Maintain Tax Exempt Status – Nonprofits

By: Susan G. Amstadtertax exempt status

MEMORANDUM

TO: Directors and Officers of [the name of the nonprofit corporation]

FROM:  Murphy, Bantz & Bury, P.L.L.C.

RE:  Maintain Tax Exempt Status and Other Post Incorporation Matters

 

Important Notes:  The information contained in this memorandum is provided as of  August 2012, and is subject to change. Nonprofit organizations should understand that it is the obligation of the nonprofit corporation’s board to stay informed of any changes.This memorandum is provided for information only regarding tax exempt status and does not take into account particular facts and circumstances relevant to any specific nonprofit corporation. Depending on such factors as what legal steps and filings have already been completed by the nonprofit corporation, the specific provisions of the corporation’s governing documents, and other facts relevant to the specific corporation, some requirements outlined in this memorandum may not apply to such corporation.

This memorandum should not be construed as legal advice.

Nonprofits reading this memorandum should contact an attorney for legal advice about how this information may apply to the corporation’s specific situation. Some corporations may need additional information not discussed in this memorandum.

Overview

A. Observance of Corporate Formalities

            Meetings of Directors

            Keeping Books and Records

B.  Directors’ Duty of Care

            Avoiding Conflicts of Interest

            Directors’ and Officers’ Insurance

C.  Maintaining Federal Tax-Exempt Status

            Operation/Exempt Purpose

            IRS Annual Return

                        Unrelated Business Income

                        Employment Tax

            Substantiation and Disclosure Requirements

D.  State Annual Report

E. Registration as a Charity

F. Washington Department of Revenue

 

A. Observance of Corporate Formalities

Incorporation as a nonprofit provides a number of advantages such as limited liability for the individuals acting on behalf of the corporation, a perpetual business existence, and eligibility for special treatment under the tax codes. However, the corporation can preserve these advantages only if it maintains what are called “corporate formalities.” Corporate formalities are the basic rules and procedures for governing and operating a corporation, many of which are usually described in the organization’s bylaws. To maintain its status as a separate legal entity which enjoys tax exempt status, the corporation must follow its bylaws and keep records of all formal corporate activities.

Meetings of Directors

Regular meetings of the board of directors meetings are one of the most important of the corporate formalities. After the Articles of Incorporation were filed and a certificate was issued by the Secretary of State, the corporation held an organizational meeting “for the purpose of adopting bylaws, electing officers and the transaction of such other business as may come before the meeting.”  Revised Code of Washington (RCW) Section 24.03.155.

The corporate record book should contain the minutes of the organizational meeting or the consent in lieu of a meeting which the clinic prepared for (name of the nonprofit corporation]. While there is no statutory requirement with respect to how frequently the board of directors should meet, regular meetings held at least quarterly will allow the board to deal with both routine and uncommon matters as they arise.  Consequently, [name of the nonprofit corporation]’s bylaws mandate [quarterly or monthly] meetings of the board.

Some of the matters appropriate for board action (and minutes of a meeting, or a consent in lieu of a meeting) include the following:

1. Election or removal of directors;

2. Appointment or removal of officers, which must include a president, one or more vice presidents, a secretary, and a treasurer.  The bylaws may provide for the appointment of other officers as the board may deem necessary.  Any two or more offices may be held by the same person, except the offices of secretary and president.

3.  Appointment of any board committees;

4. Review of financial arrangements, including review of investments, opening and closing of corporate accounts, designation and change of corporate officers authorized as signatories, review of cash flow needs and review of financial statements;

5. Approval of:  significant contracts and leases, corporate borrowing or loans, or the sale, lease, or other disposition of corporate assets;

6. Adoption of budgets and policy decisions with respect to the expenditure of funds and ratification of those expenditures; appointment of auditors;

7.  Compliance with governmental reporting requirements;

8.  Approval of indemnification of corporate directors, officers and other agents;

9.  Amendment of the articles of incorporation;

10.  Amendment, repeal or adoption of bylaws; and

11.  Approval of mergers, reorganizations and dissolutions; and generally,

12. Any other matters not delegated to an officer of the corporation.

The board of directors should also review and approve the compensation of officers and employees, and any written employment agreements, to verify they are just and reasonable. Such review should be performed at the time of hiring, and whenever compensation is modified or the employment term is extended.  Compliance with the compensation policy set forth in the bylaws should insure that salaries and benefits are reasonable.

In order to keep a proper record of your board meetings, the secretary of the corporation should draft minutes of each meeting, or a written unanimous consent form to be signed by each member of the board (or committee) evidencing any corporate actions. Those drafts are usually reviewed at the next meeting of the group, and after approval, all minutes and consent forms should be placed in the corporate record book.  While it is not necessary, and often not advisable, to attempt a verbatim record of everything that is said during a meeting, minutes to a meeting should minimally include the following:

Identification of the group that is meeting;

Date of the meeting;

List of those individuals present;

Brief description of items discussed and action taken on each item (including the wording of the motion(s) and resolution(s) adopted).  .

