IRS Advisory Committee on Tax Exempt and Government Entities Recommends Significant Changes

by Proskauer - Not for Profit/Exempt Organizations

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Last week, the IRS Advisory Committee on Tax Exempt and Government Entities (“ACT”) held a public meeting at which the panel submitted its latest round of recommendations to senior IRS executives. At the meeting, the ACT’s Exempt Organizations project team presented a report containing several recommendations intended to improve the application process for organizations seeking recognition of exempt status as a Section 501(c)(3) charitable organization, including significant revisions to the content of, and filing process for, Form 1023 (the application for recognition of exemption under Section 501(c)(3)). In the report, the ACT recommends that the IRS take the following actions to improve the efficiency, effectiveness and educational benefits of the application process:

  • create an electronic version of Form 1023 that can be filed electronically and stored, transmitted and disseminated in an electronic database format;
  • revise Form 1023 to make the form: (i) more effective as a tool for identifying organizations that are, and are not, organized for charitable purposes; (ii) more consistent in substance, format and terminology with the annual information return Form 990; (iii) more simple in format with a more concise core form and additional supplemental schedules; and (iv) more educational for applicants, many of which are small organizations that receive no professional assistance when completing the form;
  • coordinate with the Treasury Department and the Office of Chief Counsel to issue precedential guidance about, and increase public awareness of, tax-compliant alternatives to the creation of new Section 501(c)(3) organizations, such as the utilization of fiscal sponsorships and donor-advised funds, which would, in many cases, be more effective vehicles for small non-profit organizations looking to carry out activities of relatively short duration (e.g., organizations created to receive memorial donations for a deceased individual or to fundraise for a specific short-term project);
  • carefully examine recurrent complaints about the Form 1023 application process and take appropriate follow up steps to address such complaints; and
  • coordinate with state charity regulators to expand the IRS’ use of the Review of Operations (“ROO”) unit to identify and track newly recognized exempt organizations that may have a higher-than-average risk for future non-compliance with the requirements for exemption based on certain characteristics identified by state charity regulators as “red flags” for non-compliance.

The ACT had previously recommended the development of a fully e-fileable version of Form 1023 in a 2003 report and it strongly reiterates this recommendation in this year’s report, noting that the successful implementation of mandatory electronic filing of Forms 990 and 990-PF for many (but not all) filers has resulted in more accurate and complete Forms 990, significant improvement in the quality of information available to the IRS and increased transparency by making Forms 990 more readily accessible for public inspection. The ACT observes that if an electronic Form 1023 were created (and mandatory electronic filing were to be implemented for a large majority of filers) the IRS would be able to create one electronic database through which potential donors could review an exempt organization’s filing history from inception up through its most current Form 990.

Interestingly, while the ACT gave serious consideration to the creation of a shortened version of Form 1023 for small organizations, similar to the Form 990-EZ, it ultimately rejected this approach in light of the fact that Form 1023 serves an important educational role for many applicants, which are often small organizations in the start up phrase and are still contemplating how they will operate and be governed. The various questions contained in Form 1023 educate an applicant organization about the requirements that must be met to initially qualify for and maintain exempt status and signal to the organization that a comprehensive regulatory regime will apply to it if the application is approved. Accordingly, the ACT report instead focuses on ways in which Form 1023 can be redesigned to be more user-friendly and educational for all applicants, while still ensuring that the IRS receives the information that is necessary to effectively evaluate an applicant’s qualification for exemption under Section 501(c)(3).

Specific revisions to Form 1023 that the ACT recommends in the report include:

  • consolidating the content in Parts II and III of the current form (relating to organizational structure and required provisions in the organizing document) into a new Part II that would include some very high-level guidance about these requirements directly on Form 1023, with links in the electronic version to the relevant sections of the instructions;
  • including specific suggested topics to be covered in the narrative description of the organization’s past, current and presently planned activities, as well as a reminder that the description of such activities should correspond to the financial information requested in Part IV of the current form (i.e., the expenses and revenues related to the activities discussed in the narrative should be reflected in the financial information);
  • grouping the questions in Parts V and VI of the current form (relating to private inurement and excess benefit transactions) into one section and, in order to simplify the form for smaller, volunteer-run organizations, reducing the number of questions in the core Form 1023 and moving the more detailed follow up questions to a separate supplemental schedule;
  • moving follow up questions in Part VIII of the current form (relating to specific activities that may raise non-compliance concerns) onto supplemental schedules;
  • making substantial revisions to the sample conflict-of-interest policy provided in Appendix A to close significant gaps in the current sample policy’s coverage and expand the types of conflicts addressed;
  • simplifying Part IX of the current form (the financial schedules), while still keeping it consistent with Form 990;
  • providing more comprehensive instructions for applicants seeking to demonstrate qualification as a private operating foundations to indicate what type of information the IRS is looking for from such applicants; and
  • adding a new question asking whether the organization’s governing board has reviewed the Form 1023 before submitting it to the IRS (similar to Question 11 in Part VI of Form 990).

The ACT report also includes recommendations for monitoring ongoing compliance once an organization’s application has been approved. In 2005, the IRS established its ROO unit to monitor previously non-compliant exempt charitable organizations and newly approved exempt charitable organizations that may be at risk for non-compliance. The ROO unit monitors ongoing compliance through a review of the publicly available information about such organizations, typically without the organization’s knowledge, and conducts follow up inquiries as needed. The ACT reports that the state charity regulators it spoke with expressed a desire for the ROO process to be expanded to include organizations that state charity regulators have identified as being more likely to be non-compliant with the requirements for exemption in the future. The ACT recommends that the IRS coordinate with the state charity regulators to identify such newly approved but high-risk organizations, which should result in a more effective use of IRS resources. The proposed regulations for IRS information-sharing with state charity regulators would facilitate such sharing. Such ongoing monitoring of high-risk organizations would also ease some of the pressure placed on the IRS to correctly identify non-compliant applicants during the Form 1023 review process, which typically occurs at a time when the applicant organization has little, if any, operating history and thus forces the IRS to make a determination that is largely based on the applicant’s speculative representations of how it will operate in the future, rather than on its past track record.

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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