Internal Revenue Code section 501(h) – An overview

Author: LegalEase Solutions

QUESTION PRESENTED

Internal Revenue Code Section 501(h) – An Overview 

RESEARCH FINDINGS

Internal Revenue Code -Tax exempt status

An organization’s nonprofit status is governed by state law and it is determined by the organization’s articles of incorporation or trust documents.[1] However, an organization’s tax-exempt status is governed by the federal law.[2] The Internal Revenue Code specifically refers to exemption from federal income tax.[3] However, an organization should be identified as a trust, corporation or association before applying for the tax-exempt status.[4]  26 U.S. Code §501(a) and §501(c)(3) provides for tax exempt status under the Code.[5]

IRC §501(a) – Other Non Profit or Tax-Exempt Organizations

26 U.S. Code § 501(a) permits tax exemption for certain organizations described in §501(c), (a corporation organized under Act of Congress which is an instrumentality of the United States) or 501(d), (religious and apostolic organizations), or §401(a) (trusts created to form a part of qualified pension, profit-sharing, and stock bonus plans) unless specifically denied under the Code.

IRC §501(c)(3) – charitable, religious and educational organizations

To be tax-exempt under section 501(c)(3) of the Internal Revenue Code, an organization must be organized and operated exclusively for exempt purposes set forth in section 501(c)(3), and none of its earnings may inure to any private shareholder or individual.[6] Additionally, it may not be an action organization, i.e., the organization may not attempt to influence legislation as a substantial part of its activities and it may not participate in any campaign activity for or against political candidates.[7] An eligible section 501(c)(3) organization has an option for election/revocation of election to make expenditures to influence legislation.[8] However, section 501(c)(3) organizations are restricted in how much political and legislative (lobbying) activities they may conduct.[9]

Specific language contained in Publication 557

If the organization is a trust, in order to qualify under section 501(c)(3) of the Code, its organizing document must contain certain language contained in Publication 557.[10] Likewise, for or a corporation to qualify under section 501(c)(3) of the Code, its charter or articles of incorporation must contain certain language contained in Publication 557.[11] For an association to qualify under section 501(a) of the Code, the association must have a written document, such as articles of association, showing its creation.[12] Further, its articles of association must contain certain language contained in Publication 557.[13]

Legislative lobbying activities

Federal tax laws permit every charitable nonprofit organization to involve in some legislative lobbying activities.[14] Instead of imposing a complete ban on all lobbying activities of charitable nonprofits, the Congress’ intent, as provided in the Internal Revenue Code 1934, was to set a limit to such activities.[15] Therefore, all charitable nonprofits may freely engage in legislative lobbying as long as that activity amounts to only an “insubstantial” amount of the nonprofit’s activities.

Election under §501(h) of the IRC – Lobbying Activity[16]

Section 501(c)(3) states that an organization exempt under that section will lose its tax-exempt status and its qualification to receive deductible charitable contributions if a substantial part of its activities are carried on to influence legislation.[17] Section 501(h), however, permits certain eligible section 501(c)(3) organizations to elect to make limited expenditures to influence legislation.[18] Further, an organization making the election will be subject to an excise tax under section 4911 if it spends more than the amounts permitted by that section.[19] However, the organization may lose its exempt status if its lobbying expenditures exceed the permitted amounts by more than 50% over a 4-year period.[20] A public charity that makes a valid section 501(h) election may spend up to a certain percentage of its exempt purpose expenditures to influence legislation without incurring tax or losing its tax exempt status[21] as described below.

