Ways To Lose Tax-Exempt Status

There are many ways an organization can lose tax-exempt status. We’ll expand on the most common methods below. If you have questions about your specific situation, please reach out to one of BryteBridge’s specialists, who guide you with the best options for your organization.

Failure to File Tax-Returns (Most Common)

Every nonprofit organization must file a 990-tax return every year with the IRS. This requirement includes the year you formed the organization. The IRS automatically revokes tax-exempt status when a nonprofit fails to file a 990 tax return for three consecutive tax years. Each year the IRS revokes approximately 75,000 nonprofits. Losing 501(C)(3) status can cause irreparable  harm to the organization and lose confidence and support from donors and grantors. 

Operating For Private Benefit

A nonprofit organization is legally required to operate in the best interest of the general public. When a nonprofit organization does not follow this legal obligation, it commits private inurnment. Essentially, whenever a nonprofit organization makes decisions that solely benefit an individual or private company, it violates the legal requirements of the tax-exempt status. When the IRS determines private inurnment, it revokes tax-exempt status.

Whenever a nonprofit starts operating as a for-profit business or makes decisions that benefit selected individuals over the general public, it could be violating private inurnment. Let’s look at a few examples of how organizations operate for personal benefit and risk their tax-exempt status.

Financial Relationships:

Nonprofit organizations often have board members who own or represent for-profit businesses in similar markets. There is nothing wrong with having experts on the board who provide advice and support. However, if the organization begins a financial relationship with that company, things get less clear.

For example, say an organization needs to replace windows in its building. A board member is a building contractor. The organization requests quotes from multiple local contractors for the project. Say the board member’s bid is twice what other companies quote for the same project. If the nonprofit selects the board member’s proposal, it provides a private benefit to the board member’s company. In other words, the organization is not operating to benefit the general public because it overpaid for repair services. 

A nonprofit can conduct business with a board member so long as there is no private benefit. Using this same example, if the board member offered to do the repairs for just the cost of materials, the work does not benefit that person’s business.

Employee Excess:

Nonprofits often provide additional services to their employees. These might be continuing education, conference travel, or other expenses related to the employee’s duties. While nothing is out of the norm with these benefits, things change when the charges become excessive.

For example, a nonprofit may send a program staff member to a national conference for continuing education. The out-of-state conference requires a flight and hotel stay. The conference location is a mid-priced hotel with discounts for nonprofit employees.

Suppose the nonprofit chooses to send the employee on a first-class flight and book a different, much more expensive hotel. In that case, it could be providing a personal benefit.

There are sometimes legitimate reasons for choosing a more expensive hotel and flight. Perhaps the organization waited too long to book travel, and discounted rooms were no longer available. However, if a nonprofit spends money on elaborate travel, it provides a private benefit to the employee.

Other employee excesses may include spending unreasonable amounts of money on personal office decorations or reimbursement expenses.

Volunteer Excesses:

Similar to employee excesses, when nonprofits flush their volunteers with luxury excesses, it can cross the line into private inurnment. While it is crucial to appreciate volunteers, providing them with expensive thank-you gifts is generally not in the public’s best interest.

For example, say a nonprofit wants to show appreciation to its volunteers. Instead of a thank-you dinner, they put together customized gift baskets with hundreds of dollars in gift cards and products purchased by the nonprofit. Not only is this an example of private benefit, but the IRS considers gift cards given to volunteers as taxable wages.

Personal Expenses:

Whenever a nonprofit starts spending money for an employee, volunteer, or board member’s expenses, it commits private inurnment.

For example, a nonprofit founder is renovating their home and runs short on cash. Instead of placing the contractor charge on a personal credit card, the founder charges the nonprofit card. This example is a flagrant violation of private inurnment.

Supporting Politicians or Legislation

Generally, nonprofit organizations cannot make political donations of any kind. Some exceptions exist for 501(c)(4) social welfare groups, but these exceptions are scarce.

Essentially, donations to support or oppose individual candidates, political issues, or ballot initiatives risk a nonprofit organization’s tax-exempt status.

A nonprofit can advocate politically in general terms. They do not advocate for individual parties or candidates. For example, Rock the Vote is a nonprofit organization that encourages people to register to vote.

Some nonprofits advocate for policy changes that may affect the systemic issues their clients face. For example, a homeless services organization may advocate for broader laws governing affordable housing and wages. This advocacy is generally acceptable if the organization does not spend more than 10% of its time and resources on advocacy and does not support or oppose specific candidates and legislation.

Not Reporting UBIT

Unrelated Business Income Tax (UBIT) comes into play whenever a nonprofit has $1,000 or more in annual trade not directly related to the organization’s exempt purposes.

For example, a nonprofit art school may sell art supplies or artwork to help fund the operations. These sales are related to the exempt purpose. However, suppose the same organization began renting extra space in its building to a doctor’s office. In that case, the rental income is unrelated business income.

When a nonprofit receives unrelated business income, it must pay income tax (UBIT) on that income. Reporting UBIT requires a specialized 990-T, which we’ll cover later in this guide.

Operating Bingo/Games of Chance Without a License

Many nonprofit organizations raise funds with bingo or other games of chance. Otherwise known as gambling, there are special rules that govern this income. Failure to comply with federal and state laws puts a nonprofit’s tax-exempt status at risk.

All income from gambling (except for what the IRS calls “traditional bingo”) is considered unrelated business income and requires UBIT reporting and taxation. Additionally, people cannot deduct money given to a nonprofit organization for gambling-related fundraisers.

Beyond the reporting requirements, many states require specialized licenses for charitable gambling activities. Iowa, for example, requires a license application no fewer than 30-days before promoting any gambling-related activities. If the organization does not apply for the license, it is subject to penalties and potential taxes.