What does automatic revocation mean for organizations and their donors?  An organization that loses it tax-exempt status must pay corporate income tax on its annual revenues and file the appropriate income tax return.  The organization may also lose its state tax exemption if such exemption is dependent on federal tax-exempt status.  In addition, the organization will no longer be eligible to receive tax-deductible charitable contributions.

Organizations subject to automatic revocation that wish to have their tax-exempt status reinstated must file an application for exemption and pay the appropriate user fee.  In a show of heart, the IRS is allowing small organizations (i.e., those with annual gross receipts of $50,000 or less for 2010) applying for reinstatement to pay a lesser application fee of $100 instead of the usual fee of $400 or $850.  And in an even grander gesture, the IRS will treat eligible small organizations applying for reinstatement before December 31, 2012 as having established “reasonable cause” for their filing failures, meaning their tax-exempt status will be reinstated retroactive to the date it was automatically revoked. 

Eligible small organizations should consult IRS Notice 2011-43 to take advantage of retroactive reinstatement.  Other organizations seeking retroactive reinstatement should review IRS Notice 2011-44.  More information on automatic revocation, including a helpful FAQ, can be found on the IRS website and our previous posts on April 5, 2010 and July 27, 2010.

The charity's records demonstrated that the President "consistently utilized" the charity's income for private purposes.  Among the most egregious examples, the charity's records established that:

1. The President routinely made "loans to officers," but never fully substantiated the purpose of these loans.  Moreover, the charity's board approved these loans, which were withdrawals from the charity's checking account and payments for the President's personal expenses, "after the fact."  Note that since the charity had no Conflict of Interest Policy, the President who made these loans in the first place, then approved these "loans" with his wife and father.  All of these amounts went into a "Loans to Officers" account and inadequate records were kept on how this money was spent to further the charity's exempt purposes.

2. The President sold luxury vehicles to the charity, but never transferred title, and performed upgrades without being able to prove that the vehicle even existed or was owned by the charity.  Similarly, the charity paid for the President's car expenses without asking for business substantiation for these expenses.

3. The charity paid the President's personal legal expenses.

Interestingly, the IRS focused on the President's withdrawals from the charity's accounts that could not be substantiated as being for the furtherance of the charity's exempt purpose and also touched on ways in which the governing board was not providing proper oversight.  In fact, the IRS noted that the charity's inurement issues and excess benefit transactions "resulted from the organization being under the control of one-person with a family-based governing board."

Moreover, the IRS noted that because of the charity's structure, "sufficient safeguards ha[d] not been put in place to prevent future violations...."  Charities should be aware that governing procedures and policies, including a Conflict of Interest Policy and a recordkeeping policy, can provide these types of safeguards and help an organization function more efficiently and effectively.  In fact, this ruling is a staunch reminder that these policies should be used where appropriate and tailored to the needs of each organization.

This ruling should force each charity to examine its organizational and governing structures to ensure that its board constitutes an independent body so that, unlike the charity here, its governing board has no "inherent conflict of interest when placed in a position to approve financial transactions...."  

The amount of compensation paid was also at issue here because the President's salary was considered excessive based on the size of the organization's budget.  Accordingly, charities, particularly smaller charities, should use comparability data, to the extent possible, in determining the salaries of its various officers and other staff.  Also, having a well-written employment contract with senior employees or officers may help a charity better defend the terms and scope of an employee's or officer's employment and compensation.

This ruling confirms that the IRS is paying close attention to what charities are doing in their "back" offices.  Consequently, charities that are not exercising good governance practices will certainly be at risk for revocation of their tax-exempt status.

For additional information on good governance practices for charities, please see our Good Governance, Getting Back to Basics, and Lessons Learned blog entries. 

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.

The Governance Check Sheet is a two page document (IRS Form 14114), which is to be used by IRS exempt organization revenue agents in their examination of public charities.  The Check Sheet provides questions to be considered by the agent concerning six specific aspects of the organization’s corporate governance structure: (a) “Governing Body and Governance Topics;” (b) “Compensation;” (c) “Organizational Control;” (d) “Conflict of Interest;” (e) “Financial Oversight;” and (f) “Document Retention.”  The Check Sheet is designed to be completed by the agent on-line, with drop-down menus of possible responses and very little opportunity for narrative or description. 

In addition to the governance questions included in the revised Form 990, the Check Sheet addresses the following points:

·         certain organizational document issues (e.g., whether they include an articulation of a charitable purpose, and information about the composition, duties, qualifications and voting rights of board members);

·         whether board members have received copies of the organization’s articles and bylaws;

·         whether the organization’s articles and bylaws are available to the public, and if so, whether they are generally available or only on request;

·         the frequency of board meetings as compared to bylaw requirements;

·         whether there is a single individual or small group of individuals to whom the board typically defers;

·         the frequency with which the conflicts of interest policy is actually adhered to (e.g., how often have conflicted members actually recused themselves from the corresponding decision making process?);

·         the extent to which board members are provided with information concerning the organization’s financial condition and discusses those reports and related financial activities; and

·         whether the Revenue Agent’s examination was hindered by a lack of necessary documentation.

Ultimately, the Check Sheet data will be included in a long-term study the IRS is undertaking to set forth a greaterunderstanding of the connection between charities’ tax compliance and corporate governance practices.

At this point, the IRS is not expected to make poor governance practices alone an exemption level issue, but it is conceivable that evidence of problematic governance may contribute to the consideration of penalties where evidence of more severe organizational abuse exists.