A non-electing organization will generally be regarded as engaging in lobbying activity if the organization either contacts, or urges the public to contact, members of a legislative body for the purpose of proposing, supporting, or opposing legislation or the government’s budget process; or advocates the adoption or rejection of legislation.[22] Organizations are required to provide specific answers and a detailed description of any activities the organization engaged in (through its employees or volunteers) to influence legislation while providing information to the IRS.[23] The description should include all lobbying activities, whether expenses were incurred or not.[24] Examples of such lobbying activities include:

  • Sending letters or publications to government officials or legislators,
  • Meeting with or calling government officials or legislators,
  • Sending or distributing letters or publications (including newsletters, brochures, etc.) to members or to the general public, or
  • Using direct mail, placing advertisements, issuing press releases, holding news conferences, or holding rallies or demonstrations.[25]

Denial of exemption from taxation under §501(h)

Section 501(h) specifically deals with expenditures by public charities to influence legislation. The section states that “[i]n the case of an organization in which this section applies, exemption from taxation under subsection (a) shall be denied because a substantial part of the activities of such organization consists of carrying on propaganda, or otherwise attempting, to influence legislation[.]” (26 U.S. Code §501(h)). However, this denial applies only to such organizations that normally:

(A) makes lobbying expenditures[26] in excess of the lobbying ceiling amount[27] for such organization for each taxable year, or

(B) makes grass roots expenditures[28] in excess of the grass roots ceiling amount[29] for such organization for each taxable year.

26 U.S. Code §501(h)(I).

Further, the interpretation of lobbying expenditures, lobbying ceiling amount, grass roots expenditures and grass roots ceiling amount mentioned in §501(h)(I) is subject to 26 U.S. Code § 4911 (Tax on excess expenditures to influence legislation). This section applies to any organization with respect to which an election under section 501(h) (relating to lobbying expenditures by public charities) is in effect for the taxable year.

Therefore, for any tax year in which an election under section 501(h) is in effect, an electing organization must report the actual and permitted amounts of its lobbying expenditures and grass roots expenditures (as defined in section 4911(c)) on its annual return required under section 6033.[30] Pertinently, each electing member of an affiliated group must report these amounts for both itself and the affiliated group as a whole.[31]

IRC §501(h) – Eligible Organizations 

A section 501(c)(3) organization is permitted to make the election if it is not a disqualified organization.[32] §501(h) shall apply to any organization described in 501(c)(3)[33], which has elected to have the provisions of this subsection apply to such organization and which, for the taxable year that includes the date such election is made. Such organizations are described in 501(h)(4) as follows:

  1. section 170 (b)(1)(A)(ii) (relating to educational institutions),
  2. section 170 (b)(1)(A)(iii) (relating to hospitals and medical research organizations),
  3. section 170 (b)(1)(A)(iv) (relating to organizations supporting government schools),
  4. section 170 (b)(1)(A)(vi) (relating to organizations publicly supported by charitable contributions),
  5. section 509 (a)(2) (relating to organizations publicly supported by admissions, sales, etc.), or
  6. section 509 (a)(3) (relating to organizations supporting certain types of public charities) except that for purposes of this subparagraph, section 509 (a)(3) shall be applied without regard to the last sentence of section 509 (a).

26 U.S. Code §501(h)(4).

However, a private foundation (including a private operating foundation) is not an eligible organization under the section.[34]

Disqualified Organizations

On the other hand, §501(h) shall not apply to disqualified organizations listed under paragraph 5 of the section. Such organizations include:

  1. an organization described in section 170 (b)(1)(A)(i) (relating to churches),
  2. an integrated auxiliary of a church or of a convention or association of churches, or
  3. a member of an affiliated group of organizations (within the meaning of section 4911 (f)(2)) if one or more members of such group is described in subparagraph (A) or (B).

26 U.S. Code §501(h)(5).

Affiliated organizations

Organizations are members of an affiliated group of organizations only if:

  1. the governing instrument of one such organization requires it to be bound by the decisions of the other organization on legislative issues, or
  2. the governing board of one such organization includes persons
    1. who are specifically designated representatives of another such organization or are members of the governing board, officers, or paid executive staff members of such other organization, and
    2. who, by aggregating their votes, have sufficient voting power to cause or prevent action on legislative issues by the first such organization.

There are two methods by which an organization’s lobbying activity shall be measured under the Code, the expenditure test and the substantive part test.

