More than 100 501(c)(3) organizations lose their exempt status every year, according to the Nonprofit Risk Management Center. The Internal Revenue Code section 501(c)(3) is a provision in the federal tax code, which allows certain nonprofit organizations, including charities, churches, educational institutions and other organizations that meet the requirements to be exempt from certain taxes. The IRS regulates and regularly reviews exempt organizations to ensure that they are following the regulations and that the organization continues to do the work that led to its exempt status. Failing to follow the guidelines can lead to fines and, in some cases, the loss of 501(c)(3) status.
Generally, 501(c)(3) organizations may not participate in any political or substantial lobbying activity. Specifically, they may not make contributions to political campaign funds nor promote a particular candidate for office. Lobbying, or attempting to influence legislative activity, is only allowed if the expenditures are under a certain amount based on the size of the organization. To ensure that political activities will not put the organization in danger of losing exempt status, charities may file Form 5768, which allows the organization to spend a portion of their funds on lobbying; the organization may have to pay excise tax on expenditures that are more than a certain amount.
The 501(c)(3) organization's activities and income must be focused on the purpose as reported to the IRS. In other words, if your organization's exemption is based on the purpose of providing clothing to homeless people, your activities and income must focus on that purpose. If instead, you use donated funds to pay exorbitant salaries while failing to help any homeless people, you will likely lose your tax-exempt status. Similarly, if you decide to use your funds to provide college scholarships to your local high school, although it is also a charitable activity, you may put your exempt organization in jeopardy if you do not first notify the IRS that you are changing the focus of the organization.
Inurement or Personal Benefit
Inurement, which occurs if a shareholder or other insider receives personal benefits from the organization, is strictly prohibited for 501(c)(3) organizations. For example, the nonprofit may not sell property of the organization to a board member for less than the fair market value, nor may a shareholder receive free services from the nonprofit that others pay for. Employees and directors can, however, receive reasonable compensation for work completed, but exorbitant salaries would likely violate the rule.
Unrelated Business Income
Although all organizations need some income to operate, exempt organizations may not have substantial, unrelated business income. This includes money made from activities that are not related to the organization's purpose, such as renting out office space or selling merchandise. The majority of the organization's efforts must go to the exempt purpose of the organization, but some unrelated business income is permitted. Typically, exempt organizations must pay taxes on unrelated business income and report the income on Form 990-T, Exempt Organization Business Income Tax Return.
Reporting and Taxes
Generally, the IRS requires exempt organizations to file an annual report. However, certain exempt organizations, including churches and some nonprofits with very small budgets, are not required to do so. The state where the organization is located may also require the organization to file reports annually or biannually. Although 501(c)(3) organizations are exempt from certain taxes, many nonprofits must pay employment tax, excise tax, unrelated business income tax, as well as state and local taxes.