The tax-exempt sector employs 29% of the American workforce and controls nearly $53 trillion in assets according to IRS statistics. Tax-exempt organizations also account for about 26% of the $1.5 trillion in federal tax expenditures (revenue losses due to tax-exempt status). Recognizing this large financial impact, governing authorities require nonprofits and their leaders to navigate complex tax rules to retain their federal tax-exempt status. Read more to learn about recent key developments impacting the tax-exempt sector.
Internal Revenue Service Updates
Overall Staffing. The IRS continues to experience staffing constraints agencywide. For example, the number of revenue agents (employees who handle examinations) has fallen from 13,879 in 2010 to 8,307 employees in pay status as of Sept. 30, 2022. While there have been technology advances since 2010, it is not surprising that, with decreased staffing, the IRS examined only 0.49% of individual returns and 0.84% of corporation returns filed in the past fiscal year. Over 78.6% of such audits were conducted by correspondence exam as opposed to office or field audits. This continues the more recent trend of a very low level of exam coverage across all taxpayers.
IRS Appeals has faced similar staffing troubles, with only 980 employees in pay status as of Sept. 30, 2022. On the customer service front, the IRS received 46,934,303 customer service telephone calls in fiscal year 2022 but was able to answer only 13,295,428 live calls (17.4%). As of Aug. 5, 2023, IRS had 1.71 million unprocessed individual tax returns. These include tax year 2022 returns, 2021 returns that need review or correction, and late-filed prior year returns. The IRS also has 1.14 million unprocessed Forms 1040-X. As of Aug. 10, 2023, the IRS had 1.8 million unprocessed Forms 941 and 505,000 unprocessed Forms 941-X. While the IRS is working diligently to clear the backlog, it also faces constant new filing submissions, including the upcoming Sep. 15 and Oct. 15 income tax return extended deadlines for calendar-year taxpayers.
TE/GE Division Staffing. In fiscal year 2022, the IRS Tax Exempt and Government Entities Division, which oversees all nonprofits, continued its recent trend of hiring additional staffing (183 people) and ended the fiscal year with 1,513 permanent staff members. With the influx of Inflation Reduction Act funds, this division anticipates hiring more staff in FY 2023. The additional staffing continues to be necessary to process the large number of initial applications for recognition as a tax-exempt organization described in Internal Revenue Code Section 501, public charity and private foundation status determinations, and private foundations’ advance approval of scholarship grant procedures. Throughout the fiscal year, the IRS closed 136,708 determinations, including 119,928 approvals. Of those, 115,506 were for approvals of Section 501(c)(3) exempt status. Interestingly, only around 59 Section 501(c)(3) applications for exempt status were disapproved.
As of April 28, 2023, the IRS Exempt Organizations (EO) Division stated that the average age of open inventory for review was 23 days for Form 1023-EZ and 87 days for Form 1023. As of Sept. 1, 2023, the IRS had yet to assign applications submitted after the postmark dates below to specialists for review:
- Form 1023-EZ filed by Aug. 5, 2023
- Form 1023 filed by Dec. 7, 2022
- Form 1024 filed by Feb. 27, 2023
- Form 1024-A filed by Jan. 6, 2023
- Form 8940 filed by Jan. 5, 2023
EO Examinations. In addition to reviewing determination letter requests, the IRS received last fiscal year over 1,750,000 exempt organization returns and payments of $1,402,525,000 for unrelated trade or business income tax. The IRS started 3,009 examinations and closed 3,425 examinations with 77.5% resulting in a tax change. During this time, the IRS proposed revocations of 53 tax-exempt entities due to issues including Chapter 42 taxes, backup withholding, foundation status, filing requirement, unrelated trade or business income, and the failure to meet the organization and operational tests under Internal Revenue Code Section 501(c)(3). Note: The most prominent issues found in closed compliance strategy examinations relate to employment taxes, operational requirements and self-dealing.
