The New Form 1023: What Does It Mean For Charitable Organizations?
December 16, 2004
In October 2004, the Internal Revenue Service (IRS) released a new Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. The changes to the Form 1023 are quite significant and will require prospective charitable organizations to assemble considerably more information in order to complete the new Form 1023. In addition, and quite significantly, the IRS has added a number of new parts to the Form 990 that will require the upfront disclosure of more information concerning compensation and financial matters and will require prospective charities to consider whether they should adopt best practices or be prepared to provide an explanation of why they have not. Although the IRS will continue to accept the September 1998 version of Form 1023 until April 30, 2005, the IRS's Frequently Asked Questions concerning the new Form 1023 indicate that using the October 2004 version will reduce the processing time for most organizations and potentially reduce or eliminate correspondence between the IRS and the applicant organizations.
In some respects the new Form 1023 is a welcome development because it incorporates the user fee form and the consent to extend the period of limitations into the Form 1023 itself. However, the Form 1023 will require considerably greater amounts of time and expertise to complete because of the level of detail required to answer many of the new questions. At least initially, smaller organizations and those that have volunteers preparing the Form 1023 may have difficulty completing the form accurately and completely.
Part I: Identification of the Applicant
The new Form 1023 requests much of the same information as the prior form, however, an applicant must obtain an employer identification number before the application is submitted. (Because this can be done online with the IRS, this should not delay submission.) In addition, Line 12 now asks whether an organization was formed under the laws of a foreign country and the instructions provide greater detail concerning the steps a foreign-organized applicant must take in order to obtain recognition of exemption.
Part II: Organizational Structure
The new Form 1023 contains more detailed questions concerning the organizational structure of the applicant and also provides a specific section for applicants that are formed as limited liability companies (LLCs). The instructions to the Form 1023 clarify that an LLC may only have section 501(c)(3) members to qualify for exemption and notes that an LLC should not file an exemption application if it wants to be treated as a disregarded entity by its tax-exempt member. Interestingly, however, no provision was made for "funds" that can be formed by a resolution of a non-section 501(c)(3) organization pursuant to Revenue Ruling 54-243, 1954-1 C.B. 92 and Revenue Ruling 58-293, 1958-1 C.B. 146. Presumably a "fund" established in such a fashion would complete the portion of the Form 1023 relating to trusts. It would not complete the form relating to unincorporated associations because an unincorporated association, according to the instructions, must have at least two members who have signed a written document for a specifically defined purpose.
Part III: Required Provisions
The Form 1023 asks specific questions concerning the applicant's satisfaction of the organizational test of exemption relating to its exempt purposes and the distribution of its assets upon dissolution. In addition, the form asks for the specific location in the organizational document of such provisions or for references to applicable state laws that satisfy the organizational test.
Part IV: Narrative Description of Activities
The old Form 1023 required that the applicant describe its activities in detail on the form itself. Now a detailed description of proposed activities is to be included in an attachment.
Part V: Compensation and Other Financial Arrangements with Officers, Directors and Others
The old Form 1023 asked for a list of directors, trustees and officers and for a description of their compensation. The disclosures required to complete the new Form 1023 are considerably more extensive. First, the information requested extends to the five highest compensated employees who will receive compensation of more than $50,000 per year who are not listed as officers, directors or trustees. Second, information is requested concerning the five highest compensated independent contractors that receive or will receive compensation of more than $50,000 per year. These latter two requests for information are virtually identical to the information requested on the Form 990 and Schedule A. In addition, a number of additional questions are asked concerning various financial relationships with related organizations in order to tease out information concerning family or business ties. Also, as is done on the Form 990 and Schedule A, information is requested concerning compensation from related organizations.
New questions are asked concerning the establishment of compensation, including whether the organization will follow a conflict of interest policy, whether it will approve compensation arrangements in advance of paying compensation, and whether it will document in writing the date and terms of the approved compensation arrangements. These and other new questions on the Form 1023 parallel the requirements that must be satisfied in order to meet the rebuttable presumption of reasonableness under section 4958 of the Code. Importantly, however, if an organization answers "no" to any of these questions, the Form 1023 asks for a description of how the organization sets compensation that is reasonable. The implication is that if the IRS prescribed procedures are not followed, there is a greater risk they would be regarded as resulting in unreasonable compensation.
The new Form 1023 inquires as to whether the organization has adopted a conflict of interest policy consistent with the sample conflict of interest policy that is now included in Appendix A to the instructions. If an applicant answers "no," then it must explain the procedures that it will follow to assure that persons who have a conflict of interest will not have influence over the organization for setting their own compensation, and what procedures the organization will follow to assure that persons who have a conflict of interest will not have influence over the organization regarding business deals with themselves. It is unclear how the IRS would respond if an applicant could not provide this assurance, such as in the case of a family foundation that intends to compensate all of its directors for their services in that capacity.
A special conflict of interest provision is required for hospitals. The form asks for information concerning a variety of other financial matters that will require the disclosure of a considerable amount of information if an organization has any dealings with related parties at the time it is applying for exemption or expects to in the reasonably foreseeable future.