Measuring lobbying- the Substantial Part Test[35]

It is pertinent to ascertain whether an organization’s attempts to influence legislation, i.e., lobbying, constitute a substantial part of its overall activity. Whether an organization’s lobbying activities constitute a substantial part of its overall activities is determined on the basis of all the pertinent facts and circumstances in each case. A variety of factors are considered by the IRS to determine an organization’s lobbying activities is substantial. This includes factors like, the time devoted (by both compensated and volunteer workers) and the expenditures devoted by the organization to the activity.

Measuring Lobbying Activity: the Expenditure Test[36]

            Organizations other than churches and private foundations may elect the expenditure test under section 501(h) as an alternative method for measuring lobbying activity. Under the expenditure test, the extent of an organization’s lobbying activity will not jeopardize its tax-exempt status, provided its expenditures, related to such activity, do not normally exceed an amount specified in section 4911. This limit is generally based upon the size of the organization and may not exceed $1,000,000, as indicated in the table below.

If the amount of exempt purpose expenditures is: Lobbying nontaxable amount is:
≤ $500,000 20% of the exempt purpose expenditures
>$500,00 but ≤ $1,000,000 $100,000 plus 15% of the excess of exempt purpose expenditures over $500,000
> $1,000,000 but ≤ $1,500,000 $175,000 plus 10% of the excess of exempt purpose expenditures over $1,000,000
>$1,500,000 $225,000 plus 5% of the exempt purpose expenditures over $1,500,000

Under this test, an organization involved in excessive lobbying activity over a four-year period may lose its tax-exempt status, making all of its income for that period subject to tax.  In case the organization exceeds its lobbying expenditure dollar limit in a particular year, it must pay an excise tax equal to 25 percent of the excess.

Form 5768[37]

By filing the form (“taking the 501(h) election”) allows the nonprofits to elect to be measured by the objective “expenditure test.” Therefore, organizations that elect to use the expenditure test must file Form 5768, which is the “Election/Revocation of Election by an Eligible IRC Section 501(c)(3) Organization to Make Expenditures to Influence Legislation,” at any time during the tax year for which it is to be effective.  This election shall remain effective for the succeeding years unless it is revoked by the organization. Revocation of the election shall be effective beginning with the year following the year in which the revocation is filed.

Pertinently, a 501(c)(3) charitable nonprofit organization taking the 501(h) election remains a 501(c)(3) charitable nonprofit. The (h) election merely allows the nonprofit to opt out of the uncertainty of  the “substantial” activity test and use the expenditure test.[38] According to the National Council of Nonprofits, the expenditure test has great advantages over the more uncertain “substantial part” test. Per their website, in the opinion of informed attorneys and accountants, filing the 501(h) election is, for the vast majority of nonprofits, the easiest, most effective “insurance” a nonprofit can secure to protect itself from overstepping IRS limitations on lobbying activities.[39]

Tax on organizations

            An organization that conducts excessive lobbying in any taxable year may lose its tax-exempt status under the substantial part test, resulting in all of its income being subject to tax.[40] In addition, organizations that lose their exemption under section 501(c)(3), other than churches and private foundations, due to such lobbying activities generally will be subject to an excise tax of 5% of the lobbying expenditures for the year in which they cease to qualify for exemption.[41] However, this tax does not apply to private foundations.[42] Therefore, the tax does not apply to organizations that have elected the lobbying limits of section 501(h) or to churches or church-related organizations that cannot elect these limits.[43] Further, this tax must be paid by the organization.[44]

Tax on managers

            Managers may be liable for a 5% tax on the lobbying expenditures which results in the disqualification of the organization.[45] For the application of the tax, a manager would have to agree to the expenditures knowing that the expenditures would possibly result in the organization’s not being described in section 501(c)(3).[46] No tax will be imposed if the manager’s agreement is not willful and is due to reasonable cause.[47]

Excise taxes on political expenditures

The law imposes an excise tax on the political expenditures of section 501(c)(3) organizations.[48] This is a two-tier tax imposed on both the organizations and the managers of those organizations.[49] Private foundations are subject to a different set of taxes on their lobbying expenditures; churches are not subject to excise taxes on excessive lobbying.[50]

Benefits of filing 501(h) election

Electing the expenditure test by filing Form 5768 will provide many benefits for most charitable nonprofits because the organization opting the election will get to use clear definitions excluding certain activates.

