Qualification under Section 501(c)

IRS form 1023 puzzle
image © 2016 Peter Nagel
  1. The Exemption Process
    1. Section 501(c)(3) Organizations.
      1. Section 508 provides that organizations formed after October 9, 1969 will not be treated as described in Section 501(c)(3) unless and until they have notified the Internal Revenue Service that they are applying for recognition of that status.
      2. Application Forms. The application for recognition of exemption itself is normally filed on Form 1023, a rather formidable package that requests a detailed description of the organization's present and planned activities, financial statements or proposed budgets, and a variety of other information. Form 1023 is available in a "fill in the blanks," Adobe Acrobat PDF format, by downloading from the Service's website, the address of which is
        1. https://www.irs.gov/forms-instructions
        1. For certain eligible organizations, the Internal Revenue Service has made available an online, streamlined exemption application, Form 1023-EZ. Eligible organizations include only domestic organizations that expect normally not to earn more than $50,000 of gross receipts annually in the next three years, do not have assets valued at more than $250,000, whose exemption ws not previously revoked for failure to file tax returns, and meet certain other requirements
      3. Exceptions to the Filing Requirement. Section 508(c)(1) provides that the requirement for filing Form 1023 does not apply to -
        1. churches, their integrated auxiliaries, conventions or associations of churches, and
        2. any organization that is not a private foundation and that normally has gross receipts each year of not more than $5,000.
      4. Filing Fee. Organizations applying for recognition of exemption under Section 501(c)(3) have the privilege and obligation of paying the Internal Revenue Service to read their exemption applications. The filing fee that must accompany Form 1023 is currently $600. Organizations filing the online Form 1023-EZ are required to pay $275. See Revenue Procedure 2018–5, Appendix A
      5. Where to File. All exemption application packages are now filed with a central Internal Revenue Service office, the address of which is -
        • Internal Revenue Service
          P.O. Box 12192
          Covington, Kentucky 41012-0192
      6. Applications shipped by express mail or delivery service should be addressed to:
        • Internal Revenue Service
          201 W. Rivercenter Blvd.
          Attn: Extracting Stop 312
          Covington, Kentucky 41011
      7. Time for Filing. If Form 1023 is filed within the applicable deadline, and if the Service approves the application, then exemption will generally be retroactive for all purposes back to the date of incorporation. (Under no circumstances can exemption be recognized before the date the organization was formed.) This means that all contributions received between the time the organization was formed and the date of its exemption letter will be deductible, and all income that the organization earned during that time (except unrelated business taxable income) will not be subject to tax. If the exemption application is filed after the applicable deadline, then exemption will be recognized prospectively from the date of filing only.
        1. The Service uses the date of a U.S. Postal Service postmark on the envelope containing the exemption application as the date of filing. If the envelope is not postmarked (for example, has a postage meter stamp), then the date of the Service's receipt is the date of filing. Certain types of delivery services offered by certain “private delivery services” (Airborne Express, Federal Express, DHL Worldwide Express, and United Parcel Service) will also qualify for the “timely mailed/timely filing” rule. See IRS Notice 97-50, 1997-37 I.R.B. 21, and IRS Notice 97-26, 1997-17 I.R.B. 6.
        2. The applicable deadline is normally 27 months from the end of the month in which the organization was formed. For example, if a nonprofit corporation filed its Articles of Incorporation on September 1, 2017, the deadline for filing its Form 1023 would be December 31, 2019.
        3. As generous as that deadline is, further relief may be available to organizations that miss the 27-month filing deadline.
          1. If more than 27 months have elapsed since the date the applicant was created, then the applicant may request a discretionary extension of the deadline under Treasury Regulation § 301.9100-1 and -3, but must establish that it has acted reasonably and in good faith and that the granting of such relief will not prejudice the interests of the government. See Form 1023, Schedule E and applicable instructions.
          2. It used to be that, if the applicant either did not request or was not eligible for Section 9100 relief, then it might have applied for tax-exempt status under Section 501(c)(4) for the period beginning with its formation and ending on the date its Section 501(c)(3) application is filed, since there is no deadline for filing Section 501(c)(4) exemption applications. However, such an organization would likely not have filed the tax returns that it would have been required to file as a Section 501(c)(4) organization and therefore would have lost any exemption otherwise available under this procedure.
      8. Processing Time and Procedures.
        1. Exemption applications are processed on a first-in-first-out basis. In the author's experience, processing time varies wildly.
        2. Once the Service receives an exemption application, it is initially reviewed by a relatively low-level screener, who determines that the package contains all the information and documents required by the regulations and the instructions to Form 1023. Upon approval by the screener, the application is assigned to a specialist for consideration, and the applicant is mailed a notice stating that the application has been accepted for processing and providing a contact telephone number for further information.
        3. It is then the specialist's responsibility to ensure that the description of the organization's operations, projected financial activity, and other information set forth in the exemption application comply with the requirements of Section 501(c)(3). If the information provided in the application is unclear or incomplete, or discloses aspects of the applicant's organization or operations that may be inconsistent with the requirements of Section 501(c)(3), then the specialist will write back to the applicant and request an appropriate clarification, explanation, or modification.
          1. These requests for additional information typically state that a response is required within 21 days. If the applicant fails to respond within that period of time, the Service then mails the applicant a fairly disagreeable letter stating that its file has been closed, that the state Attorney General will be notified of the applicant's failure to qualify for tax-exempt status, that the applicant will be deemed to have failed to have exhausted all administrative remedies (thus precluding access to the United States Tax Court), that a new filing fee will be required, and so on.
        4. A procedure exists for requesting expedited processing of an exemption application and thus avoiding the Service's normal first-in-first-out rule of priority. To seek expedited processing, the organization must submit a letter addressed to the District Director explaining the reasons why expedited processing is necessary. Informally, Service representatives have stated that only extraordinary circumstances threatening the continued existence of the organization will warrant processing an exemption application outside of its normal priority.
      9. Denials of Exemption may be appealed administratively under the procedures set forth in Revenue Procedure 2007-52; 2007-30 I.R.B. 222. Section 7428 describes the procedures for obtaining an expedited declaratory judgment from adverse administrative determinations.
    2. Section 501(c)(9), 501(c)(17) and 501(c)(20).
      1. Under Section 505(c), voluntary employees' beneficiary associations seeking exemption under Section 501(c)(9), supplemental unemployment compensation benefits trusts seeking exemption under Section 501(c)(17), and qualified group legal services trusts seeking exemption under Section 501(c)(20) must file an exemption application in order to be recognized as tax-exempt. The filing deadlines are identical to those applicable to Section 501(c)(3) organizations.
      2. Exemption applications under Sections 501(c)(9) and (17) are filed on Form 1024.
      3. According to Treasury Regulation § 1.505(c)-1T, Question 2, trusts forming a part of a qualified group legal services plan do not need to file Form 1024, because the necessary notification is accomplished by means of the filing under Section 120(c)(4) that the plan itself is required to make.
    3. All Other Organizations. Organizations claiming exemption under provisions other than Sections 501(c)(3), (9), and (17) may (and probably should) - but are not required - to file an exemption application. They will have the opportunity of producing sufficient evidence on audit, which should probably not differ from the type of evidence required by the corresponding exemption application for these organizations, Form 1024, to substantiate their claim to exemption.
  2. Exemption Under Sections Other Than Section 501(c)(3)
    1. Section 501(c)(2).
      1. Section 501(c)(2) exempts corporations organized for the exclusive purpose of holding title to property, collecting the income it generates, and turning the entire amount of its net income over to another organization which is itself exempt under Section 501.
      2. A title-holding corporation cannot accumulate its income and retain its exemption; it must turn over the entire amount of its income each year to another exempt organization. Treasury Regulation § 1.501(c)(2)-1(b).
      3. The Internal Revenue Service has taken the position that a title-holding company may act on behalf of, and distribute its income to, only one exempt parent and to its affiliates. General Counsel Memorandum 37351; General Counsel Memorandum 39345.
      4. A title-holding company may retain income to apply to any indebtedness on the property to which it holds title, and its doing so will be treated as though it had turned the income over to its parent, which then makes a capital contribution back to the title-holding company for application to the mortgage. Revenue Ruling 77-429, 1977-2 C.B. 189.
      5. A title-holding company is entitled to claim a reasonable allowance for depreciation as an expense that can reduce its required distributions back to the exempt parent. Revenue Ruling 66-102, 1966-1 C.B. 133.
      6. Because of the limited purposes for which a title-holding company can be organized, it cannot engage in a trade or business and cannot have unrelated business taxable income other than:
        1. debt-financed income,
        2. interest, annuities, royalties, or rents that are treated as unrelated business income by virtue of the controlled corporation rules of Section 512(b)(13),
        3. rents treated as unrelated business income under Section 512(b)(3)(B)(ii) because the amount of the organization's rents are determined with reference to the lessee's profits,
        4. or rents treated as unrelated business income because they are attributable to the rental of personal property and are not incidental or because more than 50 percent of the rents are attributable to personal property. Treasury Regulation § 1.501(c)(2)-1(b).
    2. Section 501(c)(4).
      1. Exempts civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare, as well as local associations of employees, the membership of which is limited to the employees of a designated person or persons in a community, and the net earnings of which are devoted exclusively to charitable, educational, or recreational purposes.
      2. An organization is "exclusively" engaged in the promotion of social welfare if it is primarily engaged in promoting in some way the common good and general welfare of the community, such as by bringing about civic betterments or social improvements. There is therefore a considerable overlap between Section 501(c)(4) social welfare organizations and Section 501(c)(3) charities, and the regulations in fact explicitly state that a social welfare organization will qualify as a charitable organization if its activities are charitable within the meaning of Section 501(c)(3) and it is not a political action organization. Treasury Regulation § 1.501(c)(4)-1(2)(i).
      3. Political campaign activities do not constitute the promotion of social welfare, and so a Section 501(c)(4) organization cannot have as its primary purpose the direct or indirect participation in political campaigns, such as rating candidates for office. Treasury Regulation § 1.501(c)(4)-1(a)(2)(ii); Revenue Ruling 67-368, 1967-2 C.B. 194. It may, however, engage in some political activities, but may be taxable on its political expenditures under Section 527(f).
      4. The regulations acknowledge that legislative activities, or lobbying, are not a prohibited non-exempt purpose under Section 501(c)(4) organizations. Treasury Regulation § 1.501(c)(4)-1(a)(2)(ii). Thus, a social welfare organization may have as its sole purpose lobbying for the passage or repeal of legislation. Revenue Ruling 67-293, 1967-2 C.B. 185. This rule has been modified by Section 504, which prohibits an organization from qualifying under Section 501(c)(4) if it had been exempt under Section 501(c)(3) but lost that status by virtue of excessive lobbying.
