Written determination 1247016: IRS denies exemption to a proposed rural broadband network

Plain-English summary

The IRS denied IRC § 501(c)(3) exemption to a proposed organization that would build and operate an 800-mile fiber-optic broadband backbone in a rural area. The organization planned to lease network capacity to commercial telecommunications companies at cost, but would not require those companies to pass savings to consumers. The IRS found that the network served commercial providers directly, was not an inherently charitable activity, and had a substantial unrelated commercial purpose. The organization therefore failed the operational test and could not qualify for exemption.

Ruling snapshot

• Question: Did the proposed wholesale broadband network operate exclusively for charitable or educational purposes and serve a public rather than private interest?
• Outcome: Denied
• Key authorities: IRC §§ 501(a), 501(c)(3), 170, 513, 6104, 6110, and 7428; Treas. Reg. §§ 1.501(c)(3)-1(a)(1), 1.501(c)(3)-1(c)(1), 1.501(c)(3)-1(d)(1), 1.501(c)(3)-1(d)(2), and 1.501(c)(3)-1(e)(1); Rev. Ruls. 69-528, 72-124, 72-369, and 79-19

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Release Number: 201247016 Contact Person:
Release Date: 11/23/2012

Date: August 28, 2012 Identification Number:
Contact Number:

UIL: 501.03-00
Employer Identification Number:
Form Required To Be Filed:
Tax Years:

Dear

This is our final determination that you do not qualify for exemption from Federal income tax as
an organization described in Internal Revenue Code section 501(c)(3). Recently, we sent you a
letter in response to your application that proposed an adverse determination. The letter
explained the facts, law and rationale, and gave you 30 days to file a protest. Since we did not
receive a protest within the requisite 30 days, the proposed adverse determination is now final.

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.

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
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, 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,

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: June 13, 2012 Contact Person:
Identification Number:

Uniform Issue List: 501.03-00 Contact Number:
FAX Number:
Employer Identification Number:

LEGEND:

Date 1:
Date 2:
State:

Dear

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

FACTS

You were incorporated on Date 1 under State non-profit corporation law. You filed Form 1023
(Application For Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue
Code) on Date 2.

Your Certificate of Incorporation (hereinafter “Certificate”) states that you are formed exclusively
for scientific, educational, and charitable purposes within the meaning of I.R.C. § 501(c)(3).
Your specific purpose is to “conduct activities to advance communication network infrastructure
and technologies that enable the interchange of communication and information among
regional users . . . by developing, operating and maintaining a sustainable wholesale open access
communications and information network.”

Your primary activity will be the creation of an 800 mile hi-speed fiber optic broadband
telecommunications network that will provide a backbone to support the proposed expansion of
various high-speed telecommunications services in a rural area in State. Currently, this rural
area is serviced by standard telephone, cellular, and internet technologies. You intend to be the
“carrier's carrier” by providing wholesale hi-speed broadband connection paths to commercial
telecommunication companies, who will then provide retail hi-speed broadband communication
services to individual subscribers. In other words, you will provide the “backbone” through
which commercial providers will offer their services to the public. The network will be open to all
commercial providers or others requiring hi-speed broadband.

You will not provide services directly to the public. Instead, you intend to lease your hi-speed
broadband pathways to commercial telecommunication companies who will then offer their
services to the public. Currently, you have not entered into agreements with any commercial
providers because the network has not been constructed. You will operate using a “wholesale”
model. The fees charged to commercial telecommunication companies for using your hi-speed
broadband network will be based on the cost of constructing and operating it. However, you will
not require these commercial telecommunication companies to reduce prices in order to ensure
that this cost saving is passed on to the public. Instead, you believe consumers will recognize a
cost savings from these commercial telecommunication companies solely through increased
competition between commercial providers.

You will own any hi-speed broadband networks built. However, you will hire contractors to
operate and maintain your hi-speed broadband networks. These contractors have not yet been
chosen.

