Use the Form 990 Smartly

By Phyllis Katz and Jesse Bausch, Sands Anderson PC

This article is intended for educational purposes and not to provide legal advice or opinion.  The information should not be relied on as legal advice.  Legal advice can only be provided in response to a specific fact situation.

Organizations that are tax-exempt under section 501(c)(3) of the Internal Revenue Code must meet several tests to remain tax exempt: (1) they must be organized exclusively for exempt purposes and must operate solely for such purposes; (2) none of the earnings may inure to  any private shareholder or individual who has a substantial influence over the organization; (3) the organization must receive financial support from the public; (4) the organization may not engage in activities that attempt to influence legislation (except in an insubstantial manner); and (5) the organization may not participate in any campaign activity for or against political candidates.

To ensure compliance with these restrictions, non-profit organizations must annually file with the IRS a Form 990 (or a 990-EZ, 990-N, 990-PF, 990-T).[1] The 990 is an annual report which elicits information on operational and governance practices to ensure that the organization remains compliant with the requirements for the exempt status. Although money in and money out is reported, equally important is where the money goes, for what purposes the money is used, and who and how the organization is controlled.

The most recent three years of the Form 990 along with its many Schedules must be made available to the public upon request. The 990 is used by charitable foundations, governmental agencies, donors, and charity watchdog organizations. With the Internet, the 990 lives on (perhaps forever) and therefore its significance to the successful continuation of the non-profit should not be overlooked.

Exempt Purpose

501(c)(3) exempts religious, charitable, scientific organizations including those which conduct testing for public safety as well as literary, educational, national or international amateur sports competition, the prevention of cruelty to children and animals organizations. These organizations are known as “charitable organizations.” The first questions in Section III of the 990 relate to the exempt purpose and how operationally the activities are in furtherance of that purpose.  The questions ask for the organization’s mission and for program changes not previously listed in prior 990s. Further questions are found in Schedule A. Significant changes must be described in Schedule O.  Important in completing both Schedules A and O is to explain why programmatic changes are in furtherance of the charitable purpose.  Some changes may be obvious, others not.  Do not assume that they are.  The 990 also questions whether any changes have been made to the corporate documents.

Activities Not in Support of the Charitable Purpose

A 501(c)(3) organization must dedicate assets to its exempt purpose.  Therefore, the 990 asks extensive questions about where assets are distributed and whether the activities of the organization were diverted to non-exempt activities.  Questions relating to whether the organization engaged in unrelated activities, particularly business or commercial activities,[2] are just one of many inquiries intended to make sure that assets are dedicated as required. Depending on the amount of time and effort expended by persons affiliated with the organization, or the income the activity produced, engaging in activities not directly related to the exempt purpose can trigger further scrutiny by IRS.  Affiliations with non-exempt organizations are suspect. For example, the 990 asks if the organization has participated in any joint venture with a for-profit entity. If the answer is “yes,” the organization is then requested to provide information on such venture and whether the organization has a policy to evaluate its participation in a joint venture.[3]

Public Support

501(c)(3) organizations must meet the public support test. To meet this test, the organization must receive at least one-third of its support from contributions from the general public (or meet the 10% facts and circumstances test). To establish that the organization is meeting this test, it must list all contributors (with addresses) who have given more than $5,000 (or an amount equal to 2% or greater of the total contributions received).  Grants from governmental entities are included in the calculation of public support.  Part II of Schedule A asks for extensive information on where and from whom financial support comes to determine how much is “public” support.

Political and Legislative Activities

No substantial part of a 501(c)(3) organization’s activities can be involved in the carrying on of propaganda, or otherwise attempting to influence legislation. Further, there is an absolute prohibition on participating in or intervening (including the publishing or distributing of statements) in any political campaign on behalf of any candidate for public office. In Part IV, questions 3 and 4 ask the organization to describe these activities and report them on Schedule C. The 990 asks if the organization made a 501(h) election with respect to lobbying.  This election eliminates the indefiniteness of the “substantial part” test and provides an organization with specific parameters on the amount and type of allowable lobbying expenditures.  The 501(h) election is made each reporting year. The election is not binding and if circumstances change the organization can revoke the election prior to the end of the reporting year.

