Belle had finally gotten back her IRS determination letter. She did it! She finally had a 501(c)(3) organization in place to pursue her charity dream. Belle found, though, that the process of forming her charitable organization and gaining IRS tax-exempt recognition had raised so many warnings and cautions that she hesitated to launch her organization’s website, recruit its first volunteers, and serve its first patrons. What if she did something wrong? What if she broke a law or rule and lost her organization’s 501(c)(3) status? If only she had a clearer understanding of what she was supposed to avoid.

Limitations

The prior chapters should have made clear that the IRS qualifies 501(c)(3) tax-exempt organizations as much by what they must not do as by what they may do. You’ve seen that your organization’s articles of nonprofit incorporation and bylaws must name certain prohibited activities. Your organization’s 501(c)(3) application had to represent to the IRS that it did not plan to engage in other activities. Violating these prohibitions can lead to IRS excise taxes and penalties, loss of 501(c)(3) status, regulatory investigations and fines, and civil liability. Your organization’s board of directors and executive director should be on the lookout to ensure that your organization does not engage in prohibited transactions. This chapter reviews the major limitations on charitable organizations.

Inurement

A prior chapter quoted a substantial portion of Internal Revenue Code Section 501(c)(3), naming the types of qualifying charitable organizations that can escape federal income taxation. That chapter referred to express limitations in Section 501(c)(3) without stating the limitations. The first and key limitation expressly within Section 501(c)(3) is that the charitable organization must be one “no part of the net earnings of which inures to the benefit of any private shareholder or individual....” The IRS and courts interpreting this provision refer to it as the inurement doctrine. The inurement doctrine means that the charitable organization must not allow the charity’s net receipts, what in the business context we would call profits, to benefit those who control the charity or those whom they favor or designate. You must not operate your charity for your own benefit, your family’s benefit, or another person you favor. Of course, you may operate your charity for the benefit of its individual patrons, the disadvantaged individuals whom your organization serves. Just don’t let its net receipts (profits) end up in your pocket.

Examples

The prior paragraph is probably clear enough. But the verb inure is such an uncommon word with vague meaning, and the inurement line is so hard to draw in specific cases, that you might benefit from some examples. A 501(c)(3) charity could run afoul of the inurement doctrine if, for instance, its founder purchased and lived on a Mediterranean yacht with gold-plated telephones in its bathrooms, out of its net receipts. Don’t laugh. It’s happened. A charity could likewise run afoul of the inurement doctrine if from inception and onward, it devotes 100% of its funds and services to the care of the severely injured son of the charity’s founder, without giving any consideration to devoting funds and services to other severely injured beneficiaries. A charity could likewise run afoul of the inurement doctrine if it uses 100% of its donated funds to employ the founder and the founder’s unskilled spouse and adult child, without accomplishing any visible or measurable charitable service. You get the picture. A 501(c)(3) organization isn’t a vehicle to launder donations into private benefits. A 501(c)(3) organization is instead a public trust, devoted to public benefit.

Lobbying

A second limitation appearing in Section 501(c)(3) is that the charitable organization must be one “no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h))....” Lobbying is the common term the IRS, courts, and others use for otherwise lawful efforts to influence legislators to adopt or reject legislation. In other contexts, nothing is generally wrong with lobbying. Citizens and corporations have every usual right to let their representatives know their preferences on legislation, just as representatives have natural duties to listen to their constituents. But not through a 501(c)(3) organization. Charitable organizations may have strong interests in lobbying to support or oppose various bills that could greatly help or severely adversely impact the individuals or groups whom they serve, around the unmet needs the organizations address. You can imagine. But beware lobbying. Section 501(c)(3) prohibits most, although not all, of it. See a subsequent chapter for how your organization may conduct limited lobbying.

Campaigning

A third limitation appearing directly in Section 501(c)(3) is that a charitable organization must be one that “does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.” No campaigning. No hanging campaign signs around the charity’s facility, no holding campaign fundraisers in the charity’s name, and no advertising that the charity endorses a certain candidate for election or reelection. Unlike the forgoing lobbying restriction, which only limits lobbying but does not entirely prohibit it, the restriction on campaigning is absolute. Stay away from campaigning. Individuals associated with the charity may of course campaign and endorse political candidates, but they should take care to do so in their individual capacity, not as charity representatives. 

Commerciality

The commerciality doctrine places another important limit on 501(c)(3) charitable organizations. Indeed, the doctrine, which does not appear directly in the Internal Revenue Code but the IRS and courts have derived from the Code, is at the core of what constitutes a charitable organization. Charitable organizations must not operate in a commercial manner, maximizing and retaining profits through product and service selection, pricing, and marketing to the consumer public as a competitor to for-profit businesses. A charitable organization that operates too much like a commercial firm and not enough like a charity can lose its 501(c)(3) status and face income tax liability on its commercial receipts. Charitable organizations operate to some degree on market principles. They look for unmet needs and try to fill them with helpful goods and services. But charitable organizations operate charitably, at losses made up by public donations, and not in direct competition with for-profit firms.

