Other 200842053: Seller-funded down payment program served private interests

Plain-English summary

A nonprofit provided home buyers with down payment grants funded almost entirely by service fees from the sellers in the same transactions. The fee generally equaled the grant plus an administrative charge, and the organization did not verify that recipients met income limits or restrict assistance to first-time buyers. The IRS found that this circular funding benefited home sellers and real-estate businesses and operated like a commercial home-sales service. The nonprofit also paid a related company owned by its president for marketing attributed to every grant, without proof that the company performed services for each transaction. The IRS concluded that the program had a substantial nonexempt purpose, produced private benefit and insider inurement, and materially differed from the organization’s exemption application. It revoked § 501(c)(3) status retroactively, and the organization agreed to the revocation.

Ruling snapshot

• Question: Did the seller-funded down payment assistance program operate exclusively for charitable purposes?
• Outcome: Revocation. The program substantially benefited transaction participants and insiders and did not limit assistance to a charitable class.
• Key authorities: IRC §§ 170, 501(c)(3), 6104(c), 7428; Treas. Reg. § 1.501(c)(3)-1; Rev. Rul. 70-585; Rev. Rul. 2006-27

Full text (IRS public release)

DEPARTMENT OF THE TREASURY

Internal Revenue Service
TE/GE EO Examinations
1100 Commerce Street
Dallas, TX 75424

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Release Number: 200842053
Release Date: 10/17/08
Date: July 10, 2008
Address = address
XX = Date
UIL Code: 501.03-01
Legend
ORG = Organization name
ORG
ADDRESS
Person to Contact
Identification Number:
Contact Telephone Number:
In Reply Refer to: TE/GE Review Staff
EIN:

Certified Mail — Returned Receipt
LAST DATE FOR FILING A PETITION
WITH THE TAX COURT: October 8, 20XX

Dear

This is a Final Adverse Determination Letter as to your exempt status under section 501(c)
(3) of the Internal Revenue Code. Your exemption from Federal income tax under section
501(c) (3) of the code is hereby revoked effective January 1, 20XX. You agreed to the
change per your signature on the Form 6018, Consent to Proposed Action, on December
21, 20XX.

Our adverse determination was made for the following reasons:

A substantial part of your activities consists of providing down payment
assistance to home buyers. To finance the assistance you rely on home
sellers and other real-estate related businesses that stand to benefit from
these down payment assistance transactions. Your receipt of a payment
from the home seller corresponds to the amount of the down payment
assistance provided in substantially all of your down payment assistance
transactions. The manner in which you operate demonstrates you are
operated primarily to further your insiders' business interests. Therefore,
you are operated for a substantial nonexempt purpose. In addition, you
operations further the private interests of the persons that finance your
activities. Accordingly, you are not operated exclusively for exempt
purposes described in section 501(c) (3).

You failed to meet the requirements of IRC section 501(c) (3) and Treas. Reg. section 1.501
(c) (3) -1(d) in that you failed to establish that you were operated exclusively for an exempt

purpose.

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 the year ending December 31, 20XX, and for all
years thereafter. You have properly prepared returns for the years December 31, 20XX,
20XX, 20XX, and 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 initiate a suit for declaratory
judgment in the United States Tax Court, the United States Claim Court or the District
Court of the United States for the District of Columbia before the 91st day after the date this
determination was mailed to you. Contact the clerk of the appropriate court for the rules for
initiating suits for declaratory judgment.

You also have the right to contact the office of the Taxpayer Advocate. However, you
should first contact the person whose name and telephone number are shown above since
this person can access your tax information and can help you get answers.

You can call and ask for Taxpayer Advocate assistance. Or you can contact the Taxpayer
Advocate from the site where the tax deficiency was determined by calling, or writing to:
Internal Revenue Service, Taxpayer Advocates Office.

Taxpayer Advocate assistance cannot be used as a substitute for established IRS procedures,
formal appeals processes, etc. The Taxpayer Advocate is not able to reverse legal or
technically correct tax determinations, nor extend the time fixed by law that you have to file
a petition in the United States Tax 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.

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

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer: Year/Period Ended
ORG 12/31/20XX,
20XX & 20XX
LEGEND
ORG = Organization name XX = Date EMP-1, EMP-2 = 1st & 2nd employees
motto = motto website = website Bank = bank CO-1 = 1st company
DIR-1, DIR-2 & DIR-3 = 1st, 2nd & 3rd directors

ISSUE

Whether ORG operated exclusively for exempt purposes within the meaning of I.R.C. §
501(c)(3)?

FACTS

ORG is currently recognized as an I.R.C. § 501(c)(3) organization. It filed Forms 990 for the
calendar years ended December 31, 20XX, 20XX and 20XX with the Internal Revenue
Service. ORG filed no Forms 990-T, 941, 945, W-2, 1099-MISC, and/or 1099-INT for these
years. ORG has a related for-profit entity, CO-1 (CO-1). CO-1 filed Forms 1120 for 20XX,
20XX and 20XX. ORG currently has one employee (EMP-1) but the Forms W-2 and 941 are
filed thru the related company, CO-1. A Form 1099 for commissions paid to EMP-2 in the
amount of $ was not issued.

ORG’s activity, as stated in its Form 990 for 20XX, was as follows: “The organization
provides assistance to low-income first- time home buyers to be used by the recipients to
cover down payment and closing costs in order to provide the ability to realize the American
dream of home ownership.”

