IRS revoked an organization's section 501(c)(3) exemption retroactively

Plain-English summary

The IRS Appeals Office issued a final adverse determination revoking an organization's exemption under IRC § 501(c)(3), effective January 1, 2003. The organization failed the operational test because it did not conduct the exempt activities described in its application and later operated a network-marketing business without notifying the IRS of the change. The IRS also concluded that the organization was not entitled to equitable relief under § 7805(b), so the revocation would apply retroactively. Contributions to the organization were no longer deductible under § 170, and the organization was required to file federal income tax returns.

Ruling snapshot

• Question: Did the organization qualify for exemption under IRC § 501(c)(3), and was it entitled to relief from retroactive revocation under § 7805(b)?
• Outcome: Revocation
• Key authorities: IRC §§ 501(c)(3), 7428, 170, 6104(c), and 7805(b)

Full text (IRS public release)

. Internal Revenue Service Department of the Treasury

Appeals Office
Employer Identification No.:
Number: 201038020 EIN
Release Date: 9/24/2010 Person to Contact:
Date: June 29, 2010 Employee ID Number:
Tel: .
UIL: 7428.00-00 Fax:
Form Required to be Filed:
Legend
ORG = Name of Organization Tax Years:
EIN = EIN of Organization December 31, . — December 31,

NN = Name of Individual

ORG
Certified Mail

Dear

This is a final adverse determination as to your exempt status under section 501(c)(3) of the
Internal Revenue Code (IRC). It is determined that you do not qualify as exempt from Federal
income tax under IRC Section 501(c)(3) effective January 1, 2003.

Our adverse determination was made for the following reason(s):

Based on the examination of your records, it has been determined that you do not meet the
requirements of an organization described under section 501(c)(3). You failed the operational
test described in Income Tax Regulations section 1.501(c)(3)-1(c)(1).

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

You are required to file Federal income tax returns on the form indicated above. You should file
these returns within 30 days from the date of this letter, unless a request for an extension of time
is granted. File the returns in accordance with their instructions, and do not send them to this
office. Processing of income tax returns and assessment of any taxes due will not be delayed
because you have filed a petition for declaratory judgment under Code section 7428.

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 Claims, or the
district court of the United States for the District of Columbia must be filed within 90 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. To secure a petition form from the United
States Tax Court, write to the United States Tax Court, 400 Second Street, N.W., Washington,
D.C. 20217.

_ 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 1-877-777-4778 and
ask for Taxpayer Advocate assistance or you can contact your nearest Advocate’s office, in this
case by calling (904) 665-1000 or writing to:

Internal Revenue Service
Taxpayer Advocate’s Office
400 W. Bay Street, Room 535A, MS TAS
Jacksonville, FL 32202

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
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 Code section 6104(c).
You should contact your state officials if you have any questions about how this determination
may affect your state responsibilities and requirements.

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

Sincerely,

Appeals Team Manager

DEPARTMENT OF THE TREASURY
Internal Revenue Service

TAX EXEMPT AND
GOVERNMENT ENTITIES January 12, 2007

DIVIStON

Taxpayer Identification Number:

Legend EIN

ORG= Name of organization Form:

EIN= EIN of organization

NN= Name of individual Tax Year(s) Ended:

December x, 200X
Person to Contact/ID Number:

ORG 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

lf 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. Ramirrez
Director, EO Examinations

Enclosures:
Publication 892
Publication 3498
Report of Examination

Letter 3618 (04-2002)
Catalog Number 34809F

, Department of the Treasury ~ Internal Revenue Service Schedule No. or
Form 886A Explanation of Items Exhibit
Name of Taxpayer Year/ Period Ended

ORG. 200X12

Legend

ORG= Name of organization HOS= Hospital

NE-ORG= New entity organization UU= Unrelated organization

RR= Related organization ’ CT= Country

ST= State TT= Title

CY= City x= Amount, Number

NN= Name of individual X= Year

ISSUES

1. Whether the tax-exempt status of ORG., an organization that was granted exemption as a school but
   never operated as a school, effective January x, 200X.

