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The IRS and nonprofits: Fixing a broken system

When the IRS acknowledged improper targeting of conservative groups earlier this summer, the eyes of the nation were opened to the challenges and delays some nonprofits face when applying for tax-exempt status.

What they don’t know is that the problem is far more pervasive than the public has been led to believe—and that Congress’ way of dealing (or not dealing) with this issue could very well be creating the next IRS scandal for nonprofits and our nation. While news coverage of the IRS issues may have lessened as of late, the delays and their negative impact on nonprofits certainly have not.

As a society, we rely on the innovation and contributions of the nonprofit sector. These organizations step in where the private and public sectors can’t or won’t venture. And when the economy is fragile, they play an even more important role. Now, at the very time we need the nonprofit sector the most, Washington has handcuffed the process--for nonprofits of all varieties (not just politically inclined groups).

Today, for the first time in my 25 years of working with nonprofits, I’m seeing application wait times regularly exceed 12 months (and that’s just to get assigned to an agent—there’s an additional wait after that). Tax agents are not returning calls. For nonprofits, getting their tax-exempt status is essentially their license to do business, so this is not acceptable.

Imagine if small businesses needed to wait 12-18 months to get a business license to operate? Or the transportation industry needed to wait 12-18 months for drivers to be licensed? Or global companies needed to wait 12-18 months to get passports for their executives? Without their tax-exempt status, a nonprofit’s ability to raise funds is jeopardized as many donors and grantmakers simply will not contribute until an organization has its tax-exempt 501(c)(3) status. As a result, many organizations are effectively paralyzed.

The IRS more recently announced an expedited process for certain 501((c)(4)s in response to the public outcry that followed the targeting scandal, but this does nothing to alleviate the difficulties for 501(c)(3) charities—in fact, it may compound the problem as resources are diverted in this way. All in all, the problem is much larger than the IRS. Congress has added so much responsibility—without accompanying budget—to the IRS that agency employees cannot possibly do their jobs effectively.

As we wait for Congress to step in and make the necessary changes to this broken system, and provide an appropriate level of funding for the IRS, here are some alternatives or options for organizations to consider:

  • Request expedited review: in very limited circumstances, the IRS will grant expedited review of an application. Those circumstances include a significant pending grant that will be lost if the exemption is not granted by a certain time; a disaster situation (e.g., an organization setting up to assist hurricane victims); or a situation in which a court or governmental agency has imposed a specific deadline for the completion of a transaction.
  • Consider using fiscal sponsor: A “fiscal sponsor” is an existing 501(c)(3) organization that will allow other organizations or projects to operate under its 501(c)(3) umbrella. There can be negative tax and business consequences for everyone involved if the sponsorship is not properly structured, so be sure to locate an experienced fiscal sponsor and consult with knowledgeable legal counsel. A national directory of fiscal sponsors can be found at www.fiscalsponsordirectory.org.
  • Pursue a variety of funders: Some funding sources may be more open to contributing to an organization that is awaiting 501(c)(3) status. Examples include: expenditure responsibility grants from private foundations willing to make them; corporate sponsorships from businesses willing to claim a business expense deduction rather than a charitable deduction; earned income from charitable activities; volunteer services and in-kind contributions; and individuals not requiring a charitable deduction (e.g., certain crowd funding sources, social media appeals, non-itemizers and donors willing to take a chance on the 501(c)(3) determination).
  • Consider merger or other consolidation: in lieu of obtaining its own 501(c)(3) status, an organization could consider merging or otherwise consolidating with an existing (or even dormant) 501(c)(3) that shares a similar mission. However, remember that while it is possible to acquire “control” of an existing 501(c)(3), it isn’t possible to “buy” it, and there can be significant business and tax risks associated with proceeding in this manner.

For new organizations who nonetheless are still intent on going through the 501(c)(3) application process, they should be prepared to put the time in at the forefront to make the application the best it can be, and to consider some of the options listed above to get them through the purgatory of a pending application.

Meanwhile, if you share my belief that nonprofit organizations are essential to the landscape of our society, please consider contacting your elected representatives. Let them know they have the ability to reverse the alarming effect they are having on our charitable sector, and in doing so, to prevent the next IRS scandal.

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Karen Leaffer

Karen Leaffer is the managing attorney at Leaffer Law Group, a Colorado law firm serving nonprofit organizations, charitable foundations and social-minded enterprises.   She currently serves as managing editor of the Guide for Colorado Nonprofit Organizations, and is on the Colorado Secretary of State’s Business Entity Advisory Committee where she represents the nonprofit sector.

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