The Internal Revenue Service (IRS) used to be the primary watchdog over nonprofit organizations.  But there is a new sheriff in town.  State governments are throwing their weight around, concerned that the IRS’  streamlined tax exemption application process and limited auditing of nonprofits may not provide sufficient oversight of the nonprofit groups.

It began with spaghetti

Actually, the spaghetti didn’t start cooking until mid-century.  Way back in 1909 the first federal law was put in place that exempted religious, charitable, and educational organizations from federal income tax.  When our modern tax code came into being in 1913, the 1909 tax exemption language was included in it.  The 1909 law, however, applied regardless of how the nonprofit organization earned its income.  That’s what led to the great spaghetti debacle. 

The spaghetti-making Mueller company was set up as a nonprofit corporation to support the New York University School of Law.  Mueller earned money selling noodles and gave the profit to the nonprofit university. By all accounts, the Mueller company was set up properly based on the federal tax law at the time.  The Internal Revenue Service, however, thought something was wrong with the marinara sauce and took action to take away Mueller’s tax break.  

Ultimately, the Tax Court found that Mueller was following the law.  This got Congress in the kitchen to whip up a new recipe for tax exemption.  The result was the Revenue Act of 1950 that requires nonprofits to pay tax on income earned from commercial, for-profit activities, including selling spaghetti noodles.  

Over the years, more changes were made to the federal laws for tax-exempt organizations. One big change that got the state bureaucrats attention, however, was the introduction of the online Form 1023EZ.  The 1023EZ streamlines the tax exemption application process for smaller nonprofits. Nonprofits with gross income of $50,000 or less apply for 50(c )(3) status with a short online form.  Many tax exemptions are granted in 30 days or less.  This fast-food-style-service is considered half-baked by some government officials.  

States cook up some nonprofit, tax exemption regulation of their own

Most states rely on IRS recognition of tax-exempt status – that is 501(c)(3) or other 501(c) tax-exempt section – to determine if nonprofit groups are eligible for state tax exemption. (There are more than 21 categories of tax-exempt status under section 501(c) of the Internal Revenue Code). States also add regulations for how nonprofits must operate and what reports they are required to file in the state.  Nonprofit groups typically incorporate in a state. To maintain incorporation most states require organizations to file an annual report.  36 states require organizations to register and file reports relating to their fundraising activities. This is usually called “charity registration”.  If a state collects sales tax, some states allow nonprofits to apply for exemption from collecting and paying sales tax.

These state laws have changed over the years. The changes have often been described by the states as improving the system.  What I’ve seen, however, are more rules to understand and follow. California put into play the Nonprofit Integrity Act of 2004. This law was said to “improve governance procedures and enhance the filing requirements for charities.”  Those “improvements” were the addition of new rules for audits, fundraising and compensation.  New York passed the Nonprofit Revitalization Act in 2013. This law “enhanced corporate governance standard.”  The “enhancements” included requiring a written conflict of interest policy for each nonprofit, and increasing the state’s enforcement authority over the standards.  Oregon passed a law that allows the state to disqualify organizations if they spend 70% or more of their funds on fundraising.  

States join forces 

Most unusual, and interesting, is that states are cooperating more to enforce nonprofit laws.  For example, in May of 2015, all fifty states, the District of Columbia, and the Federal Trade Commission jointly filed a lawsuit against four major cancer charities. The charities were found to have used only 3% of the $200 million they raised to actually help cancer patients. The charities were required to close down and give away their assets.

In 2011, a majority of states joined forces to work on the Single Portal Initiative.  The project is to be the one-stop solution for charitable solicitation registration. The result is The State Charity Registration Portal (SCRP). The idea is that nonprofits can file state charity (fundraising) registration for multiple states through the website. Right now, the portal only allows for Connecticut and Georgia registrations.  The reality is that many states that allow nonprofits to use the portal require the organizations to file documents and forms unique to their state in addition to the multi-state form.  Hiring a firm to complete nationwide charity registration for a nonprofit can cost from $5000-10000, plus each state's registration and annual filing fees. 

Are there too many cooks in the kitchen?

If you are a small nonprofit trying to follow all these rules, you might think there are too many cooks in the nonprofit regulatory kitchen.  The rules are meant to protect the public from groups like the cancer charities that kept the donations for themselves.  However, tell that to the many nonprofit groups that get burned each year by late filing penalties, or worse, revocation of their tax-exempt status.  

There are tools available to help nonprofits succeed.  RENOSI’s state registration resources are a good place to start to find your state requirements. The bottom line is that nonprofit groups need to know that state governments have joined the IRS in the nonprofit regulatory kitchen.  Keeping track of changes in state laws and rules for tax-exempt organizations is now a necessary ingredient to nonprofit success.