Clients routinely ask what causes a taxpayer to be selected for examination. While the IRS considers many factors before starting an examination of a nonprofit, the IRS has highlighted a few areas that can increase the chances:
For the upcoming fiscal year, the IRS announced its plans to focus on the following compliance strategies for nonprofits:
Electronic Filing. In the past couple of years, the IRS has pushed the entire tax-exempt sector to electronically file Forms 990, 990-PF, 990-T and 4720. If an organization historically paper-filed without using a tax return preparer, the organization has had to find access to software to transmit its 990 series returns or engage a third-party return preparer. In addition to tax return submissions, as of Sep. 1, 2023, Forms 1023, 1023-EZ, 1024-A, 1024 and 8940 must be filed online through www.pay.gov. The user fee for Form 1023-EZ remains set at $275 and for Forms 1023, 1024-A and 1024, the fee is $600. There are various fees associated with Form 8940. Note: Organizations that intend to operate as social welfare organizations under Internal Revenue Code Section 501(c)(4) must electronically file a notice (Form 8976) with the IRS within 60 days of formation. More information can be found on the IRS website.
Reporting Compensation on Forms 990 and 990-PF. Payments to management companies, leasing companies and professional employer organizations must be reported as compensation on Form 990 and 990-PF for the services of the exempt organization’s own common law employees — as defined under federal law, not state law — instead of showing a lump-sum payment to the third-party organization. The revised form instructions reference IRS Announcement 2021-18, which clarifies that Form 990 filers can no longer rely on prior guidance to deviate from the Form 990 instructions about compensation reporting.
Changes to Form 8940. Exempt organizations must use Form 8940 (i) to notify the IRS of the intent to terminate private foundation status under § 507(b)(1)(B) and (ii) for a voluntary termination of Section 501(c)(3) recognition by a government entity.
Changes to Form 4720. The IRS revised the instructions to this form to emphasize Section 4960 compensation excise tax reporting and to clarify that the filing organization should report only its own Section 4960 excise tax information, not a disqualified person's excise tax information. Also, the revised instructions provide reminders that (i) private foundations must not pay a disqualified person's excise tax, as such payment would be prohibited self-dealing; and (ii) a foundation manager who participated in a private foundation's investment knowing that it was a jeopardizing investment under IRC Section 4944 must complete a separate Form 4720 to report and pay the manager's separate excise tax. Finally, the instructions now clarify that, although the filing organization should report the tax on a disqualified person's excess benefit transaction in Schedule I, it should neither report that tax on Part II of the core Form 4720 nor pay that tax.
Update on NIL Collectives. The IRS issued guidance addressing organizations that develop paid name, image and likeness (NIL) opportunities for college student-athletes. With NIL opportunities drastically increasing in recent years, the IRS has seen an influx of filings by NIL collectives seeking recognition as a tax-exempt organization under Section 501(c)(3). The purpose of this IRS guidance was to outline that in many cases NIL collectives would not qualify for tax exemption under Section 501(c)(3) because the private benefit they confer to student-athletes is not incidental to any exempt purpose or public interest.
The IRS outlined its concern that many NIL collectives do not operate exclusively for an exempt purpose. Instead, the paid NIL opportunities they provide for student-athletes serve non-incidental private interests because student-athletes are not a recognized charitable class, compensation does not further educational purposes, and opportunities are not awarded based on financial need. Finally, some NIL collectives pay 80% to 100% of contributions to student-athletes, so the private benefit in those cases is not quantitatively incidental. The IRS has not addressed what action, if any, it will take against NIL collectives that received determination letters recognizing their organizations as charities before the recent guidance. However, it would not be surprising if the IRS examined these organizations, which likely will result in most losing their exempt status. Donors to tax-exempt NIL collectives should be very cautious.
Substantiation of Cryptocurrency Charitable Donations. In January 2023, the IRS published guidance confirming that no charitable deduction for donations of cryptocurrency over $5,000 will be allowed unless substantiated by qualified appraisal, because cryptocurrency is treated as property, not cash, and does not meet the definition of a security. Further, price quotation from a cryptocurrency exchange (such as FTX) is not sufficient, without a qualified appraisal, to determine the value of the donation. Similar to the IRS position on other property contributions, the IRS will not grant relief on the basis of reasonable cause for noncompliance with the qualified appraisal requirement.
