In the wake of the scandal, former IRS officials and staffers of that office have come forward to complain that the management of the office has been so bad that it can only be described as “dysfunctional.” On May 14, 2013, the Treasury Inspector General for Tax Administration issued an audit report that concluded the agency’s management was ineffective. It cited long delays in processing even routine applications, inappropriate and arbitrary questions asked of applicants – (often after more than a year after the applications were filed), and the appearance of targeting applicants based on their political stance. It also appeared no one was in charge.

Even the “friends” of the agency pointed to several other problems.  There has been poor oversight and communication between the agency’s management, located in Washington, D.C. and  the line staff in Cincinnati. In addition, the internal review board that the Washington staff set up in the Cincinnati office never worked properly. Staffers had virtually no training, were given vague or incorrect advice from their managers, and left to their own devices. Mistakes by IRS management (see my post Delays at the IRS. What’s Going On?) added more than 100,000 applications to the staff’s normal workload of 60,000 applications per year, creating a huge logjam. Despite a steady stream of complaints from practitioners, no one took steps to fix the problems. In fact, things just kept getting worse.

None of this is new to practitioners — except perhaps the targeting of Tea Party applications. We’ve been putting up with a slew of ridiculous questions from the EO examiners for several years now. We’ve often had to explain the basics of nonprofit law to them. It is normal to have two applications with almost identical facts treated differently. We’ve seen our questions (and answers) disappear into the IRS juggernaut, with no results – sometimes for years. We have been complaining about a lack of guidance, a lack of consistency, the extraordinary delays in processing applications and the dysfunction of the office for a long time. Our clients have been screaming, and with justification. Finally, we have a spotlight shining on these issues. The real question is: will it do any good? Perhaps, eventually, it will. But in the short term, you can expect things to get worse.

So if you are applying for tax-exempt status and need to operate and raise funds while your application is pending, you will likely need to consider a fiscal sponsorship or donor-advised fund. These are well-known arrangements that can be put in place without too much trouble. But in the meantime, it seems, no good deed goes unpunished!

Recently, several states introduced new corporate forms, namely L3Cs, Benefit Corporations, and Flexible Purpose Corporations, each of which closely resembles a traditional for-profit entity, but is designed to legally allow for the pursuit of both social mission and profit-making. Social entrepreneurs are also increasingly creating joint venture arrangements between nonprofit and for-profit entities (see Allen Bromberger’s article A New Type of Hybrid ) which allows them to combine the best attributes of each type of entity.

Given the wide range of options and the impact that an entity’s legal structure will have on what it can legally do, it is crucial that key decisions regarding the entity’s goals, purposes, funding, management and operations be made before any decision is made as to legal structure. Ideally, incorporation should occur after you have completed your initial planning stage, but well before you need to have a legal entity capable of taking corporate action, such as opening a bank account, accepting a loan, or entering into a contract.

During the planning stage, analyze your business plan and determine your specific strategic imperatives—the things your enterprise needs to do to succeed. You should know where the initial and ongoing funding will come from. If you intend to rely on earned revenue for the bulk of your funding, a nonprofit organization may not be the right choice—even if you intend to put all of your profits back into the entity to increase your social impact—due to the restrictions on commercial activity. Nonprofits have the advantage of being able to accept tax-deductible donations from individuals, corporations, and foundations, and they can also raise capital through loans, but they cannot accept certain other types of funding, such as equity investments. If you are considering a for-profit or joint venture, be sure to discuss your legal structure with potential investors, as your investors may be restricted from investing in certain kinds of entities, due to the tax consequences or for other reasons.

You must also decide who will manage the entity and, in the case of a for-profit, the ownership structure. Develop a clear business plan that articulates your goals for creating social impact and achieving profitability, the steps you must take to accomplish these goals, and how you will know when you have succeeded. If you plan to start a nonprofit organization, make sure you have a clearly-defined charitable purpose, and that your entity is likely to qualify for tax-exempt status. However, at the moment, the IRS can take up to a year or more to process your application for tax-exempt status, so make sure you are absolutely certain that creating a nonprofit is the best way to accomplish your goals.  (See Allen Bromberger’s blog post Delays at the IRS.)

Once you have made these key decisions, a lawyer can help you select the best structure for your entity. The process to incorporate a legal entity is relatively straightforward—your lawyer will draft  Articles of Incorporation and file them with the Secretary of State. If you incorporate in a state other than your home state, you may need to file additional paperwork to qualify to do business in your home state. Depending on the state, this process can take anywhere from a few days to several weeks, so be sure to allow ample time.

