Friday, August 29, 2014

Nonprofit Payroll Tax Alert


A recent federal government report shows that thousands of nonprofits are not meeting their payroll tax obligations.  Though it may be tempting for nonprofits to avoid payroll tax responsibilities, especially when facing cash flow challenges, such avoidance is extremely risky. 

Payroll Tax Primer

            All organizations with employees owe taxes to the government, in substantial part to pass along tax dollars owed by the employees.  Payroll taxes cover both employees’ income tax obligations, and their employees’ 7.65% portion of FICA taxes for social security and Medicare taxes.   In addition, employers are separately responsible for paying the employers’ other 7.65% portion of FICA taxes.  Essentially, employers hold  employees’ tax obligations in trust and must remit them to the government taxing authorities, as well as pay the employers’ share. 

            The financial cost of each employee thus includes all tax-related costs, not just the net compensation each employee receives.  Even the most worthy charitable causes are responsible for withholding and paying their employment taxes – no excuses, no exception.   What’s the key lesson here?  Pay your taxes!

The TIGTA Report

            The U.S. Treasury Inspector General for Tax Administration (“TIGTA”) recently released a report showing that a shockingly high number of tax-exempt organizations have not been paying employment taxes.   Specifically, the TIGTA report found that 64,200 tax-exempt organizations owed almost $875 million in unpaid taxes.  According to the report, 1,200 of these organizations owed more than $100,000 each, and five owed more than $10 million each.  The rest owed varying amounts. 

            The TIGTA report recommended that the IRS more seriously address nonprofits’ delinquent payroll taxes practices.   In particular, TIGTA recommended that the IRS’s Exempt Organizations (“EO”) unit coordinate with the IRS’s payroll tax collection division to identify nonprofit organizations that may not be complying with other legal requirements regarding tax-exempt status.  In other words, payroll tax problems may indicate other tax-related malfeasance.

            The IRS’s EO unit rejected this recommendation, stating that data from collections is not useful in indicating other tax-related compliance issues such as private inurement or operation for a non-exempt purpose.  Of course, the EO unit has the flexibility to later decide that unpaid payroll taxes may point to other issues warranting IRS examination.  Notably, failure to pay payroll taxes – by itself – at this point would not constitute legal grounds for revocation of tax-exempt status.

            The IRS’s EO unit indicated that it will act upon one recommendation in the TIGTA report – that the EO unit “work with the Department of Treasury to evaluate whether a legislative proposal is warranted to strengthen the IRS’s ability to enforce payroll tax non-compliance by tax-exempt organizations.”  As such, we may see the IRS pushing for legislative action to allow the agency to address nonpayment of payroll taxes more aggressively.

What Could Go Wrong?

            1.         Penalties.  If payroll taxes are paid late, significant penalties may be owed to the organization.  While penalties may be decreased when the organization had “reasonable cause” for the late payments, this standard is extremely high.  The organization must show that the lateness was due to circumstances outside the control of the directors, rather than due to any oversight by the board.  It is also important to show that the organization has taken corrective measures to ensure that payroll taxes will be timely paid in the future.  Obtaining an abatement (i.e., reduction or elimination) of penalties based on a reasonable cause determination may be very challenging.  Organizations should instead establish payment procedures early on to help avoid late payments and the associated penalties.

            2.         Frozen/Taken Assets.  IRS has the power to freeze and levy (i.e., take from) organizational assets like bank accounts.  In that way, the IRS can ensure that the employer makes payroll taxes a high priority, albeit involuntarily.

            3.         Personal Liability for Leaders.  Unpaid payroll taxes may result in personal liability for the organization’s leaders who are responsible for overseeing timely payment.  The board of directors has a general responsibility to make sure payments are made.  Other individuals may have a more specific responsibility to ensure timely payment, and may be more likely to be held personally liable for such payments and late penalties.  This often includes the Treasurer, the Executive Director, or a director or officer who is aware that the payments are not being timely made.   Because of serious responsibility associated with payroll tax liability, both civil and criminal liability may be imposed.  Serious business indeed!

            With the recent spotlight on payroll tax noncompliance by nonprofits as shown by the TIGTA report, we may see the IRS increase penalties, more aggressively attempt to collect from officers and directors, or even press for legislative action allowing revocation of income tax exemption for organizations that have unpaid payroll taxes.  Nonprofits should thus be aware of their employment tax liability and extremely diligent in paying taxes as they are due.