      5. A Section 501(c)(4) organization may not carry on a business in a manner similar to those operated for profit, Treasury Regulation § 1.501(c)(4)-1(a)(2)(ii), and may not have as a substantial part of its activities providing commercial type insurance. Section 501(m).
      6. Examples of social welfare organizations are -
        1. A nonprofit corporation formed to preserve the appearance of a housing development and to maintain streets, sidewalks, and common areas. Revenue Ruling 72-102, 1972-1 C.B. 149; but see Revenue Ruling 74-99, 1974-1 C.B. 131, which held that a homeowners' association, to qualify for exemption under Section 501(c)(4), [1] must serve a "community" that bears a recognizable relationship to an area ordinarily identified as governmental, [2] must not conduct activities directed to the exterior maintenance of private residences, and [3] must maintain the common areas it owns for the use and enjoyment of the general public.
        2. An association devoted to the preservation of the traditions, architecture, and appearance of a community and that accomplished its goals through individual and group action before the local legislature and administrative agencies with respect to zoning, traffic, and parking regulations. Revenue Ruling 67-6, 1967-1 C.B. 135.
        3. An organization that provided the community with a facility for rifle, pistol, and shotgun practice and instructions in the safe and proper care and handling of firearms. Revenue Ruling 66-272, 1966-2 C.B. 222.
        4. A nonprofit corporation that operated a roller skating rink and charged only such nominal dues as were necessary to defray operating expenses. Revenue Ruling 67-109, 1967-1 C.B. 136.
        5. A nonprofit corporation that processed consumer complaints about products and services, met with the parties involved to encourage resolution of disputes, and provided information about the appropriate administrative and judicial forums for resolving the disputes. Revenue Ruling 78-50, 1978-1 C.B. 155.
      7. "[T]he distinction between [Section 501(c)(3) and Section 501(c)(4)] is more apparent than real...." Monterey Public Parking Corp. v. U.S., 321 F. Supp. 972, 975 (N.D. Cal. 1970). Section 501(c)(4) is therefore an attractive solution to an organization that could have qualified under Section 501(c)(3) but which failed to do so because its application for exemption was not filed on a timely basis. In these situations, it is possible to obtain income tax exemption, but not to secure the deductibility of contributions, on a retroactive basis, extending back to the date of incorporation, through a filing under Section 501(c)(4), and prospective exemption, beginning with the date of filing, under Section 501(c)(3). Revenue Ruling 80-108, 1980-1 C.B. 119.
    3. Section 501(c)(6).
      1. Exempts "[b]usiness leagues, chambers of commerce, real-estate boards, boards of trade, or professional football leagues (whether or not administering a pension fund for football players), not organized for profit and no part of the earnings of which inures to the benefit of any private shareholder or individual."
      2. Treasury Regulation § 1.501(c)(6)-1 defines a business league as follows:
      3. [A]n association of persons having some common business interest, the purpose of which is to promote such common business interest and not to engage in a regular business of a kind ordinarily carried on for profit.... Thus, its activities should be directed to the improvement of business conditions of one or more lines of business as distinguished from the performance of particular services for individual persons. An organization whose purpose is to engage in a regular business of a kind ordinarily carried on for profit, even though the business is conducted on a cooperative basis or produces only sufficient income to be self sustaining, is not a business league.
      4. Thus, the five principal requirements for qualification under Section 501(c)(6) are:
        1. association of persons having a common business interest;
        2. whose purpose is to promote that common business interest;
        3. that is not organized for profit;
        4. that does not engage in a business of a type ordinarily conduced for profit; and
        5. whose activities are directed to the improvement of business conditions or one or more lines of business, in contrast to the performance of particular services for specific persons.
      5. One approach that the Internal Revenue Service appears to have adopted in its efforts to distinguish between permissible activities that improve one or more lines of business and impermissible activities that constitute the performance of particular services is to examine whether the results or products of the activity in question are available to or benefit the industry as a whole, as opposed to a more limited group within the industry.
        1. For example, Revenue Ruling 69-387, 1969-2 C.B. 124, held that a nonprofit organization, composed of advertising agencies, that audited and verified the circulation figures of commercial periodicals would qualify for exemption, since "[c]onfirming the quality of products and services available to an industry promotes the common business interest of its members." Of particular significance to this holding was the further observation that the organization under consideration promoted the common business interest of the industry as a whole "by conducting audits to determine the quality of services available to the industry and making the results available to the industry generally."
        2. Similarly, an association of financial institutions whose sole activity was to offer rewards for information leading to the arrest and conviction of individuals who had committed crimes against its member institutions was also held to qualify for exemption under Section 501(c)(6) in Revenue Ruling 69-634, 1969-2 C.B. 124. Here, the Service reasoned that offering rewards for the apprehension of bank robbers operated in a significant fashion to deter future criminal acts and stimulated the public interest in preventing and solving such crimes, all of which benefited all members of the banking industry. Any benefit to any one member institution from the arrest of someone who had robbed that particular bank, the ruling noted, was merely incidental.
        3. In contrast, a variety of rulings have held that denial of exemption is appropriate in cases where an organization makes the results of its research or other services available only to its members. One such representative ruling, Revenue Ruling 69-106, 1969-1 C.B. 153, dealt with and denied exemption to an association formed by a group of manufacturers to carry on research and development projects described as being of common interest to the industry. The organization did not conduct research directly for any particular member, but rather the projects it undertook were selected by a committee composed of its members. Although membership in the organization was open to any participant in the industry, not all businesses chose to join. The ruling held that "[s]ince this organization distributes the results of its research only to its members, its activities are not aimed at the improvement of business conditions for the entire industry."
        4. The organization described in Revenue Ruling 66-338, 1966-2 C.B. 226, formed for the stated purpose of promoting the interests of a particular retail trade, sent field representatives to its members to advise them on individual business problems, such as the modernization and layout of those members' stores. In addition, the organization offered and sold to its members office and store operating supplies, store fixtures and display accessories, store layout and merchandising services, and electronic management services, all at discounted prices. Noting that the organization's principal activity was to provide its members with an economical and convenient purchasing program, the Service had no difficulty in concluding that the association failed to improve business conditions in the trade as a whole and that it also was primarily engaged in a business of a kind ordinarily carried on for profit.
      6. Legislative advocacy is a permissible activity for a Section 501(c)(6) organization, even if it is its sole function. Revenue Ruling 61-177, 1961-2 C.B. 117.
      7. Political campaign activities are also permissible for Section 501(c)(6) organization, so long as they do not rise to the level of the organization's primary activity. Section 527(f) will subject any direct political expenditures of a Section 501(c)(6) organization to tax.
      8. Contributions and membership fees to a Section 501(c)(6) organization are not deductible under Section 170 as charitable contributions, although they may be deductible under Section 162 as a business expense. Revenue Ruling 58-293, 1958-1 C.B. 146.
      9. Section 162(e), however, as amended by the Tax Reform Act of 1993, provides that no deduction is allowable for dues and other contributions to a business league that are attributable to influencing legislation, participating in any political campaign, grass roots lobbying, or direct contacts with a "covered executive branch official." Trade associations are now required to inform their members what portion of their dues are not deductible or pay a "proxy tax" instead.
  3. Exemption Under Section 501(c)(3)
    1. Statutory Definition.
      1. "Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve [sic] the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements) any political campaign on behalf of (or in opposition to) any candidate for public office."
    2. Statutory Categories of Section 501(c)(3) Organizations.
      1. Religious Organizations are not discussed in the regulations, but it is clear that the term "religious" is considerably broader than "church."
        1. An organization controlled by a church that printed and sold literature of a religious and educational nature to the church's parochial school system was exempt. Revenue Ruling 68-26, 1968-1 C.B. 272.
        2. An organization that provided funds to defend members of a religious sect in legal actions involving constitutional issues of state abridgment of religious freedom was exempt. Revenue Ruling 73-285, 1973-2 C.B. 174.
        3. Largely because of a sensitivity to constitutional concerns regarding the separation of church and state, the Internal Revenue Service does not determine the qualification of religious organizations on the basis of their beliefs, but maintains a neutral and nonjudgmental attitude that assumes the sincerity and validity of an applicant's stated religious beliefs.
      2. Charitable Organizations. "The term 'charitable' is used in section 501(c)(3) in its generally accepted legal sense and is therefore, not to be construed as limited by the separate enumeration in section 501(c)(3) of other tax-exempt purposes which may fall within the broad outlines of 'charity' as developed by judicial decisions. Such terms include: Relief of the poor and distressed or of the underprivileged; advancement of religion; advancement of education or science, erection or maintenance of public buildings, monuments, or works; lessening the burdens of Government; and promotion of social welfare by organizations designed to accomplish any of the above purposes, or (i) to lessen neighborhood tension; (ii) to eliminate prejudice and discrimination; (iii) to defend human and civil rights secured by law; or (iv) to combat community deterioration and juvenile delinquency." Treasury Regulation § 1.501(c)(3)-1(c)(2).
      3. Educational Organizations. The regulations define educational as including [a] the instruction or training of the individual for the purpose of improving or developing his capabilities and [b] the instruction of the public on subjects useful to the individual and beneficial to the community. Treasury Regulation § 1.501(c)(3)-1(c)(3).
        1. Examples. Treasury Regulation § 1.501(c)(3)-1(c)(3)(ii) sets forth the following examples of educational organizations:
          1. An organization, such as a primary or secondary school, a college, or a professional or trade school, which has a regularly scheduled curriculum, a regular faculty, and a regularly enrolled body of students in attendance at a place where the educational activities are regularly carried on.
          2. An organization whose activities consist of presenting public discussion groups, forums, panels, lectures, or other similar programs. Such programs may be on radio or television.
          3. An organization which presents a course of instruction by means of correspondence or through the utilization of television or radio.
          4. Museums, zoos, planetariums, symphony orchestras, and other similar organizations.
        2. Advocacy of Controversial or Unpopular Positions. Treasury Regulation § 1.501(c)(3)-1(c)(3)(i) provides that an organization will not be denied exemption because it advocates a particular position or viewpoint, however controversial it may be, so long as the advocacy takes the form of a full and fair exposition of the pertinent facts so as to permit individuals or the public to form an independent opinion or conclusion, but that an organization will not be considered educational if its principal purpose is the mere presentation of unsupported opinion.
