Introduction to Forming a 501(c)(4)

In a prior post, I introduced how to form a 501(c)(3) charitable organization. This post introduces how to form a 501(c)(4) organization. Such organizations must be operated exclusively to promote social welfare, or further the common good of the community. This encompasses a much broader range of permissible activities than those in which charities may engage, but the trade off is that contributions to a 501(c)(4) do not qualify for a charitable deduction as do contributions to charities. Another difference is that a social welfare organization, unlike a charity, can have lobbying, or attempting to influence legislation, as its primary activity; it may not, however, have influencing elections as its primary activity.

The first step in establishing a 501(c)(4) organization is to create a legal entity under state law. While a trust and a limited liability company can be used, it usually makes the most sense to form a nonprofit corporation. After the legal entity is formed, the organization's directors need to appoint officers, adopt bylaws, and apply for an employer identification number. While a 501(c)(4) organization is not required to file an exemption application (historically, such applications were submitted on Form 1024, but they are now submitted on Form 1024-A), it must notify the IRS within 30 days of formation of its intent to operate as a Section 501(c)(4) organization by electronically filing Form 8976.

A few final steps and ongoing requirements are worth noting. Prior to soliciting the public for donations, the organization will need to ensure that it has completed the charitable solicitation registration process that most states require. The organization will also need to file some version of IRS Form 990 each year; small social welfare organizations can file the 990-N postcard version online. Social welfare organizations that collect membership dues must notify anyone who pays a membership due of the amount that is attributable to lobbying and which cannot therefore be taken as a business deduction. Finally, the organization will need to ensure that it keeps its corporate entity in good standing, typically by filing an annual report with the state.

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How Certain Organizations Can Self-Declare Tax-Exempt Status

There are dozens of tax-exempt organizations under the Internal Revenue Code; the IRS has a list of these on its website, along with the application form that each one files (usually Form 1023 or Form 1024). However, most of these organizations are not actually required to submit an exemption application to the IRS: "[Certain] organizations may self-declare their tax exempt status by operating within the requirements of the applicable code section and filing the required annual returns or notices." In other words, the tax-exempt status of a new organization can often be established simply by filing its first tax return.

Self-declaration is available to cooperative associations, social and recreation clubs, and business leagues, to name a few of the more popular ones. A 501(c)(9) and 501(c)(17) organization may not self-declare. While a 501(c)(4) organization is still not required to file an application (historically with Form 1024 but now with Form 1024-A), a 501(c)(4) can no longer simply self-declare by filing the first tax return. In a future post, I will describe how to form a 501(c)(4) organization. Finally, some 501(c)(3) organizations do not need to file an application or self-declare, whereas all others with gross receipts in excess of $5,000 generally may not self-declare and must apply for exemption.

Self-declaring tax-exempt status has its downsides, most notably that the organization will not receive a determination letter from the IRS. This means that, among other things, the organization will not be publicly recognized as tax-exempt and may not be able to qualify as exempt from certain state taxes. If a self-declared tax-exempt organization does not operate within the requirements of the applicable section of the Internal Revenue Code, it could be vulnerable to an audit by the IRS. Thus, another significant benefit of formally applying for tax-exempt status is giving the IRS notice of how the organization intends to operate and providing an opportunity for the IRS to notify the organization that it is not operating as required by the Code.

Establishing tax-exempt status by self-declaration is generally only advisable for small organizations, such as those eligible to file the Form 990-N (e-Postcard) version of the Form 990. After forming a nonprofit entity under state law and obtaining an EIN from the IRS, a representative of the organization must call the IRS at 877-829-5500 and ask that the organization be allowed to file Form 990-N and then file the form. This is all that is required for a small, eligible organization to be classified as tax-exempt.

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Lobbying by a 501(c)(3) Organization

In my prior post, I provided an introduction to forming a 501(c)(3) organization. Such organizations must have charitable purposes and can not have a primary purpose of lobbying, or attempting to influence legislation. A 501(c)(3) organization classified as a private foundation is subject to excise taxes on all of its lobbying activities as well as political campaign activities under section 4945 of the Internal Revenue Code.

