By S. Eva Wolf
The entities in the following IRS Technical Advice Memorandum1 and Private Letter Rulings failed to qualify for tax exempt status because they were not operated exclusively for exempt purposes. An organization must be organized and operated exclusively for charitable, educational or other specified exempt purposes in order to qualify for tax exemption as a charitable organization under Internal Revenue Code Section 501(c)(3). The organization must serve a public rather than a private interest and engage primarily in activities that accomplish its exempt purposes. No more than an insubstantial part of the organization’s activities can be in furtherance of nonexempt purposes.
In Technical Advice Memorandum 201438034, an organization (the “Organization”) purchased and leased school buildings and then renovated, leased, and sub leased them to charter schools that it created (the “Charter Schools”). The Organization served as landlord to the Charter Schools, charged them slightly below market rents, and provided customary landlord services to them. Additionally, it operated an educational summer camp, which generated less than one percent of the Organization’s income.
The Organization was originally formed to operate a private school and was granted tax exemption on that basis; however, it later discontinued school operations and began the activities described above.
The ruling explained that leasing real property is generally a non exempt trade or business carried on for profit, and is only an exempt activity under limited circumstances.
For example, if a trade or business is an integral part of the exempt purpose of a related exempt organization or governmental entity, or if a trade or business conducts its business in a charitable manner to promote the exempt purpose of an unrelated exempt organization, it is exempt. However, none of these circumstances were present. The Charter Schools were not governmental entities or exempt organizations during the examination period, and by leasing properties at rates only slightly below market and amassing a substantial surplus, the Organization’s business was not conducted in a charitable manner. Moreover, the Organization was operating for commercial purposes, because it provided normal property services to the Charter Schools, in competition with for profit landlords, and accumulated a large surplus.
The ruling also explained that the Organization’s operation of an educational summer camp comprised only a minor portion of its time and resources, so the activity was insubstantial and not a basis for exemption.
Since the Organization ceased to operate exclusively for exempt purposes, the Internal Revenue Service revoked its exempt status, effective as of the year it changed activities.
In Private Letter Ruling 201438029, a for profit company (the “Company”) created a text based application that allows donors to make charitable contributions from their mobile devices and then licensed the application to an entity founded and managed by the company (the “Middleman”). The Middleman partnered with charitable organizations wishing to receive mobile donations and, and in exchange for a monthly fee and transaction fees, acted as a donation coordinator by marketing the application, collecting and distributing donations, and providing reconciliation and donation reports. The Middleman paid a monthly management fee and a percentage of the donations to the Company.
The ruling explained that providing commercial services exclusively to exempt organizations is not an exempt purpose. Although the Middleman provided fundraising services to charitable organizations, it did so in exchange for fees that were not substantially below costs and anticipated that such fees would be its primary source of revenue.
The ruling also explained that an exempt organization cannot provide a substantial private benefit, yet the Middleman provided a substantial private benefit to the Company.
The Middleman was founded by the Company to use intellectual property owned by the Company and licensed to the Middleman, and the Middleman was managed by the Company, which received monthly payments and a share of the donations in exchange for its management services.
The Middleman was not operated exclusively for exempt purposes, so the Middleman did not qualify for exemption under Internal Revenue Code Section 501(c)(3).
In Private Letter Ruling 201438030, an unincorporated association (the “Association”) was organized to run a beauty pageant and to promote a non charitable entity’s scholarship program. The Association is affiliated with an exempt civic organization (the “Civic Organization”), which also operates a beauty pageant, and operates under the Civic Organization’s rules. Each beauty pageant contestant receives a scholarship; however, the winner receives a larger scholarship and is contractually required to participate in a number of activities during the year following the beauty pageant. The winner also advances to the Civic Organization’s beauty pageant.
The ruling held that the Association was not organized and operated exclusively for exempt purposes, and therefore, the Association did not qualify for exemption under Internal Revenue Code Section 501(c)(3). The ruling explained that promoting a non charitable entity’s scholarship program is not an exempt purpose. The ruling also explained that the Association operates for the private benefit of the Civic Organization, because the Association provides the Civic Organization with qualified candidates for its beauty pageant and uses the Civic Organization’s rules, indicating that the Association would be unable to operate without the Civic Organization. The Association also operates for the private benefit of the contestants, because all of the contestants receive a scholarship as an incentive to participate in the beauty pageant and the winner receives a larger scholarship as compensation for future services. Moreover, the Association’s primary activity is putting on a beauty pageant, which serves a substantial non exempt purpose.
The Technical Advice Memorandum and Private Letter Rulings discussed above illustrate how tricky it can be to qualify for tax exemption as a charitable organization and the importance of engaging knowledgeable counsel when seeking exemption or changing activities.
1A Technical Advice Memorandum is guidance provided by the Office of Chief Counsel upon the request of an IRS director or an area director in response to technical or procedural questions that develop during a proceeding, including an examination of a taxpayer’s return. The advice is issued only on closed transactions and provides the interpretation of proper application of tax laws, tax treaties or other precedents. The advice rendered represents the IRS’ final position, but only with respect to the specific issue in the specific case in which the advice is issued.