When the IRS revokes a Texas nonprofit's federal 501(c)(3) status but the nonprofit appeals, what happens to its Texas sales-tax and franchise-tax exemptions, and from when?

Plain-English summary

A nonprofit's advisor described a client, a health care organization, whose federal 501(c)(3) tax-exempt status the IRS had moved to revoke - but the client was contesting the revocation in federal proceedings. The question: what does the IRS notice do to the organization's Texas exemptions, and starting when?

• During an appeal, the state exemption continues. The Comptroller normally accepts the IRS's final determination and automatically revokes the matching state exemption. But when the organization appeals, the Comptroller takes a cautious position and continues the state tax-exempt status while the federal administrative and/or judicial appeals are pending.
• If revocation is upheld - sales tax. Under Rule 3.322(b)(5)(A), the Sec. 151.310(a)(2) sales-tax exemption is treated as revoked prospectively from the earlier of the date the IRS served formal written notice of revocation on the organization or on the Comptroller. Here the IRS notice was dated November 13, 2000 (even though the IRS made the revocation retroactive to January 1, 1996), so the organization would owe sales and use tax prospectively from November 13, 2000.
• If revocation is upheld - franchise tax. The Sec. 171.063 franchise-tax exemption is treated as revoked as of the date of the IRS notification, so the organization would owe franchise tax for calendar year 2000 and all subsequent years.

Currency note: The franchise-tax analysis here is under the pre-2008 franchise tax (replaced by the margin tax effective January 1, 2008 under House Bills 3 and 3928). The sales-tax exemption and revocation rules may also have changed; confirm current law.

What this means for you

Texas nonprofits facing an IRS challenge to their exempt status

An IRS revocation notice does not instantly strip your Texas exemptions if you appeal - the Comptroller waits out your federal appeal. But if you lose, Texas does not honor the IRS's retroactive date. It counts the loss forward from the IRS's written-notice date (here, November 13, 2000), not back to the IRS's retroactive effective date (January 1, 1996). Practically, that limits the back-tax exposure to the notice-forward period.

Tax professionals

Two timing rules to carry: sales tax runs from the earlier of IRS notice to the taxpayer or to the Comptroller (Rule 3.322(b)(5)(A) / Sec. 151.310(a)(2)); franchise tax runs from the IRS notification date (Sec. 171.063), reaching the full calendar year of the notice and beyond. Texas applies its own prospective revocation date and disregards the IRS's retroactivity. Re-verify the franchise piece under the current margin tax.

Common questions

Q: Does an IRS revocation notice immediately end my Texas exemptions?
A: Not if you appeal. The Comptroller continues the state exemption while your federal administrative and judicial appeals are pending, then follows the IRS's final result.

Q: If the revocation is upheld, how far back do I owe Texas tax?
A: Not back to the IRS's retroactive date. Sales tax runs prospectively from the IRS's written-notice date (the earlier of notice to you or the Comptroller); franchise tax runs from the IRS notification date, covering that calendar year forward.

Q: Why doesn't Texas follow the IRS's retroactive January 1, 1996 date?
A: The Comptroller's rule (3.322(b)(5)(A)) revokes the state exemption prospectively from the formal notice date, not retroactively, so the earlier IRS effective date does not control the Texas liability period.

Citations and references

Statutes and rule:

• Texas Tax Code Sec. 151.310(a)(2) - sales-tax exemption for an organization exempt under IRC Sec. 501(c)(3)
• Texas Tax Code Sec. 171.063 - franchise-tax exemption for a nonprofit corporation exempt under IRC Sec. 501(c)
• 34 Tex. Admin. Code Sec. 3.322(b)(5)(A) - prospective revocation of a nonprofit's exempt status from the IRS formal-notice date

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200104214L

Original ruling text

April 17, 2001

Dear **:

I appreciated our visit wherein we discussed the situation of your client,
HEALTH CARE ORGANIZATION, and your request for an agreement or clarification
from this office. You indicated that the Internal Revenue Service ("IRS")
issued a notice to revoke your client's Section 501(c)(3) tax-exempt status
under the Internal Revenue Code ("IRC"), but that your client is contesting the
revocation in federal proceedings. You wanted to know what effect, if any,
this notice would have on your client's status as an exempt organization for
state tax purposes.

The Comptroller accepts the IRS' final determination at face value and
automatically revokes the state tax-exempt status in accordance with the IRS'
determination. However, if an exempt organization appeals the IRS' action,
then this office takes a cautious position and continues the tax-exempt status
of that organization for state tax purposes pending the outcome of all related
federal administrative and/or judicial appeals.

The Comptroller agrees with your interpretation of Comptroller's Rule
3.322(b)(5)(A). For sales tax purposes, the exemption provided by Texas Tax
Code Section151.310(a)(2) shall be deemed to have been revoked prospectively
from the earlier of the date on which the IRS served formal written notice of
the revocation on the nonprofit organization or the Comptroller. Because your
client received a formal notification of revocation from the IRS on November
13, 2000 stating that the revocation is retroactive to January 1, 1996, the
Comptroller would require HEALTH CARE ORGANIZATION to pay all sales and use
taxes prospectively from November 13, 2000, if the revocation is ultimately
upheld.

The Comptroller also agrees to apply a similar approach to franchise tax. The
exemption provided by Texas Tax Code Section171.063 shall be deemed to have
been revoked as of the date of the IRS notification. Thus, HEALTH CARE
ORGANIZATION would be required to pay franchise tax for the calendar year 2000
and all subsequent tax years, if the revocation is ultimately upheld.

If I can be of further assistance, please do not hesitate to contact me.

Sincerely,

Billy Hamilton
Deputy Comptroller

c: Jesse Ancira
Eleanor Kim
Stefanie Medack