A 501(c)(3) organization classified as a public charity, however, may engage in some lobbying, but only to a limited extent. If a "substantial part" of a charity's activities includes attempting to influence legislation, it risks losing its 501(c)(3) status or not qualifying at the outset. The "substantial part" test is a facts-and-circumstances test; the IRS considers factors such as time and expenditures devoted to lobbying to determine whether the lobbying is substantial.

Because there is inherent uncertainty in any facts-and-circumstances test, a public charity that intends to engage in some lobbying has the option under 501(h) of the Internal Revenue Code to elect to be subject to a test that is based entirely on expenditures. Making this election is accomplished by filing IRS Form 5768. By so doing, a public charity can engage in lobbying by utilizing between 20% and 5.9% (depending on the organization's size, but in no case exceeding $1,000,000) of its exempt purpose expenditures on lobbying.

While the 501(h) election is not for every public charity (and some public charities such as churches are ineligible to make the election), this election can be a good option for charities that wish to devote a small part of their activities to influencing legislation.

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Introduction to Forming a 501(c)(3)

While there are many different types of organizations that are exempt from federal income taxation, the best known is the 501(c)(3) organization. There are also many different types of 501(c)(3) organizations, which I summarized in a prior post. By default, a 501(c)(3) organization is a private nonoperating foundation unless it can qualify as a public charity by, for example, achieving certain levels of public support. Anyone can form a public charity, and many have chosen to do so in recent years.

The first step in establishing a 501(c)(3) organization is to create a legal entity under state law. While a trust and a limited liability company can be used, it usually makes the most sense to form a nonprofit corporation. Such an entity must have a charitable purpose that is recognized as such by the IRS; this link contains a description of the exempt purposes for which an organization can be organized and achieve 501(c)(3) status.

After the legal entity is formed, its directors need to appoint officers, adopt bylaws and a conflict of interest policy, and apply for an employer identification number. The next and most difficult step is completing IRS Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, and the accompanying exhibits. This step in particular is the one where it makes the most sense to work with an adviser who is familiar with nonprofit organizations because the IRS will scrutinize the exemption application.

Once the application for exemption is approved, the IRS will send a determination letter notifying the organization that it is exempt from federal income taxation under section 501(c)(3) of the Internal Revenue Code and that donors can make donations to the organization and take a federal tax deduction for such donations. A copy of Wikimedia Foundation's determination letter appears on the right.

A few final steps and ongoing requirements are worth noting. Prior to soliciting the public for donations, the organization will need to ensure that it has completed the charitable solicitation registration process that most states require. The organization will also need to file some version of IRS Form 990 each year; small charities can file the 990-N postcard version online. Finally, the organization will need to ensure that it keeps its corporate entity in good standing, typically by filing an annual report with the state.

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Donations of S-Corp Stock

Public charities have been permitted shareholders of S-Corporations since 1998. Since that time, charitably-inclined business owners have sought to donate shares of their closely-held business stock to charitable organizations. Normally, donating long-term capital gain property to a charity is highly tax efficient because (1) the donor receives a deduction for the fair market value of the donated asset, (2) the donor avoids paying tax on the asset's built-in gain, and (3) the charity, being tax-exempt, also avoids paying tax on any gain from the sale of the asset. In a previous post, I addressed some situations where the charity may some tax.

In the case of S-Corp stock, however, charities pay a lot of tax. Section 512(e)(1)(B)(ii) of the Internal Revenue Code requires that "any gain or loss on the disposition of the stock in the S corporation" is included in unrelated business taxable income (UBTI). Unlike the gain on "virtually every other asset that a charity might own," only the gain on the sale of S-Corp stock is includible in UBTI. See Christopher R. Hoyt, Charitable Gifts of Subchapter S Stock: How to Solve the Practical Legal Problems. This is a significant issue because charities typically seek to sell closely-held business interests as quickly as possible, especially stock in S-Corporations.

