IRS revokes a childcare organization's section 501(c)(3) exemption

Plain-English summary

The IRS revoked a childcare organization's section 501(c)(3) exemption because its actual operations differed materially from the information used to grant exemption. The organization accepted children regardless of family income, served cash-paying families, provided no structured educational services, and remained controlled by a single board member. The IRS concluded that the organization did not operate exclusively for exempt purposes and that its exemption had been granted in error. The revocation was made effective on the stated date.

Ruling snapshot

• Question: Did the organization continue to qualify for exemption under section 501(c)(3)?
• Outcome: Revocation
• Key authorities: IRC §§ 170, 501(a), 501(c)(3), 501(k), 503, 6104, 7428, and 7805; Treas. Reg. §§ 1.501(a)-1 and 1.501(c)(3)-1

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
1100 Commerce Street 501.03-00
Dallas, TX 75242

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Date: September 7, 2012

Number: 201252022
Release Date: 12/28/2012

LEGEND Person to Contact:
ORG - Organization name . Badge Number:
XX - Date Address - address Contact Telephone Number:
Phone
Fax
Contact Address:
ORG Employer Identification Number:
ADDRESS

CERTIFIED MAIL

Dear

This is a final notice of adverse determination that your exempt status under section

501(c) (3) of the Internal Revenue Code is revoked. Recognition of your exemption under
Internal Revenue Code section 501(c)(3) is revoked effective September 1, 19XX the following
reason(s):

1. You have not demonstrated that you are operated exclusively for exempt purposes
   within the meaning of Internal Revenue Code section 501(c)(3) and Treasury
   Regulations section 1.501(c) (3)-1(d). You did not engaged primarily in activities that
   accomplish one or more of the exempt purposes specified in section 501(c)(3). You are
   operated for a substantial non-exempt purpose, which is not an exempt purpose.

2. Your net earnings inure to the benefit of private shareholders and individuals, which is
   prohibited by IRC section 501(c)(3).

3. You are operated for a substantial private purpose rather than a public purpose, which is
   prohibited by Internal Revenue Code section 501(c)(3) and Treasury Regulations section
   1.501(c) (3)-1(d)(1)(ii).

Since your exempt status has been revoked, you are required to file Form 1120, U.S.
Corporation Income Tax Return, for all years beginning on or after January 1, 20XX.

Income tax returns for subsequent years are to be filed with the appropriate Service Center
identified in the instructions for those returns.

It is further determined that your failure to file a written appeal constitutes a failure to exhaust
your available administrative remedies. However, if you decide to contest this determination in
court, you must initiate a suit for declaratory judgment in the United States Tax Court, the
United States Claims Court, or the district court of the United States for the District of Columbia
before the (ninety-first) 91st day after the date that this determination was mailed to you.
Contact the clerk of the appropriate court for rules for initiating suits for declaratory judgment.
To secure a petition form, write to the following address: United States Tax Court, 400 Second
Street, NW, Washington, DC 20217.

Please understand that filing a petition for a declaratory judgment under IRC section 7428 will
not delay the processing of subsequent income tax returns and assessment of any taxes due.

You also have the right to contact the Office of the Taxpayer Advocate. However, you should
first contact the person whose name and telephone number are shown above since this person
can access you tax information and can help you get answers. You can call 1-877-777-4778,
and ask for the Taxpayer Advocate assistance or you can contact the Advocate from the site
where this issue was determined by writing to:

Taxpayer Advocate assistance cannot be used as substitute for established IRS procedures,
formal appeals processes, etc. The Taxpayer Advocate is not able to reverse legal or technically
correct tax determination, nor extend the time fixed by law that you have to file a petition in
Court. The Taxpayer Advocate can, however, see that a tax matter that may not have been
resolved through normal channels gets prompt and proper handling.

This letter should be kept within your permanent records.

If you have any questions, please contact the person whose name and telephone number are
shown above.

Sincerely,

Nanette M. Downing
Director, EO Examinations
Enclosures:
Publication 892

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
TE/GE EO Examinations
3251 N Evergreen Dr NE
Grand Rapids, MI 49525

Taxpayer ID Number:
Form:
Tax Year(s) Ended
ORG Person to Contact/ID Number:
ADDRESS Contact Numbers:
Telephone:
Fax:

CERTIFIED MAIL ~- RETURN RECEIPT REQUESTED
Dear

We propose to revoke our recognition of your exempt status as an organization
described in section 501(c)(3) of the Internal Revenue Code (Code). We enclose
our report of examination explaining why we are proposing this action.

