Legal Laissez-Faire?
Few provisions of the Code have a single, clear meaning that leaves no room for interpretation. Even many of those that, on the surface, appear fairly straightforward, are usually open to alternative “understandings.”
In the absence of continuous monitoring, implementation (as in the form of regulations),[i] and enforcement, there are taxpayers that may slant a particular provision of the Code to capture a more favorable result than Congress may have intended, especially when a taxpayer is facing financial pressures, whether attributable to the broader economy, their region or industry, or something else.
Under these circumstances – i.e., in the absence of official guidance, intervention, or oversight – when enough taxpayers adopt a specific practice or approach toward one of these provisions, their “behavior” may become normalized,[ii] and the law relegated to a suggestion, for all intents and purposes.
Nonprofit organizations and the parts of the Code applicable to their tax treatment, their relationships to the communities they serve, and their interactions with the general public, are no exception to the foregoing.
Indeed, the prospect or realization of funding problems for a nonprofit may impair its ability to deliver the services for which it was founded and granted tax-exempt status, but may also lead to many of the same problems encountered by troubled private businesses, including the diversion of tax dollars.
Hopefully, Someone’s Watching
For years now, many nonprofits that are organized to engage in what may broadly be described as “charitable” activities, and that rely on financial support from the general public, including governmental grants, have been under varying degrees of public scrutiny.[iii]
This is a positive state of affairs when it is likely to lead to the prevention or the correction of behaviors that are inconsistent with these organizations’ charitable missions, that may jeopardize the public financial support that such organizations enjoy – primarily in the form of tax-related benefits[iv] – or when it helps to restore the public’s trust in these nonprofits.
Query the consequences when the “watchdogs” can’t afford to watch.
Public Support
The public, both directly (through their personal financial contributions) and through the laws enacted by their elected representatives, support all manner of charitable organizations.
Such an organization’s charitable status allows it to receive nontaxable gifts from members of the public, including grant-making charitable organizations, in exchange for which such donors may claim a tax-favored deduction,[v] within certain parameters, for purposes of determining their own income, gift, and estate tax liabilities.[vi]
The organization is also exempted from federal income tax[vii] if it has demonstrated it is organized and operated exclusively for one or more “exempt” charitable purposes,[viii] serves a public rather than a private interest, and does not engage in certain proscribed activities.[ix]
Thus, the organization is exempt from income tax with respect to most of its investment income, including interest, dividends, rents, royalties, and annuities.[x]
In addition, the income derived by a tax-exempt nonprofit charity from an activity that is substantially related to its exempt purpose is not subject to federal income tax.[xi]
Query which of these sources of revenue may be able to cover a shortfall in grants?
Public Response
Historically, the close examination of a particular behavior has, in some cases, presaged the enactment of legislation[xii] that is intended to redress some institutional, or institutionally “endorsed,” practices that Congress has determined are harmful to society or may compromise the various missions with which nonprofits have been entrusted.
Depending upon the issue, and the extent to which it captures the general public’s attention, such legislative action has often been preceded by demands for the elimination of at least some of the publicly-subsidized tax benefits that nonprofit charitable organizations have long enjoyed, including their exemption from federal income tax.
Query whether, in the absence of adequate funding, a nonprofit may engage in any questionable financial behavior.[xiii]
Short of Revocation
However, instead of expressly providing for the revocation of the tax-favored status of any nonprofit that engages in the offensive practice in question,[xiv] Congress has generally[xv] adopted measures that are intended to curtail such practice by “punishing” the private persons involved, and to encourage the “correction” of any violation.
For example, when the nonprofit becomes involved in certain activities, the Code imposes what is basically a penalty tax upon the responsible individuals within the organization or upon the organization itself, depending upon the specific activity. In general, the tax is based upon the economic value of the triggering event; it may continue to be applied until there is a “correction.”
