The Charity First Series

ORGANISING AND OPERATINGA US CHARITY

A Guide to US 501(c)(3) Organisations

Kristin Konschnik and Jaime McLemore

The Charity First series aims to provide practical and straightforwardguidance on the challenges confronting charity operations today, withfundraising in the spotlight. Its individual subjects range from thoseconcentrating on the UK and Ireland to non-profit issues in the EU and other jurisdictions, from traditional to digital fundraising and from basichelp for those just entering the third sector to specialist areas for themore experienced. For further information and orders see www.charityfirstseries.org

ORGANISING AND OPERATING A US CHARITY A Guide to US 501(c)(3) Organisations

Kristin Konschnik and Jaime McLemoreWithers LLP

The publication from which this material is taken was first published electronically in 2014 bySocial Partnership Marketing LLP38 Leconfield Road, London N5 2SN

© Withers LLP, London, 2014

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ISBN: 978-1-908595-31-7

Limit of Liability/Disclaimer. While the publisher and author have used their best efforts in preparing this publication, they make no representations or warranties in respect of the accuracy or completeness of the contents of this publication. If legal advice or other expert assistance is required, the services of a competent professional should be sought.

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CONTENTS

Introduction . 5

1Income Tax Deductions . 7

What Contributions are Potentially Deductible?Which Organisations are Permissible Recipients?

Limitations on DeductibilitySubstantiation Requirements

2Recognition of 501(c)(3) Tax-Exempt Status . 11

Form 1023IRS Review

Determination LetterPublic Charity Rulings

Auto-revocation

3Organisation . 16

Type of Entity/Jurisdiction of FormationGoverning Documents RequirementsPrivate Foundation Requirements

4Operations . 19

ContributionsFundraising

Lobbying and influencing legislationExpenditures: activities and grantmaking

Business activitiesCommercial contracts for goods and services

Filing requirementsDissolution and winding up

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5Public Charities . 25Public Charities - Category 1Public Charities – Category 2Public Charities - Category 3

Benefits of Public Charity Status

6Private Foundations . 30

BackgroundDefinition

Excise Taxes

7International Considerations . 35

8Going Forward . 37

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INTRODUCTION

The United States consistently ranks near the top of charitable giving rankings as one of the more generous countries in the world and its potentially large donor base and their diverse range of charitable interests makes it an important fundraising market. Non-US organisations that are considering accessing the US market often know that US charities are formed as ‘Section 501(c)(3)’ organisations. However, they may not know much about the complex sets of rules that govern US charitable organisations at both the US federal and state level.

This booklet sets out the more relevant rules and procedures regarding an organisation’s qualification and maintenance of US charitable status, including its classification as either a public charity or a private foundation. Whether the charitable organisation qualifies as a public charity or a private foundation has a significant impact both on the level of regulation to which the organisation is subject as well as how much of a donor’s contribution is deductible.

This booklet also explains the procedural requirements for obtaining US tax-exempt status, including the US federal law formation and governing document requirements necessary to meet the ‘organisational’ test and how a charitable organisation must conduct its activities to meet the ‘operational’ test. Chapter 4 on Operations also addresses the general compliance requirements applicable to public charities and private foundations.

The rules applicable to the deductibility of contributions for US federal income tax purposes are extremely complex. This booklet sets out the general rules regarding the circumstances under which a donor is entitled to take a US federal income tax deduction for a charitable contribution and the applicable ‘percentage limitations’ that apply to those deductions.

Finally, international considerations are increasingly important and some of the more relevant of these considerations are addressed in Chapter 7, including the use of US ‘Friends of ’ organisations, donor advised funds and ‘dual qualified’ organisations, that may entitle donors subject to multiple tax systems to a deduction in more than one jurisdiction.

The goal of this booklet is to provide a broad overview of the US federal tax system that applies to charitable organisations and to highlight some of the most important considerations. However, of course, all of these rules are subject to potential exceptions and additional nuances. In

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addition, this booklet only addresses US federal income tax (rather than US state or local tax) law and is based on the US Internal Revenue Code of 1986, as amended, and the Regulations promulgated thereunder, as well as IRS rulings and case law, all as in effect as of the date of publication.

