IRS revoked an organization’s exemption after finding private benefit in down-payment assistance

View official IRS release (PDF)

Plain-English summary

The IRS issued a final adverse determination revoking an organization’s exemption under IRC § 501(c)(3), effective January 1, 2002. The organization provided down-payment assistance to home buyers and relied on home sellers and related businesses that benefited from those transactions. The IRS concluded that the organization primarily furthered insiders’ business interests and served the private interests of the people financing its activities. Contributions were not deductible under IRC § 170, and the organization was required to file Forms 1120.

Ruling snapshot

• Question: Did the organization operate exclusively for exempt purposes under IRC § 501(c)(3)?
• Outcome: Revocation
• Key authorities: IRC §§ 170, 501, and 7428

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Appeals Office

1375 E. Ninth Street Person to Contact:
Cleveland, OH 44114-1739

Employee ID Number:

Tel:
Date: yy} 1 2010 Fax:
Refer Reply to:
Number: 201044022 In Re:

Release Date: 11/5/2010 Form Required to be Filed:

EIN:
Tax Period(s) Ended:

UIL:
501.03-05

Certified Mail

Dear

This is a final adverse determination regarding 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,
2002.

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

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. 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, your 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).

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

You are required to file Forms 1120, U.S. Corporation Income Tax Return, for tax
periods beginning on and after January 1, 2002 with the Cincinnati Service Center,
Cincinnati, OH, 45999-0012.

You have waived your right to contest this determination under the declaratory judgment
provisions of Section 7428 of the Code by your execution of Form 906, Closing
Agreement Concerning Specific Matters, an executed copy of which is being sent to you
under separate cover.

You also 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 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. If
you want Taxpayer Advocate assistance, please contact the Taxpayer Advocate for the
IRS office that issued this letter. See the enclosed Notice 1214, Helpful Contacts for
Your “Notice of Deficiency”, for Taxpayer Advocate telephone numbers and addresses.

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

Sincerely,

KAREN A. SKINDER
APPEALS TEAM MANAGER

2 of 2

DEPARTMENT OF THE TREASURY
Internal Revenue Service
4330 Watt Ave., SA-111
Sacramento, CA 95821

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

September 26, 2008

Taxpayer Identification Number:

Form:
990
Tax Year(s) Ended:

Person to Contact/iID 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

© 9

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:

Taxpayer Advocate

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,

be

Edward V. Hill
Revenue Agent, EO Examinations

Enclosures:
Publication 892
Publication 3498
Report of Examination

Letter 3618 (04-2002)
Catalog Number 34809F

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

ISSUES

1. Whether XXX operated exclusively for purposes described in section 501(c)(3) of
   the Internal Revenue Code.

2. Whether revocation of the XXX tax-exempt status should be applied retroactively.
   FACTS

XXX was organized and incorporated in the State of XXX on July ,19 . In February
20 , XXX filed Form 1023, Application for Recognition of Exemption Under Section
501(c)(3) of the Internal Revenue Code. On April ,20_ , the Service issued a letter
stating that the organization was recognized as exempt fre::: Federal income tax
because it was classified as an organization described in section 501(c)(3) of the
Internal Revenue Code. It was also recognized as a public charity under section
509(aX2) of the Code.

XXX's Form 1023 advised that its activities/purposes would be:

“XXX will provide grants to first-time home buyers who meet

certain criteria. These grants can be used for their down payment 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.” .

The Form 1023 also stated sources of financial support as, “. . . Contributions from
community businesses, private individuals, and government entities.”

The organization's tax returns (Forms 990) forthe 20 -—20 tax periods included the
following statement to clarify that the organization makes grants primarily to low and
moderate income homebuyers:

“XXX provides grants primarily to qualified low and moderate
income homebuyers. The grants may be used for down
payment assistance and/or closing costs.”

The original incorporators/directors of XXX were XXX, XXX, and XXX. On January , |
20 _, each of these individuals was replaced as a director

of XXX. XXX continued to assist XXX in its operations to a limited extent until the
Board tormally appointed a new President, XXX, in September or October of 20

In February, 20. at about the same time XXX was seeking exemption, XXX, XXX, and
XXX organized a taxable Subchapter S Corporation, XXX, to conduct the sales and
marketing functions for XXX, including development of XXX's nationwide network of

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

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

commissioned sales persons and promotion of its DPA program . From the formation
of XXX until January ,20 , XXX, XXX, and XXX served as Directors of both XXX and
were the principal shareholders of XXX. The formation of XXX or its intended purpose
was not disclosed on the Form 1023. The Form 1023 also specifically advised XXX,"
XXX and XXX would not be compensated for their time.

A “Services Agreement” was executed between XXX and XXX effective as of the

day of January 20 . This agreement appointed XXX to act as the non-exclusive,
independent marketing representative of XXX. Under this agreement, XXX agreed to
perform the following primary services:

1. XXX will find and solicit mortgage providers, so that they can provide grant
   information to their clients.

2. XXX will train, support, and monitor such mortgage providers to ensure their
   compliance with the grant program requirements.

3. XXX will provide marketing data to XXX concerning the FHA loan market and
   trends, regulatory changes, and other pertinent information concerning other
   down payment assistance program providers.

XXX provided most of its marketing services to XXX through staff employees and a
network of independent contractor marketing specialists (“Marketing Representatives”)
located throughout the United States. As compensation under the contract, XXX
received a “marketing fee” equal to seventy-five per cent (75%) of the Seller Service
Fee paid by the seller to XXX.

The current XXX Board of Directors includes XXX, XXX, and XXX. Although XXX, XXX,
and XXX resigned from XXX in January 20 __, they remained as the officers of XXX
until August 20 and continue to be its principal shareholders.

XXX paid the 75% amount to XXX until February, 200. , at which time the amount of the
payment was reduced to a lower figure after complaints by XXX's new management
that the sales and marketing fees paid to XXX were excessive. XXX paid the lower
figure to XXX until August ,20 , when XXX purchased all of the assets of XXX to
allow XXX to conduct all further sales and marketing efforts from within the exempt
organization, and the relationship between the XXX and XXX was terminated. XXX
paid XXX the following amounts pursuant to the above-described arrangements:

Table 1
.Year Amount

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
Total

Every grant made by XXX was deemed attributable to marketing services provided by
XXX, therefore, XXX received a “marketing fee” from every grant transaction made by
XXX. If applicable, XXX agreed to provide XXX 30 days prior written notice that a grant
transaction was not attributable to XXX.

