Applying for Tax Exempt Status? Pitfalls to Watch Out For

​If you’ve ever considered starting a nonprofit organization, then you’ve probably taken a look at the IRS’ Application for Recognition of Tax-Exempt Status. IRS Form 1023 is a daunting application to say the least. At one point, the IRS estimated that for the average person to properly complete and submit the form would take more than 100 hours. It is the equivalent of getting audited before your organization even gets started. And after putting in all of that work, nearly 15% of applications never get approved.
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What are some of the common mistakes that could hinder or delay your application, effectively destroying your mission-driven project before it even gets off the ground?

Mistake #1: Failing to Include the Required Provisions in Your Organizing Documents
Before you even fill out Form 1023, you need to make sure that your organizing documents will meet the IRS’ requirements. Generally, your organizing documents will consist of the Articles of Incorporation that were filed with the Ohio Secretary of State and the organization’s bylaws or code of regulations.
All too often, nonprofit founders describe the organization’s purpose using overly colorful language that is more akin to a statement of hopes and dreams. But when this language is interpreted by an IRS agent, questions are raised regarding whether the organizing document expressly limits the organization’s purpose to one of the tax-exempt purposes recognized by the Internal Revenue Code. A typical 501(c)(3) charitable organization must be operated exclusively for tax-exempt purposes. If your purpose clause describes activities commonly performed by for-profit businesses or allows the organization to do almost anything to improve lives, then it will probably raise a red flag.

Mistake #2: Failing to Answer the Questions Asked in the Narrative Description Section of the Application
Nonprofit founders often assume that they’ll save the new organization some money by preparing Form 1023 on their own and then hiring a nonprofit attorney to review their work. This rarely works out that way, and the narrative description of the organization’s activities often lets us know how good (or poor) a job the founder has done.

The IRS’ question is very specific: Describe in detail the organization’s past, present, and planned activities. Simply restating the organization’s mission or purpose is not good enough. A generic, “we do X” without reference to past, present, or future also won’t suffice.
Describe “in detail” also means the IRS wants to know:

• Who is involved in conducting the activity (staff, volunteers, paid consultants?)
• What percentage of time has or will the organization devote to the activity?
• How does the organization raise funds for the activity?
• What percentage of the organization’s expenses are devoted to the activity?

Failing to answer these questions will almost certainly raise red flags in your application.

Mistake #3: Suggesting Improper Financial Benefits
I meet too many nonprofit founders who are under the mistaken impression that they “own” the organization that they are founding. (Newsflash: No one “owns” a nonprofit. They exist to benefit the community by being operated exclusively for their tax-exempt purpose.) As a result of this mistaken impression, the founder assume that they can set a salary for themselves based on their financial needs (real or perceived), and that they can fill in the board of directors with friends, family members, and business partners who will also receive relatively sweet compensation packages.

Nonprofit compensation should be based on what other, similarly situated nonprofits pay, not your personal financial budget or how much you believe the new organization will be able to raise (which is probably not as much as you think). The research that goes into compensation decisions should be documented, and the discussion and final vote should be among disinterested board members (i.e., not your family members or business partners). Can family members serve on the board? Of course. But there should be enough non-relatives to make disinterested decisions that are in the best interests of the organization and not your bank account.

Similarly, the organization should avoid, or at least minimize, business dealings with for profit entities owned or controlled by the founder, the founder’s family members, or other board members. While these types of arrangements are not automatically impermissible, they will raise red flags. Instead, make sure that you adopt (and fully understand) the IRS’ suggested conflict of interest policy (which is included in the instructions for Form 1023).

Bonus: Be Careful With Form 1023-EZ
After reviewing the detailed Form 1023, the IRS’ extensive regulations, and articles like this one, it’s easy to see the appeal of just filing Form 1023-EZ. Rather than being audited up front, the EZ version of the application is more akin to self-certifying that the organization qualifies for tax exempt status. In theory, the IRS is supposed to catch “false” certifications through its random audits of tax-exempt organizations, but it doesn’t appear that the IRS audits very many of these applications. (As far as I can tell from a review of the published data, the IRS doesn’t even calculate the percentage of nonprofit information returns that are ultimately subjected to review or audit.)
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Nevertheless, there are anecdotal reports of the IRS revoking the tax-exempt status of organizations that quickly exceed the revenue and asset limits that would have qualified them to use Form 1023-EZ in the first place. So before applying, make sure to document the organization’s financial projections so that, if audited, the organization can show why it believed it would raise less than $50,000 in revenue each year for its first three years and have less than $250,000 in assets.

​Have questions about applying for tax-exempt status?

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