History of ORG

ORG, was established in the State of in August 31, 20XX as a non-profit entity. It filed
Forms 990 in 20XX, 20XX, 20XX, & 20XX.

ORG filed the original Form 1023 with the Internal Revenue Service on November 12, 20XX.
The directors, as stated on the application, were DIR-1, DIR-2, and DIR-3.

The Form 1023 stated that: ORG will provide grants primarily to low-income, first-time
homebuyers who meet certain criteria. These grants can be used for their down payments
and/or closing costs to help them purchase their first home. They must qualify for a first
mortgage loan from a lender. The grant will be a gift from the organization and does not have
to be paid back by the buyer. At least 75% of the families will qualify as low-income units;
and either at least 20 percent of the units are occupied by residents that also meet the very low
income limit for the area or 40 percent of the units are occupied by residents that also do not
exceed 120 percent of the area’s very low-income limit. The income limits for low-income

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 12/31/20XX,
20XX & 20XX

families are in accordance with standards established by HUD, (attached hereto). This will be
the only activity of the organization at this time. 95% of our time will be used to locate
qualified recipients of these grants. Minimal contact, if any will be made with the sellers or
with brokers to assist them in the sale of residential units. Our organization plans to begin
issuing grants in December of 20XX. The grant applications will be reviewed by our grant
screening committee, which at this time will include DIR-1 and DIR-2. We will assist as many
qualified members of the community as we can in purchasing the first homes. We will target
those members of the community at the lower end of the income scale because they are
typically the ones that need the most help. Our ability to provide grants will be predicated on
contributions received by the organization from community businesses, private individual or
government entities. Hopefully we can help many worthy families and individuals.

ORG’s Operations

Starting in late 20XX, ORG has operated its motto (motto) program under the leadership of DIR-
1 for both ORG and CO-1, ORG’s related for-profit entity. ORG’s primary activities in 20XX,
20XX, 20XX, 20XX, & 20XX related to its motto program. ORG does not engage in the
business of selling homes or in financing the purchase of homes. If potential home buyers call,
ORG will provide consulting to them.

From 20XX through 20XX, ORG provided motto grants to any home buyer using a mortgage
company that would accept a “gift” from a section 501(c)(3) organization as the down payment
for the purchase of a house, as allowed by regulations issued by HUD and administered by the
Fair Housing Administration (FHA). As a result, ORG claims that 99.99 percent of its down
payment grants were made in conjunction with FHA loans. FHA has loan limits and median
income guidelines based on economic standards of living for each specific zip code which
determine who will receive a loan. The FHA is the only entity that will accept a gift from a
section 501(c)(3) organization for a down payment for the purchase of a house. FHA
underwrites the loan and requires a so-called “gift letter” from the donor for the down payment.

ORG follows these steps for its motto program:

1. A real estate contract prepared by the realtor is negotiated between a buyer and seller, where
the seller agrees to pay a so-called “seller service fee” to ORG. The seller service fee is
ORG’s only source of income. In most cases, the realtor knows about ORG’s motto program
through the mortgage broker or a builder. The seller service fee paid by the seller is a stated
fee as determined by the selling agent and the seller in coordination with the buyer of the
house plus a ORG’s service fee. The real estate contract might state that, "Seller agrees to
pay a Seller Service Fee to ORG in the amount of $ at closing." The amount to be paid was
the sum of amount of the down payment provided by ORG plus ORG’s service fee. The

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 12/31/20XX,
20XX & 20XX

seller had to agree to participate in the motto program. The real estate contract evidenced the
seller’s acknowledgement of the agreement to pay the seller service fee. The amount of
service fee per the example contract provided was a $ fee but the records provided show that
the difference between the amount sent and the amount received can very from $ to $. Most
are in that $ to $ range.

2. For FHA loans, the buyer or buyer’s lender completes and submits a grant application form
requesting motto from ORG. The buyer could submit the form to ORG by fax, postal service,
or e-mail to its website at website.

3. ORG prepares the gift letter for the buyer, and faxes it to the lender. The gift letter shows
ORG’s name, address, and phone number and is identified as non-profit 501(c)(3) .

4. ORG contacts the designated title officer to coordinate wiring instructions and closing times.
ORG faxes closing instructions directly to the title company or closing agent. The title
company or closing agent then confirms to ORG that the transaction is scheduled, and
confirms the grant amount needed by the buyer. The closing agent also signs closing
instructions stating it will return the grant amount if the loan does not close, and agrees to
collect ORG’s seller service fee from the seller. ORG then wires the down payment grant
directly to the title or escrow office by the requested closing date. If the loan does not close
within five business days of requested closing date, the title or escrow officer will return the
grant money directly back to ORG.

During 20XX through 20XX, ORG completed approximately 1,000 to 1,500 transactions per
year. At no time did ORG review or receive copies of the files of the mortgage broker, the title
company, or realtor involved with the individual home sales. ORG has no verification of income
limits of the individuals who received the down payment grants. ORG relied on FHA maximum
loan limits to qualify the borrowers.

Financial Information

This examination was performed by correspondence and most of the information as stated came
from the information provided on the Forms 990 and written or verbal communication from the
organization or it representative.

