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The IRS has busted through the logjam of applications for recognition of exemption due in part to the now available Form 1023-EZ. A shorter application released in July, the 1023-EZ provides certain “small” organizations with a streamlined process for obtaining a determination.
The IRS created the 1023-EZ to alleviate the ever-increasing backlog of applications awaiting determinations. In 2013, some organizations waited a year or longer before receiving their determination letters from the IRS. A combination of factors contributed to the backlog, including but not limited to fewer IRS staff, more section 501(c)(4) applications (because of the political scandal involved with the IRS’ handling of those (c)(4) applications), and thousands more applications than usual due to the automatic revocation enacted in the 2006 Pension Protection Act. Suffice it to say that the reasons for the backlog are many and beyond the scope of this article.
Since the release of the Form 1023-EZ, however, practitioners have noticed a large number of determinations issued, indicating that the IRS has solved its logjam, at least with respect to applications for recognition of exemption.
Format of the 1023-EZ
At three pages, the 1023-EZ is shorter than the full twenty-six page 1023. However, in order to qualify for the 1023-EZ, an applicant must complete an eligibility “worksheet.” Calling it a worksheet is somewhat deceiving because the worksheet is seven pages of detailed technical questions.
After the applicant determines that it is eligible for the shorter application, the applicant must complete the 1023-EZ. The signer of a 1023-EZ makes a number of declarations under penalties of perjury:
The necessary governing document(s) exist and such documents limit the applicant’s purpose to an exempt purpose and provide for dissolution under 501(c)(3)
The applicant is organized and operated exclusively to further a charitable or other qualifying purpose
The applicant will not support or oppose political candidates nor devote more than an insubstantial part of its activities to influence legislation
Net earnings will not inure to the benefit of private shareholders or individuals (e.g., director, officer or key management)
The applicant will not further a non-exempt purpose more than insubstantially, provide commercial type insurance, or operate with the primary purpose of regularly conducting a trade or business not related to the applicant’s exempt purpose
The information in the application is all true and correct
Unlike the Form 1023, the applicant’s governing documents are not attached to the Form 1023-EZ. Further, the applicant’s activities are not described in the Form 1023-EZ. The Form 1023 requires organizing documents and narratives of the applicant’s activities, which help the IRS determine whether the applicant’s purpose and activities qualify for exemption, thereby limiting the applicant’s exposure to liability.
Effectiveness and Concerns
Faster IRS response.
IRS determinations based on 1023-EZ applications have arrived within two to three weeks after submission, say practitioners. At least one organization that filed a 1023-EZ received a determination letter within eight days. Further, according to the IRS website on September 15, the average pending application was submitted in June 2014. Presumably, this average includes both Forms 1023 and 1023-EZ. The IRS’s goal is to resolve all applications within 270 days of filing (which is also the minimum period of time an organization must wait for a determination letter before seeking declaratory judgment).
Prior to initiating the 1023-EZ, the Commissioner of Internal Revenue, John Koskinen, reported a backlog of 60,000 applications, adding that many of those applications had been sitting in the office for 9 months.
Faster application review.
As of August 31, 2014, the IRS had processed 4,000 Form 1023-EZ applications out of 6,000 Form 1023-EZ applications received. The IRS concedes that there is little review of the 1023-EZ application but also claims that the 1023-EZ frees resources and allows the IRS to spend more of its time auditing existing exempt organizations. There are 1.5 million exempt organizations, and the IRS has the capacity to examine less than 1% of them. If the number of exempt organizations increases (due to the 1023-EZ and other factors), but the number of IRS staff remains constant (due to budget cuts), the IRS will not have the capacity to increase the number of audits proportionate to the number of new exempt organizations, making the IRS less likely to expose organizations engaged in non-exempt activities.
