Prior to 2006, certain 501(c)(3) organizations that normally had gross revenues less than $25,000 were not required to file any tax returns at all. One problem that created is that the IRS had no way of knowing whether organizations that weren't filing returns (1) had gone out of business, (2) had gross revenues less than $25,000, or (3) were supposed to file returns but were failing to do so. So, in the Pension Protection Act of 2006, Congress amended Section 6033(i) to require all Section 501(c) organizations (except churches) to file at least a very abbreviated return (containing six items of information), and it amended Section 6033(j) to provide that any organization, whatever its size, that fails to file a return for three consecutive years would automatically lose its exemption.

Section 6033(j) doesn't give the IRS any discretion in the matter. Failure to file a return for three consecutive years means that tax-exempt status is automatically revoked, whether the IRS takes any formal action or not, and there is no procedure for appeal, either within the IRS or in the courts. Because this is such a draconian penalty, in 2009 and 2010, as the third full year following the 2006 Act began to run out, the IRS was very aggressive (and creative, at least for such a bureaucracy) in trying to get the word out to the nonprofit community, including using podcasts, YouTube videos, radio PSAs, and so on, encouraging them to file returns to avoid losing tax-exemption. It even posted a list of all the organizations that had failed to file for three consecutive years and then allowed them a further grace period to file the necessary returns to avoid revocation. There were something like 400,000 - 500,000 organizations on that list, and probably 90 percent of them did nothing and ended up having their exemption revoked.

Since then, the IRS has announced procedures for getting tax-exempt status reinstated, but that requires filing a new exemption application. Some 50,000 or so organizations that did lose their tax-exempt status have reapplied in the past several years, and that extraordinary, additional workload on the Cincinnati office that processes exemption applications is one reasons why it now seems to take the IRS forever to rule on new exemption applications and is part, but not the only reason for the highly publicized delay in processing Tea Party applications.

The 1/3 test has nothing to do with the foundation's Section 501(c)(3) charitable status. There are actually two kinds of Section 501(c)(3) organizations -- "publicly supported organizations" and "private foundations." Private foundations are subject to greater restrictions on their activities (prohibitions against self-dealing, required annual distributions, stricter limitations on owning businesses, and the like), as well as lower limits on the deductibility of contributions, and so avoiding private foundation status is always desirable.

To become a publicly supported organization, a charity must show that it enjoys broad support from the general public, as opposed to having its funding concentrated in a small number of donors. One of the publicly supported organizations tests requires that 1/3 of the organization's funding come from individuals, corporate and foundation grants, and other public charities, and amounts from any one source (except other public charities or the government) in excess of two percent of the organization's total support do not count for these purposes. This 1/3 test is performed each year, but is based on the average received over the previous four years.

If an organization cannot meet the 1/3 test, it may still qualify as a publicly supported charity so long as its "good" support (grants and contributions that pass through the two-percent filter) amount to more than ten percent of its total revenue and it can show that it is engaged in a continuous fundraising program, has a board representative of the community, and satisfies other factors. The BSD Foundation appeared to have been on the verge of falling just shy of the 1/3 test, but probably would have had little difficulty satisfying the alternate 10-percent-plus-facts-and-circumstances test and therefore probably would have remained a publicly supported charity even without its recent plea for donations. Nonetheless, every new Section 501(c)(3) organization is given a five-year test period in which to attempt to meet either test, and at the end of that period must send in a worksheet to the IRS showing how it did, which means that some official in the IRS actually will take a look at the foundation's public charity status.

All publicly supported Section 501(c)(3) organizations must complete a schedule on their annual tax returns (Form 990) that demonstrates their on-going compliance with the public support test. Interestingly enough, though, the IRS simply does not seem to have the computer or personnel resources to do anything about an organization that files a 990 disclosing that it has unquestionably failed the public support test, and there are many charities that have survived the initial five-year probationary period, that have subsequently filed 990's showing that their public support is well below even the minimum 10 percent, and yet that remain classified by the IRS as a publicly supported charity, and not a private foundation.