Tax-Exempt Organizations
Introduction
Tax-exempt organizations — primarily those described in IRC §501(c)(3) — play a significant role in the U.S. tax system. The TCP exam tests your ability to recall the requirements for obtaining and maintaining tax-exempt status, identify events that can cause an organization to lose its exemption, and understand the unrelated business income tax (UBIT) rules that apply when an exempt organization engages in commercial activities outside its exempt purpose. While the depth of coverage is narrower than other entity types, the concepts are testable and frequently appear in multiple-choice questions.
Obtaining Tax-Exempt Status Under IRC §501(c)(3)
Organizational and Operational Tests
To qualify for tax-exempt status under §501(c)(3), an organization must satisfy both an organizational test and an operational test.
| Test | Requirement |
|---|---|
| Organizational test | The organization's articles of incorporation (or trust instrument/articles of association) must limit its purposes to one or more exempt purposes and must not expressly empower the organization to engage in activities that are not in furtherance of exempt purposes (other than an insubstantial part) |
| Operational test | The organization must be operated exclusively for one or more exempt purposes — in practice, this means the organization's primary activities must further its exempt purposes |
Exempt Purposes
IRC §501(c)(3) organizations must be organized and operated exclusively for one or more of the following purposes:
| Exempt Purpose | Examples |
|---|---|
| Religious | Churches, synagogues, mosques, religious orders |
| Charitable | Organizations that relieve poverty, advance education, or promote social welfare |
| Scientific | Research organizations operating in the public interest |
| Educational | Schools, colleges, museums, public libraries |
| Literary | Organizations that promote literature and literacy |
| Testing for public safety | Product-testing organizations |
| Fostering amateur sports | Amateur athletic organizations (not providing athletic facilities or equipment) |
| Prevention of cruelty to children or animals | Humane societies, animal rescue organizations |
Application Process
| Step | Detail |
|---|---|
| Form 1023 | Standard application for §501(c)(3) status |
| Form 1023-EZ | Streamlined application for smaller organizations meeting specific requirements |
| Filing deadline | Must file within 27 months of formation to receive retroactive exemption to the date of formation |
| IRS determination letter | Formal recognition of tax-exempt status |
While a §501(c)(3) organization is exempt from federal income tax on income related to its exempt purpose, it is still subject to tax on unrelated business taxable income (UBTI) — discussed below.
Benefits of §501(c)(3) Status
| Benefit | Description |
|---|---|
| Income tax exemption | Organization is exempt from federal income tax on income related to its exempt purpose |
| Deductible contributions | Donors may deduct contributions to the organization (subject to AGI-based limitations) |
| State and local tax exemptions | Many states provide property tax, sales tax, and income tax exemptions |
| Access to tax-exempt financing | May issue tax-exempt bonds for qualifying purposes |
| Postal rate discounts | Eligible for reduced postal rates |
Maintaining Tax-Exempt Status
Prohibited Activities
Certain activities will jeopardize or result in the loss of tax-exempt status:
| Prohibited Activity | Consequence |
|---|---|
| Private inurement | No part of the organization's net earnings may inure to the benefit of any private shareholder or individual (insiders) — excessive compensation, below-market rentals to insiders, or personal use of organization assets |
| Substantial lobbying | A §501(c)(3) organization may not devote a substantial part of its activities to attempting to influence legislation (lobbying); organizations may elect to be governed by specific expenditure limits under §501(h) |
| Political campaign activity | A §501(c)(3) organization is absolutely prohibited from participating or intervening in any political campaign on behalf of (or in opposition to) any candidate for public office — this is a bright-line rule |
| Private benefit | Organization must serve a public rather than a private interest — activities primarily benefiting designated private individuals can jeopardize status |
| Non-exempt activities | If more than an insubstantial part of the organization's activities does not further exempt purposes, exemption may be revoked |
Political campaign activity is the only prohibited activity with a zero-tolerance standard. Even a single instance of campaign intervention — endorsing a candidate, making campaign contributions, or publishing statements for or against a candidate — can result in loss of exempt status.
