Threats to nonprofit tax exemption in 2019
David Heinen, Vice President for Public Policy and Advocacy, North Carolina Center for Nonprofits
Most 501(c)(3) nonprofits in North Carolina are exempt from most state and local taxes. Nonprofit tax-exemption isn't merely a handout or an anachronism, but rather is part of an important social compact. In exchange for exemption from paying taxes, charitable nonprofits must operate for the public benefit rather than to maximize profits for business owners or shareholders. Tax-exempt 501(c)(3) nonprofits also give up three fundamental rights that for-profit businesses enjoy:
- Profits. No one “owns” a nonprofit. They are required by federal law to reinvest all of their net earnings back into their missions. By contrast, for-profit businesses distribute their profits to shareholders or owners. Financially sound nonprofits do, in fact, need more revenue than expenses in order to continue their work from month to month. To be sustainable, it is important for them to maintain financial reserves as a “rainy day fund” that can cover several months of operations.
- Privacy. Many documents of 501(c)(3) nonprofits are available to the public. They are required to provide their applications for tax-exempt status, which includes their basic governing documents. Those with annual budgets over $50,000 are required to make public the Form 990 that they file every year with the IRS. The 990 includes information on their programs, revenue and expenses, key employees’ salaries, governance, and the identity of directors and officers. Smaller nonprofits are also required to identify their board officers and attest to their budget size.
- Politics. Engaging in partisan politics in absolutely prohibited for 501(c)(3) nonprofits. They can lose their tax-exempt status if they make political contributions or coordinate activities with political parties or candidates for office. Very importantly, 501(c)(3) are allowed and encouraged to take positions on policy issues, educate elected officials about their issues, and lobby.
This tax exemption is essential for nonprofits' viability. If nonprofits had to pay state and local taxes, they would have significantly fewer resources available to provide essential programs and services in communities throughout North Carolina. This may not be a problem if most nonprofits were flush with extra cash. The reality, however, is that 56% of North Carolina nonprofits said last year that they didn't have enough resources to fully meet the demands for their services. New taxes on nonprofits would only make this situation worse, creating even more unmet needs in our communities.
Here is a summary of some upcoming threats - and a few opportunities - to nonprofit tax exemption that are on the Center's radar screen this year.
Sales tax refunds (or exemption)
North Carolina nonprofits pay sales tax when they purchase goods (and some services), but (most) nonprofits get the privilege of begging the state for refunds of (most of) the sales taxes they pay (as long as they keep good records and fill out the paperwork correctly). (Note: All the parenthetical disclaimers in the previous sentence should be a hint that the sales tax "exemption" process in North Carolina is far from perfect!) A few notes on a few of those parentheticals:
- North Carolina's 2013 tax reform package included a $45 million per year cap on the amount of sales tax refunds a nonprofit can receive. While this cap only affects the largest nonprofit institutions in the state, legislators have hinted that they could easily lower it as a way to generate new revenue for the state. Lowering the cap to $100,000 or $1 million per year would create significant new taxes on many large nonprofits. Lowering the cap to $1 per year would take critical resources away from the work of more than 10,000 nonprofits.
- Since 2008, a few types of 501(c)(3) nonprofits have been excluded from receiving sales tax refunds based on their (somewhat arbitrary) IRS-determined activity codes. Organizations that are "properly classified" under the National Taxonomy for Exempt Entities (NTEE) as "community improvement and capacity building", "public and societal benefit", or "mutual and membership benefit" are not permitted to receive sales tax refunds. The work of these nonprofits is no less important because of an arbitrary IRS designation, and the state tax code shouldn't discriminate against these organizations by giving them lesser tax status that most other 501(c)(3) nonprofits.
- North Carolina is one of two states (Utah is the other) that uses a refund process for nonprofit sales tax exemption. In most other states, 501(c)(3) nonprofits receive sales tax exemption certificates and vendors do not charge them sales tax at the point of sale. The refund process adds recordkeeping and reporting burdens for nonprofits. For some small nonprofits, the time and expense of tracking sales tax paid and applying for refunds exceeds the amount of sales tax they receive as refunds.
- The refund process also delays nonprofits’ use of some of their revenue for six months – and occasionally longer – while refunds are being processed. This temporary, interest-free “loan” to the state creates cash flow issues for some nonprofits.
