Tax 101: Understanding U.S. Taxation of Foreign Investment in Real Property - Part I

Read Publication

INTRODUCTION

U.S. real estate has been a popular choice for foreign investors, whether the property is held for personal use, rental or sale, or long-term investment. Since the passage of the Foreign Investment in Real Property Tax Act of 1980 (“F.I.R.P.T.A.”), the governing tax rules have developed and evolved, but have not succeeded in discouraging foreign investment. F.I.R.P.T.A. can be a potential minefield for those unfamiliar with U.S. income, estate, and gift taxation – all of which come into play. This article is the first of a series on understanding U.S. taxation of foreign investment in real property.

TAXATION OF A FOREIGN PERSON

“A foreign person is subject to U.S. income tax only on income that is characterized as U.S. source income.”

As simple as the concept sounds, there are applicable nuances, caveats, exemptions, and exceptions. Therefore, several questions must first be answered to determine the U.S. income tax consequences for a foreign person engaged in U.S. economic activities, including ownership of real property:

1. Is the income derived from a U.S. source and therefore potentially taxable?
2. Is the income taxable or exempt from tax?
3. Is the income passive or active, subject to a flat withholding tax on gross income or, alternatively, to graduated rates on net income?
4. Is the income earned by an individual or corporation or other entity, each of which may have different rules and applicable tax rates?

Recapitalization of L.L.C. Interests and Issuance of Profit Interests Held to be Gifts in Estate Freeze

Read Publication

Code §2701 is a provision which renders the transfer of a partnership or membership interest to a family member a gift. The tax typically applies in an “estate freeze” scenario, where one generation attempts to transfer assets which appreciate in value to another generation, thereby removing it from their estate for estate tax purposes. In its latest Chief Counsel Advice (“C.C.A.”), the I.R.S. held that a recapitalization of a limited liability company (“L.L.C.”) triggers a gift under Code §2701 in a case where a mother retained a right of distribution but transferred the gain or loss attributable to the L.L.C.’s assets to her sons. The I.R.S. held that the interest retained by the transferor (a distribution right on the existing capital account balance) was a senior interest, whereas the transferred interest held by the sons (the right to future gain of the L.L.C.’s assets) was found to be a subordinate interest. What is notable and most troubling here is that the interests transferred to the sons are so-called “profits interests,” issued for future services to be rendered to the L.L.C.

IN GENERAL

Code §2701 imposes special gift tax valuation rules when partnership or membership interests are transferred to family members. Family members covered under Code §2701 include the spouse of the transferor, any lineal descendant of the transferor or the transferor's spouse, and the spouse of any such descendant. In general, Code §2701 devalues interests of senior family members in order to increase the value of interests transferred to junior family members. Code §2701 generally applies to situations where the transferor retains a senior interest and transfers a subordinate interest to the transferee – such as when a parent keeps preferred shares and transfers common shares to family members.

Anti-Deferral Regimes: U.S. Taxation of Foreign Corporations

Read Publication

When a U.S. business expands abroad, it is frequently believed that the income of foreign subsidiary corporations will not be taxed in the U.S. until dividends are distributed to the U.S. shareholder. This is known as tax deferral, which is the general expectation of clients. However, in the U.S., tax deferral may be overridden by provisions accelerating the imposition of U.S. tax on U.S. shareholders of foreign corporations. As a result, income may be taxed before a dividend is distributed. This article describes the anti-deferral provisions of U.S. tax law that may be applicable in certain situations.

ANTI-DEFERRAL REGIMES

The Internal Revenue Code contains two principal anti-deferral regimes that may impose tax on a U.S. taxpayer on a current basis when its foreign subsidiaries generate income. These provisions reflect a policy under which Congress believes the deferral rules are being abused to inappropriately defer U.S. tax, especially if foreign tax is not imposed for one reason or another. The two regimes are the:

• Controlled Foreign Corporation (“C.F.C.”) regime under Code §§951-964, also known as the “Subpart F” provisions; and
• Passive Foreign Investment Company (“P.F.I.C.”) regime under Code §§1291-1298.