If you accept our proposal, please sign and return the enclosed Form 6018,
Consent to Proposed Action - Section 7428, unless you have already provided us
a signed Form 6018. We will issue a final revocation letter determining you are
not an organization described in section 501(c)(3). After the issuance of the final
revocation letter we will publish an announcement that you have been deleted
from the cumulative list of organizations contributions to which are deductible
under section 170 of the Code. If you do not respond to this proposal, we will
similarly issue a final revocation letter. Failing to respond to this proposal may
adversely impact your legal standing to seek a declaratory judgment because
you may be deemed to have failed to exhaust administrative remedies.

If you do not agree with our proposed revocation and wish to protest our
proposed revocation to the Appeals Office of the Internal Revenue Service, then
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. This written request is
called a protest. For your protest to be valid it needs to contain certain specific
information which generally includes a statement of the facts, the applicable law,
and arguments in support of your position. For the specific information needed
for a valid protest, please refer to page 6 of the enclosed Publication 3498, The
Examination Process, and page 2 of the enclosed Publication 892, Exempt

Organizations Appeal Procedures for Unagreed Issues. These documents also
explain how to appeal an IRS proposed action.

If you do submit a valid protest, then 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 and Publication 892 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. Please note that Fast Track
Mediation Services referred to in Publication 3498, generally do not apply after
issuance of this letter.

You may also request that we refer this matter for Technical Advice as explained
in Publication 892 and an annual revenue procedure. Please contact the
individual identified on the first page of this letter if you are considering
requesting Technical Advice. If we issue a determination letter to you based ona
Technical Advice Memorandum issued by the EO Rulings and Agreements
function, then no further administrative appeal will be available to you within the
IRS on the matter.

If you agreed with the proposed revocation or if you receive a final revocation
letter, you will be required to file Federal income tax returns for the tax period(s)
shown above. File these returns with the Ogden Service Center within 30 days
of the date you agreed with the revocation or the date of your final revocation
letter, whichever is sooner, unless a request for extension of time is granted. File
returns for later tax years with the appropriate service center indicated in the
instructions for those returns.

We will notify the appropriate state officials of the revocation in accordance with
section 6104(c) of the Code. Currently, only certain states are eligible to receive
notification of proposed revocation actions. You can call the person at the
heading of this letter to find out if your State is eligible to receive a notice of
revocation of your tax-exempt status.

You have the right to contact the office of the Taxpayer Advocate. Taxpayer
Advocate assistance is not a substitute for established IRS procedures, such as
the formal appeals process. The Taxpayer Advocate cannot reverse a legally
correct tax determination, or extend the time fixed by law that you have to file a
petition in a United States court. The Taxpayer Advocate can, however, see that
a tax matter that may not have been resolved through normal channels gets
prompt and proper handling. You may call toll-free 1-877-777-4778 and ask for
Taxpayer Advocate Assistance. If you prefer, you may contact your local
Taxpayer Advocate at:

If you have any questions, please call the contact person at the telephone
number shown in the heading of this letter. If you write, please provide a
telephone number and the most convenient time to call if we need to contact you.

Thank you for your cooperation.

Sincerely,

Nanette M Downing
Director EO Examinations

Enclosures:
Publication 892
Publication 3498
Form 6018

Report of Examination

In lieu of Letter 3618

Form 886-A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG December 31, 20XX
LEGEND
ORG - Organization name XX - Date State - state Founder - founder

motto - motto

ISSUE

The activities of ORG have never operated in a manner that qualifies for tax exempt status; the
organization was granted exemption in error.

FACTS

According to the application Form 1023 dated October 1, 19XX, the activities of the
organization are to “provide day care for minority and low income families” and “distress on
single parents”. The application also states that the organization will be funded by government
grants and public contributions.

The examination revealed that the sources of income for the organization are “program
service revenue”. Some motto clients receive assistance from the State of State and the
organization is paid directly by the state program, other clients pay out of pocket for
their childcare as they do not qualify based on income level for childcare assistance.
(The State of State paid childcare is not a grant program. It is a financial assistance
program for low income parents)

The other source of income is a program from the State of State that pays childcare
organizations a certain amount of money per child for meals served to them, on a tier
system based on the child’s family income level. (This is not a grant program)

The sources of income for the organization are not the same as what was listed in the
Form 1023.