Additionally, the IRS may encounter more noncompliance. Noncompliance includes not only the risks of fraud and prohibited activities such as politicking but also unknowing violations. Tax practitioners filter many applications prior to submission – an act unseen by the IRS. However, tax practitioners will be unable to filter some applications because organizations filing the 1023-EZ may choose not to consult a tax advisor due to the apparent simplicity of the form. The instructions notwithstanding, founders of many new organizations do not fully understand the requirements of Section 501(c)(3) or the declarations required on the 1023-EZ. Effective counsel not only helps founders with proper organization and operation but also steers organizations whose missions are not charitable toward a more appropriate choice of entity. Small organizations that would have sought counsel before submitting a Form 1023, may not do so when submitting the 1023-EZ and thus risk a greater chance of noncompliance.
The burden may fall to the states. The National Association of State Charity Officials claimed that the streamlined form would pave the way for fraud and increase the burden on state regulators. If an organization is required to state which form it used to apply for federal exemption, an exemption determination based on a 1023-EZ application could raise a red flag for state auditors.
Cautious donors.
Like the National Association of State Charity Officials, potential donors also may be concerned with the lack of review in the application process. The National Taxpayer Advocate has objected to the new form because an organization is not required to file its formation documents or describe its mission when the organization files the application. Because governing documents are not attached, it is uncertain that the organization’s purpose qualifies as exempt. Marcus Owens, the director of the exempt-organizations division at the IRS from 1990 to 2000 said that the IRS is unable to differentiate between a 1023 and a 1023-EZ in its Business Master File. Potential donors may request a copy of the exemption application or determination letter and choose not to contribute to organizations that receive exemption under a 1023-EZ given the risk that the organization may not actually qualify as tax exempt based upon actual facts or organization or operation.
Revenue Procedure 2014-40 says that a determination letter “issued to an organization that submitted a Form 1023-EZ … may not be relied upon if it was based on any inaccurate material information submitted by the organization.” “Inaccurate material information includes an incorrect attestation as to the organization’s organizational documents, the organization’s exempt purposes, the organization’s conduct of prohibited and restricted activities, or the organization’s eligibility to file Form 1023-EZ.”
Conversely, the Instructions for Form 1023-EZ say, “[D]onors and contributors may rely on an organization’s favorable Determination Letter under section 501(c)(3) until the IRS publishes notice of a change in status, unless the donor or contributor was responsible for or aware of the act or failure to act that results in the revocation of the organization’s Determination Letter.”
Upon close scrutiny, the filing instructions do not align exactly with Revenue Procedure 2014-14. More guidance from the IRS is necessary to clarify when a donor or a state authority may rely on a favorable determination letter granted via the 1023-EZ. In particular, private foundations should be hesitant to give grants to organizations that received determinations via the 1023-EZ. Due to additional grant making requirements for private foundations, prudent foundations may wish to exercise expenditure responsibility when making grants to an organization that received its determination via the Form 1023-EZ to avoid making a taxable expenditure.
Using the 1023-EZ
The 1023-EZ is still very young. While the IRS can spend less time on applications, the IRS may not have the resources to increase the number of examinations proportionately to the number of approved applications. Concerned donors can take precautions when giving to new organizations by requesting a copy of the application for exemption and the organizing documents as well as the determination letter issued by the IRS. Foundations can exercise expenditure responsibility over grants to organizations that filed the 1023-EZ rather than the full Form 1023. Presumably, if an organization’s revenues and assets increase, the organization will file Forms 990, and the Forms 990 will be available to the public, which may provide more assurances to donors.
Working with a tax advisor can help donors, members, and the communities determine which organizations are in good standing with the IRS and are working toward the intended mission. Applicants, and especially signers, filing a 1023-EZ should contact their tax advisors to ensure that the necessary documentation is in order and that they understand the requirements for qualifying and maintaining exempt status.
The Form 1023-EZ may have solved the immediate backlog at the IRS; however, the 1023-EZ may create problems that far eclipse the immediate relief it provides.
Posted by Rebekah Stanley, JD CPA. Rebekah is an associate in Clark Nuber’s Tax Services Group. Contact Clark Nuber.
This article or blog contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.
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