Controlled Foreign Corporations

Under Code §957(a), a foreign corporation is a C.F.C. if stock representing more than 50% of either the total combined voting power or the total value of shares is owned, directly, indirectly, or by attribution, by “U.S. Shareholders” on any day during the foreign corporation’s taxable year. With respect to a foreign corporation, a U.S. Shareholder is defined as a “U.S. person” that owns, under the foregoing expanded ownership rules, stock representing 10% or more of the total voting power of all classes of the foreign corporation’s stock that is entitled to vote. A “U.S. person” includes a U.S. citizen or resident, a U.S. corporation, a U.S. partnership, a domestic trust, and a domestic estate. Stock ownership includes indirect and constructive ownership under the rules of Code §958. Consequently, ownership can be attributed, inter alia, from foreign corporations to shareholders, from one family member to another, and from trusts and estates to beneficiaries, legatees, and heirs.

Corporate Matters: Covering Your Partner's Tax Tab

Read Publication

A district court, affirming a bankruptcy court decision, recently held that a partner can be secondarily liable for a partnership's unpaid employment taxes and that the I.R.S. could proceed with collection without having commenced specific individual action against the partner.

Case History

In Pitts v. U.S., Wendy K. Pitts, a California resident, was a general partner of DIR Waterproofing (“DIR”), a California general partnership. On March 1, 2012, Pitts filed a Chapter 7 bankruptcy petition in the U.S. Bankruptcy Court for the Central District of California. As of that date, DIR had unpaid Federal Insurance Contribution Act taxes and unpaid Federal Unemployment Tax Act taxes for various quarters in 2005, 2006, and 2007. It also had unpaid penalties.

Commencing in 2007, the I.R.S. recorded a number of tax liens naming DIR and Pitts as the taxpayers for the unpaid amounts. The I.R.S. identified Pitts as a DIR partner on the liens. At the time of the district court proceeding, the liens still encumbered the property of Pitts.

On June 21, 2007 and August 7, 2007, the I.R.S. issued Notices of Federal Taxes Due naming DIR as the taxpayer and Pitts as a partner.

As of the time of the summary judgment proceeding in June 2013, DIR still owed at least $114,859 in tax debt, plus unassessed interest. However, the I.R.S. never assessed DIR's taxes against Pitts or brought a judicial action against her.

Insights Vol. 1 No. 9: F.A.T.C.A. 24/7

Read Publication

TREASURY ACCEPTS CANADIAN NARROWING OF INVESTMENT ENTITY DEFINITION

Canada’s recently published guidance with respect to F.A.T.C.A. provides that only “listed financial institutions” should be considered investment entities subject to F.A.T.C.A. under the intergovernmental agreement (“I.G.A.”) with Canada (“U.S.-Canada I.G.A.”). The U.S. Treasury has accepted this position.

The U.S.-Canada I.G.A. provides that the definition of “investment entity” is to be interpreted in a manner consistent with the definition of “financial institution” in the recommendations of the Financial Action Task Force (“F.A.T.F.”). The F.A.T.F. provides that any natural person or legal entity that conducts, as a business, one or more listed activities or operations for, or on behalf of, a customer, would be treated as a “financial institution.” The F.A.T.F. also provides a list of designated nonfinancial businesses and professions, including certain trust and company service providers that are not otherwise financial institutions and act as trustees for trust entities. Canada’s anti-money laundering rules interpret this standard to treat the unlisted financial institutions as designated nonfinancial businesses. The Canadian F.A.T.C.A. guidance treats only the expressly listed financial institutions as investment entities, and as mentioned above, the I.R.S. has approved this position.

