Charities, foundations and other nonprofit organizations play a crucial role at all levels of society with the overarching goal of serving the public good. While this mission is admirable, the fact remains that nonprofits must comply with a number of tax regulations in order to keep their tax-exempt status. The IRS and state tax agencies expend substantial resources in order to ensure that nonprofit organizations are enriching the public, and not enriching themselves.
In fiscal year 2016, the IRS audited nearly 5,000 nonprofit organizations. Given the possibility of an audit and the importance of tax compliance in general, nonprofits must take proper measures to protect themselves. In a previous posting, we discussed the nonprofit tax issues the IRS will devote its resources to in 2017. The IRS has indicated that the most important tax issues for nonprofits in 2017 are unrelated business income tax liability and employment taxes.
Unrelated Business Income Tax Liability
The IRS defines unrelated business income as the following:
- Income earned in a trade or business
- This activity is “regularly carried on”, and
- The activity is not “substantially related” to the organization’s purpose.
Whether an activity is substantially related to the organization’s purpose depends on whether the income “contributes importantly to accomplishing the organization’s exempt purposes.” Any nonprofit that has earned unrelated business income must report this income and pay unrelated business income taxes. Examples of unrelated business income could include rental income from real estate owned by the nonprofit, gaming proceeds and investment income.
In addition, if the IRS has reason to question a given source of income for a nonprofit, the nonprofit must have adequate document to show the income is either not unrelated business income, or that it falls within one of the exceptions to the unrelated business income rule.
Every nonprofit with employees must withhold federal income taxes, as well as Social Security and Medicare taxes. Organizations that are not section 501(c)(3) organizations must also pay unemployment taxes. One major issue that often arises with nonprofits is misclassifying employees as independent contractors. Misclassification is not only an employment issue, but a tax issue. Failing to collect or properly withhold employment taxes can lead to severe penalties, including the Trust Fund Recovery Penalty (TFRP).
Other Tax Issues of Concern for Nonprofits
In addition to unrelated business income tax liability and employment taxes, the IRS may also scrutinize other issues, such as:
- An organization’s tax-exempt status or whether it is properly classified as a private foundation
- Compensation to management, directors and employees of the foundation
- If a nonprofit conducts lobbying efforts, it may be more likely to be subject to an audit
Careful tax planning and strong audit representation can provide tangible benefits to nonprofits of all sizes. As part of our full-service tax practice, we at Goldburd McCone LLP represent nonprofits facing these and other taxation issues. While based in Manhattan, our attorneys maintain a national nonprofit tax practice.