Nonprofit Scams: Exempt Status And What 501(c)(3) Really Means

Whenever I meet with a new nonprofit client, I spend a lot of time talking about the IRS, and more specifically, about 501(c)(3) tax exempt status. That’s not shocking – it is a HUGE step for new nonprofits, and helping my clients apply for (and maintain) their IRS tax exempt status is a big part of my job. But…honestly? I wish it wasn’t the primary topic of SO many of my conversations with clients.

Why not? Here’s the thing: I wish my clients understood that a nonprofit's public charity status is NOT everything. It might be necessary and important, sure. It helps communicate to donors that the nonprofit is a public charity. Maybe it conveys that it’s a professional organization that does things right (maybe). And, yes, it’s often required to secure a lot of very large gifts and grants. But it’s certainly not the end-all, be-all of a successful nonprofit. In fact, it’s just the bare minimum.

What is 501(c)(3) Public Charity Status?

First and foremost, to understand the obsession with the IRS status, you have to know what it is. Lots of people don’t realize nonprofit organizations don’t automatically have a special status with the IRS. It’s actually a rather long and involved process to apply, qualify for, and maintain your tax-exempt status with the IRS. So, what is the 501(c)(3) status you hear about all the time with nonprofits?

At base it’s permission not to pay income taxes – because you serve the public in a charitable way. To qualify for income tax exemption under the 501(c)(3) section of the IRS code, the nonprofit must have a certain kind of exempt purpose (aka: mission). According to the IRS, that means the nonprofit has to exist for one or more of these purposes: “charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition (with certain limits), and preventing cruelty to children or animals.” And there are a ton of other rules, like these charities can’t enrich any private individual or particular group or exist solely for political activities like lobbying, etc. etc. (Still awake?).

So, if an organization’s activities fits with all these rules, they can apply for their public charity c3 status (they apply with either the 1023 Full Form or 1023-EZ). If the IRS approves the application and gives the nonprofit income tax exemption, what does that actually get you? Lots of folks assume that means you don’t pay tax AT ALL, but it’s not that simple.

501(c)(3) tax-exempt status has 2 major benefits:

• They don’t pay income tax on revenue that is “substantially related” to their mission; and,
• Gifts made to the nonprofit are deductible by donors on their own tax return.

Technically, that’s it. I mean, in practice there are other benefits to getting that tax-exempt status too – things like getting to say you’re a c3, which may (or may not) qualify the nonprofit to apply for larger gifts and grants. It may allow you to apply for some state-level tax exemptions, like sales tax or property tax, etc. And, of course, the nonprofit gains the legitimacy of IRS approval (though don’t get too excited about that one yet!). But income tax exemption isn’t the silver bullet lots of folks think it will be.

501(c)(3) nonprofits still have to pay other kinds of tax (like payroll tax, sales tax, unemployment insurance, workers compensation, etc. – they are still businesses and have to follow all the other laws and rules that apply to businesses). Plus, the IRS has lots of extra regulations they need to follow to maintain those privileges.

501(c)(3) Tax Status Scams

Remember when I said not to rely on the “legitimacy” from being a 501(c)(3) public charity? Here’s why: not everyone who has 501(c)(3) public charity status deserves it. The IRS is under fire for granting tax-exempt status to scammers who are taking advantage of the 1023-EZ form – that’s the “short form” application.

This past spring of 2022, a Brooklyn man named Ian Hosang was brought up on charges of grand larceny, identity theft and conducting a scheme to defraud based on the SEVENTY SIX fake charities he set up. This man set up 76 bogus nonprofits, all sharing the same PO Box in Staten Island. There were some obvious red flags that Hosang’s operation wasn’t legit if someone looked closely, but he made it through the IRS “scrutiny” anyway. He applied for c3 status with the 1023-EZ form for all 76 of these nonprofits, and ALL of them were approved.

And here’s the real kicker – it’s not even that Hosang is this intelligent criminal mastermind that fooled everyone. It’s that the IRS doesn’t have A REAL HUMAN reviewing every single one of those particular applications, and it’s obvious that the semi-automated process is letting through some scams.

The public loves a nonprofit scandal. There’s nothing juicier than a fraud story where not only did someone steal and swindle - they did it all while claiming to be for a good cause. Donors already hold nonprofits to a high ethical standard, and these kinds of cases make the public scrutiny on the nonprofit sector even sharper.

Beyond the Tax Status

I don’t say this all to suggest that we need WAY more regulation on charities (though obviously the IRS needs to get their act together). But as a nonprofit, whether you’re new or old, big, or small, you are being compared to these scams. Your 501(c)(3) status is not proof that you’re trustworthy to donors or anyone else. Nonprofits need to build transparency and accountability into every facet of how they function.

Here's the things I try to help my clients focus on, beyond just the IRS status:

• Staying up to date with ongoing federal and state compliance
• Surrounding themselves with professionals (lawyer, accountant, insurance broker, etc.) who can help them do things right
• Measuring and demonstrating the effect their programs have on their community
• Communicating clearly to their donors and constituents
• Being transparent and accountable to their communities

There is no silver bullet to becoming a “trusted charity.” Being granted 501(c)(3) status is a great first step, but it’s far from the end of the road. Building trust with your community is something that all my clients are working on, every single day. It can be hard to do that in a vacuum – be sure to get help along the way!

If your nonprofit needs support, check out my Mission Guardian legal subscription program so you can have a strategic partner in your mission.

Jess Birken is the owner of Birken Law Office, a firm designed to help nonprofits. Ideal Client Engagements are nonprofits looking for a strategic partner who will give pragmatic advice and keep business operations on track so the mission work stays a priority.

©Copyright - All Rights Reserved

DO NOT REPRODUCE WITHOUT WRITTEN PERMISSION BY AUTHOR.