The list of questions below is a guide to help ensure you’ve answered all the key questions during the planning process.

1. Who are the founders?
2. What is your social mission?
3. What problem are you trying to solve?
4. What impact do you want to have?
5. What is your business plan and how will it address the problem you are trying solve?
6. Is your organization likely to qualify for tax-exempt status?
7. Where will you get your initial and ongoing funding?
8. Who are your funders/investors/shareholders?
9. Who are your beneficiaries/customers/stakeholders?
10. Who will control and manage the organization?
11. What are your personal and financial goals in starting this organization?
12. How long do you intend the organization to exist and what are your goals for the end of its existence?

The answers to these questions will help you and your lawyer determine which structure is right for your organization. Taking the time to answer them before you incorporate will save you hours of time and hassle once your organization is up and running.

The following steps can be taken to confirm if your organization is in compliance with its Form 990 filing obligations:

1. Have your organization’s date of incorporation, fiscal year, and Employer Identification Number (EIN) on hand.
2. Determine your organization’s annual IRS Form 990 filing deadline (e.g., calendar year organizations have a May 15 filing deadline).
3. Go to the Exempt Organizations Select Check Tool on the IRS website, and see if your organization is still eligible to receive tax-deductible contributions or if has been revoked;
4. If your organization has not been revoked, you should still check to make sure that the Form 990 (or Form 990-EZ or Form 990-N) was filed with the IRS during each of the last three (3) years.
   1. The Exempt Organizations Select Check Tool allows you to confirm if a 990-N was submitted.  The 990-N e-postcard may only be filed by organizations whose annual gross receipts are normally $50,000 or less.
   2. To confirm if a 990-EZ, 990, or 990-PF has been filed by the organization in the last three (3) years, go to Guidestar.org and search for your organization by name.
5. Make sure your organization files the Form 990 (or Form 990-EZ, 990-PF, or 990-N) every year.  The annual filing deadline is four and a half (4 ½) months after the end of your fiscal year (although extensions can be requested).
6. Be aware that your obligation to file Form 990s with the IRS arises from the organization’s date of incorporation, not the date of the IRS’s notification confirming your tax-exempt status.  For example, if your organization was incorporated in 2010 and uses a calendar fiscal year, a Form 990 should be filed with the IRS by May 15th of 2011, 2012, and 2013. The requirement to file a Form 990 by May 15, 2011 covering activities in 2010 would apply even if your organization did not receive IRS confirmation of its tax-exempt status until 2011 or even 2012.

If you have any concerns about your organization’s federal tax-exempt status, contact your organization’s accountant regarding your Form 990 filings.

In reviewing the tax returns of a selected number of colleges and universities, the IRS focused on how NPOs report their business activities, including “the characterization of activities as exempt or unrelated, the methodology for allocating expenses, the significance of recurring losses on specific activities, the calculation of net operating losses (NOLs) and the application of exceptions and modifications.”

As a result of the examination, the IRS determined that 90% of the colleges and universities reported would have increased Unrelated Business Income Tax (UBIT) liability. The reasons for the increases in the UBIT included:

(a) Disallowance of certain net operating losses (NOLs) that the IRS determined were not incurred in connection with a trade or business.  The disallowance of the NOLs to offset taxable income from other activities subject to UBIT resulted in higher tax liabilities.

(b) The incorrect allocation of expenses by NPOs of expenses as between exempt and unrelated purposes.  Only expenses allocable to unrelated activities can be used to offset income from unrelated activities to determine UBIT.

(c) Improper or miscalculated NOLs.

(d) Misclassification of activities unrelated to the NPO’s exempt purpose (thus subject to UBIT) as activities unrelated to the NPO’s exempt purpose (thus excluded from UBIT).

(e) Many NPOs did not seek or obtain professional advice on the proper classification or treatment of unrelated activities.

While the area of UBIT is a technical and complicated area of tax law, a surprising number (only 57%) of colleges and universities reported that they had their tax returns reviewed by independent accountants before they were filed with the IRS.

The IRS’s Final Report should be required reading for leaders of all colleges and universities, as well as other tax-exempt organizations, as it provides clear insight into the areas that the IRS will likely target in the future.  Expenses must be accurately allocated, and NOLs must bear the requisite relationship to the activity giving rise to unrelated business income.  Determining an organization’s UBIT liability is often not a simple task, and therefore organizations should consult with accountants and legal counsel to assist in these determinations.    Adequate time should be allowed for such consultations when organizations are completing Forms 990 and 990-T.