The IRS recently denied tax-exempt status to two organizations who were deemed to conduct too much “business” activity and not enough “charitable” activity. The two denials are the latest in a long line of rulings that require that a 501(c)(3) organization be organized and operated primarily for tax-exempt purposes. In a third case, the IRS deemed a charitable trust non-exempt when it determined that the trust administrator was receiving excessive benefit for his services to the trust.
The first denial (Denial 201235021) involved a “crowd-funding” platform: a contract hybrid that combined a 501(c)(3) nonprofit soliciting contributions online with a for-profit LLC that owned the technology and ran the charity’s operation for a fee of 20% of the gross revenue. The two had a close relationship and shared officers and directors. The LLC was owned by insiders of the charity, not by the charity itself, and the charity was effectively controlled by the founder who also controlled the LLC. The charity could not, or did not, provide information establishing that the fees it paid were at or below market. There was no cap on the fees, which meant that the LLC (and the CEO) could make a good deal of money if the platform did well. In addition, the contracts between the two were not negotiated at arms’ length. The IRS concluded that the arrangement lacked sufficient safeguards to ensure that the charity was operated for charitable purposes rather than the personal interests of the CEO, the directors and the investors.
The second denial (Denial 201235023) also involved a crowd-funding platform with a similar structure wherein most of the same people controlled both entities, but in this case the IRS cited a lack of proper record keeping or financial controls and the reimbursement of the CEO’s personal expenses as its reasons for the denial. In their decision the IRS noted that the charity merely collected and distributed contributions; it did not have any charitable or educational program of its own (merely raising money is not a charitable activity.) As it was unable to conclude that the arrangement was designed primarily to further charitable and educational purposes rather than the personal interests of the CEO and the board, it denied the application.
On September 24, 2012, the U.S. District Court in Washington, D.C. in Family Trust of Massachusetts Inc. v. U.S. refused to order the IRS to grant 501(c)(3) tax exemption to a trust that supplemented the benefits that its three hundred participating beneficiaries were receiving from Supplemental Security Income (“SSI”), Medicaid, and other governmental benefits programs. This type of trust is specifically authorized by the Medicare Act and administration of such a trust is typically considered a charitable activity. However, in this case, the trust was controlled by a single attorney, a specialist in elder law. The IRS argued that the attorney’s compensation was improper because it was tied to the size of the trust (the compensation went up as the size of the trust grew). The attorney countered that the compensation was reasonable based on his normal billing rate. The court sided with the IRS, noting that the attorney was not providing legal services to the trust at the time. The Court found that the attorney had effective control over the trust and personally benefited from it, had referred his own clients to the trust, and had operated the trust more as a commercial enterprise than a charity. Surprisingly, the court also invoked the “commerciality doctrine”, a largely obsolete rule that says an enterprise is not charitable if it engages primarily in commercial activity. In any event, the presiding judge concluded that the trust was operated like a business, and that the attorney, as an insider, was receiving too much benefit. It refused to order the IRS to grant tax exemption to the trust, in spite of the fact that the activity of the trust was charitable.
Although these kinds of rulings aren’t binding precedent, they do confirm two things: first, that the IRS is looking at these arrangements with a more critical eye than they have in the past, and second, that the burden is on the taxpayer to satisfy the IRS that individuals do not benefit unduly from the arrangement between a charity and a for-profit or from the administration of a charitable trust.
The takeaway for practitioners is that any issues relating to personal benefit must be addressed up-front in the way the hybrid is structured. For a more detailed discussion, read my article published in the Stanford Social Innovation Review A New Type of Hybrid.