However, different charities pay different rates of tax on sales of S-Corp stock. Specifically, charities that are trusts pay less tax on gains included in UBTI than do charities that are corporations. This is because trusts are taxed at trust rates, which impose a 20% rate on long-term capital gains, whereas all corporate income, including long-term capital gains, is taxed at corporate rates of around 35%. Moreover, a trust is able to deduct up to 50% of its adjusted gross income for donations to other charities, while corporations are limited to 10%.

This is what makes a Donor Advised Fund at a charity that (1) is a trust and (2) maximizes contributions to other charities, such as Fidelity Charitable, an attractive target for a gift of S-Corp stock. The legal structure of the charity reduces the tax erosion of the gift, while the donor still has the right to advise what organization will ultimately receive the proceeds from the stock sale. Below is a comparison of the post-tax benefits that a corporate charity and trust charity would enjoy from the donation and immediate sale of S-Corporation stock:

	Corporation	Trust
Gain from S-Corp. Shares	1,000,000	1,000,000
Maximum Charitable Deduction	(100,000)	(500,000)
Net Unrelated Business Taxable Income	900,000	500,000
Estimated Tax Rate	35%	20%
Unrelated Business Income Tax	315,000	100,000
Effective Tax Rate	31.5%	10%

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Reporting Refunds of Charitable Contributions

A donation to a charitable organization is an irrevocable gift, and even if the donor changes his or her mind about the gift, they generally have no legal basis on which to seek a return or refund of the donation. Furthermore, even if the charity desired to return the gift, the rules under the Internal Revenue Code are such that it should be hesitant to do so. For a good summary of these issues, see Richard R. Hammar's article, Refunds of Charitable Contributions.

If a charity nevertheless decides to refund a charitable donation, the question of whether it must then issue an IRS Form 1099 to the donor arises. In general, businesses must file a Form 1099 to report many types of income; the requirement also applies to charities.

It is clear that a taxpayer who receives the full tax benefit of a charitable donation in one year and who receives a refund of that donation in another year is required to include in gross income the amount previously deducted. In this situation, it makes sense that a charity should issue the former donor a Form 1099.

However, if the donor only received a partial tax benefit or no benefit for the donation, the charity would be placing the donor in an unfair position by issuing a Form 1099. Fortunately, the Internal Revenue Code contemplates this and does not require the charity to issue a 1099 when it refunds a charitable donation.

IRC § 6041(a) imposes the 1099 filing requirement where an organization makes a payment of, among other things, "fixed or determinable gains, profits, and income... of $600 or more." PLR 200704004 interprets this provision as follows:

While any accession to wealth can be income, not all income is fixed or determinable. Income is “fixed” when it is to be paid in amounts definitely predetermined [and] is “determinable” when there is a basis of calculation by which the amount to be paid may be ascertained. Because section 6041(a) is conditioned on a payor knowing that a payment to a payee is in the nature of income and the amount of income, if a payor cannot determine either that a payment is in the nature of income or in what amount, then the payor is not required to file an information return under the section...

The effect of the tax benefit rule can be seen in a number of contexts, for example, casualty losses, real estate tax refunds, and charitable contributions... If by its nature a payment to a taxpayer would not be an item of gross income unless the tax benefit rule applies, and the payor has no way of knowing one way or the other, then the payment is not “fixed or determinable” income falling within section 6041(a).

Accordingly, a charity should not need to report refunded charitable donations on Form 1099.

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Donations of Closely-Held Business Interests

A charitable donation of long-term capital gain property is a useful tax-planning technique for charitably-inclined individuals. The reason this works is because the donor (1) receives a deduction for the fair market value of the donated asset and (2) avoids paying tax on the built-in gain of the asset. However, in the case of a donation of an interest in a closely-held business taxed as a partnership, two issues often arise which impact this strategy: Business liabilities and ordinary-income property.

Because relief of debt is considered taxable income, a donor who has been allocated a share of a partnership's liabilities and who transfers the interest to a charity is deemed to have engaged in two separate transactions. First, a sale transaction has occurred, whereby the donor realizes income equal to the amount of debt relief. Second, a donation has occurred, whereby the donor makes a contribution equal to the fair market value of the interest less the amount of debt relief. The donor's basis is allocated pro-rata between the two transactions, meaning the donor will recognize and pay tax on the gain arising from the "bargain sale."