You are conducting two auxiliary activities. The first is a wireless pilot project, which is now
complete. This project was funded by a governmental agency with the intent to create a small
wireless network to determine whether wireless broadband was suitable to meet rural
population needs and to provide information on how wireless services fit into an open access
network. The second is a wireless clearinghouse project, which is ongoing. This project locates,
lists, and categorizes locations within State that would support cellular sites or wireless
broadband transmitters. Normally these activities would be conducted by cellular providers
looking to expand service to a community. However, this project is intended to improve this
process.

Once the network is established, your future activities would include managing and expanding
the hi-speed broadband network. No specific timeline exists for network construction;
development depends on funding availability.

LAW

I.R.C. § 501(c)(3) exempts from taxation any corporation organized and operated exclusively
for religious, charitable, scientific, testing for public safety, literary, or educational purposes,
or to foster national or international amateur sports competition, or for the prevention of cruelty
to children or animals, provided no part of the net earnings of which inures to the benefit of any
private shareholder or individual.

I.R.C. § 513(a) provides that the term “unrelated trade or business” means any trade or
business the conduct of which is not substantially related (aside from the need of such
organization for income or funds or the use it makes of the profits derived) to the exercise or
performance by such organization of its charitable, educational, or other purpose or function
constituting the basis for its exemption under I.R.C. § 501.

Treas. Reg. § 1.501(c)(3)-1(a)(1) provides that, in order to be exempt as an organization
described in I.R.C. § 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 or operational test, it is not exempt.

Treas. Reg. § 1.501(c)(3)-1(c)(1) provides that an organization will be regarded as “operated
exclusively” for one or more exempt purposes only if it engages primarily in activities which
accomplish one or more of such exempt purposes specified in I.R.C. § 501(c)(3). An
organization will not be so regarded if more than an insubstantial part of its activities is not in
furtherance of an exempt purpose.

Treas. Reg. § 1.501(c)(3)-1(c)(2) 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.

Treas. Reg. § 1.501(c)(3)-1(d)(1)(i) provides that an organization may be exempt as an
organization described in I.R.C. § 501(c)(3) if it is organized and operated exclusively for one or
more of the following purposes: religious, charitable, scientific, testing for public safety, literary,
educational, or prevention of cruelty to children or animals.

Treas. Reg. § 1.501(c)(3)-1(d)(1)(ii) 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 this requirement, the organization must establish that it is not organized
or operated for the benefit of private interests such as designated individuals, the creator or his
family, shareholders of the organization, or persons controlled, directly or indirectly, by such
private interests.

Treas. Reg. § 1.501(c)(3)-1(d)(2) explains that the term “charitable” is used in I.R.C. § 501(c)(3)
in its generally accepted legal sense and is, therefore, not to be construed as limited by the
separate enumeration in I.R.C. § 501(c)(3) of other tax-exempt purposes which may fall within
the broad outlines of “charity” as developed by judicial decisions. Such term includes: relief of
the poor and distressed or of the underprivileged; advancement of education or science;
lessening the burdens of Government; and promoting social welfare by organizations designed
to accomplish any one of the above purposes.

Treas. Reg. § 1.501(c)(3)-1(e)(1) provides that an organization may meet the requirements of
I.R.C. § 501(c)(3) although it operates a trade or business as a substantial part of its activities, if
the operation of such trade or business is in furtherance of the organization’s exempt purpose
or purposes and if the organization is not organized or operated for the primary purpose of
carrying on an unrelated trade or business.

Rev. Rul. 69-528, 1969-2 C.B. 127, determined that providing investment services on a regular
basis for a fee is a trade or business ordinarily carried out for profit, even if that service were
regularly provided to exempt organizations. Therefore, any I.R.C. § 501(c)(3) organization
providing such services would be carrying on an unrelated trade or business.

