New Year’s Nonprofits: Resolve to be Patient While Waiting for Tax-Exempt Status

by Farella Braun + Martel LLP
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The start of a New Year brings about a flurry of charitable planning. Frequently, new nonprofits are formed to support year-end charitable gift tax planning or to prepare for a January 1 start date to begin new charitable operations. New nonprofits must factor into their timeline the IRS Exemption Application review process, which is currently so backlogged that careful attention to minor details in the Exemption Application can mean the difference between ringing in the New Year with exempt status obtained in the first quarter of 2014, or waiting until the close of 2015 for exempt status.

IRS Exemption Application Review Process
When the IRS receives an Exemption Application, it conducts an initial review and assigns the Exemption Application to one of four categories: 

  1. Can be approved immediately based on the information submitted
  2. Needs minor additional information to be approved
  3. Submitted obsolete forms or does not include the items specified on the Procedural Checklist
  4. Requires additional development

If an Exemption Application falls within one of the first three categories, the applicant nonprofit should receive a Determination Letter granting tax-exempt status, or a letter requesting additional information within 90 days of the date the Exemption Application is filed.  

However, if an Exemption Application falls within the fourth category,  there is currently a 19-month wait before the application is assigned to an agent for development.  Once assigned, there are no time estimates on how long it will take for an Exemption Application to be developed and approved, as agents have a backlog of other applications they are already working on, despite the 19-month wait.   

Exemption Applications may require “development” for any number of reasons, such as charitable activities that are not clearly described, activities that do not appear charitable, or nonprofits with activities for which the IRS does not have clearly defined policies in place, such as the recent difficulty surrounding 501(c)(4) social welfare organizations.  Additionally, Exemption Applications that only require minor additional information can be relegated to the fourth category as needing “additional development,” resulting in a 19-month wait. 

IRS Guidance on Exemption Application Review Process
On September 30, 2013, the IRS released interim guidance on initial classification of Exemption Applications.  This interim guidance does not appear likely to speed up the process; indeed the wait time has increased (up from 18 months) since this guidance was published.  Now, merely getting an Exemption Application assigned to one of the four categories described above involves both an IRS classifier and a specialty group manager, who may agree or disagree with the assignment and classification.  Once this initial classification is resolved, there is now a secondary screening by a designated specialty group (based on type of nonprofit organization) to confirm that the application meets the technical requirements of a specialty case.  This is done to insure that Exemption Applications are not reviewed by the wrong specialty group. 

Timing Considerations
When the Exemption Application is filed within 27 months of the date the new nonprofit is formed (i.e., the Articles of Incorporation are filed with the Secretary of State or the trust instrument is executed and funded), the nonprofit’s tax-exempt status is retroactive and effective as of the date of formation.  This means that nonprofits formed in December of 2013 are effectively treated as tax-exempt as of that date, even if the Determination Letter approving tax-exempt status is not issued until September of 2015 (assuming a 19-month wait).  Regardless of retroactivity, waiting almost two years for a Determination Letter causes numerous problems for most nonprofits, particularly those relying on public support or donations from donor advised funds, where a Determination Letter is generally required to demonstrate tax-exempt status.  

Currently the only way to protect against the two-year delay is careful preparation of the Exemption Application in an attempt to prevent being relegated to the dreaded fourth category of “applications requiring development.”  It is extremely important that new nonprofits spend the time and effort to make sure that the application is thorough, complete, and anticipates the types of questions the IRS is likely to ask.  If anything important is left out or overlooked, even if relatively minor, the organization will have to wait nearly two years to make the correction or fill in the missing details.  

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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