Losing 501(c)(3) status means your organization is no longer tax-exempt. You must pay federal income taxes on your organization’s net income, and you may also need to pay state income and sales tax. You will struggle to get donations as they are no longer tax-deductible to donors, and you generally will not be able to receive grants or any other funding designed for 501(c)(3) organizations.
However, there are ways to request reinstatement. At Wiggam Law, our experienced tax attorneys can help non-profit organizations reinstate their tax-exempt status – or if that’s not the right option for you, we can help you understand the implications of operating as a nonprofit without tax-exempt status. To schedule a consultation, please contact us today.
Key takeaways
- The IRS may revoke your tax-exempt status for not filing returns or running afoul of the guidelines for tax-exempt organizations.
- Failure to file returns for three consecutive years results in automatic revocation.
- IRS auditors may review your returns, your finances, and your operations and recommend revocation of your tax-exempt status if you’re not in line with the requirements for tax-exempt organizations.
- To apply for reinstatement, file a new exemption form and make any necessary changes to your operations. You can apply for retroactive reinstatement if you lost your tax-exempt status for failure to file returns.
- Work with an experienced tax attorney to appeal revocation, apply for reinstatement, and get back into compliance with the IRS.
Consequences of losing your 501(c)(3) status
If the IRS revokes your 501(c)(3) status, your organization will no longer be exempt from federal taxes. It will have to file tax returns and pay tax on your organization’s net income (income including all donations, minus business expenses). You also will not be able to accept tax-deductible donations. However, you can apply for reinstatement.
The IRS may also revoke the tax-exempt status of 501(c)(4), 501(c)(5), 501(c)(6), and 501(c)(7) organizations, forcing these organizations to file and pay federal taxes. However, these organizations are subject to different rules than 501(c)(3) organizations – namely, related to political activities and the tax deductibility of donations. By extension, the audit, revocation, and reinstatement processes are slightly different.
Regardless of which part of the tax code applies to your organization, the team at Wiggam Law can help you move past revocation and back towards your mission.
Common reasons the IRS revokes 501(c)(3) status
The IRS may revoke your 501(c)(3) status if your nonprofit fails to follow the rules in any of these six categories:
- private benefit/inurement
- lobbying
- political campaign activity
- excessive unrelated business income (UBI)
- not operating in accordance with stated exempt purpose(s)
- missing your annual reporting obligation
The IRS automatically revokes tax-exempt status if you fail to file a tax return for three consecutive years – missing the annual reporting obligation is the most common reason for revocation, affecting tens of thousands of nonprofits each year. You cannot appeal an automatic revocation, but you can apply for reinstatement. The IRS will also reinstate you if the automatic revocation was done in error.
All other 501(c)(3) revocations are handled on an individual, case-by-case basis through audits. During the audit, the IRS examines your tax returns and activities. If you’re breaking the rules, you may face excise taxes or penalties, but ultimately, the IRS may decide to revoke your tax exemption.
Continue reading for more details on why the IRS may revoke a 501(c)(3) organization’s tax-exempt status.
Private benefit
You may lose your tax-exempt status if the organization benefits insiders – for example, paying excessively high salaries or providing homes or vehicles to board members, officers, directors, or employees. The IRS refers to improper personal benefit from a nonprofit as inurement.
The IRS may assess a penalty against board members who privately benefited from the corporation. Typically, the penalty is 25% – for example, if a board member received $100,000 in excess salary, the penalty would be $25,000. It must be paid by the individual – not by the organization. The penalty may increase to 200% if the situation is not fixed. Eventually, the organization may lose its tax-exempt status.
Lobbying or Political Campaign Intervention
Lobbying is the attempt to influence legislation. This includes communications with legislators or government officials who participate in formulating legislation, as well as attempts to affect the opinions of the general public about legislation (grassroots lobbying). Tax-exempt 501(c)(3) organizations are allowed to do some lobbying, as long as it’s not a substantial part of their activities.
To determine if lobbying is substantial, the IRS employs either a substantial parts test or an expenditure test.
The substantial parts test looks at several factors, including the time and money spent on lobbying. If you lose your tax-exempt exempt status due to excessive lobbying under the substantial parts test, your organization must pay an excise tax of 5% of its lobbying expenditures. The IRS may also assess a 5% tax against the organization’s managers who agreed to the lobbying expenses.