Recent Examples
For example, in 1996, legislation was enacted to deter and punish the transfer of a so-called “excess economic benefit” from a public charity to a so-called “disqualified person” by imposing a 25 percent tax upon the disqualified person and a 10 percent tax upon the organization’s managers.[xvi] This provision targets the direct or indirect transfer by the charity of an economic benefit that exceeds the value of the consideration (including the performance of services) received by the charity in exchange for providing such benefit.[xvii]
In 2010, Congress imposed additional requirements a hospital must satisfy[xviii] to qualify for tax exempt status as a charitable organization, including the performance of a community health needs assessment.[xix] In general, their purpose is to ensure that hospitals provide medical care to members of the community who are unable to afford it. Failure to satisfy any of these requirements may jeopardize a hospital’s tax-exemption, though failure to conduct the required health needs assessment will result in the imposition of a fixed monetary penalty.[xx]
Beginning in 2018, a new 21 percent[xxi] excise tax was added to the Code, which would be imposed on a public charity based on the sum of (i) the amount by which the compensation paid to any of the charity’s five most highly compensated employees during the taxable year exceeded $1 million, plus (ii) any “excess parachute payment” paid by the organization to such employee.[xxii]
Also in 2018, a new tax was introduced with respect to certain private universities, equal to 1.4 percent of a covered institution’s net investment income for a taxable year when the aggregate fair market value of the university’s investment funds at the end of that year is at least $500,000 per student.[xxiii]
Taxable Notwithstanding
It’s clear that a charitable nonprofit’s exemption from the imposition of income tax is of vital importance to the organization.
That said, there are other taxes to which such an organization, without more,[xxiv] will remain subject, and of which it may run afoul, especially under certain circumstances.
Pretty much like any other business.
Unrelated Business
Thus, the nonprofit will be taxed on its net income from an unrelated trade or business – one that is regularly carried on by the organization, but which is not substantially related to the exercise or performance by such organization of its charitable purpose or function constituting the basis for its exemption.[xxv]
A nonprofit will often engage in such an unrelated business indirectly, through a wholly owned, for-profit subsidiary corporation. The for-profit’s distribution of its earnings to its nonprofit parent will generally be exempt from income tax.[xxvi]
Query whether such an unrelated business may assume greater importance in the nonprofit’s funding and cash flow when the latter’s grant revenue falls off.[xxvii] What if the business develops into a substantial part of the organization’s activities?
Employment Taxes
If a nonprofit has employees, it must withhold federal income tax from its employees’ wages.[xxviii]
In addition, the organization must withhold and deposit the employee’s share of Social Security and Medicare (FICA) taxes and pay a matching amount.[xxix] The Social Security tax is withheld from the employee’s gross wages until the employee’s cumulative wages for the year reach the so-called “wage base limit.” Wages above the wage base limit are not subject to Social Security tax withholding. However, there is no wage base limit for Medicare tax; all covered wages are subject to Medicare tax.[xxx]
However, an organization that is exempt from federal income tax as a charitable organization[xxxi] is also exempt from FUTA tax.
In the context of a closely held for-profit business that has fallen on hard times, it is not uncommon to encounter a situation in which the owners of the business, instead of remitting to the government the employment taxes withheld from their employees’ wages, will divert those “trust fund taxes” – which the business, acting as a fiduciary, collected on behalf of the government – toward the payment of business expenses.[xxxii]
When employment taxes have been collected but have not been paid over to the government, the Code authorizes the IRS to collect the unpaid trust fund taxes from those persons in the business who were responsible for collecting, accounting for, and remitting such taxes.[xxxiii]
Responsible Person
Unfortunately, nonprofits are not immune from economic challenges and cash flow issues of the kind that may cause an officer to direct that the employment taxes withheld by the organization be used, instead, to fund the nonprofit’s charitable activities, which may include the purchase of necessary supplies, the payment of salaries, and the satisfaction of many other ordinary and necessary liabilities incurred by the nonprofit.
Thus, it is not uncommon for the responsible person penalty to be imposed upon certain key employees of a struggling nonprofit.
