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What is the advantage in incorporating when the IRS will recognize unincorporated groups as tax-exempt organizations?
Nonprofit organizations have two legal identities. At the state level, they are charitable trusts, unincorporated associations, or nonprofit corporations of some allowable design. Then, at the federal level, they have status as one of the class of 501(c)(2) through 501(c)(25) tax-exempt organizations. Most of the more than 1,000,000 tax-exempt organizations in this country are incorporated 501(c)(3) public charities.
Most nonprofits incorporate for the same reason for-profit businesses do: limited liability. Limited liability is the key to the corporate form. It means that the corporation itself, rather than the individuals involved with the corporation, absorb most liabilities incurred by the corporation. Therefore, as a nonprofit director, officer, member, or manager, your personal assets are at a lower level of risk with corporate protection.
We highly recommend the corporate form for all of our clients who are tax-exempt entities. Even among exempt organizations that in past decades were traditionally unincorporated, such as volunteer groups or charitable trusts, incorporation provides helpful protection against liability. Corporate status is especially advisable since the cost and effort of obtaining and maintaining corporate status is minimal in most states.
Additionally, corporate status provides credibility to the organization in its dealings with third parties and the community; governmental and foundation funders require it or at least want to be assured that their scarce dollars are used by properly established organizations; and of equal import, maintaining clear lines of accountability and authority can be easier under the structure of a formally constituted corporation, governing board, and set of bylaws.
Can a nonprofit organization be profitable?
Nonprofit organizations can indeed earn “profits” in the sense that they expend less money each year than is received in income. In fact, most nonprofits should attempt to do this to ensure financial stability of the entity. The distinction between nonprofit organizations and for-profit companies lies in what is done with the profits. In the for-profit corporate setting, "earnings" are distributed to shareholders. In the nonprofit setting, "surpluses" are devoted to nonprofit purposes or retained, on behalf of the public, in an organization's coffers. Surpluses are not allowed to be used for the private gain or inurement of individuals.
How does the ministerial housing allowance work?
The minister’s housing allowance is the most important tax benefit available to ministers. Section 107 of the Internal Revenue Code allows “ministers of the gospel” to exclude some or all of their ministerial income designated by their church or church-related employer as a housing allowance from income for federal income tax purposes.
Only “ministers for tax purposes” are eligible for a housing allowance on their ministerial earnings. The federal tax courts have outlined a test to identify those who fit this description. A church may call someone a “minister,” but the IRS may not treat that person as a minister for tax purposes — that depends on individual facts and circumstances.
Ministers who own or rent their homes can exclude the lowest of the following three amounts from income for federal income tax purposes when their church employer properly designates a housing allowance for them: (1) the housing allowance designated by their church; or (2) actual housing expenses (including mortgage payments, utilities, property taxes, insurance, furnishings, repairs and improvements, etc.); or (3) the fair rental value of the home (furnished, including utilities, etc.).
Ministers who live rent-free in a church-owned parsonage should not include the fair rental value of the parsonage in income for federal income taxes, but can receive a housing allowance for any items the minister pays for utilities, repairs, furnishings, or other eligible expenses. They should include the fair rental value of the parsonage in income for SECA taxes. Ministers who live rent-free in a church-owned parsonage may exclude the lower of these two amounts: (1) the housing allowance designated by their church; or (2) actual housing expenses not paid by the church (including utilities, furnishings, repairs and improvements).
There are some critically important limitations on a ministerial housing allowance. Certain items, such as cleaning services, food, and domestic helpers pay, are not eligible to be excluded as income as part of a housing allowance. Also, a housing allowance is available only for a principal residence, not for a second home, vacation home, business property or a farm. Home equity loan payments can be excluded as part of a housing allowance only if the loan is used to pay for housing expenses such as remodeling. Home equity loan payments used for college tuition or anything other than eligible housing expenses cannot be excluded from income as a housing allowance.
Unrelated business income (“UBI”) points
Many nonprofits are becoming more entrepreneurial, which in turn may result in the sale of various products out of a nonprofit organization. The key point to remember is that as long as you are acting in furtherance of your tax-exempt purposes, the Internal Revenue Code generally does not prohibit or restrict your income-generating activities.
Under the Internal Revenue Code, income derived by an organization from activities which are unrelated to its tax-exempt purposes is taxed at prevailing corporate rates. To be taxed, the activity must be regularly carried on and not substantially related to the entity’s exempt purposes. If income received is made from events or activities directly related to your tax-exempt purposes, the product sales would therefore generate income which is related to your organizational purposes and not be subject to tax. So, the crux of the matter is whether or not the product is directly related to your exempt purposes.
Even in situations where it may be difficult to show that income is related to your organization's purposes, one or more specific exclusions to the tax may apply. For example, if substantially all the work in selling the products is performed by volunteers, then the income is not taxable. Other exclusions that may apply in your case include the sale of contributed property (the thrift shop exception), services for the convenience of members, employees, and patrons (including book stores, gift shops, restaurants, and parking lots), and certain low cost items, among others.
If your organization derives a "substantial" percent of its income from activities unrelated to your tax-exempt purposes, then the organization is at risk of losing its exempt status. Neither the IRS nor case law has completely defined the term “substantial”. However, as a general rule, if unrelated income (on which the organization must pay tax) regularly falls within the range of 15 percent to 30 percent of gross income, you should consider establishing a for-profit subsidiary of the nonprofit organization.