This agreement was signed by XXX as Trustee for XXX, and by XXX as President of
XXX. Although XXX had resigned as an officer or director of XXX in ZO, ne continued
to exert substantial influence over the affairs of the organization. On July ,20 , an
Amendment to the Agreement was executed that emphasized the non-exclusive nature
of the Agreement. XXX was free to perform services for other down payment assistance
programs and to continue providing services for XXX. The term of the Agreement was
extended to January ,20 _, and was automatically extended for additional one-year
periods thereafter unless either party terminated the Agreement upon 60 days written
notice.

On August ,20 , XXX purchased all of the assets of XXX, including XXX's
contractual rights with the Marketing Representatives. The purchase price for the
assets was established by appraisal. The purchased assets were largely in the nature
of intangible intellectual property rights derived from XXX's marketing efforts. XXX paid
no further compensation to XXX (other than final amounts due under the purchase
contract) and the relationship between XXX and XXX ceased to exist.

On May .20_ , XXX made the following announcement on their website,
http://www... com:

The following is the financial information taken from the 990 returns filed by XXX and
shows the major categories of revenue and expenses from its operations:
Table 2

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

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

DPA Revenue

Other Revenue
Total Revenue

DPA Assistance

Marketing Fee
Charitable
Grants

Other Expenses
Total Expenses

Net Amount

The down payment assistance program at XXX is based on a home-buyer connecting
with a seller who agrees to participate in the grant program and pay a Seller Service
Fee (SSF) to XXX. The program worked as follows:

e Areal estate contract is negotiated between the buyer and the seller and
includes the seller's agreement to pay a service fee to XXX.

e The contract is forwarded to the title company for determination of the
transaction amounts that will be required for the final real estate closing.

e The lender prepares a grant application in the name of the buyer. The grant
amount is the amount needed by the buyer for the required down payment or for
closing costs. When the application is completed, it is forwarded, usually by Fax,
to XXX.

e XXX approves the grant. The grant award letter (gift letter) for the buyer is
prepared by XXX and faxed to the lender. The grant to the buyer is a “gift” and
does not have to be repaid by the buyer. Gift letters go out the same day the
grant application is received.

e When all of the closing arrangements have been made and signed closing
instructions have been received from the closing agent, grant funds are wired
from XXX to the title company.

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

ii

Form 886A Department of the Treasury - Internal Revenue Service | Schedule No. or

Explanation of Items Exhibit

Name of Taxpayer Year/Period Ended

During the closing process, the seller pays a “service fee” (SSF) that was wired
to XXX. This fee consists of two parts: 1) the grant amount, typically 3 to 10
percent of the sales price of the home (it is the same amount that was granted to
the purchaser), and; 2) a transactional service fee.

After XXX receives the SSF, seventy-five (75%) per cent of the service fee
charge (not the grant amount) was forwarded to XXX as compensation under the
Services Agreement.

Additional Details About the Downpayment Assistance Program

The program is compatible with FHA, conventional, or sub-prime loans.

Approximately 98% of the grants awarded were associated with FHA insured
loans.

For the non-FHA loans, grant proceeds were allowed be used to pay off existing
debt.

No roof certifications, homeowner's warranties, or home buyer’s education were

_ required for buyer or seller participation in the program. The organization had no

standards for habitability, and home inspection reports were not required for
participation in the program.

XXX provided national and local “Personal Account Executives” to set up grant
transactions for home buyers, and also provided account executives who
provided consulting and training services for real estate professionals.
Participants were not required to be first-time homebuyers.

There were no income or asset restrictions (limits) for homebuyers.

No credit checks or employment history were required for participation in the
program.

There were no geographic restrictions for home purchases and sales.

Buyers must qualify for a loan program that allows gift funds from nonprofit
organizations.

The grant to buyers could be used for a down payment or closing costs, and if
the loan was non-FHA, it could be used to pay off existing debt. Maximum grant
amount was $25,000 and the average grant amount was approximately $5,000.

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
Year/Period Ended

Name of Taxpayer

e There are no Department of Housing and Urban Development (HUD) rules or
regulations required of the exempt organization. The lenders and loan officers
are responsible to ensure compliance with FHA guidelines and procedures.

LAW
ISSUE 1

Section 501(a) of the Code provides for the exemption from federal income taxation of
corporations described in section 501(c)(3) of the Code. To be described in section
501(c)(3), an organization must be organized and operated exclusively for charitable,
educational or other exempt purposes and may not permit any of its net earnings to
inure to the benefit of any private shareholder or individual.

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) of the Code. 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.” If a substantial part of an organization's
activities furthers non-charitable purposes, the organization is not operated exclusively
for charitable purposes even though its other activities further charitable purposes. See
Old Dominion Box Co., Inc. v. U.S., 477 F.2d 340 (4th Cir. 1973), cert. denied, 413 U.S.
910 (1973).

Section 1.501(c)(3)-1(c)(2) of the regulations provides that an organization is not
operated exclusively for one or more exempt purposes if its net earnings inure in whole
or in 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 unless it serves a public rather
than a private interest. To meet this requirement it is necessary for an organization to
establish that it is not organized or operated for the benefit of private interests.

Section 1.501(c)(3)-1(d)(2) of the regulations defines the term “charitable” as used in
section 501(c)(3) of the Code as including the relief of the poor and distressed or of the
underprivileged, advancement of education, combating community deterioration and
lessening the burdens of government.

Section 1.501(c)(3)-1(d)(3)(i) of the regulations provides, in part, that the term
"educational" as used in section 501(c)(3) of the Code relates to the instruction of the
public on subjects useful to the individual and beneficial to the community.

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

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

Section 1.501(c)(3)-1(e) of the regulations 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) of the Code if the trade or business furthers an exempt purpose, and
provided the organization's primary purpose does not consist of carrying on an
unrelated trade or business.

Rev. Rul. 2006-27, 2006-21 I.R.B. 915, sets forth standards for determining when an
organization that provides funds to homebuyers for down payment or closing costs
qualifies for exemption from Federal income tax under section 501(c(3). In Situation 2,
an organization provides down payment assistance to low-income individuals and
families. It offers financial counseling seminars and conducts other educational
activities to help prepare potential low-income homebuyers for the responsibility of
home ownership. Under the organization’s grantmaking procedures, the staff
considering a particular applicant's application knows the identity of the party selling the
home to the grant applicant and may also know the identities of other parties, such as
real estate agents and developers, who may receive a financial benefit from the sale.
Moreover, in substantially all of the cases in which the organization provides down
payment assistance to a homebuyer, the organization receives a payment from the
home seller. Further, there is a direct correlation between the amount of the down
payment assistance provided by the organization to the homebuyer and the amount of
the home sellers payment to the organization. Finally, the organization does not
conduct a broad based fundraising campaign to attract financial support. Rather, most
of the organization’s support comes from home sellers and real estate-related
businesses that may benefit from the sale of homes to buyers who receive the
organization’s down payment assistance.