Rev. Rul. 72-124, 1972-1 C.B. 145, held that the aged are a charitable class and that an
organization that operates to address the needs of the aged by providing for the “primary needs”
of such individuals for housing, health care, and financial security in conformity with the criteria
specified in this ruling was held to be exempt under I.R.C. § 501(c)(3).

Rev. Rul. 72-369, 1972-2 C.B. 245, determined that an organization formed to provide
managerial and consulting services at cost to unrelated exempt organizations did not qualify

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under I.R.C. § 501(c)(3). According to the Service, providing managerial and consulting
services on a regular basis for a fee is a trade or business ordinarily carried on for profit. The
fact that services are provided at cost and solely for exempt organizations is not sufficient to
qualify the activity as charitable within the meaning of I.R.C. § 501(c)(3). Therefore, the Service
held that the organization’s activities were not charitable.

Rev. Rul. 79-19, 1979-1 C.B. 195, held the physically handicapped are distressed persons
within the meaning of I.R.C. § 501(c)(3) and therefore a charitable class.

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 private benefit, if substantial in nature, will destroy an
organization's tax-exempt status regardless of the organization’s other charitable purposes or
activities.

In B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352, 352-55, 360 (1978), the Tax Court
determined that an organization formed to provide consulting services on the topic of rural-
related policy and program development to tax-exempt organizations at, or close to cost, did not
qualify for exemption under I.R.C. § 501(c)(3) as an educational, scientific, or charitable
organization. In examining the organization’s activities, the court noted that an organization
may operate a trade or business and still qualify under I.R.C. § 501(c)(3). “Rather, the critical
inquiry is whether [the organization’s] primary purpose for engaging in its sole activity is an
exempt purpose, or whether its primary purpose is the nonexempt one of operating a
commercial business producing net profits for [the organization].” This determination “is a
question of fact to be resolved on the basis of all the evidence presented by the administrative
record.” Factors to be considered include “the particular manner in which an organization’s
activities are conducted, the commercial hue of those activities, and the existence and amount
of annual or accumulated profits.” Furthermore, “[c]ompetition with commercial firms is strong
evidence of the predominance of nonexempt commercial purposes.” Applying this analysis, the
court determined that the organization’s services obviated the need for non-profits to employ
full-time staff for that function, that the organization's fee was based on the cost of providing
services rather than the tax-exempt organization's ability to pay, that the organization realized
profit, that the organization’s financing was not typical of § 501(c)(3) organizations, and that, in
practice, the organization did not limit its services to § 501(c)(3) organizations. Therefore, the
court concluded that the organization did not qualify for tax-exempt status under I.R.C. §
501(c)(3) because it served a substantial commercial purpose.

In American Campaign Academy v. Commissioner, 92 T.C. 1053 (1989), the Tax Court
determined that the American Campaign Academy, a training program for political campaign
professionals, operated for the private benefit of the Republican party because its curriculum
was tailored to Republican interests, its graduates worked for Republican candidates and
incumbents, and it was financed by Republican sources. The Tax Court defined private benefit
as “nonincidental benefits conferred on disinterested persons that serve private interests.”
Private benefits included “advantage; profit; fruit; privilege; gain; [or] interest.”

RATIONALE

An organization seeking tax-exempt status under I.R.C. § 501(c)(3) must be organized and
operated exclusively for educational, scientific, charitable, or other exempt purposes with no

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part of its net earnings inuring to the benefit of any private shareholder or individual. See also
Treas. Reg. § 1.501(c)(3)-1(a)(1). You state that you are seeking tax-exempt status under
I.R.C. § 501(c)(3) as a charitable organization that advances education and science by
providing a hi-speed broadband telecommunications network to a rural area. Based on a review
of your activities, you are not described in I.R.C. § 501(c)(3) as explained below.