A form of sample minutes of a meeting of the board of directors is attached as Appendix A.

A sample “consent in lieu of meeting” form is attached as Appendix B.

Keeping Books and Records

The corporation should keep a corporate record book or series of books containing all of its organizational and corporate documents.  A 3-ring notebook is often used for this purpose. Documents to be kept in the corporate minute book include the articles and bylaws and any amendments to those documents, [a list of members, including names, addresses, and classes of membership] a list of officers’ and directors’ names and addresses, minutes of all board and committee meetings, meeting agendas, notice or waivers of notice of all meetings, [membership lists or certificates], the tax exemption application and determination letter, and annual reports. Documents to be kept in additional books or separate files include statements of accounts and finances, insurance policies, warranties, contracts, leases and other legal documents, and copies of all communications with board members, officers, members and contributors.  Corporate records should be kept at the registered office, the principal office, or the office of the secretary of the corporation.

B.  Directors’ Duty of Care

Individually and as a group, members of a nonprofit board of directors are responsible for the activities of the organization. As a general rule, board members are solely responsible for determining the organization’s policies.

Responsibilities fall into three categories:

1. Planning – The Board has a major responsibility to establish goals and objectives that support the association’s mission statement.

2. Directing – The Board should be able to guide the association and supervise the overall objectives in a successful manner.

3. Financial Management – The board has an obligation to maintain the financial integrity of the organization; if the-day-to-day operation is overseen by the executive director and/or controller, the board maintains oversight responsibilities.

Directors are considered fiduciaries of nonprofit organizations.  Therefore, as a general proposition, a director must perform his or her duties in good faith, in a manner he or she believes to be in the best interest of the corporation, and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances. An implicit corollary is that each director has an obligation to insure that the corporation acts in accordance with its corporate purposes (as expressed in the corporation’s articles of incorporation and bylaws) and with all applicable laws.

A director is entitled to rely on information, opinions, reports or other statements (including financial statements and data) prepared by officers or employees of the corporation, legal counsel, independent accountants, or other persons, so long as the director has a reasonable belief in the presenter’s reliability, competence, and/or expertise and acts in good faith. A director may be obligated to conduct a reasonable inquiry into the information to be relied upon when the need for such inquiry is indicated by the circumstances. Of course, a director may not rely on any information received when he or she has knowledge of facts that would cause such reliance to be unwarranted.

Members of the board should also be aware that special duties are required with regard to assets held by the corporation for investment. The board must avoid speculation, consider the probable income of the investment, as well as the probable safety of the corporation’s capital, and comply with any agreement pursuant to which assets are contributed to the corporation.

Avoiding Conflicts of Interest

A director with an indirect or direct financial interest in a transaction to which the corporation is a party is termed an “interested director”.  Transactions involving an interested director are not prohibited completely, but are permitted only if the Corporation is acting in its own interest and for its own benefit, and the transaction is approved after the board has followed the procedures set forth in the conflict of interest provisions contained in the corporation’s bylaws.  The conflict of interest provisions are summarized as follows:

A director must not place his or her interests or the interests of another person ahead of the interest of the corporation. A board member should be required to disclose a potential or apparent conflict of interest situation to the board. The disclosure should be full and immediate and include information sufficient to apprise other board members of the nature of the potential conflict, the extent of the conflict and whether the conflict is substantive or only a potential conflict.  Other board members should then determine whether the board member who has disclosed a conflict may participate in the board discussions about the conflict of interest item and whether that board member should be entitled to vote on any proposition relating to the disputed matter. The minutes of any meeting, at which a board member reveals or discusses a potential conflict, should reflect those discussions in detail.

Insurance

            Directors’ and Officers’

A nonprofit corporation may purchase liability insurance on behalf of its directors and officers to cover claims related to allegations of “bad decisions” or “wrongful acts”.  Most D&O insurance excludes claims based on:

  • Dishonest, fraudulent, or criminal acts. Even if the policy does not specifically exclude coverage for claims based on such conduct, most definitions of “wrongful act” specifically include only negligent conduct;
  • Fines, penalties or punitive damages;
  • Intentional conduct such as libel and slander – as a general rule, insurance does not cover intentional conduct;
  • Bodily injury or property damage;
  • A director or officer gaining an personal profit or advantage to which he or she was not legally entitled;
  • Employment claims, unless an endorsement for employment liability is purchased;
  • Claims brought by the corporation against its own directors or officers; or
  • Losses covered by other insurance.

