Tax-Exempt Organizations:The Basics

Tax‐Exempt Organizations:The Basics

Chicago Bar Association’s Young Lawyers SectionFederal Taxation Committee

April 18, 2017Presented by: Corbin Morris & Amanda Blaising

How might you encounter tax‐exempt organizations (TEOs)?

• You may represent them. You may be asked to do research or prepare documents for them.• They may be parties to your deals or invest in the funds you create.• You may want or be asked to do a pro bono project for one of them.• Your clients may serve on the board of directors of one of them and ask you questions.• Your client may want to create or make a significant gift to one• You may serve on a board.

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What should you know about TEOs?

• Not‐for‐profit (or “nonprofit” or “nonstock”) status is a matter of state law. TEOs are commonly organized as not‐for‐profit corporations or charitable trusts (or, in limited circumstances, as LLCs).• Depending on the state, there may or may not be a separate corporate statute for not‐for‐profit corporations.• In general, the key difference between not‐for‐profits and for‐profits is that NFPs are not designed to make a profit for their shareholders. In fact, in most cases NFPs do not have any shareholders.• Some states formally divide them into “public benefit corporations” (those designed to serve the general public or a charitable class) and “mutual benefit corporations” (those designed to serve their members). 2

What should you know about TEOs?

•Tax‐exempt status is primarily a matter of federal tax law. Being not‐for‐profit does not automatically make an organization tax‐exempt. It must qualify under a specific statutory provision to be exempt from federal income tax.•Being tax‐exempt under federal law may or may not make an organization tax‐exempt under state law. There often are different standards and exemption processes for state income tax, property tax, and sales tax exemptions.

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What does it mean to be tax‐exempt?

•Most TEOs still pay taxes on their “unrelated business income,” including debt‐financed income.•They may also pay taxes on their investment income or if they engage in certain prohibited conduct. •Exactly what it means depends in large part of what type of TEO it is.

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The Universe of TEOs

ALL TAX‐EXEMPT ORGANIZATIONSPension/retirement plans, All Section 501(c)(1)‐(c)(27) organizations

ALL SECTION 501(c)(3) ORGANIZATIONS•Operated exclusively for charitable, educational, scientific, religious, etc. purposes•Can be a nonprofit corporation or a charitable trust•Contributions are generally tax deductible under Section 170

PRIVATE FOUNDATIONS

•All non‐public charities and non‐supporting organizations•Lower Deductibility Limitations•More Excise Taxes

PUBLIC CHARITIES

•Publicly Supported Organizations under Sections 509(a)(1) and 509(a)(2)•Supporting Organizations under Section 509(a)(3)•Higher Deductibility Limitations•Fewer Excise Taxes

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What is a private foundation?

•Private foundations are creatures of tax law; they are a subset of 501(c)(3) organizations.• In fact, all 501(c)(3)s are private foundations unlessthey meet one of a number of tests allowing them to be classified as public charities.•Frequently endowed by one or limited number of individuals or entities (e.g., families, corporations, etc.).•No political campaign activity; no lobbying!

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What is a public charity?

•Public charities are 501(c)(3)s that satisfy one or more additional tests allowing them to be classified as public charities.•Some organizations are classified as public charities based on their operations (e.g., churches, schools, hospitals).•Other organizations are classified as public charities based on their financial support or based on their relationships with other publicly supported public charities.•No political campaign activity; limited lobbying.

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Financial Support Test for Public Charities:

Type 1: Donative Charity Test

Organization receives substantial support (> 1/3 of its total support) from government, public charities, and the general public.

OROrganization receives significant support (> 10% of its total support) from public sources and operates in a way that represents, serves, and is accountable to the public.

Type 2: Service Provider Charity Test

POSITIVE TESTOrganization receives substantial support (> 1/3 of its total support) from public sources and receipts from services it provides as part of its tax‐exempt function.

ANDNEGATIVE TESTRevenues from investment income and unrelated business activities are limited (< 1/3 of its total support).

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Deductibility of Contributions

•Generally, contributions to public charities may be deducted up to 50% of the donor's adjusted gross income.

•Contributions to private foundations generally are limited to 30% of the donor's adjusted gross income. • Plus, gifts of certain property other than cash or publicly traded securities must be valued at basis rather than fair market value.

