Written determination 1244021: IRS denies tax exemption to a proposed nonprofit benefiting its founder and a for-profit company

Plain-English summary

The IRS denied a nonprofit corporation's application for recognition of tax exemption under IRC § 501(c)(3). The organization did not provide enough information about its proposed activities or its Articles of Incorporation, planned commercial activities, or relationship with a founder's for-profit company. The IRS concluded that the organization would not satisfy the organizational and operational tests and that its earnings could benefit the founder and the related for-profit company. The IRS also stated that donors could not deduct contributions under IRC § 170 and that the organization had protest and court rights described in the letter.

Ruling snapshot

• Question: Did the proposed nonprofit qualify for recognition of exemption under IRC § 501(c)(3)?
• Outcome: Denied
• Key authorities: IRC §§ 170, 501(a), 501(c)(3), 6104, and 7428; Treas. Reg. §§ 1.501(a)-1(c), 1.501(c)(3)-1(a)(1), 1.501(c)(3)-1(b)(1), 1.501(c)(3)-1(c)(2), and 1.501(c)(3)-1(d)(1)(ii)

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Number: 201244021 Contact Person:
Release Date: 11/2/2012

Identification Number:
Date: August 9, 2012

Contact Number:

Employer Identification Number:
Form Required To Be Filed:

Tax Years:
UIL: 501.00-00; 501.03-00; 501.03-05; 501.32-00;
501.33-00

Dear

This is our final determination that you do not qualify for exemption from Federal income tax
under Internal Revenue Code section 501(a) as an organization described in Code section
501(c)(3).

We made this determination for the following reason(s):

First, you failed to provide sufficient information in your Application to enable us to determine
that you are eligible for recognition of exempt status. Second, you failed the organizational test
because you did not provide a copy of your Articles of Incorporation. You also fail the
operational test because you will be engaging in activities that are commercial and do not have
an exempt purpose. Third, you will impermissibly operate for the benefit of your founder and his
for-profit entity. Finally, your net earnings will likely inure to the benefit of your founder.

Because you do not qualify for exemption as an organization described in Code section
501(c)(3), donors may not deduct contributions to you under Code section 170. You must file
Federal income tax returns on the form and for the years listed above within 30 days of this
letter, unless you request an extension of time to file. File the returns in accordance with their
instructions, and do not send them to this office. Failure to file the returns timely may result in a
penalty.

If you decide to contest this determination under the declaratory judgment provisions of Code
section 7428, you must initiate a suit in the United States Tax Court, the United States Court of
Federal Claims, or the District Court of the United States for the District of Columbia before the
91st day after the date that we mailed this letter to you. Contact the clerk of the appropriate
court for rules for initiating suits for declaratory judgment. Filing a declaratory judgment suit
under Code section 7428 does not stay the requirement to file returns and pay taxes.

We will make this letter and our proposed adverse determination letter available for public
inspection under Code section 6110, after deleting certain identifying information. Please read

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the enclosed Notice 437, Notice of Intention to Disclose, and review the two attached letters that
show our proposed deletions. If you disagree with our proposed deletions, you should follow

the instructions in Notice 437. If you agree with our deletions, you do not need to take any
further action.

If you have any questions about this letter, please contact the person whose name and
telephone number are shown in the heading of this letter. If you have any questions about your
Federal income tax status and responsibilities, please contact IRS Customer Service at
1-800-829-1040 or the IRS Customer Service number for businesses, 1-800-829-4933. The
IRS Customer Service number for people with hearing impairments is 1-800-829-4059.

Sincerely,

Lois G. Lerner
Director, Exempt Organizations

Enclosure
Notice 437

Redacted Proposed Adverse Determination Letter
Redacted Final Adverse Determination Letter

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

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Date: October 25, 2011 Contact Person:

identification Number:
Uniform Issue List:
501.00-00 Contact Number:
501.03-00
501.03-05 FAX Number:
501.32-00
501.33-00 Employer Identification Number:

LEGEND

For-profit
Environmental issues
Business issue
Medical Projects
Environmental Projects
Military Projects

Dear

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

FACTS

You, Taxpayer, are a non-profit corporation formed in State1 on Date1. You submitted a Form
1023 seeking recognition of exemption under § 501(c)(3) on Date2.