The revenue ruling holds that the organization described in Situation 2 is not exempt
from Federal income tax under section 501(c)(1) because it finances its down payment
assistance activities with contributions from sellers and individuals that stand to benefit
from the transactions that the organization facilitates. The fact that the organization
relies on seller's payments for most of its funding and in substantially all of the
transactions the payment from a home seller corresponds to the amount that the
organization gives to a homebuyer indicate that the benefit to the home seller is a
critical aspect of an organization's operations. Rev. Rul. 2006-27, also holds that the
payments to homebuyers in Situation 2 are not gifts, but rebates or purchase price
reductions because sellers make the payments not out of detached and disinterested
generosity, but in response to an anticipated economic benefit, namely the sale of their
home at a higher price and in less time.

Rev. Rul. 2006-27, Situations 1 and 3 describe organizations that provide down
payment and closing costs to qualified homebuyers, in the manner that could qualify for
exemption from Federal income tax under section 501(c)(3). In Situation 1, the ©
organization’s purposes and activities relieve the poor, distressed and underprivileged
by enabling low-income individuals and families to obtain decent, safe and sanitary

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

Form 886A Department of the Treasury - Internal Revenue Service | Schedule No. or

Explanation of items Exhibit
, Year/Period Ended

Name of Taxpayer

homes. In Situation 3, the organization's purposes and activities combat community
deterioration in a specific, economically depressed area that has suffered a major loss |
of population and jobs. Importantly, these organizations conduct broad based |
fundraising programs to attract gifts, grants, and contributions from several foundations,
businesses, the general public, and receive funding from government agencies. See

Rev. Rul. 2006-27. Their policies and procedures prevent the grantmaking staff from

knowing identities of the parties involved in the transaction and whether anyone related

to the transaction had made or agreed to make or made a contribution to the

organization.

In Easter House v. U.S., 12 Cl. Ct. 476, 486 (1987), affd, 846 F.2d 78 (Fed. Cir.) cert.
denied, 488 U.S. 907 (1988), the court held that an organization that operated an
adoption agency was not exempt under section 501(c)(3) of the Code because a
substantial purpose of the agency was a nonexempt commercial purpose. The court
concluded that the organization did not qualify for exemption under section 501(c)(3)
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. Rather, the court found that the
health-related services were merely incident 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, engaged in substantial advertising, and accumulated
substantial profits. Accordingly, the court found that the "business purpose, and not the
advancement of educational and charitable activities purpose, of plaintiff's adoption
service is its primary goal" 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 court held
that an organization that operated a school to train individuals for careers as political
campaign professionals, but that could not establish that it operated on a nonpartisan
basis, did not exclusively serve purposes described in section 501(c)(3) of the Code
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 the organization's 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 benefited 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 section 1.501(c)(3)-1(d)(1 \ii) of the regulations.
The Court concluded by stating that even if the political party's candidates and entities
did “comprise a charitable class, {the organization] would bear the burden of proving
that its activities benefited members of the class in a non-select manner."

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

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

In Aid to Artisans, Inc. v. Commissioner, 71 T.C. 202 (1978), the court held that an
organization that marketed handicrafts made by disadvantaged artisans through
museums and other nonprofit organizations and shops was operated for exclusively
charitable purposes within the meaning of section 501(c)(3) of the Code. 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 by the Bureau of Indian Affairs or other government agencies.
The organization marketed only handicrafts it purchased in bulk from these
communities of craftsmen. it did not select individual craftsmen based on the needs of
the purchasers. The court concluded that the overall purpose of the activity was to
benefit disadvantaged communities. The organization’s commercial activity was not an
end in itself but merely the means through which the organization pursued its charitable
purposes. The method it used to achieve its purpose did not cause it to serve primarily
private interests because the disadvantaged artisans 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.

In Ainie 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
revenues from user fees. Because of the commercial manner in which this organization
conducted its activities, the court found that it was operated for a non-exempt
commercial purpose, rather than for a tax-exempt purpose. In reaching this conclusion,
the court stated that "[a]Jmong 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."

Rev. Rul. 67-138, 1967-1 C.B. 129, held that helping low income persons obtain
adequate and affordable housing is a "charitable" activity because it relieves the poor
and distressed or underprivileged. The organization carried on several activities
directed to assisting low-income families obtain improved housing, including (1)
coordinating and supervising joint construction projects, (2) purchasing home sites for
resale at cost, and (3) helped low income people obtain home construction loans.

Rev. Rul. 70-585, 1970-2 C.B. 115, discussed four situations of organizations providing
housing and whether each qualified as charitable within the meaning of section
501(c)(3) of the Code. Situation 1 described an organization formed to construct new

-homes and renovate existing homes for sale to low-income families who could not
obtain financing through conventional channels. The organization also provided

Form 886-A(Rev.4-68) Department of the Treasury - Internal Revenue Service
age: -9-

Form 886A Department of the Treasury - Internal Revenue Service | Schedule No. or

Explanation of Items Exhibit
Year/Period Ended

Name of Taxpayer

financial aid to eligible families who do not have the necessary down payment. When
possible, the organization recovered the cost of the homes through very small periodic
payments, but its operating funds were obtained 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 described 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. As the activities were designed to eliminate 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) of the Code.

Situation 3 described an organization formed 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 was generally old and badly deteriorated. The organization developed an
overall plan for the rehabilitation of the area; it sponsored a renewal project; and
involved residents in the area renewal plan. The organization also purchased apartment
buildings 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 is described in section 501(c)(3) of the Code 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) of the Code
because the organization's program was not designed to provide relief to the poor or
further any other charitable purpose within the meaning of section 501(c)(3) and the
regulations.

