I have been spending quite a bit of time over the last few days working on or reviewing not-for-profit returns.
It may surprise you, but – with a few exceptions – not-for-profit organizations are required to file paperwork annually with the IRS.
There is a reason for this: the tax Code recognizes some organizations as “per se” not-for-profit – churches are the classic example. Churches do not need to be told by the IRS that they are tax-exempt; they simply are. A large part of this is church:state separation, although church programs that begin to look uncannily similar to for-profit businesses are supposed to file an income tax return (known as Form 990-T) and pay tax.
Then we have the next tier: the education, charitable, scientific, etc. entities that also comprise not-for-profits. These are not “per se” and have to apply with the IRS to have their exempt status recognized. The application is done via either Form 1023 or Form 1024, depending upon the type of exempt status desired.
We talking about the March of Dimes, Doctors Without Borders or your local high school boosters club.
One thing this tier has in common is that they have to explain to the IRS what their exempt purpose is.
And there are tax subtleties at play. For example, can your exempt purpose be less than 50% of what you do? What if it is more than 50% but you have a significant (but less than 50%) non-exempt purpose? What if you start out at a more-than-50% exempt purpose but – over time – your non-exempt purpose goes over 50%?
This becomes its own field of specialization. I have met practitioners over the years whose only practice is tax exempts.
I am looking at the IRS response to a recent exempt application. I will give you a few facts and flavor, and let’s see if you can anticipate the IRS decision on the matter.
(1) A minister had an idea for a coffee shop. The shop would be separate from the church (hence the exempt application). Being separate however would allow (and maybe encourage) other churches and religious groups to participate.
(2) The coffee shop would allow believers and non-believers to interact. There would be religious activities, but the activities would not be organized by the shop. They would instead be organized by the patrons. By the way, the shop could also be used for non-religious activities. One could leave a donation for the use of the space.
(3) There are no similar businesses where the shop is located, hence it is not taking commercial opportunity from a profit-seeking business.
(4) The shop affords a gathering space that is open late, as well as provide safe space for residents to gather.
(5) The shop takes part in a job-skills training program to help underserved youth by placing them in an actual job for a six-week internship.
(6) The shop participates in a project for the children of incarcerated parents. Patrons can share gifts with the kids, such as for their birthdays and Christmas.
(7) The shop does not want to turn away anyone for inability to pay. There is a program where a customer can pay for a certain amount of coffee in advance. When a not-able-to-pay patron enters, he/she is served from those advance payments.
(8) The shop sells coffee, teas, smoothies and so forth. There are also baked goods, as well as salads and desserts.
(9) The shop roasts its own coffee, which is sourced directly from coffee farmers. This allows the farmers to earn more than other conventional means of distribution. The coffee is also available for sale, and there are plans to sell the coffee online in the future
(10) The shop uses some volunteers, but its largest expense is (understandably) wages and related payroll costs.
(11) The shop intends to give away its profits - that is, when it finally becomes profitable.
What do you think? Would you give this shop exempt status?
Here goes the IRS:
(1) To be exempt, an organization must be both organized and operated exclusively for an exempt purpose. The test has two parts: the paperwork and what is actually going on.
(2) The IRS has defined the word “exclusively” to mean “primarily.”
(3) Hot on the heels of that definition, the IRS has also said that non-exempt activities must not be “more than an insubstantial part” of activities.
OBSERVATION: You can see the evolution of law here. A non-tax specialist would anticipate that an activity is exempt if the exempt activity is 51% or more of all activities. The flip side is that a non-exempt activity should be as much as 49%.
The IRS however states that a non-exempt activity cannot be “more than an insubstantial part” of all activities.
Does “insubstantial” mean as much as 49%?
If not, then the IRS is changing definitions all over the place.
(4) The IRS has previously decided that the operation of a grocery store to provide on-the-job training to hardcore unemployed represented two purposes, not one. Each purpose has to be reviewed to determine whether it is exempt or not.
(a) And now it gets tricky. If the store is staffed principally by a target group (or volunteers) AND the store is no larger than reasonably necessary for achieving the exempt purpose, the IRS has said that the store is exempt.
(b) Conversely, if the store is not staffed by the target group (or volunteers) or larger than necessary, the IRS has said that the store is non-exempt.
(5) While the coffee shop intends to donate its profits, its main activity is the operation of a coffee shop in a commercial manner.
(6) And that activity is “more than insubstantial.”
The IRS rejected the application. The coffee shop will have to pay taxes.
Doesn’t it matter that they are giving away all profits? Isn’t there a vow-of-poverty-thing that one can point to?
And there is a key point about tax law in the world of exempts. Giving away money will not transform a for-profit activity into a not-for-profit activity. Granted, you may get a charitable deduction, but you will be taxable. The IRS has been steadfast on this point for many years. The activity itself has to be exempt, not just the monies derived from said activity. To phrase it differently, gigantic donations will not make Microsoft a tax-exempt entity.
The IRS decided the shop was too similar to a Starbucks or Caribou.
And giving away any profits wasn’t enough to change the answer.
Does the shop do great work?
Is it tax exempt?
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.