The Independent View: IRS Changes 501(c)(3) Application Rules

Amid ongoing controversy over its scrutiny of nonprofits, the Internal Revenue Service has decided it will no longer screen approximately 80% of the organizations seeking tax-exempt charitable status each year, a change that will ease the creation of small charities while doing away with a review intended to counter fraud and prevent political and other noncharitable groups from misusing the tax code.

As of July 1, any group that pays a $400 fee and declares on a three-page online form that it has annual income of less than $50,000, total assets of less than $250,000 and is in compliance with the tax-code requirements of a charity will automatically be allowed to accept donations that are tax-deductible for the donors. Previously the groups had to fill out a detailed 26-page form, submit multiple supporting documents and provide a narrative description of their intended activities.

IRS commissioner John Koskinen said the change would result in “efficiencies that will translate into a faster and better review” of bigger nonprofits, while clearing a 66,000-application backlog that has resulted in yearlong waits for groups seeking to start a charity. He said the new short form comes with 20 pages of instructions that make clear the requirements and limitations of being a charitable organization. Koskinen said that on the new short form, “people certify that they’ve gone through the instructions” under penalty of perjury.

Some charitable groups worry the IRS has opened the door to abuse of tax-exempt status that will undermine the credibility of legitimate nonprofits, which are allowed to accept deductible donations under section 501(c)(3) of the tax code. “The Form 1023-EZ will increase opportunity for fraud,” said Alissa Hecht Gardenswartz, president of the National Association of State Charity Officials, and will make it harder “to protect charitable assets from fraud and abuse and to ensure that charitable assets are used for the purposes represented to the public.”

Others worry that charities, nominally barred from political activity, will come to serve the same purpose as the powerful nonprofit organizations known as 501(c)(4)s, whose donations cannot be deducted from taxes. This could give an added tax benefit to donors who have recently funneled hundreds of millions of dollars into independent political campaign spending. “What we’ll see is the so-called dark political money that flowed into the (c)(4) world is going to begin to flow into the (c)(3) world,” says Marcus Owens, who was the director of the exempt-organizations division at the IRS from 1990 to 2000, and is now in private practice at the law firm of Caplin & Drysdale.

While charity groups agree the old process for receiving tax-exempt status was too cumbersome, they and others worry that now organizations with no true charitable purpose will seek to become charities. “It’s easier to get tax-exempt status under 1023-EZ than it is to get a library card,” says Tim Delaney, president and CEO of the Council of Nonprofits. As a result, Delaney says, bad actors “will be able to operate in the name of the charity, and the IRS will never be the wiser because they’re not looking at the underlying documentation.”

Owens says the IRS may not be able to differentiate between truly small charities and those that knowingly plan to grow beyond $50,000 in annual income. “I haven’t seen any mechanism where the IRS would be legally able to go after an organization that applied within the EZ process but then fortune shined on them,” Owens says. He also says that because of outdated software, the IRS won’t be able to track active charities back from its master file to their originating documents. An IRS official speaking on background acknowledged the software problem.

Charities complain that the change was made with little consultation from their representative lobbying organizations. The IRS sped its enactment this year by routing the change through the White House’s Office of Management and Budget for public comment under the Paperwork Reduction Act, rather than through the normal public-comment process at the IRS, nonprofit officials contend. “I just wish the IRS had used a more inclusive process from the beginning,” says Delaney of the Council of Nonprofits.