November 14, 2023

‍

If you are a faith-based nonprofit organization, you are mostly likely also a “501(c)(3).” Having “501(c)(3)” status means your organization applied for and received federal 501(c)(3) tax-exempt status from the Internal Revenue Service (IRS). To maintain your organization’s status as a 501(c)(3), your organization must always be “organized and operated exclusively for exempt purposes.” This requires you to understand the basic requirements of maintaining that status, such as operating for a particular exempt purpose (religious, charitable, etc.) and not conducting business for the financial benefit of any private individual.  

Did you know that there are very specific tests to determine whether your organization is “organized and operated exclusively for exempt purposes,” as specified in 501(c)(3)?  

These specific tests are known as the Organizational and Operational Tests of 501(c)(3). This article outlines four points to give you a better understanding of what is required to make sure your organization continues to qualify for tax exemption. As always, if you have questions about whether you are complying with the requirements of these tests, please consult with your attorney. Also, please note that this article is not meant to be an exhaustive explanation of every aspect of the Tests.  

‍

I. Limitation on Purpose and Activities

It is commonly known that, for a faith-based nonprofit organization to qualify as an exempt organization under 501(c)(3), the organization must be organized and operated exclusively or primarily for one or more of the exempt purposes listed in Internal Revenue Code Section 501(c)(3). Exempt purposes include “charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals.” A 501(c)(3) nonprofit must only carry out activities for these exempt purposes, except that it may carry out a non-exempt activity “as an insubstantial part of its activities.” We will discuss more on the substantial/insubstantial activity question in Part III below.

There are three concrete rules regarding exempt purposes that must be written directly into the articles that organize your nonprofit:  

1. the document must expressly limit the organization’s purposes to exempt purposes;

2. the document may not authorize the organization to engage in activities that do not further the exempt purpose(s), except to “an insubstantial degree;” and

3. There must be a provision that, upon dissolution of the organization, the organization’s assets will be dedicated to an exempt purpose.

Therefore, aside from anything your state law requires, you need to be sure that your organizing document expresses the exempt purpose(s) for which your organization exists, does not include any non-exempt purposes, and has a clause that gives your organization’s assets to an exempt purpose in the event the organization dissolves. The organizing document may go by different names depending on the type of entity and the state of organization; it may be called the “articles of incorporation,” the “corporate charter,” the “articles of association,” or something else. Consult your organization’s records and, if it is not clear, check your state law and/or speak to an attorney to identify your organizing document and make sure it passes the test!

‍

II. Limitations on Legislative and Political Activity

Most nonprofit leaders know that there are severe restrictions on nonprofit organizations being involved in legislative and political activity. But it is important to be aware that the limits are not absolute, and they vary depending on the type of political activity.

Influencing legislation can be allowed, but only to a limited extent. The IRS defines influencing legislation as follows: “The act of directly contacting or urging the public to contact members of a legislative body for the purpose of proposing, supporting, or opposing legislation. Attempting to influence legislation includes advocating the adoption or rejection of legislation.” The IRS regulation warns that an organization is not organized for exempt purposes if its articles of organization permit it “[t]o devote more than an insubstantial part of its activities to attempting to influence legislation by propaganda or otherwise.” Again, we will get to the substantial vs. insubstantial activity analysis below. But if your organization engages in any activity that may be lobbying/influencing legislation, you should consult with an attorney and make sure you are not endangering your exempt status.

While some legislative lobbying may be allowed, no amount of involvement with a political candidate or campaign is permitted. The IRS is quite clear on this: an exempt organization jeopardizes its 501(c)(3) status if it “if it promotes or opposes, through political literature, brochures, pamphlets, hosting or participating in events, etc., the candidacy of an individual for public office. Debates and nonpartisan voter education aren’t considered political.” This is a strict rule: not even an insubstantial amount of participation in political campaigns or support of political candidates is permitted.

For more information on this issue, check out Napa Legal’s introduction to Understanding Political Activity and Issue Advocacy.

‍

III. Purpose of Activity vs. Type of Activity Conducted

Keep in mind that the major question is not specifically about whether the type of activity your organization engages in is itself an exempt activity, but whether the activity is carried on for an exempt purpose. So, if your organization can show that it is performing what appears to be a substantial activity, but that the activity furthers the exempt purpose, the activity may be appropriate for an exempt organization.  