Excess Benefit Transactions (Intermediate Sanctions)
Under IRC §4958, the IRS may impose excise taxes on "disqualified persons" (insiders such as officers, directors, and key employees) who receive excess benefit transactions from a §501(c)(3) or §501(c)(4) organization, rather than revoking the organization's exempt status entirely.
| Tax | Rate |
|---|---|
| Initial tax on disqualified person | 25% of the excess benefit |
| Additional tax (if not corrected) | 200% of the excess benefit |
| Tax on organization manager who knowingly approved the transaction | 10% of the excess benefit (up to $20,000 per transaction) |
Example: The executive director of a §501(c)(3) educational organization receives compensation of $500,000 when comparable positions pay $300,000. The $200,000 excess benefit is subject to a 25% excise tax ($50,000) on the executive director. If not corrected (by repaying the excess), an additional 200% tax ($400,000) applies.
Intermediate sanctions (§4958) provide an alternative to revoking exempt status. The IRS uses them as a "scalpel rather than a sledgehammer" — penalizing the individual who received the excess benefit rather than punishing the entire organization and its mission.
Annual Filing Requirements
| Form | Who Files |
|---|---|
| Form 990 | Tax-exempt organizations with gross receipts ≥ $200,000 or total assets ≥ $500,000 |
| Form 990-EZ | Organizations with gross receipts < $200,000 and total assets < $500,000 |
| Form 990-N (e-Postcard) | Organizations with gross receipts normally ≤ $50,000 |
| Form 990-T | Filed to report and pay tax on unrelated business taxable income |
Failure to file Form 990 (or 990-EZ or 990-N) for three consecutive years results in automatic revocation of tax-exempt status. Reinstatement requires filing a new application.
Unrelated Business Income Tax (UBIT)
Overview
Even though a §501(c)(3) organization is exempt from tax on income related to its exempt purpose, it must pay tax at regular corporate rates on unrelated business taxable income (UBTI) — income from a trade or business that is:
- Regularly carried on, and
- Not substantially related to the organization's exempt purpose
The rationale is to prevent tax-exempt organizations from having an unfair competitive advantage over taxable businesses in commercial activities.
Three-Part Test for UBTI
| Element | Requirement |
|---|---|
| Trade or business | The activity must constitute a trade or business (selling goods or performing services) |
| Regularly carried on | The activity is conducted with a frequency and continuity comparable to similar commercial activities of taxable entities (an annual weekend fundraiser is generally not "regularly carried on") |
| Not substantially related | The activity does not contribute importantly to the accomplishment of the organization's exempt purpose (the fact that income is used for exempt purposes is not enough) |
All three elements must be present for the income to be UBTI.
Example: Bear Co. Museum (a §501(c)(3) educational organization) operates a gift shop selling art books and educational materials related to its exhibits. This income is substantially related to the museum's educational purpose and is not UBTI. However, if the museum also sells unrelated branded apparel and novelty items on an ongoing basis, that income may be UBTI.
Types of Income Generally Excluded from UBTI
Even if an activity meets the three-part test, certain types of passive income are specifically excluded from UBTI:
| Excluded Income | IRC Section |
|---|---|
| Dividends | §512(b)(1) |
| Interest | §512(b)(1) |
| Annuities | §512(b)(1) |
| Royalties | §512(b)(2) |
| Rents from real property | §512(b)(3) (rents from personal property are excluded only if incidental — ≤ 10% of total rent) |
| Capital gains from sale of property | §512(b)(5) |
| Income from research | §512(b)(7)–(9) (research performed for the government, or by a college/university/hospital) |
The passive income exclusions have important exceptions. For example, debt-financed property income is partially UBTI under §514 — if the organization borrows to acquire investment property, a proportionate share of the income is taxable. Similarly, rents from personal property are generally not excluded unless they are incidental to a real property lease.