2. Whether revocation of the organization’s tax-exempt status should be applied retroactively?

BRIEF EXPLANATION OF FACTS

Taxpayer was originally organized as ORG. It subsequently changed its name to ORG., (ORG).
ORG was granted exemption from federal income tax under section 501(a) of the Internal Revenue Code
as an organization described in section 501(c)(3). It was further determined that it was not a private
foundation within the meaning of section 509(a) of the Code, because it is an organization described in

sections 509(a)(1) and 170(b)(1)(A)(ii).

According to its Form1023, Application for Recognition of Exemption, ORG stated that the primary
purpose of the organization was to operate as a school. It had an agreement with RR (RR) to operate in
ST as an extension campus of RR. RR is located in CY, ST. ORG has never operated as an extension
campus for RR apparently as the cost would have been too expensive for ORG and its students.

Since its original organization thru current the activities of ORG have been performed by or at
least under the direction of NN.

ORG primary activity initially was the collection of food from grocery stores and the distribution of
the food to various organizations in the CY, ST area that fed the hungry. ORG does not have any records
to substantiate the amount of time that spent on this activity. They estimated that it took x to x hours a day
to pickup and delivery food. This activity had been outsourced by January 200X with the NN’s effort
limited to coordinating.

Sometime after being granted exempt status they added teaching computer techniques to senior
citizens and then teaching others how to translate the Bible. This activity continued through 200X and until
200X. Again there are no records to show the number of people taught or the amount of time spent on
these activities.

Sometime in 200X/200X, while recovering from kidney surgery, NN wrote x small religious books.
NN also served as volunteer TT at HOS. NN kept the accounting records for the ORG and did whatever
additional task needed to be done. They estimated they spent x hours a week working for ORG. Again
there is no documentation to support the activities or the amount of time.

The gross receipts for ORG for 200X were $x with $x coming from its subordinate members and
$x from sale of network marketing products to the UU. Expenditures totaled $x with $x going directly to
charity type activities. $x was spent on cell phone and amvox service for seven months, and $x was spent
on x months of electric bills, with $x spent on various insurance expenses that included auto/pickup (and
tag for truck) as well as life and health insurance on the NN’s.

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

F 886A Department of the Treasury - Internal Revenue Service Schedule No. or
= Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG. 200X12

In 200X ORG applied for and received a group exemption ruling. The group ruling was granted
March x, 200X under Section 501(c)(3).

ORG allowed other entities to be covered under its group exemption ruling for a fee. ORG
charged each organization an initial fee of $x plus a monthly fee of $x. This program allowed the other
entities to obtain exemption under 501(c)(3) without having to go thru the normal process of each entity
applying to the Internal Revenue Service for an exemption. ORG Group number with the Internal Revenue
Service is x.

Each year ORGis required to supply to the Internal Revenue Service a listing of;
(1) a statement of any changes during the year in the purposes, character, or method of operation of
its subordinates;
(2) a listing of names, mailing address and employer identification numbers of subordinates that,
since its previous report; (a) Changed names or address;
(b) were deleted from its rooster; or
(c) were added to its rooster.
(3) | For each subordinate to be added, attach a:
(a) Statement that the information on which its present group exemption letter is based applies
to the new subordinates;
(b) Statement that each has given it written authorization to add its name to the rooster;
(c) List of those to which the Service previously issued exemption rulings or determination letters;
(d) Statement that none of the subordinates is a private foundation

On October x, 200X ORG reported to the Internal Revenue Service that it had x subordinate
entities. The letter indicated that several were new subordinates and that any subordinate that was on
prior year’s report and not listed on this years report were no longer subordinates, instead of a listing of
subordinates dropped as required by their letter ruling. Of the x entities that were on the original
application for the group exemption letter of ORG in 200X only RR, which was founded by the NN’s, was
on the October x, 200X subordinate listing.

The Internal Revenue Service's listing of subordinates, as of cycle 200XXX, listed x entities as
subordinates which included only x of the entities reflected on the ORG October x, 200X listing. Review of
the website hosted by Economic Research Institute on January x 200X reflected x entities as subordinates
of ORG with x of those different from those on the IRS 200X list.