Business

Leaders and supporters of charitable organizations often consider selling goods and services unrelated to their charitable purpose commercially, and then using the funds to support the charity. But just because commercial or business activities fund charitable purposes does not make the business activities tax exempt. The destination of the funds does not matter. The nature of the activity, either charitable or business and commercial, matters for determining tax-exempt status. Your charitable organization should not be operating any business, even to generate funds to support its charitable activities. If your organization is conducting business in part, it must be reporting and paying taxes on that business income, no matter what your organization does with the business proceeds. If your organization conducts business but fails to report the profits from that business income, your organization can lose its tax-exempt status and incur substantial tax penalties.

UBIT

The IRS calls the income tax that 501(c)(3) charitable organizations must pay on business income, the unrelated business income tax, also known as UBIT. The adjective unrelated refers to the fact that the income does not advance the organization’s charitable purpose. It is income from business, not charity. If your charitable organization has unrelated business income, it must file the annual Form 990 information return. If the business income exceeds $1,000, your organization must also file Form 990-T to report the income and pay the tax. If the tax exceeds $500 annually, your organization must also make quarterly estimated tax payments. Unrelated business income can thus generate relatively substantial administrative obligations in bookkeeping and reporting. 

Examples

If you are unclear as to just what constitutes unrelated business income, consider these examples. Art museums may charge admission to help defray the cost of their collections and displays. Admission income relates directly to their charitable mission to promote understanding and appreciation of their art displays. The art museum may even sell prints of their artworks, with that revenue also relating to their charitable promotion of art appreciation. But sales of candy bars and soft drinks may produce unrelated business income on which the art museum would pay UBIT. Likewise, a church qualifying as a 501(c)(3) organization may maintain a parking lot for its members and guests to attend Sunday services. But if the church rents the parking out to local businesses during the week for their employees to park, the church may need to pay UBIT on the parking-lot proceeds, if, as it would appear, the rental is a business activity unrelated to the church’s charitable and religious mission.

Deciding

Consider the decision carefully, if your charitable organization has the opportunity to earn business income. While a few hundred or few thousand dollars in extra revenue may seem attractive, costs of bookkeeping and reporting requirements may eat up the benefit. Unrelated business income can also distract a charitable organization from its charitable purpose, distorting the allocation of resources and attention of leaders, staff, and volunteers. A charity’s business activities can also confuse the public and donors as to the charity’s mission and cause lost trust and reduced reputation. Ask whether the business revenue is worth the cost, risks, and dilution. In the second example given just above, it might be better to just let others park in the church lot during the week than to charge in a commercial manner for the parking.

Fraud

Your charitable organization must also avoid fraud and misrepresentation in its operations, especially in its solicitations. State attorney general offices maintain anti-fraud divisions to discourage, investigate, and prosecute fraud by businesses and charities. Fraud is a false statement of fact made to induce another’s reliance, causing that other a loss. Fraud is, in less technical terms, a scheme, scam, or swindle. In the context of charitable solicitations, fraud can occur when the charitable organization solicits donations for one purpose, when intending to use the donations for another purpose. Fraud can also occur when the organization solicits donations while saying it expends all donations or a high percentage of donations on direct charitable service, when to the contrary the organization spends a high percentage of donations on administrative costs. Your organization’s statements related to solicitation, and to every other matter like the measures of the organization’s charitable success, should be accurate in every respect, lest they falsely induce donations. Avoid fraud and misrepresentation.

Diversion

Diversion of charitable funds and property is another issue to watch and activity to discourage and avoid. As just mentioned above, the organization should devote donated funds, especially, to the charitable purpose for which the donor gave them. If the organization has excess donations after completing the activity for which the organization solicited the funds, the organization may be able to apply the excess to a related charitable activity. But notifying donors of the change in specific use of the funds is a good idea, to ensure that a donor does not believe that the organization’s solicitation was thus fraudulent and that the other use of the funds is an unlawful diversion. The organization should also not allow the diversion for personal use of program revenue or organization property. Charitable organizations hold their funds and property in public trust, devoted to their public purpose. Beware giving or loaning organization assets to officers, directors, employees, volunteers, or others for their personal use. Instead, sell unwanted assets at fair market value, and devote the proceeds to the organization’s charitable purpose.

Compensation

Paying excess compensation or benefits to the charitable organization’s executive director and other staff members is another concern to watch and avoid. The IRS may recover excess compensation through excise taxes and other penalties on the organization and its controlling officials. The person receiving the excess benefit may owe a 25% excise tax on the excess benefit, increased to 200% of the excess benefit if the person does not promptly restore the excess to the organization. The organization could also lose its 501(c)(3) status for paying out its funds in excess benefits to employees or others. To avoid excess-benefit concerns, when retaining an executive director and other employees, do a compensation study from information readily available online to ensure that your organization pays within the market’s range for services in equivalent roles with equivalent qualifications. Follow a sound Finance Committee and board of directors review and approval process for compensation, adjustments, and bonuses. Avoid performance-based bonuses measured directly by donations or revenue, especially when they exceed total compensation for equivalent positions in the market for employment with charitable organizations.

Key Points

• Organizations must limit their activities to retain 501(c)(3) status.

• The inurement doctrine prohibits charities from private benefit.

• Section 501(c)(3) prohibits any campaigning and substantial lobbying.

• Charities must not operate in a commercial manner. 

• Charities must pay income taxes on unrelated business income.

• Beware pursuing unrelated business for its distorting effects.

• Charities must avoid misrepresentation when soliciting donations.

• Charities must prevent diversion of charitable funds and property.

• Charities must not pay excess compensation and benefits.

Read Chapter 10.