It is easier and clearer:

The term “influencing legislation” means—

(A) any attempt to influence any legislation through an attempt to affect the opinions of the general public or any segment thereof, and

(B) any attempt to influence any legislation through communication with any member or employee of a legislative body, or with any government official or employee who may participate in the formulation of the legislation.

26 U.S. Code § 4911(d)(1).

Furthermore, in case of a nonprofit organization using the expenditure test, various exclusions are provided under 26 US Code Section 4911 so that the following activities are NOT included in the definition of “influencing legislation”:

  1. Making available the results of nonpartisan analysis, study, or research;
  2. Providing of technical advice or assistance (where such advice would otherwise constitute the influencing of legislation) to a governmental body or to a committee or other subdivision thereof in response to a written request by such body or subdivision, as the case may be;
  3. Appearances before, or communications to, any legislative body with respect to a possible decision of such body which might affect the existence of the organization, its powers and duties, tax-exempt status, or the deduction of contributions to the organization [otherwise known as “self-defense communications”];
  4. Communications between the organization and its bona fide members regarding legislation or proposed legislation of direct interest to the organization and such members [other than communications that “directly encourage” the members to engage in direct or grass roots lobbying]; and
  5. Any communications with a government official or employee” that are not for the purpose of influencing legislation. (See 26 USC Section 4911).

Form 990 is a simpler reporting form:

Form 990[51] is used for filing an annual information return required by the IRS for most organizations exempt from income tax under section 501(a), and certain political organizations and nonexempt charitable trusts. Form 990 requires all nonprofits to provide their “total expenses paid or incurred in connection with … lobbying activities.” There is no need to record, prepare, or file a detailed description of activities. However, Form 990 mandates nonprofits using the “substantial part” test to invest time and resources both recording and describing their lobbying activities, but nonprofits electing to use the “expenditure” test do not have that burden.

It is safer and has clarity:

The expenditure test objectively determines the amount of acceptable lobbying based on the nonprofit’s expenditures, instead of looking subjectively at uncertain activities. Additionally, the definition of lobbying expenditures under the expenditure test is more liberal than the definitions under the substantial part test. As a result, a nonprofit taking the 501(h) election can compute its own limits without having to artificially lower its lobbying activity to avoid potentially violating the uncertain “substantial part” test.

Provides for higher limits of lobbying expenditure:

Usually, the “expenditure test” allows higher limits for lobbying expenditures than permitted limit under the “substantial part test.” For instance, most nonprofits engage volunteers to conduct lobbying activities, including visiting with lawmakers in their statehouses during a “nonprofit lobby day.” The time spent by such volunteer is not included in the “expenditure test” as it is unpaid and there is no expenditure.

Less chance of losing tax-exempt status:

As aforementioned, under the substantial part test, an organization that conducts excessive lobbying in any taxable year may lose its tax-exempt status, resulting in all of its income being subject to tax. Additionally, section 501(c)(3) organizations that lose their tax-exempt status due to excessive lobbying, other than churches and private foundations, are subject to an excise tax equal to five percent of their lobbying expenditures for the year in which they cease to qualify for exemption. Further, a tax equal to five percent of the lobbying expenditures for the year may be imposed against organization managers, jointly and severally, who agree to the making of such expenditures knowing that the expenditures would likely result in the loss of tax-exempt status.

Safeguard a nonprofit’s legislative lobbying strategies:

Charitable nonprofits not filing the 501(h) election requires to disclose their expenditures in far greater detail under Form 990’s Schedule C. This will cause unnecessary exposure of a nonprofit’s legislative lobbying strategies that the nonprofit may prefer to keep as confidential.

