LLC denied exemption for organizational and commercial-operation failures

Plain-English summary

The IRS denied an LLC's request for exemption under IRC § 501(c)(3). The organization was not organized exclusively for an exempt purpose because its individual shareholders controlled the LLC and its documents stated that it had no members, contrary to the applicable LLC requirements. The IRS also concluded that the planned adult-day care operation would function primarily as a fee-based commercial business, without a sufficient donative element or services substantially below cost. Contributions were therefore not deductible, and the organization was given appeal instructions under IRC § 7428.

Ruling snapshot

• Question: Did the LLC qualify for federal tax exemption as a charitable organization under IRC § 501(c)(3)?
• Outcome: Denied
• Key authorities: IRC §§ 501, 170, 6104, and 7428; Treas. Reg. §§ 1.501(a)-1(a)(2), 1.501(a)-1(b)(2), 1.501(a)-1(c), and 1.501(c)(3)-1(c)(1)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Appeals

Address any reply to:

Number: 201022029
Release Date: 6/4/2010

Employer Identification Number:

Date: March 8, 2010
Form Number: 1023

Uniform Issue List

Person to Contact:

501.03-00

Contact Telephone Number:

Fax Number:

Last Day to File a Petition with the United States
Tax Court:

JUN 07 2010
Certified Mail
Dear

This is our final adverse determination as to your request for exempt status under section 501(c)(3) of the Internal Revenue Code (“Code”). Your request for tax-exempt status is denied.

If you decide to contest this determination under the declaratory judgment provisions of Code section 7428, a petition to the United States Tax Court, the United States Court of Federal Claims, or the District Court of the United States for the District of Columbia must be filed within 92 days from the date this determination was mailed to you. Contact the Clerk of the appropriate court for rules for filing petitions for declaratory judgment.

You have not demonstrated that you are organized and operated exclusively for charitable, educational, or other exempt purposes and that no part of your net earnings inure to the benefit of private shareholders or individuals as required by section 501(c)(3) of the Internal Revenue Code.

You are not organized exclusively for exempt purposes because you are a limited liability company (LLC) whose members/shareholders are not limited to organizations exempt under section 501(c)(3); instead, your members/shareholders include individuals, which violates the prohibition against inurement under section 501(c)(3). In addition, the LLC fails to meet the organizational requirements of state law, because its organizing documents state it does not have any members.

You have not demonstrated that you are operated exclusively for exempt purposes because your primary activity of operating an adult-day care center is not inherently exclusively charitable in nature, but rather is comparable to carrying on a business or trade. Your services are provided for fees primarily at market rates,

you will terminate services to individuals who later become unable to pay, services are not provided

substantially below costs, and no benefit is donated to charitable beneficiaries.

Contributions to your organization are not deductible under Code Section 170.

Until termination, you are required to file Federal income tax returns on form 1120 for any years, which are still open under the statute of limitations. You should file any returns due for these years or later years with
****. Processing of income tax returns will not be delayed because you have filed a petition for a declaratory judgment under Code section 7428.
We will notify the appropriate State officials of this action, as required by Code section 6104(c).

If you have questions about this letter, you may write to or call the contact person whose name, telephone number, and IRS address are shown on the first page of this letter. If you write, please include your telephone number, the best time for us to call you if we need more information, and a copy of this letter to help us identify your account. Keep the original letter for your records. If you prefer to call and the telephone number is outside your local calling area, there will be a long distance charge to you.

The contact person identified on the front of this letter can access your tax information and help you get answers. You also have the right to contact the office of the Taxpayer Advocate. You can call 1-877-777-4778 and ask for Taxpayer Advocate assistance. Or you can contact the Taxpayer Advocate for the IRS office that issued this notice of deficiency by calling * or writing to *. Taxpayer Advocate assistance is not a substitute for established IRS procedures such as the formal appeals process. The Taxpayer Advocate is not able to reverse legally correct tax determinations, nor extend the time fixed by law that you have to file a petition in the U.S. 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.