          1. While one federal district court has declared Treasury Regulation § 1.501(c)(3)-1(c)(3(i) unconstitutionally vague in this respect, Big Mama Rag, Inc. v. United States, 631 F.2d 1030 (D.C. Cir. 1980), the Service has announced that its policy is to "eliminate or minimize the potential for any public official to impose his or her preconceptions or beliefs in determining whether the particular viewpoint or position is educational" and to "maintain a position of disinterested neutrality with respect to the beliefs advocated by an organization." Revenue Procedure 86-43, 1986-2 C.B. 729 (setting forth factors tending to indicate that the methods used by the organization to advocate its viewpoints or positions are not educational).
          2. See also The Nationalist Movement, 102 T.C. 558 (1994), aff'd 37 F.3d 216 (1994) (newsletters advocating social, economic, and political change made substantial use of inflammatory and disparaging terms and expressed conclusions based more on the basis of strong emotional feelings than objective facts; exemption denied)
      4. Scientific Organizations must serve a public rather than private interest. Research is not synonymous with "scientific," and for research to be "scientific," it "must be carried on in furtherance of a 'scientific' purpose." Treasury Regulation § 1.501(c)(3)-1(c)(5). See discussion below on page 16 for a more detailed discussion of "scientific research."
      5. Amateur Sports Organizations are exempt if they operate primarily to foster national or international amateur sports competition and do not provide facilities or equipment. However, Section 501(j), in an effort to extend tax-exempt status to organizations training athletes for the Olympics, Pan-American games, and the like, provides that an amateur sports organization may provide facilities and equipment if its primary purpose is to conduct national or international competition in sports or to develop amateur athletes for national or international sports competition. Amateur sports organizations may also be considered educational, particularly if they are oriented towards youth athletics, but the Internal Revenue Service will not grant exemption on athletic activities that are primarily recreational, such as adult softball and bowling leagues.
    3. Specific Requirements for Particular Kinds of Section 501(c)(3) Organizations.
      1. The Service and the courts from time to time develop special requirements that must be met by specific kinds of organizations that desire to qualify for tax-exempt status. For the most part, these types of organizations are engaged in activities that compete with or closely resemble those of for-profit organizations, and so the additional guidelines represent special requirements that must be satisfied for the activity to be considered conducted in a charitable fashion.
      2. Health Care. The promotion of health has always been considered to be a charitable purpose. See Restatement (Second), Trusts, §§ 368 and 372; IV Scott on Trusts (3rd ed. 1967), §§ 368 and 372. However, largely because of the magnitude of their finances and because of their desire to compete effectively with their for-profit counterparts, nonprofit hospitals and other similar health care organizations have in recent years significantly tested the boundaries of exempt organizations tax law.
      3. Private Schools. Revenue Ruling 71-447, 1971-2 C.B. 230, noted that there has for many years been a strong federal policy against racial discrimination, including racial discrimination in education, whether public or private. Stating that "[a]ll charitable trusts, educational or otherwise, are subject to the requirement that the purpose of the trust may not be illegal or contrary to public policy" and that a "trust for a purpose the accomplishment of which is contrary to public policy, although not forbidden by law, is invalid," the ruling holds that a school "not having a racially nondiscriminatory policy as to students is not 'charitable' within the common law concepts reflected in sections 170 and 501(c)(3) of the Code and accordingly does not qualify as an organization exempt from Federal income tax."
        1. Revenue Procedure 75-50, 1975-2 C.B. 587, sets forth guidelines and recordkeeping requirements for determining whether private schools that are applying for recognition of exemption from Federal income tax under section 501(c)(3), or are presently recognized as exempt from tax, have racially nondiscriminatory policies as to students.
        2. See also Revenue Ruling 75-231, 1975-1 C.B. 158, which holds that other organizations, including churches, that conduct schools with a policy of refusing to accept children from certain racial and ethnic groups will not be recognized as tax-exempt charities under sections 170 and 501(c)(3).
      4. Low-Income Housing. Revenue Procedure 96-32, 1996-1 C.B. 717, sets forth two alternative tests under which an organization formed to provide low-income housing can qualify for exemption, one of which is characterized as a safe harbor and the other of which is called a "facts and circumstances" test. If an organization can show that its activities fall within the guidelines of the safe harbor, then it is unconditionally assured of qualifying under Section 501(c)(3) (assuming, of course, that it does not engage in any private inurement, political campaign activities, and the like, which would otherwise violate Section 501(c)(3)). If the organization does not meet the standards of the safe harbor, then it must resort to the facts and circumstances test.
      5. Housing for the Elderly and Disabled. While the elderly and disabled have traditionally been considered members of a potentially charitable class, the Service obviously does not intend to permit every upper-scale gated retirement community to qualify for Section 501(c)(3) status and has therefore released a series of rulings that distinguish between charitable housing for the elderly (and disabled) and conventional or commercial housing. See Revenue Ruling 72-124, 1974-1 C.B. 145.
      6. Scientific Research. Although Section 501(c)(3) includes "scientific" purposes in its list of the types of purposes that will entitle an organization to tax-exempt status, the Internal Revenue Service's regulations clarify that not all kinds of scientific activities will qualify under that section. For the most part, the Service equates "science" with "research," and so most of the published guidance in this area concerns organizations that claim to be engaged in scientific research within the meaning of Section 501(c)(3). See Treasury Regulation § 1.501(c)(3)-1(d)(5).
      7. Lessening the Burdens of Government. One of the historic rationales for granting tax-exempt status to certain organizations was that they were engaged in activities that the government would otherwise have had to conduct and thus exemption provided an incentive to lessen the burdens of government. However, the breadth of governmental activities is now so great that almost any organization might point to some governmental program which it claims to be assisting, and so the Internal Revenue Service takes a relatively narrow view of what constitutes lessening the burdens of government.
        1. In general, whether an organization is lessening the burdens of government requires consideration of whether the organization's activities are activities that a governmental unit considers to be its burdens, and whether such activities actually "lessen" such governmental burden.
        2. Whether an activity is in fact a burden of government depends on whether there is an objective manifestation by the government that it considers such activity to be part of its burden. The fact that an organization is engaged in an activity that is sometimes undertaken by the government is insufficient to establish a burden of government. Similarly, the fact that the government or an official of the government expresses approval of an organization and its activities is also not sufficient to establish that the organization is lessening the burdens of government.
      8. Combating Community Deterioration.
        1. Revenue Ruling 68-17, 1968-1 C.B. 247, dealt with an organization that conducted a model demonstration housing program to test the feasibility, cost, and procedural and financial aspects of providing housing for low-income families through the acquisition, rehabilitation, and resale or lease of residential structures in a deteriorating neighborhood.
        2. Revenue Ruling 70-585, 1970-2 C.B. 115 (example 3), involved a membership organization composed of the residents, businesses, and community organizations that cooperated with a local redevelopment authority in providing residents of the area with decent, safe, and sanitary housing without relocating them outside the area. The organization developed an overall plan for the rehabilitation of the area, sponsored a renewal project in which the residents themselves took the initiative, and arranged monthly meetings to involve residents in the planning for the renewal of the area. As part of the renewal project, it purchased an apartment house that it planned to rehabilitate and to rent at cost to low- and moderate-income families with preference given to residents of the area.
      9. Elimination of Discrimination and Prejudice. The organization in Revenue Ruling 70-585, 1970-2 C.B. 115 (example 2), ameliorated the housing needs of minority groups by building housing units for sale to persons of low and moderate income on an open occupancy basis. It constructed new housing available to members of minority groups with low and moderate income who were unable to obtain adequate housing because of local discrimination. These housing units were so located as to help reduce racial and ethnic imbalances in the community and were sold at or below cost to low- or moderate-income families or rented, with options to purchase, to families who could presently afford to purchase. Preference was given to families previously located in ghetto areas.
      10. Lessening Neighborhood Tensions. Revenue Ruling 68-655, 1968-2 C.B. 213, described an organization that educated the public regarding integrated housing and conducted intensive neighborhood educational programs to prevent panic selling because of the introduction of a non-white resident into a formerly all-white neighborhood. It also counseled minority group residents about the problems of living in an integrated neighborhood and ways of minimizing potential tensions and misunderstandings and encouraged and assisted white families in purchasing homes in integrated neighborhoods where it is determined that such families would help to stabilize the neighborhood. In cases where families were unable to secure financing through commercial channels for home purchases and the organization believed that the introduction of the family into a neighborhood would help accomplish its purposes, the organization made loans at prevailing bank rates.
      11. Providing Services to Other Organizations. In the case of services provided directly to individuals, some, like religion, education, and health care, are considered "charitable" simply by nature and do not depend on the character of the persons receiving them. Others, like housing or financial assistance, take on a charitable character only if the recipients are indigent, elderly, disabled, or otherwise disadvantaged. Since organizations - even organizations qualified under Section 501(c)(3) - are not considered disadvantaged, entities whose programs are directed principally to other organizations must conduct activities that are inherently charitable in nature; they cannot derive their exemption simply by virtue of the fact that they assist other charitable organizations.
        1. Revenue Ruling 72-369, 1972-2 C.B. 245, illustrates the Service's position on this issue. That ruling described an organization formed to offer various managerial and consulting services designed to enable other Section 501(c)(3) organizations to improve the administration of their programs. The services included writing job descriptions and employee training materials, personnel recruitment, preparing organizational charts, and other types of consultation on administrative matters. The fees that the organization charged for these services were adequate to permit it to pay all of its operating expenses, but not to generate a profit.
        2. After reciting the fundamental rule that an organization desiring to qualify under Section 501(c)(3) must devote itself exclusively to carrying out charitable purposes, the ruling concluded as follows:
        3. roviding managerial and consulting services on a regular basis for a fee is a trade or business ordinarily carried on for profit. The fact that the services in this case are provided at cost and solely for exempt organizations is not sufficient to characterize this activity as charitable with the meaning of section 501(c)(3) of the Code.
        4. Accordingly, the ruling held that the organization did not qualify for exemption under Section 501(c)(3).
        5. In contrast, Revenue Ruling 71-529, 1971-2 C.B. 234, announced what is perhaps the only rationale that the Service finds acceptable for granting exempt status to an organization that provides to other organizations what would ordinarily be regarded as commercial services. This ruling involved a nonprofit organization that was controlled by various colleges and universities and that managed their investment funds. It performed the investment management services at substantially below cost and heavily subsidized its operations through grants from other independent charitable organizations. Although Revenue Ruling 71-369 favorably cited the fact that the investment management agency was controlled by its members, that the investment management services were essential to the operations of the members, and that the services were provided only to members, what has subsequently emerged as the most significant basis for the ruling is the notion that the services were performed at substantially below cost.