Private Inurement

As discussed above, no portion of the net earnings of the non-profit may inure to the benefit of any private shareholder or individual.  Officers, directors and key employees may certainly be compensated for their work for the non-profit; the IRS, however, is very concerned that such individuals do not abuse their power over the non-profit for their own personal gain.  The 990 requires the organization to list the compensation of all of its officers and directors, its key employees, its most highly compensated employees and its most highly compensated independent contractors.  The 990 requests information on how such compensation is determined.  Although IRS does not require a compensation or procurement policy, it is advisable to have one in that the organization is asked to describe its method for determining compensation. Further, the 990 requires the non-profit to describe its conflict of interest policy and how its directors and officers are informed about the policy and whether they are required to report to the Board interests that could constitute a conflict of interest.

Board Governance – Organizational Policies

Part VI, Section A of the 990 asks a series of questions concerning the role, responsibilities, and the degree of management control and oversight exercised by the governing body. For example, one question is whether minutes of meetings were contemporaneously documented and disclosures recorded. The importance of the degree of management and control exercised by the governing body is reflected in the last question, in which the organization must identify how each member of the governing body can be reached if IRS should have questions. Throughout the 990 there are questions on whether the organization has developed certain policies and how those policies are implemented.  The 990 asks the organization to state whether the following policies have been adopted (and sometimes how they have been implemented): whistleblower, document retention and destruction,[4] and conflict of interest.

Tax Exempt Financing

A little known fact is that 501(c)(3) organizations may finance capital improvements on a tax-exempt basis[5]. The advantage of this is that the total costs for borrowing will be less to the organization. Because bond purchasers will have the interest earned exempt from state and federal income tax, investors will be more eager to purchase the bonds at a lower yield.  For larger, long-term projects, the savings between taxable and tax-exempt interest rates can be substantial for the non-profit. The 990 asks for information relating to tax exempt financing arrangements to avoid abuse.  Using this financing vehicle places restrictions on the use of the funds. Generally not more than 5% of the bond-financed facilities may constitute a private use (i.e., leasing a portion of such facilities to for-profit entities or engaging in an unrelated trade or business on such property).  Additionally, arbitrage requirements restrict the investment of bond proceeds to ensure that 501(c)(3) organizations do not exploit tax-exempt borrowing rates purely for investment purposes.  Schedule K to the 990 requires a non-profit to provide detailed information on any tax-exempt bonds issued for its benefit to determine if there are any private business use or arbitrage issues.

Board Review

One question to which every organization should answer “Yes” is “[whether the organization provided a copy of this Form 990 to all members of its governing body before the Form was filed?”[6]  The follow-up question is what process was used by the organization to review the Form.
To view the 990 as a pesky tax report is marginalizing its importance.  It is IRS’ audit to determine whether tax exempt status continues to be warranted. It is also a tool for marketing.  It should be treated with all the dignity and formality of a corporate annual report.  IRS provides ample room to explain trends that are unfavorable, changes in operations that may cause concern, the rationale for compensation decisions, the good management practices utilized, and, last but not least, the devotion and focus the organization has on furthering its exempt purpose.  Use it smartly.

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Phyllis C. Katz, Esquire
F. Jesse Bausch, Esquire
SANDS ANDERSON PC
P.O. Box 1998
Richmond, VA  23218
(804) 648-1636

 

This article is intended for educational purposes and not to provide legal advice or opinion.  The information should not be relied on as legal advice. Legal advice can only be provided in response to a specific fact situation.

[1] There are 33 types of organizations that are exempt from federal income tax – all are required to file a 990.

[2] Income from unrelated activities may be taxable; there are numerous exceptions but before engaging in such, careful consideration should be given to the pursuit of such activities.

[3] Question 16b.

[4] Both the whistleblower and document retention and destruction policies are required under the Sarbanes Oxley Act (Public Law 107–204, 2002).

[5] 501(c(3) organizations can obtain such financing through a governmental issuer (typically an economic development authority). 501(c)(3) bonds require a public hearing and approval by the local governing body before they may be issued.

[6] 990 Part VI, Section B, question 11.

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