DIR-1 maintained the bank accounts and checkbooks for ORG and CO-1. Each entity had its
own separate bank account. ORG’s only source of revenue is the seller service fees; its total
revenue is the gross amount of the seller service fees. As expenses, ORG pays out the down
payment grants to the home buyers. ORG keeps the difference between the seller service fees

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 12/31/20XX,
20XX & 20XX

and the down payment grants as its fee. During 20XX thru 20XX, ORG made no solicitation for
charitable contributions. ORG’s Forms 990 shows the following:

ORG 20XX 20XX 20XX

Total Revenue, Line 12 of 990
Total Expenses, Line 17 of 990
Net Income, Line 18 of 990

ORG 990 shows its financial status:

ORG 501(c)(3) 20XX 20XX 20XX

Total Assets, line 59 of 990

Total Liabilities, line 66 of 990

Total Equity, line 72 of 990

Total Liabilities & Equity, line 74 of 990

ORG’s trial balance included a balance sheet account (account #) identified as “Loan-
Shareholder’. As disclosed on the 20XX Form 990 this was a loan from an officer where the
balance at the beginning of 20XX was $. During the year the organization paid off this loan in
full. The loan was fully disclosed on the 20XX F990 return and did not bear any interest due
to the relatively small amount of the loan and the length of the loan. ORG did not make any
other loans to anyone. This note was paid off by the end of the year and the Forms 990
properly shows no loan from shareholders receivable/payable.

There is a Note Payable to Bank on a line of credit. Balance at the end of 20XX was $. The
interest rate is 4.5% with monthly payments of interest only and principal repayments as cash
flow permits. There were no principal repayments made during the 20XX year. The loan is
secured by personal guarantees of its officers. The purpose of the loan is to fund short term
timing difference between revenue coming in and payments being made.

ORG’s Forms 990 and its books and records show the following expenses:
ORG - Expenses 20XX 20XX 20XX

Contributions Paid
Accounting fees

Legal Fees

Interest Expense
Depreciation

Charitable contributions

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 12/31/20XX,
20XX & 20XX

License and permits
Amortization

Bank fees
Miscellaneous expense

Marketing cost
Total Expenses per Trial Balance and 990
Return

Marketing Expense: During 20XX through 20XX, ORG claimed it incurred marketing
expenses for amounts paid to CO-1. An agreement negotiated between ORG and CO-1 (the
related for profit company) determined the marketing expenses. DIR-1 is the president of both
entities. ORG agreed to pay to CO-1 the amount CO-1 charged ORG as marketing expenses as
long as ORG did not realize a net loss in its operations. ORG’s Forms 990 showed it paid CO-1
$, $ and $ in 20XX, 20XX and 20XX, respectively.

Internal controls

Because this was a correspondence audit, the internal controls were not examined in depth.

LAW AND ARGUMENT

Section 501 of the Internal Revenue Code of 1986 provides for the exemption from federal
income tax of corporations organized and operated exclusively for charitable or educational
purposes, provided that no part of the net earnings of such corporations inures to the benefit of
any private shareholder or individual. See section 501(c)(3). An organization seeking exempt
status must establish that it was organized and is operated exclusively for charitable or
educational purposes.

Section 1.501(c)(3)-1(c)(1) of the Income Tax Regulations provides that an organization operates
exclusively for exempt purposes only if it engages primarily in activities that accomplish exempt
purposes specified in section 501(c)(3). An organization must not engage in substantial activities
that fail to further an exempt purpose. In Better Business Bureau of Washington, D.C. v. U.S.,
326 U.S. 279, 283 (1945), the Supreme Court held 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.” See also, Old Dominion Box Co., Inc. v. United
States, 477 F.2d 340 (4th Cir. 1973), cert. denied, 413 U.S. 910 (1973) (“operating for the benefit
of private parties who are not members of a charitable class constitutes a substantial nonexempt

purpose”).

Treas. Reg. § 1.501(c)(3)-1(d)(1)(ii) provides that an organization is not organized or operated
exclusively for exempt purposes unless it serves a public rather than a private interest. To meet

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 12/31/20XX,
20XX & 20XX

the requirements of section 501(c)(3), the organization must establish that it is not organized or
operated for the benefit of private interests. When an organization operates for the benefit of
private interests, such as designated individuals, its founder or his family, or persons directly or
indirectly controlled by such private interests, the organization by definition does not operate
exclusively for exempt purposes. American Campaign Academy v. Commissioner, 92 T.C.
1053, 1065-1066 (1989).

Treas. Reg. § 1.501(c)(3)-1(d)(2) defines “charitable” for section 501(c)(3) purposes as including
the relief of the poor and distressed or of the underprivileged, and the promotion of social welfare
by organizations designed to lessen neighborhood tensions, to eliminate prejudice and
discrimination, or to combat community deterioration. The term “charitable” also includes the
advancement of education. Id.

Treas. Reg. § 1.501(c)(3)-1(d)(3)(i) provides, in part, that the term “educational” for section
501(c)(3) purposes relates to the instruction of the public on subjects useful to the individual and
beneficial to the community.

Treas. Reg. § 1.501(c)(3)-1(e) provides that an organization that operates a trade or business as a
substantial part of its activities may meet the requirements of section 501(c)(3) if the trade or
business furthers an exempt purpose, and if the organization’s primary purpose does not consist
of carrying on an unrelated trade or business.

