What Makes a Charity Tax-Exempt? Issues for Government Oversight and Due Diligence

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Gene Takagi, Image Source: Twitter

October 19, 2015; LinkedIn, “Pulse”

It should be no surprise that 15-year-old Hana co-authored a post with her uncle Gene titled, “Why Are Charities Tax-Exempt?” Uncle Gene is Gene Takagi, the managing attorney at the NEO Law Group and a nationally known expert in nonprofit law. Gene’s Nonprofit Law Blog should be on everyone’s blog feed.

Assisted by Uncle Gene, Hana has composed a very competent review of the requirements for entities to receive 501(c)(3) designations and, as she puts it, “whether governmental authorities are appropriately enforcing those requirements.”

After very helpfully reviewing Treasury regulations what it means to be “charitable” or “educational,” two of the possible purposes for 501(c)(3) status, Hana and Gene perceptively note that some critics have suggested that “it’s too easy to pass the requirements for furthering a ‘charitable’ or ‘educational’ purpose” and that this “anything goes” approach “has only been made worse by the new Form 1023-EZ” that the IRS started using last year for “streamlined” 501(c)(3) applications. The 1023-EZ form, a three-page application that simplifies qualification for 501(c)(3) status down to answering 11 basic questions about proposed activities, makes the IRS review process of the past look like an insuperable obstacle course in comparison.

With an under-resourced tax-exempt unit at the IRS, it is possible that the 1023-EZ was seen as a way of reducing a backlog of applications. Perhaps the IRS was simply admitting that the front-end review of 501(c)(3) applications wasn’t that much more robust than walking through the 1023-EZ checklist.

“With unclear guidance [from the IRS] about what it means to be operating for ‘charitable’ and/or ‘educational’ purposes,” Hana and Gene write, “there are likely thousands of charitable organizations that are operating with purposes that many critics believe are not worthy of tax-exemption.”

The Takagis’ concern zeroes in on a serious problem. The 1023-EZ process, even if a well-intentioned response to the capacity limitations of the IRS, exacerbated by the troubles of the tax-exempt unit of the Service in the wake of the Lois Lerner imbroglio, may well be counterproductive. In 2014, the president and CEO of the National Council of Nonprofits, Tim Delaney, wrote a critical review of the 1023-EZ process, highlighting potential problems that could ensue:

The new form and process would all but eliminate the current due diligence undertaken by the IRS. One experienced nonprofit executive forecasts chaos for individual donors and foundations, “if the field is suddenly flooded with hundreds of thousands, if not millions, of newly minted (c)(3)s.” State charity regulators… uniformly oppose the proposed process. The National Association of State Charity Officials has sternly warned the IRS that “that the Form 1023-EZ will increase opportunity for fraud and heighten the burden on state regulators.”

A year later, the National Taxpayer Advocate’s office has continued to raise concerns: “Because Form 1023-EZ does not require applicants to provide supporting documentation or substantiation, but only to attest they qualify for exempt status, the IRS has in effect relinquished its power to educate and regulate taxpayers before it confers exempt status.” As a result of the 1023-EZ process, the Advocate’s analysis shows that the approval rate for 501(c)(3) applications rose from 84 percent in FY2013 to 94 percent in FY2014, and the number of applicants more than doubled from 45,289 to 100,032. The 2014 number provides some evidence for Delaney’s concern, in that the Form 1023-EZ process started only in July of that year. Early results on the 1023-EZs themselves through the second quarter of 2015 indicate a 95 percent approval rate. An IRS random sample of a small number of 1023-EZ applications suggests that there might be an error rate in 1023-EZ approvals of somewhere between 21 and 29 percent compared to a more intensive due diligence process.

The Taxpayer Advocate’s report added, “The information on the e-Postcard [Form 990-N] is insufficient to allow a potential donor or researcher to determine whether the organization actually conducts exempt activities. Thus, Form 1023-EZ and Form 990-N, even taken together, provide almost no transparency.”

The IRS appears to know it has launched a dynamic that warrants a critical reexamination. The 2016 workplan for the Tax Exempt/Governmental Entities unit calls for evaluating the 1023-EZ process to come up with “potential improvements,” collect data on the trends and patterns of 1023-EZ applicants, and initiate “post-determination compliance enforcement on organizations that were granted exempt status through the submission of the Form 1023-EZ application.”

Even if the issue were simply a matter of warding off problems of nonprofit fraud and abuse, the problem extends beyond the role of the federal government. At the 2015 meeting of the National Association of Attorneys General (NAAG) and the National Association of State Charity Officials (NASCO), regulators noted “the explosive growth of the number of nonprofit organizations, due in part to the IRS Form 1023-EZ and the availability of online fundraising platforms…[and] state charity regulators…working hard to ensure that organizations are complying with their state legal obligations.” With inadequate IRS definition, due diligence, and oversight, state regulators will inexorably enter the fray to determine what the states themselves must do to ensure nonprofit probity.

Hana and Gene Takagi end their LinkedIn essay with a call for better guidance on the requirements and qualifications for tax-exempt status. “What is important is for the IRS and state agencies to consistently and fairly enforce laws to help prevent organizations from operating inconsistent with 501(c)(3),” they conclude. We need more 15-year-olds like Hana Takagi reminding the nonprofit sector to ask hard questions of itself and its regulators.—Rick Cohen