• Massive Loss of Tax Exemptions Looming
  • May 14, 2010 | Author: Jeffrey S. Tenenbaum
  • Law Firm: Venable LLP - Washington Office
  • The Internal Revenue Service is cleaning out its files.  As reported by the New York Times,1 at midnight on May 12, 2010, an estimated 400,000 charities, associations and other nonprofit organizations are expected to lose their tax-exempt status.  This is not a result of any overt action by the IRS; rather it is due to section 1223 of the Pension Protection Act of 2006 (the “Pension Protection Act”).2

    The Pension Protection Act expanded the annual IRS filing requirements for tax-exempt organizations to include virtually all such organizations.3  Previously, information returns were only required for organizations with gross receipts of $25,000 or more.  The Pension Protection Act also added a provision to the Internal Revenue Code that automatically revokes the tax-exempt status of an organization required to file an annual return that fails to do so for three consecutive years.

    The purpose of the filing requirement is to allow the IRS to get a clearer picture of the vast landscape of tax-exempt organizations.  As such, even organizations that consider themselves to be inactive are required to file returns.4  The automatic revocation provision is effective for all tax periods beginning on or after January 1, 2007.  As such, the three-year tax period for organizations that use a calendar year as their fiscal year ends on May 15, 2010, a Saturday, and required forms are due the next business day, May 17, 2010.  Failure to file the required information by this quickly-approaching deadline may result in an automatic revocation, effective as of May 17, 2010.

    Consequences of Revocation

    Revocation of tax-exempt status has several severe consequences.  First, an organization that has its exemption revoked may be required to file either Form 1120, U.S. Corporation Income Tax Return, or the Form 1041, U.S. Income Tax Return for Estates and Trusts, and pay tax on its net income.  Note that the automatic revocation provided for by the Pension Protection Act is not retroactive - it would be effective as of the required filing date for the third-year tax period (May 17, 2010 for calendar-year fiscal years) - but if a new tax-exemption application was not filed with the IRS that same day, there could be a gap period during which the organization may be treated as a taxable entity, particularly if it was exempt under Section 501(c)(3).  (This is because 501(c)(3) entities can only be recognized as exempt by filing Form 1023 with the IRS, while certain other types of exempt organizations, such as 501(c)(6) entities, can be exempt merely by effectively satisfying the tax code's organizational and operational requirements.)

    Also, if revoked, a 501(c)(3) organization will lose its ability to receive tax-deductible charitable donations.  Additionally, these organizations will be removed from Publication 78, Cumulative List of Organizations Described in Section 170(c) of the Internal Revenue Code of 1986.

    The name of every organization whose tax-exempt status has been revoked will be published as an announcement in the Internal Revenue Bulletin and included in a list of revoked organizations posted on the IRS website.  This list will be available to the public and will likely draw the attention of state charity and tax officials.  Additionally, the Internal Revenue Service will notify each organization by sending revocation letters to those organizations whose exempt status is automatically revoked.
    Late Filings

    Organizations that fail to timely file the Form 990 or Form 990-EZ can be assessed a monetary penalty of up to $20 per day (or up to $100 per day for organizations with gross receipts of $1,000,000 or more).  The Form 990-N, the electronic postcard, cannot be filed from the IRS website after the reporting period for the current tax year ends.  Alternatively, the organization could purchase software from an independent vendor that allows for late Form 990-N filings.  There is no monetary penalty assessed for not filing the electronic postcard (subject to the caveat below), and organizations might therefore be better off waiting for the next tax year to file.  If an organization fails to file the required information return (Form 990, Form 990-EZ, or Form 990-N) for three consecutive years, however, the automatic revocation provision will kick in and the organization would lose its tax-exempt status instantly as soon as the third-year’s filing is a day late.  There is no grace period and the IRS has no ability to delay, reconsider or reverse the revocation; prospective-only re-application with the IRS for recognition of tax-exempt status is the only option available.  The re-application, if and when approved, would only be effective from the date of filing of the re-application; it would not be retroactive.
    Group Exemptions

    Organizations covered under a group exemption also may be at risk of losing their tax-exempt status.  If the parent or central organization fails to file its own information return for the previous three years, the group exemption is dissolved and subordinate organizations will no longer be recognized as tax exempt.  Additionally, if the parent or central organization does not file a group return on behalf of the subordinate organizations for three consecutive years, the subordinate organizations will be revoked, provided they have not filed their own information returns for three consecutive years.  (A group return is a Form 990 with all of the subordinates’ information aggregated together, filed by the parent or central organization, and not including the parent or central organization’s information.)  Note that the annual IRS filing required of the parent or central organization in connection with group exemptions is separate and distinct from the information return filing requirement.  All subordinate organizations must either file their own individual information returns or be included in a group return in order to avoid revocation under the new three-year rule.

    If an organization is revoked for failure to file the required information returns, there is no shortened reinstatement process.  Instead, the Pension Protection Act specifies that to be reinstated as a tax-exempt organization, the organization must re-apply for tax-exempt status by filing the appropriate IRS application for recognition of tax-exempt status form (Form 1023 or Form 1024).  Note that if the application is approved, it generally will only be retroactive to the date of the filing of the application; in most cases, this means there will be a significant period of time for which the entity will be treated as taxable and not exempt.  Each application must be accompanied by the appropriate user fee depending on the organization’s expected gross revenue.  Because the process for applying for recognition of tax-exempt status can be both time-consuming and expensive, it will be much easier and less expensive for organizations to meet the filing obligations provided by the Pension Protection Act.

    Avoiding Revocation

    Automatic revocation can be avoided, and there is still time to file an information return.  Forms are due by the 15th day of the fifth month after the close of the organization’s fiscal year (May 17, 2010 for organizations that use a calendar year).  Filing is especially easy for organizations with gross receipts of less than $25,000, as they only need to fill out an online postcard, Form 990-N.  Organizations with gross receipts of more than $25,000 are required to file either Form 990 or Form 990-EZ.

    Additionally, an organization that needs additional time to prepare its Form 990 can request an automatic three-month extension by filing Form 8868, Application for Extension of Time to File an Exempt Organization Return, before the due date for the Form 990.  An additional three months can requested, for a total extension time of six months, if the organization can show reasonable cause for the delay in filing.  Please note that extensions do not apply to Form 990-N, the online postcard.  As such, organizations that request additional time will be required to file the longer Form 990 or Form 990-EZ.

    Additional resources on the new filing requirements and automatic revocation are available at the following links:

    1 Stephanie Strom, “One-Fourth of Nonprofits Are to Lose Tax Breaks,” New York Times, April 22, 2010.
    2 The Pension Protection Act of 1996, Pub. L. No. 109-280.
    3 Some organizations such as churches and governmental units remain exempt from filing information returns.  See 26 U.S.C. §60339(a)(3)(j) (2009).
    4 If an organization with gross receipts of less than $25,000 ceases operations, it must file notice with the Internal Revenue Service.  See 26 C.F.R. § 6033(i)(2).