Included on the website of ORG published on 12/13/200X was the statement “for those who are
signing up for a non profit group exemption status for $x, you will receive a full year free monthly
association fee-worth $x...” In addition, on the same website in 200X was a statement that “NN and | have
started x faith-based organizations in CT, and assisted over x groups to acquire 501(c)3 Non-Profit
Subordinate Status in CT.” This statement was subsequently removed from the website.

At about the same time the group ruling was granted by the IRS, the NN’s joined a network
marketing group as a means to fund ORG. The network marketing activity was in the NN’s name. Network
marketing is similar if not the same as Multi-level Marketing. It is a means where products or services are
distributed by individual distributors instead of a wholesale/retail system employed by “Normal
Businesses.” Such as, one distributor getting another person (distributor) involved in using and distribution
the product or service. Levels are created and the initial person gets monies based upon the sales, use of
products of those they introduced into the program and those in their line below them for a certain number
of levels. They may receive actual cash payments or larger discounts on their purchases from the —
organization or a combination of both.

Form 886-Acrev.468) Department of the Treasury - Internal Revenue Service
Page: -2-

BE 8 86 A Department of the Treasury - Internal Revenue Service Schedule No. or
om Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG. 200X12

On June x, 200X, the NN’s transferred their network marketing activity to a new entity that they
incorporated called NE-ORG. NE-ORG is owned and controlled by the NN’s. NE-ORG was incorporated
as a for profit corporation on May x, 200X and elected non-profit status by a Board meeting on December
x, 200X and filed articles with the State on February x, 200X for the non-profit election. NE-ORG reported
all of its activities on Forms 990 for 200X and 200X.

NE-ORG was not included as a subordinate organization of ORG on the subordinate listing filed
with the IRS in October x, 200X.

After initiation of the IRS examination of ORG and NE-ORG, the NN’s filed amended returns to
remove the network marketing activity from the Form 990 of NE-ORG and add it to the NN’s personal
1040 for 200X. For 200X the NN’s reported the net working activity on their personal Form 1040, but did
not file an amended Form 990 for NE-ORG for 200X to remove the networking activity.

Total receipts reported on the original form 990 for NE-ORG for 200X were $x, with $x coming
from network marketing activities and the balance of $x from other than network marketing activity, of
which $x was from the NN’s.

On the filed amended return the receipts and the expenditures for 200X were exactly the same
amount. Of the $x listed as spent by NE-ORG; $x went to ORG; $x to a mortgage payments on principal
residence and $x to NN (their son). Most of the balance ($x) was not determined.

The website of ORG has links to the network marketing activity and advises its subordinate
organizations on how to use the network marketing activity to fund their exempt organizations activities.

LAW and Anaylsis

Issue 1.

Section 501(c)(3) of the Code exempts from federal income tax organizations organized and
operated exclusively for charitable, educational, and other exempt purposes, provided that no part of the
organization's net earnings inures to the benefit of any private shareholder or individual.

Section 1.501(c)(3)-1(a)(1) of the regulations provides that in order to be exempt as an
organization described in section 501(c)(3) of the Code, the organization must be one that is both |
organized and operated exclusively for one or more of the purposes specified in that section.

Section 1.501(c)(3)-1(c)(1) of the regulations provides that an organization will not be regarded as
operated exclusively for exempt purposes if more than an insubstantial part of its activities is not in
furtherance of exempt purposes.

Section 1.501(c)(3)-1(d)(ii) of the regulations provides that an organization is not organized or
operated exclusively for one or more exempt purposes unless it serves a public rather than a private
interest. Thus, it is necessary for an organization to 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, directly or indirectly, by such private interests.

Section 1.501(c)(3)-1(d)(2) of the regulations provides that the term "charitable" is used in section
501(c)(3) of the Code in its generally accepted legal sense, and includes the promotion of education.