        6. It necessarily follows that such an organization can only provide its below-cost services to the same types of other organizations to which it might make cash grants, that is, for the most part, other organizations that are themselves described in Section 501(c)(3). Just as one Section 501(c)(3) organization cannot typically make a grant to, say, a trade association to be used to further its commercial objectives, neither can such an organization make its services available, on a below-cost basis or otherwise, to any other non-Section 501(c)(3) organization.
  4. Primary Purposes and Permissible Nonexempt Activities
    1. Organizational Test.
      1. Treasury Regulation § 1.501(c)(3)-1(b)(2) imposes an organizational test on Section 501(c)(3) organizations that requires that their Articles of Incorporation [1] limit the purposes of the organization to one or more exempt purposes, and [2] do not expressly authorize the organization to engage, other than as an insubstantial part of its activities, in any activities which in themselves are not in furtherance of one or more exempt purposes.
      2. Purposes Limited to Those Permissible Under Section 501(c)(3). The Articles of Incorporation may specify purposes that are as broad as, or more limited and specific than, those stated in Section 501(c)(3), so that an organization's Articles of Incorporation may state that it is organized for "charitable purposes as defined in Section 501(c)(3)" or, less elegantly, for "Section 501(c)(3) purposes." If there is no contrary state law, it is also permissible for the Articles to state that the organization is organized for "charitable" purposes. Treasury Regulation § 1.501(c)(3)-1(b)(1)(ii).
      3. Purposes Cannot be Broader than Permitted Under Section 501(c)(3). However, an organization will fail the organizational test if its Articles of Incorporation specifically empower it to carry on activities, other than to an insubstantial extent, that do not further the exempt purposes set forth in Section 501(c)(3) or if its purposes are broader than those described in Section 501(c)(3). Treasury Regulation § 1.501(c)(3)-1(b)(1)(iii) and (iv). Thus, the Articles should not contain a statement such as "this corporation is authorized to carry on a manufacturing business" or "the purposes of this corporation shall include the operation of a social club." If the purposes of the corporation are broader than are permitted by Section 501(c)(3), then it is irrelevant that the corporation actually operated only for permissible purposes or that its members had the intention of thus confining its activities.
      4. Purposes Including Lobbying or Political Campaign Activities. An organization is not "organized" for acceptable purposes if its Articles of Incorporation expressly authorize it to devote more than an insubstantial part of its activities to influencing legislation or to participate in political campaigns. Treasury Regulation § 1.501(c)(3)-1(b)(3).
      5. Dissolution Clause. To satisfy the organizational test, either the governing instrument must also contain, or applicable law must provide for, the perpetual dedication of the organization's assets for charitable purposes upon its dissolution. This usually means that the organization's Articles of Incorporation provide that its assets be distributed to one or more other organizations exempt under Section 501(c)(3) on its liquidation. Treasury Regulation § 1.501(c)(3)-1(b)(4).
    2. Operational Test.
      1. In addition to being organized for Section 501(c)(3) purposes, Section 501(c)(3) requires that an organization must also operate "exclusively" for permissible purposes.
      2. The Service's regulations clarify that "exclusively" does not really mean "exclusively." Otherwise, the unrelated business income tax provisions of the Code would be meaningless and unnecessary. On the other hand, the regulations are a bit confusing and contradictory in their explanation of the permissible level of nonexempt activities in which a Section 501(c)(3) may engage.
      3. The first sentence of Treasury Regulation § 1.501(c)(3)-1(c)(1) helpfully provides that a Section 501(c)(3) organization will be considered to operate "exclusively" for one or more exempt purposes "only if it engages primarily in activities which accomplish one or more of such exempt purposes specified in section 501(c)(3)." [emphasis added] According to the dictionary, "primarily" means "for the most part."
      4. The next sentence, however, suggests that the Service has perhaps consulted a different dictionary, for it states that "[a]n organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose." Again according to the dictionary, "substantial" means "largely but not wholly."
      5. Complicating the analysis is Treasury Regulation § 1.501(c)(3)-1(e), which seeks to reconcile exempt status with the carrying on of business activities, as follows:
      6. An organization may meet the requirements of section 501(c)(3) although it operates a trade or business as a substantial part of its activities, if the operation of such trade or business is in furtherance of the organization's exempt purpose or purposes and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business, as defined in section 513. In determining the existence or nonexistence of such primary purpose, all the circumstances must be considered, including the size and extent of the trade or business and the size and extent of the activities which are in furtherance of one or more exempt purposes.
      7. It is important to keep in mind that, while the statute speaks in terms of "purposes," what is really of concern are the activities in which an organization engages, and the Internal Revenue Service will typically pass over an organization's statements of claimed purposes to determine or infer purposes on the basis of its actual activities. This does, of course, involve a considerable weighing of facts and circumstances, places a significant emphasis on the skillfulness with which an organization can articulate and justify its activities, and is a largely subjective and discretionary process. It also somewhat reduces the precedential value of reported cases and revenue rulings.
        1. Revenue Ruling 73-128, 1973-1 C.B. 222, described an organization whose stated objectives were to "provide educational and vocational training and guidance to nonskilled persons who are unable to find employment or cannot advance from poorly paid employment due to inadequate education." The organization's actual activities, however, involved the manufacture and sale of a line of toy products which were, for the most part, sold through regular commercial channels. Nonetheless, because it conducted its manufacturing and merchandising business by recruiting unskilled individuals who were residents of a particular economically depressed community and who were unemployed or under-employed and providing them with new skills through on-the-job training while they earned a living, the ruling held that the organization was entitled to tax-exempt status.
        2. For this reason, it is vital that an applicant for tax-exempt status be able to describe its proposed activities with clarity and specificity.
          1. Part IV of Form 1023 is therefore somewhat deceptive. Six lines long, it asks the applicant to describe your past, present and planned activities in a narrative, and that narrative -- which should generally take the form of a comprehensive essay -- is probably the most important component of the exemption application
          2. Revenue Procedure 90-27, 1990-1 C.B. 514, explains the reasoning behind that question as follows:
          3. Exempt status will be recognized in advance of operations if proposed operations can be described in sufficient detail to permit a conclusion that the organization will clearly meet the particular requirements of the section under which exemption is claimed. A mere restatement of purposes or a statement that proposed activities will be in furtherance of such purposes will not satisfy this requirement. The organization must fully describe the activities in which it expects to engage, including the standards, criteria, procedures or other means adopted or planned for carrying out the activities, the anticipated sources of receipts, and the nature of contemplated expenditures. Where the organization cannot demonstrate to the satisfaction of the Service that its proposed activities will be exempt, a record of actual operations may be required before a ruling or determination letter will be issued. In those cases where an organization is unable to describe fully its purposes and activities, a refusal to issue a ruling or determination letter will be considered an initial adverse determination from which administrative appeal or protest rights will be afforded.
  5. Public Benefit and Private Inurement
    1. Public Benefit.
      1. The concept of public benefit is not clearly articulated in the statute but is clearly implicit in the requirements for qualification under Section 501(c)(3). Since organizations seeking exemption under this section must demonstrate that they are organized and operated exclusively for religious, charitable, educational, or scientific purposes, and the like, all of which contemplate some benefit to the public at large, the Internal Revenue Service considers that an organization that benefits private interests in anything more than an insignificant or incidental fashion has failed this test.
      2. While some private benefit is unavoidable, such as when a hospital patient is cured of disease or a university student receives job counseling, it is essential that the benefit accruing to the particular patient or student or other private individual be merely incidental to the organization's serving the public as a whole.
      3. General Counsel Memorandum 39633 illustrates the application of the public benefit test in a highly instructive fashion. The memorandum dealt with an organization that represented that it had conducted extensive research, the results of which demonstrated that medical students from minority or economically disadvantaged families were more inclined establish a practice in a medically underserved areas, but were equally likely to have incurred a greater debt burden to finance their education, a burden that would be more difficult to discharge from the cash flow to be expected from a practice in an underserved area. If some of this debt burden could be relieved, the organization believed, these students could be encouraged to forgo a more lucrative practice and to establish their practice in minority or economically depressed locations.
        1. Accordingly, the organization proposed to offer low-interest loans to eligible individuals for the purpose of restructuring and refinancing their educational debt, and each such loan was to be conditioned upon the borrower's agreement to practice for a period of four years in an underserved area.
        2. As admirable as these goals might have been, in its memorandum, the Service's chief counsel's office concluded that the "circumstances under which the organization will make the loans and provide other assistance will not bear a reasonable relationship to the promotion of health in the community involved but will, in fact, result in substantial economic or private benefit to the recipients of the loans." As a result, the Service denied the organization its exemption.
        3. In reaching this conclusion, the memorandum noted that "[t]he provision of assistance in the form of refinancing and restructuring debt obligations for 'economically disadvantaged and/or minority health care professionals' does not alone constitute an exempt purpose under Section 501(c)(3)." This statement reflects the Internal Revenue Service's belief that minority health care professionals are not per se impoverished or underprivileged and that they do not for any similar reason qualify as a charitable class.
        4. The memorandum did comment that the organization might have salvaged its program had it been able to show more convincingly that the loans, although incidentally providing some assistance to private individuals, were instrumental in carrying out a significant and demonstrable charitable activity, such as bringing needed medical services to underserved areas. While the organization had represented that it would consult with the appropriate governmental agencies and would be influenced by the definition of medically underserved areas set forth in the Department of Health and Human Services' regulations pertaining to the National Health Service Corps, the Service felt that this representation was inadequate, that the organization did not actually commit to placing its beneficiaries in locations meeting the Department of Health and Human Services' criteria, and that it would instead rely on its own "imprecise definition of the term for placement purposes."
      4. Qualitative and Quantitative Aspects. Whether or not any private benefit is so substantial as to justify denying an organization exemption depends on both the quality and the quantity of the private benefit involved.
        1. In order for the benefits accruing to private individuals to be qualitatively incidental, they must be a logical consequence of the benefits to the public at large. In other words, it must be impossible for the organization to accomplish its exempt mission without also providing some private benefits.
          1. Revenue Ruling 70-186, 1970-1 C.B. 128, granted exemption to an organization that preserved a lake as a public recreational facility and improved the purity of its water, even though these activities also improved the property values of homes along the lakefront.
          2. General Counsel Memorandum 38827 (December 7, 1981) considered a communal religious organization whose members lived, worked, and worshipped together in a wilderness area and engaged in logging, farming, fishing, and similar activities to the extent necessary to provide its members with a subsistence existence. The memorandum held that the provision of minimal food and lodging to its members primarily furthered its charitable purposes, since it was a fundamental tenet of the organization's sincerely held beliefs that they must exist interdependently in the wilderness with a minimum of food and lodging.