Sincerely yours,

/s/
Appeals Team Manager

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION
Date:
MAR 8 2010 Contact Person
Identification Number:
Contact Number:
FAX Number:
Employer Identification Number:

Legend: UIL Index:

M = Applicant 501.03-00

N = Member 501.03-05

O = Member 501.03-30

P = Director

Q = Director

R = Director

X = state

a = date

b = date

c = date

Dear

We have considered your application for recognition of exemption from Federal income tax
under Internal Revenue Code section 501(a). Based on the information provided, we have
concluded that you do not qualify for exemption under Code section 501(c)(3). The basis for
our conclusion is set forth below.

Issue:

Does M qualify for federal tax exemption under IRC 501(c)(3) as a charitable organization?

Facts:

Organization:

M incorporated in the state of X on date a, under the X Limited Liability Company Act. M listed N
and O as the individual members of M. The Articles stated that M will not have managers, and
that management of the company is reserved to the members. N and O were also listed as the

organizers of M.

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On date b, N and O filed a Certificate of Amendment for M. Article 4(a) stated that M is
organized exclusively for charitable, religious, educational, and scientific purposes. The specific
purpose is to provide adult day health care to enable functionally impaired individuals to reside
in a supportive home environment, rather than in nursing home care; to maintain clients at the
highest level of functioning possible; to improve the quality of life for the participants among their
peers and to provide support for their families and other caregivers.

Article 6 stated that the amendments were approved by all members of the limited liability
company in accordance with section H of Article 2.23 of the Act.

On date c, N and O filed additional amended Articles that contained the following provisions:

Article 7 stated that “The shareholders hereby form a Limited Liability Company to further
charitable purposes subject to the provisions of the Limited Liability Company Act as currently in
effect as of this date. M’s organized document provisions are consistent with LLC laws, and are

enforceable at law and at equity.”

Article 7 stated that ” the company shall continue for a period perpetual unless dissolved by (a)
any event which makes it unlawful for the business of the company to be carried on by the
shareholders or (b) the death, resignation, expulsion, bankruptcy, retirement of a shareholder or
of the occurrence of any other event that terminates the continued organizational structure of
the company, or (c) any other event causing a dissolution of a Limited Liability Company under

the laws of the State of X.”

Article 9 states that M has no members, nor will it have a membership body. The management
and administration of the company will be directed by the two organizing shareholders (N and
O). The shareholders possess no ownership rights, only voting rights. The company will
undertake no additional shareholders. Total voting shares authorized and issued are 100 voting

shares, 51 belonging to N and 49 to O.
Article 10 expanded M’s Board of Directors to include P, Q and R.

Article 11 appoints N as the Chief Executive Officer, and O as the Executive Shareholder.
These two officers are authorized to make all decisions relating to the sale, development, lease
or other disposition of the company’s assets; the purchase or other acquisition of other assets of
all kinds; management of all or any part of the company's assets; borrowing money on the
company’s assets; the prepayment, refinancing or extension of any loan affecting the company’s
assets; the compromise or release of any of the company’s claims or debts; and the employment
of persons, firms or corporations for the operation and management of the company’s business.

Article 11 authorizes these officers to execute or deliver all contracts, conveyances,
assignments, and contracts; all checks, drafts and other orders for payment; all promissory
notes and loans; and all other instruments of any kind relating to the company’s assets.

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Article 12 provides that the salaries of the officers shall be adjusted from time to time by the

Board of Directors.

Article 16 provides that upon dissolution, any assets remaining after payment of liabilities shall
be distributed exclusively to exempt organizations for exempt purposes within the meaning of

IRC 501(c)(3).

Article 17a provides that the company will not pay dividends, and that no part of the earnings
shall inure to the benefit of its Board of Directors, officers, or other persons, except as
reasonable compensation for services rendered.

Article 18 prohibits M from merging with or converting into a for-profit entity, or purchasing or
acquiring for-profit entities. M's assets cannot be transferred to any other organizations, except
to organizations exempt under IRC 501(c)(3) or governmental units or instrumentalities in
exchange for fair market value.

These amended articles stated that “the company has no members, has not received any
capital, and has not commenced business. In accordance with Section G of Article 2.23 of the
Act, the amendments to the articles of organization were approved by a majority of the initial
managers named in the articles of organization.”

