In general, a corporation, community chest, fund or foundation may be eligible for exemption if it satisfies several basic requirements. The organization must be organized and operated exclusively for one or more specified charitable purposes. The organization must satisfy a proscription against any inurement of its net earnings to private shareholders or individuals. Also, legislative activities of charitable organizations must be confined within permissible levels, and political activities are prohibited. The following discussion elaborates on these basic requirements.
Organizational and Operational Tests
To qualify for exemption as a charitable organization, an organization must be organized and operated exclusively for one or more specified exempt charitable purposes. The permitted exempt purposes of a charitable organization are limited to the following: religious; charitable; scientific; testing for public safety; literary; educational; fostering national or international amateur sports competition; and the prevention of cruelty to children or animals.
The organizational aspects of this requirement are known as the organizational test while the operational rules are referred to as the operational test.
The focus of the organizational test is on the articles of organization of a charitable organization. The articles of organization includes the trust instrument, corporate charter, or other written instrument by which the organization is created. The articles of organization must limit the purposes of the organization to one or more of the exempt charitable purposes. The articles must not expressly empower the organization to engage in activities which are not in furtherance of its exempt purposes, including excessive legislative activities or any political activities. Finally, the assets of the organization must be dedicated to an exempt purpose, both during its operation and upon its dissolution.
The focus of the operational test is on the purposes for which the organization is operated and on the activities through which those purposes are accomplished. An organization is regarded as operated exclusively for exempt purposes if it engages primarily in activities which accomplish one or more permitted charitable purposes. The operational test is not satisfied if more than an insubstantial part of an organization's activities is not in furtherance of its exempt purposes. A single nonexempt purpose, if substantial in nature, will result in denial or loss of exemption.
A common question arising under the operational test pertains to the impact of commercial activities on a charity's exempt status. The tax consequences to a charitable organization of engaging in a commercial activity depend on both the nature and extent of the commercial activity. The conduct of a commercial activity that is related to the organization's charitable purposes has no tax impact. The potential adverse consequences of carrying on an unrelated business activity are loss of exemption or taxation of the business income. If the commercial activity represents only an insubstantial part of the organization's overall activities, the tax exemption is not affected; however, income from the unrelated business activity may be subject to the unrelated business income tax. If an unrelated business activity is operated as a substantial part of an organization's overall activities or represents a substantial nonexempt purpose of the organization, the organization is not eligible for exemption.
The net earnings of a charitable organization may not inure to the benefit of any private shareholder or individual. A charity may not be used for the benefit of private interests such as designated individuals, shareholders, the organization's creator or the creator's family. Thus, the ban on private inurement is directly concerned with improper benefit to those who control the organization or are otherwise associated with the organization. The requirement also has a broader focus that is designed to ensure that a charitable organization serves the public interest rather than any private interest.
The ban on private inurement is enforced in two ways. First, if the inurement is so significant that the organization no longer has a primary charitable purpose, the organization will lose its tax exemption. Second, any individual participating in an act of private inurement is subject to a 25% excise tax on the amount of the inurement.
Limitation on Lobbying Activities
A charitable organization must confine its lobbying activities within permissible levels. Two alternative tests are available to determine whether legislative activities are excessive. Under the substantial part test, an organization is prohibited from engaging in legislative activities as a substantial part of its activities. The substantial part test is a somewhat subjective test which may be used by any charitable organization. In addition to losing its exemption for engaging in excessive lobbying under the substantial part test, an organization may be subject to an excise tax on its disqualifying lobbying expenditures. The alternative test is the expenditure test, an objective test by which certain charitable organizations may elect to have their legislative activities measured based on expenditures for lobbying purposes. Two tiers of sanctions are imposed under the expenditure test. The first sanction is a tax on excessive lobbying expenditures. The second level of sanction is loss of exemption, which does not occur unless the organization makes highly excessive lobbying expenditures on a regular basis.
Prohibition of Political Activities
A charitable organization may not participate or intervene in any political campaign on behalf of or in opposition to a candidate for public office. In addition to losing its exemption for engaging in political activities, an organization may be subject to an excise tax on its political activities. Moreover, the IRS has authority to make termination assessments or to seek injunctive relief to prevent flagrant violations of the prohibition of political activities.
The foregoing discussion was designed to acquaint you with the basic requirements for eligibility as a tax exempt charitable organization.
We can discuss how these requirements apply to the organization you propose to create.