          3. See also Alive Fellowship of Harmonious Living, 47 T.C.M. 1134 (1984) (conducted courses on the doctrine of "polarity" for a tuition of $1,500 to $7,500 per year and provided to full members a nominal cash allowance, room, board, medical care, and an assumption of outstanding liabilities such as attorneys' fees and child support).
        2. A quantitative analysis simply requires a balancing of the level of benefits flowing to private persons with the benefits flowing to the public. For example, Revenue Ruling 76-152, 1976-1 CB. 151 denied exemption to an organization that selected modern works of art for display and possible sale and retained a commission of ten percent of any sales proceeds, while remitting the balance to the artist.
      5. Church Cases.
        1. The Church of the Living Tree, 71 T.C.M. 3210 (1996) (exemption denied an unincorporated association whose chief executive officer and spiritual leader was to be known as the "Advocate of the Tree" and whose primary purpose was to be the planting and cultivation of trees, with some emphasis on "establishing an industry of papermaking from appropriate fiber sources ... to relieve trees from the assaults of the pulp and paper industry for wood chips." The "church's" sole "project community" was located at the founder's home address, and the founder was a handmade paper craftsman who donated his residence, business assets, automobiles, and the like to the "church" and continued to use them rent free.)
        2. Ecclesiastical Order of the Ism of Am, Inc., 80 T.C. 833 (1983). (exemption denied an organization whose primary activity consisted of counseling existing and prospective members of the income tax advantages of becoming ministers in its religion.)
        3. Church of Scientology of California, 83 T.C. 575 (1984), aff'd, 822 F.2d 844 (9th Cir. 1987) (Denial of charitable deductions to a church that believed that an immortal spiritual being exists in every person, that a person becomes aware of this spiritual dimension through a process known as "auditing," which involves a one-to-one encounter between a participant (known as a "preclear") and a Church official (known as an "auditor") who uses an electronic device, the E-meter, to identify the preclear's areas of spiritual difficulty by measuring skin responses during a question and answer session. The Tax Court noted an extensive commercial purpose documented in written directives from the church to its subordinates to "make money. Make money. Make more money.")
          1. Note: The Scientology litigation continued for a period of over ten years and included several cases that were appealed to the United States Supreme Court.
          2. Further Note: On October 1, 1993, the Internal Revenue Service entered into a comprehensive Closing Agreement with the Church of Scientology that finally recognized the church's tax-exempt status and the deductibility of contributions to it. The text of the Closing Agreement has been reprinted in 19 Exempt Organizations Tax Review, No. 2, p. 227 (February 1998).
        4. The Basic Unit Ministry of Alma Karl Schurig, 670 F.2d 1210 (D.C. Cir. 1982) (exemption denied).
        5. Bubbling Well Church of Universal Love, Inc., 670 F.2d 104 (9th Cir. 1982) (exemption denied).
        6. Chief Steward of the Ecumenical Temples and the Worldwide Peace Movement and His Successors, 49 T.C.M. 640 (1985) (exemption denied).
        7. But see Church of the Visible Intelligence that Governs the Universe. 4 Cls. Ct. (1983) (exemption approved).
        8. But see Alive Fellowship of Harmonious Living, 47 T.C.M. 1134 (1984) (exemption approved).
    2. Private Inurement.
      1. An organization is not exempt if its net earnings inure to the benefit of any private shareholder or individual.
      2. "Net earnings" is defined expansively as including assets, and not just earnings in a financial accounting sense.
      3. A "private shareholder or individual" includes any person who has a personal and private interest in the activities of the organization. Treasury Regulation § 1.501(a)-1(c). Thus, the prohibition on private inurement generally requires an examination of transactions between the exempt organization and persons who are presumably in a position to influence its policies and activities.
      4. Certain arrangements, even with insiders, that are entered into for fair value, are not considered private inurement. Thus, an exempt organization may, for example, pay reasonable compensation for services rendered to it, may loan money on commercially reasonable terms (except to board members, a practice that is prohibited under Colorado law), and may lease its property at a reasonable fair market rental. The reasonableness of the compensation, loan terms, and rentals, however, is an inherently factual question that is usually resolved with reference to similar transactions entered into at arm's-length by other, unrelated parties.
      5. In Revenue Ruling 69-383, 1969-2 C.B. 231, for example, the Service approved an arrangement between a hospital and a radiologist in which the hospital provided the space, equipment, supplies, and technical support staff necessary for the operation of a radiology department and agreed to pay the radiologist a fixed percentage of the gross billings from that department. While this ruling is of considerable interest for its acceptance of what appears to be a sort of profit-sharing arrangement, it expressly stated that its conclusion depended on the fact that the radiologist had no role whatsoever in the administration of the hospital, that the arrangement was negotiated at arm's length, and that the amount received by the radiologist was not excessive when considered in light of the compensation paid to radiologists having comparable responsibilities and patient loads at other hospitals.
      6. Examples of private inurement.
        1. A nonprofit corporation authorized by its Articles of Incorporation to make loans to other charitable corporation made loans instead to its founders. Best Lock Corp., 31 T.C. 1217 (1959).
        2. A school paid excessive rents to a dominant group of persons that managed its affairs and financed improvements on real estate that they owned. Texas Trade School, 30 T.C. 642 (1958).
        3. An unaccredited law school made unsecured, interest-free loans to its founders to enable them to purchase and furnish a home, awarded noncompetitive scholarships to their children, and paid a variety of non-business expenses. John Marshall Law School, 81-2 U.S.T.C. ¶ 9745 (Ct. Cl. 1981).
        4. General Counsel Memorandum 39862 conducted a review of one unpublished and two previously released private letter rulings involving hospitals that had sponsored the creation of medical staff joint ventures that purchased the expected net revenue streams for a term of years from various hospital departments at a discounted present value. The memorandum recommended that all three private letter rulings be revoked and further suggested that all appropriate audit authorities be notified "about the potential abuse in these arrangements" with a view towards revoking the exempt status of any hospital that engaged in a similar transaction without the benefit of an advance ruling. The Service observed that it would have been improper "under most circumstances for a charitable organization to borrow funds under an agreement, even with an outside lender, where the organization would pay as interest a stated percentage of its earnings" and concluded that:
          1. Giving (or selling) medical staff physicians a proprietary interest in the net profits of a hospital under these circumstances creates a result that is indistinguishable from paying dividends on stock. Profit distributions are made to persons having a personal and private interest in the activities of the organization. Thus, the arrangements confer a benefit which violates the inurement proscription of section 501(c)(3).
        5. Westward Ho, 63 T.C.M. 2617 (1992). The proprietors of several restaurants in the downtown business district of Burlington, Vermont decided to form a nonprofit corporation whose Articles of Incorporation described its purposes as follows:
          1. Providing travel grants or loans to certain indigent and antisocial persons who may have a strong desire or need to leave the Burlington, Vermont area, but who lack the means to pay for transportation to their destination of choice.
          1. It turns out that a certain homeless person in Burlington habitually caused disturbances in the restaurants and bars owned by Westward Ho's founders and on one occasion threw a planter of poinsettias at a bartender. Westward Ho's only concrete activity therefore consisted of buying this annoying person a one-way ticket to Seattle. He accepted the ticket and "was the only person who was relocated under petitioner's program."
          2. The applicant had, as Judge Mary Ann Cohen of the United States Tax Court noted, "no formal program for identifying individuals who could be benefited by relocation" and "no program for confirming the potential lifestyles in the cities to which the persons to whom grants were to be given were to be relocated or for exploring whether or not an individual would be benefited by voluntary relocation." The applicant also "discouraged applications for its services."
          3. Upholding the Internal Revenue Service in a memorandum decision, the Tax Court concluded that Westward Ho furthered its founders' private interests in more than an incidental fashion and denied it tax-exempt status under Section 501(c)(3).
    3. Intermediate Sanctions.
      1. Background. The private inurement restrictions have historically proved largely unworkable. On the one hand, the Internal Revenue Service repeatedly found itself in the uncomfortable position of evaluating the reasonableness of compensation, the fairness of loans, leases, and sales, and the like, with respect to transactions between Section 501(c)(3) organizations and insiders. In addition, the Service was frequently reluctant to exercise the only remedy available to it - revocation of exemption - in those cases where it discovered private inurement that was not egregious. In addition, that remedy most significantly affected the organization itself, and not the insiders who both caused the transaction and benefited from it.
      2. Enactment of Remedial Legislation. The Taxpayer Bill of Rights 2, enacted in 1996, added Section 4958 to the Code, which now imposes a series of penalty excise taxes with respect to certain transactions that are defined by statute, but which resemble private inurement. The Internal Revenue Service issued proposed regulations on the intermediate sanctions rules on August 4, 1998. See 98 TNT 147-3.
      3. Operation of the Statute. Section 4968 applies to subject to tax certain "disqualified persons" and, in certain situations, on certain "organization managers" with respect to what are termed "excess benefit transactions" with an "applicable tax-exempt organization" The tax imposed on a disqualified person who receives an excess benefit in an excess benefit transaction is 25 percent of the amount of the excess benefit. If the initial tax is imposed and the transaction is not timely corrected, then an additional tax of 200 percent of the amount of the excess benefit is imposed. A third tax, equal to ten percent of the excess benefit is imposed on any "organization managers" who participated in the transaction. If the organization manager also benefited from the transaction, then he or she may be liable for both the ten and the 25 percent taxes.
      4. Definitions.
        1. An "applicable tax-exempt organization" is any organization that either [a] is described in Sections 501(c)(3) or (4), or [b] was described in Sections 501(c)(3) or (4) during the five-year period ending on the date of the excess benefit transaction.
          1. Since the effective date of Section 4958 was September 14, 1995, the five-year "look-back period" does not begin before that date.
          2. Since Section 501(c)(4) organizations do not have to apply for that status, the proposed regulations state that any organization that has in fact applied for and received recognition of such status, that has filed a tax return claming that status, or that has otherwise held itself out as being described in that section will be deemed to be a Section 501(c)(4) organization.
        2. A "disqualified person" is any person who was in a position to "exercise substantial influence" over the affairs of the organization at any time during the five years preceding the date of the transaction. The proposed regulations describe certain statutory categories of disqualified persons, certain persons deemed to have substantial influence, and certain person deemed not to have substantial influence.
          1. Statutory disqualified persons include family members of disqualified persons (spouses, brothers or sisters, spouses of brothers or sisters, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, and great grandchildren). In addition, any entity (corporation, partnership, or trust) in which a disqualified person, a family member, or a "deemed" disqualified person holds a 35-percent or more interest is a statutory disqualified person.
