The Tax Issues Facing Tax-Exempt Organizations

In the latest episode of Tax Notes Talk, David Thompson of the National Council of Nonprofits talks about how tax policy affects tax-exempt organizations and tax issues on the nonprofit industry’s radar today. 

The post has been edited for length and clarity.

Fred Stokeld: I’m here today talking with David Thompson, vice president of public policy at the National Council of Nonprofits.

David Thompson: Hi, Fred. Thanks for having me.

Fred Stokeld: My pleasure. In general, nonprofits are tax-exempt organizations. Why does the National Council of Nonprofits care so much about tax policy?

David Thompson: I heard that on a webinar just yesterday of nonprofit people saying, “Well, we’re tax- exempt. Why are we talking tax?” Charitable nonprofits are affected by tax policy at all levels and branches of government.

Let me give you some examples. At the local level, all the property owned by charitable nonprofits used for that purpose is exempt from property taxes throughout the country. But a lot of city council members don’t get that memo and then try to tax the property owned by charitable nonprofits or try to impose fees that are actually taxes, or demand “voluntary payments in lieu of taxes.” Pennsylvania alone has 5,000 jurisdictions, so you could see that that’s a big issue across the country or can be.

Every state every year is tinkering with its tax laws. Tax exemptions are not immune from that annual tinkering. States are regularly looking at expanding or increasing the exemption for income tax, property tax, sales and use taxes, as well as dealing with the unemployment taxes that nonprofits pay. That’s at the state level.

At the federal level each branch of government is active every day in the tax policy world relating to tax-exempt nonprofits. We recently filed an amicus brief in the U.S. Supreme Court dealing with the big case involving the Schedule B contributors that the attorney general of California is requiring charitable nonprofits to file. That’s the judicial branch.

In the executive branch, we’re regularly involved in filing public comments with the IRS on things like regulations on the unrelated business income tax for silos, which was a big deal from the 2017 tax law. 

And then legislatively, last year was a very big and active year for charitable nonprofits, particularly with the refundable payroll tax credit. That’s something that benefits everyone, but it was invented to help charitable nonprofits. We don’t pay income tax, so an income tax credit doesn’t do us any good. We do pay payroll taxes. Congress created the refundable payroll tax credit to help nonprofits and everyone else. 

Fred Stokeld: Let’s talk about the COVID-19 pandemic. How has the pandemic affected nonprofits in the past year?

David Thompson: I’d say the pandemic has affected nonprofits exactly like every for-profit business and worse. It sounds flippant, but the reality is charitable nonprofits were forced to shut down just like restaurants and performance venues. But nonprofits still have their mission to continue. Children still needed to be fed. Homeless people still needed to be found and brought to shelters. Shelters needed to be run. Nonprofits had to keep operating. They couldn’t hunker down, hibernate, and wait out the pandemic, so our costs went up.

Here’s a classic example. The food bank of Los Angeles used to operate with 120 volunteers. Those volunteers, who were mostly older people, could not come to work anymore. The food bank had to hire 120 people. It was unemployed people who got jobs, which is a good thing, but the cost went up exponentially. Donations probably went up, but probably not enough to cover those 120 employees plus all the other expenses like personal protective equipment. Nonprofits had to continue operating and undergo increased costs, but at the same time, donations never kept up.

Fred Stokeld: Has Congress passed any tax policies during the past year to help charities and other nonprofits cope with the economic difficulties caused by the pandemic? 

David Thompson: Absolutely. I’m going to say it again: The refundable payroll tax credit. I hear the angels singing whenever that phrase is uttered. Both the Families First Act and the [Coronavirus Aid, Relief, and Economic Security] Act extended it in the year-end COVID-19 bill. Each includes some form of improvement on the refundable payroll tax credit. That’s a good thing. That was important.

Also unemployment insurance. That’s a tax policy issue because it’s usually run through state tax bureaus and so forth. That matters because there’s usually an unemployment tax on employers at the federal level. Congress created both a funding system through Treasury and the Department of Labor to help employers make sure they weren’t having to pay the increased costs for unemployment at least for last year.

They covered it for a group called reimbursing employers — those who opt out of the state system, but still have to pay the cost. Charitable nonprofits, local governments, and tribal governments can opt out. It’s a tax issue in that the federal government covered part of those costs. But those entities — it’s nonprofits that I’m concerned about — had to pay tremendous amounts of money. Congress helped, but not enough.

The very good news is that nonprofits were top of mind throughout the process. We didn’t get everything we wanted and we’re still pushing for more, but those are some of the tax issues that helped nonprofits continue operating.

Fred Stokeld: Turning to the states, the American Rescue Plan Act [(P.L. 117-2)] prohibits state and local governments from using COVID-19 relief funds provided by the act for tax relief. Now more than 20 states are speaking out against the prohibition, and Ohio has filed a lawsuit to overturn the ban. David, what is your take on this?