In fact, earlier this year, at a trial in a U.S. District Court,[xxxiv] the jury was asked to determine whether an individual taxpayer was a “responsible person” with respect to the employment tax responsibilities of a nonprofit tax-exempt charity.
The employer-charity withheld the required employment taxes from its employees’ wages but then failed to remit such taxes to the government.
The government sought to collect the unpaid taxes from an individual taxpayer, who argued that he was not a responsible person.
The Court explained that, under the Code, any person required to collect, truthfully account for, and pay over any tax who willfully fails to collect, account for, and pay over such tax, or who willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.[xxxv]
The Court then explained that the jury must decide whether the individual taxpayer had the status, duty, and authority to avoid the charity’s “nonremittal of the withholdings” – in other words, whether he was responsible for such taxes. If the jury agreed with the IRS that the taxpayer was responsible, it would then have to determine whether the taxpayer had acted willfully and recklessly in carrying out this responsibility.[xxxvi]
The taxpayer asserted, and the judge agreed in concept, that more than one person can be responsible for the employer’s obligation to withhold and remit such taxes. “The Court will tell the jury this,” the judge stated.
The Court added, however, that “the deep and disputed question” that had to be addressed first was the extent of the taxpayer’s authority to pay the taxes. Toward the resolution of that issue, the Court continued, the taxpayer was “entitled to offer evidence about the authority of the higher-ups at” the charity in his effort to prove the limitations of his own powers and duties. Still, if the taxpayer had the power to remit the taxes, “a supervisor’s direction not to do so will not absolve [the taxpayer] of liability.”
What’s Ahead?
We’re heading into unchartered territory. Some sources of public funding have been turned off, the markets are rattled – which may temporarily deny access to other sources, and there is some uncertainty in the broader economy. Hopefully, things will work, for the most part, without serious hardships for nonprofits or the beneficiaries who depend on them.
Of course, there are going to be exceptions; some may be more severe than others. Although the great majority of organizations will remain within the law, a not insignificant number may consider, and ultimately follow through with, a “strategy” that is sometimes utilized by businesses in distress: intentionally failing to remit to the taxing authorities those taxes that the business has withheld or collected on behalf of the government – typically, the employee’s share of employment taxes on wages paid by the employer.
Why would a nonprofit engage in such inappropriate behavior? For the same reason that a business would do so – to remain viable, to continue operations and fulfilment of its mission, and to preserve employees’ jobs.
Their reasoning goes something like this: “Revenues were down. We just needed some time to recover – the tax money was going to help us sustain operations until our situation stabilized. At that point, we would have paid the taxes owing.”
As you can imagine, it rarely works out that way; operations cease, the organization fails, and the responsible persons are left holding the proverbial bag.
There are times, however, in which this decision is not adopted as a matter of “company policy” but, rather, is undertaken – unbeknownst to the rest of the organization – by a couple of well-positioned officers of the nonprofit, who may not represent all of its responsible persons.
It is imperative for a nonprofit to implement safeguards to protect itself, as best it can, from economic disruptions that may jeopardize its ability to carry put its purpose.[xxxvii] It is also imperative that it implement measures to ensure that funds cannot be diverted from their intended use, even if for the benefit of the nonprofit.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] On which reliance may not be as justified as it once was following the Supreme Court’s overruling of Chevron deference in its decision in Loper Bright Enterprises v. Raimondo, 603 U.S. 369 (2024).
[ii] So-called “custom and practice.”
[iii] Some of the more recent reasons for such scrutiny are covered here: https://www.taxslaw.com/2023/11/activities-contrary-to-public-policy-revoking-the-tax-exempt-status-of-universities/#_ednref5 and https://www.taxslaw.com/2023/10/hospitals-and-community-benefit-senators-see-a-shortfall/.
[iv] For example, exemption from income tax under IRC Sec. 501(a), and the ability to receive gifts from donors for which the donors may claim a tax deduction under Sec. 170, Sec. 2055, or Sec. 2522.
[v] Or, in the case of most private foundations, to avoid the imposition of an excise tax for failing to make enough of its resources available to operating charities.
