Other 200842050: Commercial real-estate activity displaced the charity’s exempt purpose

Plain-English summary

A charity’s stated purposes were helping economically and socially deprived children, providing job training, and offering substance-abuse services. During the examined years, however, it primarily earned commercial rent and parking income from property it owned. It also invested substantial assets in a wholly owned for-profit corporation engaged in property development and commercial rental, shared consolidated financial reporting with that company, and exercised control over it. The IRS concluded that the organization’s financial activity was predominantly commercial even without attributing the subsidiary’s activity to the parent. It failed the § 501(c)(3) operational and primary-purpose tests, so the IRS revoked its exemption retroactively. The organization proposed divesting holdings and returning to its stated exempt functions during the appeal, but did not agree to close the case.

Ruling snapshot

• Question: Did the organization satisfy the operational test when commercial rentals and a controlled real-estate subsidiary dominated its activity?
• Outcome: Revocation. Its primary activity was commercial rather than charitable.
• Key authorities: IRC §§ 482, 501(a), 501(c)(3), 511-515; Treas. Reg. §§ 1.501(c)(3)-1(c), 1.501(c)(3)-1(e)

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
TE/GE: EO Examination
625 Fulton Street, Room 503

Brooklyn, NY 11201
TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Date: July 18, 2008
Release Number: 200842050
Release Date: 10/17/08
UIL Code: 501.03-01
XX = Date
Address = address
Legend
ORG = Organization name
ORG
ADDRESS
Taxpayer Identification Number:
Person to Contact:
Identification Number
Contact Telephone Number:
LAST DATE FOR FILING A PLEADING
WITH THE TAX COURT, THE CLAIMS
COURT, OR THE UNITED STATES
DISTRICT COURT FOR THE DISTRICT
OF COLUMBIA: October 16, 20XX
Dear

This is a final determination regarding your exempt status under section 501(c)(3) of the
Internal Revenue Code (IRC). Recognition of your exemption from Federal income tax
as an organization described in Internal Revenue Code section 501(c)(3) is retroactively
revoked to January 1, 20XX because it is determined that you are not operated

exclusively for an exempt purpose.

IRC 501(c)(3) exempts from taxation organizations which are organized and operated
exclusively for charitable or educational purposes, no part of the net earnings of which
inure 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 and which do not participate in, or intervene in, any political campaign on
behalf of (or in opposition to) any candidate for public office.

We have determined that you are not operating exclusively for any charitable purpose,
educational purpose, or any other exempt purpose. Our examination reveals that you
are not conducting charitable activities, educational activities, or any other exempt
activities pursuant to IRC section 501(c)(3), and that you failed to meet the “operational

test” under Treas. Regs. 1.501(c)(3)-1(c).

We are revoking your exemption from Federal income tax as an organization described
in section 501(c)(3) of the Internal Revenue Code effective January 1, 20XX.

Contributions to your organization are no longer deductible under section 170 of the
Internal Revenue Code.

You are required to file Federal income tax returns on Form 1120. These returns
should be filed with the appropriate Service Center for all years beginning January 1,

20XX.

Processing of income tax returns and assessment of any taxes due will not be delayed
should a petition for declaratory judgment be filed under section 7428 of the Internal

Revenue Code.

If you decide to contest this determination in court, you must file a pleading seeking a
declaratory judgment in the United States Tax Court, the United States Court of Federal
Claims, or the United States District Court for the District of Columbia before the 91st
day after the date this final determination was mailed to you. Please contact the clerk
of the appropriate court for rules regarding filing pleadings for declaratory judgments
and refer to the enclosed Publication 892. You may write to these courts at the

following addresses.

You have the right to contact the office of the Taxpayer Advocate. Taxpayer Advocate
assistance is not a substitute for established IRS procedures, such as the formal
appeals process. The Taxpayer Advocate cannot reverse a legally correct tax
determination, or extend the time fixed by law that you have to file a petition in a United
States court. The Taxpayer Advocate can, however, see that a tax matter that may not
have been resolved through normal channels gets prompt and proper handling. You
may call toll-free and ask for Taxpayer Advocate Assistance. If you prefer, you may
contact your local Taxpayer Advocate at: Internal Revenue Service.

We will notify the appropriate State Officials of this action, as required by section
6104(c) of the Internal Revenue Code.

If you have any questions, please contact the person whose name and telephone
number are shown in the heading of this letter.