The donation is further complicated if the partnership owns ordinary-income property. This is because I.R.C. § 170 requires the amount of a charitable deduction to be reduced to the extent that a sale or exchange of the contributed property would generate ordinary income.

Chapter 7 of the IRS's Partnership Audit Technique Guide contains an example addressing the impact of the debt-relief issue, which I've modified below so that it also illustrates the impact of ordinary-income property, or "hot assets." In this example, an individual donor contributes a partnership interest valued at $50,000 to a public charity. The donor's basis in the interest is $40,000 and the donor is allocated $30,000 of partnership liabilities. In addition, the partnership owns a fully-depreciated piece of equipment which, if sold, would result in $2,000 of ordinary income allocated to the donor. The consequences of this donation on the donor should be as follows:

Bargain Sale:			Footnotes:
	Deemed Proceeds:	30,000	1.
	Allocated Basis (pro-rata):	-24,000	2.
	Gain on Bargain Sale:	=6,000
	Ordinary Income Portion:	1,200	3.
	Capital Gain Portion:	4,800
Donation:
	Gross Donation:	20,000
	Ordinary Income:	-800	4.
	Allowable Deduction:	=19,200

1. Rev. Rul. 75-194, 1975-1, C.B. 80.
2. Treas. Reg. § 1.1011-2(c).
3. The proper allocation of the gain on the bargain sale between ordinary income and capital gain is not clear. See Jonathan G. Tidd, Charitable Gifts of Limited Partnership and Limited Liability Company Interests, Trusts & Estates, October 2015.
4. I.R.C. § 170(e)(1)(A).

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50 States' Charitable Solicitation Registration Search

In a previous post, I discussed the various laws requiring nonprofit organizations wishing to solicit donations from the public to register with the state. Nearly all states that require charitable solicitation registration make registered organizations' information available to the public. In this post, I've collected links to each states' webpage for searching for charities that have qualified to solicit contributions within the state.

In utilizing these state databases, it is important to keep in mind that the standard for registering is different in every state. Texas, for example, does not require charities or non-profit organizations to register unless they solicit for law enforcement, public safety, or veterans causes. Other states, such as Louisiana, only require registration of paid fundraisers or charities that contract with paid fundraisers from outside of the organization.

This post will be updated as necessary; please comment below if you come across broken links or updated resources:

Alabama*	Illinois	Montana^	Rhode Island
Alaska	Indiana^	Nebraska^	South Carolina
Arizona^	Iowa^	Nevada	South Dakota^
Arkansas	Kansas	New Hampshire	Tennessee
California	Kentucky	New Jersey	Texas
Colorado	Louisiana*	New Mexico	Utah
Connecticut	Maine	New York	Vermont^
Delaware^	Maryland	North Carolina	Virginia
District of Columbia	Massachusetts	North Dakota	Washington
Florida	Michigan	Ohio	West Virginia
Georgia	Minnesota	Oklahoma	Wisconsin
Hawaii	Mississippi	Oregon	Wyoming^
Idaho^	Missouri	Pennsylvania

*Registration required, no online search available
^No registration required

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Charitable Solicitation Registration

Nearly every state requires charitable organizations that solicit money to register before fundraising. Often, there are exceptions to registration, such as a church soliciting from its membership or organizations that are regulated under other laws such as political action committees. Otherwise, however, the definition of "soliciting" is very broad and could arguably include simply maintaining a website requesting donations, depending on the state.

Additional registration requirements often apply to professional fundraisers, fundraising counsel, and commercial co-ventures. For an excellent summary of these laws in all U.S. jurisdictions, see State Charitable Solicitation Registration Requirements by Asiatico & Associates, PLLC.

Fortunately, a charitable organization that intends to engage in a nationwide fundraising campaign can register in most jurisdictions using a single form, thanks to the Unified Registration Statement, or URS. The URS is available as an alternative to filing the state-specific form in each participating jurisdiction; thus, a nonprofit may use either the state form or the URS in most registration states.

