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Today in Tax: Qualifying and Keeping a Religious Organization Tax-Exempt Requires a Bona-Fide Tax-Exempt Purpose

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Churches and religious organizations can both qualify as tax-exempt organizations described in Code Section 501(c)(3). In the case of churches, qualification can be achieved more simply than for a non-church. The allure of tax-exempt status can tempt some into casting their activities as having a religious bent or falling within the ambit of a church or worship practice. A recent IRS ruling shows that these types of ploys don’t always have the intended result.

Federal tax law permits churches and religious organizations to receive tax-exempt status under Internal Revenue Code Section 501(c)(3). A church is automatically tax-exempt. And, though many still choose to apply, churches do not need to apply for recognition of tax-exempt status by submitting IRS Form 1023. On the other hand, religious organizations must apply for and be granted tax-exempt status.

Because churches are automatically tax-exempt, while religious organizations are not, proper classification of these organizations is important. The IRS publishes a variety of attributes it associates with a church, whereas a religious organization encompasses a broader field of nondenominational ministries, interdenominational and ecumenical organizations, and other entities whose principal purpose is the study or advancement of religion.

But, even though churches and religious organizations have different qualification procedures, both forms of organization will lose tax-exempt status if they do not actually satisfy the requirements applicable to organizations described in Code Section 501(c)(3). This means that churches and religious organizations must be organized for exempt purposes and operated in furtherance of those purposes.

Private Letter Ruling 202210022 illustrates one organization’s attempt to test the limits of this principle. The IRS ruled that the applicant was not operated exclusively for exempt purposes and therefore was not entitled to exemption. In its application for tax exemption, the entity claimed it was a religious organization formed and operated exclusively for religious purposes. Specifically, the entity’s bylaws stated that it “blended different religious and philosophical concepts while having a fluid structure that is constantly evolving.” The entity’s Form 1023 described two forms of worship, one of which included the use of “divine sacramental cannabis.”

Although some forms of worship could hypothetically include the consumption of cannabis, the IRS found that the entity’s approach was a thinly veiled description of growing, processing, selling, and consuming cannabis—each of which is flatly prohibited under federal law. By engaging in an illegal activity the entity had a substantial non-exempt purpose, and the IRS rejected the entity’s tax-exempt application.

This is a good reminder to both religious and non-religious organizations applying for tax-exempt status that they must be organized and operated exclusively for exempt purposes. Exempt purpose is defined by law as including activities that are charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals. The IRS interprets “exclusively” as meaning that only an insubstantial amount of an entity’s activities may be for non-exempt purposes, as determined on the facts and circumstances of each case.

For those nonprofits that have already received their tax-exempt status approval, it is important to periodically audit existing activities to ensure that substantially all activities are performed for exempt purposes in order to avoid the risk of having tax-exempt status revoked.

Connect with David and Eric on LinkedIn: (David Brandon / Eric Robertson).

Access last week’s installment here.