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Oops: IRS Wrongly Gave Tax-Exempt Status to Many EZ Filers

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When the Internal Revenue Service introduced its streamlined application for recognition as a 501(c)(3) entity in July 2014, it intended to ease the burden for small organizations by allowing them to attest that they met exempt status requirements without providing supporting material or substantiation.

But the agency’s good intentions had some unexpected outcomes. A new report by the Taxpayer Advocate Service, which recommended adoption of Form 1023-EZ, finds that the IRS approves a significant portion of these applications for organizations that do not legally qualify for tax-exempt status.

According to the report, a study of a representative sample of 408 organizations in 20 states that make articles of incorporation viewable online at no cost found that:

  • 37% do not meet the organizational test for qualification as a 501(c)(3) organization
  • 30% of these organizations’ articles of incorporation do not have an acceptable purpose clause
  • 23% of these organizations’ articles of incorporation do not provide for distribu­tion of assets upon dissolution as the law requires

Most taxpayers seeking recognition as 501(c)(3) organizations must apply to the IRS to have their exempt status recognized. Eligibility to request exempt status using the three-page Form 1023-EZ requires, among other things, that the organiza­tion’s gross receipts not have exceeded $50,000 in any of the last three years and that its total assets do not exceed $250,000.

Prior to July 2014, organizations submitted their applications on the 12-page Form 1023, which the IRS estimated took more than nine hours to complete on average.

The report said that in more than 90% of cases, it took researchers five minutes or less to review articles of incorporation and determine wheth­er applicants met the organizational test. They found a wide variety in wording, but getting the words “almost right” does not satisfy the legal requirement for tax-exempt status.

The report said that of the 124 groups with either an inadequate purpose clause or none at all in their articles of incorporation, 61 had websites on which researchers could obtain additional information. They were able to ascertain the organization’s purpose in 42 cases, but found the purpose of the remaining 19 obscure.

In addition, just 11 of the 61 websites identified a contact person, and only 19 identified the organization’s directors.

Researchers found that eight organizations had filed a U.S. Corporation Income Tax Return for at least one tax period before obtaining recognition of exempt status, “which raises the question of whether the organizations merely continued to operate a for-profit entity in the guise of an exempt organization.” ‘Missed Opportunity’

The report’s author Jill MacNabb, senior attorney advisor to the National Taxpayer Advocate, came down hard on the IRS. “Those that intended to organize and operate exclusively for an exempt purpose but simply drafted their articles of incorporation inartfully did not receive from the IRS the minimal amount of service needed to identify the deficiency and notify the organization of the need to correct it.”

MacNabb said the IRS abetted organizations that misrepre­sented their exempt-status qualifications, intentionally or otherwise, in mislead­ing the public. “Taxpayers’ right to quality serviceand their right to be informed were thereby undermined.”

The IRS, she said, “missed a valuable opportunity to avert noncompliance as the organizations commenced or continued their operations.”

MacNabb recommended that the IRS adjust Form 1023-EZ to require organizations to submit their organizing documents, unless they are available online at no cost, and to require a narrative statement of the organization’s activities and its financial information.

Furthermore, the agency should make a determina­tion only after reviewing these materials, MacNabb said. If a deficiency can be corrected by amending the organizing document, the IRS should require the applicant to submit an amendment that corrects the deficiency and has been approved by the state.

It should also continue its efforts to gain electronic access to articles of incorporation of corporations organized in states that do not presently make these records publicly available online.

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