Public Liability

Public liability insurance covers the organization’s liability for harm caused to others for which it is directly or vicariously liable including harm caused by the negligence of a volunteer.  The RCW Section 4.24.670 prescribes the amount of coverage that must be in place in order to protect volunteers from liability for their acts or omissions.

The elements of any policy of insurance such as deductibles, co-insurance levels, exclusions and other aspects can vary significantly. The board should review such items carefully and consider consulting and insurance broker knowledgeable in this field.

C.  Maintaining Federal Tax-Exempt Status

Operation/Exempt Purpose

In order to maintain tax-exempt status, an organization must continue to meet each of the requirements that qualified it for federal tax exemption in the first place. In particular, an organization must be operated primarily for the exempt purposes set forth in its organizational documents.  Activities that are not in furtherance of exempt purposes are permitted only if they are insubstantial (for example, in terms of time and money expended) in relation to an organization’s exempt purpose activities. Violating any of the following prohibitions may result in denial or revocation of tax-exempt status.

  • The corporation must never allow any of its assets to benefit an “insider”
  • The corporation must not participate, directly or indirectly, in any campaign for political office
  • The corporation may not attempt to influence legislation except as an insubstantial part of its activities

IRS Annual Return

Like any tax payer, most tax-exempt organizations, other than churches, must keep books and records and file a yearly return or notice with the IRS.  If an organization does not file annually for three consecutive years, it loses its tax-exempt status.  The annual information form an organization is required to file is determined by either the organization’s type or its financial activity. For example, all private foundations file Form 990-PF. Small organizations file the Form 990-N, also known as the ePostcard; mid-sized organizations may file Form 990-EZ; and larger organizations must file the full Form 990.  Organizations should refer to Annual Exempt Organization Returns (www.irs.gov/charities) to determine the appropriate form to file for their organization.

For the 2010 tax year (filed in 2011), organizations with annual gross receipts normally less than $50,000 are eligible to file Form 990-N (e-Postcard), but may choose to file a complete Form 990 or Form 990-EZ.  The e-Postcard is due every year by the 15th day of the 5th month after the close of the corporation’s tax year (either calendar or fiscal).  For example, if the corporation’s tax year ended on December 31, the e-Postcard is due May 15 of the following year.  The e-Postcard must be filed even if the application for exemption is still pending.  An officer of the organization must call Customer Account Services at 1-877-829-5500 and ask that the organization be set up to allow filing of the e-Postcard.

Completing the e-Postcard requires the eight items listed below:

  1. Employer Identification Number (EIN), also known as a Taxpayer Identification Number (TIN).
  2. The corporation’s tax year
  3. Legal name and mailing address
  4. Any other names the organization uses
  5. Name and address of a principal officer
  6. Web site address if the organization has one
  7. Confirmation that the organization’s annual gross receipts are normally $50,000 or less
  8. If applicable, a statement that the organization has terminated or is terminating (going out of business)

There is no paper form; the e-Postcard must be filed electronically by accessing this site: http://epostcard.form990.org.  The IRS is no longer mailing tax packages to tax-exempt organizations required to file an annual Form 990, 990-EZ, 990-PF, 1120-POL, or 5227. Instead, these organizations will receive a postcard from the IRS explaining how to obtain forms, instructions or other tax products.

Unrelated Business Income Tax

Even though an organization is recognized as tax exempt, it still may be liable for federal tax on its “unrelated business income”.  Unrelated business income is income from a trade or business, regularly carried on, that is not substantially related to the charitable, educational, or other purpose that is the basis of the organization’s exemption. Such a business must be “insubstantial” or the organization will lose tax-exempt status altogether.

Generally, a trade or business is an activity that involves selling goods or services to produce income.  The fact that profits from such activity are essential to the organization’s ability to carry out its exempt purpose does not turn an “unrelated” business into a “related” one.  Instead, the business must be connected to the exempt purpose by more than the mere production of funds in order to avoid the tax on net income.

Even if there is an unrelated trade or business, its net income is only taxed if the business is regularly carried on. In determining whether a trade or business is regularly carried on, the frequency and continuity of the business are compared with the frequency and continuity of a similar business conducted by a non-exempt organization. Generally, an activity is not regular if it is carried on only one or two weeks per year. Infrequent conduct such as an annual fundraising event is not regular. Because the determination of whether a trade or business is unrelated or regularly carried on depends on the particular facts of each situation, the organization should consult a tax advisor regarding its specific activities.

An exempt organization that has $1,000 or more of gross income from an unrelated business must file Form 990-T.  An organization must pay an estimated tax if it expects its tax for the year to be $500 or more.  The obligation to file Form 990-T is in addition to the obligation to file the annual information return, Form 990-N, 990-EZ, 990 or 990-PF.