Rev. Rul. 85-1, 1985-1 C.B. 177, holds that an activity is a burden of government only if
there is an objective manifestation by a governmental unit that it considers the activity
to be its burden. The ruling also provides that little weight should be given to
government officials th:at merely praise or express approval of an organization and its
activities. Instead, the government must formally recognize the organization and its
operations as relieving its burdens. Several factors set forth in the revenue ruling bear
on whether the governmental unit has made an objective manifestation. These factors

are:

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

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

e Astatute specifically creates the organization and clearly defines the
organization's structure and purposes.

e The activity is an integral part of a larger governmental program, or is acted
jointly with a governmental unit.

e The governmental unit controls the activities of the organization, for example by
appointing the board members.

e The organization pays governmental expenses.

e Regular government funding of the organization’s activities through grants or
general obligation bonds backed with the full faith and credit of the governmental
(as opposed to general revenue bond financing).

e The governmental unit is not prohibited from performing the particular activity.

Rev. Rul. 85-2, 1985-1C.B. 178, holds that an organization lessens the burden of
government if it engages in activities that a governmental unit considers to be its burden
and such activities actually lessen such governmental burden. An organization must
demonstrate through all the relevant facts and circumstances that a governmental unit
considers the organization to be acting on its behalf, thereby freeing up the government
assets that would otherwise be devoted to the particular activity.

In Columbia Park and Recreational Association, Inc. v. Commissioner, 88 T.C. 1
(1987), affd without published opinion 838 F.2d 465 (4th Cir. 1988), the court provided
that expending funds for services and items similar to those in the budget of a municipal
government is insufficient to establish that a governmental unit accepted the activities
as its responsibility.

In Public Industries, Inc. v. Commissioner, T.C. Memo 1991-3, the court stated that
even if a governmental unit considers an activity to be a proper governmental function,
an organization must establish that it has a solid relationship with the governmental unit
to support a finding that the organization was acting on the governmental unit's behalf.
On the issue of whether the organization's activities actually lessen the burdens of
government, the court noted that showing that an organization's activities might improve
general economic conditions or might reduce the negative consequences if the
activities are not conducted is not enough to demonstrate that organization's activities
actually lessen the government's burden.

In Quality Auditing Company, Inc. v. Commissioner, 114 T.C. 498 (2000), an
organization that developed a certification program for safe construction claimed that it
was lessening the burdens of government. Governmental agencies were among those
that requested that the organization develop the certification program. The court held
that the government's concem with obtaining high quality work in public construction
projects falls short of establishing that the government considers the certification

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

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

program to be its own responsibility and that the organization was acting on its behalf.
In addition, the court stated that even if the certification program lessened the burdens
of government, because it also conferred benefit on private owners and developers, it
furthered a substantial nonexempt purpose by lessening the burdens on private parties.

Even if an organization's activities serve a charitable class or are otherwise charitable
within the meaning of section 501(c)(3), to qualify for exemption from Federal income
tax under section 501(a) as on organization described in section 501(c){3), the
organization must demonstrate that its activities serve a public rather than a private
interest within the meaning of Reg. Section 1.501(c)(3)-1(d)(1). Rev. Rul. 72-147,
1972-1 C.B. 147, held that an organization that provided housing to low income families
did not qualify for exemption under section 501(c)(3) of the Code because it gave
preference to employees of a business operated by the individual who also controlled
the organization. The ruling reasoned that, although providing housing for low income
families furthers charitable purposes, doing so in a manner that gives preference to
employees of the founder's business primarily serves the private interest of the founder
rather than a public interest.

In KJ's Fund Raisers v. Commissioner, T.C. Memo 1997-424 (1997), affd, 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. The organization's 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.

An organization does not serve a public rather than a private interest within the
meaning of Reg. Section 1.501(c)(3)-1(d)(1) if any of its net earnings inure to the
benefit of any insiders. Treas. Reg. section 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 of

an organization's charitable assets. See People of God Community, 75 T.C. 127, 133

(1980). Payment of excessive compensation is a form of inurement. For example, in

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

ee

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

Mabee Petroleum Corp. v. U.S., 203 F.2d 872, 875 (5th Cir. 1953), the Fifth Circuit held
that the organization’s payment of a full-time salary for part-time work was inurement.

Receipt by an exempt organization of less than fair market value in a sale or exchange
of property with an insider is also a form of inurement. In Sonora Community Hospital
v. Commissioner, 46 T.C. 519 (1966), two doctors transferred their private practice of
medicine, including the building in which the practice was housed, to a non-profit
hospital they controlled. A portion of the building was occupied by a for-profit laboratory
under a prior agreement with the two doctors. The doctors caused the hospital to
acquiesce in the arrangement with the laboratory. The hospital received no
consideration for the assignment of its space to the laboratory either as part of the sale
or through a share of the laboratory's gross revenues. Payments in consideration of the
assignment that should have been paid to the hospital were paid directly to the two
doctors. The doctors performed no services for the laboratory. The Tax Court held that
the arrangement resulted in an inurement of the hospital's charitable assets to the two
doctors.

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 board of directors obtained
an independent appraisal of the hospital and hired independent counsel to represent
the organization. The closing, however, occurred almost two years after the appraisal.
The parties failed to make adjustments to the values established in the appraisal. The
Tax Court determined that the purchase price received by the organization on the sale
of the hospital was not within a reasonable range of what could be considered fair
market value. Accordingly, the Tax Court held that the sale transaction resulted in
inurement within the meaning of section 501(c)(3).

The provision of inurement can be direct or indirect. In Anclote Psychiatric Ctr., supra,
the sale transaction giving rise to the inurement was between an exempt organization
and a for-profit corporation formed by the organization's directors. 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.

In Church by Mail, Inc. v. Commissioner, 765 F.2d 1387 (9th Cir. 1985), the Ninth Circuit
treated as inurement compensation paid by a controlled entity to the organization's
insiders. In Church by Mail, two individuals, Reverend Ewing and Reverend McElrath,
ran a church that mailed printed sermons to several million homes. They also owned a
for-profit advertising agency which provided the Church's printing and mailing services.
The Ninth Circuit found that the combined compensation paid to Reverend Ewing and
Reverend McElrath by the Church and the advertising agency was excessive. The
Ninth Circuit rejected the Church's argument that the portion of the compensation paid

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

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

by the advertising agency should not be included in the determination of
reasonableness and treated this portion as indirect inurement of the Church's earnings
to the Church's insiders. Id. The Ninth Circuit based its conclusion on the following
legal principle: “[W]hen a second organization is created which serves to funnel income
to the individual who controls the purportedly exempt organization and the income
exceeds a reasonable salary, the income inures to the benefit of a private person within
the meaning of 1.R.C. section 501(c)(3).” Id.

