If you’re just starting a nonprofit, chances are you’ve been doing some research about 501c3 status. However, while it’s great to be tax exempt, there are a few 501c3 violations that can lose you that privilege!
This post will help you stay in compliance by learning:
- Definitions and examples of the six 501c3 violations
- How to avoid breaking 501c3 rules by accident
- How to report 501c3 violations
- What the process looks like if you’re found to be noncompliant
What is a 501c3 Nonprofit?
A 501c3 nonprofit is a type of organization that the IRS exempts from paying federal income tax. In most cases, donations to these types of organizations are deductible on donors’ taxes. This status must be applied for with theIRS and is possible to lose if you commit 501c3 violations. Understanding fundraising laws for nonprofits is critical to staying in compliance and on the good side of the IRS.
In order to qualify for 501c3 status as opposed to any of the other types of nonprofit statuses, your nonprofit’s defined purpose must be:
- Charitable
- Religious
- Scientific
- Educational
- Literary
- Fostering national/international amateur sports competition
- Preventing cruelty to animals/children
- Or, testing for public safety
Becoming a tax-exempt nonprofit won’t just save you money—it’ll also build your credibility as an organization.
How to Get 501c3 Tax Exempt Status
Your nonprofit can apply for 501c3 status by filing one of these two forms:
- Form 1023. This is a long and detailed form that requires a lot of information about the workings of your organization. It has a $600 fee associated.
- Form 1023-EZ. This is a simplified and streamlined form that you can fill out online. It’s available for smaller nonprofits with annual gross receipts of less than $50,000 and total assets of less than $250,000. It has a $275 fee associated.
If your application is approved, your nonprofit will receive a 501c3 determination letter within six months.
State tax exemption will have specific rules depending on where you’re located. Check out the differences in starting a nonprofit in California versus starting a nonprofit in Texas to see some key differences!
6 Types of 501c3 Violations
The guiding principle of 501c3 organizations is that they MUST exist primarily for their tax-exempt purpose!
1. Private Benefit & Inurement
501c3 rules can be broken in cases where an individual is unfairly benefiting from the organization’s operations. This can either be an issue of private benefit or inurement, which are slightly different!
Inurement happens when someone with a close relationship to your nonprofit is unfairly benefiting from its resources. Think staff members, officer and directors! An example could be if a paid employee also holds a board position and starts making decisions about their own salary.
Inurement often comes in two forms:
- Excess compensation (manipulating pay raises or bonuses)
- Improper use of assets (personal promotion on a mailing list, personal use of a company vehicle, personal use of a company card, etc.)
Private benefit is the term used when the person benefiting is not an insider. If a nonprofit’s top priority was driving customer traffic to a private business, that would be a case of private benefit.
This isn’t to say that partnerships with businesses aren’t allowed. 501c3 violations happen when the welfare of the private business is prioritized over the wellness of beneficiaries.
2. Excessive Lobbying
Lobbying is defined by the IRS as “attempting to influence legislation,” which could look like:
- Contacting representatives in support or opposition of legislation
- Encouraging supporters to contact their representatives in support or opposition of legislation
- Advocating for the adoption or rejection of legislation
Now, while tax exempt nonprofits are allowed to lobby, 501c3 violations come up when the lobbying is defined as excessive. Lobbying can be a part of what you do, it just can’t be the whole thing!
Want to test if your lobbying activities would be a problem? Fill out Form 5768 to take the 501 (h) election, also known as an “expenditure test.” This takes away the uncertainty of what over-lobbying looks like, and can ease your worries moving forward.
3. Political activity
501c3 organizations and their representatives absolutely may not campaign for or against candidates for elected office! This applies to federal, state and local elections. Whether this be for the president or a local school board official, this rule is set in stone.
The obvious examples of participating in political activity as making a public statement by a candidate or contributing to a campaign. However, you can stumble into prohibited 501c3 political activity even if you’re trying to “stay neutral.”
For example:
- Organizing a telephone drive for voting that skews towards one candidate
- Inviting one candidate to a very large fundraising event and another to a smaller one
- Having multiple candidates at an event but favoring one with certain types of questions or the speaking order
501c3 rules DO permit your organization to promote non-partisan voter education! You can supply all sorts of educational materials and encourage people to hit the voting booths, but you can’t sway them.
This is a difference between 501c3 vs 501c4 organizations. 501c4’s are identified as “social welfare groups” rather than charitable organizations. As a result, donations to these organizations are not tax deductible, and they are allowed to engage in political activity.
A couple examples of 501c4 organizations would be Planned Parenthood and the National Rifle Association.
4. Unrelated Business Income
Unrelated business income (UBI) refers to excessive income from a business practice that isn’t fully related to your exempt purpose. This could include income generated from the sale of merchandise, advertising space or special services.
