Our Nonprofit Was Denied Tax Exemption: What to Tell Our Initial Donors?

Your donors are waiting to claim a charitable deduction, but the IRS refused to grant 501(c)(3) status: Now what?

Question

We started our nonprofit last year. Since we were in the process of applying for 501(c)(3) tax exemption, we decided to hold our first fundraiser. We advised all attendees and potential donors that we had not yet been approved for tax exemption, but that once we were approved, any donation they made would be tax deductible.

To put donors at ease, we told them that we were confident in our application materials and had no doubts that we would be approved. We received quite a few donations that we’ve already put to good use. Unfortunately, we found out this year that we were denied tax exemption. We are embarrassed and are unsure what to do.

Do we have to tell our donors that we didn’t receive tax exemption? If we have to tell them, what should we say?

Answer

One of the worst things that can happen to a new nonprofit is to receive notification from the Internal Revenue Service (IRS) that it has not been approved for tax exemption. Your nonprofit can choose to appeal the determination, or it can start the application process over. With either process, it will take considerable time before you receive a final determination from the IRS. In the meantime, your nonprofit’s donors will be waiting to find out whether the donation they made is tax deductible.

It might be tempting to keep this information from your donors, with the hopes that your appeal or new application will be granted. But keeping this information from a donor can be fraudulent and unethical, opening up the possibility of a donor filing a lawsuit against your nonprofit. And even if a donor doesn’t sue, the donor could spread the word about your nonprofit’s behavior. It’s not a good way to start building a name for your new nonprofit.

The best course of action is to be open and honest with your donors by advising them that tax exemption was denied.

Notification should be in the form of a letter. Here is a sample of language to include:

We regret to inform you that the IRS has not approved our application for tax exemption. Because the IRS did not approve our application, the donation you made to our organization is not tax deductible. We plan to pursue tax exemption further, and if we are subsequently approved, the donation you made may be deductible. We suggest that you speak with a tax adviser on this issue. We appreciate your understanding and will notify you should our exemption status change. Please contact us with any questions.

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