Action Item 15: Developing a Multilateral Instrument to Modify Bilateral Tax Treaties

Read Publication

AN EXERCISE IN “POINT/COUNTERPOINT”

Implementation of many of the B.E.P.S. Action Items would require amending or otherwise modifying international tax treaties. According to the O.E.C.D., the sheer number of bilateral tax treaties makes updating the current treaty network highly burdensome. Therefore, B.E.P.S. Action Item 15 recommends the development of a multilateral instrument (“M.L.I.”) to enable countries to easily implement measures developed through the B.E.P.S. initiative and to amend existing treaties. Without a mechanism for swift implementation of the Action Items, changes to model tax conventions merely widen the gap between the content of the models and the content of actual tax treaties.

Discussion of Action Item 15 has centered on the following issues:

• Whether an M.L.I. is necessary,
• Whether an M.L.I. is feasible, and
• Whether an M.L.I. is legal.

In the spirit of these ongoing discussions concerning Action Item 15, we offer our commentary in a “point/counterpoint” format.

Action Item 13: Guidance on Transfer Pricing Documentation and Country-by-Country Reporting

Read Publication

INTRODUCTION

On July 19, 2013, the Organization for Economic Cooperation and Development (“O.E.C.D.”) released its full Action Plan on Base Erosion and Profit Shifting (the “B.E.P.S. Action Plan”), with expectations to roll out specific items over the subsequent two years. According to the O.E.C.D., the B.E.P.S. Action Plan will allow countries to draft coordinated, comprehensive, and transparent standards that governments need to prevent B.E.P.S., while at the same time updating the current rules to reflect modern business practices. Of the 15 action items listed in the B.E.P.S. Action Plan, four relate specifically to transfer pricing and several others indirectly address this area, as well. The four with direct impact on transfer pricing are Action Items 8, 9, 10, and 13:

• Action Items 8, 9, and 10 (Assure that Transfer Pricing Outcomes are in Line with Value Creation) develop rules to prevent B.E.P.S. by (i) adopting a broad and clearly delineated definition of intangibles; (ii) ensuring that profits associated with the transfer and use of intangibles, capital, or other high-risk transactions are appropriately allocated in accordance with value creation; (iii) developing transfer pricing rules for transfers of hard-to-value intangibles; and (iv) updating the guidance on cost contribution arrangements.
• Action Item 13 (Re-examine Transfer Pricing Documentation) develops rules regarding transfer pricing documentation to enhance transparency for tax administrations, taking into consideration the compliance costs for multinationals.

With these and the 11 other Action Items, the O.E.C.D. aims to foster (i) coherence of corporate income taxation at the national level; (ii) enhanced substance, through bilateral tax treaties an in transfer pricing; and (iii) transparency and consistency of requirements.

Action Item 8: Changes to the Transfer Pricing Rules in Relation to Intangibles - Phase I

Read Publication

INTRODUCTION

Unlike some of the other B.E.P.S Action Items, Action Item 8 has a basis in existing O.E.C.D. rules. In this regard, the O.E.C.D. Transfer Pricing Guidelines41 have established the operating rules for transfer pricing. It is understandable that Action Item 8 merely presents a series of amendments to Chapters I, II, and VI of the O.E.C.D. Guidelines.

Action Item 8 states that it seeks to:

• Clarify the definition of I.P.,
• Provide guidance on identifying transactions involving I.P., and
• Provide supplemental guidance for determining arm’s length conditions for transactions involving I.P.

Action Item 8 also considers the treatment of local market features and corporate synergies.

Action Item 6: Attacking Treaty Shopping

Read Publication

BACKGROUND

Action Item 6 addresses abuse of treaties, particularly focusing on treaty shopping as one of the most important sources of B.E.P.S. The approach adopted amends the O.E.C.D. Model Convention that borrows from the U.S.'s approach to treaties but expands upon it in a way that can be very helpful to the U.S. and other developed countries if adopted by the C.F.E. next year in their final report. Among other measures, the report recommends inclusion of a Limitation on Benefits (“L.O.B.”) provision and a general anti-avoidance rule called the Principal Purpose Test (“P.P.T.”) to be included in the O.E.C.D. Model Convention. While it is expected the report will be finalized next year, whether countries will adopt the recommendations is the crucial factor that is still unclear.