A Limited Liability Company Agreement signed and dated by N and O on date b was amended,
signed and dated on date c. This agreement basically restated the provisions of the amended
Articles, and again stated that M has no members, only two shareholders (N and O).

M filed Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the
Internal Revenue Code, on November ,20 . N and O were listed as “Member/Employee”

with projected salaries of $4500 each.

In correspondence dated June ,20 and July 20 , IRS notified M that exemption under
IRC 501(c)(3) is granted to a limited liability company only if all of its members are themselves
organizations that are exempt under 501(c)(3). In a response received by IRS on July ,20 ,
M claimed that it has no members that that N and O are its shareholders.

On July ,20 , IRS again notified M that exemption under IRC 501(c)(3) is granted to an LLC
only if all of its members are themselves organizations that are exempt under 501(c)(3). On
August 15, M responded by quoting the charitable purpose clause of its amended Articles of
Incorporation (Article 4a). M reiterated that it has no members.

In correspondence dated August ,20 and September , 20, IRS outlines an acceptable
course of action that could lead to M receiving exemption, that is, re-formation as a regular
corporation.

M's organizational structure was discussed with O in a phone call on September, 20. In a
letter dated October ,20 , N requested that M’s case be reopened, stating that it is not a

membership organization.

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In a letter dated October ,20 , but faxed to IRS on February ,20 , N stated “I don’t know
if you are familiar with Spiritual things, (Things having to do with God); however, I will attempt to
explain to you why we choose not to be M, :

Where M, LLC is concerned, we must be in compliance to the will of the “ ”. He
has ordained that this facility be M, LLC. We dare not submit to the will of men to make it M,

for it is a mandate on our lives that we follow His instructions. This is our solemn and only
reason for pursuing M, LLC. Except the Lord builds the house, men labor in vain. Psalms
127:1. We are striving to obey our God, nothing more or nothing less.”

Operations:

M's planned activity is providing “adult day care service for a growing number of people who
have some ability for self-care and do not require constant medical attention, especially senior
citizens and handicapped individual.” M plans to apply for a Rural Development Grant to build a
facility on land transferred to M by N and O.

Revenue from gifts, grants and contributions were projected to be approximately $200,000 in

20 and 20 . An unusual grant of $ was expected in 20 . Additional revenue was

expected to come from private functions, weddings, family reunions, business meetings, daily

lunch, transportation, nutrition education and computer education. These latter activities (in

italics) were later disavowed as “not necessary for the maintenance and upkeep of
” (correspondence received July ,20 ).

M submitted a schedule of fees to be charged on an hourly or monthly basis. M provided the
following information about who would be eligible to receive services, and the sources of fees:

• The original Form 1023 application indicated that “most clients are recipients
%, “% private pay, % veterans” (Schedule F).
• Part IX of Form 1023 referenced a system of paying “Associates” who would receive
“free service”.
• Schedule F, Section II listed possible groups of clients who would be unsubsidized by
the applicant (e.g. Medicaid patients, private pay, long term care, veterans)

Later correspondence from M included further inconsistent information about possible clients
and sources of funds:
• A flyer advertised “Free services to who qualify” with no explanation.
(correspondence received July ,20 )
• Correspondence dated August 1, 20 stated that “Fees will not be provided below
cost”
• Correspondence dated August, 2007 stated that “Associates were to pay fees for
benefits, such as free service, plaques, recognition from the facility’.

Law:

A “person” who can function as a member of an LLC includes a corporation, organization,

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government or governmental subdivision or agency, business trust, estate, trust, partnership,
association, and any other legal entity (Government Code Section 311.005). Generally,
the liability of the members is limited to their investment and they may enjoy the pass-through
tax treatment afforded to partners in a partnership. The members are considered the owners of
the LLC.

The Business Organization Code (BOC) was enacted in 2003 to be effective on January
,20 . It codified eleven statutes, including the Limited Liability Company Act.
The BOC applies to all new corporations, partnerships, limited liability companies and

other domestic filing entities formed on and after that date. Existing domestic and foreign
entities will automatically become subject to the BOC on January ,20__, unless those entities
elect early adoption of the BOC by filing an early adoption statement with the secretary of state.

