Tax-exempt Organizations Must be Aware of Complicated Tax Issues

For organizations that theoretically pay no tax, tax-exempt organizations have remarkably complicated tax issues.  The term “tax-exempt organization” simply means that the organization is exempt from federal income  taxes.  Tax-exempt organizations remain subject to state and federal tax issues that can involve great complexity.  To maintain tax-exempt status, many organizations must file an annual information return known as form 990.  Even though no tax is due, form 990 is a complicated form that requires disclosure of financial information, governance policies, and other matters.

Organizations that engage in business activity unrelated to their exempt purposes are subject to unrelated business income tax (UBIT).  Numerous technical legal concepts can be relevant to determining if income is unrelated business income or if any exclusions apply.  Familiarity with these concepts is important because it may be possible to structure a business arrangement so that its income is not taxable.  For instance, if an organization receives the publishing rights to a book whose content is unrelated to its exempt purposes, income derived from sales of the book will be unrelated business income if the organization directly markets and sells the book.  However, if the organization transfers rights to the book to a commercial publisher in exchange for a royalty, the royalty payments will not be unrelated business income.  Even issues such as how property was acquired can be relevant to determining if income derived from the property is unrelated business income.  The complexity of UBIT laws make it worthwhile for tax-exempt organizations to seek competent counsel prior to engaging in any new business activity.

Sales tax is another area where exempt organizations often face difficult tax issues.  The types of sales tax exemptions available to tax-exempt organizations vary widely from state to state.  Organizations should be familiar with the sales tax exemptions of all states in which they have operations or sell their goods.  It is common for organizations to confuse exemption from paying sales tax as exemption from charging sales tax.  Exemption from paying sales tax means that the organization is exempt from paying sales tax on purchases of goods that it uses in carrying out its exempt activities.  On the other hand, if an organization is exempt from charging sales tax the organization may sell its goods to others without charging the purchaser sales tax.  Exemptions from paying sales tax are more common than exemptions from charging sales tax.  In most states tax-exempt organizations must charge sales tax on their sales of goods to the public.  A few states exempt all or broad classes of exempt organizations form charging sales tax, but it is more common for states to exempt specific types of transactions from sales tax.  For instance, at least one state exempts churches from charging sales tax to their members. 

Unless the organization is very small, the organization likely has at least one employee, which means that the organization must pay employment taxes.  It is important to note that not all of those who are compensated for providing services to the organization are employees.  If the individual is an independent contractor, then the organization is not responsible for paying federal employment taxes.  Determining if an individual is an independent contractor or an employee involves a factual inquiry into the type of relationship and the behavioral and financial controls the organization exercises.  Many states do not require tax-exempt organizations to pay state unemployment insurance taxes until the number of employees or amount of payroll exceeds a certain level.  Organizations should be aware of their employment tax obligations in each state in which they have at least one employee.  Employment tax issues for churches involve additional considerations.  For example, federal law provides favorable treatment to ministers in the areas of Social Security taxes and housing allowances.

Property tax matters are not usually as complicated as those of other taxes, but it is important for tax-exempt organizations to be aware of issues that could create property tax liability.  A common belief is that a tax-exempt organization is automatically exempt from paying property taxes on real estate owned by the organization.  This belief is incorrect because it is necessary for the organization to apply for and be granted exemption.  Another misconception is that real estate is exempt from property taxes if a tax-exempt organization purchases the property from another tax-exempt organization.  Organizations should not expect property tax exemptions to be transferrable; each new owner will likely need to apply for exemption.  An organization that does not apply for exemption risks receiving property tax bills and legal action against the property if it does not pay the bills.  Resolving these issues can be costly and time-consuming.  Organizations that use at least a portion of their facilities for revenue-generating purposes, such as renting or leasing space to third parties, risk property tax liability based upon these uses.  To maintain full property tax exemption, organizations should carefully consider who they will allow to use their facilities and the terms of use.   

In conclusion, the term “tax-exempt organization” is somewhat of a misnomer since tax-exempt organizations face complicated tax issues.  Form 990 requires organizations to make numerous technical disclosures about the organization.  Moreover, tax-exempt organizations frequently encounter liability for unrelated business income taxes, sales taxes, and employment taxes. Organizations that are not careful with their real estate matters may be liable for property taxes.  Determining if an organization is subject to these taxes or if exemptions apply can require detailed analysis.  David L. Bea & Associates is experienced at advising tax-exempt organizations on various tax matters.  If you have any questions, please do not hesitate to contact us.    

© 2011 David L. Bea & Associates.  The foregoing article was provided for general information.  Seek specific legal advice for your situation.