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How to Lose Your 501(c)(3) Tax Exempt Status

Updated: Aug 11, 2021

Each year, the IRS revokes the tax-exempt status of more than 100 501(c)(3) organizations. Organizations recognized as exempt from federal income tax under this section of the Internal Revenue Code include private foundations as well as churches, educational institutions, hospitals, and many other types of public charities. Here are some things to be mindful of.

Unrelated Business Income (UBI)

An activity that can potentially jeopardize an organization’s 501(c)(3) tax-exempt status is having too much income generated from activities that are unrelated to the exempt function of the organization.

This income comes from a regularly-carried-on trade or business that is not substantially related to the organization’s exempt purpose. “An organization that produces unrelated business income as a result of its unrelated trade or business may have to pay taxes on that income. Generally, organizations that generate unrelated business income should file Form 990-T, Exempt Organization Business Income Tax Return, and pay tax on the income.

Income-producing activity must meet three conditions before the income is potentially taxable.

  • Activity must be a trade or business.

  • The trade or business must be regularly carried on.

  • The business activity is not substantially related to an organization’s exempt purpose.

Private benefit/inurement

A 501(c)(3) organization’s activities should be directed exclusively toward some exempt purpose. Its activities should not serve the private interests, or private benefit, of any individual or organization (other than the 501(c)(3) organization) more than insubstantially. The intent of a 501(c) (3) organization is to ensure it serves a public interest, not a private one. Inurement includes the payment of dividends, the payment of unreasonable compensation to insiders, and the transfer of property to insiders for less than fair market value.

Political Activity

All section 501(c)(3) organizations are prohibited from directly or indirectly participating in, or intervening in, any political campaign on behalf of (or in opposition to) any candidate running for public office. The prohibition applies to all campaigns (federal, state and local level). “Political campaign intervention includes any and all activities that favor or oppose one or more candidates for public office

Annual reporting obligation

While 501(c)(3) public charities are exempt from Federal income tax, most of these organizations have information reporting obligations under the Internal Revenue Code to ensure they continue to be recognized as tax-exempt.

Public charities generally file either Form 990, Return of Organization Exempt from Income Tax, Form 990- EZ, Short Form Return of Organization Exempt from Income Tax, or submit online Form 990-N, Electronic Notice (e-Postcard) for Tax-Exempt Organizations not Required To File Form 990 or 990-EZ.

Operation in accord with stated exempt purpose(s)

If you stop doing all or a significant amount of the exempt activities you told the IRS you were going to do in your original application for exemption—you could lose your exemption. If your organization’s direction has changed, let us know. It could prevent future problems.

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