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What does it mean to be a private foundation?Private Foundation Excise Tax ‐ Overview

•Code Section 4940 – Tax on Net Investment Income•Code Section 4941 – Tax on Self‐Dealing•Code Section 4942 – Tax on Failure to Meet Minimum Distribution Requirements•Code Section 4943 – Tax on Excess Business Holdings•Code Section 4944 – Tax on Jeopardizing Investments•Code Section 4945 – Tax on Taxable Expenditures

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Code Section 4940 Tax on Net Investment Income

•An excise tax of 2% is imposed each taxable year on the net investment income of a private foundation. • “Net investment income” means gross investment income and net capital gain, less expenses paid or incurred in earning the gross investment income. •Possible reduction of tax rate to 1% by virtue of certain increased distributions for charitable purposes.

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Code Section 4941 Excise Tax on Self‐Dealing

•An excise tax of 10% is imposed on each act of self‐dealing between a "disqualified person" and a private foundation. •Additional 200% tax is imposed if the act of self‐dealing is not "corrected" (e.g., repaid by the disqualified person to the private foundation).

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•Generally, self‐dealing means any direct or indirect:a. Sale or exchange, or leasing, of property between a foundation and a

disqualified person; b. lending of money or other extension of credit between a foundation

and a disqualified person; c. furnishing of goods, services, or facilities between a foundation and a

disqualified person; d. payment of compensation (or payment or reimbursement of

expenses) by a foundation to a disqualified person;e. transfer to, or use by or for the benefit of, a disqualified person of the

income or assets of a foundation;f. agreement by a foundation to make any payment of money or other

property to a “government official”, other than an agreement to employ such individual for any period after the termination of the individual’s government service if such termination is within 90 days.

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•Disqualified Persons include:• a substantial contributor to the foundation (i.e., more than $5,000 and 2% of total contributions, or creator of trust);• a “foundation manager” (i.e., officer, director, trustee, or individual with similar powers or responsibilities)• an owner of more than 20% of a corporation, partnership, trust or other enterprise that is a substantial contributor;• a family member of (a), (b) or (c) (spouse, ancestor, child, grandchild, great grandchild or spouse of child, grandchild or great grandchild);• a corporation, partnership, trust or estate of which persons in (a) ‐ (d) own more than 35%; and• a government official (a defined term).

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Code Section 4942 Failure to Distribute Income

•Private foundations are required to make annual "qualifying distributions" equal to their minimum investment return (generally 5% of the net asset value of non‐exempt use assets).• If not so paid, an initial tax of 30% of the amount undistributed at the beginning of the second taxable year is imposed.•Additional 100% tax of the amount undistributed is imposed at the close of the taxable period.

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Code Section 4943 Excess Business Holdings

•A private foundation generally may have “permitted holdings” in an incorporated “business enterprise” equal to 20% of the voting stock, reduced by the voting stock owned by all disqualified persons. •General Grace Period ‐ a five‐year divestiture period for excess business holdings acquired after May 26, 1969, other than by purchase (e.g., by gift or bequest). Possible additional five years in extraordinarily complex situations.

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Code Section 4944 Jeopardizing Investments

•Generally, a tax is imposed on investments that jeopardize the carrying out of the exempt purposes of a foundation. Exception for program‐related investments. •A program‐related investment is an investment, the primary purpose of which is to accomplish charitable purposes, and no significant purpose of which is the production of income or appreciation of property. PRI’s may earn income.

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Code Section 4945 Taxable Expenditures

A private foundation generally is subject to a 20% tax on amount of a taxable expenditure, and an additional tax of 100% of amount if expenditure is not corrected within the taxable period.

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Code Section 4945 Taxable Expenditures

Taxable Expenditures include:1. amounts paid to carry on propaganda or otherwise

attempt to influence legislation; 2. amounts paid to influence the outcome of an election; 3. grants to individuals for travel, study or other similar

purposes, unless such grants satisfy the requirements of section 4945(g);

4. grants to organizations (other than most public charities that are not “non‐functionally integrated” Type III supporting organizations), unless the foundation exercises “expenditure responsibility”; and

5. amounts paid for any purpose other than one specified in section 170(c)(2)(B) (e.g., charitable, educational, etc.).

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What does it mean to be a public charity?

•Fewer excise taxes than for private foundations•Code Section 4958 – Tax on Excess Benefit Transactions•Must accurately calculate and closely monitor public support test status•May engage in limited lobbying activities•Generally fewer limitations on operations and grantmaking (if applicable)

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© 2017 Quarles & Brady LLP ‐ This document provides information of a general nature. None of the information contained herein is intended as legal advice or opinion relative to specific matters, facts, situations or issues. Additional facts andinformation or future developments may affect the subjects addressed in this document. You should consult with a lawyer about your particular circumstances before acting on any of this information because it may not be applicable to you or your situation.

QUESTIONS?

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