When clients think about forming a 501(c)(3), they often focus on getting IRS recognition. In practice, the bigger risks usually arise after approval, when organizations fail to maintain compliance. Here are the major issues I'd advise clients to understand from the outset.
1. Maintaining a Charitable Purpose
A 501(c)(3) must operate primarily for exempt purposes (charitable, educational, religious, scientific, etc.). Activities that don't further those purposes should remain incidental.
Common pitfalls:
- Mission drift over time.
- Using charitable assets for non-charitable projects.
- Making grants without appropriate oversight.
2. Private Inurement and Private Benefit
This is one of the most significant compliance risks.
A charity cannot allow its earnings or assets to improperly benefit:
- Founders
- Officers
- Directors
- Key employees
- Their family members or businesses
Examples include:
- Excessive compensation
- Below-market leases to insiders
- Personal use of organizational assets
- Favorable contracts with related parties
The IRS can impose intermediate sanctions (excise taxes) or revoke exemption in serious cases.
3. Governance and Board Responsibilities
Although federal tax law doesn't prescribe a governance structure, good governance helps demonstrate compliance.
Clients should:
- Hold regular board meetings.
- Maintain minutes.
- Adopt conflict-of-interest policies.
- Document major decisions.
- Ensure directors fulfill fiduciary duties under state nonprofit law.
Many states also impose additional governance requirements.
4. Annual IRS Filings
Every exempt organization (with limited exceptions) must file an annual information return:
- Form 990
- Form 990-EZ
- Form 990-N
- Form 990-PF (private foundations)
A critical pitfall:
Failure to file for three consecutive years results in automatic revocation of tax-exempt status.
Many organizations lose exemption simply because no one was assigned responsibility for these filings.
5. State Compliance
IRS recognition does not satisfy state requirements.
Clients often overlook:
- Annual nonprofit corporate reports
- Charitable solicitation registration
- Attorney general reporting requirements
- State tax exemptions
- Sales and use tax applications
- Employment registrations
Requirements vary significantly by state.
6. Public Charity Status
Many organizations qualify as public charities only by meeting public support tests.
Pitfalls include:
- Overreliance on one donor.
- Insufficient public fundraising.
- Failure to monitor public support percentages.
If the organization fails the applicable support test, it may become a private foundation, triggering a different regulatory regime.
7. Unrelated Business Income (UBI)
A nonprofit may earn unrelated business income, but excessive or poorly managed UBI can create problems.
Clients should understand:
- Income from a regularly carried-on trade or business unrelated to the exempt purpose may be taxable.
- Significant unrelated activities can jeopardize exempt status if they become substantial relative to exempt activities.
- Form 990-T may be required.
8. Political Activity and Lobbying
Political campaign activity:
- A 501(c)(3) may not participate or intervene in campaigns for or against candidates for public office.
Lobbying:
- Limited lobbying is permitted, provided it does not become a substantial part of the organization's activities (or the organization elects the expenditure test where eligible).
Campaign intervention is an area where a single misstep can have serious consequences.
9. Restricted Funds
Organizations should honor donor restrictions.
Pitfalls include:
- Spending restricted funds on general operations.
- Commingling restricted and unrestricted funds.
- Inadequate accounting for restricted gifts.
Good accounting systems are essential.
10. Recordkeeping
Clients should maintain records supporting:
- Donations
- Grants
- Expenses
- Payroll
- Board actions
- Major contracts
- Fundraising
- IRS filings
Poor documentation often becomes the biggest problem during audits or investigations.
11. Employment and Independent Contractors
Tax exemption does not exempt an organization from employment law.
Clients should comply with:
- Payroll tax withholding
- Wage and hour laws
- Employee benefits rules
- Worker classification requirements
- State unemployment and workers' compensation laws, as applicable
12. Acknowledging Charitable Contributions
Organizations receiving charitable donations should provide appropriate written acknowledgments.
For many cash contributions of $250 or more, donors need a contemporaneous written acknowledgment to substantiate their deduction. Special rules apply when donors receive goods or services in exchange for contributions (quid pro quo contributions).
13. Fundraising Compliance
Fundraising can trigger additional obligations, including:
- State charitable solicitation registrations.
- Registration in multiple states if soliciting nationally.
- Written contracts with professional fundraisers where required.
- Compliance with disclosure requirements in certain jurisdictions.
14. Dissolution Restrictions
Upon dissolution, remaining charitable assets generally must be distributed for exempt purposes and cannot be distributed to founders, directors, or members.
Practical advice for clients
A helpful compliance checklist includes:
- Keep a functioning, independent board with documented meetings.
- Review conflicts of interest annually.
- File Form 990 (or the applicable return) every year on time.
- Monitor compensation for reasonableness.
- Track restricted funds separately.
- Evaluate unrelated business activities before launching them.
- Register for charitable solicitations where required.
- Maintain complete financial and governance records.
- Review state filing deadlines annually.
- Consult legal and tax advisors before significant changes in activities or transactions involving insiders.
For many organizations, the greatest long-term compliance risks are not complex tax issues but routine administrative failures—missed annual filings, inadequate governance, undocumented related-party transactions, and neglecting state registration and reporting obligations. Establishing clear compliance calendars, board policies, and internal controls early can substantially reduce those risks.