SECURE 2.0 was signed into law Dec. 29, 2022. For more information, see McGuireWoods’ May 15, 2023, legal alert.
The Charitable Act. Senate Bill 566 was introduced earlier this year to address the ability to claim above-the-line charitable deductions for those taxpayers who do not report itemized deductions. For 2021, each taxpayer was permitted to claim a deduction of up to $300 ($600 if filing jointly) for contributions made even if the taxpayer claimed the standard deduction. This law was not extended to cover tax year 2022. The proposed Charitable Act legislation would amend the law to allow a deduction in the 2023 and 2024 tax years for a taxpayer who does not itemize and would increase the potential deduction amount up to one-third of the taxpayer’s standard deduction.
State of Giving in the United States
The 2022 Giving USA report was released June 2023. The estimated total charitable giving for tax year 2022 was $499.33 billion, which was a decrease of 3.4% over the revised total of $516.65 billion contributed in 2021. Adjusted for inflation, giving decreased by 10.5% in overall growth. Contributing to this decline were the economy, inflation and drops in the stock market and disposable personal income. Giving by individuals declined by 6.4% to $319.04 billion. The largest gifts by some of the wealthiest Americans reached a total of nearly $14 billion in 2022. These mega-gifts represent about 5% of all individual giving in 2022, for the second year in a row. Giving by foundations and corporations and through bequests all grew from the prior year. In fact, giving by foundations represented 21% of total giving in 2022, the largest share on record for this category.
Use of 501(c)(4) Social Welfare Organizations. Recently, multiple wealthy families have used a strategy of creating a Section 501(c)(4) social welfare organization instead of forming a charitable foundation. This strategy allows donors to escape taxes on gifts and capital gains while at the same time keep information secret and avoid certain restrictions on charities.
For example, Patagonia founder Yvon Chouinard set up Holdfast Collective, a 501(c)(4), and transferred all but 2% of Patagonia company stock. Chouinard, his wife and their two adult children transferred all of the company’s voting stock, or 2% of all shares, to the newly created Patagonia Purpose Trust. The 501(c)(4) social welfare organization is expected to inject $100 million a year into environmental nonprofits and political organizations. The giveaway was valued at roughly $3 billion and did not merit a charitable tax deduction, with the family paying $17.5 million in gift taxes on the donation to the trust.
Another recent example is Barre Seid, CEO of Tripp Lite, a manufacturing company that donated company stock to Marble Freedom Trust, a Section 501(c)(4) organization. Marble Freedom Trust’s mission is to maintain and expand human freedom consistent with the values and ideals set forth in the Declaration of Independence and the Constitution of the United States.
State and Local Developments
First Restatement of Charitable Nonprofit Organizations. The American Law Institute is introducing the First Restatement of Nonprofit Organizations. The First Restatement of Charitable Nonprofit Organizations will focus on restating a single law of charities, to the extent possible. It will include (1) a definition of a charity, (2) governance and management of assets, (3) changes and closures, (4) restrictions on assets, (5) regulations, and (6) standing (complaints and review).
Massachusetts — Guide for Board Members of Charitable Organizations. Massachusetts published a guide providing recommendations in key areas of responsibility to help board members of charitable nonprofit organizations carry out their important roles. Included in the guide is a call for boards to emphasize the connection between the board, the organization’s leadership and the communities they serve, and to center the charitable missions of their organizations in all of their work.
Kansas Law — Donor Intent Protection Act. In April 2023, Kansas enacted a law that provides legal recourse to an individual charitable donor when the recipient charitable organization does not follow the donor’s gift restrictions. This law recognizes enforcement of written donor-imposed restrictions in an endowment agreement. It allows a donor to sue in a Kansas district court within two years after discovery of the breach of the endowment agreement, but not more than 40 years after the establishment of the endowment fund. The law allows the court to order a remedy to restore, to the extent possible, the donor’s intent expressed by the endowment agreement. The law also allows a charitable organization to obtain a judicial declaration of rights and duties, which the organization may seek before or during any lawsuit brought under this act.