RECOMMENDATIONS

The key recommendations can be found in Paragraph 14. It contains two basic recommendations:

• Countries should agree to include in the tax treaties an express statement of the common intention to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance through use of treaties.
• Countries should demonstrate their commitment to this goal by adopting an L.O.B. provision and a P.P.T. provision in income tax treaties.

The report also notes that special rules may be needed to address application of these rules to collective investment funds (“C.I.F.’s”). The provision should be supplemented by a mechanism that would deal with conduit arrangements not currently dealt with in tax treaties.

Action Item 5: Countering Harmful Tax Practices More Effectively

Read Publication

The Organization for Economic Co-operation and Development (“O.E.C.D.”) worked together with G20 countries to develop a 15-point action plan to deal with Base Erosion and Profit Shifting (“B.E.P.S.”). The goal of the B.E.P.S. Action Plan is to develop a single global standard for automatic exchange of information and stop corporations from shifting profits to jurisdictions with little or no tax in order to ensure taxation in the jurisdiction where profit-generating economic activities are performed and where value is created.

B.E.P.S. occurs in situations where different tax laws interact in a way that creates extremely low global tax rates or results in double non-taxation. This kind of planning gives a competitive advantage to multinational entities that have substantial budgets to engage high-powered tax advisers and to implement their plans.

The O.E.C.D. published deliverables that intend to eliminate double non-taxation resulting from B.E.P.S. The final measures will be completed in 2015 and will be implemented either through domestic law or the existing network of bilateral tax treaties.

ACTION ITEM 5: HARMFUL TAX PRACTICE

Harmful Tax Competition: An Emerging Global Issue

In 1998, the O.E.C.D. published the report Harmful Tax Competition: An Emerging Global Issue (“the 1998 Report”) with the intention of developing methods to prevent harmful tax practices with respect to geographically mobile activities. These methods have been adopted in the Forum on Harmful Tax Practice (“F.H.T.P.”) with some modifications. Significant attention is given to:

• Elaborating on a methodology to define a substantial activity requirement in the context of intangible regimes; and
• Improving transparency through compulsory spontaneous exchange on rulings related to preferential regimes.

Action Item 2: Neutralizing the Effects of Hybrid Mismatch Arrangements

Read Publication

On the heels of the discussion drafts issued in March, the Organization for Economic Cooperation and Development (“O.E.C.D.”) released the initial components of its plan to fight base erosion and profit shifting (the “B.E.P.S. Action Plan”). Action Item 2 addresses the effects of hybrid mismatch arrangements and proposes plans to neutralize the tax deficits caused.

These responses aim to tackle the following issues created by the hybrid mismatch arrangements:

• Reduction in overall tax revenue,
• Unfair advantage given to multinational taxpayers with access to sophisticated tax-planning expertise, and
• Increased expense often incurred in setting up hybrid arrangements compared to domestic structures.

This article introduces the different hybrid arrangements, looks at the proposed changes in both domestic law and international tax treaties, and discusses the ripple effect this could have if implemented.

INTRODUCTION

A hybrid mismatch arrangement is one that exploits a difference in the way an entity or instrument is taxed under different jurisdictions to yield a mismatch in total tax liability incurred by the parties. The two possible mismatches that could result are either a “double deduction” (“DD”) or a deduction that is not offset in any jurisdiction by ordinary income (“D/NI”). These mismatches are brought about by the different interpretations afforded to the entities and transactions in relevantjurisdictions. The root cause of the hybrid mismatch is that an entity may be a “hybrid entity” and an instrument may be a “hybrid instrument.” Understanding the different hybrid arrangements is instrumental to understanding the plan proposed by the O.E.C.D.

