State Tax Law and Compliance for Nonprofits: A General Summary of Requirements

When most of us first think about tax, we tend to focus on federal requirements as being of foremost importance.  While federal rules are extremely important for the nonprofit organization, state tax compliance is actually a much wider universe covering a very large body of rules.  With the current unprecedented budget shortfalls that states are experiencing, most states are stepping up enforcement efforts.  Not paying attention to state tax authorities can be a very expensive mistake.

This article will briefly look at significant state tax areas and discuss what should be of concern to nonprofit financial managers.

Unrelated Business Income Tax:  All but a few states require income tax to be paid on net unrelated business income.  Most states simply require this be reported and paid via the state corporate income tax return; tax rates are generally the same as regular corporations and estimated payments are required.  Therefore, if an organization files a Federal 990-T, it will most likely have at least one state filing requirement.  Organizations which operate in more than one state need to be aware of nexus rules which may require them to apportion income to other states and to then file in these jurisdictions.  Particular attention should be paid to pass-through unrelated business income being reported on K-1's that is earned in another state.  This may give rise to a filing requirement in a state in which the organization has no other nexus.  Failure to file in a state over a period of time can result in heavy penalties and interest in addition to taxes. 

Sales and Use Tax:  The rules for nonprofit sales/use tax vary considerably from state to state.  Generally, organizations are required to pay sales and use tax on their own purchases unless they have an exemption issued by the state.  Some states exempt all charitable organizations while others will exempt only certain types of charitable organizations.  It is important to obtain an exemption certificate from the state if an organization qualifies for exemption in the state.  Use tax is a self-reported tax on purchases from out of state that are not taxed in the state where purchased.  Certain types of merchandise are excluded from sales and use tax on a state-by-state basis.

It is important that an exemption from payment of sales/ use tax does not exempt an organization from collecting sales tax on merchandise that it sells.  Generally, there is a requirement to collect sales tax on sales within the organization's home state and to customers in any state where the nonprofit has nexus.  This is true for all types of sales including phone, mail, and internet.  Thus, it is important for an organization to determine exactly which states require it to register, collect, and remit the tax.  Keep in mind, nexus can be caused  by something as simple as having an employee working from home in the next state.  Certain types of sales by nonprofits may be excluded by some states from collection of sales tax.  A sales tax audit can be a very arduous and expensive process for the organization, with the state going back several years in assessment of both tax and heavy penalties.

Payroll Tax:    Withholding of employee state income tax is a requirement in most states with an individual income tax.  The requirements for withholding can be complex for employees that reside in a state outside of the organization home state.  Additionally, in a payroll audit, states (just like the IRS) will take a close look at whether independent contractors are actually employees controlled by the organization.  Thus it is important that a careful analysis be made to determine if a contractor is actually going to be considered an employee under both federal and state law.  The IRS has established guidelines for making this determination.

Escheat Tax:  More commonly called "Unclaimed Property Tax," this can be a real trap for the unwary.  Un-cashed vendor checks and un-cashed payroll checks are a couple of items that most people don't think of as unclaimed property (most typically, we think of unclaimed bank deposits and securities).  Nonprofits should familiarize themselves with the rules in their home states and take a close look at their own exposure for items on their books.  If unclaimed property does exist, the organization should consider filing an escheat return and paying on these items.  Many states are really looking at this as a revenue booster in hard times and are even hiring outside vendors to aggressively enforce their law and collect funds.

Charitable Registration:   Most states require nonprofits who solicit contributions in their state to be registered in that state.  This generally means any of kind of solicitation including mailings and phone calls from another state.  Large, national organizations often are required to register in all 40 plus states that require registration.  After initial registration with a state, renewal forms must be filed each year to stay in compliance.  Both state requirements and due dates for renewals vary considerably from state to state.  There are fees associated with each filing. 

Failure to register in a particular state can, in the most extreme case, result in the organization being barred from solicitation in the state and having to return contributions to contributors.  Usually, however, first time penalties are much less draconian.  This is not an area to ignore as investigation by a state attorney general, even if the penalty is minor, does not generate great publicity for a charitable organization.

Conclusion:  Each state will have additional filings such as property tax and annual registrations to maintain corporate status.  It is vitally important to stay up to date with complete and accurate returns, payments, and reports.