Protect Tax-Exempt Status with Sound Practices

If your agency is tax exempt, you enjoy a number of advantages that arise from your good standing in the community. Let’s count the number of preferential tax treatments.

You may be aware already that these traditional benefits are being eroded. Perhaps you have been asked to pay a “voluntary” contribution toward municipal services in lieu of property tax. Perhaps your reduced-price water service has been eliminated. You may have heard that a local hospital or nursing home’s property tax exemption has been revoked.

In some states, laws have been passed that require exempt entities to provide charity care at least equal in value either to the organization’s state and local tax subsidies, or a percentage of their net revenue.¹ Others are pending.²

In my home state of Illinois, several large nonprofits have lost their property tax exemptions in the past few years, which has sent shock waves through the legal community that serves exempt clients.³ We are scrambling to help our clients re-interpret their traditional missions, charitable programs, funding streams and payment policies. Some of the lessons learned can help you tighten your practices and inoculate your agencies from losses such as these.

A Brief History

If your organization existed at the beginning of the last century, most of its funding would have come from churches, civic organizations, and individuals. State programs were modest, at best. Federal funding was unheard of until the 1930s. For this reason, state and local governments eased the charity’s financial burden by exempting them from paying sales and property taxes.

In the last half of the 20th century, beginning with programs such as Medicaid and Aid to Dependent Children, the federal government entered the arena. Federal programs have evolved over time, as have state and local programs that wrap around them. Most of you are adept at capturing government funds, and many of you tap into private insurance dollars as well. The net result is that many of you are now funded (sometimes almost entirely) by contracted funds, both public and private, and your reliance on private philanthropy has greatly diminished.

Unfortunately, many of you take it for granted that sales tax and property exemptions granted long ago—when every dollar spent was a dollar that had been donated— will continue into the future. They may not.

States that are struggling with increased legal responsibilities and fewer funds are now looking at property and sales tax exemptions, and asking themselves whether the benefit to the communities you serve is equal to the exemptions they have bestowed upon you.

In other words, you need to be able to prove, at any time, that the value of your programs to the community equals or exceeds the value of your tax exemptions. How can you do this?

Criteria for Exemptions

Relieving a Burden of Government. When I am seeking an exemption for any sort of public welfare organization, the criterion that I focus on is known as “relieving a burden of government.”

Typically we demonstrate in our application that, without the presence of this organization, the government would have to provide the care directly that its intend- ed beneficiaries need.⁴

Most of you can demonstrate easily that your programs and services are equivalent in every way to those that your state, county, or local welfare departments provide.

Your contractual arrangements with these government agencies are proof that the services they purchase from you are services that they are legally obligated to provide and would provide if you were not there to do it for them.

Removing Barriers to Service. private philanthropy allows you to remove additional barriers to your programs and services, you can build a stronger case for being a true charity and further separate your organization from those that are merely commercial contractors.

To be on the safe side, I suggest that you make it clear that providing charitable subsidies to ensure access is an established policy of your organization. When I draft bylaws for my service clients, I routinely insert a provision that confirms a policy of waiving fees where the client cannot afford to pay. Please note that the offer of charity care is not wide open, but is based upon the organization’s financial ability to provide it. (See the sidebar for suggested language.)

If you do not have an active fundraising program, I suggest that you seriously consider putting one together. (Contact Pat Heinz, Alliance director of resource development, at 202-429- 0400, ext. 17, to learn more about the Alliance’s Resource Development Services program.)

Providing In-Kind Services. One way exempt organizations stand out is by providing valuable services by unpaid volunteers. Documenting in-kind donated services on your financial statements offers you the opportunity to demonstrate charity in a way that is often overlooked by your accounting firms.

Nonprofit GAAP (Generally Accepted Accounting Principles)—specifically, FASB 116⁵—provides the means to recognize certain types of contributed services. Specifically, this applies where the services rendered require specialized skills, are provided by individuals possessing those skills, and would typically need to be purchased if not provided by way of contribution.

The value of the in-kind donation is expressed as income during the period the services were provided, and an equal amount is recorded as an expenditure during that same period. The amount of in-kind services can often be stunning to those who have never taken the trouble to tabulate them in the past. The value of in-kind services can be many thousands, if not millions of dollars.⁶

If you have volunteers who provide specialized services such as reading enrichment, foster care respite, etc., be sure to document the time involved and the monetary value of that service.

Remember Your Exempt Roots. If you are a tax exempt charity, it means that, once upon a time, you successfully demonstrated to the Internal Revenue Service that you met two important tests.

First, that you are organized as an exempt entity. Second, that you are operated as an exempt entity. The organizational test is satisfied by a review of corporate documents— your articles of incorporation and bylaws, and your conflict-of-interest policies. The operational test is satisfied by a review of your day-to-day operations.

In this changing fiscal environment, in order to continue to qualify for property and sales tax exemptions, you must return to your exempt roots. It really is as simple as that.

ENDNOTES

1. Texas requires nonprofit hospitals to spend at least four cents of every dollar of net revenue on charity care and another penny in some way that benefits the community. In calculating that amount, hospitals can include charity care as well as short falls from reimbursements on government programs such as Medicaid. The law is controversial. See “Are hospitals doing enough charity care?” Fort Worth (Texas) Star-Telegram, July 30, 2006.

2. In Illinois, the attorney general proposed the Tax Exempt Hospital Responsibility Act, that mandates Illinois tax-exempt, nonprofit hospitals to provide charity care in an amount equal to eight percent of the hospital’s total annual operating costs (as reported each year in the hospital’s most recently settled Medicare cost report).

3. In Illinois, a hospital lost its property tax exemption when the Illinois Department of Revenue concluded that waived billings constituted only .723 percent of its annual revenues. The administrative judge noted that the charity care “is so seriously insufficient that it simply cannot withstand the constitutional scrutiny required to justify a property tax exemption.” It also cited overly aggressive attempts to collect money from poor and uninsured patients.

4. Relevant factors look to such questions as whether the activity is an integral part of a larger governmental program, or is acted jointly with a governmental unit, and the amount of government funding involved. “IRS Exempt Organizations Determinations Manual,” Section 3, Sub. 7.25.3.9.1 (02231).

5. “Statement No. 116 of the Financial Accounting Standards Board.” See a summary of FASB 116.

6. In 1999, the Illinois Department of Revenue refused to grant a property tax exemption to La Leche League International’s new headquarters. The department considered the League to be nothing more than a commercial publishing house, as its financial statements reflected cash transactions involved in the League’s publishing activities and nothing more. At an administrative hearing, we presented evidence that a year’s worth of in-kind donations of time by physicians, nurses, and lactation consultants could be valued in the millions of dollars. Revenues from breastfeeding manuals and pamphlets were only a small part of the organization’s actual work. The department reversed its decision and exempted the organization from paying some $78,000 in annual property taxes.

Kathryn Vanden Berk practiced law for nine years before serving as the president of two residential treatment centers for children. Now practicing in Chicago, she focuses on nonprofit start-ups, corporate and tax law, and employment issues. She serves as adjunct faculty at several Chicago universities, and is a member of the Advisory Board of the Axelson Center for Nonprofit Management at North Park University. She authored a handbook on starting nonprofits that is available from the Nonprofit Financial Center, Chicago, and a chapter in the Illinois attorney’s handbook Not-for-Profit Corporations, 2004 Ed., Illinois Institute of Continuing Legal Education. In 2004 she authored Retooling Employment Standards for the Future, a publication of the First Nonprofit Educational Foundation, Chicago. She can be reached by e-mail or at 312-558-1690.

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