In Easter House v. U.S., 12 Cl. Ct. 476, 486 (1987), aff'd, 846 F. 2d 78 (Fed. Cir.), the U.S.
Court of Federal Claims considered whether an organization that provided prenatal care and
other health-related services to pregnant women, including delivery room assistance, and placed
children with adoptive parents qualified for exemption under section 501(c)(3). The court
concluded that the organization did not qualify for the tax exemption because its primary activity
was placing children for adoption in a manner indistinguishable from that of a commercial
adoption agency. The court rejected the organization’s argument that the adoption services
merely complemented the health-related services to unwed mothers and their children. Instead,
the court found that the health-related services were merely incidental to the organization’s
operation of an adoption service, which, in and of itself, did not serve an exempt purpose. The
organization’s sole source of support was the fees it charged adoptive parents, rather than
contributions from the public. The court also found that the organization competed with for-
profit adoption agencies; it engaged in substantial advertising; and it accumulated substantial
profits. Moreover, although the organization provided health care to indigent pregnant women, it
did so only when a family willing to adopt an indigent woman’s child had paid for the mother’s
health care. Accordingly, the court found that the “business purpose, and not the advancement of
educational and charitable activities purpose, of plaintiffs adoption service is its primary goal”

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 12/31/20XX,
20XX & 20XX

and held that the organization was not operated exclusively for purposes described in section
501(c)(3). Easter House, 12 Cl. Ct. at 485-486.

In American Campaign Academy v. Commissioner, 92 T.C. 1053 (1989), the Tax Court held that
an organization that operated a school to train individuals for careers as political campaign
professionals, but could not establish that it operated on a nonpartisan basis, did not exclusively
serve the purposes described in section 501(c)(3) because it also served private interests more
than incidentally. The court found that the organization was created and funded by persons
affiliated with entities of a particular political party and that most of its graduates worked in
campaigns for the party’s candidates. Consequently, the court concluded that the organization
conducted its educational activities with the objective of benefiting the party’s candidates and
entities. Although the candidates and entities benefiting from the organization’s activities were
not organization “insiders,” the court stated that the conferral of benefits on disinterested persons
who are not members of a charitable class may cause an organization to serve a private interest
within the meaning of Treas. Reg. § 1.501(c)(3)-1(d)(1)(ii). The court found that even if the
political party’s candidates and entities comprised “a charitable class, [the organization] would
bear the burden of proving that its activities benefited members of the class in a non-select
manner.” American Campaign Academy, 92 T.C. at 1077.

In Aid to Artisans, Inc. v. Commissioner, 71 T.C. 202 (1978), the Tax Court held that an
organization that marketed handicrafts made by disadvantaged artisans through museums and
other non-profit organizations and shops operated exclusively for charitable purposes within the
meaning of section 501(c)(3). The organization, in cooperation with national craft agencies,
selected the handicrafts it would market from craft cooperatives in communities identified as
disadvantaged based on objective evidence collected by the Bureau of Indian Affairs or other
government agencies. The organization marketed only handicrafts it purchased in bulk from
these communities of craftsmen. The organization did not market products produced by studio
craftsmen, nor did it select individual craftsmen based on the needs of the purchasers. The court
concluded that the overall purpose of the organization’s activity was to benefit disadvantaged
communities. The organization’s commercial activity was not an end in itself but the means
through which the organization pursued its charitable goals. The method the organization used
to achieve its purpose did not cause it to serve primarily private interests because disadvantaged
artisans who directly benefited by the activity constituted a charitable class and the organization
showed no selectivity with regard to benefiting specific artisans. Therefore, the court held that
the organization operated exclusively for exempt purposes described in section 501(c)(3).

In Airlie Foundation v. Commissioner, 283 F. Supp. 2d 58 (D.D.C., 2003), the court relied on the
commerciality doctrine in applying the operational test to an organization that operated a
conference center as its primary activity and derived most of its income from user fees. Because
of the commercial manner in which the organization conducted its activities, the court found that

é . De artment of the Treasu i
I orm 886 A Rev.4 68) Pp ry Internal Revenue Service

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer: Year/Period Ended
ORG 12/31/20XX,
20XX & 20XX

it was operated for a non-exempt commercial purpose, rather than for a tax-exempt purpose. In
reaching this conclusion, the court stated:

Among the major factors courts have considered in assessing commerciality are competition with
for-profit commercial entities; extent and degree of below cost services provided; pricing
policies; and reasonableness of financial reserves. Additional factors include, inter alia, whether
the organization uses commercial promotional methods (e.g. advertising) and the extent to
which the organization receives charitable donations.

See also, Living Faith Inc. v. Commissioner, 950 F.2d 365 (7th Cir. 1991) (holding that a
religious organization which ran restaurants and health food stores in furtherance of its health
ministry did not qualify for tax-exempt status because it was operated for substantial commercial
purposes and not for exclusively exempt purposes).

In Rev. Rul. 67-138, 1967-1 C.B. 129, the IRS held that helping low-income persons obtain
adequate and affordable housing is a “charitable” activity because it relieves the poor and
distressed or underprivileged. There, the organization carried on several activities directed to
assisting low-income families obtain improved housing, including (1) conducting a training
course on various aspects of homebuilding and homeownership; (2) coordinating and supervising
joint construction projects; (3) purchasing building sites for resale at cost; and (4) lending aid in
obtaining home construction loans.

In Rev. Rul. 70-585, 1970-2 C.B. 115, the IRS described four situations where organizations
provided housing and discussed whether each qualified as a charitable organization within the
meaning of section 501(c)(3). Situation 1 involved an organization formed to construct new
homes and to renovate existing homes for sale to low-income families who could not obtain
financing through conventional channels. The organization also provided financial aid to low-
income families who were eligible for loans under a Federal housing program but did not have
the necessary down payment. The organization made rehabilitated homes available to families
who could not qualify for any type of mortgage. When possible, the organization recovered the
cost of the homes through very small periodic payments, but its operating funds came from
federal loans and contributions from the general public. The revenue ruling held that by
providing homes for low-income families who otherwise could not afford them, the organization
relieved the poor and distressed.