David Thompson: My take is twofold. This is the $350 billion provided to the states and local governments through the American Rescue Plan Act. The statute expressly says that state and local governments can use this money to spend with nonprofits through grants, unemployment, and a variety of programs. That’s the good news. We were thrilled with that part of the statute.

The guardrail was the provision that says states cannot use this money for tax cuts. In most cases, it is being litigated. I think there are 16 states litigating this issue and 20 states raising objections. Treasury Secretary Janet Yellen said at some point the Treasury Department will be issuing guidance to narrow the areas of challenge. For nonprofits, a very big and outstanding question is: Can the states use this money to pay down the debt they owe on unemployment insurance? The debt they owe to the Treasury Department?

Lots of states have hundreds of millions of dollars in debt to the Labor Department. Can they pay that down? One would hope. But what if they put the money to plus-up their trust fund so there was no longer a deficit in the state unemployment trust fund? Most states have an automatic tax hike when the trust fund goes below a certain amount. If they use the money to fill up and remove the deficit in the trust fund, that will defer or eliminate a tax hike, which might trigger the law.

We’ve asked the people who literally wrote the language of the bill: Does it apply? Nobody knows the answer yet. That’s a huge issue because nonprofits that contribute to the unemployment system are on the hook. They’re waiting to know whether they’re going to have to pay 50 percent increase in their unemployment tax, or even 100 percent, which Massachusetts is threatening.

This is a major issue. We hope it’s resolved cleanly because I don’t think anyone wants to hurt employers, but it’s an issue that’s out there that’s causing consternation.

Fred Stokeld: A number of states are considering legislation to limit the nonprofit property tax exemptions by imposing fees or payments in lieu of taxes. I understand this is not something the nonprofit sector supports. In your opinion, why would states want to go this route? And what are the National Council of Nonprofits and other nonprofit representatives doing in response?

David Thompson: States are always tinkering with their tax laws and it’s also local governments as well if they can. Why would they do it? For two reasons. They see nonprofits as a pot of money. The whole point of tax policy is to find pots of money and tax it. We don’t take that personally.

We do take personally that there’s the reality that charitable nonprofits do not engage in partisan election-related activities. We don’t run candidates against people who pass bad laws. We can’t do it. We think that’s the way the law should be. Sometimes they think of nonprofits as an easy mark, that they can go after nonprofits because they can’t fight back. 

We’ve seen this in Connecticut regularly that politicians target the salaries of executives. If they pay a salary over a certain amount, they will try to curb the property tax exemption. We’ve seen it in Montana, Nebraska, Nevada, and elsewhere around the country. It’s a bit of a populist angle. 

I should add it’s not just legislative. It’s also tax auditors and tax officials who run for elections. They see it as finding new money so that they don’t have to raise property taxes on residences. It’s politics. What we’re doing is highlighting that the reason nonprofits are exempt from property taxes is because we provide more to the community than the taxes ever would.

Our argument when a state or local government official says, “We have a budget hole so we need your money,” our answer is always, “Your budget hole is smaller already because of the nonprofits in the community.” Nonprofits always provide the greater benefit than the tax exemption itself. We demonstrate that nonprofits contribute more to the community and that we earn our tax-exempt status every day. 

The negative part of the message is we were here before you were elected, and we’ll be here after you’re elected, so you should listen to us instead of trying to bash us. The positive side is we know the problems in the community. Instead of taxing nonprofits and then building a community pool, why don’t you work with us to build a community pool together? For every challenge in a community, nonprofits are probably already on the ground working on it and working through it.

Fred Stokeld: Looking ahead, what federal and state tax policies would you like to see passed to help charities and other nonprofits cope with the pandemic and other challenges?

David Thompson: As I’ve said, we really like the employee retention credit and we like the improvements to it. Congress has already stepped up at the end of 2020 and this year. That’s good news there. Additional things we need is unemployment relief and charitable giving incentives.

The 2017 tax law doubled the standard deduction. That was done not to smite nonprofits, but to reduce the burden of tax preparation. That made perfect sense. An unintended consequence was that the number of people who itemize shrank from 30 percent of taxpayers down to 10 percent. That means that only 10 percent of federal taxpayers get an incentive for giving to charitable nonprofits. If you don’t itemize, you don’t get an incentive. 

There are other things that Congress can be doing. A few years ago, Congress made permanent the IRA charitable rollover. That was a very good benefit for those ages 701/2 and over. It allowed them to roll money over from their IRA to charitable nonprofits without it suffering a tax consequence. There are lots of ideas for improving that, such as rolling it over into charitable remainder trusts to generate some income, or to lower the age and expand who can take advantage of that incentive.