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

FE 886A Department of the Treasury- Internal Revenue Service Schedule No. or
= Explanation of Items Exhibit
Name of Taxpayer . Year/Period Ended
ORG. 200X12

The presence of a single substantial nonexempt purpose can destroy the exemption regardless
of the number or importance of exempt purposes. Better Bus. Bureau v. United States, 326 U.S. 279.
283, 90 L. Ed. 67, 66 S. Ct. 112 (1945); Am. Campaign Acad. v. Commissioner, 92 T.C. 1053, 1065
(1989); see also Old Dominion Box Co.., Inc. v. United States, 477 F2d. 340 (4" Cir. 1973), cert. denied,
413 US 910 (1973) (“operating for the benefit of private parties who are not members of a charitable class
constitutes a substantial nonexempt purpose”). When an organization operates for the benefit of private
interests, such as designated individuals, the creator or his family, or persons directly or indirectly
controlled by such private interests, the organization by definition does not operate exclusively for exempt

purposes. Am Campaign Acad. v. Commissioner, supra at 1065-1066.

in Christian Stewardship Assistance vs. Commission 70 T.C. 1037, an organization was formed as
a nonprofit corporation to support and assist religious, educational and/or other nonprofit organizations in
their relationships with their contributors and in stimulating proper application of Christian stewardship
principles among their contributors. To reimburse its cost of operation, petitioners charge a fee to each
subscribing organization.

Respondent determined that the described activities, although helpful to charitable organizations are
not exclusively for charitable purposes, but rather serve private interest by advising individuals about
methods to decrease Federal income and estate taxes.

In Revenue Ruling 69-545, a hospital did not qualify under section 501(c)(3) of the Code because it
must be organized and operated exclusively for one or more of the purposes set forth in that section.
Hospital B was initially established as a proprietary institution (same as network marketing) for the benefit
of its owners. Although its ownership had been transferred to a nonprofit organization, the hospital
continued to be operated for the private benefit of the original owners who exercised control over the EO
through the board of trustees. They had used their control to restrict staff (determine amount
contributions), to enter into favorable rental agreements (who deducts what expenses), and to limit
emergency room care and hospital admission to their own patients. These facts indicated that the hospital
was operated for the private benefit of its original owners, rather than for the exclusive benefit of the
public.

In Living Faith, Inc vs. Commissioner 950 F.2™ 365, a nonprofit organization operated restaurants

and food stores in accordance with doctrines of the Seventh-day Adventist Church. Their application was
denied because it was not operated exclusively for exempt purposes. Living Faith operated two vegetarian
restaurants and health food stores in Illinois. These two facilities-the subject of this litigation-were open to
the public. They had several purposes listed to (1) teach restaurant management, (2) teach vegetarian
cooking, (3) minister to those...changing their way of life....,(4) learn how to communicate with others. In
addition to purveying food and health products, Living Faith disseminated various informational materials
which promoted both the healing and message of Jesus Christ and....
Each day before the facilities opened, Living Faith conducted devotional talks....., Bible reading....... , Bible
Studies....... It occasionally provided meals to the needy.......... The nonexempt purpose cannot be
substantial. A single activity may be carried on for more than one purpose. The fact that an organization's
primary activity may constitute a trade or business does not, of itself, disqualify it from classification under
501(c)(3), provided the trade or business furthers or accomplishes an exempt purpose. If one of the
activities purposes, however, is substantial and nonexempt, the organization will be denied exempt status
under 501(c)(3), even if its activity also furthers an exempt purpose.

In making its decision, the Tax Court considered the following factors to be critical to its
determination: (1) Whether an activity has a substantial nonexempt purpose is a question of fact; (2)
Does it conduct its business in an apparently commercial manner? Does the organization use promotional
materials and “commercial catch phrases” to enhance sales? (3) Is the organization in competition with
commercial firms?

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

é

F 886 A Department of the Treasury Internal Revenue Service Schedule No. or
om Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG. 200X12
TAXPAYER’S POSITION

The organization believes that it is entitled to exemption under section 501(c)(3) because its
primary purpose is to lead men and women to a life of Christian Fellowship and relationship with God. It’s
programs of caregiving through food programs, and aid to seniors, disabled and downtrodden in all
aspects of their lives are section 501(c)(3) activities.