According to the URS website, 37 jurisdictions currently accept the URS (although Arizona's registration law was recently repealed), with 14 of those requiring a state-specific supplemental form. Colorado, Florida, and Oklahoma, and most recently Nevada, require charitable solicitation registration but do not accept the URS. Nevada is not currently listed on the URS website and others as a state that requires charitable solicitation because the requirement is so recent, becoming effective January 1, 2014. Be sure to check state law before soliciting for your charity!

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Nonprofits Reference Chart

Section 501(c)(3) of the Internal Revenue Code is only one of nearly three dozen Code sections that provide for tax-exempt status for certain organizations. The IRS has an good chart, located at this link, summarizing those other sections and organizations. At the same time, there are numerous sub-categories of 501(c)(3) organizations. The purpose of this post is to supplement the IRS's chart with a list of distinct tax-exempt entities that fall under 501(c)(3). The organizations described below apply for tax-exempt status with IRS Form 1023 and can receive contributions which are tax-deductible to the donor:

Code Sections	Description
509(a)	All 501(c)(3) organizations are private nonoperating foundations unless described in another line on this chart
509(a)(1) and 170(b)(1)(A)(i)	A church or a convention or association of churches
509(a)(1) and 170(b)(1)(A)(ii)	A school, meaning an educational organization with regular faculty, curriculum, and enrolled body students in attendance
509(a)(1) and 170(b)(1)(A)(iii)	A hospital providing medical or hospital care, medical education or medical research
509(a)(1) and 170(b)(1)(A)(iv)	An organization operated for the benefit of a college or university that is owned or operated by a governmental unit
509(a)(1) and 170(b)(1)(A)(v)	Certain governmental units
509(a)(1) and 170(b)(1)(A)(vi)	An organization that receives a substantial part of its financial support in the form of contributions from publicly supported organizations, from a governmental unit, or from the general public
509(a)(2)	An organization that normally receives not more than one-third of its financial support from gross investment income and receives more than one-third of its financial support from contributions, membership fees, and gross receipts from activities related to its exempt functions
509(a)(3)(B)(i)	Type I supporting organization, which must be operated, supervised, or controlled by one or more 509(a)(1) or (2) organizations
509(a)(3)(B)(ii)	Type II supporting organization, which must be supervised or controlled in connection with one or more 509(a)(1) or (2) organizations
509(a)(3)(B)(iii)	Type III supporting organization, which must be operated in connection with one or more 509(a)(1) or (2) organizations
509(a)(4)	An organization which is organized and operated exclusively for testing for public safety
170(b)(1)(A)(vii) and 170(b)(1)(F)(i)	A private operating foundation
170(b)(1)(A)(vii) and 170(b)(1)(F)(ii)	A private nonoperating conduit foundation
170(b)(1)(A)(vii) and 170(b)(1)(F)(iii)	A common fund foundation

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Donor-Advised Funds

For the charitably-motivated individual, the easiest way to support a nonprofit and qualify for a tax deduction is to simply make a donation to an eligible charity (the IRS maintains an on-line list of most such organizations at their EO Select Check page). However some individuals wish to retain some degree of control over exactly how their funds are utilized to support charitable endeavors. The strategies for doing this are innumerable, but one popular alternative that is almost as easy as an outright contribution is a contribution to a donor-advised fund.

A donor-advised fund is a separately-identified fund or account owned and controlled by a public charity over which a donor retains nonbinding advisory privileges. Any public charity can establish a donor-advised fund, and can even do so inadvertently if the charity operates one of its accounts "as if contributions of a donor... are separately identified" and the donor expects to have an advisory role over how the contribution is used.

Donor-advised funds have been around for decades, but were not mentioned in the Internal Revenue Code until the Pension Protection Act of 2006. Congress's objective in addressing the issue was to curtail perceived abuses whereby such funds were established "for the purpose of generating questionable charitable deductions, and providing impermissible economic benefits to donors and their families..." The response was an excise tax on any consideration paid by a donor-advised fund to a disqualified person, without regard to any consideration received in exchange, which is how standard excise taxes under Code Section 4958 function.