Action Item 1: The O.E.C.D.'s Approach to the Tax Challenges of the Digital Economy

Read Publication

The O.E.C.D.’s Action Plan adopted in Saint Petersburg in 2013 aims at tracking where economic activities generating taxable profits are performed and where value is created. It aims at ensuring that taxation follows the economic activities and the creation of value and not the other way around. Action Item 1 of the Action Plan (the “Action 1 Deliverable”) focuses on the tax challenges of the digital economy. Along with the 2014 Deliverable on Action 15 (Developing a Multilateral Instrument to Modify Bilateral Tax Treaties), the Action 1 Deliverable is a final report.

The Action 1 Deliverable published on September 16, 2014 mainly reiterates the March 2014 Public Discussion Draft on Action 1 (click here to access our article on the 2014 Public Discussion Draft). It restates that, while B.E.P.S. is exacerbated in the digital economy space, the digital economy cannot be ring-fenced from other sectors of the economy for B.E.P.S. purposes because the digital economy is an ever growing portion of the entire economy. The Action 1 Deliverable thus refers to other Actions to address common B.E.P.S. issues that are not specific to the digital economy. Action Item 1 also refers to the O.E.C.D.’s International V.A.T./G.S.T. Guidelines with regard to V.A.T. issues raised by the digital economy. Although the Action 1 Deliverable adds relatively little to the previously published Public Discussion Draft on Action Item 1, the benefit of a set of uniformly accepted rules should not be understated. With European countries struggling to raise tax revenue in order to close budget gaps, the risk of adverse unilateral action by one or more countries is real. During a symposium held in Rome at the beginning of the month, certain European countries, and especially Italy, pushed for unilateral action with regard to the taxation of the digital economy. If that action proceeds to enactment, digital tax chaos could be encountered.

Israeli Law Confronts International Tax Treaties and Principles Via New Treatment of Mixed-Beneficiary Trusts

Read Publication

HISTORY AND OVERVIEW OF ISRAELI TAXING MODELS IN RESPECT OF NON-ISRAELI TRUSTS

Pre-2006 Situation – the Corporate Model

Israel has come a long way in its efforts to tax foreign-established trusts, which historically were assumed to have been used to shelter Israeli-source funds of high net worth Israeli residents and their families. Prior to the adoption of any relevant comprehensive Israeli tax legislation in 2006, the practice consisted mostly of viewing trusts and beneficiaries similarly to corporations and shareholders.

Thus, under customary Israeli international tax rules, if the “management and control” of the non-Israeli trust was effected outside of Israel, the trust was considered to be nonresident because the trust’s assets were situated outside of Israel and the trustees had full discretion over their control. No formal powers were exercised directly or indirectly by Israeli beneficiaries. Hence, the trust was simply not subject to Israeli taxation. Moreover, discretionary distributions were viewed as tax-free gifts. In this way, wealthy Israelis could cause foreign trusts to be funded by Israeli-source wealth and invested outside Israel without subjecting the resulting income to Israeli tax.

Israel has neither an estate/inheritance tax nor a gift tax, which means that bona fide gifts and inheritances are free of tax for both the donor or the decedent and the recipient. Thus, a foreign trust ostensibly became the perfect Israeli tax planning tool. Assets could be donated by an Israeli settlor to a foreign irrevocable discretionary trust for the benefit of family members. Legally, the assets were no longer owned by the Israeli donor but rather by a foreign body managed and controlled by a foreign trustee. Therefore, the trust’s non-Israeli assets and income were outside the scope of Israeli taxation. Distributions by these trusts to Israeli resident beneficiaries that were bona fide discretionary gifts were exempt in the hands of an Israeli recipient.

