By: Tatum Perez, Esq.
Tax-exempt status in the United States has a long history rooted in the belief that certain organizations serve a public good and therefore deserve relief from taxation. Over time, this idea evolved into a formalized legal framework that supports charitable, religious, educational, and other mission-driven institutions. However, with these benefits come specific rules and risks. Nonprofits can lose their tax-exempt status if they fail to comply with IRS regulations.
Early Origins
The concept of exempting charitable and religious organizations from taxes dates to colonial America and draws from English common law traditions. These early tax exemptions were informal and local, focused primarily on relieving churches and other community-based institutions from property tax obligations.
Formalization Under Federal Income Tax Law
The federal income tax was introduced in 1913 after the ratification of the 16th Amendment. That same year, Congress passed the Revenue Act of 1913, which explicitly granted income tax exemptions to organizations “organized and operated exclusively for religious, charitable, scientific, or educational purposes.” This was the first major codification of tax-exempt status at the federal level.
Creation of Section 501(c)(3)
In 1954, Congress refined the rules by incorporating them into the Internal Revenue Code under Section 501(c)(3), which remains the core statute governing tax-exempt charities. This section introduced several key limitations:
Organizations must be both organized and operated exclusively for exempt purposes;
They must not distribute earnings to private individuals (known as the prohibition on “private inurement”);
They are subject to strict limits on lobbying and are prohibited from participating in political campaigns.
Further Oversight in the 1969 Tax Reform Act
The Tax Reform Act of 1969 introduced additional oversight for private foundations, a subset of 501(c)(3) organizations, which are often funded by a single donor or family. These rules were designed to prevent wealthy individuals from using foundations for personal benefit. The Act imposed restrictions on self-dealing, required minimum annual distributions of foundation funds, and established reporting obligations for transactions with founders or other insiders (called “disqualified persons”).
Policy Rationale for Tax Exemption
Tax exemption is more than just a financial benefit; it is a policy tool. The rationale is to encourage private institutions to provide public benefits that might otherwise fall to government agencies. These include services such as education, health care, disaster relief, and the arts. The tax exemption effectively subsidizes these organizations, allowing them to direct more resources to their mission and attract public donations through deductible contributions.
How Organizations Lose Tax-Exempt Status
Despite these benefits, tax-exempt organizations must adhere to strict guidelines. Failure to comply can lead to revocation of their status. Common ways nonprofits lose their exemption include:
Private Inurement and Excess Benefit Transactions: If an organization uses its assets to benefit insiders, such as paying excessive salaries or funneling resources to founders, it violates the inurement prohibition.Deviating from Exempt Purposes: If the organization drifts from its mission and starts operating like a for-profit business or generates too much unrelated business income without proper tax handling, the IRS may find it no longer qualifies.Political Activity and Lobbying Violations: While 501(c)(3) organizations can engage in limited lobbying, they are strictly barred from endorsing political candidates. Violating these rules can result in immediate revocation.Failure to File Required Returns: Nonprofits must file annual information returns (typically Form 990). If an organization fails to file for three consecutive years, its tax-exempt status is automatically revoked.Fraud or Misrepresentation: Submitting false information on the IRS application or during audits can also lead to loss of exemption.
Coming Soon: Read Part 2 of this topic about the Trump administration’s attempt to revoke Harvard’s tax-exempt status – one of the highest-profile challenges in recent history.
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