Updated Form 1023 Tuesday, Mar 13 2018

Earlier this year the IRS updated Form 1023, the application through which over 1.5 million entities have gained recognition of tax exempt status.  As discussed below, I consider the changes incorporated to be reasonable and largely welcome.

The most noteworthy changes included 1) a lowering of application fees (invariably a welcome development for applicants), 2) an increase in the information required on the EZ form, and 3) some updating to the full form, reflecting ten years of changes, and elimination of some obsolete items.

The change in fee structure is noteworthy because it is unusual for a government agency to actually lower a fee for a service.

Form 1023.  The full Form 1023 application fee was reduced from $850 to $600.  The previous option of paying $400 for an organization with $10,000 or less in annual revenue was rightly eliminated.  Three years ago when the EZ form was introduced for organizations with revenues under $50,000 a year at a cost of only $275, the $400 option was rendered meaningless except in the less common case of an organization not qualified to file the EZ form, such as a church.

Form 1023-EZ.  The application fee for Form 1023-EZ has remained the same at $275, despite the fact that the IRS has increased the amount of information required on the application, likely resulting in greater IRS review time.  Paradoxically this increase in information required is actually a welcome change to the short form.  The qualifications worksheet for the earlier EZ form was simply incorporated by reference, rather than incorporating the relevant, deciding qualifications into the body of the form.  It was too easy for unknowing applicants to simply check a box that they were qualified to use the EZ form, that they were properly formed, had proper purposes, etc.  The new format requires an applicant to expressly verify that the organization is not a church, school, or hospital (for which the EZ form is inappropriate) before making application.  It also requires an applicant to iterate in words the main purpose for which the nonprofit organization was created.  Not all legal purposes qualify an entity for tax exemption.

Frankly, I believe that the IRS could have beneficially gone even further by incorporating the complete qualification worksheet in the form.  If excluding the qualification checklist from the body of the form was intended to make it easier to complete – a mere 2-page document compared to the intimidating stack of pages in the full Form 1023 – in essence the qualification restrictions appear meaningless.  Potentially (and what has been happening) as a result of the appearance of simplicity, unrepresented fledgling nonprofits will be lured into filing the form themselves without so much as a glance at the instructions or qualification worksheets.  This has resulted in some undesirable consequences for entities that were not formed properly, or were not qualified to use the EZ form in the first place.  Since the IRS does not require provision of the founding documents, these are sometimes improperly prepared.  At least some of the common mistakes could be prevented if the yes/no checklist for EZ qualification was in the body of the Form.

Group Exemption.  The Group Exemption application fee dropped from $3,000 to $2,000 in the latest revision of the 1023 family.  In years past there was the expectation among nonprofit professionals that the Group Exemption might be phased out eventually; this lowering of the fee would seem to indicate that such elimination is not on the IRS’ near-term agenda.

This reduction of the fee is reasonable in light of the fact that the application itself is one of the simplest in the 1023 family to complete.  In fact, there is not an official form for this process; a mere letter is required.  The requisite information to be enclosed in such letter is clearly prescribed in IRS materials.  Most entities seeking a Group Ruling have been in existence for some period, have already obtained an individual exemption, and are now seeking to restructure as a central organization in the hub of other mini-versions of itself.  In this scenario, there is less cause for concern on the part of the IRS since it has had a full opportunity to scrutinize the entity previously.  In consequence a lower price tag on the application is thought appropriate.

In fact, the IRS achieves its own purposes by granting Group Exemption rulings.  The central organization takes on the role of the IRS in that it evaluates its subordinates in the Group for proper tax exempt formation and operation on an annual basis.  Each year the central organization requires financials and updates from its subordinates and merely reports to the IRS as to which organizations should still be included.  Because most entities holding Group Exemption ruling are/have been advised by counsel, there will usually be a higher understanding of the exemption requirements with these central organizations; this will often, in turn, help the subordinates gain an understanding of exemption rules.  Because the subordinates are often smaller associations, this level of scrutiny achieves a greater compliance with requirements than if each filed the Form 1023-EZ on their own.

In the last five years there has been an ebb and flow in the IRS’ efficiency, which has resulted in widely varying wait times for exemption determinations.  Anecdotally, it was observed that in the heyday of recent IRS efficiency, around 2010 or 2011, some full applications flew through the examination process in as little as 5 weeks.  On the other hand, 2013 was observed to be the worst year – with wait times up to a year and a half for simple applications needing no interaction with the IRS; the applications were simply stuck in the ostensibly unmovable backlog and remained unassigned for months on end.  Due to this backlog the IRS created the Form 1023-EZ option for smaller organizations to get through the mire more quickly, allowing exemption specialists to focus on more complicated applications.

