Applying for Tax Exemption? Toy with the IRS at Your Peril

Posted on February 5, 2010 by Jacob I. Friedman

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.

In denying the petitioner tax exemption, here are some of the faux pas that the court pointed to:

1. In the numerous letters that were exchanged between the organization and the IRS, the organization’s answers were “often curt and, for the most part, referred [the IRS] back to prior letters and the initial application.”  (Interestingly, the court notes that, at times, the IRS inquiries “were not coherent.”)

2. The organization’s letters included conclusory statements that the requirements for tax exempt status were satisfied.

3. In response to a question on how the conflict of interest policy would be implemented, the organization said that it copied the policy from the instructions.

4. Most of the organization responses were general and conclusory.

5. The organization supplied a sample pooled trust agreement when requested to supply the actual agreement that would be used by the organization. 

The lesson of the case is to fully and timely respond to all questions, even if the organization or its representative believes that the IRS is asking questions that are unnecessary or repetitive. 

We have seen situations where playing games has resulted in inordinate delay and extensive additional legal fees.  If the IRS unduly delays in issuing a determination of exemption, try filing a Form 911, a form not commonly known among practitioners, with the National Taxpayer Advocate Office.  For an interesting annual report by that office, see the National Taxpayer Advocate's 2009 Annual Report to Congress, which discusses, among other things, how targeted research and increased collaboration are needed to meet the needs of exempt organizations.
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With the New Form 990, Directors and Trustees Must Complete a Complicated Disclosure Form

Posted on January 28, 2010 by Elizabeth M. Mills

The IRS completely redesigned Form 990, the Return of Organization Exempt from Income Tax, to be filed for calendar year 2008 and subsequent periods.  This Form is filed by most tax-exempt organizations and is open to public inspection.  One stated purpose of the makeover was to increase transparency and disclosure of exempt organization operations, thereby improving governance and highlighting conflicts of interest and insider dealings.  One major change in the Form is that it requires extensive reporting concerning the organization’s governance and management policies, the independence of its board, and board members’ and key employees’ family and business relationships with each other and with the reporting organization.

Organizations that report on a calendar year basis will already have filed their first year of the new form and at this point should review their information-gathering procedures to identify any needed improvements.  Organizations that have a June 30 year-end either will already have filed with the new form for the period ending June 30, 2009 or will be in an extension period for filing.  Organizations that have not yet filed the new form should be reviewing their disclosure questionnaires to make sure they are collecting all needed information.

Questions about board members’ and key employees’ family and business relationships with each other have been on the Form 990 in one guise or another in recent years.  Section 501(c)(3) organizations have also had to answer generally worded questions about board members’ relationships with the reporting organization.  However, on the new Form 990, the questions have become more specifically defined and the detail required to answer them has increased.  In addition, for the first time, Form 990 asks about the number of independent board members – with a very specific definition of “independent.”  The information needed to determine independence overlaps with, but is not identical to, the information needed to answer the questions about family and business relationships.

What this means is that the reporting organization must seek more personal information than ever before from its board members and other individuals connected with the organization in order to accurately complete the Form 990.  Moreover, the current focus of the IRS and the public on tax-exempt organization abuses, and the publicity surrounding the issuance of the new Form 990, will cast a spotlight on organizations’ responses to this form.

The information exempt organizations must now obtain from their board members, officers, and key employees includes:

·        Whether they or any of their family members engaged in any business transactions with the organization;

·        Whether entities of which they or their families owned more than 35 percent engaged in any business transactions with the organization;

·        Whether they do business, other than as a member of the general public, with another board member, officer, or key employee, or with an entity of which another board member, officer, or key employee is a director, officer, or more than 35 percent owner;

·        Whether they have a family relationship with any other director, officer, or key employee of the organization; and

·        Whether they are a director, officer, or greater than 10 percent owner of an entity of which another of the organization’s directors, officers, or key employees is a director, officer, or greater than 10 percent owner.

A complete list of the required information would run several pages.  Also, in some cases, questions must be asked of former board members and officers who are compensated by the organization.

The IRS dictates in the Form 990 instructions and materials posted on the IRS web site that the reporting organization must make a reasonable effort to obtain the information needed to answer these questions.  The instructions specify that distributing a questionnaire asking about these matters is sufficient; in other words, the organization need not require documentation, search records, or hire private detectives.  Although many organizations already have conflict of interest policies in place, not all organizations currently circulate annual disclosure questionnaires.  Of those who do, very few will have existing questionnaires that ask the specific questions needed to elicit the required information.  Also, many organizations do not circulate the questionnaire to all the groups (board members, officers, and key employees) that must complete it.

Consequently, many organizations are instituting new procedures to meet this requirement.  New questionnaires will need to be prepared and circulated, along with an explanation of why this information is being requested.  Persons about whom information will be disclosed on the Form 990 when completed may appreciate knowing, before the Form 990 is filed, what will be disclosed about them.  Finally, because some reporting individuals may be unaware of existing, reportable, indirect relationships, the organization should be diligent in review of questionnaires to catch anything that is an indirect business relationship that would otherwise go unreported.

The new Form 990 undoubtedly requires additional effort and intrusive questions to ensure compliance with reporting requirements.  On the plus side, much of the information that is gathered can be useful in avoiding the appearance of a conflict of interest in the organization’s decision-making.  Respondents should know that the new Form 990 requirements are moving their organization toward best governance practices.
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