Title 3, Section 101.101 of the Business Organization Code states that a limited liability
company must have at least one member. This applies to all LLCs formed on or after January

,20 . LLCs formed before this date have until January ,20 to comply with this
requirement. They also have the option to comply before January , 20

A corporation formed before January ,20 may file amendments to its organizing document,
but only if it agrees to adopt the Business Organization Code ( ). Unless the LLC
adopts the , it would not be allowed to amend the Articles of Formation to include a

nonprofit purpose.

Section 501(c)(3) of the Internal Revenue Code exempts from federal income tax corporations,
and any community chest, fund, or foundation, organized and operated exclusively for religious
or other exempt purposes, no part of the net earnings of which inures to the benefit of any

private shareholder or individual.

Section 1.501(a)-1(a)(2) of the Income Tax Regulations provides that an organization is not
exempt from tax merely because it is not organized and operated for profit. In order to establish
its exemption, it is necessary that every such organization claiming exemption file an
application.

Section 1.501(a)-1(b)(2) of the regulations provides that the Commissioner may require (from an
organization applying for exemption) any additional information deemed necessary for a proper
determination of whether a particular organization is exempt under section 501(a) of the Code,
and when deemed advisable in the interest of an efficient administration of the internal revenue

laws, he may in the cases of particular types of organizations prescribe the form in which the
proof of exemption shall be furnished.

Section 1.501(a)-1(c) of the regulations defines a "private shareholder or individual” as a person
having a personal and private interest in the activities of the organization.

Section 1.501(c)(3)-1(c)(1) of the regulations provides that an organization “operates
exclusively” for 501(c)(3) purposes only if it engages primarily in activities that accomplish such

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purposes. It does not operate exclusively for 501(c)(3) purposes if more than an insubstantial
part of its activities does not further such purposes.

Section 1.501(c)(3)-1(c)(2) of the regulations provides that an organization is not operated
exclusively for exempt purposes if its net earnings inure in whole or part to the benefit of private

shareholders or individuals.

Section 1.501(c)(3)-1(d)(1)(ii) of the regulations provides that an organization is not organized or
operated exclusively for exempt purposes under Section 501(c)(3) of the Code unless it serves
a public rather than a private interest. Thus, an organization must establish that it is not
organized or operated for the benefit of private interests, such as designated individuals, the
creator or his family, shareholders of the organization, or persons controlled by such private

interests.

Rev. Rul. 69-528, 1969-2 C.B. 127, held not exempt under section 501(a) of the Code an
organization formed to provide investment services for a fee exclusively to 501(c)(3)
organizations. The Service reasoned that providing investment services on a regular basis for a
fee is a business ordinarily carried on for profit and would constitute unrelated business if
conducted by one tax-exempt organization for other tax-exempt organizations.

Rev. Rul. 72-369, 1972-2 C.B. 245, held not exempt under section 501(c)(3) of the Code an
organization formed to provide managerial and consulting services at cost to unrelated 501(c)(3)
organizations. The Service reasoned that providing managerial and consulting services on a
regular basis for a fee is a trade or business ordinarily carried on for profit.

In Rev. Rul. 77-4, 1977-1 C.B. 141, an organization whose only activities were preparing and
publishing a newspaper of local, national, and international news articles with an ethnic emphasis,
soliciting advertising and selling subscriptions to that newspaper in a manner indistinguishable
from ordinary commercial publishing practices was held to be not operated exclusively for
charitable and educational purposes and did not qualify for exemption.

University of Maryland Physicians, P.A. v. Commissioner, T.C.M. 1981-23, held exempt under
section 501(c)(3) of the Code a professional service corporation established by clinical
departments of a teaching hospital for administrative efficiencies in collecting professional fees.
Each shareholder was a hospital staff physician and faculty member of the affiliated school.
The court accepted the corporation's for-profit status because that was the only kind of
corporation permitted to practice medicine in the State.

Organizations described in section 501(c)(3) of the Code, whether corporations, associations, or
trusts, generally are organized as nonprofit or charitable organizations. In the University of

Maryland case, the court recognized exemption of the entity, organized under for-profit laws,

under the compelling circumstance that the organization could not otherwise practice medicine,

a recognized charitable activity.