Introduction

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1INCOME TAX DEDUCTIONS

Very broadly, US taxpayers are eligible to claim a US federal income tax deduction for contributions to charitable organisations. However, this general rule is subject to limitations on the amount that may be deducted and to restrictions with respect to permissible recipient organisations and the type of property that may be contributed.

What Contributions are Potentially Deductible?A contribution to a permissible recipient organisation (see below) is potentially deductible if it is made voluntarily and the donor intends the contribution to be a gift, but only to the extent that the contribution exceeds the fair market value of any goods and/or services the donor receives in exchange. For example, if a donor attends a charity dinner that costs £100 per person and the charity estimates the value of the dinner is £70 (and notifies the donor of the value), the donor has made a charitable contribution of £30, assuming he intends this additional amount as a gift.

A charitable contribution can be made either in cash or certain types of property. Cash contributions are relatively straightforward and generally individual taxpayers can claim a deduction for the amount contributed on their US federal income tax return for the year in which the amount was paid to the charity (whether in cash or by cheque or credit card), subject to the limitations described below. The payment of a charity’s expenses may also constitute a deductible charitable contribution in some cases.

Property may also be gifted to charity, provided the donor relinquishes ‘dominion and control’ over the property. Examples of property that may be gifted include shares of stock, real estate and tangible personal property (including works of art, books, antiques, cars, etc). Specific restrictions apply to particular types of property such as partial interests in property (a classic example is a conservation easement), which are beyond the scope of this booklet.

Generally, the amount of a charitable contribution is the amount of money or the fair market value of the property donated (assuming no goods or services are received by the donor in exchange). However, the value of a contribution of property that would have generated ordinary income to the donor if sold must be reduced by the amount of any

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ordinary income that would have been recognised (i.e. arising income that is taxable) on a sale, although the donor does not recognise this income in most circumstances. Further, the value of a contribution to most private foundations of appreciated property that would have generated long-term capital gain to the donor if sold generally must be reduced by the amount of any long-term capital gain that would have been recognised on the sale, although again, the donor does not generally recognise this gain.

As described in more detail below, the donor generally must obtain a receipt from the charity setting out the amount of the donation, the value of any goods and/or services the donor received in return, and the portion of the donation that is potentially deductible.

Which Organisations are Permissible Recipients?Subject to very limited exceptions under certain bilateral treaties with other countries (e.g., Mexico, Canada and Israel), a contribution is only deductible for income tax purposes if the donee organisation (i) is formed under the laws of the United States (or a political subdivision thereof), (ii) is organised and operated exclusively for religious, charitable, scientific, literary, or educational purposes, to foster national or international amateur sports competition or for the prevention of cruelty to children or animals, (iii) is not involved in lobbying or advocating for or against any candidate for political office, and (iv) does not benefit any private shareholder or individual. Generally speaking, the organisation must also apply for, and be granted, recognition by the US Internal Revenue Service (‘IRS’), although this is not required for all charitable organisations. Organisations that meet these requirements often are called Section 501(c)(3) organisations.

Generally, contributions to organisations that are formed outside the United States are not deductible by the donors for income tax purposes, even if those organisations have qualified as, or would be treated as, Section 501(c)(3) organisations. However, contributions to qualifying foreign organisations are deductible for gift and estate tax purposes. This general rule for income tax deductions also denies deductibility to any contributions made to a US organisation that were ‘earmarked’ for a non-US organisation; however, a US organisation may apply funds it receives outside the United States if it exercises sufficient ‘discretion and control’ over those funds. Contributions to organisations also are not deductible if the organisation has discriminatory policies or engages in certain types of activities (e.g. terrorist activities or attempting to influence legislation).

1. Income Tax Deductions

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Limitations on Deductibility In addition to the restrictions set out above, a donor may only deduct charitable contributions to the extent that those contributions do not exceed a specified percentage of his ‘adjusted gross income’ (broadly, gross income from all sources less certain allowable deductions). There are three applicable percentage limitations: a 50% limitation, a 30% limitation and a 20% limitation.

