.  When such an organization voluntarily applies to the IRS for recognition of exemption, it has been the IRS’s practice to grant a determination letter recognizing exemption retroactively to the date of formation as long as the organization has always met the applicable requirements, which can be a number of years.  This is demonstrated on the Form 1023, or application for recognition of Section 501(c)(3) status, which asks if the filing organization wishes to ask for retroactive recognition of its status as a Section 501(c)(4) organization if it has missed the Section 501(c)(3) filing deadline.

The IRS has now changed its procedures to conform this practice with the 27-month deadline for filing exemption applications already imposed by Section 508 of the Internal Revenue Code for Section 501(c)(3) organizations, even though there has been no statutory change imposing this limit.  The IRS has also changed its procedures to conform to the PPA prohibition on tax exemption for non-filing organizations.

This makes it more important than ever for any organization that believes it is tax-exempt but has not applied to the IRS for a determination letter recognizing its exemption to do so promptly and to make sure that the necessary Form 990-series return is filed annually and on time. Failure to timely apply can mean generally foregoing the ability to receive a determination letter that recognizes the organization’s exemption retroactively to the date of its formation.  Further, in the event that the organization is ever subject to automatic revocation, the organization will not be able to have its exempt status reinstated retroactively unless it can establish reasonable cause for its failure to timely file the applicable Form 990-series return for three consecutive years.

On December 28, 2012, the Internal Revenue Service released the long-awaited final regulations for Type III supporting organizations, as well as temporary regulations addressing annual distribution requirements.  The text of the temporary regulations also serves as the text of the proposed regulations.  The final regulations describe all of the other requirements (outside of the annual distribution requirement explained below) of a Type III supporting organization’s relationship with its supported organization.

A supporting organization is an organization described in Section 509(a)(3) of the Code.  These organizations achieve their public charity status by providing support to one or more public charities (supported organizations).  Among other requirements, a supporting organization must satisfy a relationship test establishing one of three types of relationships with one or more supported organizations.  As a result, there are three corresponding types of supporting organizations.  A Type III supporting organization is “operated in connection with” one or more supported organizations.

Prior to the enactment of the Pension Protection Act of 2006 (“PPA”), the regulations for Type III supporting organizations provided for a responsiveness test requiring a supporting organization to be responsive to the needs or demands of its supported organization(s), and an integral part test requiring a supporting organization to maintain a significant involvement in the operations of one or more supported organizations that are dependent on the supporting organization for the type of support it provides.

The PPA, among other things, changed the requirements to qualify as a Type III supporting organization by requiring Type III supporting organizations that are “non-functionally integrated” to pay a certain amount to their supported organization(s).  Type III “functionally integrated” supporting organizations, on the other hand, are not required to meet a payout requirement because of their activities related to performing the functions of their supported organizations.

In large part, the final regulations are very similar to the proposed regulations issued in 2009.  Highlights of unchanged provisions include:

(i)     Notification Requirement – Like the 2009 proposed regulations, the final regulations require that, for each taxable year, a Type III supporting organization must provide to each of its supported organizations: (1) a written notice addressed to a principal officer of the supported organization describing the amount and type of support provided to the supported organization; (2) a copy of the supporting organization’s most recently filed Form 990; and (3) a copy of the supporting organization’s governing documents, including any amendments.  The PPA required such notification as required by the IRS, so this requirement is now in effect.

(ii)   Responsiveness Test – The final regulations provide that all Type III supporting organizations must satisfy the ‘‘significant voice’’ responsiveness test by (1) demonstrating one of three necessary relationships between their officers, directors, or trustees and those of their supported organization(s), and (2) showing that this relationship results in the officers, directors, or trustees of the supported organization having a significant voice in directing the use of the income and assets of the supporting organization.

(iii)   Like the 2009 proposed regulations, the final regulations provide that a Type III supporting organization is functionally integrated, and therefore not subject to a distribution requirement, if it either: (1) engages in activities substantially all of which directly further the exempt purposes of the supported organization(s) to which it is responsive by performing the functions of, or carrying out the purposes of, such supported organization(s) and which, but for the involvement of the supporting organization, would normally be engaged in by the supported organization(s); or (2) is the parent of each of its supported organizations.