Insights Vol. 1 No. 8: Updates & Other Tidbits

Read Publication

U.K. WINDFALL WINDING DOWN

After an arduous path through the courts regarding the creditability of the U.K. windfall tax, the Third Circuit followed the holding of the U.S. Supreme Court and found the tax to be creditable in a case involve PPL Corp.

The U.S. and foreign countries can tax foreign-sourced income of U.S. taxpayers. To lessen the economic cost of double taxation, U.S. taxpayers are allowed to deduct or credit foreign taxes in computing income or net tax due. The amount of the U.S. income tax that can be offset by a credit cannot exceed the proportion attributable to net foreign source income. Code §901(b) specifies that a foreign credit is allowed only if the nature of the foreign tax is similar to the U.S. income tax and is imposed on net gain.

The U.S. entity PPL is a global energy company producing, selling, and delivering electricity through its subsidiaries. South Western Electricity PLC (“SWEB”), a U.K. private limited company, was an indirect subsidiary that was liable for windfall tax in the U.K. Windfall tax is a 23% tax on the gain from a company’s public offering value when the company was previously owned by the U.K. government. When SWEB paid its windfall liability, PPL claimed a Code §901 foreign tax credit. This was denied by the I.R.S. and the long and winding litigation commenced.

Initially, the Tax Court found the windfall tax to be of the same character as the U.S. income tax. The decision was reversed by the Third Circuit Court of Appeals, which held that the tax was neither an income tax, nor a war profits tax, nor an excess profits tax. It took into consideration in determining the tax base an amount greater than gross receipts. Then, the Supreme Court reversed, finding that the predominant character of the windfall tax is an excess profits tax based on net income. Therefore, it was creditable. In August, the Third Circuit followed the Supreme Court’s decision and ordered that the original decision in the Tax Court should be affirmed.

The U.S.-Sweden I.G.A.: A Practitioner's Perspective

Read Publication

Sweden recently entered into an intergovernmental agreement (“I.G.A.”) with the U.S. to address the application of F.A.T.C.A. to Swedish financial institutions. The subsequent modifications to Swedish law to accommodate the I.G.A. were made public on August 11, 2014 in a proposal by the Ministry of Finance. The proposal added numerous modifications to the requirements for compliance and published the reporting forms that will be due starting next year. The complexity of F.A.T.C.A. compliance will trigger a number of changes in many areas of Swedish legislation, which are likely to be approved by the Swedish Parliament in the fall of 2014. It is clear that F.A.T.C.A. will make life more complex for the regulated groups.

F.A.T.C.A. will have a broad, sweeping effect on Swedish financial institutions (“F.I.’s”), including large Swedish banks, insurance companies, and private equity companies. These F.I.’s have been planning for F.A.T.C.A. and have implemented technology, procedures, and training that have caused them to incur in significant costs. However, based on personal experience, it appears that there is a large group of “institutions” that do not understand that they are in fact F.I.’s and must act accordingly. Recently, when discussing due diligence procedures mandated by F.A.T.C.A. with management of a Swedish permanent establishment, the response was simply “thanks for the heads up,” which indicated that the compliance requirements were not yet on the company’s radar.

Some of these institutions may revert to the simplest solution – barring Americans from being accepted as investors or account holders. This solution, however, is suboptimal for an F.I. as it eliminates a large group of Swedish/U.S. dual citizens from the client base. Of greater importance is the fact that barring Americans does not mean an institution can ignore F.A.T.C.A. F.A.T.C.A. requires disclosure of U.S.-controlled foreign entities that may be account holders at these institutions, a task that will require creating new on-boarding procedures and a review of all preexisting accounts.

Insights Vol. 1 No. 8: F.A.T.C.A. 24/7

Read Publication

ISRAEL IS BECOMING THE I.R.S.'S STRICTEST ENFORCER OF F.A.T.C.A.