Situation 2 involved an organization formed to ameliorate the housing needs of minority groups by
building housing units for sale to persons of low and moderate income on an open-occupancy basis.
The housing was made available to members of minority groups who were unable to obtain
adequate housing because of local discrimination. The housing units were located to help reduce
racial and ethnic imbalances in the community. Because the activities were designed to eliminate

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -8-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer: Year/Period Ended
ORG 12/31/20XX,
20XX & 20XX

prejudice and discrimination and to lessen neighborhood tensions, the revenue ruling held that the
organization was engaged in charitable activities within the meaning of section 501(c)(3).

Situation 3 related to an organization established to formulate plans for the renewal and
rehabilitation of a particular area in a city as a residential community. The median income level in
the area was lower than in other sections of the city and the housing in the area generally was old
and badly deteriorated. The organization developed an overall plan for the rehabilitation of the
area, sponsored a renewal project, and involved residents in the area renewal plan. It also bought an
apartment building that it rehabilitated and rented at cost to low- and moderate-income families
with a preference given to residents of the area. The revenue ruling held that the organization was
described in section 501(c)(3) because its purposes and activities combated community
deterioration.

Situation 4 described an organization formed to alleviate a shortage of housing for moderate-
income families in a particular community. The organization planned to build housing to be
rented at cost to moderate-income families. The revenue ruling held that the organization failed
to qualify for exemption under section 501(c)(3) because the organization’s program was not
designed to provide relief to the poor or to further any other charitable purpose within the
meaning of section 501(c)(3) and applicable Treasury Regulations.

In early 2006 the IRS issued Revenue Ruling 2006-27, 2006-21 I.R.B. 915, which describes three
organizations involved in providing down payment assistance and determines whether each
qualifies for exempt status under § 501(c)(3). The organization described in Situation 1 makes
assistance available to low-income families to purchase decent and safe homes throughout the
metropolitan area in which it is located. Individuals are eligible to participate if they are low-income
and have the employment history and financial history to qualify for a mortgage with the exception
that they do not have the funds necessary for down payments.

The organization in Situation 1 offers financial seminars, conducts educational activities to prepare
the individuals for home ownership, and requires a home inspection report before providing funds
for down payment assistance. To fund the program, the organization conducts broad based
fundraising that attracts gifts, grants, and contributions from the general public. Further, the
organization has policies in place to ensure that the grant making staff does not know the identity or
contributor status of the home seller or other parties who may benefit from the sale and does not
accept contributions contingent on the sale of particular properties.

Because the organization described in Situation 1 relieves the poor and distressed, requires a home
inspection to insure that the house is habitable, conducts educational seminars, has a broad based
funding program, and has policies to ensure that the organization is not beholden to particular
donors, the Service held that the organization is operated exclusively for charitable purposes and
qualifies for exemption from federal taxation as an organization described in section 501(c)(3).

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

Page: -9-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer: Year/Period Ended
ORG 12/31/20XX,
20XX & 20XX

The organization described in Situation 2 of Revenue Ruling 2006-27 is like that described in
Situation 1 except that (1) its staff knows the identity of the party selling the home and may know
the identity of other parties involved in the sale; (2) the organization receives a payment from the
seller (the amount of which bears a direct correlation to the amount of down payment assistance
provided) in substantially all the cases in which the organization provides assistance to the home
buyers; and (3) most of its financial support comes from home sellers and related businesses that
may benefit from the sale of homes to buyers who receive assistance from the organization.

Because the organization described in Situation 2 provides down payment assistance amounts that
directly correlate to the amounts provided by home sellers and relies primarily on payments from
home sellers and real-estate related businesses that stand to benefit from the transactions to finance
its program, the Service held that the organization described in Situation 2 is not operated
exclusively for exempt purposes and does not qualify for exemption from federal income tax as an
organization described in section 501(c)(3).

Benefiting Private Interests

Even if an organization's activities serve a charitable class or are otherwise charitable within the
meaning of section 501(c)(3), the organization must show that its activities serve a public rather
than a private interest within the meaning of Treas. Reg. § 1.501(c)(3)-1(d)(1).

In Rev. Rul. 72-147, 1972-1 C.B. 147, the IRS held that an organization that provided housing to
low-income families did not qualify for exemption under section 501(c)(3) because it gave
preference to employees of a business operated by the individual who also controlled the
organization. The ruling concluded that, although providing housing for low-income families
may further charitable purposes, doing so in a manner that gives preference to employees of the
business of the organization’s founder primarily serves the private interest of the founder rather
than a public interest.

In Church by Mail, Inc. v. Commissioner, 765 F.2d 1387 (9th Cir. 1985), the Ninth Circuit held
that a church that conducted its activities by mail did not qualify for exemption under section
501(c)(3) because a substantial purpose of its activities was to benefit a for-profit corporation
controlled by the church’s insiders. The church employed an advertising agency controlled by its
insiders to provide all of the printing and mailing services for the church’s mass mailings. The
advertising agency devoted approximately two-thirds of its time to the work for the church. The
majority of the church’s income was paid to the advertising agency. Although the advertising
agency claimed to have clients unrelated to the church, it did not advertise its services and
refused to identify its other clients. The Ninth Circuit held that the church was operated for the
substantial non-exempt purpose of “providing a market for [the advertising agency’s] services”

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -10-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer: Year/Period Ended
ORG 12/31/20XX,
20XX & 20XX

and, thus, primarily served the private interests of the advertising agency and its owners rather
than a public interest. Id. at 1391.

