If you’ve recently submitted an application to the IRS for recognition of tax exemption, you’ve likely noticed that there are huge delays. Though you may still have to wait for your organization’s determination letter, understanding the reasons behind these holdups can help you navigate the setbacks and, in some cases, speed up the process.
Most charitable organizations are required to submit an application for exemption (Form 1023) to the IRS to be recognized as tax-exempt under Section 501(c)(3) of the Internal Revenue Code. Exceptions include religious organizations, which are not required to submit an application of exemption to the IRS. Other organizations, such as social welfare organizations and trade associations, may file Form 1024 for a determination of exempt status. However, these organizations can operate as tax-exempt without filing an exemption application.
It’s generally in an organization’s best interest to apply early for recognition of tax-exempt status under Section 501(c)(3). Understandably, many donors are reluctant to make contributions (especially large ones) to organizations without an IRS determination letter. Contributions from private foundations (PFs) and donor advised funds (DAFs) are subject to rules that prohibit taxable expenditures and grants to organizations that are not classified as public charities under 501(c)(3). Such grants count as taxable expenditures unless the grantor exercises expenditure responsibility over those grants. Typically, PFs and DAFs do not want this responsibility.
In addition to fundraising from the public, many states require charitable organizations to have a determination letter issued by the IRS prior to charitable solicitation or to obtain a sales tax exemption.
A Perfect Storm
Overall, the recent and significant delays in processing exemption applications at the IRS are a perfect storm, in that they can be attributed to a combination of the following factors:
- Automatic Revocation of Exemption under Pension Protection Act. Beginning in 2011, the IRS automatically revoked roughly 275,000 exemptions because they did not file legally required annual reports for three consecutive years. Many of these organizations have submitted applications for reinstatement of exemption, which has contributed to an influx in applications.
- IRS Scrutiny of Self-Declared 501(c)(4), (5) and (6) Organizations. In early 2013, the IRS sent a nine-page questionnaire to more than 1,300 organizations that declared themselves tax-exempt without a determination letter. The IRS indicated that completing the questionnaire was optional, but encouraged. This recent IRS scrutiny likely caused a number of self-declarers to apply for tax exemption, further boosting the volume of applications in the funnel.
- IRS Resignations, Dismissals, and StaffingShortages. According to a report from the Treasury Inspector General for Tax Administration (TIGTA), the IRS used inappropriate criteria that identified for review Tea Party and other organizations applying for tax-exempt status based upon their names or policy positions, instead of indications of potential political campaign intervention. As a result, their applications were subjected to unnecessary scrutiny and inappropriate questions. After this report was released, the IRS Commissioner resigned, and many senior leaders in the IRS Exempt Organizations Group have subsequently resigned or retired, leading to overall staffing shortages.
- The IRS’s Self-Certification Process. This new process is available to certain 501(c)(4)s and is likely to create delays in processing other applications as the IRS attempts to prioritize applications, rather than process them in the order received.
At the annual public meeting of the Advisory Committee on Tax Exempt and Government Entities (ACT) on Sept. 12, Commissioner Werfel indicated that the IRS made significant progress in addressing the problems in the 501(c)(4) application process.
Further, the IRS has charted a path forward with intermediate actions, and Commissioner Werfel released an 83-page report in June that addresses the findings of TIGTA and acknowledges both organizational and individual failures within the IRS.
On the heels of Werfel’s report, National Taxpayer Advocate Nina E. Olson released a statutorily mandated mid-year report to Congress that identifies the priority issues the Taxpayer Advocate Service (TAS) will address during the upcoming fiscal year. The report stated that there is a lack of guidance and transparency in connection with the legal standard “primarily” required for section 501(c)(4) organizations to qualify for tax-exempt status. Treasury regulations provide that an “organization is operated exclusively for the promotion of social welfare if it is primarily engaged in promoting in some way the common good and general welfare of the people of the community.”
It may be too early to tell if these IRS actions are substantive and whether they will substantially reduce the amount of time it takes them to review exemption applications. Marcus Owens, former head of the IRS’s Exempt Organizations division, didn’t appear to be optimistic when he commented, “It’s outrageous that the IRS is so dysfunctional in processing applications.” He attributed the delays to staffing shortages, as well as the lack of a plan for resolving hard technical issues raised by the applications. Owens said that the process is slowing down even more now, due to management shake-ups over the scandal involving the handling of conservative groups. As a result of the fallout, senior management of the exempt unit at the IRS was replaced with people who have no familiarity with the area.
In other words, things may be improving, but not quickly.
Paul Hammerschmidt is the director of the Exempt Organization Tax Practice in the BDO Greater New York Nonprofit Practice, where he is responsible for the team’s overall service approach and directing its day-to-day work. Having assisted nonprofits with tax issues for more than 25 years, Paul’s experience includes reviewing nonprofit operations to ensure compliance with tax regulations, assisting organizations in analyzing proposed transactions to identify any potential excess benefit transactions and ensuring compliance with intermediate sanctions. Paul also has experience in the evaluation of fundraising activities to determine compliance with IRS and state requirements. Paul is currently an active member of the Exempt Organization Committee of the New York State Society of Certified Public Accountants (NYSSCPA) and the American Institute of Certified Public Accountants (AICPA).