A recent report from the Taxpayer Advocate Service asks the IRS to devote more of its resources to catching 501(c)(3) compliance concerns early rather than trying to correct potential issues on the back end. If your organization recently applied for public charity status, the chances of receiving additional IRS scrutiny have increased significantly. The IRS may be looking at its applications for tax exemption. The report indicates that more oversight for the Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code and the Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code may be needed.
An independent sector of the IRS, the Taxpayer Advocate Service looks for ways the IRS can improve its reporting requirements. For its report, the Taxpayer Advocate Service examined recent changes to the applications for tax exemption. One of these was the Form 1023-EZ, a shorter tax-exempt status application available for smaller organizations. Another area it examined was the streamlined process for applicants using the Form 1023. Finding deficiencies in both processes, the Taxpayer Advocate Service is recommending the IRS collect more information about applicants before granting tax exemption.
Organizations applying for tax-exempt status must include organizing documents that establish how the organization meets the requirements as part of their Form 1023. The IRS reviews these articles of incorporation to identify and address potential tax-exempt compliance concerns before the organization receives its nonprofit designation. Once the organization provides sufficient evidence about its structure and purpose, then the IRS grants tax-exempt status.
The examination of Forms 1023 led to an administrative backlog. In 2013, the IRS noted that organizations were waiting upwards of 18 months to be assigned to an agent who could review their applications.
In response, the IRS provided small organizations with another option. Entities with gross receipts of $50,000 or less and assets of $250,000 or less could use the three-page, Form 1023-EZ. The IRS estimated 70 percent of all 501(c)(3) applicants would qualify for use of the form.
Narrative explanations of the organization’s activities and substantiating information about financial data are not required for applicants that are eligible for Form 1023-EZ. Instead, organizations use the form’s “checkbox approach” to demonstrate their eligibility for exemption.
Issues Arise When Articles of Incorporation Not Included
To test how the Form 1023-EZ was working, the IRS took a sample of 1023-EZ applicants and asked for additional information about their organizational structure, activities, revenues and expenses. When the IRS asked for extra documentation, the agency approved applicants at a lower rate than it did when it took the attestations from the Form 1023-EZ alone. Furthermore, the review found that an estimated 20 percent of applicants in the sample did not meet the organizational structure requirements for tax exemption, even though their application said they did.
The Taxpayer Advocate Service also took a representative sample of organizations that had their Form 1023-EZ applications approved. The Advocate Service found several instances where the applicant should have provided the IRS with additional information about its eligibility for tax exemption.
One example involved an organization created to pay for an individual’s medical expenses. The organization’s application was approved, but the Taxpayer Advocate Service questioned whether the purpose of the organization would serve a public interest, one of the qualifiers needed for tax exemption.
As an extra measure of security, the Taxpayer Advocate Service recommends all organizations, including those using the Form 1023-EZ, electronically submit articles of incorporation and provide a description of their actual or planned activities and summary financial information related to revenues and expenses.
Streamlined Procedures May Not Address Core Issues
Starting in 2014, the IRS adopted a streamlined approach for the long-form applications as well. Select applicants can forgo certain documentation requirements if they can prove they meet organizational and operational standards for tax exemption through other “representative attestations.” For example, organizations that are corporations that do not submit their substantiating documents with the application may not be required to because the information is available through online state records. The IRS, in that instance, would ask the applicant organization to verify that it was a legally formed corporation.
The IRS reviewed the compliance rates with the approach by examining organizations that had been approved under the streamlined system. Of the sample, roughly 8 percent of organizations that were asked to provide additional assurance that they met the 501(c)(3) requirements at the time of their application still did not meet their requirements.
To minimize the risk of continued compliance concerns, the Taxpayer Advocate Service recommends that the IRS wait until additional information requested is documented and in-hand before it approves an organization for tax-exempt status.
Post-Approval Corrective Actions
The Taxpayer Advocate Service raised concerns that the IRS is devoting too many of its resources to the post-approval correction process. It is recommending the IRS spend more time on the front end with both its Form 1023 and Form 1023-EZ applicants rather than soliciting for necessary documentation after-the-fact. The report suggests that the scrutiny up front would cut down on long-term compliance concerns.
If the IRS follows the Taxpayer Advocate Service’s suggestions, it could mean that applicant organizations will be facing more scrutiny when they file their Forms 1023 or 1023-EZ.
For More Information
If you have any specific comments, questions or concerns about the Form 1023 application process, please contact us.
Amy O’Loughlin is a Senior Tax Manager and member of the Not-For-Profit Practice. She is located in the CBIZ Phoenix office. She can be reached at email@example.com or 602.650.6233.