Miscellaneous rules

If an exempt organization changes its legal structure, such as its form is changed from a trust to a corporation, it must file a new exemption application to establish that the new legal entity qualifies for exemption.[52] However, if the organization is inactive for a period of time but does not cease being an entity under the laws of the state in which it was formed, its exemption will not be terminated.[53] Furthermore, unless the organization is covered by one of the filing exceptions, it will have to continue to file an annual information return during the period of inactivity.[54] Additionally, if the organization has been liquidated, dissolved, terminated, or substantially contracted, it should file its annual return of information by the 15th day of the 5th month after the change and follow the applicable instructions to the form.[55] In addition, if the organization amends its articles of organization or its internal regulations (bylaws), then the changes should be reported following the instructions provided under Form 990, Form 990-EZ, or Form 990-PF.[56]

[1] http://www.irs.gov/Charities-&-Non-Profits/Before-Applying-for-Tax-Exempt-Status

[2] Id.

[3] Id.

[4] http://www.irs.gov/Charities-&-Non-Profits/Definition-of-a-Trust

[5] http://www.irs.gov/Charities-&-Non-Profits/Applying-for-Tax-Exempt-Status

[6] http://www.irs.gov/Charities-&-Non-Profits/Charitable-Organizations/Exemption-Requirements-Section-501(c)(3)-Organizations

[7] Id.

[8] http://www.irs.gov/pub/irs-pdf/f5768.pdf

[9] http://www.irs.gov/Charities-&-Non-Profits/Charitable-Organizations/Exemption-Requirements-Section-501(c)(3)-Organizations

[10] http://www.irs.gov/Charities-&-Non-Profits/Definition-of-a-Trust

[11] http://www.irs.gov/Charities-&-Non-Profits/Definition-of-a-Corporation

[12] http://www.irs.gov/Charities-&-Non-Profits/Definition-of-an-Association

[13] Id.

[14] https://www.councilofnonprofits.org/taking-the-501h-election

[15] Id.

[16] Form 5768 (election under section 501(h)

[17] http://www.irs.gov/pub/irs-pdf/f5768.pdf

[18] Id.

[19] Id.

[20] Id.

[21] http://www.irs.gov/instructions/i990sc/ch02.html

[22] Id.

[23] Id.

[24] Id.

[25] Id.

[26] The term “lobbying expenditures” means expenditures for the purpose of influencing legislation.

[27] The lobbying ceiling amount for any organization for any taxable year is 150 percent of the lobbying nontaxable amount for such organization for such taxable year.

[28] The term “grass roots expenditures” means expenditures for the purpose of influencing legislation.

[29] The grass roots ceiling amount for any organization for any taxable year is 150 percent of the grass roots nontaxable amount for such organization for such taxable year.

[30] http://www.irs.gov/pub/irs-pdf/f5768.pdf

[31] Id.

[32] Id.

[33] Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.

[34] http://www.irs.gov/pub/irs-pdf/f5768.pdf

[35] http://www.irs.gov/Charities-&-Non-Profits/Measuring-Lobbying:-Substantial-Part-Test

[36] http://www.irs.gov/Charities-&-Non-Profits/Measuring-Lobbying-Activity:-Expenditure-Test

[37] Id.

[38] https://www.councilofnonprofits.org/taking-the-501h-election

[39] Id.

[40] http://www.irs.gov/Charities-&-Non-Profits/Measuring-Lobbying:-Substantial-Part-Test

[41] http://www.irs.gov/pub/irs-pdf/p557.pdf

[42] Id.

[43] Id.

[44] Id.

[45] Id.

[46] Id.

[47] Id.

[48] Id.

[49] http://www.irs.gov/pub/irs-pdf/p557.pdf

[50] http://www.irs.gov/Charities-&-Non-Profits/Measuring-Lobbying:-Substantial-Part-Test

[51] https://www.councilofnonprofits.org/benefits-of-filing-the-501h-election

[52] http://www.irs.gov/pub/irs-pdf/p557.pdf

[53] Id.

[54] Id.

[55] Id.

[56] Id.