Government Affiliate: Section 115 and 501(c)(3) Organizations

Generally, there are three categories of organizations under the Internal Revenue Service Code: purely governmental entities, section 115 quasi-governmental organizations, and 501(c)(3) charitable organizations. Because each classification outlines different rules for both deductions and contributions, organizations often desire to “fit” within one, or more than one, category depending upon their exemption goals.

A purely governmental organization, such as a city government, is exempt from income taxation under the doctrine of intergovernmental tax immunity. This exemption is codified in I.R.C. Section 115, which states that a purely governmental organization’s taxable “gross income” does not include “income derived from any public utility or the exercise of any essential governmental function and accruing to a State or any political subdivision thereof….”

Different rules apply, however, to quasi-governmental organizations, such as a public library, that could be reasonably considered either “governmental” or “private.” Because these rules present considerably different ramifications in terms of deductions and contributions, the question of whether an organization is to be deemed a “section 115” organization or a 501(c)(3) organization is paramount. The answer to this question depends upon several criteria.

If an organization is quasi-governmental it can attain tax exemption for certain income under I.R.C. Section 501(c)(3) by either receiving a determination letter from the Internal Revenue Service or satisfying the 501(c)(3) criteria listed below. In order to obtain a determination letter an organization must file a Form 1023 Application for Exemption, available online at http://www.irs.gov/pub/irs-pdf/f1023.pdf. Generally, the I.R.S. will issue a determination letter within three to six weeks.

The 501(c)(3) Criteria:

In order for quasi-governmental organizations to obtain 501(c)(3) status, they must satisfy four criteria: (1) they must be a separately-organized entity; (2) they must pass the organizational test; (3) they must not possess a disqualifying regulatory power; and (4) they should not be an integral part of the state or municipal government.

Separately Organized

This requirement mandates that the organization be either an Iowa nonprofit corporation, or a trust. If neither a corporation nor a trust, the association must possess the following characteristics: (1) specified associates; (2) an objective by the associates to carry on the activity for which the organization was formed; (3) continuity of life; (4) centralized management; (5) limited liability; and (6) free transferability of interests.

The Organizational Test
The organization’s enabling documents must state one or more purposes exempt under 501(c)(3): religious, charitable, scientific, public safety, literary, or educational. The organization’s enabling documents must also have a dissolution clause leaving assets to a comparable nonprofit.

Regulatory Powers
If the organization possesses any one sovereign power traditionally reserved for governmental entities such as the power to tax, the power of eminent domain, or a police power, it cannot receive exemption under 501(c)(3).

Integral Part of Local Government
A state or municipality itself cannot qualify for exemption under 501(c)(3). Questions, however, often arise regarding whether a branch or department of a state or municipality is to be deemed an “integral part” of the local government. Traditionally, six factors are considered under the “integral part test”: (1) whether the organization was created by executive order of the Governor of a state; (2) whether the organization was created by executive order of the Governor of a state as an official state agency; (3) whether a state or state agency has the power to appoint and remove the organization’s board; (4) whether a state or state agency has the power to abolish the organization; (5) whether a state or a state agency monitors the organization’s activities; and (6) whether the organization uses government employees to conduct its activities.

The Ramifications
Organizations generally desire 501(c)(3) status for two reasons. First, deductibility limitations for 501(c)(3) organizations are potentially increased from 30 percent to 50 percent. Second, I.R.C 4945 effectively removes limitations on private foundation gifts to 501(c)(3) organizations.

Deductibility Limitations Increased
Under I.R.C. Section 170(b)(1)(A)(v), gifts not given ‘to’ a state or political subdivision ‘for the use of’ a state (or political subdivision) may be deducted from the organization’s taxable income to the extent that the aggregate of such contributions does not exceed 50 percent of the taxpayer’s contribution base for the taxable year. On the other hand, under the I.R.C., a gift ‘for the use of’ a state (or political subdivision) is subject to the 30 percent limitation under I.R.C. section 170(b)(1)(B). Because 501(c)(3) organizations are not “state” organizations under the I.R.C., they qualify for the higher deductibility limitation of 50 percent.

I.R.C 4945 Limitations Removed
Gifts to government-affiliated entities can be problematic for private foundations because of penalty taxes applicable to them. Under I.R.C. 4945 a private foundation is subject to penalty tax unless the gift is given for charitable purposes or the foundation making the grant exercises “expenditure responsibility.” If a quasi-governmental organization attains 501(c)(3) status, however, it becomes charitable. Because private foundations can make gifts for charitable purposes, that foundation does not have to meet the “expenditure responsibility” requirement under I.R.C. 4945.

Form 1023 Application for Exemption, available on line at http://www.irs.gov/pub/irs-pdf/f1023.pdf.

Additional information available at: http://www.irs.gov/pub/irs-tege/cpe2004h_ ref_guide_organizations.pdf