United States: The Waiting Game: What To Do (And Not Do) While An Exemption Application Is Pending

So, you have thoughtfully and thoroughly prepared the Form 1023 Application for Recognition of Exemption Under Section 501(c)(3) ("Form 1023" or "application") on behalf of a charity, and filed it with the IRS along with a completed checklist and the correct user fee.  The charity is now anxious to fundraise and accept donations, commence its charitable programs, or start making grants. Now what?

Once upon a time you could reasonably approximate the processing time for a Form 1023, based on various facts and characteristics.  A non-operating private foundation that only makes grants to domestic public charities?  One could anticipate receiving a favorable determination letter in three to six months.  A public charity with highly compensated employees, joint venture activity, affiliated entities, and/or and foreign activities?  One could similarly predict a longer processing time and greater likelihood that the IRS would respond with questions and a request for further information, regardless of how carefully the Form 1023 was prepared.

Currently, IRS processing time for a Form 1023 is both a guessing and waiting game.  The IRS standard "receipt acknowledged" letter states that if the Form 1023 "can be processed based on information submitted" (translation – minor or no questions) ("first group"), a determination letter should be received within 90 days from the date of the letter.  It then adds that if a Form 1023 requires "additional information" to be processed (translation – questions regarding activities or operations) ("second group"), then correspondence should be received from an IRS specialist approximately 180 days from the date of the letter.  After 180 days, inquiries about status can be made through IRS Customer Account Services.  Yet, a quick click on the IRS website Where's My Exemption Application?  indicates that currently the average date of a pending Form 1023 application is June 2013, nine months and still "pending".  In addition, recent experience and reports from other practitioners indicate processing time ranging from 90 days to 18 months, with even some "first group" applications taking over one year.

The slowdown is likely due to a number of different factors, including lack of personnel (a longtime problem), a backlog of applications due to the 2013 furlough, the influx of new Forms 1023 filed by organizations whose exemptions were automatically revoked for failure to file an informational return for three years, and possibly catch-up processing for organizations that were delayed due to the IRS "Be on the Lookout" (BOLO) list, such as certain "Tea Party" related organizations and others.

Provided below is a list of some common questions from charities with pending applications, and some technical and practical answers.

Can we solicit contributions and accept donations? 

  • Assuming a Form 1023 was filed in a timely manner, a favorable determination of exempt status will be retroactive to the date the entity was created under state law (e.g. date of incorporation); however, until the letter is received, there is no certainty for the organization or its donors regarding the deductibility of contributions.
  • While its Form 1023 is pending, an organization cannot represent to a donor that it is exempt from tax, or that the donor will be eligible for a charitable income tax deduction.  Accordingly, the organization cannot provide the donor with the usual thank you/substantiation letter for income tax purposes, because it cannot state that any portion of the donation is eligible for charitable income tax deduction.  The same is true for grant applications to other charitable organizations – the organization cannot yet represent that it is tax exempt.
  • Contributions or grants, whether by an individual, corporation, or another charitable entity to an organization that is not yet determined to be exempt can create tax risks for a donor and/or might impose additional requirements on the donor (e.g., taxable expenditure issues for a private foundation).  Such contributions might even be prohibited under the organization's governing documents or policies.  If exempt status is not confirmed in time to support a donor's charitable income tax deduction in the year of donation, the deduction can be taken only by filing an amended return once the exemption is granted retroactively.  Thus, as a practical matter, fundraising while the Form 1023 is pending is challenging at best and, due to longer IRS processing times, many more organizations are turning to fiscal sponsorship arrangements with existing charities (an often misunderstood arrangement that is an intended subject of a future blog entry).
  • Regardless of pending status, an organization soliciting donations from the general public may be subject to state charitable solicitations laws, which generally require registration with and reporting to that state's Attorney General or another state agency prior to conducting any solicitations.

Can we commence our charitable activities?

  • It depends.  If the organization has funding and the activities are clearly charitable (e.g., grants to domestic public charities by a private foundation), the organization can generally commence its activities, including hiring employees and entering into leases.  Some activities require more caution during the time the application is pending, including, for example, foreign activities and other "red flag" activities that generally receive greater scrutiny by the IRS, and scholarship grants by private foundations, which can have adverse tax consequences for the organization if commenced before approval by the IRS of scholarship grant criteria.
  • Some states require registration with the Attorney General or another state agency to give notice of existence and contemplated activities, regardless of whether the organization will be soliciting contributions.  If the organization will be conducting activities outside its state of formation, it may also need to register to do business in that state before commencing activities.
  • There may be other state law considerations, such as whether or how the organization can obtain an exemption from state sales tax prior to determination of exempt status and the application of real estate tax exemptions. 

Do we need to file an annual return?

  • Form 990-PF – Private foundations must file a Form 990-PF for all tax years from date of formation (even if a Form 1023 has not yet been filed); there is no de minimus exception and a return must be filed even if the organization has no assets.
  • Form 990/990-EZ– A charitable organization claiming tax exempt status as other than a private foundation, and not otherwise exempt from filing (e.g., churches and their integrated auxiliaries), and which normally has gross receipts of more than $50,000 must file a Form 990 or Form 990-EZ on an annual basis from date of formation.  Subject to a limited exception for organizations affiliated with a church or religious order, a supporting organization described in Internal Revenue Code Section 509(a)(3), however, must file a Form 990 or 990-EZ regardless of the amount of its gross receipts.
  • Form 990-N – Unless otherwise exempt from filing (see Form 990 Instructions "B. – Organizations Not Required to File Form 990 or 990-EZ), an organization that normally has gross receipts of $50,000 or less must submit Form 990-N (e-postcard) on an annual basis (or it can file a Form 990/990-EZ) .Since an organization's EIN is not entered in the IRS' system until determined exempt, an organization with a pending Form 1023 will need to contact the IRS directly at its toll free line (877) 829-5500 and request that the IRS manually enter its EIN so that the e-postcard can be filed thereafter.
  • Failure to file the required informational return for three consecutive tax years can result in automatic revocation of exempt status.  Consider a calendar year organization formed in December that files its Form 1023 a year later, experiences an 18 month processing time and neglects to file for some time because it hasn't received funds yet.  Such an organization could inadvertently trigger automatic revocation not long after obtaining its exemption and will then need to seek reinstatement.
  • Form 990-T – An organization must also file Form 990-T for any year of existence (including any year in which its Form 1023 is pending) in which it has gross income of $1,000 or more from a regularly conducted trade or business (unrelated business taxable income).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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