The regulations make a significant change in the requirements to qualify as a non-functionally integrated Type III supporting organization.  The September 2009 proposed regulations provided that a non-functionally integrated Type III supporting organization would have to annually distribute a “distributable amount’’ equal to 5 percent of the fair market value of its non-exempt-use assets.  The Treasury Department and the IRS decided to base this distribution requirement on non-exempt-use assets, rather than on income, due to concerns that the income-based payout test could result in little or nothing being paid to charity if the supporting organization’s assets produced little to no income.  The provisions in the proposed 2009 regulations regarding the amount that nonfunctionally integrated Type III supporting organizations must annually distribute have thus been significantly revised in response to comments.  Consequently, the temporary and proposed regulations change this requirement to the greater of 85 percent of adjusted net income or 3.5 percent of the fair market value of a supporting organization’s noncharitable use assets.

The final regulations also reserve a provision for a special rule for supporting organizations that support a governmental supported organization.

The regulations are effective as of December 28, 2012.

Interestingly, the preamble to the regulations states that there are certain topics regarding supporting organizations, based on the IRS’s and the Treasury Department’s review of all comments received on the supporting organization regulations, about which we can expect future proposed regulations.  We will have to wait and see exactly what unfolds for supporting organizations.

To read more about supporting organizations, please click here or read previous blog entries on supporting organizations.

Extensions

The Pension Protection Act of 2006 contained several time-limited provisions for favorable tax treatment of certain contributions. These provisions generally expired at the end of 2007 and have been extended several times for two-year periods, most recently in 2010 . Some, but not all, of these provisions are extended by the TRA. Specifically, TRA extends the following through the end of 2013:

• IRA Charity Contribution (Code Section 408(d)(8)(F), permitting a distribution of up to $100,000 tax-free from an IRA to a qualifying charity by those over 70 ½. As in the previous extension, taxpayers have the month of January 2013 to elect to make charitable distributions treated as effective in 2012;

• Contribution of Conservation Easement (Code Section 170(b)(1)(E)(vi)), permitting favorable deductions for donating conservation interests in capital gain real property to charity;

• Contribution of Food Inventory (Code Section 170(e)(3)(C)(iv)), permitting enhanced deductions for contributions of food inventories; and

• Contributions of property by S corporations (Code Section 1367(a)), limiting an S corporation shareholder’s reduction in basis of the S corporation’s stock to a pro rata share of basis (rather than fair market value) of property contributed by the corporation.

However, two provisions for enhanced charitable deductions – contributions of book inventories to public schools and corporate contributions of computer inventory – were not extended. These were in Code Sections 170(e)(3)(D)(iv) and 170(e)(6)(G), respectively.

The TRA also extends the special rule limiting an exempt organization’s taxable income on interest and other payments from controlled corporations to only the amount of payment in excess of fair market value, provided that the contract for the payments was in effect in 2006 (Code Section 512(b)(13)).

Overall Deduction Limitation

After an absence of several years, the overall limitation on itemized deductions – the so-called Pease provision – is back permanently. This will affect charities by reducing high-income individuals’ benefit from charitable contribution deductions. As before, if individuals’ adjusted gross income exceeds a threshold amount, their itemized deduction total will be reduced by the lesser of: 80 percent of otherwise allowable deductions; and 3 percent of adjusted gross income in excess of the threshold amount. This can reduce the amount of a charitable contribution that can be deducted to as little as 20 percent of the contribution amount. Threshold amounts have been almost doubled from the previous levels; thus, no limitation applies for married couples filing jointly with adjusted gross income of up to $300,000. On the other hand, estate tax charitable deductions remain unlimited.

Tax-Exempt Financing

Governmental entities issuing tax-exempt bonds, and Section 501(c)(3) organizations which borrow the proceeds of tax-exempt bonds, were concerned that the tax-free nature of the interest on such bonds would be further limited. These bonds are, of course, an important source of capital for governments and Section 501(c)(3) organizations. The TRA did not impose any additional limitations, but limitations may be considered in further talks about sequestration and spending reductions, or if wholesale tax reform goes forward.

Co-op Health Insurers

The Affordable Care Act, or health reform act, allocated federal funds for grants and loans to a new type of nonprofit cooperative health insurer, to be made before July 1, 2013. Code Section 501(c)(29) provides for tax exemption for such cooperative health insurers but only if they have received a grant or loan under the Affordable Care Act provisions. The TRA rescinded budget authority for grants and loans effective immediately, so organizations that planned to become Section 501(c)(29) organizations but had not yet received a grant or loan will not have this opportunity.