Indirect inurement can occur even if the organization's insiders are not formally in
control of the intermediary used to funnel the funds from the organization to the
insiders. In Church of Scientology of California_v. Commissioner, 823 F.2d 1310, 1315

_ (9" Cir. 1987), 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. At the time
of the transfer, the founder and his wife were not directors, officers or employees of the
corporation. The founder was no longer serving as the head of the church but
continued to exert significant control over the church by making policy statements,
directives and orders. 823 F.2d at 1314. In particular, his approval was required for all
financial planning. /d. The directors of the corporation 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 organization's funds
funneled through the corporation constituted inurement to the founder and his family.
823 F.2d at 1318.

The prohibition on inurement in section 501(c)(3) is absolute. The Service 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, 412 F.2d 1197, 1202; Airlie
Foundation, 283 F. Supp. 2d 58. Moreover, for purposes of establishing that inurement
occurred, it is not necessary to calculate the precise amount of inurement as long as it
is shown that the value of the transfer giving rise to inurement is not within a reasonable
range of what could be considered fair market value. See Anclote Psychiatric Ctr. v.
Commissioner, T.C. Memo 1998-273.

An organization may ordinarily rely on a favorable determination letter received from the
Internal Revenue Service. Treas. Reg. §1.501(a)-1(a)(2). See also Rev. Proc. 2008-9,
An organization may not rely on a favorable determination letter, however, if the
organization omitted or misstated a material fact in its application or in supporting
documents. Id. In addition, 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 determination letter is issued. Id.

The Commissioner may revoke a favorable determination letter for good cause. Treas.
Reg. § 1.501(a)-1(a)(2). Revocation of a determination letter may be retroactive if the

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

ee

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

organization omitted or misstated a material fact or operated in a manner materially
different from that originally represented. Id.

ANALYSIS
ISSUE 1

XXX does not qualify as an organization described in I.R.C. section 501(c)(3) because it
operates a program that:

1. does not exclusively serve an exempt purpose described in section 501(c)(3);

2. provides substantial private benefit to persons who do not belong to a charitable
   class, and;

3. results in inurement of a substantial portion of it’s net earnings to the benefit of
   the founders and original board members of the exempt organization.

Charitable purposes include relief of the poor and distressed. See section 1.501(c)(3)-
1(d)(2) of the regulations. XXX's down payment assistance program does not operate
in a manner that establishes that its primary purpose is to address the needs of low-
income people by enabling low-income individuals and families to obtain decent, safe
housing. See Rev. Rul. 70-585, Situation 1. The down payment assistance program
did not serve exclusively low-income persons. Despite the representations in its
application for exemption, XXX does not have any income limitations for participation in
its DPA program. Instead, the program is open to anyone, without any income
limitations, who otherwise qualified for these loans. The program is not even limited to
' first-time homebuyers as XXX stated in its intentions on its Form 1023.

XXX's DPA program does not limit assistance to certain geographic areas or target
those areas experiencing deterioration or neighborhood tensions. See Rev. Rul. 70-
585, Situation 4. Down payment assistance is available for any property that is
otherwise able to qualify for a mortgage. Arranging or facilitation for 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) of the

• Code.

Only an insubstantial portion of the activity of an exempt organization may further a
nonexempt purpose. As the Supreme Court held in Better Business Bureau of
Washington D.C.., Inc. v. United States, 326 U.S. 279, 283 (1945), 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 XXX’s DPA
program were directed to exclusively low-income individuals or disadvantaged
communities, XXX's total reliance for financing its DPA activities on home sellers or
other real-estate related businesses standing to benefit from the transactions

Form 886-A(Rev.4-68) Department of the Treasury - Internal Revenue seni.
‘age: -

Form 886A Department of the Treasury - Internal Revenue Service | Schedule No. or

Explanation of items Exhibit
Year/Period Ended

Name of Taxpayer

-

demonstrates that the program is operated for the substantial purpose of benefiting
private parties.

Like the organization considered in American Campaign Academy v. Commissioner, 92
T.C. 1053 (1989), XXX is structured and operated to assist the private parties who fund
it and give it business. Sellers who participate in XXX's DPA program benefit from
achieving access to a wider pool of buyers, thereby decreasing their risk and the length
of time the home is on the market. They also benefit by being able to sell their home at
the home's full listed price or by being able to reduce the amount of the negotiated
discount on their homes. Buyers who participate in XXX's DPA program benefit by
being able to purchase a home without having to commit more of their own funds. Real
estate professionals who participate in XXX's DPA program, from real estate brokers to
escrow companies, benefit from increased sales volume and the attendant increase in
their compensation. It is evident from the foregoing that XXX's DPA program provides
ample private benefit to the various parties in each home sale.

The manner in which XXX operated its DPA program shows that the private benefit to
the various participants in XXX's activities was the intended outcome of XXX's
operations rather than a mere incident of such operations. XXX's down payment
assistance procedures are designed to channel funds in a circular manner from the
sellers to the buyers and back to the sellers in the form of increased home prices. To
finance its down payment assistance activities, XXX relies exclusively on sellers and
other real-estate related businesses that stand to benefit from the transactions it
facilitates. XXX neither solicits nor receives funds from other sources. Before providing
down payment assistance, XXX's grantmaking staff takes into account whether there is
a home seller willing to make a payment to cover the down payment assistance the
applicant has requested. XXX requires the home seller to reimburse it, dollar-for-dollar,
for the amount of funds expended to provide down payment assistance on the seller's
home, plus an administrative fee of 8 or$ perhome sale. XXX secures an
agreement from the seller stipulating to this arrangement prior to the closing. No DPA
assistance transactions take place unless XXX is assured that the amount of the down
payment plus the fee is or will be paid by the seller upon closing. XXX's instructions to
title and escrow companies provide that at the close of escrow the seller's contribution,
along with any XXX fees, must be sent to XXX. XXX's receipt of a payment from the
home seller corresponding to the amount of the down payment assistance in virtually
every transaction indicates that the benefit to the home seller (and others involved in
the transaction) is not a mere accident but rather an intended outcome of XXX’s
operations. In this respect, XXX is like the organization considered in Easter House
which provided health care to indigent pregnant women, but only when a family willing
to adopt a woman’s child sponsored the care financially.

XXX's promotional material and its marketing activities show that XXX operated in a
manner consistent with a commercial firm seeking to maximize sales of services, rather
than in a manner that would be consistent with a charitable or educational organization

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

Form 886A

Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of items Exhibit
Name of Taxpayer Year/Period Ended

=?

seeking to serve one or more of the charitable purposes enumerated in section
501(c)(3). The manner in which XXX operated its DPA program shows that XXX was in
the business of facilitating the sales of homes in a manner indistinguishable from an
ordinary trade or business. In this respect XXX's operations were similar to an
organization which was denied exemption because it operated a conference center for
commercial purposes. See Airlie Foundation v. Commissioner, 283 F. Supp. 2d 58
(D.D.C., 2003).