In United States v. Wells Fargo Bank, 485 U.S. 351, 108 S. Ct. 1199 (1990) the Court held that an
organization must prove unambiguously that it qualifies for tax exemption.

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Harding Hospital, Inc. v. United States, 505 F.2d 1068 (1974), holds that an organization seeking a
ruling as to recognition of its tax exempt status has the burden of proving that it satisfies the
requirements of the particular exemption statute. Whether an organization has satisfied the
operational test is a question of fact.

In Federated Pharmacy Services, Inc. v. Commissioner, 72 T.C. 687 (1979), the court upheld the
Commissioner's denial of exemption under section 501(c)(3) of the Code. The organization was
organized to operate a pharmacy to sell drugs at discount prices to elderly and handicapped
persons. It had no commitment to use excess receipts to provide drugs for free or below cost to
the elderly or handicapped. The organization served elderly and handicapped persons almost
exclusively, and did not sell toiletry articles, magazines, cards, or other items normally sold by for-
profit pharmacies. The organization's board consisted of community leaders, none of whom
obtained any personal financial benefit from participation. The organization used the services of
volunteers instead of paid employees. All gifts were used for the benefit of financially distressed
senior citizens who, because of catastrophic illness or accident, incurred large prescription drug
bills. The court reasoned that the organization operated its business primarily for commercial
purposes, in competition with for-profit drug stores. The mere fact that products sold by the
organization were helpful to health did not necessarily entitle it to exemption under section
501(c)(3).

Several courts have considered whether services were provided “substantially below cost” within

the meaning of section 501(m)(3)(A) of the Code. Paratransit Insurance Corp. v. Commissioner,
102 T.C. 745 (1994) held that annual percentages (of charges as a percentage of expenses) of

60%, 80% and 84% were too high. Nonprofits’ Insurance Alliance of California v. Commissioner,
32 Fed. Cl. 277 (1994) held percentages of 47% (in a 2-month year), 65% and 78% to be
unacceptably high.

Analysis:
Organizational Test:

As stated earlier, IRC 501(c)(3) requires that an organization must be both organized and
operated for charitable purposes in order to qualify for federal tax exemption.

Limited Liability Companies are comparable to for-profit corporations in that the member-owners
control the organization and have the potential right to receive distributions of the LLC’s
earnings and other assets, upon dissolution, if not earlier.

Tax exemption under IRC 501(c)(3) is available to limited liability companies that have members
(i.e. owners) that are themselves organizations that are exempt under IRC 501(c)(3). This is
a courtesy that the Service extends to exempt organizations. It is not available to LLCs that have
members who are individuals, because the individuals would control (and own) the LLC. This is
inconsistent with exemption under IRC 501.

Although M claims that it has no members and is not a membership organization, state
law requires LLCs to have at least one member. M’s default members are N and O. Although

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M's governing documents purport to guard against distributions to non-501(c)(3) members,
such members may be entitled to distributions under the laws applicable to LLCs in . The IRS
cannot depend on state laws to guarantee that distributions will not inure to individuals.

While N and O were given ample opportunity to change the organizational structure of M, or to
explore the requirements for finding an exempt owner for M, they consistently refused to do so.
As a result, M does not meet the organizational test, and does not qualify for tax exemption

under IRC 501(c)(3).

Operational Test:

There is much in M’s application that is consistent with federal tax exemption. M is planning to
provide services to the handicapped and elderly. M expanded its Board of Directors to include a
majority of unrelated, uncompensated individuals. In addition, N deeded the facility for the

property to M.

In spite of the somewhat inconsistent information presented, the totality of statements made by
M during the development of this case indicate that services will be provided primarily for fees.
There are no plans for a sliding fee scale and services will not be provided substantially below
cost. The clients will be members of one or more charitable classes (i.e. the elderly or
handicapped), but there is no “donative element”. Services are being sold primarily at fair
market rates, and nothing is being given (i.e. donated) to the charitable beneficiaries.