          2. Persons "deemed" to have substantial influence include voting members of the governing body, officers, and treasurers and chief financial officers.
          3. Persons "deemed" notto have substantial influence include other tax-exempt organizations and employees whose compensation is less than the limits applicable to highly compensated employees under Section 414(q)(1)(B)(i) and who are not substantial contributors or management of the organization.
          4. In all other cases, a facts and circumstances test applies -
            1. Factors tending to show substantial influence are: the person founded the organization; the person is a substantial contributor; the person's compensation is based on revenues derived from activities of the organization the person controls; the person has managerial authority or serves as a key advisor to another person with managerial authority; or the person has a controlling interest in an entity that is a disqualified person.
            2. Factors tending to show the absence of substantial influence are: the person has taken a vow of poverty; the person is an independent contractor, such as an attorney or accountant acting in that capacity; or any preferential treatment that the person receives based on the size of that person's contributions are also offered to any other donor making a comparable contribution as part of a solicitation intended to attract a substantial number of donors.
        3. An "organization manager" is any person who is an officer, director, or trustee of the organization or who has similar powers and responsibilities (regardless of title). A person is considered to be an officer if he or she is specifically so designated in the organization's organizational documents or regularly exercises "general authority to make administrative or policy decisions" on the organization's behalf. Someone who can recommend decisions, but not implement them without the approval of a superior, is not an officer.
          1. Persons who are not officers, directors, or trustees, but who serve on a committee that seeks to invoke the presumption of reasonableness with respect to compensation based on that committee's actions, will be deemed organization managers.
          2. In order for an organization manager to become liable for the ten percent excise tax, that person must have participated in the excess benefits transaction and that participation must have been knowing and willful.
            1. Participation includes silence or inaction where there is a duty to speak or act.
            2. "Knowing" means that the person [i] has sufficient knowledge of the facts so that, based solely on those facts, he or she has actual knowledge that the transaction would be an excess benefit transaction, [ii] is aware that such an act would violate the federal tax laws, and [iii] negligently fails to make reasonable attempts to ascertain whether the transaction is in fact an excess benefit transaction. "Knowing" does not mean "having reason to know."
            3. "Willful" means that an act is "voluntary, conscious, and intentional." Motive is not a factor, and participation cannot be willful if the organization manager does not know that the transaction is an excess benefit transaction.
            4. There is a further exception for participation due to reasonable cause. This means that the organization manager acted with ordinary care and prudence.
            5. Reliance on a reasoned opinion of counsel will ordinarily result in participation not being considered willful and its being considered motivated by reasonable cause.
      5. Excess Benefit Transactions. An excess benefit transaction is any transaction in which the value of an economic benefit provided, directly or indirectly, by an applicable tax-exempt organization to a disqualified person exceeds the value of the consideration which the disqualified person provides to the organization.
        1. Disregarded Benefits. The following benefits provided to a disqualified person are disregarded:
          1. Reimbursement for reasonable expenses of attending meetings of the governing body (but not luxury travel or spousal travel).
          2. De minimis benefits provided to a disqualified person solely as a member of or volunteer for the organization if the benefit is provided to members of the public in exchange for a membership fee of $75 or less per year.
          3. Any benefit that the disqualified person receives as a member of a charitable class that the organization intends to benefit as part of its charitable mission.
        2. Special Rule for Reasonable Compensation. In cases where an organization provides compensation to a disqualified person, the performance of services for an organization is considered acceptable consideration, but the compensation for those services must be reasonable. For these purposes, all forms of cash and noncash compensation, and related economic benefits, must be taken into account.
          1. The reasonableness of compensation must be determined contemporaneously with the performance of services. This means that an organization cannot exercise hindsight to argue that compensation previously paid was, in fact, reasonable.
          2. The organization must also have intended economic benefits to be treated as compensation by clear and convincing evidence. This usually means that the organization properly reports the compensation (on Forms W-2 or 1099) before an IRS audit occurs. It also prevents an organization from seeking to justify, after the fact, that the benefits it provided to a disqualified person could have been reasonable compensation if they had been treated as such.
          3. There is a rebuttable presumption that a transaction is not an excess benefit transaction if -
            1. the transaction is approved by the organization's governing body or a committee of the governing body composed entirely of individuals who do not have a conflict of interest with respect to the transaction,
            2. the governing body (or committee) obtained and relied upon appropriate data as to comparability before making its determination, and
            3. the governing body (or committee) adequately documents the basis for its decision concurrently with making its determination.
          4. The proposed regulations go into substantial additional detail as to what it means to have a conflict of interest, what appropriate comparability data means, and how a decision is to be documented.
          5. There is one obvious trap in the rebuttable presumption procedures. Since the reasonableness determination must be made by a governing body composed entirely of individuals who do not have a conflict of interest, a board cannot invoke the rebuttable presumption procedures if all of the board members are to be compensated. The reason is that each board member would then be voting on compensation to be paid to another, who will in turn be voting on the compensation to be paid to the first, and the proposed regulations make it clear that such reciprocity is a conflict of interest. Moreover, it may not be possible to delegate the entire board compensation issue to a committee composed of non-compensated, non-board members, since such a committee may not have the authority under state law to make such a decision, and since the proposed regulations state that, if a committee's decision must be ratified by the full governing body in order to become effective under state law or the organization's governing documents, the committee will not be regarded as having approved the transaction.
        3. Special Rules for Revenue-Based Benefits. The Internal Revenue Service has struggled for years with the propriety of revenue-based or percentage compensation arrangements, since Section 501(c)(3) clearly states that no part of the net earnings may insure to the benefit of any private individual. However, Section 4958 authorizes the Service to issue regulations on compensation arrangements of this nature, and the recently released proposed regulations have done so.
          1. In general, a revenue-sharing transaction may constitute an excess benefit - whether or not the benefit exceeds the value that the disqualified person gives back to the organization - if it permits the disqualified person at any time to receive additional compensation without providing proportional benefits that contribute to the organization's accomplishing its charitable purposes.
          2. An example of an acceptable revenue-based compensation arrangement would be one involving an investment manager who receives a percentage of the growth of an organization's portfolio.
          3. An example of an unacceptable compensation arrangement is a manager who receives a percentage of the net revenues, where the total amount that the manager may receive will increase if the manager causes gross revenues to increase (which may make the organization's services more expensive) or causes expenses to decline (which may diminish the quality of those services).
          4. If a revenue-based transaction results in an excess benefit after the date of the Service's publication of final regulations, then the entire economic benefit provided to the disqualified person will constitute an excess benefit. Until that time, only the excess portion will constitute an excess benefit.
  6. Political Campaign and Legislative Activities.
    1. Action Organizations. An "action" organization is not considered to be operated exclusively for exempt purposes. An action organization is one a substantial part of whose activities consists of attempts to influence legislation, that participates to any extent in any political campaign, or whose primary objectives can be accomplished only by the enactment or defeat of legislation and that advocates and campaigns for the achievement of that objective, as opposed to engaging in nonpartisan study and analysis. Treasury Regulation § 501(c)(3)-1(c)(3)(ii), (iii), and (iv).
    2. Political Campaign Activities. There is an absolute prohibition against Section 501(c)(3) organization's participating in any fashion in political campaigns, either in favor of or in opposition to, any candidate for elected office. See Association of the Bar of the City of New York v. Comm'r, 88-2 U.S.T.C. ¶ 9535 (1988) (Service refused to permit a bar association that rated candidates for elective and appointive positions on the bench to convert from Section 501(c)(6) to Section 501(c)(3) status).
    3. Lobbying.
      1. Section 501(c)(3) provides that "no substantial part" of an eligible organization's activities can consist of "carrying on propaganda, or otherwise attempting to influence legislation (except as otherwise provided in subsection (h))." The principal difficulty with the statutory language is that it neither defines "substantial" nor indicates what factors are to be measured or taken into account in determining whether particular activities are in fact substantial.
      2. Several court decisions that have attempted to measure whether an organization's lobbying activities rise to the level of being substantial within the meaning of Section 501(c)(3), but these decisions have been based on the particular factual circumstances of each case and do not carry any special precedential weight in other situations.
        1. Seasongood v. Commissioner, 227 F.2d 907 (6th Cir. 1955), held that an organization did not violate the substantiality test, based upon testimony from its founder that neither he nor its other volunteers devoted more than 5 percent of their time to lobbying on the organization's behalf.
        2. Haswell v. United States, 500 F.2d 1133 (Ct. Cl. 1974), discussed at considerable length the difficulties involved in apportioning such expenses as printing and duplication costs, travel and entertainment, and general administrative overhead between charitable activities and lobbying efforts and concluded that the organization involved committed between 16 and 20 percent of its financial resources to legislative activities and therefore engaged in substantial lobbying.
        3. Christian Echos National Ministry, Inc. v. United States, 470 F.2d 849 (10th Cir. 1973), noted that "[t]he political activities of an organization must be balanced in the context of the objectives and circumstances of the organization to determine whether a substantial part of its activities was to influence or to attempt to legislation" and observed that the use of percentages altogether "obscures the complexity" making that determination.
        4. Abortion Rights Mobilization, Inc. v. U.S., 82-2 U.S.T.C. ¶ 9477 (D.D.C. 1982); 84-1 U.S.T.C. ¶ 9232 (D.D.C. 1984); 85-1 U.S.T.C. ¶ 9253 (D.D.C. 1985); rev'd and dismissed, 89-2 U.S.T.C ¶ 9477 (2d Cir. 1989) (Challenge to the tax-exempt status of the Roman Catholic Church based upon its activities in opposition to abortion).
    4. Section 501(h) Election.
      1. To eliminate much of the uncertainty surrounding this substantiality standard, Section 501(h) permits certain Section 501(c)(3) organizations to make an election to be governed by precise safe harbor rules relating to the scope of their legislative and lobbying activities. This election is made by filing Form 5768 with the Internal Revenue Service, and is effective with respect to the current year and all future years. The election may be revoked, but only prospectively, that is, for years that begin after the date of filing the revocation.
      2. ection 4955 imposes an excise tax on the political expenditures made by an organization that otherwise would have qualified under Section 501(c)(3).
  7. Restrictions Applicable to Private Foundations
    1. Tax on Net Investment Income.
      1. Section 4940 imposes an excise tax of 2 percent on the net investment income of private foundations.
      2. “Net investment income” is the amount by which the sum of the private foundation’s “gross investment income” and “capital gain net income” exceeds its allowable deductions.
