Is Your Tax-Exempt Status in Jeopardy?

June 24, 2011

A legal update titled “Is Your Tax-Exempt Status in Jeopardy?” by counsel Milton Cerny, partner Michelle McKinnon and associate Kelly Hellmuth was republished in Practical US/Domestic Tax Strategies, a monthly newsletter that examines federal, state and local tax developments for an audience of in-house tax counsel, tax managers, tax directors and CFOs of Fortune 1000 companies, and in Thomson Reuters’ Checkpoint database, a leading electronic database for tax, accounting and legal professionals.


Is Your Tax-Exempt Status in Jeopardy?

June 21, 2011

On June 7, 2011 the IRS announced that approximately 275,000 organizations automatically lost their tax-exempt status for failure to file required annual federal returns Form 990 or 990N for three consecutive years. See “IRS Posts List of Organizations that Lost Tax Exempt Status and Announces Procedures for Reinstatement of Exemption.”

Now an IRS Advisory Committee on Tax Exempt and Government Entities (TE/GE) has recommended that IRS revise its group ruling procedures to exclude certain organizations, to do away with group returns and require subordinate organizations to file individual returns Form 990, all in the name of transparency, accountability and responsibility. See Advisory Committee on Tax Exempt and Government Entities Report, June 15, 2011.

Who Would Be Affected if the Recommendations Are Implemented?

The Report indicates that there are 4,300 group rulings covering approximately 500,000 subordinate organizations included in these rulings, not counting 100,000 to 150,000 churches. Of the 4,300 central organizations, approximately 700 elect to file a group Form 990 return on behalf of their subordinate units. Approximately 2,500 of the 4,300 group exemptions are held by 501(c)(3) organizations such as churches and other charitable organizations, labor unions, social welfare organizations and social clubs, including fraternal organizations and veterans’ organizations. One group ruling of a major religious organization (like the Catholic Church) can cover as many as 30,000-40,000 subordinate units.

What is a Group Ruling?

The group ruling predates the Internal Revenue Code of 1939 and was a procedure adopted basically for the administrative convenience of the IRS and to relieve burdens on organizations so that they would not be required to file individual applications if they were controlled or administered by a central organization. The group returns procedure was adopted for the same reason so that a central organization could file one return covering its subordinate units. Over the past 70 years, the IRS has periodically updated its revenue procedure on group exemptions. The last guidance was Publication 4573 in 2006 which contained a series of questions and answers about group rulings.

What Has Caused This Review of the Group Ruling Procedure?

TE/GE Advisory Group focused on three issues:

  1. Should the group exemption mechanism be retained;
  2. Are the current procedures adequate to achieve the tax policy objectives of transparency, accountability and responsibility; and
  3. Can current procedures be revised to enhance tax policy objectives?

Findings and Recommendations

  • Retain the group exemption concept.
  • Eliminate group returns by amending §1.6033-2(d) to remove authority of central organizations to file group returns.
  • Update Rev. Proc. 80-27 to provide guidance regarding general supervision or control by central organizations over subordinate units.
  • Require group exemption holders that have a Form 990 filing requirement to disclose on Schedule O of the Form 990 information about the composition of the group and describe the central organization’s control and supervision over the group.
  • Include subordinate units, including churches, in publications 78 list of organizations contributions to which are deductible by donors.
  • Delete Type III 509(a)(3) supporting organizations from the group exemption ruling.
  • Provide a significant transition period for existing groups to comply with any changes to the group ruling procedure.

Factors That Indicate Whether a Central Organization Has Supervision or Control over Subordinate Units

The report has suggested a series of possible factors to determine the existence of general supervision and control. They would include:

  • Central organization appoints a broad observer over the subordinate organization;
  • Central organization has ownership rights over property of each subordinate organization so if a subordinate leaves or is removed from the group the property will be transferred to the central organization;
  • Each subordinate has substantially similar articles, by laws and or corporate policies approved by the central organization;
  • Subordinate must file reports with its central organization at least annually on basic governance, operations and finances;
  • Subordinate that is required to file annual Form 990, 990-EZ or 990-N provides a copy to the central organization;
  • Each subordinate provides central organization a copy of its annual financial statement, if prepared;
  • Central organization has audit rights over each subordinate organization and its operations;
  • Significant funding is provided either to/from the central organization to the subordinate organization or from/to the subordinate organization to the central organization;
  • Subordinate units articles and bylaws must be provided to the central organization together with any amendments; and
  • Subordinate unit must notify the central organization if the IRS or other governmental authority audits the subordinate organization or if the subordinate organization receives a notice from the IRS or other governmental authority that it has failed to file a required form or report.

These are factors to be considered under a facts and circumstances list and all factors are not equally important. As you see from these factors regarding property rights and governance, a number of issues will have to be dealt with not the least of which are in the church area regarding constitutional reports and church policy. There are also increased burdens for reporting and record keeping that will need to be discussed and refined. That is why the Committee recommended that any changes of the current Rev. Proc. be submitted for public comments.

What Does This Mean for My Organizations?

These are only recommendations at this point that will need to be reviewed on an individual organization by organization basis to determine what effect they could have on their current tax-exempt status. If a new IRS procedure is published for comments, consideration should be given to making your views known to the IRS.

There May Not Be Much Time

This is an issue whose time has come,” said Holly Paz, director of IRS Exempt Organizations Rulings and Agreements, in response to the recommendations, adding that the Pension Protection Act, the Form 990 redesign, and the focus on nonprofit governance of exempts have increased the expectation of transparency and accountability for these organizations. “While the times have changed, the group exemption process has not,” she said. Adding that “the question then becomes whether we should continue to delegate to a third party the IRS’s authority to grant or revoke exemption.” Paz further added “the IRS is not sure it should maintain the group exemption program at all and wants to study the issue before deciding.”

Paz indicated that two recommendations the committee made can be accomplished rather quickly. That is the elimination of group returns and the prohibition against Type III organizations participating in group rulings.

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