Staying Compliant Using Form 1023-EZ

Last week, we shared an update from the IRS on Form 1023-EZ, which has streamlined approval of 501(c)(3) applications. Using the new form, nonprofits typically receive a determination letter in less than 30 days, sometimes as little as two weeks.

Tax exempt in two weeks? There has to be a catch, right?

There is no catch. However, just because you have your 501(c)(3) doesn’t mean you’re done. There are plenty of compliance activities leading up to and after 501(c)(3).

Nonprofits filing Form 1023-EZ must still conform to IRS and state requirements before and after applying for 501(c)(3). Noncompliance can result in loss of newly-earned 501(c)(3) status, loss of good standing, and various penalties at the federal and state level.

Before Applying for 501(c)(3)

When you file the original Form 1023, you must submit a copy of your Articles of Incorporation (with IRS-mandated provisions), bylaws, a narrative of purpose, financial statements, and more. With these documents, you are making your case to the IRS for tax exemption.

With Form 1023-EZ, you do not submit any of these documents. What you DO do is certify, under penalty of perjury, that you have all of these documents available if the IRS requests them. Slim chance of that happening, right?

Actually, no. The IRS randomly selects 3% of applications for “predetermination review.” In plain English, that means the IRS pulls them out of the queue to make sure nothing fishy is going on. The real downside is that those organizations must answer questions related to their finances and operations, similar to those questions asked on Form 1023. Essentially, the IRS comes back with questions, which as always, delays your application.

By the way, if 3% doesn’t sound like a lot to you, it’s a near certainty in astronomy and physics!

The IRS is ramping up its scrutiny of nonprofits filing Form 1023-EZ beginning in 2016. This means these organizations have a higher risk of an audit, as the IRS never fully examined your operations before approving tax exempt status.The current thought is that the IRS audits about 1% of nonprofits, but many industry practitioners don’t believe this will happen on a practical large scale.

However, if you are audited, here is a short list of what the IRS might request. The IRS won’t review only your activities and corporate documents, but also your operations, books, and records. This fact is enough to make many organizations consider filing the full Form 1023 instead.

All of this means that your organization shouldn’t just jump into the 1023-EZ application. You need custom Articles of Incorporation with additional provisions, bylaws, a conflict of interest policy, and financial projections. Even if you are eligible for Form 1023-EZ, you might not want to risk an audit later.

After Becoming a 501(c)(3)

When the IRS approves your 1023 or 1023-EZ application, you receive a favorable determination letter indicating 501(c)(3) status. This is a red-letter day for most nonprofits, as it grants you federal tax exemption, and allows donors to make tax-deductible contributions to your organization.

But, you’re not done! Just because you’re exempt at the federal level doesn’t mean you’re exempt at the state level. Many states require you to file for corporate or sales tax exemption with the state’s Department of Revenue.

You’ll have Department of State reports, typically known as annual or biennial reports. Failure to file these on time incurs state penalties and administrative dissolution.

You must also consider charitable solicitation registration. Forty states and the District of Columbia require charities to register before asking for funds. This protects citizens from unregulated or illegitimate charities. If you solicit funds in any of those 41 jurisdictions, you must register, file an exemption, or perhaps not need to do anything. Registration requirements depend on your planned income and solicitation activities. Additionally, these registrations must be renewed on a periodic basis!

Internally, you should be keeping good records, including minutes of meetings. Any changes to bylaws or other internal policies, government registrations, and other important documentation should be kept in your nonprofit’s records kit.

Compliance is more than just paperwork. These registrations lay the foundation for your nonprofit’s success. Banks, vendors, donors, and grantmakers all request proof of your registrations from time to time. Without them, good luck opening a bank account, convincing donors to give to your cause, and applying for grants.

Proper registrations and compliance imply increased credibility. Donors, grantmakers, and partners often search for nonprofits before they give. If they don’t see that you’ve registered, you may lose out on funding!

To recap, if the risk of an IRS or a state audit isn’t enough, know that the more compliant (and more legitimate) your organization is, the better chance you have to succeed.

Achieving Compliance

As we’ve written before, compliance is sort of like Zen. It is an enlightened state, for sure, but not impossible to achieve. Simply becoming a 501(c)(3) is not enough. You must stay in good standing with the Department of State, Department of Revenue, Attorney General, and IRS in order to operate year after year.

That’s where we come in. Harbor Compliance not only guarantees approval of your 501(c)(3), but we also help you become and stay compliant. We prepare all the initial registrations your nonprofit needs in its state of formation, and we meet with you annually to review state, IRS, and internal compliance. Visit our formation page, and check out our Compliance Package. Don’t leave compliance to chance, leave it to the experts. Get started with us today.