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, 71 T.C.
202 (1978), XXX's trade or business was not utilized as a mere instrument of furthering
charitable purposes but was an end in itself. XXX provided services to home sellers for
which it charged a market rate fee. XXX did not market its services primarily to persons
within a charitable class. XXX's primary goal consisted of maximizing the fees it
derived from facilitating the sales of real property. XXX did not solicit or receive any
funds from parties that did not have interest in the down payment transactions. Like the
organizations considered in American Campaign Academy, supra, and Easter House v.
U.S., 12 Cl. Ct. 476, 486 (1987), affd, 846 F.2d 78 (Fed. Cir.) a substantial part of
XXX's activities furthered commercial rather than exempt purposes. XXX is
substantially similar to example 2 of Rev. Rul. 2006-27.

Furthermore, XXX's activities were structured to provide substantial private benefit to
XXX's insiders. Facts establish that XXX and XXX entered into a marketing agreement,
effective(January 1, 2001) Under the terms of the agreement XXX performed all of the
marketing and processing for the DPA activities of XXX. The agreement called a fee
equal to 75% of the seller service fee paid by the seller to XXX. Every grant made by
XXX was deemed attributable to marketing services provided by XXX, therefore, XXX
received a fee from every grant transaction made by XXX. For the years at issue, XXX
was the source of substantially all of XXX's gross revenues. Like the organization in
KJ's Fund Raisers, supra, XXX's operations resulted in a substantial private benefit to
XXX's insiders. ,

XXX's operations also resulted in inurement to insiders, XXX, XXX and XXX who are
the sole shareholders of XXX. Inthe yearended December ,20 XXX paid to XXX
a marketing service fee of $ and in the yearended December ,20 _ they
paid a marketing service fee of $ . Ina valuation report prepared by XXX,
CPA, CVA, Valuation/Economist Specialist of the Internal Revenue Service, dated April
, 20 , the fair market service fee for the 20 year was determined to be $ |
and forthe 20 year the fee was $ . The excess marketing fees paid to XXX
allowed the for-profit S Corporation to accumulate a large net income and constitutes
inurement of XXX’s assets to the benefit of the three insiders.

XXX's operaticns are the same as those of organization Y in Situation 2 of Rev. Rul.
2006-27. Under that revenue ruling, which is controlling in this case, Y does not

Form 886-A(Rev.4-68) Department of the Treasury - Internal Revenue Service
age: -17-

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

operate exclusively for a charitable purpose but instead operates primarily for the
private benefit of other participants in the home sales transactions it facilitates. For the
same reasons that Y is held not to be exempt in Rev. Rul. 2006-27, XXX is not exempt
as an organization described in section 501({c)(3).

XXX's (“ *) program does not meet the operational test
set forth in Treas. Reg. § 1.501(c)(3)-1(c) because its program is nearly identical to the
program discussed in situation 2 of Rev. Rul. 2006-27. Rev. Rul. 2006-27 articulates
the Service's position on when an organization that provides down payment assistance
operates in a manner that is consistent with section 501(c)(3), and when it does not. In
Rev. Rul. 2006-27, the IRS held that an organization that relies on funding primarily
from home sellers to provide downpayment assistance to home buyers is not operated
exclusively for charitable purposes. Just like organization Y in situation 2 of the
revenue ruling, the critical aspect of XXX's operations is the receipt of a payment from
the home seller corresponding to the amount of its downpayment assistance.

Rev. Rul. 2006-27 is factually on point, and it is controlling in this case.

In addition, Rev. Rul. 2006-27 restates existing applicable law in effect at the time XXX
began and operated its Down Payment Assistance (DPA) program. Therefore, even if
there were not a revenue ruling directly on point, XXX fails to meet the requirements set
forth in the Internal Revenue Code and in Treasury Regulations. As discussed below,
like Y in Situation 2, XXX is not operated exclusively for charitable purposes, and as
discussed below, like Y, more than an insubstantial part of its activities is not in
furtherance of an exempt purpose.

Rev. Rul. 2006-27 sets forth the Service's position on applicable rules and standards
for determining whether organizations that provide down payment assistance to home
buyers qualify as tax-exempt organizations described § 501(c)(3). Revenue rulings are
binding on the Service and constitute formal statements of policy and the official
position of the Internal Revenue Service on the application of existing tax law to specific
facts. See Tualatin Valley Builders Supply, Inc. y. United States, 2008-1 USTC 50,280
(9" Cir. April 10, 2008)" citing Omohundro v. United States, 300 F.3d 1065 (9"" Cir.

kkk

" Actually, XXX's operations are even more egregious than the organization described in situation 2 of the
revenue ruling. In situation 2, only low income homebuyers received down payment assistance. Under
XXX's program there are no income limitations. Any homebuyer is able to receive down payment
assistance from XXX as long as the home buyer buys a home from a seller that has enrolled the home
with XXX's program.

• The 9" Circuit in Tualatin Valley describes an IRS revenue ruling in the tollowing manner:

A revenue ruling is “an official interpretation by the Service that has been published in the

Internal Revenue Bulletin ... for the information and guidance of taxpayers, Internal

Revenue Service officials, and others concerned.” Statement of Procedural Rules §

601.601(d)(2)(i)(a). Revenue rulings “do not have the force and effect of Treasury

Department Regulations ..., but are published to provide precedents to be used in the
footnote continues next page

Form 886-A(Rev.4-68) Department of the Treasury - Internal Reven us Service
‘age: -18-

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

2002); Sidell v. Commissioner, 225 F.3d 103, 111 (5th Cir. 2000); and Weisbart v. U.S.
Dep't of Treasury, 222 F.3d 93, 98 (2™ Cir. 2000).

Situation 1 of Rev. Rul. 2006-27 describes an organization whose activities exclusively
further a charitable purpose and do not confer more than incidental private benefit, and
therefore qualifies for tax exemption. Situation 2 describes an organization that does
not qualify as a tax-exempt organization because its activities do not exclusively further
a charitable purpose, and the substantial private benefit it confers on home sellers and
its commercial focus overshadow any charitable purposes served. XXX's down
payment assistance activities lack even the favorable elements described in both
Situations 1 and 2, and include all of the problematic elements flagged by Situation 2.
Therefore, XXX does not qualify for tax exemption.

