What Happens When a Nonprofit Loses Its Tax-Exempt Status? IRS Guide

Introduction

It is important for 501(c)(3) nonprofit organizations to maintain their tax exempt status. This is very important to all nonprofits because losing tax exempt status could interrupt operations and losing public trust could affect financial reserves. Nonprofit executives understand what is necessary to maintain tax exempt status. This article explains what is important for nonprofits and offers practical help to manage and prevent losing tax exemption.

How Can Nonprofits Lose Their Tax-Exempt Status?

The IRS keeps an eye on nonprofits and can take away tax-exempt status for a number of reasons:

Failing to File 990s for 3 Years

Not reporting for 3 years will also cause automatic revocation of exemptions. The IRS requires nonprofits to submit Form 990, 990-EZ, or 990-N (the e-Postcard) to determine if tax-exempt organizations are still complying with their tax-exempt purpose and purpose and financial transparency for their tax-exempt status. Nonprofits will lose their exemptions without even being notified if they fail to submit 3 years worth of 990s.

Engaging in Non-Exempt Activities

Nonprofits are required to only engage in activities that fulfill their exempt purpose. The IRS can take away your tax exempt status if you fulfill activities that are outside your exempt purpose. For instance, a tax-exempt educational charity that chooses to run a commercial enterprise unrelated to its purpose will lose its tax-exempt status.

Participating in Unauthorised Political Activities

501(c)(3) entities must comply with specific guidelines regarding their participation in politics. They are prohibited from backing or opposing political candidates. They must also ensure that lobbying does not become a major proportion of their activities. Arresting political campaign participation or lobbying activities in substantial amounts will lose their tax-exempt status from the IRS.

Reporting Irregular Business Income

Even if the IRS allows nonprofits to have Unrelated Business Income Activities, such nonprofits must report these activities. If these activities generate a high amount of income, the tax-exempt status may be challenged.

Negative Effects of Losing Tax-Exempt Status

Losing tax-exempt status will have major consequences, not only on the reputation of a nonprofit, but also on its finances and operations:

• Donors will no longer receive tax deductions: If the nonprofit tax-exempt status is revoked, donations will no longer be tax-deductible. This may prompt the donor to withdraw their support, leading to critically reduced income. This will directly impact the nonprofit operations in fulfilling their mission.
• The organization may have to pay corporate income tax: Once the nonprofit no longer has tax-exempt status, they are treated like a taxable corporation, and will owe federal, and possibly state income taxes. This, in turn, increases operational costs.
• Loss of grants and public funding: Losing your organization’s 501c3 status will mean the loss of any active and future public or private grants. You cannot gain or maintain certifiable grants without publicly accessible 501c3 status.
• Required to notify donors and public: Nonprofits must manage the public perception of the nonprofit and report changes of 501c3 status or any other relevant financial status to the public and donors to manage public perceptions.
• Reputational damage: Tax status loss brings into question the governance of charitable entities and loss of 501c3 status is reputationally damaging. Governance issues and reputational damage can have a compounding negative effect on the donors, volunteers, and partners of the organization.

Does Tax-Exempt Status Expire?

Not exactly. In fact, it does not expire and can last indefinitely even if the charity stops providing exempt services. The only way to lose it is through voluntary relinquishing of the status and/or through the IRS regulations not maintaining it after 3 consecutive years of not filing any of the 990 forms.

Nonprofits must meet annual compliance requirements, including timely filings and adherence to exempt purposes. Therefore, even if it does not expire, it may be lost if not actively maintained through the nonprofit’s ongoing obligations.

Restoring a Tax-Exempt Status

If you have had a tax-exempt status revoked, you can restore it by following these steps:

1. Submitting an IRS Reinstatement Form: If you are a 501(c)(3) nonprofit organization, you will use Form 1023 for reinstatement. Other nonprofit organizations also use Form 1024. Smaller organizations that automatically had their tax-exempt status revoked often will be able to use Form 1023-EZ.
2. User Fee Payment: The IRS requests reinstatement application review fees. These fees depend on organization type, size, and which IRS form you file.
3. Non-Compliance Explanation: Organizations must explain why tax and IRS regulations were not followed stating return filing omissions, and non-compliance actions. The organization must also present steps to correct the situation and fulfill compliance.
4. IRS Processing Time: The IRS can take a few weeks to a couple of months to review reinstatement requests. The time it will take mainly depends on how complex your situation is and the IRS workload.
5. Reinstatement With Retroactive Effect: Restoring tax-exempt status to the exact date it was revoked is possible. This is important for maintaining tax liabilities and donor confidence. You will need to request this reinstatement with the IRS.

How Long Can a 501(c)(3) Be Inactive?

The IRS has no specific time limits on how long a nonprofit can stay inactive. However, inactivity does not mean an organization does not need to file annual returns. Failing to file the annual returns, even during inactivity, results in automatic revocation. Also, a nonprofit that intends to dissolve has to follow the legal requirements for closing a nonprofit to avoid legal liabilities or future compliance issues.

How to Keep Your 501(c)(3) Status

Maintaining a tax-exempt status requires a lot of effort; thus, you should:

• Set reminders on your calendar for Form 990 filing deadlines to avoid missed filings.
• Periodically review your activities to ensure you stay within your nonprofit’s exempt purpose see activities, as well as avoiding prohibited political activities or unrelated business activities.
• Keep good records, including boards minutes, for each meeting as proof of governance to show compliance.
• Keep up with the IRS nonprofit regulations, as well as legal or tax compliance pertaining to your nonprofit.
• Consider using nonprofit accounting and compliance software to monitor activities, deadlines for filing, and other compliance records.

Conclusion

A nonprofit organization can lose its tax-exempt status which can affect its finances, lose the trust of the community, and damage its reputation. This can be avoided by carefully ensuring the organization fulfills all compliance requirements. In the event there are no compliance requirements filled and the tax-exempt status is revoked the organization can look up the reinstatement requirements and continue its operations without losing a considerable amount of time.

Being a nonprofit is a privilege and can be very beneficial. This is why nonprofit leaders, accountants, and advisors must educate themselves on the IRS rules, maintain good governance, and considerable records. This is all to protect the tax-exempt status of the nonprofit.

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