Earlier this summer, the IRS published a memorandum (the “Memorandum”, available here), casting serious doubt on whether NIL collectives qualify for tax-exempt status under Section 501(c)(3) of the Internal Revenue Code (the “Code”). The Memorandum concludes that an organization that develops paid NIL opportunities for student-athletes will not, in many cases, qualify for tax-exempt status because the private benefits to student-athletes are not incidental to the organization’s exempt purposes (click here for a separate Michael Best client alert about the Memorandum and NIL collectives).
Beyond the NIL context, and while not directly addressed in the Memorandum, the Memorandum raises questions regarding whether (and to what extent) an organization described in Section 501(c)(3) of the Code can rely on a favorable determination letter from the IRS. Put another way, can the IRS issue a favorable determination letter to an organization, change its position months or years later, and then revoke or modify its original determination? If you’re on the edge of your seat, skip down to the response to Q3.
In this FAQ-style article, our goals are to discuss (1) the consequences the Memorandum may have on NIL collectives relying on a favorable IRS determination letter; (2) the rules pertaining to taxpayer reliance on favorable determination letters; and (3) when retroactive revocation may be appropriate for organizations that filed a Form 1023 with a material omission or misstatement of fact.
Q1: Does the Memorandum impact the tax-exempt status of NIL collectives previously determined by the IRS to be exempt under Section 501(c)(3) of the Code?
- The Memorandum has no immediate and automatic impact on the tax-exempt status of NIL collectives. As a non-precedential internal document, the Memorandum reflects the IRS’s position on the tax-exempt status of NIL collectives but does not constitute official guidance to taxpayers. A NIL collective that has received a favorable determination letter generally may continue to rely on that determination.
- Congress is certainly interested in this topic. Introduced in the U.S. Senate on May 4, 2023, the “Athlete Opportunity and Taxpayer Integrity Act” would deny a tax deduction for contributions (except contributions made directly to certain institutions of higher education) used to compensate one or more secondary or post-secondary school athletes for the use of their names, images, or likenesses by reason of their status as athletes.
Q2: When can the IRS revoke a favorable determination letter?
- Favorable determination letters and rulings may be revoked or modified by the IRS “at any time in the wise administration of the taxing statues." Meaning, an organization may be at risk of having its tax-exempt status revoked in a post-determination review if the IRS changes its position on a particular topic. Post-determination reviews allow the IRS to “assure uniform application of the statutes, tax treaties, regulations, court opinions, or guidance published in the Internal Revenue Bulletin." This may lead to the IRS determining, upon re-examination, that an organization’s favorable determination letter should be revoked.
- An adverse determination may be challenged by filing a petition or complaint for declaratory judgment under Section 7428 of the Code in the U.S. Tax Court, U.S. Court of Federal Claims, or the U.S. District Court for the District of Columbia within 90 days of the date of the adverse letter.
Q3: We provided a robust description of our organization’s activities on IRS Form 1023 and our activities have not changed since that time. Are you saying that the IRS can “re-examine” its original favorable determination?
- The short (and frustrating) answer is “Yes.” The IRS can change its position with respect to the underlying basis for an organization’s tax exemption. As mentioned in the response to Q2, a favorable determination letter may be revoked or modified by the IRS “at any time in the wise administration of the taxing statues” to assure the uniform application of the law on a particular topic.
- As applied to NILs, the IRS could theoretically reevaluate its original favorable ruling to these organizations and determine that exemption under Section 501(c)(3) is no longer appropriate.
Q4: If that’s the case, what benefit is there in a well drafted Form 1023 application?
- A robust IRS Form 1023 (“Application for Recognition of Exemption Under Section 501(c)(3)”) may insulate an organization from more substantial tax consequences in the event the IRS later revokes tax-exempt status. Once an organization’s tax-exempt status has been revoked, the question becomes whether revocation is prospective or retroactive.
- Retroactive revocation is appropriate if (1) the tax-exempt organization made a material misstatement or omission in its original Form 1023; or (2) the facts upon which the tax-exempt status of the organization was based, such as the activities disclosed in its Form 1023, have materially changed.
- In short, if the activities of a tax-exempt organization remain materially the same as those described in its Form 1023 and the organization did not misstate or omit any material facts in its Form 1023, then that organization may avoid the retroactive revocation of its tax-exempt status (but may not be able to avoid revocation altogether).
Q5: What impact, if any, does revocation have on past donors?