1. Exempt Purposes

An organization satisfies the operational test if it is operated exclusively for one or more exempt
purposes. Treas. Reg. § 1.501(c)(3)-1(d)(1). An organization is “operated exclusively” for one
or more exempt purposes only if it engages primarily in activities that accomplish one or more of
such exempt purposes specified in I.R.C. § 501(c)(3). Treas. Reg. § 1.501(c)(3)-1(c)(1). The
presence of a single, substantial non-exempt purpose will destroy the exemption regardless of
the number or importance of any truly exempt purposes. Better Business Bureau of
Washington, D.C., Inc. v. United States, 326 U.S. 279 (1945). You fail the operational test
because you are not operated exclusively for one or more exempt purposes.

The term “charitable” is used in I.R.C. § 501(c)(3) in its generally accepted legal sense and is
not to be construed as limited by the separate enumeration in that section. See Treas. Reg. §
1.501(c)(3)-1(d)(2). The term “charitable” includes the following: relief of the poor and
distressed or of the underprivileged; advancement of education or science; lessening the
burdens of Government; and promotion of social welfare by organizations designed to
accomplish any of the above. Additionally, a purported charitable activity must benefit a
sufficiently large and indefinite class. The Service has recognized charitable classes to include
the poor, distressed and underprivileged, the aged, and the sick or handicapped.

You intend to provide a hi-speed fiber optic broadband “backbone” for commercial
telecommunications companies. You state that access to the hi-speed broadband network will
be provided to these commercial telecommunications companies at cost. However, merely
providing services at cost is not charitable. See Rev. Rul. 72-369, 1972-2 C.B. 245. Although
the public is the intended recipient of the ultimate benefit of your hi-speed broadband network,
you provide your services to commercial telecommunications companies and not to the public.
However, even if your services were provided directly to the public, providing hi-speed
broadband service is not an inherently charitable activity. Therefore, the hi-speed broadband
network you provide is neither charitable nor is the class of persons serviced, commercial
telecommunications companies, a charitable class. Indirect public benefit is not sufficient to
render your activities charitable. Thus, you have not shown that you are operated exclusively
for one or more exempt purposes.

2. Private Benefit

You serve substantial private interests in violation of I.R.C. § 501(c)(3). An organization is not
organized or operated exclusively for one or more exempt purposes unless it serves a public
rather than private interest. Treas. Reg. § 1.501(c)(3)-1(d)(1)(ii). Thus, it is necessary for an
organization to establish that it is not organized or operated for the benefit of private interests

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such as designated individuals, the creator or his family, shareholders of the organization, or
persons controlled, directly or indirectly, by such private interests. An organization’s activities
may benefit the private interests of disinterested persons as well. American Campaign
Academy v. Commissioner, 92 T.C. 1053, 1069 (1989). “Prohibited private benefits may include
an ‘advantage; profit; fruit; privilege; gain; [or] interest.’” Id. at 1065-66 (1989) (citing
Retired Teachers Legal Fund v. Commissioner, 78 T.C. 280, 286 (1982)). Applicant must show
that no more than an insubstantial part of its activities benefit private interests or any other
nonexempt purpose. Id. at 1066.

Your hi-speed broadband telecommunications network provides substantial private benefit to
commercial providers. First, your construction of this hi-speed broadband network obviates the
need for commercial providers to construct such hi-speed broadband networks themselves,
which creates a significant cost savings to commercial telecommunications companies. For
example, your wireless clearinghouse project reduces the cost of entry for commercial
telecommunication companies by identifying locations that would support cellular sites or
wireless broadband transmitters. Second, you will operate at cost but will not have any
agreements requiring commercial providers to pass the cost savings you create on to the public.
Although you argue that your activities create competition among telecommunication
companies, which you expect to force prices down for the public, you do not provide any
evidence that consumers will recognize any cost savings by the services you provide to
commercial telecommunication companies. Finally, you provide no services directly to the
public; all of your services are provided directly to commercial telecommunication companies.
Although the public will derive some benefit from the increase in coverage and availability of
commercial telecommunication companies, the primary benefit is to the commercial
telecommunication companies who receive access to a population that is otherwise unavailable
without a considerable capital outlay.

