20.4 Types of Tax-Exempt Organizations

20.4 Types of Tax-Exempt Organizations

REG Area V, Group F asks you to recall the different types of tax-exempt organizations. This is Remembering and Understanding. The Blueprint does not ask you to compute Form 990-T line by line, to apply the public-support fraction, or to plan a §501(c)(3) application the way Tax Compliance and Planning might. Know the roster, know that exemption is from federal income tax on exempt-function income, and know unrelated business taxable income as a concept. Entity-level corporate tax on a taxable C corporation remains Section 18.2; do not put a food bank on Form 1120 merely because it has a bookstore.

What “tax-exempt” means

An organization described in IRC §501(c) is generally exempt from federal income tax on income from the activities that carry out its exempt purpose — dues that fund the league, contributions that fund the charity, admission fees that fund the museum. It is not exempt from every federal tax. Employment taxes still apply to employees. Some §501(c)(3) private foundations pay excise taxes. And income from an unrelated trade or business can be taxed even though the organization remains exempt on its related income.

Exemption is a status. It is not a bank-account label. Putting receipts in a “foundation” checking account does not make a for-profit partnership tax-exempt.

The REG-typical §501(c) roster

Other §501(c) paragraphs exist (labor and agricultural organizations under (c)(5), fraternal societies, cemetery companies). REG's working set is the four rows above. If a stem gives a trade association, think (c)(6). If it gives a food bank, school, church, or hospital, think (c)(3). If it gives a neighborhood civic group that promotes the common good, think (c)(4). If it gives a golf and dining club funded by members, think (c)(7).

Private inurement is the rule that net earnings may not inure to the benefit of insiders (founders, officers, large donors with control). Paying reasonable compensation for services is not inurement. Setting the charity up to funnel profits to the founder's for-profit affiliate is.

Unrelated business taxable income (concept)

Unrelated business taxable income (UBTI) is income from a trade or business, regularly carried on, that is not substantially related to the organization's exempt purpose. The organization remains exempt. That slice of income is still taxable, generally at corporate rates, on Form 990-T. REG Core stops at recognition: a university's endowment dividends are typically not UBTI; a university's off-campus commercial pizza chain that competes with local restaurants and is not run by students as part of the educational program is the classic relatedness failure.

Investment income (dividends, interest, many royalties, many rents from real property, gains from property that is not inventory or dealer property) is generally excluded from UBTI by statute, with debt-financed and controlled-subsidiary exceptions you should not compute on REG. Do not treat every dollar a (c)(3) receives as tax-free, and do not treat UBTI as a revocation of exemption by itself. Unrelated activity that becomes the organization's primary purpose is a qualification problem, which is different from paying tax on a side business.

Applying for recognition — Form 1023 and Form 1024

Most organizations that want §501(c)(3) status file Form 1023 (or Form 1023-EZ if they fit the streamlined criteria). The IRS issues a determination letter. Churches, their integrated auxiliaries, and conventions of churches are not required to apply in order to be described in §501(c)(3), though many still do. Most other §501(c) types (including (c)(4), (c)(6), and (c)(7)) use Form 1024 or Form 1024-A. Annual information reporting is Form 990, 990-EZ, or 990-N, depending on size; that is not the income-tax computation on unrelated income. Form 990-T is the UBTI return. REG asks you which form family matches the exemption type, not to complete Part IV of Form 1023.

Public charity versus private foundation (one paragraph)

Every §501(c)(3) organization is either a public charity or a private foundation. Public charities include churches, schools, hospitals, and organizations that receive broad public support (and certain supporting organizations). Private foundations are typically funded by a small group of donors — a family or a single corporation. They remain §501(c)(3), so gifts can still be deductible, but they face extra excise taxes (net investment income, failure to make minimum charitable distributions, self-dealing, excess business holdings, and taxable expenditures) and tighter deduction limits on gifts of appreciated property. REG Core: name the two buckets and the idea that private foundations are more restricted. Do not compute the two-percent net-investment-income tax on the exam.

Worked: trade association versus charity

Facts. Two organizations ask you to classify them.

North Central Widget Association is funded by member dues. It publishes industry statistics, runs a trade show for widget manufacturers, and lobbies the state legislature on widget-safety standards. It does not operate a soup kitchen and does not tell donors that dues are tax-deductible charitable contributions.

River City Food Bank is funded by public donations. It collects and distributes food to low-income families. Officers are paid reasonable salaries. It does not intervene in political campaigns.

Analysis. The Association is a §501(c)(6) business league: common business interest of a line of business, dues-funded, not a charity. Member dues are not §170 charitable contributions. The Food Bank is a §501(c)(3) charitable organization. Qualifying donor contributions are generally deductible. Neither pays federal income tax on dues or on contributions that fund the exempt function. If the Food Bank also ran a regular commercial cafe selling meals to the general public at a profit, that cafe would be analyzed as UBTI, not as a reason to reclassify the Food Bank as a C corporation on Form 1120.

Wrong REG answers: treating every nonprofit as (c)(3); treating a trade association as (c)(3) because “it helps the economy”; treating a food bank as a (c)(7) social club; assuming dues to a (c)(6) are deductible charitable gifts; assuming UBTI automatically revokes exemption.

/practice/cpa-regPractice questions with detailed explanations