You submitted a “Certificate of Incorporation” issued by State1 and dated Date1 but did not
provide a copy of your Articles of Incorporation. You also submitted certification from State2
showing that you are registered as a foreign nonprofit corporation in State2. You did not adopt
Bylaws and although you stated that you adopted a conflict of interest policy, you did not
provide a copy.

You indicated in your application that you would be engaged in a variety of activities. You
stated that you would engage in economic development, operate as a cooperative hospital

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service organization under § 501(e), operate as a charitable risk pool under § 501(n), operate a
school, provide hospital or medical care, provide low-income housing or housing for the elderly
or handicapped, provide scholarships, fellowship, educational loans, or other educational grants
to individuals, and that you will simultaneously be a publicly supported charity and a private
operating foundation.

You partially completed various schedules for the Form 1023, including Schedule B (schools,
colleges, and universities), Schedule C (hospitals and medical research organizations),
Schedule D (509(a)(3) supporting organizations), Schedule E (organizations not filing Form
1023 within 27 months of formation), Schedule F (homes for the elderly or handicapped or low-
income housing), Schedule G (successors to other organizations), and Schedule H
(organizations providing scholarships, fellowships, educational loans, or other educational
grants to individuals and private foundations requesting advance approval of individual grant
procedures).

You also submitted a copy of your business plan. In this document, you list several of your
objectives. These include demanding changes to laws regarding Environmental issues and a
Business issue. You also state that your purposes include stopping venture capitalists, Medical
projects, building affordable residential homes, providing disaster relief, and preventing divorce.
You also provide that you will create a prison and develop new Environmental projects and
Military projects.

You have a close relationship with For-profit. That organization shares its director and founder,
Founder, with you. In your business plan, you make repeated reference to For-profit and its
activities and products. You also filled out Schedule D of the Form 1023 and stated that your
supported organization is For-profit. On Schedule D, you provided that you will distribute at
least 85% of your income to For-Profit. You also included with your application a single
“charter” document for both you and For-profit. You state that you “started” with For-profit, but
“decided to start a wonderful NPO Exempt Corporation” because you “failed to secure [your]
funding.”

On your Application and supporting documentation, you list Founder as your founder, CEO, and
chairman. You listed no other officers, directors, trustees, or employees. You stated that
Founder’s annual actual or estimated compensation is $250,000.

LAW

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

Section 1.501(c)(3)-1(a)(1) of the Income Tax Regulations (“regulations”) provides that, in order
to be exempt as an organization described in section 501(c)(3), an organization must be both
organized and operated exclusively for one or more of the purposes specified in such section. If
an organization fails to meet either the organizational test or the operational test, it is not
exempt.

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Section 1.501(c)(3)-1(b)(1) of the regulations provides that an organization is organized
exclusively for one or more exempt purposes only if its articles of organization contain specific
language enumerated in this section.

Section 1.501(c)(3)-1(b)(1)(i) of the regulations states that an organization is organized
exclusively for one or more exempt purposes only if its articles of organization (a) limit the
purposes of such organization to one or more exempt purposes, and (b) do not expressly
empower the organization to engage, otherwise than as an insubstantial part of its activities, in
activities which in themselves are not in furtherance of one or more exempt purposes.

Section 1.501(c)(3)-1(b)(1)(iii) of the regulations states that an organization is not organized
exclusively for one or more exempt purposes if its articles expressly empower it to carry on,
otherwise than as an insubstantial part of its activities, activities which are not in furtherance of
one or more exempt purposes, even though such organization is, by the terms of such articles,
created for a purpose that is no broader than the purposes specified in § 501(c)(3). Thus, an
organization that is empowered by its articles “to engage in a manufacturing business” or, “to
engage in the operation of a social club” does not meet the organizational test regardless of the
fact that its articles may state that such organization is created “for charitable purposes within
the meaning of” § 501(c)(3).

Section 1.501(c)(3)-1(b)(1)(iv) of the regulations states that in no case shall an organization be
considered to be organized exclusively for one or more exempt purposes, if, by the terms of its
articles, the purposes for which such organization is created are broader than the purposes
specified in § 501(c)(3).

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(a)-1(c) of the regulations defines
the words “private shareholder or individual” in § 501 to refer to persons having a personal and
private interest in the activities of the organization.

Section 1.501(c)(3)-1(d)(1)(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, to meet the requirements of this subsection, 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.

