Changing your tax status.

Tax-exempt organizations do change. A Section 501 (c) (3) educational group may find the membership becoming more professional and itself more commercial. Unless the association changes its status to 501 (c)(6), it will be limited in permitted activities: no political campaigning, for instance. A 501 (c) (6) organization may want to narrow its focus and, as a 501(c)(3), enjoy a lower postal rate. There are several fundamental differences between 501 (c) (3) and 501 (c) (6) organizations. Before seeking initial recognition or reclassification of your organization's exempt status from the Internal Revenue Service, consider these differences.

Preferential postal rates. Qualifying for special postal rates is more difficult for a 501 (c) (6) organization than a 501 (c) (3). If an organization opts for 501 (c) (6), the test is whether the primary purpose for which it operates is educational. The postal service makes that determination.

Legislative activities. No substandard part of a 501 (c) (3)'s activities may consist of attempts to influence legislation. Certain 501 (c)(3) public charities may elect to have their lobbying activities governed by expenditure tests in lieu of being subject to the "substantial part" test. (For more details, see "Legal," March 1992.) A 501 (c)(6) may permissibly engage in any amount of legislative activity germane to the common business interests of the organization's members.

Political activities. A 501 (c) (3) is absolutely prohibited from engaging in any political activity. If the primary purpose and activities of an organization otherwise qualify under 501 (c) (6), then participation in political activities will not disqualify exemption.

Contributions, gifts, and bequests. Contributions, gifts, and bequests are tax deductible when made to a 501 (c)(3). A 501(c)(6) is not a qualified donee for such purposes. However, dues paid to a 501 (c)(6) are generally deductible under Section 162.

FUTA and FICA taxes. A 501 (c)(3) is not subject to the Federal Unemployment Tax, whereas a 501 (c)(6) does not enjoy this special treatment. Both types of organizations are subject to FICA (social security) taxes.

Unrelated business income tax. Both 501 (c) (3) and 501 (c) (6) organizations are subject to unrelated business income tax provisions.

Special annuity provisions. 501(c)(3)s are able to offer employees the benefit of special taxation of annuity provisions under Section 403(b). Currently, 501 (c) (6) groups have no alternative retirement savings plans unless they adopted 401(k) plans before June 30, 1986.

State and local taxes. 501 (c) (3)s--and not 501 (c) (6)s --may enjoy collateral tax exemption or partial tax exemption under some state and local income, property, sales, use, or other forms of taxation.

Extent of nonqualifying activities. A 501 (c) (3) organization may engage in very few activities that do not further its defining purposes. A 501(c)(6) may engage in other activities as long as it primarily undertakes 501(c)(6) activities.

Information returns. Both 501 (c) (3) and 501 (c) (6) organizations are generally required to file annual information returns, IRS Form 990. In addition, a 501 (c)(3) is required to file Schedule A of the Form 990.

Donations and bequusts. Bequests and donations received by a 501 (c)(3) donee may be used only for 501 (c) (3) purposes. So, if it is reclassified as a 501 (c) (6), the group must closely monitor how it spends those funds. Also, examine the terms of gifts and wills for any restrictions or limitations.

Recognition by IRS. If an organization decides to seek reclassification from 501(c)(3) to 501(c)(6), IRS must be notified and a Form 1024 exemption application filed. Normally a voluntary change from 501(c)(3) recognition occurs through formal dissolution or a nonqualifying activity. If the activities of an organization will be substantially the same and section 501(c)(6) recognition seems appropriate, IRS might reclassify a group retroactively.

There are four basic steps to changing the tax-exempt status of your organization. Let's suppose you wish to change your organization's tax status from its current exemption under section 501(c)(3) of the Internal Revenue Code to a new exemption under section 501(c) (6). In most cases, at a minimum you will have to accomplish the following.

1. Consult with legal counsel about the tax ramifications of the proposed change and the steps needed to carry it out. Counsel should ask your reasons for the change, discuss how the Internal Revenue Code treats such a change, and raise relevant questions to settle before making any change. For example:

* How will the new 501 (c)(6) organization handle assets dedicated to 501 (c) (3) purposes only?

* A 501 (c) (3) organization is forbidden to give its money and assets to a non501 (c)(3) activity. How will the current 501 (c)(3) turn over its assets to the new 501 (c) (6)?

* If the organization maintains a Section 403(b) annuity plan, what happens to the plan assets when the association changes its tax status?

* Will the reclassified association be able to keep the special postal permit for second- and third-class mailings?

* Instead of reclassifying, should the association keep its current corporate structure, incorporate a new 501(c)(6) entity, and gradually transfer the relevant activities to the new corporation?

2. Check to see whether the membership's vote of approval is required. (If not, the board of directors' approval almost certainly is.) Check the articles of incorporation, bylaws, and relevant state statute. Be certain to have legal counsel investigate whether it is permissible under the relevant state statute to conduct such a vote by a mail ballot so members can vote without having to attend a meeting.

3. Obtain IRS approval. Be prepared for a thorough examination of the current and planned activities of the organization.

4. Amend the articles and bylaws. This may require membership approval. At a minimum, a board vote will be required.

George D. Webster is general/counsel to ASAE and a partner in Webster, Chamberlain & Bean, a Washington, D.C., law firm.