In both Situation 1 and Situation 2, the organizations were conducting the following
activities which are consistent with tax exempt status. XXX lacks all of these favorable
elements:

e Making assistance available exclusively to low-income individuals (XXX's
program is open to everyone, regardless of their income or assets).

e Using a standard, such as the standards set by Federal housing statutes and
administered by the Department of Housing and Urban Development, to
determine who is a low-income individual. (XXX's program does not use any
standards to determine who is a low-income individual; it is open to everyone,
regardless of their income or assets).

e Providing assistance to low-income individuals who have the employment history
and financial history necessary to qualify for a mortgage, and would so qualify
but for the lack of a down payment. (XXX does not limit its assistance to low-
income individuals who would otherwise be able to purchase a home and qualify
for a mortgage but for the lack of a down payment.)

e Offering financial counseling seminars and conducting other educational
activities to help prepare potential low-income home buyers for the responsibility
of home ownership. (XXX does not offer financial counseling seminars and does
not conduct other educational activities to help prepare potential low-income
home buyers for the responsibility of home ownership, other than posting
educational information about homeownership on its website.)

continued footnote
disposition of other cases, and may be cited and relied upon for that purpose.” §
601.601(d)(2)(v)(d).

Form 886-A(Rev.4-68) Department of the Treasury - Internal Revenue Service
age: -19-

Form 886A Department of the Treasury - Internal Revenue Service | Schedule No. or |

Explanation of Items Exhibit

Name of Taxpayer | Year/Period Ended

Establishing that a home purchased through the program meets standards for
habitability by requiring a home inspection report. (XXX does not attempt to
establish that a home purchased through the DPA program is habitable, and
does not require a home inspection report.)

In the areas where Situations 1 and 2 differ, XXX lacks all of the favorable elements
described in Situation 1 and goes beyond the negative elements described in Situation

2.

‘ identities of any other parties who may receive a financial benefit from the sale, it

In Situation 1, X organization conducted a broad based fundraising program that
attracted gifts, grants and contributions from several foundations, businesses,
and the general public to fund its down payment assistance program and other
activities. In Situation 2, Y organization did not conduct a broad based
fundraising campaign to attract financial support but rather was supported mostly
from the home sellers and real estate-related businesses that may benefit from
the sale of homes to buyers who received Y’s downpayment assistance. Like Y,
XXX does not conduct a broad based fundraising program that attracts gifts,
grants and contributions; instead, it relies almost exclusively on payments from
its client home sellers, which are contingent on the sale of particular properties.

In Situation 1, X organization structured the grantmaking process in a way to
ensure that its grantmaking staff did not know the identity of the party selling the
home to the grant applicant or the identities of any other parties, such as real
estate agents or developers, who may receive a financial benefit from the sale;
and also did not know whether any of the interested parties to the transaction
had been solicited for contributions or had made pledges or actual contributions:
to the organization. In Situation 2, Y organization's staff considering an
application for downpayment assistance knew the identity of the party selling the
home to the applicant and sometimes also knew the identities of other parties,
such as real estate agents and developers, who may receive a financial benefit
from the sale. Even worse than situation 2, XXX's staff not only knew the identity
of the party selling the home to the downpayment assistance applicant and the

contractually required such interested parties to make payments to the
organization that would cover the “assistance” provided to the buyer, plus XXX's

service fees.

in Situation 1, X organization did not accept any contributions contingent on the
sale of a particular property or properties. In Situation 2, in substantially all of the
cases in which Y organization provided down payment assistance to a home
buyer, Y received a payment from the home seller, and there was a direct
correlation between the amount of the down payment assistance provided by Y
and the amount of the home seller's payment to Y. Even worse than Situation 2,
in every situation where XXX's transfers funds to a buyer, it has previously

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

Page: -20-

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

contractually required the home sellers to make a payment that would cover the
“assistance” provided, plus XXX’s service fees.

In Rev. Rul. 2006-27, Situation 2, the Service concluded that Y organization did not
qualify for exemption from federal income tax as an organization described in
§501(c)(3). As described above, XXX's operations are even further removed from
being charitable than those described in Situation 2; thus, XXX does not qualify for
exemption from federal income tax as an organization described in §501(c)(3).

ISSUE 2

An organization may not rely on a favorable determination letter if the organization
omitted or misstated a material fact in its application or in supporting documents. See
Rev. Proc. 2008-9. In addition, 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 determination
letter is issued. Id. The examination of XXX's operations revealed that XXX omitted or
misstated material facts in its Form 1023 and that the organization operated materially
different from the representations the organization made to the Service on its Form
1023 and subsequent filings.

First, XXX entered into a series of marketing relationships with XXX, a for profit entity,
that resulted in the inurement of its net earnings to individuals, mainly XXX's founders,
XXX, XXK and XXX.

Second, XXX operated contrary to its representations on Form 1023 that it would
provide grants to, “first-time homebuyers who meet certain criteria. These grants can
be used for their downpayment and/or closing costs to help them purchase their first
home.” In fact, XXX did not limit eligibility for its DPA program to first-time home
buyers. Moreover, its operations show that the DPA program was open to any one who
qualified for a FHA loan, regardless of a homebuyer's income, status as the first-time
homebuyer, or the location of a participating home. XXX did nothing to ensure that the
homebuyers would in fact be able to afford the homes purchased through its program
or that the homes were safe.

Section 501(c)(3) of the Code and the regulations thereunder establish certain tests
that an organization must meet to qualify for tax-exempt status. One of the tests is the
prohibition on inurement of the organization's net earnings to the benefit of any private
shareholder or individual. See IRC § 501(c)(3), Treas. Reg. § 1.501(c)(3)-1(c)(2).
Section 4958 of the Code imposes certain excise taxes on excess benefit transactions
that provide excess economic benefits to certain disqualified persons with respect to
public charities described in sections 501(c)(3). The term “excess benefit transaction”
includes, but is potentially broader than, the term “inurement.” See IRC § 4958(c)(4).

Form 886-A(Rev.4-68) Department of the Treasury - Internal Revenue seis
age: -21-

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

XXX admits that a portion of its net earnings inured to the private benefit of XXX and its
shareholders.

In the 1996 House Report on section 4958, Congress stated that “intermediate
sanctions for excess benefit transactions may be imposed by the IRS in lieu of (or in
addition to) revocation of the organization's tax-exempt status.” H. Rep. No. 104-506,
104" Cong., 2d Sess., at 59 (1996) (emphasis added). The Report also stated, ina
footnote, that, in general, revocation of tax-exempt status, with or without the imposition
of excise taxes, would occur only if an organization no longer operates as a charitable
organization. H. Rep. No. 104-506, 104" Cong., 2d Sess., at 53, 59, note 15.

