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What to Know About Group Tax Exemptions

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What to Know About Group Tax Exemptions

April 11, 2024 Davis Law Group

The IRS offers group exemptions whereby a central organization’s federal tax exemption will apply to its subordinates and obviate any need of the subordinates to separately apply for exemption.

Rather than each organization receiving an individual exemption letter, a group exemption letter is sent to the central organization.

Central and Subordinate Organizations

The IRS defines a central organization as an organization that has one or more subordinates under its supervision or control. The IRS only recently defined supervision and control in proposed changes that are more fully discussed below. A central organization has supervision over a subordinate if it annually reviews the subordinate’s finances and activities. The central organization must also notify the subordinate in writing regarding the requirements to maintain tax-exempt status. A central organization has control over a subordinate organization if it appoints a majority of the subordinate’s officers or directors. A central organization may also have control if its officers or directors serve as officers or directors of the subordinate.

The IRS defines a subordinate organization as a chapter, local, post, or unit of a central organization. A subordinate organization does not need to be incorporated, but it must have an organizing document and an EIN. Foreign organizations, private foundations, qualified nonprofit health insurance issuers, and Type III supporting organizations cannot qualify as subordinates.

The Central Organization’s Application

A central organization must be tax-exempt to secure a group exemption for its subordinates. Therefore, the central organization must obtain recognition of its own exemption by filing Form 1023 (or the appropriate equivalent). To obtain the group exemption, the central organization must submit a letter to the IRS rather than an application form. The central organization may submit this letter at the same time it submits Form 1023 (or the equivalent) or after it submits Form 1023. Generally, the IRS does not require churches to apply for tax-exempt status through Form 1023, but, to be a central organization for a group exemption, a church must formally apply. Once a church is recognized as tax-exempt, it may apply by letter for a group exemption on behalf of its subordinates. Churches are exempted from filing annual group exemption updates with the IRS. Such annual updates are discussed in further detail below.

In the group exemption letter, the central organization must include information about the subordinates, including that such subordinates:

  1. Are affiliated with the central organization,
  2. Are subject to its general supervision or control,
  3. Are eligible for tax-exempt status,
  4. Are not private foundations, and
  5. Are on the same accounting period as the central organization if they will be included in group returns (discussed below).

The central organization must also include a description of the purposes and activities of the subordinates and attach a sample copy of a uniform governing instrument adopted by the subordinates (like articles of incorporation). The central organization must also state that each subordinate has provided it with written authorization to include the subordinate in and remove the subordinate from the group exemption. Finally, the letter must list the subordinates that will be included in the group exemption, including the subordinates’ names, mailing addresses, and EINs. The central organization may attach a directory of subordinates if it has one.

The letter must be signed by an officer of the central organization. The officer must affirm that all the information is true to the best of the officer’s knowledge.

Maintaining the Group Exemption

Once the group exemption is received, the central organization and subordinate organizations must ensure they fulfill all the requirements to maintain the exemption. Each organization under the group exemption must file an annual information return, which is usually Form 990. The central organization may file a group return for some or all of its subordinates. The group exemption will be revoked if the central organization fails to file the annual return for three consecutive years. Alternatively, subordinates may elect to file their own returns. If subordinates fail to file their returns for three consecutive years, they will no longer be exempt under the group exemption. The central and subordinate organizations must decide whose responsibility it is to file.

The group exemption will dissolve as to all entities if the central organization notifies the IRS that it is going out of existence. The group exemption will also dissolve as to all entities if the central organization fails to maintain its tax-exempt status (e.g., by engaging in political campaign activity, failing to report unrelated business income, providing financial benefits to insiders, etc.). The group exemption may be removed from particular subordinates if the central organization notifies the IRS that those subordinates no longer qualify because they fail to meet one of the requirements listed in the group exemption letter (e.g., by no longer associating with the central organization, no longer operating under the supervision or control of the central organization, etc.). A subordinate that is removed from the group exemption may file a separate application for tax exemption.

The central organization must also provide the IRS with Supplemental Group Ruling Information (SGRI) each year. The SGRI annual update must state any changes in the operation or character of its subordinates. The SGRI must also notify the IRS of any subordinates that have changed their names or addresses, of any subordinates that will no longer be included in the group exemption (e.g., have ceased to exist, disaffiliated, etc.), and of any new subordinates that need to be added to the exemption. The name, mailing address, and EIN of all affected subordinates must be listed. If new subordinates are being added to the exemption, the SGRI must also include the information required in the initial letter.

Deductibility of Contributions

If contributions to the central organization are deductible, then contributions to subordinate organizations are also deductible. However, subordinate organizations do not receive their own exemption letter and are not listed in the IRS’s Tax-Exempt Organization Search. This prevents potential donors from verifying that contributions to the subordinates will be tax deductible. Donors must verify with the central organization that the subordinate is included in the central organization’s group exemption. It may be helpful if the central organization maintains a directory of subordinate organizations so that donors can quickly confirm that their donations to a specific subordinate will be deductible.

Pending Changes

In 2020, the IRS promulgated proposed changes to the group exemption system. The changes have yet to be officially adopted. The IRS is not granting any more group exemptions until the changes take effect.

The new requirements intend to alleviate some of the IRS’s administrative burden regarding group exemptions. One major change is that a central organization will need at least five subordinate organizations to obtain a group exemption. Currently, there is no minimum number of subordinates required before the IRS will grant a group exemption.

Some other major changes include the matching requirement, the primary purpose requirement, and the uniform governing instrument requirement. The matching requirement mandates that subordinates need to be described in the same 501(c) paragraph as the central organization. Therefore, a central organization that is a 501(c)(3) will only be allowed to have subordinates which also qualify as 501(c)(3)s. Currently, subordinates may be exempt under a different paragraph of 501(c) than the central organization. So, it is possible that a 501(c)(3) central organization has 501(c)(4) or 501(c)(9) subordinates.

The primary purpose requirement mandates that subordinates qualifying under any other section of 501(c) besides 501(c)(3) must be described by the same National Taxonomy of Exempt Entities (NTEE) Code. There are over 400 NTEE Codes. The uniform governing instrument requirement calls for subordinates to adopt the same governing instrument; therefore, subordinates will no longer be able to have different organizing documents.

Any pre-existing subordinate will be grandfathered into the current requirements, but any subordinate added after the proposals are officially adopted will need to comply with the changes.

The proposed changes clarify that subordinates are allowed to file a declaratory judgment under Internal Revenue Code Section 7428 if they have an actual controversy involving IRS determinations. Controversies regarding IRS determinations might arise, for example, when the IRS determines that a subordinate cannot join a group exemption. In such a case, the subordinate can file its own declaratory judgment and does not have to rely on the central organization filing on its behalf.

Davis Law Group Can Help

Clearly, this determination and administration of group exemptions is complicated and can have dire circumstances if handled incorrectly. Our experienced business and nonprofit attorneys can help you navigate the paperwork and systems required by the IRS. Contact us to today regarding your group exemptions or other non-profit matters so you and your members can have peace of mind.