What – Another Tax? Nonprofits’ State “Franchise” Taxes and Related State Tax Compliance
It is indeed a joyful day when a nonprofit receives the anticipated IRS determination letter, recognizing its tax-exempt status. But note: such status is under federal law and only for income tax liability generally. What state tax considerations exist? A minority of states impose additional legal compliance steps for state “franchise” or income tax exemptions. Additional taxes may be owed such as on a nonprofit’s purchases, sales, employment activities, real estate ownership, and specific types of revenues. This article focuses on state franchise or income tax obligations and related legal compliance aspects.
“FRANCHISE” AND INCOME TAXES – PATCHWORK OF STATE LEGAL REQUIREMENTS
The word “franchise” is deceptive within this state tax context, as it does not refer at all to business franchises (e.g., McDonalds, Chick-Fil-A). Most generically, a franchise tax involves the privilege under which an entity pays for the right to do business in a certain state, perhaps for a fixed fee, tiered fee, or based on the entity’s income. A franchise tax thus may operate like a state income tax (although not necessarily), and sometimes in addition to or instead of a state income tax.
Thankfully, many states automatically exempt nonprofits from income and franchise taxes solely on the basis of their federal income tax exemption – as recognized by the IRS. Indeed, 34 states currently do not require any exemption application or annual tax return from most nonprofit organizations in conjunction with state income or franchise taxes. Consequently, if the organization has its IRS determination letter or is automatically considered tax-exempt under federal law (e.g., church, other house of worship, or integrated auxiliary), the organization is exempt from the state income taxes too if it operates in one or more of these 34 states.[1]
On the other hand, a nonprofit’s exemption is not automatic in 16 states[2] and the District of Columbia. Of these, some states require a nonprofit to submit an initial filing establishing their exemption, which should be sufficient. For example, Louisiana and Massachusetts require nonprofits operating within the respective states to submit a copy of their IRS determination letter to state regulators. Others, such as New York and Utah, require the organization to submit an application form. A few states do not require any initial filing to obtain tax exemption, although they do require nonprofits to send annual tax returns to maintain the exemption. For example, Georgia asks that nonprofits submit copies of their annual IRS information return, such as the IRS Form 990.
California, Texas, and the District of Columbia rank among the strictest jurisdictions for state-level income or franchise tax exemptions affecting nonprofits. California requires both an initial exemption application and annual reporting to its Franchise Tax Board. Texas technically only requires an initial application, but many organizations will not qualify for exemption until they obtain their IRS determination letter. During the pendency of such IRS process, Texas requires the filing of annual returns and possibly even payment of the franchise tax (although most organizations will qualify for a “No Tax Due” report, at least in their first year while they are waiting on the IRS). D.C.’s tax exemption application is very complex, as it involves applying for exemptions from several taxes at once and must be completed in a very particular order in conjunction with other D.C. filings upon beginning to conduct business in D.C.
MULTI-JURISDICTIONAL TAX COMPLIANCE
What if a nonprofit operates across state lines? Its tax compliance will be complicated, no doubt! For example, what if a nonprofit is based in D.C. and has staff in other jurisdictions (or vice versa)? Generally speaking, the nonprofit should determine whether it must register to “do business” in the additional jurisdiction (sometimes known as a “foreign” registration). The legal threshold for determining whether to register in an additional jurisdiction varies from state to state. With increased remote work activities and many nonprofit operations on a multi-state basis (including fundraising),[3] multi-jurisdictional legal compliance thus needs careful planning to ensure full compliance!
SERIOUSLY – MORE STATE TAX COMPLIANCE
States sometimes have special rules for certain types of nonprofits, too. For example, some of the states that do not generally require an exemption application or annual filings will require them for a specific subset of organizations. Common examples are nonprofit homeowners’ associations and political organizations.
Additionally, an organization with federal “unrelated business income,” that is, revenue derived from activities that are not “related” to its tax-exempt mission (or otherwise not exempt) will also need to file a state tax return (along with a federal IRS Form 990-T). Stated differently, if the organization owes UBIT at the federal level, it probably owes a tax in at least one state, too.[4]
The State of Washington is a major outlier in nonprofit taxation. Washington imposes its “Business and Occupation Tax” on the gross receipts of entities doing business in the state. Unlike all other states, Washington does not generally exempt nonprofits from the tax! Only certain donations and specific types of fundraising activity are exempt from taxation, whereas thrift store sales, programs involving fees-for-services arrangements, and other revenues may likely result in a tax obligation. A few other very specific exemptions or deductions, such as tuition fees paid to accredited educational institutions or day care services provided by churches exist. Nonprofits operating in Washington should work closely with an accountant to ensure they take advantage of any available exemptions and deductions.
For nonprofits making retail purchases or sales, remember state tax on retail sales and retail purchases too! Such taxes similarly vary widely among states. Some states quite generously provide exemption from retail purchases based only on a nonprofit’s IRS determination. States on the other end of the tax spectrum do not allow any such tax exemption, and several states provide for a middle-ground approach. State taxes on a nonprofit’s sales (e.g., T-shirts, signage) can get particularly complicated if carried out online.[5]
Bottom line: Nonprofit leaders should be attentive to state tax obligations, both for their nonprofit home state and multi-state activities. Such state tax obligations may include franchise tax registration and reporting if the nonprofit operates in certain states. And hopefully they will not come as a surprise!
[1] As additionally confusing, Delaware’s annual state report for nonprofit is labelled as a “franchise” report. Such report is not at all tax-related, however, as nonprofits are generally exempt from Delaware franchise taxes.
[2] States as referenced here include Arkansas, California, Connecticut, Georgia, Indiana, Louisiana, Maryland, Massachusetts, Mississippi, Montana, New York, North Carolina, Oklahoma, Texas, Utah, and Washington.
[3] For more information about legal compliance for remote work activities, please see Wagenmaker & Oberly law firm’s blog article here. For more information about multi-state fundraising and related legal compliance, please see Wagenmaker & Oberly law firm’s blog article here.
[4] For more information about unrelated business income tax, please see Wagenmaker & Oberly law firm’s blog article here.
[5] For more information about state tax obligations resulting from nonprofit retail purchases, please see Wagenmaker & Oberly law firm’s blog article here. For more information about state tax obligations resulting from nonprofit retail sales, please see Wagenmaker & Oberly law firm’s blog articles How Much Do We Collect? Sales Tax Liability for Nonprofit Sales and State Sales Tax Liability in Wayfair’s Wake.