It remains to be seen, but I suspect that the IRS desires to encourage the pursuit of Group Exemption Rulings through this more accessible fee structure, thereby, as discussed, lessening its overall workload.

Overdue Updating.  In addition to removing the obsolete option for small organizations under $10,000 in annual revenue (mentioned above), the new Form 1023 also finally removed the messy red add-on guidance that graced the form for the last five years, directing applicants to override portions of the existing instructions.  Examples included the outdated mailing address instructions, as well as the nearly 2/3 page of confusing language that referred to the “advanced ruling” protocol, which has been obsolete since 2008.  The Form 1023 now appears much cleaner with the 2018 upgrade.

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New IRS Procedure Grants Charities Greater Mobility Thursday, Mar 1 2018

The IRS has recently released a revised Revenue Procedure giving tax exempt entities greater flexibility.  Previously an organization needed to decide at the onset where they wanted to be incorporated for the long haul, knowing that any future adjustment to the organization’s home state would require that organization to file the IRS Form 1023 “Application for Exemption” all over again.  These restrictions were unambiguous in the 40 and 50 year-old Revenue Rulings 67-390 and 77-469 which spelled out the requirements and provided clear examples.  As a result, it was unusual to see a charity switch locations due to the associated paperwork and hassles involved.

But now the IRS has expressly abandoned the restrictions of those Revenue Rulings and opened the door to new strategic possibilities for charities to consider.

With the same stroke the named regulations also stated that entities moving from one qualifying exempt structure to another would be excused from the need to reapply.  For example, an unincorporated association that has been approved for exemption and later becomes incorporated would – under the old rules – be required to apply all over again because a new legal entity had been created.  The rules now do not require reapplication in that scenario.

Rationale.  The rationale given for these changes is one of consistency.  The previous rules governing when an organization must re-apply for a FEIN, and when it must re-apply for exemption were not in line with one another, leading to somewhat irrational results.

Presumably this change will simplify matters for the IRS by creating a reduction in its workload once the redundant examination of “old-but-newly-headquartered” charities is eliminated.  The old law requiring a thorough examination of a charity which had changed nothing in terms of its exempt purposes, but merely its address may not have been the best allocation of scarce IRS resources – especially since the exempt organization would have already been scrutinized by the Service in determining qualification for exemption.

State Law.  This change in the rules will highlight the different corporate codes of the various states.  It will now be state rules that govern whether a charity can successfully transfer operations in one fluid motion, as opposed to the herky-jerky dissolution and reincorporation process.  The state tools to be used to make changes to an entity’s jurisdiction are the articles of domestication and articles of conversion, options currently available on a state-by-state basis.  It remains to be seen whether any changes to state codes or attempts at uniform protocol will follow this change in an effort to make the new IRS’s Procedure more seamless.

Potential Pitfall?  A conceivable area where the gate-keeping function might fall through the cracks, however, is in the case of a true “reincorporation” into another state, rather than just the filing of articles of conversion which could move the corporation to its new home under the same charter.  When unsupervised charities are writing their own articles of incorporation, things tend to go amiss.  One of the most-cited reasons for the rejection of a Form 1023 application is that the founding document either didn’t have a proper purpose clause or the required dissolution clause.

On the other hand, to the average visionary the idea of moving state locations might appear to be just the sort of legal matter that might warrant hiring an attorney for the process, which would (generally) lower the incidence of improperly scribed articles of incorporation.  Additionally, it might be assumed that an organization that was originally required to get it right in the first state would have a higher likelihood of getting it right in the second state, but time will tell.

It will be interesting to watch whether the added privileges of movement will lead to increased productivity in the exempt world, or if the released grip of IRS oversight will simply allow early-stage carelessness to sneak into the process.  Mistakes made in founding documents can lead to undesirable results.  If an entity builds on an improper foundation, the tax consequences can be bleak when the error is finally discovered.  Of course, the new IRS guidelines make clear that the organizational and operational tests are still required for any relocated entity, but how will this compliance be verified?  A relocated entity will, of course, be required to report the change on the following annual report to the IRS (Form 990), but the level of scrutiny given to the new incorporation documents remains to be seen.

Anecdotally, when the IRS made the Form 1023-EZ available, the rules regarding proper formation were still in place, but many start-up founders breezed right over these requirements.  This resulted in many improperly formed “charities” that had false assurances of status because they had forked over the $275 and gotten an official notice from the IRS.  The appeal of the “EZ” form has made it altogether too easy for well-intended charities to develop on improper foundations.

It will be interesting to watch guidance emerge to accompany this new latitude in the nonprofit world.

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