Deductions for contributions to public charities (see Chapter 5) and certain types of private foundations (including private operating foundations, discussed in more detail in Chapter 6) are limited to 50% of the donor’s adjusted gross income for the year of the contribution.

The deduction for a contribution to a private foundation is limited to 30% of the donor’s adjusted gross income for the year of the contribution. The deduction for a contribution of ‘capital gain property’ (i.e. property that would generate capital gain if sold by the donor) to a public charity also is limited to 30% of the donor’s adjusted gross income if the donor elects to deduct the fair market value of the property; if the donor chooses to deduct the base cost (rather than fair market value) of the property, the limitation is raised to 50% of the donor’s adjusted gross income. Finally, the deduction for a contribution of appreciated property to a private foundation is limited to 20% of the donor’s adjusted gross income.

These limitations are subject to priority ordering: 50% limitation deductions are counted first, 30% limitation deductions second, and 20% limitation deductions last. To the extent a donor does not fully utilise his available 50% limitation, the 30% limitation may be used, and then the 20% limitation. The ordering of charitable contributions can be very complicated for donors who make cash and non-cash contributions to public charities and private foundations. For more information on ordering contributions by priority, including example calculations, please see IRS Publication 526 (http://www.irs.gov/pub/irs-pdf/p526.pdf), specifically the section entitled ‘Limits on Deductions’. Very broadly, the maximum a donor can contribute in any taxable year is 50% of his adjusted gross income.

However, if a donor makes a charitable contribution in a taxable year that exceeds the applicable limitation, he generally can carry any excess charitable contribution forward and deduct it in the 5 taxable years immediately succeeding the year in which he made the donation (subject to the same limitations).

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1. Income Tax Deductions

About The Authors

Kristin KonschnikKristin is a US tax lawyer based in Withers LLP’s London office. She practices in the US tax exempt organisation area with a particular focus on cross-border charitable giving, including the establishment of US ‘friends of ’ organisations and ‘dual qualified’ charity structures to enable tax-efficient giving in multiple jurisdictions. Kristin advises on a range of US charitable matters, including initial qualification as a Section 501(c)(3) US tax-exempt organisation and ongoing compliance requirements and charitable operations and advises individual clients on the formation and operation of philanthropic vehicles. In addition to her work with charitable organisations, Kristin advises companies and individuals on US and international transactional tax matters, including cross-border sales and acquisitions, hedge and private equity fund structures and tax-efficient US inbound and outbound business and investment structures. She represents clients before the US Internal Revenue Service in a variety of matters, manages Withers’ voluntary disclosure practice in London and advises clients on the Foreign Account Tax Compliance Act. She also speaks and writes regularly on a variety of US tax topics, including taxation of US charitable organisations. Jaime McLemoreJaime McLemore is a US qualified Associate at Withers LLP on the US Wealth Planning team in London and advises on a wide range US tax issues, including charitable giving and structuring. Jaime specialises in advising individuals with regard to both lifetime and legacy charitable gifts as well as advising US and non-US non-profit organisations with regard to US tax and compliance matters. Jaime also advises more generally on US estate planning and trust structuring for private clients. Jaime recently co-authored an article about the impact of the Foreign Account Tax Compliance Act on non-US charities.

The Charity First Series

For the full list of titles in the Charity First Series, including titles in preparation, see our publications list.

Titles already published include: Academy Schools – from Conversion to Successful OperationData Protection for FundraisersFundraising for Small Charities Legacy Fundraising from Scratch Major Gift Fundraising Prospect Research Raising Funds from Grant Makers Structuring Not-for-Profit Operations in the UK The Gift Aid Guide

Also published by Social Partnership Marketing Invisible Grantmakers - an annual listing of unpublished grantmaking trusts. See www.socialpartnershipmarketing.co.uk for further details.

Full version ISBN: 978-1-908595-31-7