By Kim Hunwardsen
Many non-profit organizations, and companies that do business with them, make innocent mistakes that affect their state tax liability.
In recent years, non-profit organizations have found themselves to be recipients of state sales and use tax audits. In many instances, the resulting assessment was large and caught these organizations by surprise. This current trend has not only affected these non-profit organizations, but also their vendors, suppliers, service providers and any others that deal with them. Generally, the large assessment is not the result of impropriety or intentional disregard of the law, but a misperception of the rules as they apply in the tax arena to non-profit organizations.
Misconception # 1: All non-profit and 501(c)(3) entities are tax exempt, thus, THAT MEANS ALL taxes.
The terms “non-profit” and “tax exempt” are not necessarily interchangeable. A non-profit organization is one that conducts business for the benefit of the general public without shareholders and without a profit motive. But, just because an organization does not have a profit motive, does not mean that legislatures have exempted them from all taxes.
Generally, 501(c)(3) entities are exempt from federal income tax under the Internal Revenue Code. Although most states follow the exemption from income tax for 501(c)(3) entities, NOT all states unilaterally exempt 501(c)(3) entities from income tax. Additionally, even though an entity is exempt from state income taxes it may still be subject to a litany of other types of taxes such as sales and use, fuel, property, payroll and a variety of other state and locally imposed taxes.
First, a non-profit organization must meet specific tax exemption requirements as outlined in the laws for each specific state. One common non-profit error is assuming that an exemption from state income taxes ALSO includes state sales taxes. This is not the case. Most states require a separate application for exemption from state sales taxes, and the tests are very different from those allowed for income tax exemptions. Typically, it’s harder to obtain a state sales tax exemption than it is to obtain a federal income tax exemption because state requirements are more stringent.
For example, if a non-profit has a retail store, or if it has lost its tax exempt status, the non-profit’s activities will be taxable. Further, it is important to be aware of the many exceptions that apply to non-profit entities. Well-established case law denotes that the burden of exemption is on the entity, NOT on the government or tax enforcement agency. Exemptions are a matter of legislative grace, thus, they are rigidly enforced.
Misconception # 2: Every state treats non-profit organizations the same.
This misconception usually is the result of businesses being familiar with the laws of one state and assuming that they can apply those general principles to the laws of other states. Although there are similarities, entities and transactions are not treated the same in every state. For example, Texas is quite generous with 501(c)(3) entities and gives large latitude for exemptions amongst non-profit entities. South Dakota, on the other hand, is much less generous and has strict guidelines on entities in order to allow certain tax exemptions. Thus, assuming that Texas exempt non-profit laws apply to a transaction with a South Dakota non-profit could result in a significant misunderstanding; and, possibly, large tax assessments, if the non-profit were ever audited.
Misconception # 3: A copy of the IRS determination letter is all that is needed to show that an organization is tax-exempt.
As mentioned above, most states require a separate application to establish tax exempt status. To evidence the tax exempt status, many states and cities have entirely different exemption certificate letters or permits which are different than that received by the IRS. The specific state or local exemption certificate must be provided to a seller to execute an exempt transaction. In some states, even the timing of the receipt of the exemption certificate can determine if the exemption is valid.
For example, in Colorado, the 501(c)(3) letter is adequate to attain the state exemption, but not for many home rule cities, which administer their own separate set of sales and use tax laws.
Therefore, it is important to know the proper documentation requirements in the states in which a non-profit organization operates and the applicable time frame for obtaining the correct documentation in each jurisdiction. If a non-profit does not follow the appropriate process and documentation to verify tax exempt status, the result could be costly.
Misconception # 4: All transactions with governmental agencies and governmental entities are exempt from all taxes.
While the Federal government itself is typically exempt from state taxation based on the Supremacy Clause of the U.S. Constitution, it is not always the federal government itself that is ACTUALLY making purchases. Instead, entities working under a government contract might make purchases, acting as an agent for the Federal government. Often states view such transactions and the taxation decision quite differently. In addition, each state has its own rules about the taxability of transaction with its own government, quasi-government entities and the governments of other states. Therefore, treating all transactions with governmental entities the same could have costly tax consequences.
South Dakota, for example, exempts the purchases by the other state governments and the District of Columbia if that state provides a similar exemption for South Dakota government entities. This means, one has to look to the other state in order to determine if the South Dakota exemption will apply.
In conclusion, non-profit organizations need to be aware of the following:
- The laws in your state or applicable states where your non-profit organization is operating, whether on its own or its agents;
- What types of entities and transactions are subject to sales and use tax; and
- The proper documentation needed to substantiate a tax exempt transaction.
It is the responsibility of the non-profit organization to understand applicable tax implications. For assistance or to learn more, please contact your tax advisor.