The term “charity,” when used in the context of federal tax law, refers to all organizations described in section 501(c)(3) of the Internal Revenue Code, regardless of the specific activities or pattern of support, including churches, donor-supported organizations, private foundations, hospitals and colleges/universities. Because the term is as defined by the Internal Revenue Code and regulations, it is not perfectly congruent with the concept of charity under common law or even necessarily the statutory law of a particular state. For example, organizations recognized as tax-exempt under section 501(c)(4) may have purposes that qualify as charitable for state law purposes, but are not charities for federal tax purposes.
The IRS interacts with charities in three major ways: the application for tax-exempt status, the annual return filing process and in the context of an examination or audit. The only exceptions to the preceding are with regard to churches and closely allied religious organizations (“integrated auxiliaries”), which are not required to file applications for tax-exempt status in order to hold themselves out as tax-exempt nor are they required to file the annual information return, the Form 990.
As a general proposition, an organization must first be created under state law as either a non-profit, non-stock corporation, a charitable trust or a non-profit association before it can file for federal income tax exemption. Individuals, partnerships or other flow-through entities cannot qualify for tax-exempt status. In order to have tax-exempt status recognized retroactively to its date of formation, the organization must file an application for tax-exempt status on Form 1023 within 27 months of its formation. Because of the limitation on retroactive tax-exempt status, organizations usually file the application based on proposed activities, before actual activities or fundraising has begun. As a result, the application process provides some assurance that an organization will be structured as a charity, but because actual activities may legitimately differ from activities as they were anticipated at the point of the application filing, the efficacy of the application process in establishing that actual operations of an organization are charitable is less certain. As part of the application process, the IRS may request additional information beyond that required by the questions in the application, but the agency does not have the practical ability to require a period of actual operations before processing the application. The reason for that is because an applicant organization is entitled to seek a declaratory judgment from the Tax Court, the U.S. District Court for the District of Columbia or the Court of Federal Claims if the IRS has failed to rule on its application within 270 days of its filing. In such a declaratory judgment action, the burden of proof is shifted to the IRS, making it difficult to assert that an applicant does not qualify for tax-exemption. Once an application for tax-exempt status has been approved, a determination letter reflecting the tax exemption is issued. At that point, the application, all attachments and all correspondence to or from the applicant and the IRS becomes publicly-available, either from the IRS or from the organization itself. It should be noted that the fact of a pending application or the denial of an application are not a matter of public record.
The second major aspect of charity oversight involves the filing of the annual information return, that is, one of the variations of the Form 990, including the Form 990-N for small entities, the Form 990-EZ, the long-form Form 990 for larger entities, and the Form 990-PF for private foundations. With the exception of churches and integrated auxiliaries of churches, all charities are required to file a Form 990. The Form 990-T is used to report unrelated business income and pay tax on any net unrelated income, and, unlike the Form 990 itself, would be filed by all charities, including churches, that have such income.
The third major point of interaction between charities and the IRS occurs in the context of an examination, popularly referred to as an audit. As noted above in the discussion on Authorization, section 7602 gives the IRS the authority to ascertain whether a particular return is correct or not, thus placing the audit focus on returns, not on organizations or activities more generally, and effectively precluding the IRS from opening an examination prior to the due date of a return. Slightly more that half of the employees in the Exempt Organizations Division are involved in the examination program, which is conducted pursuant to an annual workplan issued by the Director of the Division and implemented by the Director of EO Examinations. Historically, the annual workplan has been publicly released in order to stimulate voluntary compliance with tax law requirements through the highlighting of particular issues of concern.
With the exception of examinations of churches, the IRS is authorized to select returns for review based on specific leads (complaints, media reports, information arising through the application or private letter ruling processes), as a result of surveys, or through random selection. Churches can only be examined pursuant to procedures specified in section 7611 and the Treasury regulations promulgated under that section, which effectively restrict the ability of the IRS to examine churches without reasonable cause. In view of resource constraints, the IRS is able to examine the returns of only a few thousand organizations in any given year.