M is similar to the organizations described in Revenue Rulings 69-528, 72-369 and 77-4. These
rulings described organizations that provided services and conducted activities on terms
ordinarily seen in for-profit businesses. Based on the facts and circumstances M has
presented, it appears M will operate a commercial business as an end in itself. M has a paid
staff, and no free or subsidized services are provided.

This is similar to the organization described in Federated Pharmacy Services (supra). In that
case, the organization was essentially structured as a commercial activity. The fact that health

services were provided was insufficient to warrant exemption.

Unlike the organization described in University of Maryland v. Commissioner (supra), there is no
requirement that M structures its business in this way.

In addition, M has not provided unambiguous explanations of why it qualifies for tax exemption
(U.S. Bank v. Wells Fargo Bank; Harding Hospital v. U.S.). Statements were inconsistent and
incomplete, even after several exchanges of correspondence.

Accordingly, M has not met the operational test as described in IRC 501(c)(3) and sections
4.501(c)(3)-1(c) and 1(d) of the Income Tax Regulations.

Determination:

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M does not meet the organizational requirements under IRC 501(c)(3) because its members are
individuals, and not exempt organizations.

M also does not meet the operational requirements under IRC 501(c)(3) because the manner in
which it plans to operate is commercial in nature.

Accordingly, M does not meet the requirements for federal tax exemption under IRC 501(c)(3).

Contributions to M are not deductible under section 170 of the Code.

You have the right to file a protest if you believe this determination is incorrect. To protest, you
must submit a statement of your views and fully explain your reasoning. You must submit the
statement, signed by one of your officers, within 30 days from the date of this letter. We will
consider your statement and decide if the information affects our determination. If your
statement does not provide a basis to reconsider our determination, we will forward your case to
our Appeals Office. You can find more information about the role of the Appeals Office in
Publication 892, Exempt Organization Appeal Procedures for Unagreed Issues.

Types of information that should be included in your appeal can be found on page 2 of
Publication 892, under the heading “Regional Office Appeal”. The statement of facts (item 4)
must be declared true under penalties of perjury. This may be done by adding to the appeal the
following signed declaration:

“Under penalties of perjury, I declare that I have examined the statement of facts presented in
this appeal and in any accompanying schedules and statements and, to the best of my
knowledge and belief, they are true, correct, and complete.”

Your appeal will be considered incomplete without this statement.

If an organization’s representative submits the appeal, a substitute declaration must be included
stating that the representative prepared the appeal and accompanying documents; and whether
the representative knows personally that the statements of facts contained in the appeal and
accompanying documents are true and correct.

An attorney, certified public accountant, or an individual enrolled to practice before the Internal
Revenue Service may represent you during the appeal process. If you want representation
during the appeal process, you must file a proper power of attorney, Form 2848, Power of
Attorney and Declaration of Representative, if you have not already done so. You can find more
information about representation in Publication 947, Practice Before the IRS and Power of
Attorney. All forms and publications mentioned in this letter can be found at www.irs.gov, Forms

and Publications.

If you do not file a protest within 30 days, you will not be able to file a suit for declaratory
judgment in court because the Internal Revenue Service (IRS) will consider the failure to appeal
as a failure to exhaust available administrative remedies. Code section 7428(b)(2) provides, in

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part, that a declaratory judgment or decree shall not be issued in any proceeding unless the Tax
Court, the United States Court of Federal Claims, or the District Court of the United States for
the District of Columbia determines that the organization involved has exhausted all of the
administrative remedies available to it within the IRS.

If you do not intend to protest this determination, you do not need to take any further action. If
we do not hear from you within 30 days, we will issue a final adverse determination letter. That
letter will provide information about filing tax returns and other matters.

Please send your protest statement, Form 2848, and any supporting documents to the
applicable address:

Mail to: Deliver to:
Internal Revenue Service Internal Revenue Service
EO Determinations Quality Assurance EO Determinations Quality Assurance
Room 7-008 550 Main Street, Room 7-008
P.O. Box 2508 Cincinnati, OH 45202

Cincinnati, OH 45201

You may fax your statement using the fax number shown in the heading of this letter. If you fax
your statement, please call the person identified in the heading of this letter to confirm that he or
she received your fax.

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

Sincerely,

Robert Choi
Director, Exempt Organizations
Rulings & Agreements

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