Not-For-Profit/Exempt Organizations Blog : Non-Profit Lawyers & Attorneys : Proskauer Rose Law Firm : Tax & Corporate Law for 501(c), 501(3) Organizations

             Incorporating under Delaware law can be an attractive option for a not-for-profit organization because Delaware law often grants greater flexibility with respect to the governance and structuring of the organization.   For example, under Delaware law, a corporation (whether organized for profit or not) is only required to have one director, whereas the majority of states require a not-for-profit organization to have at least three directors, and Delaware law does not require a corporation to have officers.  

            Unlike many other jurisdictions, Delaware does not have a separate code governing not-for-profit corporations. Instead, not-for-profit corporations are governed by the same Delaware General Corporation Law (the “DGCL”) that applies to for profit corporations. Typically, although other entity options are available for forming a Delaware not-for-profit organization (such as a trust or a limited liability company), most Delaware not-for-profit entities choose to incorporate as a nonstock corporation (i.e., a corporation that is not authorized to issue capital stock and that has “members” and a “governing body” rather than “shareholders” and a “board of directors”). 

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It is essential that all public charities understand the basic rules surrounding their exemption.  Indeed, achieving tax-exempt status is only half the battle – once an organization has established that it is tax-exempt, it must set up the proper checks to ensure that it meets ongoing compliance obligations.  Plainly, certain activities can jeopardize an organization’s tax-exempt status or subject it to penalties.  Because the IRS revised its Compliance Guide for Public Charities and we are in such a highly regulatory environment, we thought it would be helpful to discuss some of the basic rules surrounding tax exemption.

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A majority staff director for the Senate Finance Committee said in an April discussion on philanthropy in the 21st century that perhaps it might be time to consider the tax liability for an entity that is neither wholly charitable nor wholly for-profit.  In fact, the director said that the Senate Finance Committee wrestled with the problem of a quasi-charitable entity in enacting the health care legislation, and said that the tax treatment of not-for-profit organizations might be revisited further in the tax reform context.

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In an interesting recent decision, International Schools Services Inc. v. West Windsor Township, N.J., the New Jersey Superior Court Appellate Division ruled that a not-for-profit organization whose purposes were to aid, promote and encourage educational organizations should lose its property tax exemption because its operation and use of the property was conducted for profit.  This decision should make not-for-profits with affiliated for-profits or an ongoing working relationship with for-profits carefully scrutinize their activities with these for-profit entities.

The not-for-profit challenged property tax assessments for the 2002 and 2003 tax years on office condominium units it owned in the township. The not-for-profit argued the property was exempt under N.J.S.A. 54:4-3.6 as property actually used in the work of a not-for-profit corporation organized exclusively for the moral and mental improvement of men, women and children.  Following the township's denial of tax exemption, the not-for-profit appealed to the New Jersey Tax Court.  The not-for-profit admitted that a portion of the property was leased to unrelated and related for-profit organizations, and did not claim an exemption for the portion of the property used for those purposes.

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The Tax Court recently delivered some sound advice – do not play “cat and mouse” with the IRS.  In Ohio Disability Association v. Commissioner, a Tax Court Memo filed November 12, 2009, the Tax Court rejected the petitioner’s request for a declaratory judgment that it qualified as a public charity.  The court’s rejection was based on its inability to conclude that the organization would operate exclusively for exempt purposes.

The opinion is instructive on how not to deal with the IRS in the exemption process.  Organizations seeking IRS recognition of tax exemption (which is required of almost all charities, except for churches) must file a 26-page Form 1023, which is explained in 38 pages of instructions.  The IRS also has extensive questions and answers further explaining Form 1023.

Notwithstanding the broad scope of the questions on the Form 1023, it is quite typical to receive further extensive questions from the IRS following its review of the Form 1023 submission package.  These questions usually seek elaboration on the current and proposed activities of the organization, compensation structure, information about the Board members, copies of documents referred to in the application (e.g., bond offering, leases, and employment agreements).  Some practitioners sometimes treat these supplemental IRS questions in a cavalier manner, considering them a nuisance.  This type of response is a mistake, as the petitioner in Ohio Disability Association v. Commissioner learned.  At a minimum, responding to IRS questions in this manner often leads to extensive delay in obtaining an IRS exemption letter.

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The IRS has reported that user fees will increase for all applications for exemption (Forms 1023, 1024, and 1028) postmarked after January 3, 2010:

• $400 for organizations whose gross receipts are $10,000 or less annually over a 4-year period (Currently $300)
• $850 for organizations whose gross receipts exceed $10,000 annually over a 4-year period (Currently $750)
• $3,000 for group exemption letters (Currently $900).

What's More...

Cyber Assistant, a web-based software program designed to help 501(c)(3) applicants prepare a complete and accurate Form 1023 application, will become available during 2010.  Once the IRS announces the availability of Cyber Assistant,  the user fees will change again:

• $200 for organizations using Cyber Assistant (regardless of size) to prepare their Form 1023
• $850 for all other organizations not using Cyber Assistant (regardless of size) to prepare their Form 1023.

We will let you know as soon as Cyber Assistant is available.

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People have been whispering among themselves about the L3C, an emerging low-profit limited liability company structure that aspires to link business methods with charitable purposes and give socially oriented businesses greater access to investor capital.  The structure was created by Robert M. Lang, Jr., CEO of the Mary Elizabeth & Gordon B. Mannweiler Foundation.  Conceptually, the L3C is a hybrid not-for-profit/for-profit entity: like a not-for-profit, it has a primary purpose of charity, but like an LLC, it can have equity holders that have a right to distribution of profits.  Notably, although profit is allowed in an L3C, it cannot be a significant purpose of the organization.  Vermont passed the nation’s first L3C statute in April, 2008, effectively making the form legal in every state since a Vermont L3C can technically do business nationally (even internationally).  Illinois, Michigan, the Crow Indian Nation in Montana, Utah, and Wyoming have followed suit, and similar bills are currently pending in Arkansas, Missouri, North Carolina, Oregon, and Tennessee.

The L3C is taxed like any other for-profit entity and is not eligible for tax exemption under Section 501(c)(3) of the Internal Revenue Code.  L3Cs hope to encourage an influx of new capital into charitable causes that are too risky for for-profit ventures and that nonprofit dollars alone cannot sustain.  The L3C effectively creates a market for investment in companies that offer low rates of return, but contribute to the community, unlike the non-profit, which offers no rate (and sometimes a negative rate) of return on investment.  Therefore, if an entity has a charitable mission, but does not believe it can be profitable, or has a social mission, but probably could not secure program-related investments ("PRIs") from private foundations, it would be better off forming as a not-for-profit or for-profit entity, respectively. 

L3Cs envision a tiered investment structure. The first tier relies on PRIs to cover the areas of highest risk.  Under current law, private foundations are required to spend at least 5% of their net asset value annually.  PRIs essentially function as loans that will be, at least theoretically, repaid.  Even with no interest, the PRIs will still count as qualifying distributions towards the 5% requirement.  The L3C creators believe that private foundations will make PRIs with L3Cs because the PRI requirements are incorporated directly into the L3C structure itself, eliminating the need for private foundations to apply for private letter rulings from the Internal Revenue Service ("IRS"), which can take up to 18 months to process and cost $50,000 or more in legal fees, plus a substantial fee to the IRS. 

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