            For questions regarding tax-exempt nonprofits, payroll tax requirements for nonprofit organizations, or legal issues pertaining to nonprofits generally, please contact one of our attorneys at info@wagenmakerlaw.com or 312.626.1600, or visit us at www.wagenmakerlaw.com.

Wednesday, August 27, 2014

Is the IRS Back in Church?


With fall approaching, the next election cycle is just around the corner – just in time for new IRS developments affecting churches and other religious institutions.  As with all section 501(c)(3) organizations, religious institutions are prohibited from engaging in “political campaign activities.”  That is, they may not advocate for or against a particular candidate for office, or otherwise seek to influence an election.  For many, such restriction seems like a constitutional violation of First Amendment free speech and religious liberty protections.  In recent years, IRS officials have refrained from auditing religious institutions and thereby have avoided this issue.  But recent court and IRS activity this summer begs the question:  Until now?

A.        IRS Background

Some legal and historical background is in order.  Due to constitutional safeguards for religious institutions, the law imposes heightened restrictions and procedures as to when and how the IRS may audit them.  In particular, Section 7611 of the Internal Revenue Code requires “an appropriate high-level Treasury official” to “reasonably believe” that a religious institution is engaged in improper activities before the IRS may commence an audit.  The regulations accompanying section 7611 designate such official as a “Regional Commissioner” – that is, the head of an IRS region.  As a result of the IRS’s 1998 internal reorganization, however, IRS “regions” no longer exist, making this regulatory definition obsolete. 

In 2009, a Minnesota church challenged an IRS audit, arguing that the IRS’s reworked definition of “high-level Treasury official” was legally deficient.  Therefore, as the church claimed, its alleged political campaign activity could not be investigated.  The federal court agreed, finding that the subject IRS official in that audit was only a “mid-level” employee.  In doing so, the court recognized that Section 7611’s intent is to protect religious institutions from overly aggressive IRS examinations and other government intrusions into religious liberty.   Since then, the IRS has neither conducted any new audits of religious institutions nor corrected the Section 7611 regulatory language.

B.        Fallout from Freedom From Religion Foundation

This summer, however, new information surfaced as a result of the Freedom from Religion Foundation’s settled lawsuit against the IRS.  The lawsuit challenged the IRS’s perceived policy of selective non-enforcement of the section 501(c)(3) political campaign prohibition. In connection with the settlement, and apparently in response to such challenge, an IRS letter penned by Mary Epps (acting director of IRS’s Exempt Organizations Examinations) was issued to the U.S. Department of Justice and then became publicly available.  In the letter, Ms. Epps states that the IRS has actually processed several alleged church violations of the political campaign prohibition.  Specifically, the IRS’s Political Activities Referral Committee (“PARC”) now has a list of 99 churches that it believes merit a “high priority examination” for such violations, dating from 2010 to 2013.  (click here for a copy of the letter.)

C.        What Lies Ahead?

Some believe that by Ms. Epps’s letter, a clear signal has been sent:  the IRS is ready to resume scrutiny of churches and other religious institutions.  This would mean not only enforcement of political campaign intervention prohibitions, but also other areas of potential trouble for churches such as unrelated business income tax (“UBIT”), which may affect certain fundraising activities, as well as employment tax liability (e.g., clergy tax, independent contractor versus employee distinctions, excessive compensation issues). 

Others are concerned that such stepped-up scrutiny also may lead to governmental abuse and other inappropriate treatment of religious institutions, in violation of their First Amendment protections.  The IRS’s recent conservative-targeting scandal, as well as the fact that current IRS regulations allow for viewpoint discrimination in politically related areas, are certainly dangerous portents in that regard.  (See also “Speak Up: Issue Advocacy in Increasingly Politicized Times.”) In the meantime, as has also occurred in recent years, religious institutions may attempt to provoke a constitutional showdown on the political campaign ban itself.   For example, the “Pulpit Freedom Sunday” annual campaign, sponsored by the Alliance Defending Freedom, advocates religious freedom for church pastors to speak out on abortion, marriage, and other topics in the crosshairs of politics.  The next Pulpit Freedom Sunday is right around the corner – on October 5, 2014. 

D.        What should responsible religious institutions do now? 

First, make sure that your organization’s operations and procedures are fully compliant with tax-related requirements.  This review should include a wide range of income-generating activities and clergy employment tax practices.  Second, the board and executive staff should have a thorough understanding on what the organization and its representatives may and may not do with respect to politically related activities.   Third, keep up with evolving legal developments, as applicable requirements and standards can change.  Fourth, remember that our country’s religious institutions serve critical roles for our society’s well-being and betterment and therefore are to be honored and respected. 

