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Reinstating Tax-Exempt Status for Nonprofits

In recent years, many nonprofit organizations have made the regrettable discovery that their tax-exempt status has been automatically revoked by the IRS. The loss of exempt status creates several undesirable results that may be compounded by the fact that the discovery of the revocation often does not occur until several years after the effective revocation date. In the interim, it is likely that the organization not only failed to report taxable income to the IRS but also falsely represented to the general public that donors were entitled to a tax deduction in exchange for charitable contributions made to the organization.

This problem has its origin in the Pension Protection Act of 2006, which created  numerous new rules for nonprofits. One of these rules provides that any tax-exempt organization that fails to file the appropriate tax return for three consecutive years will automatically lose its tax-exempt status. A second key rule created the requirement that nonprofits with less than $50,000 in annual revenue must file a simplified information return with the IRS. Previously, these small nonprofits had no filing requirement at all, but now they would be required to annually file Form 990-N, also known as the e-postcard, regardless of how little revenue they might have received.

Unfortunately, even though these changes went into effect more than a decade ago, many nonprofits remain blissfully unaware of the requirements. Indeed, the number of nonprofits that have fallen into this trap and have had their exempt status revoked is quite staggering. A recent check on the IRS web site indicates that more than 29,000 Pennsylvania nonprofits have had their exempt status revoked, and nationwide the number is over 750,000. Most of these nonprofits are 501(c)(3) public charities, but the list also includes other 501(c) tax-exempt organizations such as civic leagues, labor organizations, chambers of commerce, recreational clubs, fraternal societies, and Armed Forces posts.

The consequences of automatic revocation can be significant. From the nonprofit’s perspective, the loss of exempt status generally means that the organization will have to pay tax on the income it receives. Most nonprofits that have had their exempt status revoked are required to file Form 1120, U.S. Corporation Income Tax Return, or Form 1041, U.S. Income Tax Return for Estates and Trusts, and to pay any tax due as indicated on the return. Likewise, a private foundation that loses its exempt status must continue to file Form 990-PF, Return of Private Foundation, in addition to possibly having to file Form 1120 or Form 1041. Normally, failure to file these tax returns results in a penalty equal to 5 percent of the tax balance due for each month that the return is late, up to a maximum of 25 percent, but for policy reasons the IRS will not impose these penalties in the case of automatically revoked organizations.

Another important consequence of revocation is that donors are no longer entitled to claim a tax deduction for contributions to a 501(c)(3) public charity that has had its exempt status revoked. Although revocation is automatic, effective as of the due date of the third consecutive unfiled Form 990 return, the IRS does attempt to notify a revoked organization by letter, sent to the last known address, and will also publish a revocation notice on the IRS web site. But for a variety of reasons, many nonprofits do not discover for months or even years that their exempt status has been revoked. During that time, the organization may have accepted countless charitable contributions that were not deductible by the donors but were probably deducted nonetheless. The cutoff date for deductible contributions is the date the IRS publishes the name of the nonprofit on its list of revoked organizations. While it is unlikely that the IRS has specifically targeted deductions claimed in this manner, if such deductions are identified as the result of an unrelated IRS audit, they would of course be disallowed. Not only would this be sure to irritate past donors and undermine goodwill, but no public charity wants, and perhaps few can afford, to tell their prospective pool of donors that contributions to the organization are no longer deductible.

The good news is that automatic revocation can be avoided by simply filing the appropriate Form 990, and organizations that are eligible to file Form 990-N can do so electronically, in short order. But if revocation has already occurred, there are several options for reinstatement. These options have cumulative requirements that increase with complexity depending on the type of organization and how long it has been since the organization’s exempt status was revoked.

At one end of the spectrum is a streamlined procedure for retroactive reinstatement, available to organizations that were eligible to file Form 990-N or Form 990-EZ and that reapply for exempt status within 15 months of revocation. Retroactive reinstatement is also available for organizations that were required to file Form 990, provided that all previously required returns are filed and the organization can establish that it had reasonable cause for failing to file the returns in the first place. If more than 15 months have passed since revocation and if the IRS rejects the organization’s argument to establish reasonable cause for failing to file required returns, then reinstatement will still be permitted but will only be effective as of the postmark date of the application.

Many nonprofits operate on a shoe-string budget and have high turnover among members, officers, and directors. Most are justifiably more concerned about their charitable mission than they are about tax filing requirements. But running afoul of these requirements can have serious repercussions for the ongoing viability of the organization. Fortunately, staying compliant is often simply a matter of obtaining good information and timely advice in order to accurately prepare and file the appropriate Form 990.


DISCLAIMER: The foregoing does not constitute legal advice and has been prepared for informational purposes only. Please contact us directly with questions about how these and other nonprofit laws and procedures relate to your specific organization.

Prepared by GKH attorney Doug Smith. Attorney Smith practices in the areas of Estate Planning and Administration, Business Succession Planning, Nonprofit Organization, Corporate and Commercial Law, and Tax Law.