In KJ's Fund Raisers v. Commissioner, T.C. Memo 1997-424 (1997), aff'd, 1998 U.S. App.
LEXIS 27982 (2d Cir. 1998), the Tax Court held that an organization formed to raise funds for
distribution to charitable causes did not qualify for exemption under section 501(c)(3) because
the primary purpose of its activities was to attract customers to its founders’ private business.
The founders of the organization were the sole owners of KJ's Place, a lounge at which alcoholic
beverages were served. The founders served as officers of the organization and, at times, also
controlled the organization’s board. The Tax Court found that the founders exercised substantial
influence over the affairs of the organization.

KJ’s Fund Raisers’ business consisted of selling "Lucky 7" or similar instant win lottery tickets
exclusively to patrons of KJ's Place. The lottery tickets were sold during regular business hours
by the owners of the lounge and their employees. The organization derived most of its funds
from its lottery ticket sales. The organization solicited no public donations. From the proceeds
of the sales of the lottery tickets, the organization made grants to a variety of charitable
organizations. Although supporting charitable organizations may be a charitable activity, the
Tax Court nevertheless upheld the Commissioner’s denial of exemption to the organization on
the ground that the organization’s operation resulted in more than incidental private benefit to
KJ’s Place and, indirectly, its owners. The Second Circuit affirmed.

Private Inurement

An organization serves a private rather than a public interest within the meaning of Treas. Reg. §
1.501(c)(3)-1(d)(1) if any of its assets or earnings inure to the benefit of any insiders or other
disqualified persons. See Treas. Reg. § 1.501(c)(3)-1(d)(1)(ii). Although stated in terms of the
"net earnings" of an organization, the inurement doctrine applies to any transfer of an
organization's charitable assets. See People of God Community v. Commissioner, 75 T.C. 127,
133 (1980).

Excessive compensation for services is a form of inurement. For example, in Mabee Petroleum
Corp. v. U.S., 203 F.2d 872, 875 (5th Cir. 1953), the court held that payment of a full-time salary
for part-time work constitutes inurement. Furthermore, payment to one person for services
performed by another (or for services presumed to be performed, without any proof of
performance) is a form of inurement. In Church of Scientology v. Commissioner, 823 F.2d 1310,
1314, 1317-18 (9th Cir. 1987), the court ruled that royalties received by the organization’s
founder on the sale of publications written by others were among the improper benefits received
by the founder from the organization. In The Founding Church of Scientology v. U.S., 412 F.2d
1197, 1202 (Ct.Cl. 1969), the court held that the organization’s payment of salary to the

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -11-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer: Year/Period Ended
ORG 12/31/20XX,
20XX & 20XX

founder’s daughter constituted inurement without any proof that she actually performed any
services for the organization.

The provision of inurement can be direct or indirect. In Church of Scientology v. Commissioner,
supra, 823 F.2d at 1315, the organization transferred in excess of $3.5 million to a for-profit
corporation incorporated by the organization’s founder and his wife. The directors of the
corporation were high-ranking members of the Church of Scientology. The directors approved
the founder’s decision to transfer $2 million from the corporation’s account to the ship Apollo,
aboard which the founder and his family lived. The Ninth Circuit held that the funds funneled
through the for-profit corporation constituted inurement to the founder and his family. Id. at
1318.

In Anclote Psychiatric Ctr. v. Commissioner, T.C. Memo 1998-273 (1998), an organization’s
board of directors caused the organization to sell its largest asset — a hospital — to a for-profit
entity formed by the directors. The Tax Court determined that the purchase price received by the
organization on the sale of the hospital was below market. Accordingly, the Tax Court held that
the sale transaction resulted in inurement within the meaning of section 501(c)(3). Although the
for-profit corporation was the direct beneficiary of the below-market sale transaction, the Tax
Court held that the transaction resulted in “an advantage” to the shareholders of the for-profit
corporation and that this “advantage” constituted inurement of the organization’s charitable
assets to the shareholders.

The prohibition on inurement in section 501(c)(3) is absolute. The IRS has the authority to
revoke an organization’s exempt status for inurement regardless of the amount of inurement. See
Spokane Motorcycle Club v. U.S., 222 F. Supp. 151 (E.D. Wash. 1963); The Founding Church
of Scientology v. U.S., supra, 412 F.2d at 1202.

The Effective Date of Revocation

As a general rule, an organization may rely on a favorable determination letter received from the
Internal Revenue Service. See Treas. Reg. § 1.501(a)-1(a)(2); Rev. Proc. 2003-4, § 14.01 (cross-
referencing § 13.01 et seq.), 2003-1 C.B. 123. An organization may not rely on a favorable
determination letter, however, if it omitted or misstated a material fact in its application for
exemption or in supporting documents. Furthermore, an organization may not rely on a
favorable determination if there is a material change, inconsistent with exemption, in the
organization’s character, purposes, or methods of operation after the IRS has issued the
determination letter. See Treas. Reg. § 601.201(n)(3)(ii); Rev. Proc. 90-27, § 13.02, 1990-1
C.B. 514.

