Could Your Nonprofit Lose Its Tax-Exempt Status?
Termination of your nonprofit's tax exemption is unlikely, but it's not impossible.
If you're like most people affiliated with a 501(c)3 nonprofit organization, you'd rather be serving your community or championing your cause than worrying about the latest IRS requirements. But virtually all IRS publications dealing with nonprofit matters make sure to remind you that noncompliance with tax laws and IRS regulations can result in termination of your nonprofit's tax exemption. Is this just a scare tactic, or is the threat real? (Note: For information on a new IRS filing requirement that could impact your nonprofit and its ability to maintain tax-exempt status, see Nolo's article Many Nonprofits Must File IRS Form 990-N to Stay Tax-Exempt.)
Fortunately, a look at history shows that a nonprofit must engage in some truly egregious conduct to lose its 501(c)3 tax exemption -- basically, it must act in such a way that it fails to carry out its exempt functions. For example, a nonprofit could lose its tax exemption by spending all of its time and resources running a for-profit business that's unrelated to the organization's exempt purposes or by diverting contributions, grants, and other income to personal use.
How often does this happen? According to some recent statistics from the U.S. General Accounting Office, in 2001 the IRS made a total of nine revocations of tax-exempt status -- that's nine out of over one million nonprofits that lost their status. There's probably a better chance that your nonprofit's office will be hit by a meteor.
Odds aside, this doesn't mean that you can freely flout the tax laws. The IRS can -- and often does -- impose fines, penalties, and back taxes on nonprofits that break the rules.
And if the worst happens, and the IRS revokes your nonprofit's tax-exempt status, get ready for financial trouble. Your ex-nonprofit will be treated as a regular taxable corporation as of the date of revocation. This means all the income it receives will be taxable, and donors will not be able to deduct their contributions. (However, contributions received by the former nonprofit will be treated as nontaxable gifts made during the years the organization was considered to be tax-exempt.)
But gifts obtained under false pretenses -- for example, in cases where donors were lied to about how the money would be used -- are taxable income to the ex-nonprofit. If that's not bad enough, the ex-nonprofit's officers and directors may have to pay excise taxes if they engaged in excess benefit transactions.
For more information on making sure your non-profit stays in the good graces of the IRS, see Every Nonprofit's Tax Guide; How to Keep Your Tax-Exempt Status & Avoid IRS Problems, by Stephen Fishman (Nolo).