The implementing regulation, Treas. Reg. § 1.501(c)(3)-1(f)(2), became effective on
March 28, 2008 for excess benefit transactions occurring after March 28, 2008.

Although the regulation was not effective at the time the transactions in this case
occurred, it provides a framework for analysis and is helpful in applying previously
existing general principles to this case. The regulation states that the IRS will consider
all relevant facts and circumstances in determining whether to combine revocation of
exempt status with intermediate sanctions. Five factors are listed, but the list is not
exhaustive and the Service can take into account the many unique factors that may
arise in any given case or affect the Service's ultimate discretion on the issue of
revocation. Id. An application of the five factors to this case makes it clear that
revocation of XXX’s exempt status is appropriate, even with the imposition of excess
benefit taxes.

The first factor looks to the size and scope of XXX's activities furthering an exempt
purpose. XXX did not operate to further an exempt purpose, so this factor weighs in
favor of revocation. The second factor looks to the size and scope of the excess
benefit transactions relative to the size and scope of the exempt purpose activities.
Again, XXX did not operate to further an exempt purpose. Therefore, its excess benefit
transactions are not offset or put into any kind of perspective by an extensive record of
charitable activities. Thus, the second factor also weighs in favor of revocation.

XXX argues that the third, fourth, and fifth factors listed in the regulation weighed
against revocation, because XXX it implemented safeguards to prevent future excess
benefit transactions, and it made good faith efforts to seek correction from the
disqualified persons involved. XXX can be given credit for the pre-audit voluntary
compliance it made in this regard. The third, fourth and fifth factors could help to
compensate for excess benefit transactions conducted by an organization that
otherwise qualified for exemption. However, because XXX’s activities failed to further
an exempt purpose in the first place, it does not qualify for tax exempt status.

Consistent with the legislative history to section 4958, the final regulations under
section 4958 provide that the substantive requirements for exemption under § 501 (c)(3)
still apply even if an organization engages in transactions that are also subject to excise

Form 886-A(Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -22-

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

taxes under § 4958. Treas. Reg. § 1.501(c)(3)-1(f)(2). Unlike the heaith care
organizations in Caracci v. Commissioner, 456 F.3d 444 (5th Cir. 2006), XXX did not
otherwise engage in substantial activities that furthered a charitable purpose. Remedial
actions taken by XXX, although commendable, do not negate this fact. Therefore,
revocation in response tc the inurement is appropriate.

Revocation of an organization's determination letter recognizing exempt status may be
retroactive if the organization omitted or misstated a material fact, operated in a manner
materially different from that originally represented, or engaged in a prohibited
transaction for the purpose of diverting corpus or income from its exempt purpose, and
if the transaction involved a substantial part of the corpus or income of the organization.
See The Statement of Procedural Rules § 601.201(n)(6)(i). XXX made several material
misstatements on its application for exemption, justifying a retroactive revocation.
These include, but are not limited to, misstatements about how XXX would help only
first-time homebuyers obtain downpayments and that the organization would be:
“targeting those members of the community at the lower end of the income scale . . .”

In addition, XXX misstated and omitted material facts concerning its financial support
sources. On Form 1023, XXX indicated that its ability to provide Grants would be,
“predicated on contributions received by the organization from community businesses,
private individuals, or government entities. Hopefully, we can help many worthy
families.” Form 1023, Part 1, Statement 1. In fact, XXX had only one main source of
financial support -- sellers’ contingent payments.

XXX has not operated consistently with some of the statements made in the
application, and its operations are materially different from what was described.
Consequently, it is appropriate to revoke XXX's determination letter recognizing it as a
tax-exempt organization described back to effective date of the determination letter.
Moreover, revocation in this case is both retroactive and prospective.

CONCLUSION

In order to qualify for exemption under IRC section 501(c)(3) an organization must be
both organized and operated to achieve a purpose that is described under that Code
section. XXX's DPA program is not operated in accordance with Internal Revenue
Code section 501(c)(3) and the regulations there under governing qualification for tax
exemption under the Code. XXX provides down payment assistance, purportedly in the
form of a gift, to individuals and families for the purchase of a home. XXX offers its
down payment assistance to interested buyers regardless of the buyers’ income levels
orneed. XXX's DPA activities do not target neighborhoods in need of rehabilitations or
other relief such as lessening neighborhood tensions or eliminating prejudice and
discrimination.

Form 886-A(Rev.4-68) Department of the Treasury - Internal Revenue Service
age: -23-

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

a

XXX operates in a manner indistinguishable from a commercial enterprise. XXX's
primary activity is brokering transactions to facilitate the selling of homes. XXX's
primary goal is to maximize the fees from these transactions. XXX's brokering services
are marketed to homebuyers, sellers, realtors, lenders, home builders, and title
companies regardless of the buyers’ income level or need and regardless of the
condition of the community in which the home is located. Alliances are built with the
realtors, lenders, home builders, and title companies to assure future business for the
mutual benefit of the participants. There are no roof certifications, homeowner's
warranties or home buyer's education required for buyer or seller participation in the
program. XXX has no standards for habitability, and home inspection reports are not
required for participation in the program. XXX does not engage in any counseling or
other activities that further charitable purposes. Because XXX's primary activity is not
conducted in an manner designed to further section 501(c)(3) purposes, XXX is not
operated exclusively for exempt purposes within the meaning of section 501(c)(3).

In addition, XXX's activities have resulted in inurement of charitable assets to XXX's
insiders. Under the terms of a marketing agreement XXX had with XXX all of the DPA
activities of XXX were carried out through XXX. For the years at issue, XXX was the
source of substantially all of XXX's gross revenue and existed for a substantial
nonexempt purpose of creating a market for XXX. The marketing fees paid by XXX to .
XXX have been determined to be excessive by a Valuation/Economist Specialist of the
Internal Revenue Service and resulted in substantial private benefit to XXX and
inurement to the three owners of XXX,XXX, XXX and XXX.

For the foregoing reasons, revocation of exempt status is proposed. The facts show
that in 20 and20 XXX operated in a manner materially different from that
represented in its form 1023 application the government proposes that the revocation
be effective retroactively to the date of the organization's inception, July , 19

TAXPAYER'S POSITION
XXX's position with respect to the issues, facts, applicable law and government's

position as discussed in this report is unknown. XXX will be allowed 30 days to review
this report and respond with their position.

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