By Jeffrey J. Petrell, CPA, JD
Many CPAs either represent nonprofit or charitable organizations, or volunteer their time as board members. These CPAs need to be aware of increasing challenges to tax-exempt organizations on the state and local level, particularly regarding exemption from real estate, Pennsylvania sales and use, and local government gross receipts taxes. Pennsylvania Act 55 of 1997,1 the Institutions of Purely Public Charity Act (IPPC), governs these types of exemptions.2
State and local governments continually challenge nonprofit and tax-exempt organizations to increase their revenues. The challenges may come from the Department of Revenue - which decides whether an entity meets the criteria of a purely public charity - or from local counties, cities, municipalities, and school districts that want to increase the real estate and gross receipts tax base by taxing nonprofits as opposed to raising taxes on for-profit businesses and residents.
The intent of the IPPC Act was to eliminate inconsistent application of eligibility standards for charitable tax exemptions, thus reducing confusion and confrontation among traditionally tax-exempt institutions and political subdivisions and ensuring that charitable and public funds are not unnecessarily diverted to litigate eligibility for tax-exempt status. Based on a review of the cases decided and pending in the Pennsylvania court system, it does not appear that this goal has been satisfied over the past 10 years. Challenges continue, so nonprofits and their boards have to be prepared to defend their exemptions. As a CPA, you can assist in this preparation, but you need to be familiar with the IPPC Act.
Under §5 of the IPPC Act, an institution of purely public charity satisfies the following five criteria:
-- Must advance a charitable purpose
-- Must operate entirely free from profit motive
-- Must donate, or render gratuitously, a substantial portion of its services (community service)
-- Must benefit a substantial and indefinite class of persons who are legitimate subjects of charity
-- Must relieve the government of some of its burden (government service)
Tax-exempt and nonprofit organizations need to realize that they do not automatically qualify as a purely public charity because they are organized under the Pennsylvania nonprofit law. They must meet this five-point test and must continually work at maintaining that exemption. Following is a more detailed breakdown of the five points listed above.
Charitable Purpose
An organization must be structured and operate to achieve one of the following purposes:
-- Relief of poverty
-- Advancement and provision of education
-- Advancement of religion
-- Prevention and treatment of disease or injury
-- Aid for government or municipal purposes
-- Provide for any purpose recognized as important and beneficial to the public, and which advances social, moral, or physical objectives
An organization desiring to meet the charitable-purpose test must ensure that it has a well-documented mission and that organizing documents properly lay out its mission and charitable purposes. In addition, the organization should take every opportunity to communicate its exempt purposes to the public, either through its Form 990 or other means.
No Private Profit Motive
The institution must operate entirely free from private profit motive. This test is satisfied if the nonprofit organization meets all of the following requirements:
-- There is no private inurement to private shareholders or other individuals.
-- The institution applies or reserves all of its revenue in excess of expenses to either further its charitable purpose or to fund other institutions that advance a charitable purpose.
-- The institution does not base the compensation of its directors, officers, or employees primarily on financial performance.
-- Articles of incorporation, or other governing documents, prohibit the use of surplus funds for private inurement to any person in the event of the institutions sale or dissolution.
The Department of Revenue and local taxing authorities are challenging charitable organizations in the area of executive compensation. Charitable organizations should ensure that they are not paying excessive compensation, and should annually ensure that salaries and compensation paid to officers, directors, and employees are considered "reasonable." An independent compensation study may be beneficial for nonprofit organizations. If the resources to obtain an independent study are not available, an organization should perform its own reasonableness study by reviewing data of similar associations from the Forms 990 that are open to public inspection.3 Another important practice is to have an independent board of directors, or subsection of the board, annually approve compensation arrangements.
Community Service
An organization will meet this test if it meets one of seven subtests. Six of the seven subtests are quantitative tests, whereby an organization must demonstrate that it is performing enough community service to be granted exemption. The seventh test is for foundation or fundraising organizations, whereby an organization will meet this test if it raises funds on behalf of other purely public charities and contributes a substantial portion of its funds to those other purely public charities.
Organizations should continually collect and document the required statistical and quantitative data, and determine ways to enhance community service activities. The IPPC Act defines "uncompensated goods and services" as all of the benefits provided by the institution to the community, and they are valued as the difference between the full cost of the goods or services and any fees received for such goods or services. Organizations need to demonstrate that they are providing community services in return for the exemptions that they are receiving.
Organizations may also want to consider entering into a voluntary agreement with a local government to make payments-in-lieu-of-taxes payments (PILOT payments). The legislature put many incentives in the IPPC Act for charities that enter into PILOT agreements. In addition to automatically meeting the relief of government burden test, the organization will receive credit toward the community service test, ranging from 150 percent to 350 percent of the amount paid. This is one way to minimize future exemption challenges by paying an agreed-upon amount to the local governments each year.
Benefitting Legitimate Subjects of Charity
Legitimate subjects of charity are defined as those who are unable to provide themselves with what the institution provides for them. Therefore, an organization should clearly document whom it is benefiting, why the beneficiaries are subjects of charity, and why the donations are substantial and indefinite.
Government Service
An organization will meet the relief of a government burden test if it meets one of six subtests. Three of the six are met if an organization provides a service that the government would be required to provide or fund, or that reduces dependence on government programs. Another subtest is met if the organization receives regular payments for services rendered under a government program that are less than the full costs incurred by the organization. Institutions that advance or promote religion, and that are owned and operated by a corporation or other entity as a religious ministry, will meet the government burden test if it meets the other four purely public charity tests.
As discussed previously, organizations can also meet the government burden test by entering into a voluntary agreement with a local government to make PILOT payments.
Conclusion
The IPPC Act also created a provision that allows small businesses to file a complaint with the Secretary of State if they feel a nonprofit is using its tax-exempt status to engage in unfair competition. There have been challenges on this front, so a charitable organization should take measures to ensure that any business it starts or funds should be related to its exempt purposes as described in its organizing documents.
Challenges to tax-exempt status will continue in the future on several fronts, and nonprofits and charities need to ensure they meet the IPPC Act’s tests to overcome these challenges. In addition, organizations seeking exemption from Pennsylvania sales and use tax need to gather this information and provide it to the Pennsylvania Department of Revenue on Form Rev-72. The exemption needs to be renewed every five years, so charities will need to demonstrate that they meet the tests of a purely public charity.
CPAs that either represent or sit on the boards of nonprofits and charities should demonstrate to their organizations the benefit of documenting the IPPC Act’s tests, and clearly communicating their community value to the state and localities in which they operate.
1 10 P.S. §375
2 Exemptions from Pennsylvania corporate net income tax, capital stock tax, and franchise tax are not governed by the IPPC Act. These exemptions are obtained if corporations are tax-exempt organizations under §501 of the IRC or if they are organized as not-for-profit under the laws of the Commonwealth and would qualify as exempt organizations as defined by §501.
3 Forms 990 filed by tax exempt organizations can be viewed at www.guidestar.org.
Jeffrey J. Petrell, CPA, JD, is a partner in the tax services department of Carbis Walker LLP in Pittsburgh. He can be reached at jpetrell@carbis.com.
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