        1. “Gross investment income” includes interest, dividends, rents, payments with respect to securities loans, and royalties to the extent that such income is not subject to the tax on unrelated business taxable income.
        2. A deduction for depreciation is allowed, but only on a straight–line basis.
        3. Capital gains are taken into account only to the extent that the property disposed of was held for the production of income, dividends, rents, royalties, and unrelated business income. There is no capital loss carryover.
        4. Tax–exempt interest and associated expenses are disregarded.
      3. Quarterly estimated tax payments are required. Section 6154(h).
      4. The applicable rate will be reduced from two to one percent if the foundation has made “qualifying distributions” that equal or exceed the sum of [a] the average percentage payout for the base period” times an amount equal to the assets of the foundation for the year, plus [b] one percent of the foundation’s net investment income. Section 4940(e).
      5. Of ironic interest is the fact that this tax was originally designed to finance the Service’s audit activities with respect to private foundations. The revenues raised by this tax were so adequate for these purposes that Congress reduced the applicable rate from four to two percent in 1978.
    2. Self-Dealiing.
      1. Section 4941 imposes a series of excise taxes on acts ofself–dealing between a private foundation and a disqualified person. A tax of five percent of the amount involved with respect to each act of self–dealing is imposed each year upon the disqualified person, other than a foundation manager, participating in the transaction, and a tax of 2–1/2 percent of the amount involved is imposed each on each foundation manager knowing it to be an act of self–dealing, unless that manager’s participation in the transaction was not willful and was due to reasonable cause. Additional taxes of 200 percent and 50 percent, respectively, are imposed on the disqualified persons and foundation managers if the prohibited transaction is not corrected and unwound by the time the Service either mails a notice of deficiency with respect to, or assesses, the initial taxes.
      2. “Self–dealing” includes any direct or indirect
        1. Sale, exchange, or leasing of property between a private foundation and a disqualified person. A transfer of real or personal property will be treated as a sale or exchange if the property is subject to a mortgage which the foundation assumes or which was placed upon the property less than 10 years prior to the foundation’s acquisition of the property. Section 4941(d)(2)(A).
        2. Lending of money or other extension of credit between a private foundation and a disqualified person.
        3. Furnishing of goods, services, or facilities between a private foundation and a disqualified person.
        4. Payment of compensation or payment or reimbursement of expenses by a private foundation to a disqualified person.
        5. Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation.
        6. Agreement by a private foundation to pay money to a government official, other than an agreement to employ that official if he is terminating employment within the next 90 days.
      3. Obviously crucial to the imposition of the prohibited transaction excise tax is the definition of a disqualified person. The definition is structured in recognition of the fact that the founders of a foundation are the most likely to control its affairs and to engage in abusive transactions. Disqualified persons therefore include:
        1. Substantial contributors, that is, persons who have given more than the greater of $5,000 or two percent of the total contributions and bequests received by the foundation before the close of the year. Once a person becomes a substantial contributor, that person will never lose that status, even if the foundation’s total receipts are later sufficiently large such that the person would not have satisfied the two–percent threshold at such later date. Treasury Regulation § 1.507–6(b)(1). However, Section 507(d)(2)(C), added to the Code by the Deficit Reduction Act of 1984, provides that a person can cease to be a substantial contributor if that person and all related persons have not made any contributions during the previous 10 years, were not foundation managers, and the Service determines that the aggregate contributions made by the person and all related persons, taking appreciation into account, were insignificant when compared to the aggregate contributions made by one other person.
        2. Foundation managers, defined as any officer, director, or trustee of a foundation, or any other person having a similar authority, as well any employees having authority or responsibility with respect to any act or failure to act that constitutes a prohibited transaction.
        3. An owner of more than 20 percent of the total combined voting power of a corporation, of the profits interest of a partnership, or of the beneficial interest in an unincorporated enterprise that is a substantial contributor.
        4. A family member of any person described in (a) through (c).
        5. A organization in which any person described in (a) through (d) owns more than 35 percent of the total combined voting power, a partnership in which any such person owns more than a 35 percent profits interest, or a trust in which any such person holds more than a 35 percent beneficial interest.
      4. In light of the expansive definition of the self–dealing and disqualified persons, there are fortunately several transactions that are excepted:
      5. A loan to a foundation without interest and if the proceeds are used exclusively for purposes described in Section 501(c)(3).
      6. The furnishing of goods, services, or facilities by a disqualified person to a foundation is not self–dealing if it is done without charge, and the goods, services, or facilities are used exclusively for purposes described in Section 501(c)(3).
      7. The furnishing of goods, services, or facilities by a foundation to a disqualified person is not self–dealing if it is done on a basis that is no more favorable than the goods, services, or facilities are offered to the general public.
      8. The payment of reasonable compensation by the foundation is permitted.
    3. Minimum Distribution Requirements.
      1. Section 4942 imposes an excise tax on a foundation that fails to distribute a sufficient portion of its income each year for charitable purposes. The tax, which is imposed upon the foundation itself, is equal to 15 percent of the income required to have been distributed. If the income remains undistributed at the end of the correction period, then the tax is equal to 100 percent of the undistributed income. In general, a private foundation is required to distribute an amount each year equal to five percent of the value of its assets.
    4. Excess Business Holdings.
      1. Section 4943 imposes an excise tax on a private foundation equal to five percent of the value of its excess business holdings.
      2. Foundations are permitted to hold no more than 20 percent of the voting stock in a corporation, reduced by the value of all voting stock held by disqualified persons. If all disqualified persons together do not own more than 20 percent of the voting stock in corporation, then the foundation may hold nonvoting stock.
      3. A similar rule applies to interests in a partnership, substituting profits interest for voting stock and capital interest for nonvoting stock.
      4. A foundation may not hold any interest in any other unincorporated enterprise.
      5. “Functionally related businesses” are not treated as impermissible holdings, nor are businesses at least 95 percent of the gross income of which is derived from passive sources.
    5. Jeopardizing Investments.
      1. Section 4944 imposes a five percent per year tax on a private foundation and on its management, if the foundation invests any amount in such a manner as to jeopardize its charitable purposes.
    6. Taxable Expenditures.
      1. Section 4945 imposes a ten percent tax on a private foundation and 2–1/2 percent tax on its managers if the foundation makes any taxable expenditures. If the taxable expenditures are not corrected, then the tax rises to 100 percent imposed on the foundation and 50 percent on its managers. Taxable expenditures include
      2. Any amount paid to carry on propaganda or otherwise to attempt to influence legislation,
      3. Any amount paid to influence the outcome of any specific public election, or to carry on any voter registration drive,
      4. Any amount paid as a grant to an individual for travel, study, or other purposes, unless the grant–making procedures are approved by the Service in advance,
      5. Any grant to any other organization, unless the recipient organization is a public charity or the grantor foundation exercises expenditure responsibility with respect to the recipient to ensure that the grant is spent as directed,
      6. Any amount spent other than for a charitable, education, religious, or similar exempt purpose.
    7. Termination of Private Foundation Status.
      1. Once an organization is classified as a private foundation, it can terminate that status only pursuant to the procedures set forth in Section 507. Section 507 describes the circumstances that will result in the involuntary termination of private foundation status and the procedures by which a private foundation may convert to a public charity.
      2. Involuntary Terminations. If there have been either repeated willful acts or a willful and flagrant act giving rise to excise tax liability, then the private foundation’s status as such will be terminated once it pays a penalty tax imposed by Section 507(c), or that tax is abated.
        1. The tax is the lower of [1] the amount which the foundation establishes by adequate records or corroborating evidence as theaggregate tax benefit resulting from Section 501(c)(3) status, or [2] the net value of the assets of the foundation.
        2. The aggregate tax benefit resulting from a private foundation’s Section 501(c)(3) status is the sum of [1] the aggregate increases in income taxes that would have been imposed on all substantial contributors to the foundation if all deductions for contributions they had made to the foundation since February 28, 1913 had been disallowed, the aggregate increases in income taxes that would have been imposed on the foundation itself for taxable years beginning after December 31, 1912 had it not been exempt, and [3] interest computed from the first day that the taxes under [1] and [2] would have been payable.
          “There is one difference between a tax collector
          and a taxidermist — the taxidermist leaves the hide.”
          Mortimer Caplin, former Commissioner,
          Internal Revenue Service,Time, February 1, 1963
      3. Voluntary Conversion to Public Charity Status. If there have been no repeated willful acts and no willful and flagrant act giving rise to Section 4941et seq, excise tax liability, a private foundation may convert itself to a public charity by either
        1. distributing all of its assets to one or more public charities described in Section 170(b)(1)(a)(other than clauses (vii) and (viii)) that have been in existence as public charities under that section for a continuous period of 60 calendar months immediately prior to the distribution, or
        2. otifying the Internal Revenue Service in advance of its intent to operate as a public charity and in fact meeting all of the requirements of Section 509(a)(1), (2), or (3) for a continuous period of 60 calendar months (12 calendar months for certain organizations converting after December 31, 1969). If the organization so notifies the Service but fails to establish that it has operated as a public charity to the satisfaction of the Service, then the private foundation excise tax provisions will not apply to the foundation during the 60–month conversion period.
  8. Public Charity Classification
    1. History of, and Congressional Response to Abuses.
      1. Studies by the Treasury Department and hearings by Congress prior to 1969 disclosed that a variety of organizations qualifying for tax–exempt status and operating without any oversight or constraints had engaged in transactions considered to be abusive:
        1. Funds established to provide scholarships for deserving students awarded grants only to close family members of the founder.
        2. Donations of closely–held businesses to foundations whose managers devoted more attention to the accumulation of earnings within the business than making distributions for the benefit of charity.
        3. Individuals who treated foundation assets as private bank or brokerage accounts, borrowing funds, exchanging assets, and the like.
      2. While the conduct in which many of these charities engaged arguably provided cause for revocation of their exempt status, the Internal Revenue Service was unable to administer its enforcement of existing law on an even basis. In many situations, revocation of an organization’s exemption was considered too harsh a penalty in view of the conduct that had occurred, and in others, the Service tended to examine the arm’s–length nature of the transactions in an effort to determine their fairness to the charity involved.
      3. Accordingly, Congress decided to impose specific prohibitions on particular charitable organizations and to provide a series of graduated penalties for their violation.
      4. To distinguish between charitable organizations to which the new penalties would apply and all other charities, Congress enacted Section 509. Of help towards understanding the mechanics of Section 509 is the underlying philosophy expressed in the legislative history of the Tax Reform Act of 1969 –– that organizations that either rely on a broad spectrum of public support or that are closely related to or controlled by other public charities can generally be expected to operate in a responsible manner and need no additional level of governmental supervision. On the other hand, organizations that are largely funded by a limited group of individuals and that operate relatively autonomously would be categorized as private foundations to which the new restrictions apply.
