Self-Declared Exempt Organizations – A Guide to Ensure IRS Compliance

Self-Declared Exempt Organizations

In its 2012 workplan, the IRS announced it will be paying closer attention to self-declared exempt 501(c)(4), (c)(5) and (c)(6) organizations. These groups include social welfare organizations; labor, agricultural and horticultural groups; as well as business leagues and chambers of commerce.

Such organizations consider themselves to be tax-exempt because of the nature of their activities, but they have not filed for nor received a formal determination letter from the IRS. These groups are allowed to operate without an official IRS determination because, unlike the 27 month filing deadline for 501(c)(3) charities, they are not subject to a deadline for filing an application for exemption.

The IRS has stated that it will send a comprehensive questionnaire to such organizations in 2012 to ensure that they have classified themselves correctly and that they are complying with applicable rules. Because of the increased scrutiny, now is a good time for such organizations to review their activities to ensure compliance with the law.

Self-declared organizations may also wish to file Form 1024 to obtain formal IRS recognition of their tax-exempt status. Of these organizations, by far the most popular are 501(c)(4) and 501(c)(6) organizations. Accordingly, the basic requirements for these groups are as follows:

501(c)(4) Social Welfare Organizations

In order to be a 501(c)(4) Social Welfare Organization, an organization must meet certain operational criteria. An organization is operated exclusively for the promotion of social welfare if it is primarily engaged in promoting the common good and general welfare of the community or is committed to civic betterment and social improvements.

In 1997, Congress passed a law to avoid the harshness of revocation in non-egregious cases of private inurement. These rules are known as the excess benefit rules.

An excess benefit is essentially any transaction where an insider is overpaid or otherwise strikes an unreasonable bargain in the insider’s favor. For example, excessive compensation for services, overpaying for goods, assuming debt or lending at unreasonably low interest rates can all lead to excess benefit transactions.

In such cases, the insider who received the excessive benefit is required to make the organization whole and is also subject to a first-tier penalty in the amount of 25% of the excess benefit. A second-tier tax, equal to 200% of the amount of the excess benefit, can be imposed if the prohibited transaction continues uncorrected.

501(c)(6) Business Leagues and Chambers of Commerce

To qualify as a 501(c)(6) business league, the organization must be organized to promote its members’ common business interests. Similar to a 501(c)(4) organization, a 501(c)(6) organization cannot engage in unrelated business activity to more than an incidental degree and is prohibited from performing services for individual members. Rather, the organization must promote the industry it was formed to support as a whole including persons who are not members of the league.

A 501(c)(6) chamber of commerce is an organization of the same general class as a business league except that where a business league serves only the common business interests of a single industry,  a chamber of commerce serves the economic interests of a community.

It is an organization where the common business interest is generally the economic welfare of an entire community. Membership in a chamber of commerce is voluntary and open generally to all business and professional men in the community.

Additional Traits Common to 501(c)(4) and 501(c)(6) Organizations

Certain characteristics are common to both 501(c)(4) and 501(c)(6) organizations. Specifically, such organizations must:

  • not be organized for profit;
  • ensure that no part of its net earnings inure to the benefit of any private shareholder or individual; and
  • ensure that unrelated business activities are conducted on an insubstantial basis if at all.

In addition, both (c)(4) and (c)(6) organizations may devote a substantial part of their activities to lobbying purposes so long as it is related to their exempt purpose. For tax purposes, lobbying essentially means attempting to influence legislation by urging members of the legislature to propose, support, or oppose legislation. Lobbying also includes asking members of the public to take action expressing their support or opposition to legislation.

Both (c)(4) and (c)(6) organizations are also permitted to participate in political campaigns so long as such activities are related to their exempt purpose and are insubstantial in relation to their overall activities. However, the amounts expended for such activities may be treated as political organization taxable income.

Also, the organizations must notify dues paying members of the portion of dues that the organization reasonably estimates will be allocable to the organization’s political campaign expenditures during the year as that portion of dues is not deductible as a business expense. Alternatively, such organizations may elect to pay a proxy tax on the amount of member dues that were used for political campaign or lobbying activities.

Charitable Tax Deduction

Section (c)(4) and (c)(6) organizations should be aware that unless the organization is a public entity that uses the donation for public services (e.g., state or local government, or volunteer fire department) charitable deductions to the organization are not tax deductible.

Update: As of January 7, 2013, applications for exemption that are filed after the 27 months following the entity’s formation will receive a letter dating back to the postmark date of the application. The IRS will no longer issue retroactive recognition of exemption for organizations that have not filed within 27 months of formation. See, Rev. Proc. 2013-9.

Ellis Carter is a nonprofit lawyer licensed to practice in Washington and Arizona. Ellis advises tax-exempt clients on federal tax matters nationwide.

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