GOVERNMENT’S POSITION

Based on the facts determined during the examination, the organization does not qualify for
exemption as a school, its original reason for exemption status, since its operations were never that of a
school. It never informed the government even when applying for group ruling that it had never operated
as a school and was instead carrying on other charitable activities such as a food bank.

Its activities of operating as a food bank and teaching of Seniors on the use of computers was in
prior years and does not have documentation that supports the amount of time or money involved in these
activities. The Food Bank activity was outsourced in 199X. The teaching of senior citizens on how to use
computers ended sometime in 200X due to lack of funding.

Rather ORG’s primary activities have involved promoting a network marketing activity from its
website that is more than insubstantial and directly confers a private benefit to its directors and at least
one of its purported subordinate organizations which in actuality has been used to conduct for profit
marketing on behalf of the NNs.

Although operating the network marketing may have some benefit to the public as a result of
educating about water purification, such education would appear quite minimal and not much different
from customer education resulting from the sale of any product. Rather, the operating of the network
marketing and the sale of the units by NE-ORG (subordinate organization of ORG), its directors or any
other of its subordinates is clearly allowing the supposed charity to operated for the private benefit and
interests of the NN’s. See Rev. Rul. 69-545.

As noted above, an organization that operates for the benefit of private interests, such as
designated individuals, by definition does not operate exclusively for exempt purposes. This case is
similar to Living Faith, in that network marketing is the means to generate revenues vs. operation of a
restaurant and health food store. in the instant case ORG uses its website to advocate its network
marketing as a means to secure financing for various exempt activities. However, the primary activity of
ORG has never been to operate a school. Since 200X its main activity has been to solicit others to its
networking marketing operations that directly benefit the founders of ORG and any of the other
Subordinate Exempt Organization Directors’ that join the networking marketing. ORG only benefits
indirectly from the activity by eventually getting whatever funds the Directors decide to donate to ORG.

CONCLUSION

Based on the foregoing reasons, the organization does not qualify for exemption under section
501(c)(3) and its tax exempt status should be revoked.

LAW

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

F 886A Department of the Treasury- Intemal Revenue Service Schedule No. or
™ Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG. 200X12
Issue 2.

IRC § 7805(b) provides that the Secretary may prescribe the extent, if any, to which any ruling
(including any judicial decision or any administrative determination other than by regulation) relating to the
internal revenue laws shall be applied without retroactive effect.

Rev. Proc. 98-1, 1998-1 I.R.B. 7 provides that except in rare or unusual circumstances, the
revocation or modification of a letter ruling will not be applied retroactively to the taxpayer for whom the
letter ruling was issued or to a taxpayer whose tax liability was directly involved in the letter ruling provided
that: (1) there has been no misstatement or omission of material facts; (2) the facts at the time of the
transaction are not materially different from the facts on which the letter ruling was based; (3) there has
been no change in the applicable law; (4) the letter ruling was originally issued for a proposed transaction,
and (5) the taxpayer directly involved in the letter ruling acted in good faith in relying on the letter ruling,
and revoking or modifying the letter ruling retroactively would be to the taxpayer's detriment.

TAXPAYER'S POSITION

The organization claims that it meets the five criteria to obtain equitable relief under section
7805(b) on the basis that it operated under the good faith belief that it qualified as an educational and
charitable organization under section 501(c)(3) of the Code.

GOVERNMENT’S POSITION

Section 7805(b) relief should not be granted in this case, since the organization, contrary to its
position, does not meet the listed five criteria; the organization failed to conduct the tax-exempt activities
that it reflected in its application for exemption. When the organization realized that it would not nor could
not operate as authorized and changed its exempt purpose it did not notify the Service of this change as
required by regulations. When it applied for group ruling it did not notify that it was conducting network
marketing. It also did not mention that it was no longer a school as authorized in the original application.
Accordingly, the failure to disclose the information is an omission of a material fact and the organization's
tax-exempt status should be revoked retroactively.

CONCLUSION

Based on the foregoing, the organization is not entitled to section 7805(b) relief.

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