4 Reasons Applying for Tax-Exempt Status is Better with Form 1023

Starting a tax-exempt, non-profit organization can be a challenging adventure, but is certainly worthwhile. It creates an opportunity to help those in need, rally around a cause, give back to a community, and create something lasting that you can be proud of. To be recognized as a tax-exempt organization, a non-profit must submit an Application for Recognition of Exemption Under Section 501(c)(3) to the IRS. This application (Form 1023) is quite comprehensive and can appear daunting to new and small non-profits.

richmond-business-lawyerTo get around the detail required in the 1023, some organizations choose to submit the “Streamlined Application for Recognition of Exemption Under Section 501(c)(3)” (Form 1023 EZ). “Streamlined” ooooooo, doesn’t that sound grand? We should all be so lucky to use a streamlined tax form, right? Well, actually for most non-profits with goals of tax-exempt status, the more comprehensive and initially scarier looking form is actually the better choice. Here are four reasons why, with a little background first.

 

A Little Background

To get our heads around the process of creating a non-profit or that of creating a tax exempt organization we have to first understand one basic essential truth: all tax exempt organizations are non-profits, but not all non-profits are tax exempt organizations. So while many of us refer to tax exempt entities as “non-profits” the two are actually different things. At it’s a core a non-profit is just an organization that does not distribute its profits to owners. Obtaining tax-exempt status is an extra step beyond simply forming a non-profit, and bestows some significant benefits, namely exemption from income tax and the ability of donors to deduct contributions.

The complexity of designing a tax exempt organization results from it having three internal primary audiences to satisfy, rather than the two a for-profit or non-exempt, non-profit business appeals to. The latter must meet: 1) the expectations, needs, and goals of its founders & stakeholders, and 2) the requirements of state level entity law. A tax-exempt non-profit must satisfy these two along with the internal management rules supplied by federal tax law. State level entity laws govern the structure, rights, responsibilities, and liabilities of the organization’s internal stakeholders (directors, officers, agents). Federal tax law supplies another body of rules affecting the internal management and operations of a tax exempt entity. While there are many types of tax-exempt entity, when we speak of these we generally tend to mean a 501(c)(3) organization. These are organizations organized exclusively for charitable, religious, educational, scientific, literary, prevention of cruelty to children and animals, public safety testing, and amateur sports competition purposes.

With that settled let’s finally get to why Form 1023 is better than 1023 EZ.

 

Reason #1: Sometimes Less Isn’t More; It’s Just Less

The most attractive aspect of the EZ is its simplicity. The EZ initially appears much easier to complete than the 1023 (EZ is only 3 pages long vs. 1023, which is over 20 pages). However, this initial impression is misleading. The EZ provides no opportunity for clarification or explanation, meaning that for activities and operations that are legitimate if done properly you are incentivized to just say “no” to them because a yes without explanation could lead to risk of denial. For example, the EZ asks whether an organization will participate in political lobbying. A quick web search will show the EZ user that public charities should not do any substantial lobbying activities. You don’t have to be a lawyer to see there may be some gray area in “substantial”. Meanwhile, the 1023 asks the same question but gives an opportunity to describe these operations and how they will be in compliance with the law. Without an opportunity to explain an EZ applicant may feel it is safer to forgo all lobbying and just answer “No” on the application rather than risk a denial for saying yes.

 

Reason #2: ALL the Rules Apply, Even to EZ Filers

Once an organization applies for and receives tax-exempt status, even if it used an EZ to apply, the organization must still comply with every rule applicable to a public charity. Just because you didn’t know a rule existed because it wasn’t spelled out in the EZ doesn’t give you a pass or exemption on compliance. In contrast, the 1023 gives you a chance to face those rules, learn them, and plan for how to operate within them. By not giving you the opportunity to plan for the rules, the EZ creates the risk that if you’re later audited you won’t be in compliance with many aspects of required operations.

 

Reason # 3: Only Certain Organizations May Use the 1023 EZ

The EZ is for organizations with less than $50k revenue. If you receive a grant that’s larger than expected and you had reason to know this was possible there could be risk of being accused of making a material misstatement and losing exempt status. Also, the receipt of a large grant for an EZ filer may be an audit consideration.

 

Reason #4: Planning is Fun

If success is great, and planning leads to success, then planning is great too. Disregarding the actual merits of that syllogism for a moment, the greatest advantage of the 1023 is the opportunity to plan. Some of you may think “But planning is SOOO boring”. Well, if you’ve ever laid out the rooms in your future dream house, picked options on your future car, or dreamt of what you would do with lottery winnings, Congratulations! You’re already a planner. Well-planned businesses and organizations tend to operate more efficiently and successfully than their seat of the pants counterparts. This is particularly important in the tax exempt organization & nonprofit world where a community or cause depends on an organization’s efforts, and where potential donors want to know their donations are being put to their highest good.

I like to embrace the 1023 and use it as an opportunity to map out the operations of an organization, its programs and activities, and its compliance with various laws. The EZ may get your foot in the door, but it may ultimately get you into a room you aren’t ready for.

 

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© Christopher Way 2017