[vi] I should add, there is also access to tax-exempt financing through State and local governments that may issue tax-exempt bonds to finance the activities of charitable organizations described in IRC Sec. 501(c)(3). Because interest income on tax-exempt bonds is excluded from gross income, investors generally are willing to accept a lower pre-tax rate of return on such bonds than they might otherwise accept on a taxable investment. This, in turn, lowers the cost of capital for the users of such financing.
[vii] IRC Sec. 501(a). Of course, unrelated business income is taxable. IRC Sec. 511 et seq.
[viii] Specified in IRC Sec. 501(c)(3). Among the purposes specified by the Code are religious, charitable, scientific, educational, and literary. In general, an organization is organized and operated for charitable purposes if it provides relief for the poor and distressed or the underprivileged.
For many years, the IRS has applied a ‘‘community benefit’’ standard for determining whether a hospital is charitable. Congress took the standard a step further – see IRC Sec. 501(r).
An organization is not treated as organized or operated exclusively for one or more exempt purposes unless it serves a public rather than a private interest. Reg. Sec. 1.501(c)(3)-1.
In addition to the foregoing statutory and regulatory requirements, the purpose and activities of a charitable organization must not be so contrary to an established public policy as to undermine any public benefit that might otherwise be conferred. See Bob Jones University v. United States, 461 US 574 (1983). Although Bob Jones involved racial discrimination, the IRS seems to have extended the decision’s reasoning; see, for example, TAM 8910001:
“To warrant exemption under section 501(c)(3), an institution must fall within a category classified in that section and must demonstrably serve and be in harmony with the public interest. The institution’s purpose must not be so at odds with the common community conscience as to undermine any public benefit that might otherwise be conferred.”
[ix] Like devoting more than an insubstantial part of its activities to attempting to influence legislation by propaganda or otherwise, or directly or indirectly participating in, or intervening in any political campaign on behalf of or in opposition to any candidate for public office.
[x] IRC Sec. 512(b).
A significant exception to this favorable rule applies to income derived from property with respect to which there is acquisition indebtedness (“debt-financed property”; for example, debt incurred to purchase rental real property), in which case the amount of such investment income that is excluded from unrelated business income is reduced. IRC Sec. 512(b)(4) and Sec. 514.
[xi] For example, tuition paid to a college or medical fees paid to a hospital.
[xii] Usually implemented by regulations.
[xiii] Fraudulent conveyances? Elder abuse? (Think life insurance or testamentary planning.)
[xiv] The IRS already has the right to revoke an individual organization’s tax exemption where the organization is operated for the benefit of private interests, where it campaigns for or against candidates for elected office, where a substantial portion of its activities includes lobbying (“attempting to influence legislation”), where it operates an unrelated trade or business as a substantial part of its activities, or where its activities are contrary to a fundamental public policy.
[xv] And predictably.
[xvi] This provision was based in part upon the private foundation self-dealing rules (IRC Sec. 4941).
[xvii] IRC Sec. 4958. Pub. L. 104-168.
[xviii] In addition to the community benefit standard and the general requirements of IRC 501(c)(3).
[xix] IRC Sec. 501(r). Hospitals must conduct a “community health needs assessment” at least once every three years and adopt an implementation strategy to meet those needs. They must have written financial assistance and emergency medical care policies. For emergency and other medically necessary care, hospitals may not charge individuals eligible under the financial assistance policy more than the amounts generally billed for care provided to those with insurance coverage. For all other medical care, hospitals must charge such patients less than the full, established prices for such care. Hospitals must also make reasonable efforts to determine whether an individual is eligible for financial assistance before beginning extraordinary collection actions.
[xx] All the relevant facts and circumstances are considered. See Reg.Sec. 1.501(r)-2. Where a tax-exempt hospital system operates more than one facility, one of which is noncompliant, the IRS may treat the income from the noncompliant facility as taxable in lieu of revoking the entire organization’s tax-exempt status for failing to comply. In addition, the IRS may levy an excise tax upon a hospital that has failed to perform the required community needs assessment. IRC Sec. 4959.
