To enjoy the benefits of Section 501(c)(3) tax-exempt status, nonprofits (other than churches and their integrated auxiliaries), must apply to the IRS using its Form 1023 or the newer Form 1023-EZ. A few years ago, with Form 1023 processing times bogged down to a year or more, the IRS issued the streamlined Form 1023-EZ application as a way to expedite decisions made on tax-exempt applications. But this cure is not so curative, as reflected in recently published Internal Revenue Service (IRS) reports. These reports flash caution signals for nonprofits seeking Section 501(c)(3) approval.
The IRS Reports
On March 19, 2018, the IRS published its accomplishments for the 2017 fiscal year. Included in this publication are statistics related to post determination compliance exams of organizations that filed Form 1023-EZ and were granted tax-exempt status. Of the 1,182 organizations randomly selected to serve as the sample group for examination, only 49% were found to have been accurately approved with no changes required for their organizational documents. That means that a shockingly high 51% of organizations examined did not actually qualify for tax-exemption at the time the IRS did in fact grant its approval of the applicants’ Form 1023-EZ applications. The full text of this publication may be found on the IRS website here.
The IRS’s publication confirms major concerns voiced by the Taxpayer Advocate Service (TAS). In January of this year, TAS delivered its annual report to Congress detailing the “most serious problems” (MSPs) involving taxpayers that plagued the year 2017. Listed among these MSPs is Form 1023-EZ. TAS is an independent office within the IRS established by statute to ensure the fair treatment of taxpayers. Among its statutory functions are the tasks of identifying problem areas in taxpayers' dealings with the IRS, proposing administrative changes to mitigate such problems, and detailing at least 20 MSPs in an annual report to Congress.
In the 2017 report, TAS identified Form 1023-EZ as an MSP that negatively impacts the taxpayer's statutory rights to: (1) be informed, (2) quality service, and (3) finality. TAS found that Form 1023-EZ does not require enough information to make an accurate finding as to whether the applicant qualifies for tax-exempt status under Section 501(c)(3) of the Code. This is not the first time Form 1023-EZ has come under fire. TAS has identified Form 1023-EZ as an MSP since its introduction by the IRS in mid-2014.
The main problem identified by TAS with respect to Form 1023-EZ is the significant number of erroneous approvals made by the IRS. The TAS report analyzed a representative sample of 337 organizations in states that make articles of incorporation freely available online, whose Form 1023-EZ applications were approved by the IRS. Of these organizations that received a favorable determination from the IRS, almost half (i.e., 42%) did not meet the statutory requirements of tax-exempt status under Section 501(c)(3) of the Code. More specifically, these organizations failed the organizational test, which focuses on whether the organization’s formation documents (e.g., articles of incorporation) demonstrate that it is organized exclusively for purposes described in Section 501(c)(3) of the Code. More information regarding TAS’s findings may be found here.
Tempted by Form 1023-EZ
TAS reported that the average processing time for a Form 1023 application, which continues to be on the rise, was 113 days in fiscal year 2017. By contrast, Form 1023-EZ applications are often processed in a matter of weeks and “virtually” all applications are approved. As the TAS report concludes, however, Form 1023-EZ was a near-sighted solution to processing times that has come “with a high cost to the integrity of the U.S. tax exempt sector.”
The abysmal statistics found in the IRS reports described above are likely due to Form 1023-EZ’s essentially self-certifying nature. It requires only scant information about the applicant and a certification of eligibility to file Form 1023-EZ—most notably, that the applicant is not a church and does not reasonably expect to receive more than $50,000 annually. Additionally, the Form 1023-EZ filing fee is lower than that of Form 1023: $275 instead of $600. It is thus quite tempting to use Form 1023-EZ if eligible.
Best Practices for Section 501(c)(3) Approval – Stick with Form 1023
The problem of erroneous approvals of Form 1023-EZ applications identified by TAS and confirmed by the IRS’s recent publication confirms that the best practice is to apply for tax-exempt status using the original Form 1023 regardless of eligibility to use Form 1023-EZ. As tempting as the simplified Form 1023-EZ may be, it is best to take all necessary precautions to ensure the accuracy and finality of a tax-exempt determination, both for the nonprofit organization and your donors. All necessary precautions may include investing the extra time needed to prepare supporting documents and file Form 1023.
Form 1023 is formally identified as Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. The form itself, along with accompanying narrative and financial information, is intentionally designed as a vetting process. More specifically, the applicant’s Form 1023 information should show that it is “organized and operated exclusively” for charitable, educational, religious, or other qualified purposes as described in Section 501(c)(3) of the Code. Form 1023 requires detailed information regarding the organizational structure, planned activities, and finances of the applicant to ensure the applicant meets specified criteria to be recognized as a Section 501(c)(3) organization. Depending on the type of nonprofit organization, the Form 1023 application process also provides the critical opportunity to show the IRS that the applicant organization will be legally compliant going forward—for example, no improper private benefit resulting from compensation or otherwise, no illegal international activities, no improper contracts or other business relationships, sound governance through well-developed bylaws, legally compliant articles of incorporation (with requisite IRS-mandated limitations and dissolution language), and satisfaction of applicable public support tests for Section 501(c)(3) status. Notably, the IRS’s approval of a timely submitted Form 1023 should result in tax-exempt status as of the date of incorporation, so it may be worthwhile for nonprofit organizations to take the time needed to properly complete the Form 1023 application and then await the IRS determination letter.
By contrast, Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, asks only minimal questions and requires a Form 1023-EZ Eligibility Worksheet (to screen out non-eligible applicants like churches, schools, and LLCs). It assumes that the applicant understands applicable Section 501(c)(3) organizational and operational requirements. That may be true, such as if the applicant seeks out legal counsel and is knowledgeable about tax-exempt legal matters. In such circumstances, using Form 1023-EZ may be a wise and cost-effective approach for small nonprofits. As demonstrated by the alarming statistics in the IRS reports, however, that does not seem to be the case for a significant number of organizations using Form 1023-EZ.