What is a tax exempt business?

If there is one thing that new business owners under estimate it is the effect taxes can have on the business. Everyone knows that income is taxed but the tax codes are so complicated there seems to be an endless number of considerations that must be made in filing taxes annually. Wouldn’t it be so much easier to qualify as a tax exempt organization to avoid all of that? Being tax exempt might not be as simple as it sounds.

Requirements

There are two tests that must be met for an organization to qualify as a tax exempt business. The first is the organizational test and the second is the operational test. If an organization fails to meet either of these tests it cannot be exempt.
The organizational test is pretty strait forward and simple. In order for an organization to be tax exempt the organizing documents must restrict the organization purposes to exempt purposes. An example of this would be an organization that is set up to teach students how to fix and repair vehicles. Education is a tax exempt purpose. The organizing documents, such as articles of incorporation, must restrict the purpose of this organization to education. They are not permitted to include selling auto supplies or employees repairing vehicles for profit in its purpose.
The operational test is a little more complicated. The base line rule for this test is that the operating rules must further the exempt purpose. This is a complicated way of saying that the organization must act as a charity. To determine if an organization is charitable the IRS looks to the primary purpose of the organization. This means that incidental nonexempt activities won’t disqualify the organization so long as it remains incidental. If we look to our automotive school example, if the school was to perform repairs on vehicles and in return the owners of the vehicles were to pay the school for the work done as long as the primary purpose of the organization was to educate and not to make money for repairing vehicles then this is considered incidental. If the students of the school were already certified mechanics then obviously the primary purpose is to make a profit for the repairs and not to educate.
Charitable operations include hospitals and healthcare, legal services and public interest firms, community development and low income housing, environmental protection, disaster relief, education, religious organizations, and other exempt purposes. For all of these operations the organization must meet the community benefit standard. This means that it is open to the public, controlled by an independent community-represented board, open staff policy and surplus is used for improvements. As long as our automotive school discussed above allowed anyone to enroll; the controlling body included community members; it didn’t restrict who can be employed; and any surplus in income was put back into improving the school, then this test would be met.

Restrictions

Even if an organization meets these two tests there are still restrictions that the organization must adhere to. These are above and beyond simply making sure the organization continues to comply with the above tests.
The first and most obvious restriction is the organization cannot violate public policy. This encompasses more then simply avoiding unlawful activity. This restriction comes into play mostly when there is discrimination. A prime example of this would be a group like the Ku Klux Klan. They are not organized to make a profit in any way but they obviously discriminate heavily and therefore they cannot be a tax exempt organization.
The next restriction is that no part of the net earnings may inure to the benefit of any private shareholder or individual. Inurement occurs when an organization permits an insider unwarranted personal use of or benefit from organizational assets. An insider is a founder, officer, director, manager or any of these individual’s family members. This basically boils down to that individuals that run the organization cannot benefit from their position. This does not mean that cannot receive a reasonable salary or be compensated for expenses but abuse of their position can violate this restriction. Violations result in heavy taxes for both the organization and the individuals involved.
The third restriction is that the organization cannot be operated for a targeted private individual. This would be an organization that is set up simply to benefit one person. If someone set up an organization to benefit a man that was recently paralyzed and continue to supplement his income to make up for any loss he would experience or additional expenses he would have. This would be for the benefit of one person alone and would result in the organization losing its tax exempt status.
The next restriction is that a tax exempt organization is not permitted to participate in political campaigns. Even religious organizations can lose their exempt status by this kind of activity. Organizations are permitted to educate voters as long as they refrain from advocating for or against a candidate. They can also help to register voters but must refrain from targeting people with a certain view point.
The tax exempt business must not participate in substantial lobbying. This can be complicated and confusing. It should be avoided but if necessary the organization should consult someone prior to taking any actions. This rule applies to all levels of government and both direct lobbying and a grassroots campaign to get voters to contact government officials. The law says that a tax exempt organization must not normally make lobbying expenditures in excess of the lobbying ceiling amount of 150 percent of their § 4911 amount. Public charities must always pay a tax sanction on lobbying or they can lose their tax exempt status.
The final restriction is that the business is not permitted to operate in a commercial manner. Substantial commercial activity destroys the charitable purpose. The IRS looks to the extent of the commercial activity to the size of the trade or business to determine if there is substantial commercial activity. A good example of this is a gift shop in an art museum. The gift shop is commercial activity but compared to the rest of the business it is very minor.

Public Charity vs. Private Foundation

There is a difference between a public charity and a private foundation. These seem like the same type of entity but in the eyes of the IRS they are different. A public charity receives substantial support from qualifying grants and contributions and is a community foundation or service provider. A private foundation is a charitable organization that usually receives contributions from a single source, has investment income and makes charitable grants to others rather then run its own programs.
The biggest reason that anyone should take note of this difference is that private foundations are under more restrictions then public charities are. The organizing documents of the foundation must specify payout requirements and must prohibit self-dealing and taxable expenditures. Foundations are also prohibited from dealing with certain individuals. There are other regulatory requirements for private foundations and taxable activity for them.

Gaining tax exempt status is very beneficial for an organization. That is the reason that the IRS puts so many retrictions and requirements on gaining this. If they didn't then we would see churches and schools become the leaders in business because they would be able to avoid the dark cloud that most of us hate to see come every year.