Sincerely Yours,

Marsha A. Ramirez
Director, EO Examinations

Enclosure:
Publication 892

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG
20XX12
LEGEND
ORG = Organization name XX = Date XYZ = State CPA = CPA
CO-1 = 1st company Dir-1 & DIR-2 = 1st & 2nd director.
Issue:

Does ORG satisfy the operational test of Reg. §1.501(c)(3)-1(c), which requires exempt
organizations to be engaged primarily in exempt activity.

Facts:

ORG was incorporated in the State of XYZ on February 23, 19XX. It applied for and received
recognition as a 501(c)(3) not for profit organization on January 31, 19XX. It has operated as

such since that time.
ORG’s exempt purpose as stated on its application is as follows:

“Training program for economically and socially deprived children, job training and substance
abuse services.”

ORG’s exempt purpose as stated in its Articles of Incorporation are as follows:

1. To engage in the development of economically and socially deprived children in the
areas, of among other things, job training, education, health, housing, etc.

2. To provide substance abuse services.
3. To engage in any other lawful purpose and business; and

4. To do anything permitted by Section ' of the Corporations and Associations
Article of the Annotated Code if XYZ.

In the year under examination and the prior and subsequent years, this organization has engaged
primarily in commercial activity. No amendments have been filed with the IRS stating that the
organization has changed the nature of their exempt purpose.

ORG owns a commercial property that generates unrelated business income. This income is
generated from commercial rentals and parking lot income.

In the current, prior and subsequent years ORG had revenue and expenses as follows:

20XX 20XX 20XX 20XX Percentage

Program Revenue $
UBI Rental Revenue $

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -1-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/ Period Ended
ORG
20XX12
Program expense $

UBI Rental expense $
In addition to the above UBI activity, ORG has invested substantial assets in the formation of a

for profit corporation, CO-1 The business activity of this corporation is property development
and commercial real estate rental. ORG’s 20XX independent audit report issues a consolidated
report for these two entities. Per the audit report, ORG is the sole shareholder of CO-1 This
equity position establishes that ORG exercises control of this for profit corporate entity.

A parent’s exempt Status may be jeopardized if the commercial activities of its subsidiary can be
considered to be, in fact, activities of the parent. If the parent corporation so controls the affairs
of the subsidiary that it is merely an instrumentality of the parent, the corporate subsidiary may
be disregarded (See IRC 482). This is because the subsidiary is in reality an arm, agent or

integral part of the parent.

Currently, the definition of “control” in the case of exempt organizations having taxable
subsidiaries, is ownership directly, indirectly, or by attribution of at least 50 percent of stock,
by vote or value (rather than 80 percent of combined voting stock, under present law), and
extends “control” rules where exempt organizations in the aggregate own more than 50 percent
of the subsidiary's stock. Other indications of control are common corporate offices, common
management, and not arms length transactions.

The 20XX 1120 tax return for CO-1’s return indicates that ORG has invested a total of $ in CO-

1. This consists of $ for common stock and $ in additional paid in capital. Revenue for this year
is stated as $. Associated expenses are stated as $.

If CO-1 commercial activity is attributed to the parent (ORG) for the year under audit, the
percentage of the organization’s exempt purpose revenue and expenses is further diminished.
Total financial activity for 20XX is as follows:

20XX

Program Revenue (990) $
UBI Rental Revenue (990T) $
Subsidiary Revenue (1120) $
Total $

Program expense (990) $
UBI Rental expense (990T) $
Subsidiary Expense (1120) $
Total $

Under either scenario, ORG falls far short of the standard for exemption as found in the

“operational” test of Reg. §1.501(c)(3)-1(c)
The Law:

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -2-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG .
20XX12

The law requires that an organization claiming exemption under Code Sec. 501(c)(3) also be
operated exclusively for the prescribed exempt purposes. Under the “operational” test of Reg.
§1.501(c)(3)-1(c), an organization is regarded as operated “exclusively for” exempt purposes
only if it engages primarily in activities that accomplish one or more of the exempt purposes. As
with the “organizational” test, an organization is not regarded as exempt “if more than an
insubstantial part of its activities is not in furtherance of an exempt purpose.”

IRC §501(a) provides tax-exempt status to organizations that are described under IRC §501(c).
Among the organizations that qualify for tax-exempt status are those described under IRC
§501(c)(3) as: corporations organized and operated exclusively for religious, charitable,
scientific, etc. purposes. In order to qualify as an organization exempt from tax under IRC
§501(c)(3), the organization must be both (1) organized exclusively for one or more of the
exempt purposes specified in the Code section (known as the “organizational test”), and (2)
operated exclusively for this purpose (known as the “operational test”). In applying both of
these tests, the term “exclusively” does not mean “solely” or “absolutely without exception.”
Nonetheless, the presence of a single nonexempt purpose, if substantial in nature, precludes

tax-exempt status.