    2. Structure of Sections 508 and 509.
      1. Section 509 states that every organization qualifying for tax exemption under Section 501(c)(3) is a private foundation unless it can demonstrate that it meets the requirements of Sections 509(a)(1) through (3). In addition, Section 508(b) states that every organization that is described in Section 501(c)(3) and which does not notify the Internal Revenue Service that it is not a private foundation shall be presumed to be a private foundation. This notice requirement is therefore intimately related to the requirement set forth in Section 508(a) that every organization claiming to be exempt under Section 501(c)(3) will not be treated as being exempt unless it has applied to the Internal Revenue Service for recognition of that status.
      2. However, it is important to note that private foundation status, in contrast to tax exemption, is only a presumption, and that presumption can be rebutted from time to time by presenting the sort of facts that would initially have justified public charity status on Form 1023. In addition, the nature of the presumption means that an organization that has initially received recognition as a public charity under one of the Section 509(a) subsections can later establish that it continues to be a public charity under one of the other subsections if it fails the test of the subsection under which it originally qualified.
      3. Sections 509(a)(1) and (2) deal with organizations that are largely supported by contributions from the general public, other public charities, or the government and by the receipts from the conduct of the activities that constitute the basis of their exemption. Classic examples are the United Way or American Cancer Society (Section 509(a)(1)) and a museum or symphony orchestra (Section 509(a)(2)). These support tests generally require a certain percentage of the organization’s gross revenues to derive from acceptable sources, depend on the existence of a sufficient number and diversity of donors or patrons, and are measured over a rolling four–year average.
      4. Section 509(a)(3) public charity status, in contrast, does not require any particular sources of support, does not depend on an examination of revenues over any period, and stems only from the existence of the necessary relationship between the organization in question and one or more other public charities.
    3. Community Institutions and Publicly Supported Organizations.
      1. Section 501(a)(1) simply contains a cross–reference to Section 170(b)(1)(A) (other than its clauses (vii) and (viii), which in turn describes six categories of public charities, five of which are intrinsically public in nature, and the sixth of which is public by virtue of its broad public support.
      2. Section 170(b)(1)(A)(i): Churches and convention of churches.
        1. There is no definition in the Internal Revenue Code or the Internal Revenue Service’s regulations as to what constitutes a church.
        2. For an example of the difficulty of defining a church, see Chapman v. Commissioner, 48 T.C. 358 (1967) (a majority and two concurring opinions concluded that an organization was not a church, but each adopted a different definition). See also De La Salle Institute v. U.S., 195 F.2d 891 (N.D. Cal. 1961) (applying “the common meaning and usage of the word”).
        3. The Service has adopted a working definition (which is said to have originated in a speech given by a former IRS Commissioner) that focuses on 15 characteristics:
          • a distinct legal existence
          • a recognized creed and form of worship
          • a definite and distinct ecclesiastical government
          • a formal code of doctrine and discipline
          • a distinct religious history
          • a membership not associated with any other church or denomination
          • an organization of ordained ministers
          • ordained ministers selected after completing prescribed studies
          • a literature of its own
          • established areas of worship
          • regular congregations
          • regular religious services
          • Sunday schools for the religious instruction of the young
          • schools for the preparation of ministers
          • any other facts and circumstances
      3. Section 170(b)(1)(A)(ii): Schools, defined as educational organizations that normally maintain a regular faculty and curriculum and that normally have a regularly enrolled body of pupils or students in attendance at the place where its educational activities are normally carried on.
      4. Section 170(b)(1)(A)(iii): Hospitals and medical research organizations.
        1. The term “hospital” includes federal, state, county, and municipal hospitals, as well as rehabilitation institutions, outpatient clinics, and community mental health or substance abuse treatment centers, so long as their principal purpose is providing medical care. Medical care is in turn defined as the treatment of any physical or mental disability or condition, whether on an inpatient or outpatient basis, provided that the cost of the treatment is deductible by the person treated under Section 213. However, convalescent homes, homes for children or the aged, and institutions whose principal purpose is vocational training of the handicapped are not hospitals. Treasury Regulation § 1.170A–9(c)(1).
        2. To qualify for public charity status as a medical research organization, an entity must be engaged in the continuous and active conduct of medical research in conjunction with a hospital. Treasury Regulation § 1.170A–9(c)(2).
      5. Section 170(b)(1)(A)(iv): Supporting organizations for state colleges and universities.
      6. Section 170(b)(1)(A)(v): Governmental units described in Section 501(c)(1).
      7. Section 170(b)(1)(A)(vi): Publicly Supported Organizations. These are organization that “normally” receive “a substantial part” of their “support” (excluding income received in the exercise of their exempt functions) from governmental units or from “direct or indirect contributions” from the general public.
        1. “Normally” means that the organization meets the support test on the basis on a rolling four–year average.
        2. Treasury Regulation § 1.170A–9(e)(2) and (3) state that the words “substantial part” mean more than one–third; in other words, in order to qualify under Section 170(b)(1)(A)(vi), an organization must demonstrate that at least one–third of its total support is derived from permissible sources. Under certain circumstances, however, an organization can continue to qualify under Section 170(b)(1)(A)(vi), even though its support from permissible sources falls as low as 10 percent of its total support, provided that the organization can point to sufficient facts and circumstances to establish that it is essentially dependent upon, and is operated continuously to solicit, public support from permissible sources.
        3. Before determining what constitutes permissible support from governmental units or from the general public, which forms the numerator of the support test fraction, it is necessary to define the term “support” itself, the denominator of the fraction.
          1. Income derived from the performance of particular activities that are related to the reasons why the organization was originally granted tax–exempt status is totally excluded from both the numerator and the denominator of that fraction. While income of this nature is usually disregarded in whole, if it amounts to almost all of the organization’s total receipts, the organization will not qualify under Section 170(b)(1)(A)(vi). Treasury Regulation § 1.170A–9(e)(7)(ii).
          2. “Support” does include investment income, but does not include gains from the sale of capital assets. Treasury Regulation §1.170A–9(e)(7)(i).
          3. “Support” does include gifts, grants, contributions, and membership fees, the net income from unrelated business activities, tax revenues either paid to or expended on behalf of the organization, and the value of facilities or services furnished by a governmental unit without charge. Section 509(d).
        4. Two percent limitation. Direct contributions from the general public mean amounts received as donations from individuals, trusts and estates, and corporations. However, gifts from these sources can be counted towards the more–than–one–third support test fraction only to the extent that the total of all donations from any one such source does not exceed two percent of the organization’s total support. In other words, while the total amount of all contributions received from any one source will be included in full in the denominator of the fraction, only that portion that does not exceed the two–percent limitation can be included in the numerator. The following schedule illustrates the application of this “two percent limitation”:
          Total Amount
          Amount Taken
          Into Account
          Donor A
          Donor B
          Donor C
          Donor D
          Donor E
          Total Support
          2 Percent Limitation =
          2% x $12,000
          = $240
          Total “Public Support” =
          5 x $240
          = $1,160
          $1,160 / $12,000 =

          Donor A is the only individual who had donated an amount less than or equal to two percent of the organization’s total support. and so all of his donation may be taken into account. However, a portion of each of the other contributions must be disregarded because of the two–percent limitation, and the remaining portions that may be counted total only $1,160. Since $1,160 is less than 33–1/3 percent of $12,000, the organization would fail the more–than–one–third test.
        5. Contributions from other publicly supported charities that qualify under Section 170(b)(1)(A)(vi) in their own right are considered “indirect contributions from the general public.” However, grants from these organizations are not subject to the two–percent limitation, unless they are simply passing through contributions that their donors have specifically earmarked as being made for, or for the benefit of, the organization claiming Section 170(b)(1)(A)(vi) status. Treasury Regulation § 1.170A–9(e)(6)(v).
        6. Grants from governmental units are similarly not subject to the two percent limitation, again unless they were originally made by individuals and were earmarked to be turned over to the ultimate recipient. Treasury Regulation § 1.170A–9(e)(6).
          1. The one difficulty with governmental grants, however, is distinguishing between grants that constitute amounts received for the performance of the organization’s exempt purposes, which are excluded from both the numerator and the denominator of the more–than–one–third support test, and grants that enable the organization to maintain a facility or to provide a service to the general public, which are considered donative support that may be counted in full.
          2. Just as a Section 170(b)(1)(A)(vi) organization must disregard amounts paid by the general public for services or products furnished in the course of carrying out the organization’s tax–exempt function, similar amounts paid by the government must also be excluded. Thus, a grant made by the Forest Service to an environmental research organization to study the effects of mining activities in an area subject to possible mineral leasing would probably be considered payment for carrying out the organization’s exempt activity and would not be taken into account. In contrast, the regulations state that payment to an organization to maintain a public library open to the public enables the organization to benefit the public at large, does not serve the immediate needs of the governmental payor, and could be counted in full. Treasury Regulation § 1.170A–9(e)(8).
    4. Organizations Supported by Earned Income.
      1. Section 509(a)(2) contains a two–part test for public charity status and describes an organization which normally receives:
      2. more than one–third of its support in each taxable year from any combination of
      3. gifts, grants, contributions, or membership fees, and
      4. gross receipts from admissions, sales of merchandise, performance of services, or the furnishing of facilities, in an activity that is not an unrelated trade or business, but not including any such receipts from any person or from any government agency in any taxable year to the extent that such receipts exceed the greater of $5,000 or one percent of the organization’s receipts for such year
      5. from persons other than disqualified persons, from governmental units, or from organizations described in Section 170(b)(1)(A), and
      6. not more than one–third of its support from the sum of
        1. gross investment income, and
        2. any unrelated business taxable income, net of the tax imposed on that income.
      7. Unlike Section 170(b)(1)(A)(vi), there is no margin for error in connection with the more–than–one–third test. There is also none in connection with the second prong, the not–more–than–one–third test, so that even one dollar in excess of the prohibited levels of investment income will disqualify an organization from Section 509(a)(2) status.
    5. Supporting Organizations. Section 509(a)(3) defines a “supporting organization” as one that operates in some fashion for the benefit of another public charity (the “supported” organization), that is responsive to the supported organization by virtue of some sort of institutional relationship between the two, and that is not controlled by a “disqualified person.” Perhaps the clearest example of a supporting organization is an entity established by a university or hospital to conduct fundraising and to maintain an endowment, where the university or hospital board appoints all the members of the endowment organization.