IRS Study Reveals that 37% of Form 1023-EZ Applicants Improperly Received 501(c)(3) Tax Exemptions

The IRS Taxpayer Advocate Service (TAS) recently submitted its 2015 Annual Report to the United States Congress. That report contained an analysis of Form 1023-EZ that the IRS released in July 2014 as a streamlined 501(c)(3) application. The findings in the TAS report were extremely troubling.

Two of every five organizations that obtained 501(c)(3) tax exemptions using Form 1023-EZ were not in fact eligible 501(c)(3)s. These organizations received 501(c)(3) status by the IRS despite not meeting basic eligibility requirements.

This report also includes a plan for how the IRS intends to remedy the problem. There are thousands of new 501(c)(3) nonprofits that improperly received their tax exempt statuses. The IRS intends to audit 1023-EZ filers to identify ineligible organizations.

Background

Upon the release of Form 1023-EZ in July 2014, the IRS had over 66,000 applications for tax exemption in its backlog, resulting in IRS processing times of a year and a half, or more. Widespread use of that form certainly has reduced that number, with some applications receiving their determination letters in as little as two weeks. With the long form 1023 application, organizations had to demonstrate their eligibility for federal tax exemption with detailed information and supporting documents. With Form 1023-EZ, organizations simply check boxes attesting to their eligibility.

The Problem

The Taxpayer Advocate Service is a branch of the IRS, which bills itself as “your voice at the IRS.” From their 2015 Annual Report to Congress, which you can read in full here: “Form 1023-EZ does not solicit any narrative of the organization’s activities, any financial data, any substantiating documents, or any explanatory material. With the adoption of Form 1023-EZ, the IRS effectively abdicated its responsibility to determine whether an organization is organized and operated for an exempt purpose.” In other words, the IRS has basically rubber stamped thousands of organizations into approval. Per the TAS report, a staggering percentage of those organizations were ineligible.

Inviting Fraud

According to Tim Delaney, President of the National Council of Nonprofits, “The shorter form may have helped reduce the IRS’s backlog of applications, but it has invited fraud.” The IRS is approving 95% of 1023-EZ applications, more or less at face value. Per the National Council of Nonprofits, “The Taxpayer Advocate Service found that 37 percent of IRS-approved applications it reviewed failed to meet the minimum legal requirements for 501(c)(3) exempt status…Thus, the IRS has inappropriately granted tax-exempt status to two out of every five applicants.”

This information was discovered through a search of Secretary of State records. Twenty states make corporate documents, such as Articles of Incorporation, publicly available at no cost. The IRS requires that certain purpose, dissolution, and other clauses be included in the Articles of Incorporation. A review of state records revealed that many organizations had no purpose disclosed, or purposes that are not eligible for tax exemption.

Per the report, one applicant’s Articles of Incorporation stated that his organization’s purpose was to raise funds to pay for his father’s medical bills. Another charter’s dissolution clause stated that the nonprofit’s assets would go into the pocket of one of the directors upon the entity’s termination. Both of these entities were improperly granted federal tax exemption.

One Solution: Audits

Since release of the 1023-EZ, the IRS has conducted a “pre-determination review” of a sample of 1023-EZ filers (about 3%). Some organizations who file 1023-EZ will be selected at random for a more in-depth review. Because of the data presented in the TAS report, it is likely that the IRS will attempt to ramp up these reviews to identify ineligible organizations.

In addition, the Taxpayer Advocate Service reported that the IRS plans to audit organizations that filed 1023-EZ. According to the TAS, this solution is inefficient, costly, and backwards.

Our Position: Don’t Cut Corners

Trying to save money and cut corners during the 501(c)(3) application process may invite bigger issues down the line. With these recent developments, the challenge is not only obtaining 501(c)(3) approval, but also making sure your organization is not placed at risk in the event of an audit. If your organization faces an audit by the IRS or other government agency, it is critical to have the proper structure and documentation in place.

At Harbor Compliance, our specialists conduct thorough 1023-EZ eligibility reviews and file the streamlined applications for organizations that are eligible. Furthermore, we carefully prepare each government application to ensure organizations meet 501(c)(3) requirements. This includes not only 1023 and 1023-EZ forms, but also the articles of incorporation, bylaws, conflict of interest policies, and other required documents.

If you’re starting a nonprofit, it’s more important than ever to set up your organization for success. View our nonprofit formation services to see how you can put our expertise on your side.