In a previous post, I explained the steps for starting a non-profit in Texas. Those steps included state incorporation (i.e., filing a certificate of formation), adopting bylaws, adopting certain governance policies (e.g., conflict of interest policy), conducting an organizational meeting, and applying for a federal Employer Identification Number.
In this post, I discuss applying for Section 501(c)(3) tax-exempt status. In general, for a non-profit to obtain the IRS’s recognition as a Section 501(c)(3) tax-exempt organization, an IRS Form 1023 application must be filed (or an IRS Form 1023-EZ). Below I explain the nuances of IRS Form 1023.
Why apply for Section 501(c)(3) tax-exempt status?
The Internal Revenue Code (“Code”) classifies non-profits that are organized and operated exclusively for charitable, religious, educational, and scientific purposes as exempt from federal income taxes.[1] Further, a non-profit that is classified as tax-exempt under Section 501(c)(3) is eligible for tax-deductible contributions.[2] To earn this official tax-exempt status, most non-profits must successfully apply using IRS Form 1023.
Non-profits that successfully apply for Section 501(c)(3) recognition receive an IRS determination letter. If IRS Form 1023 is properly filed within 27 months of state incorporation, the IRS determination letter will recognize federal tax exemption effective as of incorporation. If IRS Form 1023 is filed after the 27-month period, then the effectthe date of filing the application.[3]
IRS Form 1023 vs. IRS Form 1023-EZ.
There are two different versions of IRS Form 1023. The standard version is Form 1023, and the expedited version is called Form 1023-EZ. As of January 31, 2020, Form 1023 must be submitted electronically online at Pay.gov.
To be clear, only certain non-profits are eligible to file Form 1023-EZ. The Instructions for Form 1023-EZ provide an Eligibility Worksheet to determine appropriateness of filing Form 1023-EZ. The Eligibility Worksheet asks thirty questions. If the non-profit answers “Yes” to any of the Eligibility Worksheet questions, then that organization is not eligible to apply for exemption under Section 501(c)(3) using Form 1023-EZ. The following are some of the questions asked:
Do you project that your annual gross receipts will exceed $50,000 in any of the next 3 years?
Have your annual gross receipts exceeded $50,000 in any of the past 3 years?
Do you have total assets the fair market value of which is in excess of $250,000?
Are you requesting classification as a private operating foundation?
Are you requesting classification as a supporting organization under Section 509(a)(3)?
In a future post, I’ll dive deeper into the differences between Form 1023 and Form 1023-EZ as well as the pros and cons of each.
User fees.
The user fee for Form 1023 is $600, and the user fee for Form 1023-EZ is $275. The user fees must be paid through Pay.gov when the application is filed.
Who is not required to file IRS Form 1023?
Churches (including synagogues, temples, and mosques) and integrated auxiliaries of churches and conventions or associations of churches may be considered tax-exempt under Section 501(c)(3) without filing Form 1023 (or Form 1023-EZ).[4] Even though these organizations aren’t required to seek recognition of tax-exemption, they may choose to file Form 1023 (or Form 1023-EZ, if eligible) to receive a determination letter stating they are recognized as exempt under Section 501(c)(3) status.
IRS Form 1023, in general.
A completed Form 1023 application details the organization’s legal compliance with Section 501(c)(3) and the organization’s activities. The goal is to draft the application so the IRS agent can read the non-profit’s story and effortlessly understand why the non-profit is tax-exempt under Section 501(c)(3).
Once complete, the application for exemption should include: (i) Form 1023 itself, (ii) supplemental responses to questions within Form 1023, (iii) corporate documents (e.g., certificate of formation and bylaws), (iv) schedules, if necessary, and (v) supporting materials (e.g., conflict of interest policy). If an attorney is submitting the application on behalf of the non-profit, then a Form 2848 power of attorney should be included too.
It’s important to remember that if the IRS approves exempt status under Section 501(c)(3), then the complete Form 1023 and any supporting documents will be open for public inspection. That is another reason why the goal should be a well-prepared and accurate application.
IRS Form 1023 is divided into nine parts.
Part I asks preliminary questions about the name of the nonprofit, its EIN, and the names of officers and directors.
Part II seeks information about the corporation structure. The applicant will attach a file-stamped Certificate of Formation and adopted bylaws to satisfy this Part II.
Part III addresses the corporation’s exempt purpose and the distribution of charitable assets upon the dissolution of the organization. The Instructions to Form 1023 provide examples of acceptable clauses for both the exempt purpose and dissolution requirements. However, I recommend that both clauses include more depth than the basic examples provided in the Instructions.
Part IV is the heart of Form 1023. The first question addresses the organization’s past, present, and planed activities. To answer this question properly, you must explain the following:
What is the activity?