For more information regarding compliance with laws and regulations applicable to religious institutions or nonprofits generally, contact one of our attorneys at 312.626.1600 or info@wagenmakerlaw.com, or visit us on the web at www.wagenmakerlaw.com.

Wednesday, August 20, 2014

By Executive Order – No LGBT Discrimination


President Obama recently signed an executive order prohibiting federal contractors and subcontractors from engaging in employment decisions based on sexual orientation and gender identity.  The President’s order amends previous executive orders regarding employment discrimination dating back to the 1960s, which were implemented to prevent racial discrimination in hiring and contracting decisions made by organizations receiving federal funding.  Previously, the order prohibited employment decisions based on race, color, religion, sex, or national origin.  President Obama extended the order to include sexual orientation and gender identity.  The new order has led a number of nonprofits receiving federal funds to question if, and to what degree, they may be required to comply with these provisions.

In particular, organizations have noticed that no “religious exemption” exists for churches, other religious institutions, and other faith-based nonprofits, to the extent their religious tenets may clash with the new provisions.  Notably, the order leaves a provision intact – as signed by then-President Bush in 2002 – exempting religious organizations from the prohibition against using religion as a factor in employment decisions.  Courts have ruled that this exemption includes taking into account actions by employees or applicants that conflict with the organization’s beliefs.  This leaves a question, for example, as to whether organizations that uphold religion-based sexuality values, but receive federal funding from a contract, can terminate or refuse to hire an individual based on such beliefs. 

What does the President’s order mean for nonprofit organizations?

First, nonprofit organizations should recognize that the order currently only affects federal contractors and subcontractors and federally assisted construction contracts.  If the organization does not have any such contracts, it is not affected by the President’s order. 

Second, note that most federal grants do not fall under the provisions of the order.  That’s because grants are not considered federal contracts.  There is, however, a section of the underlying order amended by President Obama that affects grantees who use grant funds to construct facilities.  The provision states that all executive departments and agencies that provide grants involving construction contracts must require that grant recipients include the anti-discrimination provisions in any construction contract that is paid even in part from federal grant funds.  This does not mean that the grantee organization itself will have to incorporate the anti-discrimination provisions into its hiring policies, but it does  require its construction contractors and subcontractors to do so, which may be of concern to some religious organizations accepting such federal funds. 

Current grant programs that provide nonprofit organizations with funds for construction of facilities to house their charitable programs include Community Facility Grants from the USDA, grant programs for higher education institutions that serve low-income or minority students, and grants through the National Endowment for the Humanities, which awarded over $8 million in the 2013 fiscal year.  If organizations refuse to require their contractors and subcontractors to prohibit employment decisions based on sexual orientation or gender identity, they will not be eligible to obtain such funds for the purpose of construction.

Who else will be affected?

While most funds provided to nonprofits by the federal government have historically come from grants, some change is afoot.  For example, organizations providing support for military troops or engaging in natural disaster or other relief efforts increasingly may find that funds are available through contracts with the federal government to provide such services, rather than through federal grants.

Critics of President Obama’s order have expressed concern that it sets a disturbing precedent for future executive orders, to affect not just federal contractors and federally assisted construction contracts but also grantees in general.  This would force many organizations, which are in the best position to provide cost-effective and beneficial charitable services, to choose between accepting needed government funds and their sincerely held religious beliefs.  A further concern is that such a governmental approach could lead to other restrictions against religious institutions and other faith-based organizations, such as with respect to their tax-exempt status, which would not only impair First Amendment religious liberty interests but also lead to further declines in provision of charity. 

For more information regarding the effect of the President’s order on employment policies of nonprofit organizations, or for questions regarding the law and nonprofits generally, contact one of our attorneys at 312.626.1600 or info@wagenmakerlaw.com, or visit us on the web at www.wagenmakerlaw.com.

Wednesday, August 13, 2014

Section 501(c)(2) Tax-Exempt Title Holding Corporations: The Good, the Bad, and Other Options


 
The problem of risk to nonprofits


            Lawyers often advise to “separate valuable assets from risky activities.”  It’s a legal maxim with which nonprofit directors and officers should be familiar.  Keeping valuable assets away from risky activities may provide an organization with protection in the event of a lawsuit or other liability.  Exempt organizations have sometimes used  501(c)(2) title-holding corporations or other tax-exempt corporate structures to provide such protection.  Nonprofit leaders should be aware of the protections available through such risk management options.

