The IRS is applying “an antiquated and counterproductive standard to a dynamic sector” in limiting the growth of nonprofit news outlets, erecting “serious and unnecessary obstacles to critical innovation,” according to a new report released this morning. The document — the result of a year’s study based at the Council on Foundations and supported by the Knight Foundation — calls for a number of changes in how the Internal Revenue Service decides whether a news outlet can qualify for 501(c)(3) status.

Nonprofit news outlets have been on the rise in recent years as traditional media have contracted and shed journalists, many of whom have gone on to create community news startups. That influx has led to an increase in applications for tax-exempt status at the IRS, where some organizations have waited years for approval. Both current and future nonprofit media outlets are at risk from “archaic,” “inconsistent,” and “obsolete” IRS guidelines, according to the report, “The IRS and Nonprofit Media: Toward Creating a More Informed Public.”

“Given the severe contraction of newspapers and the harm that has occurred to communities as a result, it’s really important that we have nonprofit media innovation to help fill some of those gaps,” said former Federal Communications Commission advisor Steven Waldman, who chaired the Nonprofit Media Working Group which authored the report. The working group was comprised of people from the Investigative News Network, Knight Foundation, the Ford Foundation, the Benton Foundation, the McCormick Foundation, and MinnPost, among others. (Disclosure: Knight is a funder of Nieman Lab.)

The report looks at the experience of nonprofit media like The San Francisco Public Press, The Lens, The Chicago News Cooperative, and others, to diagnose problems in the IRS pipeline. The major ones: the lengthy and inconsistent process for granting tax-exempt status; confusion among current nonprofits over how they can conduct business; and a failure by the IRS to recognize how old distinctions between nonprofit and commercial media have been changed by new technology.

“We’re calling on the IRS to modernize its rules,” Waldman told me. “If they do, the nonprofit innovation will continue and they can play an important part in helping us solve the gap in accountability reporting.” The report recommends the IRS update its methodology for granting tax-exempt status by focusing on how media organizations provide a community benefit as well as discounting operational similarities between nonprofits and for-profits. Knight, Ford, and the Foundation Center also plan to work with Guidestar to create a better system to create a comprehensive database of nonprofit news sites and track the creation of new ones.

In order to received tax-exempt status, media outlets have to pass a series of operational tests that look at their stated purpose and organizational structure. “Journalism” itself is not a stated acceptable category of nonprofit activity — but “education” is, which has led many news organizations try to meet that criteria. The report found the IRS did not always share that interpretation. When Rhode Island’s Johnston Insider applied for nonprofit status, it got this note from the IRS: “While most of your articles may be of interest to individuals residing in your community, they are not educational.” And when INN, the consortium of journalism nonprofits, finally received its status after two years, it was “on the condition — among others — that it remove the word ‘journalism’ from the ‘purpose’ clause in its articles of incorporation.”

The report says the IRS has indicated to potential media nonprofits that their chances for success would improve if they were more explicitly educational, as The San Francisco Public Press was told “that a nonprofit producing journalism would be more easily approved if it had grown out of a university or a community education center.”

The Public Press received its nonprofit status in the fall of 2012 after waiting 32 months. As Jeff Hermes of the Digital Media Law Project wrote: “Although the IRS did not explain its decision to the Public Press, with luck this represents a positive shift in the agency’s attitude toward journalism as an educational endeavor.”

Another big obstacle for media organizations seeking nonprofit status is the way they produce and support their work. One element the IRS looks at is how distinguished a nonprofit’s business model is from that of a commercial enterprise. While the IRS has denied nonprofit status to newspapers in the past because they were too similar to for-profit business, the lines between nonprofit and for-profit in the media are blurring, Waldman said. “The digital revolution has made it possible for anyone to publish quickly and inexpensively,” he said. “Nonprofits and for-profits use the same techniques. It doesn’t make sense to look at that anymore to determine if something is nonprofit or for-profit.”

Those similarities also extend to the business side, as nonprofit media, like for-profits, are looking for new sources of revenue. In recent years, we’ve seen nonprofits find success with a mix of membership programs, events, and subscriptions. But IRS rules can restrict the types of strategies nonprofits use to support their journalism. In the eyes of the IRS, too much revenue coming from subscriptions and advertising or sponsorships can tip nonprofits into commercial business, the report says.

The report’s authors argue that those restraints not only place nonprofits at a disadvantage in exploring new sources of revenue, but it can also cause complications with funding from foundations and other philantropic donors:

Further, foundations increasingly require their nonprofit grantees to have “earned revenue” strategies, in the hope that these organizations will eventually be able to operate independently. Thus, nonprofits find themselves in a Catch 22. Philanthropists say they will only fund groups that avoid dependence on philanthropy, while the IRS appears to be saying that the same groups can have tax-exempt status only if they do depend on philanthropy.

Waldman said the issue is urgent because the media industry’s continuing transformation will reward agility; while commercial media will find ways to evolve, nonprofit media needs freedom from the IRS to innovate in its business model too, he said.

It’s uncertain if the IRS will take action right now. Waldman said his group hopes to keep the pressure on the agency to make changes to its regulations in the near future. “We think the IRS can just do this itself — it doesn’t need an act of Congress,” Waldman said. “This is all very well within their current statutory authority.”

Photo by Steve Depolo used under a Creative Commons license.