- In determining whether a donor’s contribution to a tax-exempt organization is deductible under Section 170 of the Code, a donor may rely on the tax-exempt status of an organization, as reflected in IRS records, on the date of the gift. Reliance is generally proper “until the date of a public announcement” stating that the organization ceases to qualify as a tax-exempt organization eligible to receive contributions deductible under Section 170. Thus, revocation should not impact past contributions for which donors claimed a deduction.
Q6: What constitutes a material omission or misstatement of fact?
- If a misstated or omitted fact would have changed the IRS’ original favorable determination regarding an organization’s tax-exempt status, the fact likely is material.
- In this respect, tax-exempt organizations that file the short Form 1023-EZ rather than the full Form 1023 may face additional risk of retroactive vs. prospective revocation because the Form 1023-EZ provides for disclosure of very little information about an organization’s activities.
Q7: What constitutes a material change of facts?
- Generally, when an activity is consistent with the stated purpose of an organization, as described in its Form 1023, engaging in that activity is unlikely to constitute a material change of facts. Conversely, where a significant activity is inconsistent with the stated purpose and activities disclosed in an organization’s Form 1023, then engaging in that activity may constitute a material change of facts. Further, ceasing significant activities upon which an organization’s tax-exempt status was based also may constitute a material change of facts.
Q8: What if an organization reports and describes changes in its activities on Form 990? Will that prevent retroactive revocation?
- Reporting a change of activities on a Form 990 or Form 990-PF likely will not prevent the retroactive revocation of a ruling or determination letter – though disclosure of such activities is required by the Form 990 (Part III, lines 2 and 3) and Form 990-PF (Part VI-A, line 2).
- An organization may request a private letter ruling from the IRS with respect to the tax consequences of proposed changes in the organization’s purposes or activities. A favorable private letter ruling would provide protection from retroactive revocation. Keep in mind, however, that requesting such a ruling can be a substantial undertaking for most charitable organizations, as it requires a significant IRS user fee, in addition to the time and legal fees to prepare such a request.
Q9: What impact, if any, does the recent Supreme Court affirmative action ruling have on charities with exemptions based in whole or in part on various DEI grantmaking, programs, or initiatives? Could the IRS reexamine those rulings?
- It is unclear how the IRS will apply the Supreme Court’s decision in Students for Fair Admissions to charitable organizations. In that case, the Court held, among other things, that the admissions process employed by Harvard University and the University of North Carolina violated the Equal Protection Clause of the Fourteenth Amendment. In its application of the “public policy doctrine,” the IRS could, conceivably, change its position as to whether charities engaged exclusively or primarily in DEI activities are properly classified as tax-exempt since such activities now might be considered to be “contrary to a clearly defined and established public policy."
Q10: Looking forward to a future IRS examination, what can an organization do to guard its tax-exempt status?
- On the front end, an organization should consult with legal counsel to be sure the basis for tax exemption, as described in IRS Form 1023, has a firm foundation in tax law. There may be times the IRS changes its position, but generally speaking the activities that qualify for tax exemption are predictable based on existing guidance.
- Organizations already in existence can dust off their Form 1023 and familiarize themselves with what was originally disclosed to the IRS. Have the organization’s purposes and activities changed substantially since that time? If so, have these changes been disclosed to the IRS? “Mission creep” is not uncommon. If this has happened to you, we recommend you consult with legal counsel to assess your risk.
- Take a close look at the organization’s activities and consider getting legal counsel involved (some call this a “legal audit”). Is the organization currently engaged in any activity that could jeopardize the organization’s tax-exempt status or that could otherwise result in negative tax consequences? For example, review the reasonableness of compensation paid to key employees, lobbying and political activity, related party transactions, transactions with insiders, and compliance with the organization’s governing documents. Putting in the work before an examination begins will be time well spent.
Please don’t hesitate to reach out to your Michael Best attorney if you have questions about your organization’s tax-exempt status or need assistance with any of the issues raised in this article.
 26 C.F.R. §§601.201(l) & 601.201(m).
 Rev. Proc. 2023-5, §11.03(1).
 Rev. Proc. 2018-32 §4.01.
 IRS Info. Letter 2013-0004.
 Students for Fair Admissions v. President and Fellows of Harvard College, 143 S.Ct. 2141 (2023).
 26 C.F.R. § 601.201(l) - (m) (determination letters and rulings may be revoked or modified by the IRS “at any time in the wise administration of the taxing statues”). See Jean Wright and Jay H. Rotz, Illegality and Public Policy Considerations (1994 CPE Text), available at https://www.irs.gov/pub/irs-tege/eotopicl94.pdf.