Even though the Internal Revenue Service approves 94 percent of the applications it receives from charities for tax-exempt status filed through the simplified Form 1023-EZ, approximately a quarter of them do not meet the IRS’s own requirements.

IRS building sign

A recent report by the National Taxpayer Advocate pointed out that Treasury Department regulations generally require 501(c)(3) organizations to pass an “organizational test” by including acceptable purpose and dissolution clauses in their organizing documents. However, according to the IRS’s pre-determination reviews of some Form 1023-EZ applicants, 25 percent don’t qualify for tax-exempt status because they don’t meet this test.

A 2015 study by the Taxpayer Advocate Service of a sample of approved Form 1023-EZ applicants in 20 states that make articles of incorporation viewable online at no cost found that 37 percent of them don’t meet the organizational test. A similar study last year by the Taxpayer Advocate service indicated that 26 percent of the approved organizations didn’t meet the organizational test. In the 2016 study, 4 percent of the approved organizations consisted of two limited liability companies; two churches; seven schools, colleges, or universities or supporting organizations; and one private operating foundation. However, the Taxpayer Advocate noted that such organizations are not eligible to file the Form 1023-EZ.

Laura Kalick, tax director in BDO’s Nonprofit and Education practice, agreed there are some significant documentation shortcomings in the Form 1023-EZ since the narrative description of activities, articles of incorporation and bylines are not required to be submitted.

“In essence they have to meet the purposes test and have a dissolution clause, but they aren’t required to submit those articles and bylaws to the IRS with the form,” she said. “They just have to say, ‘Yes, we are OK and we’re not going to have any private inurement.’ The IRS doesn’t have to see a narrative or the financial information at this point.”

That type of information can be burdensome to provide for a small charity, she acknowledged, and it would be a considerable burden for the IRS to have to check all of that information. To be able to file the streamlined form, a charity can’t have received more than $50,000 in each of the past three years, nor expect that gross receipts will exceed $50,000 per year for the next three years, or have total assets of over $250,000. From July 1, 2014 through June 24, 2016, the IRS received nearly 88,000 of the forms.

The National Taxpayer Advocate recommended the IRS require Form 1023-EZ applicants to submit their organizing documents, unless they are already available online at no cost, along with summary financial information. It said the IRS should make a determination only after it considers the narrative statements along with the additional information. The IRS agreed to revise Form 1023-EZ to require a narrative statement of applicants’ activities, but the Taxpayer Advocate said more information is still needed.

“The Taxpayer Advocate had recommended that the organizations submit their organizing documents and summary financial information and a narrative statement, but to date this has not been something that the IRS has been requiring,” said Kalick. “What the IRS appears to be doing instead is taking a sampling of organizations and looking at those organizations to see if they are in fact in compliance.”

As imperfect as it is, the Form 1023-EZ helps reduce the workload of the overburdened IRS.

“It’s sort of a balancing act,” said Kalick. “It’s easier for them to do the post-submission review and less costly and more effective than for every organization to have to fill in the full-blown Form 1023. They certainly listened to the Taxpayer Advocate, but they have decided this is the better way to go to make it much more streamlined. In fact, to encourage more use of the Form 1023EZ, they reduced the user fee from $400 to $275 as of July 1, 2016.”

The IRS anticipates the reduction of the user fee will contribute to an increase in the adoption rate. Once a charity has been approved for tax-exempt status, it then has to file a Form 990 or the more streamlined 990-N or 990-EZ. The IRS recently added interactive features to the 990-EZ with question marks that provide additional information when filling it out online (see Form 990-EZ for nonprofits updated).

“Both the 990 and the 990-EZ provide so much information that if the organization grows to the size to require the more extensive form, then the IRS and the public are getting more information about the organization,” said Kalick. “That being said, just because you fill out a full-blown Form 1023 and the IRS approves it doesn’t mean that we’re getting all the information. What happens if you fill out the application for exemption and then you do something different than what you said you were going to do on your application? There are just so many exempt organizations out there that it’s impossible to police everything. We’re a nation of voluntary compliance and we have to accept a very high level of faith on everybody’s part.”

The Form 1023-EZ does not include a number of key organizational and operational tests for weighing an organization’s right to claim tax-exempt status. “In essence they ask whether you have the appropriate provisions in your articles of incorporation, but because you’re not actually submitting those articles of incorporation and bylaws then they can’t do a cross-check,” said Kalick. “A 501(c)(3) has to be organized for charitable, educational, scientific or religious purposes, and have no private inurement, no substantial lobbying, and no political activity. The assets have to be dedicated in perpetuity to charitable purposes, so in essence you have to say that upon dissolution the residual assets will go to another 501(c)(3) organization.”

Kalick agrees with the National Taxpayer Advocate’s recommendations about providing more information. “The Taxpayer Advocate report said it would really not be very difficult to have the articles of incorporation provided as part of the application and also that there should be some narrative and some basic financial information,” said Kalick. “I think that makes sense. Filling out the full-blown form is really difficult, but I really like the idea of putting in a narrative because a good number of organizations just have very broad general charitable purposes. They will say the organization is organized exclusively for charitable and educational purposes, and then they have the dissolution clause, but the narrative really tells what the organization is going to do. What one person thinks is charitable might not be charitable in the eyes of the IRS.”

Michael Cohn

Michael Cohn, editor-in-chief of AccountingToday.com, has been covering business and technology for a variety of publications since 1985.