Other Specific Exclusions
| Exclusion | Description |
|---|---|
| Volunteer labor | Income from a trade or business in which substantially all the work is performed by volunteers |
| Convenience of members | Income from a trade or business carried on by a §501(c)(3) organization primarily for the convenience of its members, students, patients, officers, or employees (e.g., a university cafeteria) |
| Donated merchandise | Income from the sale of donated goods |
| Qualified sponsorship payments | Payments where there is no arrangement or expectation of a substantial return benefit (e.g., corporate sponsor name/logo without qualitative advertising) |
| Bingo games | Legal bingo games in jurisdictions where not ordinarily carried on for profit |
Computing UBTI
| Component | Calculation |
|---|---|
| Gross unrelated business income | Revenue from all unrelated business activities |
| − Directly connected deductions | Expenses directly attributable to carrying on the unrelated business |
| − Specific deduction | $1,000 (reduces UBTI; if UBTI before the deduction is ≤ $1,000, no tax is owed) |
| = Unrelated Business Taxable Income (UBTI) | Subject to tax at regular corporate rates (21%) |
Example: Illini Entertainment Foundation (a §501(c)(3) organization) operates a parking garage that generates $150,000 of revenue and $90,000 of directly connected expenses. The parking garage is not substantially related to the foundation's exempt purpose and is regularly carried on. UBTI = $150,000 − $90,000 − $1,000 = $59,000, taxed at 21% = $12,390.
Debt-Financed Property
When a tax-exempt organization acquires property using borrowed funds, a portion of the income from that property (and any gain on disposition) is treated as UBTI, even if the income would otherwise be excluded as passive income.
| Concept | Rule |
|---|---|
| Debt-financed property | Any property held to produce income for which there is acquisition indebtedness at any time during the year |
| Percentage taxable | The percentage of income treated as UBTI equals the average acquisition indebtedness / average adjusted basis of the property (the "debt-financed percentage") |
| Gain on sale | The same debt-financed percentage applies to gain on disposition |
Example: Kingfisher Industries Charitable Foundation (§501(c)(3)) purchases an office building for $1,000,000, financing $600,000 with a mortgage. Rental income is $100,000. The debt-financed percentage = $600,000 / $1,000,000 = 60%. UBTI from the rental = 60% × $100,000 = $60,000 (even though real property rents are normally excluded from UBTI).
Siloing Rule
Under the Tax Cuts and Jobs Act, UBTI from each unrelated trade or business must be calculated separately — losses from one unrelated business cannot offset income from a different unrelated business for UBTI purposes. Each activity is "siloed."
The siloing rule prevents exempt organizations from using losses from one commercial activity to shelter UBTI from another. Each unrelated trade or business must be independently evaluated for UBTI purposes.
Summary
| Topic | Key Concept |
|---|---|
| §501(c)(3) requirements | Must pass organizational and operational tests; organized for religious, charitable, scientific, educational, or other exempt purposes |
| Application | Form 1023 (or 1023-EZ); file within 27 months for retroactive exemption |
| Private inurement | Net earnings may not inure to the benefit of insiders — excessive compensation or sweetheart deals prohibited |
| Lobbying | May not devote a substantial part of activities to lobbying (may elect expenditure test under §501(h)) |
| Political campaign activity | Absolutely prohibited — zero tolerance; any participation can cause loss of exempt status |
| Intermediate sanctions (§4958) | 25% excise tax on excess benefit to disqualified person; 200% if uncorrected; 10% on approving manager |
| Annual filing | Form 990/990-EZ/990-N required; 3 consecutive years of non-filing = automatic revocation |
| UBTI three-part test | Trade or business + regularly carried on + not substantially related to exempt purpose |
| Excluded passive income | Dividends, interest, annuities, royalties, real property rents, capital gains |
| Excluded activities | Volunteer labor, convenience of members, donated merchandise, qualified sponsorship payments |
| UBTI computation | Gross UBI − directly connected deductions − $1,000 specific deduction = UBTI (taxed at 21%) |
| Debt-financed property | Income from debt-financed property is proportionally UBTI (debt / basis percentage) |
| Siloing rule | UBTI calculated separately per business; losses from one cannot offset income from another |