IRC Code Sec. 501(c)(3) Organizations: Organized and Operated: Primary purpose doctrine

Code Sec. 501(c)(3) requires an organization to be organized and operated exclusively for
exempt purposes in order to qualify for tax-exempt status under that provision. In this context,

the term “operated exclusively for exempt purposes” is interpreted as “engaged primarily in
activities” in furtherance of one or more of the organization's exempt purposes (Reg.

§1.501(c)(3)-1(c)(1)). This is known as the primary purpose doctrine.

FINAL-REG, TAX-REGS, §1.501(c)(3)-1. Organizations organized and operated for
religious, charitable, scientific, testing for public safety, literary, or educational purposes,
or for the prevention of cruelty to children or animals

a) Organizational and operational tests

(1) In order to be exempt as an organization described in section 501(c)(3), an organization
must be both organized and operated exclusively for one or more of the purposes
specified in such section. If an organization fails to meet either the organizational test or
the operational test, it is not exempt.

FINAL-REG, TAX-REGS, §1.501(c)(3)-1. Organizations organized and operated for religious, charitable,
scientific, testing for public safety, literary, or educational purposes, or for the prevention
of cruelty to children or animals

(c) Operational test

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -3-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG
20XX12

(1) Primary activities. —An organization will be regarded as “operated 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). An organization will not be
so regarded if more than an insubstantial part of its activities is not in furtherance of an

exempt purpose.

Case law that supports these regulations is as follows:

In the Better Business Bureau of Washington, D.C. v US, SCt, 326 US 279, 66 SCt 112, the U.S.
Supreme Court has declared that “the presence of a single (nonexempt) purpose, if substantial in
nature, will destroy the exemption regardless of the number or importance of truly (exempt)

purposes.”

In Living Faith, Inc., CA-7, 92-1 ustTc $50,003, 950 F2d 365, A not-for-profit corporation that
operated vegetarian restaurants and health food stores did not operate exclusively for exempt
purposes and accordingly did not qualify as a tax-exempt organization. Although the restaurants
and health food stores were operated to further the dietary goals of the Seventh Day Adventist
church, the purpose of the restaurants and health food stores was substantially commercial.

In New Faith, Inc., 64 TCM 1050, Dec. 48,572(M), TC Memo. 1992-601, a nonprofit public
benefit corporation that obtained most of its revenues from providing food to the general public
from lunch trucks in exchange for donations was not operated exclusively for a tax-exempt
purpose. The commercial activity accounted for nearly all of its gross revenues and there was no
evidence that any food items were offered at below-cost prices to needy persons.

In Make a Joyful Noise, Inc., 56 TCM 1003, Dec. 45,405(M), TC Memo. 1989-4, an organization
did not satisfy its burden of proving that the IRS' revocation of its tax-exempt status under Code
Sec. 501(c)(3) was erroneous. The organization was not regarded as “operated exclusively” for
one or more exempt purposes because it did not engage primarily in activities in order to
accomplish its exempt purpose. Its primary activity was the management and operation of bingo
games for other exempt organizations —a trade or business activity that did not qualify as an
exempt activity under Code Sec. 501(c)(3).

In Senior Citizens of Missouri, Inc., 56 TCM 480, Dec. 45,126(M), TC Memo. 1988-493, a
taxpayer that was organized for aiding handicapped and elderly citizens was denied tax-exempt
status because it did not prove that it operated exclusively for such tax-exempt purpose.

In Housing Pioneers, Inc., CA-9, 95-1 USTC $50,126, 49 F3d 1395, a housing corporation that
was organized to provide affordable housing for low-income and disabled people did not qualify
for tax-exempt status as a charitable organization because it was not operated exclusively for
exempt purposes. The organization became a co-general partner in two for-profit limited
partnerships in order to take advantage of a state (California) property tax reduction for low-

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -4-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG
20XX12

income rentals, by receiving a portion of the tax credits with which to pursue its charitable
purposes.

In Airlie Foundation, DC D.C., 2003-2 usTc $50,719, 283 FSupp2d 58, an organization that
operated its conference center in a manner consistent with that of a commercial business did not
qualify for tax-exempt status. The taxpayer brought a declaratory judgment action against the IRS
seeking reinstatement of its exempt status based on the argument that its conference activities
were undertaken principally to advance educational and charitable purposes. However, the
totality of the circumstances established that it furthered a substantial nonexempt purpose.