Fortunately, these rules are easy to follow because a public charity owns the donor-advised fund and will vet an individual's recommended distributions. The donor receives an immediate tax deduction, subject to the least restrictive AGI limitations, for contributions made to their donor-advised fund, and the donor can make additional contributions and recommendations indefinitely. Donor-advised funds are free to set up, cheap to maintain, and the fund investments are professionally managed. A donor-advised fund is a simple yet meaningful approach to charitable giving.

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Activities of Charitable Organizations

Individuals wanting to form their own charitable organization are not alone; the number of public charities has increased substantially in the past few years. I.R.C. section 501 describes certain organizations that are exempt from tax. Section 501(c)(3) and Treas. Reg. 1.501(c)(3)-1(d)(2) generally describe the following exempt purposes for which a charity can be organized:

Religious Organizations. Includes organizations operated exclusively for religious purpose and organizations that advance religion. Some, but not all religious organizations qualify as a "church," which are treated somewhat preferentially compared to other religious organizations.

Organizations Providing Relief for the Poor Underprivileged. These are the "classic" type of charitable organizations; they are permitted to provide a wide range of assistance for low-income persons, including transportation, housing assistance, counseling, legal aid, and day care services.

Social Welfare Organizations. Includes organizations that build or maintain public buildings, monuments, or works; lessen the burdens of government; lessen neighborhood tensions; eliminate prejudice and discrimination; defend human and civil rights secured by law; or combat community deterioration and juvenile delinquency.

Health Organizations. Includes hospitals and health-care providers that promote the health of the community and which provide below-cost medical services to lower income individuals.

Scientific Organizations. Includes organizations that perform research that is beneficial to the public and that is normally made available to the public as well.

Public Safety Testing Organizations. Includes organizations that test consumer products, construction standards, and equipment for safety.

Educational and Literary Organizations. Includes organizations that train individuals so as to develop their capabilities or the instruction of the public on subjects beneficial to the community. Many other types of charitable organizations also have educational purposes.

Amateur Sports Competition Organizations. Includes organizations that operate exclusively to foster national or international amateur sports competition, as long as they do not provide athletic facilities or equipment.

Organizations for the Prevention of Cruelty to Children or Animals. Includes organizations protecting children from unfavorable work conditions and animal welfare organizations.

Source: Webster, 451 T.M., Tax-Exempt Organizations: Operational Requirements.

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Unrelated Business Income Tax

Certain organizations are exempt from paying income tax under the Internal Revenue Code. These include charitable, religious, and scientific organizations; certain pension, profit sharing, and stock bonus plans; IRAs; colleges and universities; and medical savings and college savings accounts. To the extent that these organizations generate "exempt function income," such as "income from dues, fees, charges, or similar items paid by members for the purposes for which exempt status was granted," such income is not subject to federal income tax.

For exempt organizations, income that meets certain characteristics is not exempt function income and is instead unrelated business taxable income on which tax must be paid. Activities that (1) constitute a trade or business, (2) are regularly carried on, and (3) are not substantially related to furthering the exempt purpose of the organization generate unrelated business taxable income.

A "trade or business" is defined as "any activity carried on for the production of income from selling goods or performing services." To be "regularly carried on," the activities would "show a frequency and continuity, and [be] pursued in a manner similar to, comparable commercial activities of nonexempt organizations." Finally, for an activity to be "not substantially related" to the exempt purpose, the activity would lack a "[substantial] causal relationship to achieving exempt purposes (other than through the production of income)."

The specific rules regarding UBIT are numerous, with certain types of income being subject to UBIT depending on the type of exempt organization that generates the income or the intended purpose of the income. Deductions directly connected with producing the unrelated income are generally deductible in a similar manner as regular business deductions, although certain types of deductions are disallowed. Conceptually, the purpose behind the UBIT rules is to prevent normal for-profit businesses from experiencing unfair competition from an exempt organization engaging in the exact same activity without having to pay the tax that the for-profit business pays.

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