Income becomes taxable if:
- It comes from a trade or business
- The business is ongoing (think year-round ecommerce stores!)
- The business primarily exists to raise funds for your organization rather than for accomplishing its exempt purpose
There’s nothing wrong with cracking into a new stream of revenue—you just want to make sure you don’t end up breaking 501c3 rules in the process.
Here’s how to avoid this trouble:
If you make over $1,000 from your nonprofit merchandise, your tax-exempt nonprofit might need to file Form 990-T for Unrelated Business Income Tax (UBIT).
There are a few exceptions, including:
- Volunteer labor
- Business for the convenience of members (like a school cafeteria)
- Sales of donated merchandise
- Bingo
IRS Guide 598 breaks down UBIT exceptions even further, but if you’re feeling confused, it’s worth it to connect with a tax attorney to avoid 501c3 violations.
5. Failure to Submit Annual Reports
With the exception of churches and church-affiliated organizations, all 501c3 organizations need to file their applicable version of Form 990 every year. The version you need will usually be determined by how much money you earned that year and have in the coffers overall!
Here are the guidelines for which form you should choose:
- Form 990 is for nonprofits with gross receipts over $200,000 or assets over $500,000 at the end of the tax year.
- Form 990-EZ is for nonprofits with gross receipts less than $200,000 and total assets less than $500,000 at the end of the year.
- Form 990-N, Electronic Notice (e-Postcard) is for nonprofits with annual gross receipts that are generally $50,000 or less.
If you miss filing Form 990 for three years in a row, you automatically lose your tax exempt status. If that happens, you need to re-apply from the start.
Outside of the required annual filing, we also highly recommend putting out publicly available annual reports! This is a great way to celebrate your accomplishments and be transparent with your members, donors, beneficiaries and major funding bodies.
6. Operation in accord with stated exempt purpose(s)
Deviating from your charitable, tax exempt purpose is one of the 501c3 violations that can be avoided with open communication. If you realize that your direction is changing, connect with IRS Exempt Organizations as soon as possible! The folks who work there can help you figure out what steps you can take to stay tax exempt.
What Happens if Your Nonprofit Commits 501c3 Violations?
If your nonprofit commits 501c3 violations, you can expect intervention like:
- An audit or on-site investigation from the IRS
- Implementation of procedures to avoid future violations
- Removal of staff and board members
- Excise taxes for improperly used funds
- Financial penalties from the IRS
The IRS does have the power to revoke your tax exempt status, and absolutely will use it! However, it’s rare that that’s their first course of action, and there is often room for course correction.
But remember—even if you don’t lose your tax exempt status, 501c3 violations are a bad look for your nonprofit. The best way to avoid losing trust with your community is to stay compliant in the first place!
How to Avoid 501c3 Violations in Your Nonprofit
Here are a few tips on avoiding 501c3 violations arising in your nonprofit:
- Develop a thorough conflict of interest policy in your nonprofit bylaws. This policy can be a lifesaver when issues of private benefit and inurement arise. Catching conflicts of interest early—and having a process in place to manage them!—can prevent complications from blowing up into full 501c3 violations.
- Onboard staff and stakeholders. Avoid confusion by making sure your whole team understands what 501c3 prohibited activities look like. Clear examples can be what keeps someone from making a mistake like posting a political opinion on Instagram with a picture of them in your nonprofit’s t-shirt!
- Keep detailed financial reports. The best way to avoid an audit is to have all your financial ducks in order. And, should the IRS want to take a peek, detailed and accurate documentation can quickly show that you’re in compliance.
- Have your secretary take fantastic board meeting minutes. Just like your financial reports, your meeting minutes can be used in legal investigations. An accurate history of your board’s history of decision making is a must-have!
- Call on the experts when you need them. Look—501c3 violations are no joke. If you’re feeling unsure at any point, shell out the cash for some legal advising. It’s worth it to avoid the future headache of a major compliance issue.
- Address issues as they arise. Whether it be having a special meeting with your board of directors or reaching out to the IRS, any choice is better than sweeping sticky legalities under the rug. As you manage potential conflicts, document everything to show you’ve done your best!
How to Report 501(c)(3) Violations
You can report 501c3 violations by contacting the Exempt Organizations Examination Division. Filing Form 13909, the Tax-Exempt Organization Complaint (Referral) Form, is useful for ensuring you have all the information you need.
Your complaints can be sent by mail to:
IRS EO Classification
Mail Code 4910
1100 Commerce Street
Dallas, TX 75242
Once you’ve made your report, the IRS can’t tell you about any action it has taken or is planning on taking. This might be frustrating, but it’s a matter of confidentiality.
Keeping Your Nonprofit in Compliance
We hope this information has helped to clear up any worries you might have about 501c3 violations. Remember, most things are resolvable with clear communication and a willingness to make some changes. As long as you know the rules, they’re easy to follow!