Part VI: Members and Other Individuals and Organizations That Receive Benefits from the Organization
This section is intended to elicit information concerning past, present and planned activities involving the provision of goods, services or facilities to individuals. Some of these questions are found in the old Form 1023 but a new question is added concerning whether individuals will receive goods, services or funds through the organization's programs that have family or business relationships with any insider.
Part VII: Applicant's History
The old Form 990 required completion of a schedule if the organization was the successor to a for-profit entity. The new form defines "successor" and requires completion of the schedule whether the predecessor was for-profit or exempt. In addition, a new question is added as to whether an organization is submitting this application more than 27 months after the end of the month in which you were legally formed? If the answer to that questions is "yes," a new Schedule E must be completed.
Part VI: Members and Other Individuals and Organizations That Receive Benefits from the Organization
This section is intended to elicit information concerning past, present and planned activities involving the provision of goods, services or facilities to individuals. Some of these questions are found in the old Form 1023 but a new question is added concerning whether individuals will receive goods, services or funds through the organization's programs that have family or business relationships with any insider.
Part VII: Applicant's History
The old Form 990 required completion of a schedule if the organization was the successor to a for-profit entity. The new form defines "successor" and requires completion of the schedule whether the predecessor was for-profit or exempt. In addition, a new question is added as to whether an organization is formed more than 27 months after the end of the month in which it was legally formed. If the answer to that questions is "yes," a new Schedule E must be completed.
Part VIII: Specific Activities
Several questions are asked regarding specific types of activities that may create exemption questions or problems such as involvement in political campaigns as well as influencing legislation. A new question is added asking whether the organization will be operating bingo or other gaming activities.
The new Form 1023 has replaced the generic question concerning the organization's sources of support with more detailed questions concerning how the organization will be conducting its fundraising, whether it will be conducting fundraising activities for other organizations, and whether it will be maintaining separate donor advised funds.
Several new questions are asked concerning whether the organization will engage in economic development, use persons other than employees or volunteers to develop its facilities, participate in joint ventures, or own or have rights in intellectual property.
These series of questions will require considerably more effort on the part of the organization to complete.
Part IX: Financial Data
The Form 1023 requests the same kind of information as did the old one except that in the balance sheet it specifically asks for itemized lists for a number of items, including stocks and bonds, loans receivable, and various liabilities.
Part X: Public Charity Status
The questions pertaining to the public charity status of the organization have been simplified and, as previously noted, the consent to extend the statute of limitations if an organization requests an advance ruling as to its public charity status is integrated into the new form.
Part XI: User Fee Information
The new Form 1023 eliminates the separate form that previously was required concerning the user fee.
Schedules
The schedules that are required for specific types of organizations including churches, educational organizations, hospitals and medical research organizations, and supporting organizations are greatly expanded and have been made more complex. In addition, a new schedule has been added for organizations not filing the Form 1023 within 27 months after formation and a new schedule has been added for organizations making grants to individuals, as well as for private foundations requesting advance approval of individual grant procedures.
Form 1023 Checklist
The new Form 1023 contains a checklist, as did the old one. The difference with the new Form 1023, however, is that the checklist is required to be filed along with the exemption application.
General Observations and Collateral Consequences
The IRS has greatly improvedthe disclosures required to be made by prospective charities. During the past few years, numerous examples of abuses of public charities as well as private foundations that have been formed by unscrupulous individuals, often with the assistance of unscrupulous financial planners and advisors, have exposed the need to increase the disclosure of important information. The new form requires disclose of family and business relationships as well as proposed transactions in the exemption application, rather than depending upon the IRS ferreting improper transactions out during an examination. The IRS has neither the resources nor the practical ability to mount such an effort.
The IRS may have overstepped its boundaries by requiring so much information concerning whether the prospective charity has adopted the IRS's own self-styled "best practices" or has adopted a conflict of interest policy. While many of the practices identified in Form 1023 are, in fact, quite "good" practices, the IRS has made no effort to solicit any public comment concerning true "best practices." Furthermore, the conflict of interest policy included as an exhibit to the Form 1023, while reasonable, is not appropriate for a number of types of organizations such as family foundations, when no one is compensated for services on the Board or as an officer. Another inadvertent consequence of expanding the information requested on the new Form 1023 is the convergence between the federal law of tax-exempt status and state laws concerning corporate governance and similar matters.
If an organization fails to fully disclose the information requested on the Form 1023, or changes its practices after it receives exemption and fails to notify the IRS of those changes, questions will be raised concerning the reliability of the ruling or determination letter. In general, a ruling or determination letter recognizing exemption may not be relied on if there is a material change inconsistent with exemption and the character, the purpose, or the method of operation of the organization. See Treas. Reg. §601.201(n)(3)(ii). Thus, it may be easier for the IRS to revoke exemption of an organization retroactively than it was prior to the publication of the new Form 1023.