Rev. Proc. 75-50, 1975-2 C.B. 587 sets forth guidelines and recordkeeping requirements
regarding racially nondiscriminatory policies for private schools that are applying for recognition
of exemption under § 501(c)(3).

Rev. Proc. 2011-9, 2011-2 I.R.B. 283, section 4.03 provides that exempt status may be
recognized in advance of the organization's operations if its proposed operations are described
in sufficient detail to permit a conclusion that it will clearly meet the particular requirements for
exemption pursuant to the section of the Code under which exemption is claimed. Section
4.03(2) states that the organization must fully describe all of the activities in which it expects to
engage, including the standards, criteria, procedures or other means adopted or planned for

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carrying out the activities, the anticipated sources of receipts, and the nature of contemplated
expenditures.

In Better Business Bureau of Washington D.C., Inc. v. United States, 326 U.S. 279 (1945), the
Supreme Court held that 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.
The Court found that a trade association had an "underlying commercial motive" that
distinguished its educational program from that carried out by a university, and therefore, the
association did not qualify for exemption.

In Church by Mail v. Commissioner, 765 F.2d 1387 (9th Cir. 1985), affg 48 T.C.M. (CCH) 471
(1984), the court found that it was unnecessary to consider the reasonableness of payments
made by the applicant to a business owned by its officers. The court noted that “the critical
inquiry is not whether particular contractual payments to a related for-profit organization are
reasonable or excessive, but instead whether the entire enterprise is carried on in such a
manner that the for-profit benefits substantially from the operation of the Church.”

The organization has the burden of providing sufficient documentation or other substantive
information regarding its activities and operations, which would establish entitlement to tax
exempt status, including establishing that its net earnings will not inure to the benefit of private
individuals and that it will not serve private interests. See, e.g. Harding Hospital, Inc. v. United
States, 505 F.2d 1068 (6th Cir. 1974); Founding Church of Scientology v. United States, 412
F.2d 1197, 1200, 1202 (Ct.Cl. 1969); Church of Technology v. United States, 26 Cl.Ct. 713, 737
(1992); Share Network Foundation v. Commissioner, 78 T.C.M. (CCH) 6 (1999).

New Dynamics Foundation v. United States, 70 Fed. Cl. 782 (2006), was an action for
declaratory judgment that the petitioner brought to challenge the denial of his application for
exempt status. The court, in finding that the actual purposes displayed in the administrative
record supported the Service’s denial, stated “It is well-accepted that, in initial qualification
cases such as this, gaps in the administrative record are resolved against the applicant.”

The court noted that if the petitioner had evidence that contradicted these findings, it should
have submitted it as part of the administrative process. The court also highlighted the principle
that exemptions from income tax are matters of legislative grace.

In Bubbling Well Church of Universal Love v. Commissioner, 74 T.C. 531, 534-535 (1980) aff'd,
670 F.2d 104 (9th Cir. 1980), the Tax Court explained that an organization that is closely-
controlled by related individuals must clearly demonstrate that private interests will not be
served and that net earnings will not inure to the benefit of insiders. Given the control over the
petitioner organization by related individuals, the court could not conclude “from the information
in the administrative record that part of the net earnings did not inure to the benefit of the
[controlling] family or, stated another way, that petitioner was not operated for the [family’s]
private benefit.” In reaching this conclusion, the court noted that the situation:

. calls for open and candid disclosure of all facts bearing upon petitioner's
organization, operations, and finances so that the Court, should it uphold the
claimed exemption, can be assured that it is not sanctioning an abuse of the
revenue laws. If such disclosure is not made, the logical inference is that the facts,
if disclosed, would show that petitioner fails to meet the requirements of section
501(c)(3).

In La Verdad v. Commissioner, 82 T.C. 215 (1984), an organization was formed to provide
education and charity, but failed to provide sufficient details regarding its proposed operations.
The court held that it failed to prove that it would operate exclusively for exempt purposes under
§ 501(c)(3) of the Code.

In Church of Eternal Life and Liberty, Inc. v. Commissioner, 86 T.C. 916 (1986), the court held
that a church with only two members was not eligible for recognition of tax exemption because
its net earnings inured to the benefit of one of these members. The court noted that where an
individual or small group has exclusive control over the management of the organization’s funds
and is the principal recipient of the distributions of the organization, prohibited inurement is
strongly suggested.