Disclosure Requirements

In general, exempt organizations must make available for public inspection certain annual returns and applications for exemption, and must provide copies of such returns and applications to individuals who request them.  Copies usually must be provided immediately in the case of in-person requests, and within 30 days in the case of written requests.  The tax-exempt organization may charge a reasonable copying fee plus actual postage, if any. The IRS must also make this same information available to the general public.

Charitable Contribution ReportingThe Internal Revenue Code applies substantiation requirements for donors, and disclosure requirements for charitable organizations, in connection with charitable contributions. For a detailed discussion of the substantiation and disclosure requirements for charitable contributions, see IRS Publication 1771, Charitable Contributions: Substantiation and Disclosure Requirements.

Contributions

Donors will be entitled to rely on the determination letter in making donations to the corporation unless the IRS changes the corporation’s status and publishes a notice of the change. The corporation must inform the IRS of any change in its sources of support, purpose, character or method of operation, and any amendments to its articles of incorporation or bylaws. While an organization’s Form 1023 is waiting for approval from the IRS, the organization may operate as a tax-exempt organization. Although donors have no assurance that contribu­tions are tax-deductible for federal income tax pur­poses until the application is approved, contribu­tions made while an application is pending would qualify if the application is approved. However, if the application is disallowed, contributions would not qualify.

State Annual Corporate Report

Nonprofit corporations must file an annual report with the Washington Secretary of State and pay a corporate renewal fee each year, even if there is no change within the company.  The registered agent should receive the renewal notice in the month prior to the corporation’s anniversary month, but failure to receive the notice is no defense to a penalty for failure to file on time.   Failure to complete an annual report will result in delinquent fees and automatic dissolution of the corporation. The annual report may be filed online at www.sos.wa.gov/corps.

Registration as a Charity

In addition to filing the annual report, organizations that raise funds from the general public may be required to register with the Charities Program of the Secretary of State.  An organization is not required to register if it raises less than twenty-five thousand dollars in revenue in any accounting year, all activities including fund-raising are conducted by volunteers, and its officers or members do not receive any assets of or benefits from the organization.  Registration requirements and forms are found at www.sos.wa.gov/charities.  The Corporation should register before engaging in charitable solicitations in Washington.

Online filings are now available for organizations conducting fundraising activities in Washington State that are exempt from the registration requirement with the Charities Program. There is NO filing fee.  Registration is available at: http://www.sos.wa.gov/charities/OnlineFilingsareNowAvailable.aspx.

Even if the organization is exempt from registration, it must still comply with the conditions for solicitations as described in the RCW Section 19.09.100.  The full text of the statute may be found on line at: http://apps.leg.wa.gov/rcw/default.aspx?cite=19.09.

The City of Spokane also requires an organization to obtain a permit when conducting charitable solicitation.  Additional information is available at:  www.spokanecity.org/departments/finance/taxlicenses/licenses/#charitablePermit

State Tax Liability – Registration with the Washington State Department of Revenue

Unlike most states’ and the federal tax systems, Washington’s tax system, specifically its business tax, applies to nonprofit organizations.  In Washington, nonprofit organizations are generally taxed like any other business. They must pay business and occupation (B&O) tax on gross revenues generated from regular business activities they conduct.  All property, real and personal, is subject to tax, unless specifically exempted.  An organization must apply to the Department of Revenue for the exemption; it should not assume that a property tax exemption is automatic.  A nonprofit organization must pay sales tax on all goods and retail services it purchases as a consumer, such as supplies, lodging, equipment, and construction services.  In addition, nonprofit organizations must collect and remit retail sales tax on its sales of goods and retail services.  Nonprofit organizations with $12,000 or more per year in gross receipts from sales, and/or gross income from services subject to the B&O tax or who are required to collect or pay to the Department of Revenue retail sales tax or any other tax or fee which the department administers (regardless of the level of annual gross receipts) must register with the department.

General information may be found at: http://dor.wa.gov/content/doingbusiness/businesstypes/industry/nonprofit/default.aspx  The Department of Revenue also has a general publication on nonprofit tax liability, available at http://dor.wa.gov/docs/pubs/industspecific/nonprofit.pdf.

Employment/Workers Compensation Tax

If a tax exempt organization has employees, it is responsible for Federal Income Tax Withholding and Social Security and Medicare taxes. In addition, some exempt organizations are responsible for Federal Unemployment Tax.  Two key publications on employment tax issues are Publication 15, Circular E, Employer’s Tax Guide, and Publication 15-A, Employer’s Supplemental Tax Guide.  A corporation with employees must also register with the Washington Department of Labor and Industry.  This is accomplished by filing a Master Business Application.  More information is available at www.dol.wa.gov/business.

Local Business License

All businesses operating in the City or with the City are required to obtain a City of Spokane Business License.  Information is available at www.spokanecity.org/departments/finance/taxlicenses/business.

Finally, THINGS CHANGE – including the information in this memo.  Information and forms available on a website are usually the most current versions available.