There are lots of other incentives. But the universal charitable deduction is probably the big kahuna among the tax policy issues.

Fred Stokeld: The universal charitable deduction is when it makes the deduction available to non-itemizers. Do you think the economic downturn caused by the pandemic will improve the chances of enacting legislation to enhance the charitable deduction for non-itemizers?

David Thompson: No one has an accurate crystal ball anymore. The pandemic has changed everything. The fascinating news about the universal charitable deduction is that the support for it is genuinely bipartisan. In the Senate, there’s a bill introduced called the Universal Giving Pandemic Response and Recovery Act. I know how we tax people love nicknames, so it’s the UGPRRA.

UGPRRA has tremendous bipartisan support from across the political spectrum. Sen. Catherine Cortez Masto, D-Nev., Sen. James Lankford, R-Okla., Sen. Mike Lee, R-Utah, as well as Sen. Chris Coons, D-Conn., and Sen. Amy Klobuchar, D-Minn. are people from all over the political spectrum who support expanding charitable giving for nonprofits. Right now if we go with a budget reconciliation approach where it’s only Democrats this time, I don’t know if that helps or hurts. We just don’t know.

The good news is that support for the universal charitable deduction is improving. It’s consistently improved since 2017. Before the 2017 tax law that doubled the standard deduction there was bipartisan support for a universal deduction of some form. That’s continued to grow through the Congress after the 2017 tax law.

In mid-March the bills advocating that were reintroduced. The current and most popular version would provide the universal charitable deduction of a third of the standard deduction, so about $4,000 for an individual and $8,000 for a couple.

This is building on the progress of the universal charitable deduction that was enacted in the CARES Act. You will recall the CARES Act in 2020 created a $300 deduction. The first $300 that someone donated they could take off on their taxes even though they take the standard deduction. That was only good for 2020.

The end-of-the-year tax law said that for 2021, it’s $300 for an individual or $600 for a couple. We’re making progress. Can we jump up to $4,000 for 2022? I don’t know yet, but we’re working on it.

The good news from the nonprofit perspective is that everybody in the nonprofit community supports this. Every charitable nonprofit will accept charitable donations. Some rely on them more than others, but across the breadth of the nonprofit community, this is a popular proposal.

We’ve relearned the lesson that grassroots really matters. Associations and nonprofits across the country are heavily engaged in promoting this. They’re doing Zoom calls with senators and representatives, and this is always the number one issue. I’d say in a regular year maybe not. This year it could generally happen. Now we may need for bipartisanship to break out, which we haven’t seen in a while, but it could happen.

Fred Stokeld: Let’s switch gears a bit. In January the National Council of Nonprofits asked the IRS to replace Form 1023-EZ with an exemption application that would seek more information from applicants and thereby stop undeserving organizations from obtaining tax-exempt status. Have you received a response from the IRS?

David Thompson: We have not. To sum up the Form 1023 in one word I’d say an abomination. Historically the IRS relied on the Form 1023 for applications for tax-exempt status. It’s a 10-page form. It was an endurance contest. It was painful, but by the time an individual or a group of people completed the 1023, they knew how to run a nonprofit. They knew what the rules are and what was expected of them. They had had to do their due diligence and learn how to be a contributing member of the nonprofit society.

We had the scandal involving the IRS that they allegedly were targeting conservative groups using the 1023-EZ to weed out conservative applicants. The fact didn’t quite live up to the myth, but that created a problem. The IRS needed to deal with a backlog of applicants. The Citizens United case in 2010 opened the floodgates to money in politics and people quickly discovered that they can give money through a noncharitable nonprofit like a 501c(4) social welfare organization and still do politics and keep donors secret. 

The IRS discovered they had to do something so they came up with a short form. Most of us think the short form for smaller organizations is a decent idea, but they went way too far. In the old days of baseball, you had to have an actual ticket to get into the Washington Nationals stadium. Now you can just wave a piece of paper the right color and get through the ticket gates. It’s the same here. You can be a legitimate, honorable nonprofit, or you can be a bunch of bad actors if the IRS didn’t catch you at the gate. That’s important because public trust is important.

This is not just me saying bad actors came in. The taxpayer advocate has regularly said that people not eligible for tax-exempt status organizations were getting through the system. Based on their audits, it ranged from 26 percent to 46 percent. Nearly half of the applicants they studied and audited did not qualify for tax-exempt status and the IRS should not have approved them.

That’s a serious problem for the charitable nonprofit community. It’s a problem for state law enforcement as well. We all know IRS has mostly abdicated its enforcement of the tax-exempt field. They’re not going after bad actors nearly enough. That means that the state law enforcement officials, the attorneys general of the state, and charities officials have it as their job to weed out the bad actors. That puts more burdens on them.