In American Science Foundation v. Commissioner, 52 T.C.M. (CCH) 1049 (1986), the Court
determined that an organization was not eligible for recognition of tax exemption because it
failed to provide sufficient information to permit the conclusion that its activities will be
exclusively in furtherance of exempt purposes.

RATIONALE

To qualify for exemption under § 501(c)(3), a taxpayer must demonstrate that it is both
organized and operated exclusively for exempt purposes and that no part of its earnings inure to
private individuals. § 501(c)(3); § 1.501(c)(3)-1(a)(1). You have not demonstrated that you are
organized and operated for exclusively exempt purposes. Additionally, your assets and income
may inure to the benefit of your Founder and For-profit. Therefore, we can not recognize you as
exempt from taxation. See § 501(c)(3); § 1.501(c)(3)-1(d)(1)(ii).

To be organized exclusively for exempt purposes, an organization’s articles of organization
must limit its purposes to one or more exempt purposes, and must not expressly empower the
organization to engage, other than as an insubstantial part of its activities, in activities which do
not further one or more exempt purposes. §§ 1.501 (c)(3)-1(b)(1)(i), (iii) and (iv). As noted
above, although you submitted documentation that you are incorporated, you did not provide a
copy of your Articles of Incorporation. As such, you have not demonstrated that your Articles of
Incorporation contain the requisite language and therefore fail the organizational test. §

1.501 (c)(3)-1(b)(1).

Additionally, you are not operated for exclusively exempt purposes. An applicant is required to
submit sufficient information during the application process for the Service to conclude that the
organization is in compliance with the organizational and operational requirements of section
501(c)(3) before a ruling is issued. Rev. Proc. 2011-9, supra. The organization has the burden
of establishing through the administrative record that it operates as a § 501(c)(3) organization.
American Science Foundation, 52 T.C.M. 1049. Denial of exemption may be based solely upon
failure to provide information describing in adequate detail how the operational test will be met.
See Id.; La Verdad v. Commissioner, 82 T.C. 215.

Exempt status can be recognized in advance of operations if proposed operations can be
described in enough detail to permit a conclusion that the organization will clearly meet the
requirements of section 501(c)(3). Rev. Proc. 2011-9, supra; American Science Foundation, 52
T.C.M. 1049. The organization has the burden of providing sufficient substantive information

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regarding its activities and operations to establish entitlement to tax-exempt status. See, e.g.,
Founding Church of Scientology, 412 F.2d at 1200, 1202; Church of Spiritual Technology, 26
Cl.Ct. at 737; Bubbling Well Church of Universal Love, 74 T.C. at 535; Share Network
Foundation, 78 T.C.M. at 4-5. Any gaps contained in the administrative record are resolved in
favor of the Service. New Dynamics, 70 Fed. Cl. at 802 (‘It is well-accepted that, in initial
qualification cases such as this, gaps in the administrative record are resolved against the
applicant”). Information that is vague or nonspecific is not sufficient to meet the requirements
under section 501(c)(3). Share Network Foundation, 78 T.C.M. (CCH) 6.

Your Application does not present adequate information to allow us to determine that you meet
the operational test. Your application lists a myriad of activities that you intend to engage in, but
did not describe how you will engage in those activities and how those activities further exempt
purposes. For example, you state that you will economic development but did not explain how
your activities would provide for economic development. You stated that you would operate as
a cooperative hospital service organization under § 501(e), provide hospital or medical care and
completed Schedule C, but did not provide any details on how you are providing hospital or
medical care. Similarly you stated that you will operate a school and completed Schedule B, but
did not describe your schools. Additionally, while you stated that your schools would comply
with Rev. Proc. 75-50, supra, you also indicated on Schedule B that you have an objective to
maintain segregated education. Although some of the activities you list may be exempt
activities, you did not provide sufficient information about how you propose to conduct your
activities to permit us to determine whether they will advance these purposes as required by
Rev. Proc. 2011-9, Section 4.03. Therefore, you are not operated exclusively for exempt
purposes.

An organization will also not be organized and operated exclusively for exempt purposes if it is
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. § 1.501(c)(3)-1(d)(1)(ii). Your earnings appear to inure to Founder and you
appear to operate for the benefit of For-profit rather than for a public interest. Therefore, you
are not operated exclusively for exempt purposes.