Consider the following scenario: A terrible accident occurs on the grounds of a nonprofit preschool.  Multiple parties later sue the preschool for accident-related injuries.  The preschool has substantial and valuable real property holdings.  If the preschool is held liable for damages resulting from the accident, the outcome for the church may be catastrophic.  The organization’s insurance protection may be stretched beyond policy limits.  If the insurance coverage limits are reached or portions are outside the scope of the coverage itself, the organization is ultimately responsible.  In a worst-case scenario, a court may order liquidation of the organization’s real property to pay the judgment. 

Mitigating Risk and Other Benefits – the 501(c)(2)

            Dating back to 1916, Congress has provided nonprofit entities with a means to mitigate risk.  Presently, the 501(c)(2) title-holding corporation provides such protection.  A 501(c)(2), like its section 501(c) siblings, is exempt from federal income tax.  The (c)(2), however, has a single limited purpose:  to hold title to property on behalf of another exempt entity.  A (c)(2) is generally controlled by a parent tax-exempt organization, and the (c)(2) holds title to property (which can be real, personal, or intellectual property), which may be used for the parent’s exempt purposes.  Income from the (c)(2) passes to the parent.   In theory, if the parent organization is sued, as in the above example, its liability from potential damage suits should be limited to the organization itself, and not the separate legal entity that holds title to the property held.  In reality, the limitation of liability will depend on several variables, such as proper legal structuring of the entities and the organizations’ observance of corporate formalities.  Before structuring such an arrangement, interested entities should consult with experienced legal counsel.   

Beyond the limitation of liability, the IRS has identified the following additional benefits of the 501(c)(2): 
·      enhancement of ability to borrow;
·      limitations imposed in gifts and bequests to exempt organizations that effectively require such gifts to be kept in separate entities;
·      clarity of title;
·      accounting simplification; and
·      limitations imposed by various state laws on organizations that would be recognized as exempt under the federal revenue laws.   

See 1986 EO CPE Text, C. IRC 501(c)(2) - Title-Holding Corporations at 2, “Background.” 

            A further advantage of a c(2) is that only its net income may be available to creditors.  Nonprofits thus may use a c(2) to protect certain revenue streams from access by creditors, which may be a very valuable benefit.

Narrow Focus

            Organizations that consider the benefits of utilizing a 501(c)(2) should also carefully evaluate their limitations.  First, a (c)(2) may not operate a trade or business.  That’s true even if the business is conducted in the building to which the (c)(2) holds title.  According to the IRS, “Where the active operation of any business other than the rental of real estate has been involved, exemption has consistently been denied.”  Accordingly, the charter statement in the (c)(2)’s articles of incorporation should specifically restrict its corporate purposes to comply with 501(c)(2).  Qualified legal counsel should be consulted in the drafting of such articles.  Where the scope of the organization’s activities are not appropriately limited,  tax exemption may be denied.

Potential Alternatives

            Though the 501(c)(2) provides risk diversification, it is not always the best vehicle for nonprofits to utilize.  Often, a nonprofit will elect to establish a supporting organization under 501(c)(3) to hold title to property for risk management purposes.  A supporting organization does not carry the same purpose and operational limitations imposed under (c)(2).  Further, the c(2) is generally not a good choice for religious worshipping bodies, like a church, mosque, or synagogue.  To elaborate, the federal regulations that exempt certain controlled or closely affiliated organizations of religious institutions from also filing Form 990 do not specifically cover 501(c)(2) organizations.  For this reason, many religious institutions have strategically elected to utilize a supporting organization under (c)(3) or a limited liability company, both of which, if structured properly, can qualify as exempt from filing Form 990 and from having to file an application with the IRS for recognition of tax-exempt status. 

            Nonprofit leaders, with the advice and counsel of qualified legal professionals, should carefully vet the advantages and disadvantages of various risk-management structures.  Furthermore, organization leaders must remember that establishing the proper corporate structures is only the beginning of a successful risk-diversification process.  Care must be taken through the organization’s life to ensure that proper corporate formalities are followed.  Otherwise, courts may allow creditors to “pierce the veil” and allow access to valuable corporate assets.

            The adoption and use of a 501(c)(2) title-holding corporation may serve as a valuable tool for tax-exempt organizations for helping protect organizational assets.  The formation of such an entity, however, requires careful evaluation of the c(2)’s purposes and limits. For further information about the 501(c)(2) and its alternatives, or if you have questions about whether a 501(c)(2) title holding company would be a useful corporate structure for your tax exempt entity, please contact one of our attorneys at inf@wagenmakerlaw.com or 312.626.1