In Interneighborhood Housing Corp. v. Commissioner, T.C. Memo 1982-66, The sole issue for
decision is whether INHC was organized and operated exclusively for one or more exempt
purposes within the meaning of section 501(c)(3). The court stated that A major part of your
activity is the management of eight multiple family dwellings for a fee. Income Tax Regulation
section 1.501(c)(3)-[1]\(a\)(1) states "In order to be exempt as an organization described in section
501(c)(3), an organization must be both organized and operated exclusively for one or more of
the purposes specified in such section." The management of buildings for a fee is not an exempt
activity within the scope of section 501(c)(3) * * *. Accordingly, your organization does not meet
the requirements for exemption under that section of the Code.

In Federation Pharmacy Services, Inc. v. Commissioner, 625 F.2d 804 (8th Cir. 1980), aff'g 72
T.C. 687 (1979), the appellate court held that a nonprofit pharmaceutical service was not exempt

as a charitable organization because it was operated for the substantial commercial purpose of
providing pharmacy services to the general public. Although it provided special discount rates for
handicapped and senior citizens in its area, it was not committed to providing any drugs below
cost or free to indigent persons. Therefore, although its services did improve health in the area, it
was primarily a commercial venture operated in competition with other area pharmacies.

In Senior Citizens Stores v. United States, 602 F.2d 711 (5th Cir. 1979), an organization whose
stated purpose was to provide training, jobs, and recreation for senior citizens by operating retail
stores did not qualify for exemption under IRC 501(c)(3). Although it incidentally served the
needs of senior citizens, the evidence indicated that the retail sales operation was an end in itself.
Proceeds from the business were used almost exclusively for its perpetuation. Thus, the
organization’s primary activity was the operation of the retail store, which was not devoted

exclusively to charitable purposes.

In Orange County Agricultural Society and Greater United Navajo Development Enterprises Inc.,
(Cited Below) the activities of the subordinate organization were attributed to the parent and as a

result, exemption was lost.

In Orange County Agricultural Society, Inc., CA-2, 90-1 USTC 950,076, 893 F2d 647

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -5-


Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG
20XX12

An agricultural society no longer qualified as a tax-exempt organization since it was not operated
exclusively in furtherance of its stated exempt purpose of promoting the interests of agriculture
and horticulture. The society's involvement in automobile racing activities that were conducted
on the racetrack at the society's fairgrounds was extensive. Although a separate corporation
was formed to conduct the racetrack business, it was merely a corporate shield designed to
protect the society against potential liability arising from the racing activities.

In Greater United Navajo Development Enterprises Inc., 74 TC 69, Dec. 36.890. Affd, CA-9, a
corporation organized to assist the poor of the Navajo Nation did not qualify as an exempt
organization because it was not operated exclusively for exempt purposes. Through its agent, a
wholly owned subsidiary corporation, the corporation engaged in non-charitable, profit-
motivated activities, leading to a finding that non-exempt business activities were more than an
insubstantial part of the corporation's total activities.

Taxpayer’s Position:

My findings were presented at the closing conference to DIR-1, CPA CPA, and DIR-2, the
current Director of ORG. At that time, no one took issue with the facts as they are stated in this
document. Nor did anyone dispute my interpretation of the law as it is cited in this document.
However, since none of the persons present at the meeting was a lawyer, the T/P felt that it would
be prudent at this point to consult a lawyer.

The T/P’s lawyer would like to cure the problems with the organization by divesting of certain
holdings and refocusing the organization and its assets on the exempt functions as stated in the
application for exempt status.

ORG will pursue this option during the appeals process and therefore there will not be an agreed
closing of this case.

Service Position and Recommendation:

The Service’s position on the operational test and primary activities is consistent with the cited
case law. The “primary activities” portion of the regulation helps to harmonize the regulation
with the unrelated business income tax provisions set forth in Regs. 1.501(c)(3)-1(e)(1) which
allow an exempt organization to engage in unrelated trade or business activity so long as
engaging in such trade or business is not the organization's primary purpose. The not “more than
an insubstantial part of its activities” standard can be understood by reference to Better Business
Bureau v. U.S., 326 U.S. 279 (1945), which held that an organization which engaged in some
educational activity but pursued nonprofit goals outside the scope of the statute was not exempt
under IRC 501(c)(3). The Court stated that an organization is not operated exclusively for
charitable purposes if it has a single noncharitable purpose that is substantial in nature. This is
true regardless of the number or importance of the organization's charitable purposes.