To use the expenditure test, you must file Form 5768 (Election/Revocation of Election by an Eligible IRC Section 501(c)(3) Organization to Make Expenditures to Influence Legislation). Then, your lobbying expenditures must stay under the following limits based on your total exempt purpose expenditures:
| Total Exempt Purpose Expenditures | Lobbying Expenditure Limit |
|---|---|
| $500,000 or less | 20% of total exempt purpose expenditures |
| Over $500,000 and up to $1 million | $100,000 plus 15% of exempt purpose expenditures over $500,000 |
| Over $1 million but under $1.5 million | $175,000 plus 10% of exempt purpose expenditures over $1 million |
| Over $1.5 million and up to $17 million | $225,000 plus 5% of exempt purpose expenditures over $1.5 million |
| Up to $17 million | Up to $1 million |
If you elect to use the expenditure method and you exceed the limit, you’ll face an excise tax of 25% of the excess lobbying expenditures. If you engage in excessive lobbying at any point in four years, you will lose your tax-exempt status and be taxed on all income received during that period. The expenditure test applies until you request a revocation. Revocation applies the year after your request.
Political campaigning
You can lose your 501(c)(3) status for participating in political campaigns. Section 501(c)(3) organizations cannot directly or indirectly engage in campaigning, including:
- contributing to political campaign funds and
- making public statements in favor of political candidates.
However, they can engage in voter education or registration, as long as there’s no political bias.
Earning too much unrelated business income
If you earn income that is not related to your main purpose, you may need to file tax returns for unrelated business income (UBI) and pay tax at the corporate income tax rate, but too much UBI may put your organization at risk.
Nonprofits earn UBI in a variety of ways – for example, renting out space in a building owned by the nonprofit, selling items to non-members, or accepting advertising in a nonprofit magazine. The IRS doesn’t clearly define how much UBI is too much, making it critical to work with an experienced tax attorney if your non-profit status is at risk.
Not operating based on the stated exemption
When you apply for tax-exempt status, you explain your organization’s purpose, and you must notify the IRS if your operations change or are not in line with your stated exemption.
IRS audits of 501(c)(3) status
The IRS may audit the financial returns or activities of tax-exempt organizations to ensure they comply with the rules. If not, the auditor can propose revocation of your tax-exempt status.
At that point, you have 30 days to appeal. During the appeal, you maintain your tax-exempt status, and the IRS can’t disclose anything publicly about the audit.
During the appeals conference, your representatives get to present your side of the story to an appeals officer. You must prove that the auditor was incorrect and that you’re in line with the rules for Section 501(c)(3) organizations. The agent who conducted the original audit is not at the conference.
If Appeals agrees with the revocation, they’ll send a final adverse determination letter. At that point, you lose your tax-exempt status, but you have 90 days to petition the U.S. Tax Court, the U.S. Court of Federal Claims, or the U.S. District Court for the District of Columbia.
How to reinstate tax-exempt status after revocation
You can apply for reinstatement if the IRS revokes your tax-exempt status, either automatically or after an audit. To apply for reinstatement after automatic revocation, file Form 1023 or 1023-EZ. This is the form you use to apply for tax exemption, but you’ll need to fill out sections four, five, six, or seven when requesting reinstatement.
If you lost tax-exempt status after an audit, make sure you exhaust your appeals options first. If you cannot avoid revocation, you can operate as a non-tax-exempt nonprofit, but if you want to get back your tax exemption, you’ll need to address the reasons for the revocation, make changes to your organization, and then apply for reinstatement with Form 1023.
FAQs about losing your 501(c)(3) tax-exempt status
Which returns should I file if I lose tax-exempt status?
If you lose tax-exempt status, most nonprofits should file Form 1120 (U.S. Corporation Income Tax Return). However, if your organization is an estate or trust, you should file Form 1041 (Estates and Trusts). Check with your state department of revenue to figure out which returns you should file on the state level.
Can the IRS shut down my nonprofit?
No, the IRS does not have the right to shut down nonprofits, seize their assets, or take control of the organization. The agency can only revoke its tax-exempt status on the federal level.
What is a 501(p) suspension?
A 501(p) suspension occurs when the IRS revokes a non-profit’s tax-exempt status for terrorist activities. These rules allow the IRS to bypass the appeals process required with most tax-exempt revocations, but the organization still has the right to challenge the determination.
Does 501(c)(3) revocation mean loss of nonprofit status?
No, 501(c)(3) revocation means an organization lost its tax-exempt status on the federal level. Nonprofits are established at the state level. After revocation, the organization typically becomes a taxable nonprofit corporation.
Are all tax-exempt organizations banned from political activity?
No, not necessarily. Organizations that are tax exempt under the 501(c)(3) rules cannot campaign at all and cannot perform substantially lobbying. However, 501(c)(4), (5), (6), and (7) tax-exempt organizations are allowed to do more lobbying and even campaigning. Make sure you understand the unique rules for your tax-exempt organization.
Can the U.S. President revoke tax-exempt status?
No, the U.S. President cannot revoke a nonprofit organization’s tax-exempt status. The President also cannot legally instruct the IRS to investigate or audit a specific group.
Contact Wiggam Law today
At Wiggam Law, we have extensive experience representing all kinds of entities in front of the IRS. If you’re facing an audit of your nonprofit organization, appealing revocation, applying for reinstatement, or dealing with any other problems, we can help. To learn more, contact us today.