Who conducts the activity?
Where is the activity conducted?
What percentage of your total time is allocated to the activity? (Combined time percentages should add up to 100%.)
How is the activity funded (for example, donations, fees, etc.) and what percentage of your overall expenses is allocable to this activity?
How does the activity further your exempt purposes?
Don’t skimp here! Your narrative description of activities should be specific and accurate. The narrative should focus on the exempt purpose activities, not all activities (e.g., how the board was recruited). To support the narrative, the organization should attach website excerpts, newspaper articles, relevant policies, and any positive publicity it has received.
After completing the narrative description of activities, the applicant must answer additional questions in Part IV of Form 1023. Question 2 asks for an NTEE code. Older versions of Form 1023 did not ask for this. The IRS uses the National Taxonomy of Exempt Entities (NTEE) system to classify nonprofit organizations. The remainder of Part IV seeks confirmation of legal compliance with Section 501(c)(3). There are a series of questions addressing the organization’s activities with members, individuals, and organizations that might receive benefits. Additional questions ask about political campaign intervention and attempts to influence legislation.
Part V is where the non-profit explains compensation and other financial arrangements that could give rise to conflicts of interest. One of the most important decisions a board determines is what constitutes reasonable compensation. The rules for this determination are robust. And the IRS is very interested in conflicts of interest issues, which may arise when an officer/director uses her position to confer special benefits on herself, her family, friends, and others. This is why I recommend that a conflict-of-interest policy is included in the Form 1023 application.
Part VI concerns revenues and expenses that are consistent with the organization’s description in the Form 1023 application. The number of years of financial information required depends on the organization’s incorporation date. If the non-profit existed for less than one year, it must provide projections of its likely income and expenses for the current year and projections of its likely income and expenses for the next two years based on a reasonable and good faith estimate of its future finances for a total of three years of financial information. There is a different rule for organizations that have existed for more than one year but fewer than five years, and a third rule for organizations that have existed for five years or more.
Part VII addresses subclassification under Section 501(c)(3). Organizations that are exempt under Section 501(c)(3) are private foundations unless they are: (i) churches, schools, hospitals, governmental units, entities that undertake testing for public safety, organizations that have brough financial support from the general public, or (ii) organizations that support one or more organization(s) that are themselves classified as public charities. Organizations that meet one of the exceptions above are classified as public charities and those that do not are classified as private foundations. Private foundations are further classified as nonoperating private foundations or private operating foundations. Foundation classification is important because different tax rules apply to the operations of each entity. Interestingly, Form 1023 allows organizations to let the IRS pick the foundation classification for them. I don’t recommend this, but it is an option.
Part VIII addresses the effective date of exemption. As stated above, if IRS Form 1023 is properly filed within 27 months of state incorporation, the IRS determination letter will recognize federal tax exemption effective as of incorporation. If Form 1023 is filed after the 27-month period, then the organization must complete Schedule E.
Part IX addresses whether the non-profit is required to file annual information returns (Form 990, 990-eZ, or Form 990-PF) or notices (Form 990-N, e-Postcard). Most organizations must file one of the above. If an organization claims that it is excepted from filing a Form-990 series return or notice, then the narrative description in Part IV must address the basis for the exception.
Schedules.
Certain applicants may need to complete specific schedules to Form 1023. The following organizations must complete the corresponding schedule:
A church = Schedule A
A school, college, or university = Schedule B
A hospital or medical research organization = Schedule C
A section 509(a)(3) supporting organization = Schedule D
Filing Form 1023 application more than 27 months from the date of formation and/or applying for reinstatement of tax-exempt status after being automatically revoked = Schedule E
A low-income housing organization = Schedule F
A successor to other organizations = Schedule G
An organization providing scholarships, fellowships, educational loans, or other educational grants to individuals and/or a private foundation requesting approval of individual grant procedures = Schedule H
Final thoughts.
In short, applying for tax-exemption under Section 501(c)(3) is a daunting task. There are numerous challenges to overcome to make certain that the organization is legally compliant with Section 501(c)(3). Since the stakes are high, I recommend speaking with an attorney who understands the nuances of IRS Form 1023.
This material is provided for informational purposes only. It is not intended to constitute legal advice nor does it create a client-attorney relationship between the Texas Hospitality and Non-profit Law Center, PLLC and any recipient.
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[1] I.R.C. § 501(c)(3). [2] I.R.C. § 170. [3] The organization must complete Schedule E to IRS Form 1023. [4] The Code does not specifically define the term church. However, courts have defined the term church for tax purposes as involving various factors or characteristics including public worship, shared doctrine, and observance of religious rituals.