By bad actors, we mean charitable nonprofits that are created to promote private inurement. And for those with donors to dictate that their nieces and nephews get scholarships to various colleges, or use the money to engage in partisan election-related activities, or other things that are taboo and should not be allowed.

These bad actors are engaging in politics. They’re pushing their political will and they’re getting a tax deduction for it. That’s all wrong. We strongly support more money for the IRS to enforce the law of tax-exempt and government entities. We need state government to have the tools they need to enforce the law. It’s important because if the public doesn’t trust charitable nonprofits, they’re not going to donate their time and money.

Regularly we see local newspapers using the phrase “political nonprofits.” Those aren’t charitable nonprofits. Those are 501(c)(4)s, 501(c)(5)s, chambers of commerce, and so forth. When the public thinks of political nonprofits, they think disgust. They don’t want anything to do with us. We, the National Council of Nonprofits and all charitable nonprofits, have to be vigilant to set the record straight, and we need law enforcement to help in that.

Fred Stokeld: Finally, another thing we’re keeping an eye on is that the U.S. Supreme Court will hear arguments on whether states can require charities to disclose the identities of their donors to straight regulators on the IRS Form 990 Schedule B. Where do you stand on this issue? Where does the National Council of Nonprofits stand on the issue? And what do you expect to see from oral arguments?

David Thompson: The National Council of Nonprofits is in the controversial and unenviable position of being in the middle in the center of the firing squad. Eighty amicus briefs have been filed in this case. We filed one of them. There are plenty who were saying the freedom of assembly of donors is sacred. That’s never been ruled on by the U.S. Supreme Court. We see law enforcement saying that their rights and powers should be unfettered. They probably overstate that as well.

Our position is public disclosure of donors is a bridge too far. We and all charitable nonprofits are adamantly opposed to public disclosure of donors. But there’s a lot of confusion on that. Lots of the briefs that we’ve read keep talking about public disclosure of donors, which is not an issue before the court. It’s a red herring that’s used to scare people.

The actual issue before the court is: Can the attorney general require disclosure on a confidential nonpublic basis of the schedule B schedule of contributors? This is the exact same form that the IRS demands. The burden on a nonprofit to file it at the state level is to create a PDF and attach it to whatever private, confidential disclosure they make to the state government.

Our view is that law enforcement is a critical partner of nonprofits in preserving public trust. As long as there’s no shenanigans, there’s no tracking down looking up who the donors are and then exerting political pressure against them. This should absolutely be allowed because law enforcement needs the tools. We see it also as a deterrent by requiring the Schedule B — and let me reiterate the federal government and the IRS are not adequately enforcing the law, but the states are.

The states have a preexisting duty back to common law before there was a republic. Attorneys general had the duty to enforce the law, to create and enforce the law governing trusts, which is what charitable nonprofits are. The states have their own authority and we need them to be weeding out the bad actors.

The filing of requirement of the Schedule B is a flag. It’s a deterrent. If you know that it’s being filed with the state regulators, you’re less likely to engage in shenanigans. You’re less likely to go into that state and do bad acts. We see it as a deterrent. We don’t think it’s unfettered, but as long as it’s confidential and protected information that only law enforcement people can use for law enforcement purposes, it’s not an issue of donor privacy or donor rights. It’s an issue of law enforcement because the purpose of the law isn’t to create tax breaks for donors.

The purpose of charitable nonprofits is to advance their mission. Tax law supports the ability of nonprofits to advance their mission, and they can’t do it without public trust. If it supports public trust, we’re for it. If it violates public trust, we’re going to get engaged on behalf of the charitable community against all-comers trying to tarnish the community.

Fred Stokeld: Well, David, this has been a very good discussion and I appreciate your time. Before we wrap up, is there any final thoughts you’d like to share?

David Thompson: Charitable nonprofits are engaged in their communities at all levels. We need the support of the legal profession to keep an eye out and to identify opportunities. We need government officials and the readers of Tax Notes to know that nonprofits are problem solvers in the communities and that the vast majority are engaged in problem-solving. 

One final point is the vast majority of charitable nonprofits are small. Eighty-eight percent have budgets of $500 million. Ninety-two percent have budgets of $1 million or revenues of $1 million or less. People think of a hospital or a national name brand nonprofit, but most of the work of nonprofits occurs in communities by smaller organizations. Policy ideas that are thrown out may be targeting a big nonprofit, but the impact can be devastating to the smaller nonprofits. The point is don’t do it. The point is reach out to nonprofits. We engage with government. We engage with the for-profit community every day, and we’re all about problem-solving. Give us a call.

Fred Stokeld: David, it has been a pleasure talking with you today. Thank you very much for your time.

David Thompson: Hey Fred, thank you. And thank you for all the articles you write. This is very helpful to all of us.