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -12-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer: Year/Period Ended
ORG 12/31/20XX,
20XX & 20XX

The Commissioner may revoke a favorable determination letter for good cause. See Treas. Reg.
§ 1.501(a)-1(a)(2). Revocation of a determination letter may be retroactive if the organization
omitted or misstated a material fact or operated in a manner materially different from that
originally represented. See Treas. Reg. § 601.201(n)(6)(i): Rev. Proc. 2003-4, § 14.01 (cross-
referencing § 13.01 et seq.).

THE INTERNAL REVENUE SERVICE’S POSITION

ORG does not qualify as an organization described in I.R.C. § 501(c)(3). ORG operates a
program that does not serve exclusively an exempt purpose described in section 501(c)(3); it
provides substantial private benefit to persons who do not belong to a charitable class, including
its president; and its program results in inurement of a substantial portion of ORG’s net earnings
to the benefit of the organization’s insiders, including its president.

Charitable purposes include relief of the poor and distressed. See Treas. Reg. § 1.501(c)(3)-
1(d)(2). ORG’s motto program does not operate for a primary purpose of addressing the housing
needs of low-income people. See Rev. Rul. 70-585, Situation 1. At no time did its motto
program serve exclusively low-income persons. ORG has offered no evidence to shows it has
income limitations for participation in its motto program. ORG does not screen applicants for its
motto program based on their income. Its records do not include data on the buyers’ incomes,
instead, ORG’s program is open to anyone, without income limitations, who otherwise qualified
for a mortgage loan. ORG does not limit its program to first-time homebuyers.

ORG does not limit its motto program to certain geographic areas, and it does not target areas
experiencing deterioration or neighborhood tensions. See Rev. Rul. 70-585, Situation 4. Motto
is available for any residence where the buyer otherwise qualifies for a mortgage. Arranging or
facilitating the purchase of homes in a broadly-defined geographic area does not combat
community deterioration or serve other social welfare objectives within the meaning of section
501(c)(3).

Only an insubstantial portion of the activity of an exempt organization may further a non-exempt
purpose. As the Supreme Court held in Better Business Bureau of Washington D.C., Inc. v.
United States, supra, 326 U.S. at 283, the presence of a single non-exempt purpose, if substantial
in nature, will destroy the exemption regardless of the number or importance of truly exempt
purposes. Even if ORG directed its program exclusively to low-income individuals or
disadvantaged communities, its total reliance on sellers for financing its motto program
demonstrates that ORG operates its motto program for the substantial purpose of benefiting
private parties.

Like the organization considered in American Campaign Academy v. Commissioner, supra, 92
T.C. at 1053, ORG structured and operated its motto program to help the private parties who

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -13-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer: Year/Period Ended
ORG 12/31/20XX,
20XX & 20XX

fund it and give it business. A seller who participates in ORG motto program benefits from
access to a wider pool of potential buyers, thereby decreasing risk and the length of time the
home is on the market. The seller also benefits by selling the home at its full listed price or by
reducing the negotiated discount on the home. The various real estate professionals who
participate in ORG ‘s motto program, from real estate brokers to escrow companies, benefit from
increased sales volume and the attendant increase in their compensation. It is obvious that
ORG’s motto program provides ample private benefit to the various parties in each home sale.

The manner in which ORG operated its motto program shows that the private benefit to the
various participants in ORG’s activities, especially DIR-1, was the intended outcome of its
operations rather than a mere incident of its operations. ORG designed its motto program to
channel funds in a circular manner from the sellers to the buyers and back to the sellers in the
form of proceeds from the sale of their homes that may have been sold at artificially inflated
prices.

To finance its motto activities, ORG relies exclusively on sellers and other real-estate related
businesses that will benefit from the transactions ORG facilitates. ORG neither solicits nor
receives funds from sources other than the sellers of homes. Before providing a motto grant,
ORG takes into account whether the home seller will make a payment to it to cover the motto
grant the applicant has requested, as well as ORG’s own fee. ORG requires the seller to
reimburse it, dollar-for-dollar, for the amount of the motto grant given to the buyer of the home,
plus an administrative fee of several hundred dollars per home sale. ORG secures an agreement
from the seller stipulating to this arrangement prior to the closing. No motto transactions take
place unless and until ORG has the seller’s assurance that the seller will pay the amount of the
motto grant plus ORG’s fee. Its instructions to the title and escrow companies provide that at the
close of escrow the seller’s contribution, along with ORG’s fees, must be sent to ORG within
five days. ORG will not do business with escrow companies that do not disburse funds to it
timely and appropriately. ORG’s receipt of a payment from the home seller corresponding to the
amount of the motto grant to be given to the buyer in virtually every transaction indicates that the
benefit to the home seller (and others involved in the transaction) is not incidental to ORG’s
operations, but rather the intended outcome. In this respect, ORG is like the organization
considered in Easter House v. U.S., supra, 12 Cl. Ct. at 476, which provided health care to
indigent pregnant women, but only when a family willing to adopt a woman’s child agreed to pay
for the health care.

ORG’s promotional materials, including its website and its marketing activities show that it
operated in a manner consistent with a commercial firm seeking to maximize sales or services,
rather than in a manner that is consistent with a charitable or educational organization seeking to
serve one or more of the charitable purposes enumerated in section 501(c)(3). The manner in
which ORG operated its motto program shows that it was in the business of facilitating the sales
of homes in a manner indistinguishable from an ordinary trade or business. Thus, ORG’s

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -14-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer: Year/Period Ended
ORG 12/31/20XX,
20XX & 20XX

operations were similar to an organization which was denied exemption because it operated a
conference center for commercial purposes. See Airlie Foundation v. Commissioner, supra, 283
F.Supp. 2d at 58.

