Charitable organizations provide invaluable services across the U.S. and worldwide. Nonprofits recognized under Section 501(c)(3) of the Internal Revenue Code enjoy valuable tax-exempt status—but that status can be lost if compliance standards are not met.
Below are five critical risks every nonprofit should avoid, along with proactive steps leaders can take to protect their mission.
1. Failure to Meet the Organizational Test & Exempt Purpose
To qualify under 501(c)(3), an organization must be organized exclusively for exempt purposes, with assets permanently dedicated to them. Organizing documents must:
- Limit activities to exempt purposes
- Avoid granting authority to engage in non-exempt activities
- Dedicate assets permanently to exempt use (e.g., dissolution provisions transferring to another 501(c)(3))
Activities must serve a public—not private—interest. Organizations engaged in politically sensitive issues should stay vigilant regarding changing laws.
2. Private Benefit or Private Inurement
- Private benefit: occurs when activities benefit individuals outside the charitable class. This is permissible only if the benefit is incidental or de minimis.
- Private inurement: occurs when insiders (such as board members, officers, or key employees) receive improper benefits. This is strictly prohibited and can trigger significant financial penalties for both the organization and the individual involved.
Excessive compensation is a common risk area. To mitigate it, organizations should:
- Benchmark pay against comparable nonprofits
- Use an independent review committee
- Keep thorough written documentation of the process
3. Failure to File Form 990
Nonprofits must file an annual Form 990 by the 15th day of the 5th month after fiscal year-end or face fines, with certain exceptions.
Failure to file for three consecutive years results in automatic revocation of tax-exempt status.
Form types:
- 990-N (e-Postcard): Receipts < $50,000
- 990-EZ: Receipts < $200,000 and assets < $500,000
- 990: Receipts > $200,000 or assets > $500,000
- 990-PF: Required for private foundations
Even an illegible return may count as failure to file.
4. Political Campaign Activity & Excessive Lobbying
- Political campaigns: 501(c)(3)s may not endorse candidates, donate to campaigns, or distribute biased voter materials. Violations can trigger excise taxes.
- Lobbying: Public charities may lobby, but it must not be substantial. Private foundations cannot lobby at all.
IRS tests:
- “No Substantial Part” Test: Facts-and-circumstances; “substantial” often >5%.
- Section 501(h) Expenditure Test: Dollar-based, requires election via Form 5768.
5. Unrelated Business Income Tax (UBIT)
Organizations with unrelated business income over $1,000 must file Form 990-T.
The IRS applies a three-part test:
- Trade or business intended for profit
- Regularly conducted like commercial activity
- Not substantially related to exempt purpose
Using UBI proceeds for mission work does not make the income exempt.
What Nonprofit Leaders Should Do
Avoiding risks is only half the battle. To actively protect exempt status, leaders should:
1. Strengthen Governance
- Maintain strong bylaws and oversight
- Review activities regularly for alignment with exempt purpose
2. Document Decisions
- Keep board minutes and records of compensation, policies, and related-party transactions.
3. Monitor Compliance
- Use calendars to track IRS/state deadlines
- Assign responsibility for filings and compliance reviews
4. Educate Leadership
- Train staff and board on IRS restrictions
- Clarify limits on lobbying, political activity, and unrelated income
5. Oversee Finances
- Benchmark compensation
- Review revenue streams to separate mission-related from unrelated income
These practices reduce risk while strengthening transparency, accountability, and donor trust.
Next Steps
Protecting your organization’s tax-exempt status is critical to fulfilling your mission. If you have questions about compliance or need guidance tailored to your nonprofit, contact Han Group for expert support.