What is considered “reasonable compensation,” and how do we get there?
The Intermediate Sanctions Act’s final passage in 2002 codified the required and mandatory path for 501(c)(3) organizations to maintain “the rebuttable presumption of reasonableness” in its compensation determinations and covers any and all transactions made between an organization and a “disqualified person” (“DP”).
For compensation decisions, the organization must first identify all of the DPs as prescribed under the Act (e.g., Founder, President, CFO, defined “highly paid” executive, and any and all of these identified DP’s family members). It is the sum total of these DPs whose compensation must be determined in the manner described herein. The Act has a five-year lookback period incorporated to ensure that any and all DPs are identified and included in the process.
Once the DPs have been identified, the organization must obtain comparable data and analysis for compensation levels of similarly situated staff members (i.e., from organizations of similar size, revenue, geographical location, etc.). Good comparability data can be commissioned from firms that specialize in executive compensation and benefits, and we typically assist our clients in finding such good sources.
Then, an independent compensation committee (“ICC”) made up of people who are not conflicted under the law from determining compensation of those DPs being reviewed must be selected and appointed by the governing body of the organization. The five-year lookback period applies to this group as well to ensure no conflicts exist that would hinder their objectivity. The ICC then reviews the comparability data and applies it to the DP being reviewed, taking into consideration a myriad of factors (performance, education, tenure, experience, job skills, uniqueness, etc.) in determining compensation of the DPs.
The decisions of the ICC then must be recorded contemporaneously in final form for the corporate record in order to rely upon the safe harbor of the “reasonability” of the compensation determinations.
If the process outlined in the Intermediate Sanctions Act is not followed, the penalties can become quite onerous. If compensation is deemed to be “unreasonable” by the IRS, then any “excess benefit” would have to be repaid by the DP to the organization, and the DP would face a penalty of up to two-hundred twenty-five percent (225%) of the excess benefit for each year of “unreasonable compensation.” In addition, those nonprofit organizational leaders who approved any such “unreasonable compensation,” would be subject to a penalty of 10% of each excess benefit transaction, up to $10,000 per transaction.
We spend a good amount of our efforts guiding all of our clients through compensation determinations under the Intermediate Sanctions Act, and if your organization needs assistance in this area, we can walk you through the process as well.
Are ministers/child care workers/doctors/teachers required to report child abuse?
All fifty states have enacted some version of mandatory child abuse reporting statutes in an effort to protect children from being abused in various forms of defined abuse. The statutes define “mandatory reporters” specifically. In most states, such mandatory reporters must report both actual and reasonably suspected cases of child abuse. Failure to do so is a crime. Our clients’ staff members are frequently identified as mandatory reporters under these statutes, and should never assume that they have no duty to report.
In any case where one is not considered to be a mandatory reporter, states allow for also-anonymous and confidential "permissive reporters," meaning that they may report cases of abuse to the designated civil authorities but are not legally required to do so.
Our clients often ask if they would be held liable if they report a suspected incident of child abuse that later proves to be unfounded. The answer to this question is that every state grants "limited immunity" to reporters of child abuse. Reporters cannot be held liable, unless they make a false report "maliciously."
Please contact us if you ever have any question as to whether or not you should make any such report.
Prohibitions/Limitations on Political Activities
As you are likely aware, tax-exempt organizations are prohibited from devoting more than an insubstantial portion of their resources on political activities. The rationale for this prohibition is that in return for the grant of tax-exempt status and the ability to receive tax-deductible donations, an organization is required to engage primarily in 1) recognized charitable or nonprofit activities which 2) benefit the entirety of the public. Political “lobbying” is not considered to be a charitable activity which would justify such privileged status. Likewise, an organization engaging in partisan lobbying for or against a particular party, candidate, or legislation serves to benefit only that portion of the public which sympathizes with its point of view.
To date, the term “insubstantial” has not been clearly defined in this context. Roughly, if no more than five percent of an organization's total efforts are devoted to political activities, it is probably acting within legal limits.
Nevertheless, many organizations shy away from activities they presume to be lobbying but which in fact fall outside of the definition of lobbying, which is narrowly defined by the IRS. Generally speaking, lobbying is the expression of a view or a call to action on specific legislation. Lobbying does not include, for instance, nonpartisan analysis of legislation, the expression of a position on issues (as opposed to a particular piece of legislation) of public concern, or action taken in "self-defense" of the organization.
How can we be sure that our organization is in compliance with all applicable rules and regulations?
There have been numerous changes in the law over the past five years applying specifically to tax-exempt organizations, many of which such entities are likely not even aware. We offer a comprehensive legal compliance review (“LCR”) for all of our clients, in which we visit the organization to interview and tour the facility(ies) and operations with key personnel discussing all of the various issues that apply to nonprofit, tax-exempt organizations in general and to their corporation specifically. At that on-site visit, we will gather all of the information necessary to review any and all such activities of the organization to ensure that your nonprofit is in compliance with all statutes, regulations, and administrative requirements applicable to the entity. Call or write us for a copy of our LCR checklist to see all of the points we cover in our review. It is common for us to modify our review to only those items that a client would request, but we always want to be sure and identify any and all such possible corporate matters, events, and activities.
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