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -6-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG
20XX12

Regarding the attribution of the commercial activities of CO-1 to that of ORG, this requires that
the doctrine of corporate entity be disregarded. Legally, this is not easy (See Moline Properties,
Inc vs. Commissioner of Internal Revenue). However, a parent’s exempt status may be
jeopardized if the commercial activities of its subsidiary can be considered to be, in fact,
activities of the parent. If the parent corporation so controls the affairs of the subsidiary that it is
merely an instrumentality of the parent, the corporate subsidiary may be disregarded (See IRC
482). This is because the subsidiary is in reality an arm, agent or integral part of the parent. As
such, the activity of the CO-1, Inc. should be considered the activity of ORG

ORG does not pass the operational or primary purpose test. The majority of the financial activity
of this EO is commercial in nature. The primary activity of ORG is carrying on a business with
the general public in a manner similar to organizations that are operated for profit. Status as a
501(c)(3) organization should be revoked. Additionally, the activity of the wholly owned
subsidiary should be considered the activity of ORG

Conclusion

In order to be exempt as an organization described in section 501(c)(3), an organization must be
both organized and operated exclusively for one or more of the purposes specified in such
section, and if an organization fails to meet either the organizational or operational test, it is not
exempt for purposes of section 501(a). ORG does not meet the criteria of a 501 (c) (3) and
classification as such should be discontinued as of January 1, 20XX.

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -7-

DEPARTMENT OF THE TREASURY
Internal Revenue Service
1100 Commerce Street
Dallas, TX 75242

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

February 2, 2007

Taxpayer Identification Number:

ORG
ADDRESS Form:

Tax Year(s) Ended:
Person to Contact/ID Number:

Contact Numbers:
Telephone:
Fax:

Certified Mail - Return Receipt Requested

Dear

We have enclosed a copy of our report of examination explaining why we believe
revocation of your exempt status under section 501(c)(3) of the Internal Revenue Code

(Code) is necessary.

If you accept our findings, take no further action. We will issue a final revocation letter.

If you do not agree with our proposed revocation, you must submit to us a written
request for Appeals Office consideration within 30 days from the date of this letter to
protest our decision. Your protest should include a statement of the facts, the
applicable law, and arguments in support of your position.

An Appeals officer will review your case. The Appeals office is independent of the
Director, EO Examinations. The Appeals Office resolves most disputes informally and
promptly. The enclosed Publication 3498, The Examination Process, and Publication
892, Exempt Organizations Appeal Procedures for Unagreed Issues, explain how to
appeal an Internal Revenue Service (IRS) decision. Publication 3498 also includes
information on your rights as a taxpayer and the IRS collection process.

You may also request that we refer this matter for technical advice as explained in
Publication 892. If we issue a determination letter to you based on technical advice, no
further administrative appeal is available to you within the IRS regarding the issue that
was the subject of the technical advice.

Letter 3618 (04-2002)
Catalog Number 34809F


If we do not hear from you within 30 days from the date of this letter, we will process
your case based on the recommendations shown in the report of examination. If you do
not protest this proposed determination within 30 days from the date of this letter, the
IRS will consider it to be a failure to exhaust your available administrative remedies.
Section 7428(b)(2) of the Code provides, in part: "A declaratory judgment or decree
under this section shall not be issued in any proceeding unless the Tax Court, the
Claims Court, or the District Court of the United States for the District of Columbia
determines that the organization involved has exhausted its administrative remedies
within the Internal Revenue Service.” We will then issue a final revocation letter. We
will also notify the appropriate state officials of the revocation in accordance with section
6104(c) of the Code.

You have the right to contact the office of the Taxpayer Advocate. Taxpayer Advocate
assistance is not a substitute for established IRS procedures, such as the formal
appeals process. The Taxpayer Advocate cannot reverse a legally correct tax
determination, or extend the time fixed by law that you have to file a petition in a United
States court. The Taxpayer Advocate can, however, see that a tax matter that may not
have been resolved through normal channels gets prompt and proper handling. You
may call toll-free 1-877-777-4778 and ask for Taxpayer Advocate Assistance. If you
prefer, you may contact your local Taxpayer Advocate at:

If you have any questions, please call the contact person at the telephone number
shown in the heading of this letter. If you write, please provide a telephone number and
the most convenient time to call if we need to contact you.

Thank you for your cooperation.

Sincerely,

Marsha A. Ramirez
Director, EO Examinations

Enclosures:

Form 6018

886-A

Publication 892 & 3498

Letter 3618 (04-2002)
Catalog Number 34809F