Earlier today, I had the honor of testifying at the first hearing of the Select Committee on the Non-Profit Sector. Here is my draft written testimony (some of which I omitted from my verbal testimony in the interest of time):

Good afternoon Madame Chair and Members of the Select Committee. It’s a historic day marking the State’s recognition of the critical importance of nonprofits on the everyday lives of its citizens and residents. My name is Gene Takagi, and I’m honored to speak to you today, from a federal law perspective, about the regulation of nonprofits operating in California.

Nonprofits are governed by myriad federal laws, including many related to their specific tax-exempt status. I’ll focus most of my discussion on 501(c)(3) organizations, which include both private foundations and public charities.

Whether we’re talking about the charitable or uncharitable nature of an activity, insider compensation to board members or officers, excessive payments to any person or entity, lobbying and political activities, earned income activities, or deceptive fundraising practices, there are federal laws covering those matters.

The Internal Revenue Service oversees federal tax law compliance of tax-exempt organizations. The IRS does so principally by reviewing the annual information returns (known as Forms 990) that most exempt organizations, except churches, must file with the IRS. The Forms 990 are also public documents that are available online or upon request. The IRS also reviews complaints from the general public, members of Congress, federal and state government agencies, and internal sources.

Under federal law, 501(c)(3) organizations must be organized and operated for a charitable, educational, religious, or similar exempt purpose. This means that:

• the organization must not be operated for the benefit of private interests; and
• only an insubstantial part of the organization’s activities may be devoted to something that is not in furtherance of its exempt purpose, like a purely commercial activity

Violation of these principles can result in revocation of the organization’s tax-exempt status.

If an exempt organization engages in a regularly carried on commercial business that does not contribute substantially to furthering its exempt purpose, it will generally be subject to the unrelated business income tax – the rationale being that tax-exempt organizations should not have an unfair advantage in competing with taxable entities in commercial spaces. Earned income from activities substantially related to furthering an exempt organization’s exempt purpose, like tuition for schools, fees for health care services, or admissions to museums, would not be subject to the unrelated business income tax.

There are also federal laws that prohibit excessive compensation, and impose substantial penalties on insiders (like directors and officers) that receive excessive compensation or any form of excess benefit for which the insider did not provide adequate value in return. Not only must the excessive portion be returned to the organization, but, for charities, penalties of 25% and 200% of the excessive portion may be imposed on the insider. Other board members who knowingly approved the excess benefit transaction may also be hit with penalty taxes of 10% of the excessive portion. If the private inurement or private benefit violation is particularly egregious, the organization may have its exemption revoked.

For 501(c)(3) organizations, federal tax law limits the amount of lobbying they can engage in and absolutely prohibits political campaign intervention, that is they can neither support nor oppose a candidate for public office. They can, however, engage in get-out-the vote drives, voter registration, and issue advocacy, if done in a nonpartisan manner. For 501(c)(4) social welfare organizations, like the Sierra Club, AARP, and the NRA, 501(c)(5) unions, and 501(c)(6) trade and professional associations and chambers of commerce, there is no limit to lobbying so long as it furthers their exempt purpose and the organizations can engage in political campaign intervention so long as that is not their primary activity.

The political campaign intervention prohibition applies to 501(c)(3)s in large part because only they can receive deductible charitable contributions. But the prohibition, which was implemented with the signing of the so-called Johnson Amendment, is largely unenforced and is currently threatened with calls for repeal. A full repeal of the Johnson Amendment would permit the use of deductible charitable contributions for electioneering, including by churches that neither have to apply, nor report, to the IRS (or the Attorney General). We should expect much more dark money to flow through exempt organizations, and specifically through charities, if the Johnson Amendment is repealed.

Unlike public charities, private foundations are also absolutely prohibited from lobbying. In addition, they are subject to a minimum distribution requirement, excise taxes on their investment income, and an additional regime of regulations.

An organization, except for a church, must apply to the IRS for 501(c)(3) status. To solve a continuing problem of backlogged applications for processing, with wait times often exceeding well over one year, and faced with decreasing Congressional funding, the IRS implemented a streamlined application (Form 1023-EZ) in 2014 for most small organizations projecting less than $50,000 in annual gross receipts. Many, including the National Taxpayer Advocate, are critical of the streamlined application, which requires applicants merely to attest, rather than demonstrate, that they meet fundamental aspects of qualification as an exempt entity.

Beyond but including its regulation on tax-exempt organizations, the IRS is particularly focused on laws regarding employment taxes, funds spent outside of the United States, and organizations acting as foreign conduits. With reduced funding, the IRS is using data-driven strategies to review compliance.

We should not overlook the role of other departments and agencies in regulating nonprofits. Of course, nonprofits must comply with federal labor and employment laws, consumer protection laws, intellectual property laws, lobbying laws, and privacy laws. Nonprofit schools must comply with federal education laws. Nonprofit hospitals must comply with federal health care laws. Nonprofits providing housing must comply with federal fair housing laws. Nonprofit grantmakers must comply with federal anti-terrorism and foreign corrupt practices laws. And the many nonprofits that receive federal funding must comply with myriad regulatory compliance requirements associated with such funding.

Nearly 30% of reporting charities have revenues of less than $100,000. About 95% have revenues of less than $1 million and reportedly account for only about 6% of total donations. These organization must find and allocate resources to comply with an array of existing laws while still maximizing the valuable and often critical services they provide to their beneficiaries. They are vital to civil rights, women’s rights, LGBTQ rights, environmental rights, children’s welfare, health, education, arts, and justice. They are key to our civil society. And the vast majority operate in good faith in the best interests of our communities.

Thank you,