[xxi] The federal corporate income tax rate. IRC Sec. 11.
[xxii] IRC Sec. 4960. Pub. L. 115-97. Coaches – don’t get me started.
[xxiii] IRC Sec. 4968. Pub. L. 115-97. Ostensibly to encourage the expenditure of such funds.
Net investment income is determined using rules similar to those of IRC Sec. 4940(c) (relating to the net investment income of a private foundation).
This year has seen the introduction of bills to increase the tax rate imposed on such income. See, for example, Rep Lawler’s (NY) bill: https://lawler.house.gov/uploadedfiles/endowment_accountability_act.pdf .
[xxiv] For example, the use of a for-profit subsidiary.
[xxv] IRC Sec. 511, Sec. 512, Sec. 513; Reg. Sec. 1.513-1.
[xxvi] IRC Sec. 512(c). If a business regularly carried on by a partnership of which an exempt organization is a member is an unrelated trade or business with respect to such organization, such organization in computing its unrelated business taxable income shall include its share of the gross income of the partnership from such unrelated trade or business and its share of the partnership deductions directly connected with such gross income.
[xxvii] Including, perhaps, with respect to the payment of compensation to individuals also employed by the nonprofit. The excess benefit rules foresaw such a diversion of funds in determining whether compensation paid to a disqualified person was reasonable.
[xxviii] Unlike other exempt organizations or businesses, a church isn’t required to withhold income tax from the compensation it pays to its duly ordained, commissioned or licensed ministers for performing services in the exercise of their ministry.
[xxix] Pub. L. 98-21, Social Security Amendments of 1983. Again, there is an exception for wages paid for services performed by a duly ordained, commissioned or licensed minister of a church in the exercise of their ministry.
[xxx] Wisconsin exempts from its state unemployment tax system certain religious organizations that are “operated, supervised, controlled, or principally supported by a church or convention or association of churches” and that are also “operated primarily for religious purposes.”
However, the Wisconsin Supreme Court held that Catholic Charities was not “operated primarily for religious purposes” and, thus, did not qualify for the tax exemption. Specifically, the state court held that Catholic Charities’ activities were not “typical” religious activities because Catholic Charities served and employed non-Catholics, Catholic Charities did not “attempt to imbue program participants with the Catholic faith,” and its services to the poor and needy could also be provided by secular organizations.
Catholic Charities claimed that the state violated the First Amendment’s Religion Clauses by denying a religious organization an otherwise-available tax exemption because the organization does not meet the state’s criteria for religious behavior.
Oral arguments were held last month. The Supreme Court is expected to rule by some time in June
Catholic Charities Bureau, Inc., v. Wisconsin Labor & Industry Review Commission, et al., U.S. Supreme Court, Docket No. 24-154.
[xxxi] Under IRC Sec. 501(c)(3). In general, nonprofit organizations that aren’t Sec. 501(c)(3) organizations are not exempt from withholding federal income, social security, or Medicare tax from their employees’ pay, or from paying FUTA tax.
[xxxii] The business will usually have deluded itself into thinking that it will make the government whole after the business has turned the proverbial corner. In most cases, however, there is no corner, just a downward spiral.
[xxxiii] The “responsible person” penalty.
[xxxiv] Williams v. United States, No. 4:22-cv-942-DPM, 2025 BL 9831, 2025 US Dist. Lexis 5770 (E.D. Ark. Jan. 13, 2025), Court Opinion.
[xxxv] IRC Sec. 6672(a).
[xxxvi] Whether the taxpayer acted willfully or not may be influenced by what he knew and when, including what he knew about the unpaid tax liability, when the charity planned to pay, whether it intended to pay, whether other bills were being paid instead, and whether he has received assurances from others with tax-related authority and responsibility.
[xxxvii] These may include the maintenance of emergency funds, and the preparation of plans to partner with other nonprofits or for-profits.