Operating a trade or business of facilitating home sales is not an inherently charitable activity.
Unlike the trade or business in Aid to Artisans, Inc. v. Commissioner, supra, 71 T.C. at 202,
ORG did not use its motto program as a mere instrument of furthering charitable purposes but as
an end in itself. ORG provided services to home sellers for which it charged a market rate fee.
ORG did not market its services primarily to persons within a charitable class. Its primary goal
was maximizing the fees it derived from facilitating the sales of real property. ORG did not
solicit or receive any contributions from parties that did not have an interest in the motto
program. Like the organizations considered in American Campaign Academy v. Commissioner,
supra, 92 T.C. at 1077, and Easter House v. U.S., supra, 12 Cl. Ct. at 486, a substantial part of
ORG’s activities furthered commercial rather than exempt purposes.

Furthermore, ORG structured its motto program to provide a substantial private benefit to its
insiders. ORG and CO-1, a for-profit corporation wholly-owned by DIR-1, had an exclusive
marketing agreement whereby ORG carried out its motto program through CO-1. For 20XX,
20XX and 20XX, the years at issue, ORG was the source of substantially all, if not in fact all, of
CO-1’s gross revenues. Like the organizations described in Church by Mail Inc., v.
Commissioner, supra, 765 F.2d at 1387, and KJ’s Fund Raisers v. Commissioner, supra, T.C.
Memo 1997-424, at least since the end of 20XX, ORG existed for the substantial nonexempt
purpose of creating business for CO-1. Thus, like the organizations in Church by Mail and KJ’s
Fund Raisers, ORG ‘s operations resulted in a substantial private benefit to ORG’s insiders, CO-
1 and CO-1’s owner, DIR-1.

ORG’s operations also resulted in inurement of its charitable assets to its insiders. Pursuant to its
agreement with CO-1, ORG agreed that every grant made by ORG is attributable to marketing
services performed by CO-1. As a result, ORG paid CO-1 the fee from every motto transaction
without regard to whether there was proof of actual services performed by CO-1. Payment to
one person for services performed by another (or for services presumed to be performed, without
any proof of performance) constitutes inurement. See, e.g., Church of Scientology v.
Commissioner, supra, 823 F.2d at 1317-18. Furthermore, where a party to a transaction giving
rise to inurement is a for-profit corporation in which the organization’s insiders are shareholders,
the advantage accruing from the transaction to the shareholders who are insiders constitutes
inurement. See Anclote Psychiatric Center v. Commissioner, T.C. Memo 1998-273. In the
absence of proof that every motto transaction engaged in by ORG was actually attributable to
CO-1’s services, ORG ‘s marketing arrangement with CO-1 will be treated as resulting in
inurement of ORG ‘s net earnings to CO-1, and indirectly, to its sole shareholder, DIR-1.

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -15-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer: Year/Period Ended
ORG 12/31/20XX,
20XX & 20XX

ORG is very similar to Situation 2 of Rev. Rul. 2006-27, where to finance it motto activities,
ORG relies on sellers and other real-estate related businesses that stand to benefit from the
transactions ORG facilitates, Further more, in deciding whether to provide assistance to a low-
income applicant, ORG’s grant making staff know the identity of the home seller and may also
know the identities of other interested parties and is able to take into account whether the home
seller or another interested part is willing to make a payment to ORG. ORG’s receipt of a
payment from the home seller corresponding to the amount of the motto is substantially all of the
transactions, and ORG’s reliance on these contributions for most of its funding indicate that the
benefit to the home seller is a critical aspect of ORG’s operations. In this respect, ORG is like
the organization considered in Easter House, which received all of its support from fees charged
to adoptive parents, so that the business purpose of the adoption service because its primary goal
and overshadowed any educational or charitable purposes. Like the organization considered in
American Campaign Academy, ORG is structured and operated to assist private parties who are
affiliated with its funders. Like the organization considered in American Campaign Academy,
Easter House, and Columbia Park Recreation Associations, ORG does not operated exclusively
for exempt purposes.

Based on the foregoing, ORG does not operate exclusively for exempt purposes, and,
accordingly, is not entitled to exemption under section 501(c)(3). The IRS proposes revocation of
ORG’s exemption back to January 1, 20XX. Since then, the organization has operated in a
manner materially different from that represented in its Form 1023 and upon which the IRS
granted ORG its tax exemption.

THE TAXPAYER’S POSITION

ORG has indicated its agreement to the government’s position of revocation of exemption
effective January 1, 20XX, by signing Form 6018 Consent to Proposed Action Section 7428.

CONCLUSION

ORG does not operate exclusively for exempt purposes, and, accordingly, is not entitled to
exemption under section 501(c)(3). The IRS proposes revocation of ORG’s exemption back to
January 1, 20XX (the earliest year under examination). Since then, the organization has operated
in a manner materially different from that represented in its Form 1023 and upon which the IRS
granted ORG its tax exemption.

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -16-

DEPARTMENT OF THE TREASURY
Internal Revenue Service
Attention: Terri Anderson, Stop 4925STP
30 East 7th Street, Suite 1130B

TAX EXEMPT AND St. Paul, MN 55101

GOVERNMENT ENTITIES
DIVISION

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:
Publication 892
Publication 3498
Report of Examination

Letter 3618 (04-2002)
Catalog Number 34809F