On May 4, 2014 Israel reached a Model 1 agreement with the U.S. Israel has shown a strong eagerness to accept F.A.T.C.A. In 2012, the Association of Banks in Israel urged the country's central bank, the Bank of Israel, to ask the government to reach a F.A.T.C.A. agreement with the United States. Earlier in 2014, even before the signing of the F.A.T.C.A. agreement, the Bank of Israel ordered Israeli financial institutions to begin to implement F.A.T.C.A. procedures, including appointing an officer to oversee F.A.T.C.A. compliance, identifying U.S. customers, making them sign I.R.S. declarations (such as I.R.S. Form W-9 or Form W-8BEN), and expelling any clients unwilling to do so. Israel has shown strong support and an eagerness to uphold the enforcement of F.A.T.C.A.

The Israeli Ministry of Finance has drafted proposed regulations that would impose criminal penalties on Israeli financial institutions (including banks, brokerage houses, and insurance companies) that do not comply with F.A.T.C.A. reporting obligations.

CANADIANS CHALLENGE F.A.T.C.A. AGREEMENT

On August 11, through the Alliance for the Defense of Canadian Sovereignty, two U.S.-born Canadians filed a lawsuit against the Canadian government asserting that the Canadian I.G.A. was unconstitutional.

A statement of claim at the Federal Court of Canada in Vancouver was filed against the defendant, the Attorney General of Canada, contesting the Model 1 reciprocal I.G.A. that Canada and the United States signed on February 5.

Corporate Matters: Delaware or New York L.L.C.?

Read Publication

When a client is considering commencing business operations in New York, we are often asked whether it is preferable to form a limited liability company (“L.L.C.”) in New York or in Delaware. As we have mentioned in a previous issues, Delaware is generally the preferred jurisdiction for incorporation and the jurisdiction we typically recommend.

We thought it might be helpful to set out a short summary of issues that one will encounter in choosing between a New York or a Delaware L.L.C. and the relevant advantages and disadvantages of using either state.

Filing Fees

The fee for filing the articles of organization for a New York L.L.C. is $200, while the fee for filing a certificate of formation in Delaware is only $90.00. However, if the Delaware L.L.C. intends to conduct business in New York, it must file an application of authority for a foreign limited liability company, accompanied with a certificate of good standing from Delaware.

The determination of whether the Delaware L.L.C. is conducting business in New York is largely fact specific. The filing fee for the application for authority is $250, and the Delaware fee for a certificate of good standing can range from $50 (for a short form certificate) to $175 (for a long form certificate).

I.R.S. Issues New Form 1023-EZ: Streamlined Exemption for Small Charities

Read Publication

On July 1, 2014, the Internal Revenue Service (“I.R.S.”) introduced a new, shorter application form to help small public charities apply for recognition of tax-exempt status, under §501(c)(3) of the Internal Revenue Code (“the Code”), more easily.

Ruchelman P.L.L.C. used the new Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, for a client and received recognition of tax-exempt status in less than three weeks. Recognition of tax-exempt status ordinarily can take months, if not years (in the case of charities operating abroad). Prior to the introduction of Form 1023-EZ, expedited processing was available only under certain circumstances, generally in the case of a mass disaster (e.g., terrorist attack, hurricane, etc.).

The new procedures may reduce the need for small charities to engage in fiscal sponsorships with larger public charities. Under a fiscal sponsorship, the larger charity agrees to sponsor the start-up charity, receiving and administering charitable contributions on behalf of the sponsored organization, for a fee.

The new Form 1023-EZ, is three pages long, compared with the standard 26-page Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. Most small organizations (which the I.R.S. estimates to be as many as 70% of all applicants) qualify to use the new streamlined form. Most organizations with gross receipts of $50,000 or less and assets of $250,000 or less are eligible. These are the same organizations that are eligible to file an “ePostcard” annual return on Form 990-N.

The Form 1023-EZ must be filed using pay.gov (the secure electronic portal for making payments to Federal Government Agencies) and a $400 user fee is due at the time the form is submitted.