Form 1023 – The Bad
Most parts of Form 1023 that I’ve labeled The Bad are connected in one way or another to the management of the nonprofit’s monies. Why label these sections as such?
Anytime money is involved, matters of business can get a bit complicated.
Therefore, I urge nonprofit founders to think long and hard about the answers they provide – even the ones that seem harmless – to questions in Part V, VI, VII, and X.
Part V addresses compensation of employees, directors, independent contractors, and others connected to the work of the nonprofit. Answer these questions honestly. The IRS is trying to gauge your ability to be responsible and transparent about current and future compensation plans.
Will you pay your executive director considerably more than the average salary typically paid for that position? If so, that could be a red flag for the IRS, especially if you plan on hiring yourself to fill that position.
Are any of your board members on payroll? Although this isn’t forbidden by the IRS, having volunteer board members double as paid employees could give the IRS screening committee reason to pause.
One thing to keep in mind when filling out Part V is that the more complicated your answers, the more likely your application could be delayed or rejected.
For that reason, I advise you to research salaries for executive directors, development personnel, and any other paid position so you have an understanding of what is standard versus what may appear a bit unorthodox to the officer assigned to evaluate your application.
In addition, I urge nonprofit founders to be very careful about payments made to board members. There is a reason the IRS requires nonprofits to submit a conflict of interest policy in Part V. It wants to make sure the interests of the nonprofit are paramount and are not infringed upon or compromised by the personal interests of board members and other stewards of the nonprofit.
Use common sense in Part V. If an action seems as if it will make the accounting of the nonprofit questionable and less transparent, don’t do it. Instead of paying your volunteer board member slash part-time accountant $70,000 to balance the books and complete tax forms, it may be cleaner and simpler to hire an outside accountant for less money to handle those duties on behalf of the nonprofit.
When it comes to the money, your nonprofit will fare better on the 1023 and in the future if it chooses to keep things clean and simple.
For many applicants, Part VI becomes a problem if the nonprofit distributes food, services and funds to anyone connected to the organization.
For instance, if the only people receiving services through the nonprofit are family members and friends, the IRS is going to have a BIG problem with that arrangement.
Remember, a nonprofit is prohibited from allowing an individual, group or entity to profit on its behalf. Any activity that suggests a person or select group is profiting from the organization will cause the IRS to deny tax exempt status. Please keep this in mind when completing Part VI.
Part VII can be a headache for you if:
- You are a successor of a nonprofit that was founded by someone else or
- You are an applicant who waited 27 months or more after forming the nonprofit to seek tax exempt status.
On the surface, it may appear that this section has nothing to do with money.
When dealing with succession, how someone has handled all aspects of the nonprofit, including the monies, will always be of interest to the IRS.
The same is true for someone who has waited longer than 27 months to file for exemption. During that period, the IRS will be curious about how donations and other monies were managed and accounted for by the nonprofit.
That is why, in both cases, you will have some explaining to do through Schedules G and E respectively.
When filling out those schedules, make sure you are truthful and as transparent as humanly possible.
Finally, Part X may look harmless at first glance, but it isn’t.
This section determines whether or not your nonprofit qualifies as a public charity or a private foundation.
Upon receipt of your 1023 application, the IRS begins with the assumption that you are applying as a private foundation. As a result, you have to prove you are indeed a public charity.
What’s the big deal if both public charities and private foundations qualify for exemption?
Tax exemption for private foundations is not as comprehensive as exemption for charities. Public charity status is the more favorable and, consequently, the more sought after of the two.
To qualify as a public charity, a nonprofit must pass the following public support test:
- An organization must receive 1/3 of its total support from governmental agencies, contributions from the general public, and contributions and grants from other public charities or
- An organization must receive 10% of its total support from governmental agencies, contributions from the general public, and contributions and grants from other public charities. It must also pass a facts and circumstance test.
A facts and circumstance test forces the nonprofit to demonstrate general support, the existence of a funds solicitation program and additional facts regarding the nonprofit.
Of the two options on the public support test, the ideal box to be able to check is the first one which indicates you receive 1/3 of your total support from the government, the general public and from charities.
However, if that is not true for your organization, you will need to work a little harder to prove to the IRS through option two that you are indeed a public charity and not a private foundation.
Still with me? Good! We’re almost done with Form 1023.
I’ll be posting a link to Deconstructing Form 1023: Act III shortly. In that post, I’ll help you confront the ugly side of the exemption process.
Until then, keep your head up and keep fighting the good fight for those in need.
“I’m a non-profit expert with 20 years in the trenches. Having seen new non-profit organizations struggle to get off the ground and compete with established charities for monies and other resources, my primary objective is to level the playing field for emergent non-profits and other charitable start-ups so they are better equipped for long-term sustainability, increased community impact and overall financial success.” Reet Alexander
*”The Good, the Bad and the Ugly” artwork by artist Billy Perkins.