- The refund process is also inefficient for state and local governments. It requires DOR to process thousands of extra filings every year and creates additional costs for local governments when the jurisdiction of a refund application is different than the jurisdiction where an original sales tax transaction was sourced.
Here are three basic principles that lawmakers should follow when considering changes to nonprofit sales tax refunds or exemption:
First, do no harm. While the current nonprofit sales tax refund process is far from perfect, lawmakers should not make it worse by lowering the $45 million annual cap or creating other limitations or exclusions that would create new taxes on certain nonprofits.
Second, consider making the sales tax exemption processes fairer by removing the caps and exclusions that create disparate tax treatment for a few charitable nonprofits. After all, the social compact described above that is the basis for nonprofit tax exemption is applicable to all 501(c)(3) tax-exempt organizations, regardless of their size, mission, or IRS-assigned activity code.
Third, look for ways to reduce red tape for nonprofits, and for state and local governments that adminster the refund process. Shifting to a point-of-sale exemption for nonprofits - without limitations or loopholes - could be a solution that ultimately saves money for nonprofits and for government.
Property tax exemption
Currently, many 501(c)(3) nonprofits that own property in North Carolina do not have to pay local property tax if this property is "wholly and exclusively" used for mission-related purposes. Local governments (counties and municipalities) determine whether nonprofits are exempt from paying property tax in their jurisdiction. However, under the state constitution, the standards for nonprofit property tax exemption must be consistent throughout the state. There are actually seven separate state statutes that provide for property tax exemption for various types of 501(c)(3) nonprofits. The North Carolina Law Review published an excellent article last fall that included an overview of North Carolina's nonprofit property exemption laws and the ways they are carried out by local governments.
As many counties, cities, and towns in North Carolina struggle to find enough revenue to provide all of their services, it is only natural that they will look for untaxed property as a way to generate new public money without raising local property tax or sales tax rates. In other states, public officials have imposed a variety of new nonprofit taxes, fees, and payments in lieu of taxes (or PILOTs) as a way to raise additional local revenue.
Nonprofits often collaborate with local governments to provide essential services to communties. And nonprofits are certainly sympathetic to the challenges of local governments that are asked to provide more and more services with fewer financial resources - after all, most nonprofit organizations are facing the same demands!. However, it is important for policymakers to understand that taxing nonprofits is not the right solution to local governments' financial challenges. As the National Council of Nonprofits has noted: "Governments cannot impose new taxes and fees on nonprofit organizations without diminishing the impact that nonprofits have in their communities."
Franchise tax exemption
This year, legislators may consider changes to North Carolina's franchise tax, which is essentially a privilege license tax on businesses operating in North Carolina. Currently, 501(c)(3) nonprofits are exempt from paying franchise tax. In the past, when lawmakers have developed plans to restructure business taxes, they have sometimes failed to carry over existing nonprofit exemptions into their new proposals.
Potentially, the application of franchise tax to nonprofits could take away a quarter of a billion dollars a year from the work of charitable organizations in North Carolina. Depending on how reworked franchise taxes are calculated, small nonprofits could be hit the hardest if nonprofit tax exemption were to go away. As lawmakers consider proposals to lower franchise tax rates on businesses, it will be important for them to resist the urge to eliminate nonprofit exemption from franchise tax - either as an unintended oversight or as a way of making up for state revenue that would be lost with lower taxes on businesses.
A final thought . . . or two
The challenge for nonprofits is that many policymakers - particularly those who don't fully understand the work nonprofits do - assume that limiting or eliminating tax exemption is an easy, pain-free way to raise revenue for the state and local governments without raising taxes on individuals and businesses. Consequently, nonprofits will always need to be prepared to respond to proposals to limit sales tax refunds, eliminate property tax exemption, and impose other new taxes or fees on charitable organizations. To help nonprofits more fully fulfill their missions, legislators should not only reject any proposals to create new taxes and fees on nonprofits, but should work to ensure that existing state and local tax exemption is administered in a way that is clear, consistent, and fair.
At the same time, it is essential for all 501(c)(3) nonprofits to work together as a sector to preserve - and improve upon - nonprofit tax exemption. New taxes and fees on nonprofits - even if they initially only apply to a few organizations - ultimately harm our communities by taking resources away from the work of charitable nonprofits throughout North Carolina.