In Part 1, we went over the steps to establish a non-profit organization as a legal entity. But that step alone will not grant the organization tax-exempt status. Only the IRS can recognize an organization as a tax-exempt entity. So once your legal entity is formed, how do you apply for tax-exempt status?
This week we’ll take a look at Form 1023 versus 1023-EZ and dive into the requirements for using the EZ version of the form. In future posts, we’ll cover Form 1023 in more detail and look at fiscal sponsorship as an alternative to applying for recognition as a tax-exempt organization.
Applications for Recognition as a Tax-Exempt Organization
There are two ways of applying for recognition as a tax-exempt organization: IRS Form 1023-EZ or IRS Form 1023. A few years ago, the IRS rolled out IRS Form 1023-EZ as a simpler application process for small nonprofits to apply for their tax-exempt status. The IRS seemed to recognize that the standard application was too complex and too time-consuming (both for the organization and the IRS) for smaller nonprofit organizations. The IRS has a several months-long backlog to process applications for tax-exempt status, and something needed to change…hence, the “EZ” version of the application.
The difference between the EZ application and Form 1023 is pretty significant. The EZ Application is 3 pages, and the IRS estimates that on average, it takes the average person more than 18 hours to complete Form 1023-EZ. (It’s a short form, but you have to spend time getting your records and financial projections together, read the instruction booklet, figure out what the IRS is asking, and do other research to properly answer the questions).
In contrast, the standard Form 1023 is 28 pages (and with the various narrative descriptions and attachments, the final application can easily end up being 35-45 pages or more). And the IRS estimates Form 123 will take the average person more than 105 hours to properly complete and submit! (And that doesn’t include the various schedules you may have to complete depending on how you answer the questions.)
Needless to say, if the nonprofit organization qualifies to apply using Form 1023-EZ, then doing so can save you significant time and money. So what qualifications does the organization need to meet to take the EZ route?
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Annual Gross Receipts
So what makes a nonprofit “small” for purposes of using Form 1023-EZ? First, the organization’s annual gross receipts must be less than $50,000. The IRS will look at any money the organization has raised in each of the past 3 years, as well as what you project the organization will raise in each of the next 3 years. Obviously, financial projections aren’t an exact science, but the projected revenues should have some relationship to the projected expenses. (Even nonprofit organizations cannot operate at a budget deficit year in and year out.) Similarly, the projected expenses should be reasonable when compared to the purpose of the organization. Can the nonprofit realistically fulfill its program objectives on less than $50,000 per year?
In addition to the current and projected gross receipts, the IRS also considers the fair market value of the organization’s assets. The organization must have less than $250,000 in assets to qualify for Form 1023-EZ.
Entity Type: Don’t Form a Nonprofit LLC
The organization must be formed as a corporation, unincorporated association, or a trust. While the Ohio Secretary of State will let you form a nonprofit LLC, the IRS will not allow you to use Form 1023-EZ if you set up the entity that way. If you otherwise qualify as a small nonprofit, it will be significantly easier to dissolve the nonprofit LLC and form a proper nonprofit corporation than it will be to proceed with the nonprofit LLC and have to file for tax-exempt status using the standard 1023 application. Save yourself the headache and don’t form a nonprofit LLC!
A nonprofit organization will also be disqualified from using Form 1023-EZ if it is a successor to a for-profit business. In other words, if you started out as a for-profit business and then try to convert to a nonprofit entity, you are raising a red flag with the IRS and will not able to use the EZ application. The nonprofit will raise this same red flag if it is taking over the assets or activities of a for-profit business. And you cannot circumvent this by dissolving the old for-profit business and starting a new nonprofit entity with the same officers or directors; the IRS would still consider the new nonprofit a successor to the for-profit business because the two entities have the same management.
Similarly, the nonprofit organization cannot have lost its tax-exempt status or be a successor to an organization that previously lost its tax-exempt status. However, there is an exception for organizations that lost their tax-exempt status for failing to file their annual 990.
Because of the separation of church and status, churches (including mosques, temples, synagogues, etc. that regularly meet for religious worship) generally do not have to apply for recognition as a tax-exempt organization. However, many choose to do so to have the official determination letter and the legitimacy that comes with it. Unfortunately, churches and associations of churches that decide to apply for recognition cannot use Form 1023-EZ.
Certain other types of activities will also preclude a nonprofit organization from filing Form 1023-EZ. These include, among other things, schools, hospitals, certain research organizations, cooperative service organizations, supporting organizations, credit counseling or similar service organizations, organizations that form partnerships with for-profit entities, organizations that have donor advised funds. Before submitting Form 1023-EZ, you should carefully complete the Eligibility Worksheet included with the instructions.
If you have questions about applying for tax-exempt status, or just want to save yourself hours of time and frustration, then schedule a consultation.