3. Substantial Commercial Purpose

You are operated for substantial commercial purpose because your primary activity, the
operation of the hi-speed broadband network, is generally considered a trade or business
ordinarily carried on for profit. An organization may meet the requirements of I.R.C. § 501(c)(3)
although it operates a trade or business as a substantial part of its activities if the operation of
such trade or business is in furtherance of the organization’s exempt purpose or purposes and if
the organization is not organized and operated for the primary purpose of carrying on an
unrelated trade or business. Treas. Reg. § 1.501(c)(3)-1(e)(1). An “unrelated trade or business”
is any trade or business the conduct of which is not substantially related (aside from the need of
such organization for income or funds or the use it makes of the profits derived) to the exercise
or performance by such organization of its charitable, educational, or other purpose or function
constituting the basis for its exemption under I.R.C. § 501(a). I.R.C. § 513(a).

In determining the existence, or nonexistence, of such primary purpose, all the circumstances
must be considered, including the size and extent of the trade or business and the size and
extent of the activities which are in furtherance of one or more exempt purposes. Treas. Reg. §
1.501(c)(3)-1(e)(1). “[T]he critical inquiry is whether petitioner's primary purpose for engaging in
its sole activity is an exempt purpose, or whether its primary purpose is the nonexempt one of
operating a commercial business producing net profits for [the organization].” B.S.W. Group,
Inc. v. Commissioner, 70 T.C. 352, 357 (1978). Factors to be considered include “the particular
manner in which an organization’s activities are conducted, the commercial hue of those

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activities, and the existence and amount of annual or accumulated profits.” Id. “Competition
with commercial firms is strong evidence of the predominance of nonexempt commercial
purposes.” Id. at 358.

For example, Rev. Rul. 69-528, 1969-1 C.B. 279, involved an organization that regularly carried
on an investment service business. The organization was formed to provide investment services
on a fee basis exclusively to exempt organizations. The Service determined that providing
investment services on a regular basis for a fee is a trade or business ordinarily carried on for
profit. Therefore, the organization did not qualify under I.R.C. § 501(c)(3) because it regularly
carried on the business of providing investment services, which would be an unrelated trade or
business if carried on by any tax-exempt organizations on whose behalf it operated. Furthermore,
Rev. Rul. 72-369, 1972-2 C.B. 245, determined that providing managerial and consulting services
on a regular basis for a fee is a trade or business ordinarily carried on for profit. Providing
services at cost and solely to exempt organizations is not sufficient to make the activity
charitable. Finally, in B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352 (1978), the Tax Court
determined that an organization formed for the purpose of providing consulting services
“primarily in the area of rural-related policy and program development” did not qualify under
I.R.C. § 501(c)(3) because providing consulting services is a business “ordinarily carried on by
commercial ventures organized for profit.”

Like the organizations in Rev. Rul. 69-528, Rev. Rul. 72-369, and B.S.W. Group, access to your
hi-speed broadband network is provided for a fee. Such services are usually provided by
commercial telecommunication companies organized for profit. These factors indicate that
operation of the hi-speed broadband network is a trade or business ordinarily carried on for
profit serving a substantial non-exempt commercial purpose. Thus, your primary purpose is the
carrying on of an unrelated trade or business because operation of the hi-speed broadband
network, as previously discussed, serves no exempt purpose.

CONCLUSION

Based on the above, we have made a determination that you fail to meet the requirements
necessary to be recognized as a tax-exempt organization under § 501(c)(3) because you are
not organized and operated exclusively for one or more exempt purposes. 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.

This declaration must be signed by an elected officer, a member of the board of directors, or a
trustee rather than an attorney or accountant.

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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
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 (SE:T:EO:RA:T3)

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,

Director, Exempt Organizations