You stated that Founder is your founder, CEO, and chairman. You did not indicate that you
have any other officers, directors, or trustees. You also have not adopted bylaws for the
selection of these individuals. You do not have any employees. You stated that you have
adopted a conflict of interest policy but did not provide a copy of this document. You also
indicated that Founder’s annual compensation will be $250,000 per year. Because Founder is
the only person associated with your organization and especially considering your lack of
safeguards such as a conflict of interest policy, we believe that your net earnings will ultimately
inure to the benefit of Individual. Because your net earnings will most likely inure to the benefit
of Founder, you do meet the requirements of section 1.501(c)(3)-1(c)(2) of the regulations. In
addition, similar to what the court noted in Church of Eternal Life and Liberty, the fact that you
are a single individual with exclusive control over the management and distribution of your
organization’s funds, “strongly suggests” prohibited inurement. 86 T.C. at 927.

Additionally, there are several indicators in your Application that you are operating for the
benefit of For-profit. For example, you provided a copy of your and For-profit’s charter which
explicitly states that you started your organization because For-profit failed to secure funding. In
addition, on Schedule D for supporting organizations, you stated that your supported

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organization is For-profit. You also indicated on Schedule D that at least 85% of your income
will go to For-profit.

Courts have repeatedly held that an organization that operates to provide commercial benefits
to a related for-profit has a substantial non-exempt purpose. For example, in Church by Mail v.
Commissioner, the court found that it was unnecessary to consider the reasonableness of
payments made by the applicant to a business owned by its officers. The court noted that “the
critical inquiry is not whether particular contractual payments to a related for-profit organization
are reasonable or excessive, but instead whether the entire enterprise is carried on in such a
manner that the for-profit benefits substantially from the operation of the Church.” 765 F.2d at
1392. Similarly, it appears from a thorough examination of your Application that you founded
your organization in order to fund For-profit. In addition, the few activities you were able to
describe are so intertwined with those of For-profit that it is difficult to discern the distinction
between you and For-profit. Consequently, because you operate for the benefit of Founder and
For-profit, you do not qualify for recognition of exemption.

CONCLUSION

Your application for exemption is denied. First, you failed to provide sufficient information in
your Application to enable us to determine that you are eligible for recognition of exempt status.
Second, you failed the organizational test because you did not provide a copy of your Articles of
Incorporation. You also fail the operational test because you will be engaging in activities that
are commercial and do not have an exempt purpose. Third, you will impermissibly operate for
the benefit of Founder and For-profit. Finally, your net earnings will likely inure to the benefit of
Founder. Therefore, you do not qualify for recognition of exemption under section 501(c)(3) of
the Code.

You have the right to file a protest if you believe this determination is incorrect. To protest, you
must submit a statement of your views and fully explain your reasoning. You must submit the
statement, signed by one of your officers, within 30 days from the date of this letter. We will
consider your statement and decide if the information affects our determination.

Your protest statement should be accompanied by the following declaration:

Under penalties of perjury, I declare that I have examined this protest statement, including
accompanying documents, and, to the best of my knowledge and belief, the statement
contains all the relevant facts, and such facts are true, correct, and complete.

You also have a right to request a conference to discuss your protest. This request should be
made when you file your protest statement. An attorney, certified public accountant, or an
individual enrolled to practice before the Internal Revenue Service may represent you. If you
want representation during the conference procedures, you must file a proper power of attorney,
Form 2848, Power of Attorney and Declaration of Representative, if you have not already done
so. For more information about representation, see Publication 947, Practice before the IRS
and Power of Attorney. All forms and publications mentioned in this letter can be found at
www.irs.gov, Forms and Publications.

If you do not file a protest within 30 days, you will not be able to file a suit for declaratory
judgment in court because the Internal Revenue Service (IRS) will consider the failure to protest

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as a failure to exhaust available administrative remedies. Code section 7428(b)(2) provides, in
part, that a declaratory judgment or decree shall not be issued in any proceeding unless the Tax
Court, the United States Court of Federal Claims, or the District Court of the United States for
the District of Columbia determines that the organization involved has exhausted all of the
administrative remedies available to it within the IRS.

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

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

Internal Revenue Service
TE/GE

1111 Constitution Ave, N.W.
Washington, DC 20224

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

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

Sincerely,

Lois G. Lerner
Director, Exempt Organizations