For example, if an organization exists for various exempt charitable, scientific, and educational purposes such as preserving the ecology and maintaining local wildlife, and the organization engages in farming using practices that will conserve the area’s ecology and natural wildlife, that may be an activity for an exempt purpose. In this case, the court held that, even though these farming practices produced thousands of dollars of income, the purpose of the activity was to demonstrate to farmers that “profitable farming can be combined with wildlife management and conservation of natural areas.” This purpose fit within the exempt charitable, scientific, or educational purposes for which the organization was formed.

Be careful; this is not an easy question and there are no easy answers about when the purpose of an activity furthers an exempt purpose. There have been many cases where 501(c)(3) organizations have lost their tax-exempt status because they were engaging in non-exempt business activities, even if they were giving some of the profits directly to charitable works.

If your organization engages in any activity and you are unsure whether it definitely is carried on for an exempt purpose, speak to an attorney so you can make sure your organization’s activities are not putting your 501(c)(3) status at risk.

‍

IV. Operating Exclusively for Exempt Purposes – Substantial and Insubstantial Activities

As we noted above, a 501(c)(3) organization cannot engage in activities for non-exempt purposes in general, and in influencing legislation in particular, unless the activity is only to “an insubstantial degree.” It’s worth taking a look at the precise language in the IRS Treasury Regulations, which state:

An organization will be regarded as “operated exclusively” for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of such exempt purposes specified in section 501(c)(3).

An organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.

“Operated exclusively” for exempt purposes, then, means that only an “insubstantial” part of its activities may be for non-exempt purposes. The obvious question presents itself: When does activity cross the line from insubstantial to substantial?  

A commentary on the operational test organizes the ways to determine whether an activity is substantial into three questions:  

1. How much of the organization’s income is derived from the activity?

2. How much does the organization spend on the activity compared to its total spending?

3. How much time do the organization’s employees devote to the activity compared to their total hours worked?

Unfortunately, these are only general concepts; there are no hard and fast rules to tell you how much money is too much, how many employee hours are too many, to be considered an insubstantial activity. This is a subjective analysis based on the facts of your organization’s particular circumstances.  

While we can’t offer a universal rule, an example from a court case might help to illustrate how the substantial activities test is applied.  

A nonprofit corporation was organized for the exempt purpose of promoting the interests of agriculture.¹ The organization sponsored an annual fair involving the exhibition of animals, farm and garden products. The organization’s fairgrounds also contain an auto racetrack, where races were held both around the time of the fair and during the rest of the year. Putting aside the other issues in the case, the court accepted that the fair was in furtherance of the exempt purpose, as were the auto races held as public entertainment immediately before and during the annual fair. But the races held throughout the rest of the year were not held with the intent to attract people to the fair and were thus activities for a non-exempt purpose. The races constituted approximately 30-35% of the organization’s annual revenue. The court held that the non-exempt activity was substantial and that it was proper for the organization’s 501(c)(3) status to be revoked.

So again, if your organization is involved in any activities unrelated to your organization’s exempt purpose(s), it is best to speak to an attorney to determine whether any of these may cross the line into “substantial activities.”

‍

Conclusion

These four points about the Organizational and Operational Tests are definitely not the only things to know about maintaining your organization’s 501(c)(3) status. But this should serve as a good starting point to getting acquainted with the tests and ask yourself some questions to make sure you are passing the tests:

• Do my organization’s articles of organization specify that the organization is incorporated only for exempt purposes, and do they provide that the organization’s assets go to an exempt purpose in the event of dissolution?
• Is my organization involved in influencing legislation, supporting political campaigns or candidates, or political activity of any kind?

• Are all my organization’s activities carried on in furtherance of an exempt purpose?
• Does my organization engage in any activities not carried on in furtherance of an exempt purpose? And if so, how substantial are those activities?

If, after reading this article, the answer to any of these questions raises any concerns, it is time to address the issue and speak to an attorney.

‍

------------------------------------

¹ See Orange Cnty. Agric. Society, Inc. v. Commissioner, 893 F.2d 529 (2d Cir. 1990).