On November 12, 19XX the Service sent a letter to the organization requesting additional
information required to process the application Form 1023. The additional information
requested included:
• Some blank portions of the Form 1023
• A modification to the Board of Directors (since Founder, the founder, was the only
listed board member)
• More detailed information on the educational or charitable activities of the motto

Founder responded to the additional information request. Founder stated in her letter
December 2, 19XX that:
• She was unable to obtain any additional board members other than herself

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

Form 886-A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit

Name of Taxpayer Year/Period Ended

ORG December 31, 20XX

• Her clientele is limited to children who qualify for their childcare to be paid for by the
State of State due to low income.

The examination revealed that Founder has continued to be the only board member, and
her clientele has not been limited to low income children. The examination revealed she
services children that paid the organization directly for the services. (Often referred to in
the industry as “straight pay” kids who are not from low income families)

On December 3, 19XX the Service sent a letter indicating they had not yet received the
additional information requested; information required to process the application 1023. (The
information was received shortly after in the form of the response directly above)

On December 9, 19XX the Service sent the organization a letter requesting additional
information (again) to process the application 1023. The information requested included:
• Lease details since the lease was not at an arms length transaction
• Another request for a modification to the Board of Directors (since at that time
Founder was still the only board member)
• More detailed information on the educational and charitable activities of the
organization

On January 15, 19XX the Service sent the organization a letter indicating that the additional
information the service requested to make a determination on the application 1023 had not yet
been received, and the determination was being closed. The organization was not granted tax
exempt status.

On February 13, 19XX the organization responded to the request for additional information.
The response indicated:
• A market value of the home, but not a market lease value
• The organization was still unable to obtain any additional board members
• A response stating “This organization is able to improve & promote educational
opportunities for children by making it possible for the minority & low income
children to attend structured learning environments and school while parents, who
cannot afford childcare, can be employed”

It was determined during the examination that Founder has been the only board
member for the life of the organization.

All other documents reviewed in the application Form 1023 indicated that the children
were too young for educational activities and that the primary charitable cause was the
fact that the children were from low income families.

Form 886-A (rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -2-

Form 886-A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit

Name of Taxpayer Year/Period Ended

ORG December 31, 20XX

The claim by the organization for the basis of qualifying for tax exemption has
alternated between servicing exclusively low income families, and providing
educational services to children. The organization has done neither during its
existence. (All children regardless of income level are accepted, and no educational
material is presented to the children, as stated by Founder in her December 2, 19XX
letter to the Service) (“These pre-school children are under age four. No structured
educational services are provided”)

In the records secured for the 20XX calendar year, Founder listed five cash paying
customers. Her motto license is for a maximum of 12 children. Her cash paying
customers were not an insubstantial amount of business, and further shows that her
clientele was not limited to low income children.

APPLICABLE LAW AND ANALYSIS

Internal Revenue Code section 501(c)(3) exempts from Federal income tax: corporations, and
any community chest, fund, or foundation, 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 (but only if no part of its activities involve
the provision of athletic facilities or equipment), or for the prevention of cruelty to children or
animals, no part of the net earnings of which inures to the benefit of any private shareholder or
individual, no substantial part of the activities of which is carrying on propaganda, or otherwise
attempting to influence legislation (except as otherwise provided in subsection (h)), and which
does not participate in, or intervene in (including the publishing or distributing of statements),
any political campaign on behalf of (or in opposition to) any candidate for public office.

Treasury Regulation section 1.501(a)-1(c) defines a private shareholder or individual for section
501 purposes as those persons having a personal and private interest in the activities of the
organization.

Treasury Regulation section 1.501(c)(3)-1(a)(1) 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.

Treasury Regulation section 1.501(c)(3)-1(b)(1) 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.

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

Form 886-A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit

Name of Taxpayer Year/Period Ended

ORG December 31, 20XX

Treasury Regulation section 1.501(c)(3)-1(c)(1) states 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 section 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.

Treasury Regulation section 1.501(c)(3)-1(c)(2) states, in part, 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.

Treasury Regulation section 1.501(c)(3)-1(d)(1)(i) provides that an organization may be
exempt as an organization described in section 501(c)(3) if it is organized and operated
exclusively for one or more of the following purposes:

(a) Religious,

(b) Charitable,

(c) Scientific,

(d) Testing for public safety,

(e) Literary,

(f) Educational, or

(g) Prevention of cruelty to children or animals.

A ruling or determination letter that recognizes exemption under IRC 501(c)(3) is a written
statement to an organization that applies the law to the facts and representations in an
organization's Form 1023. Should that letter recognizing exemption be revoked, as long as (a)
there has been no misstatement or omission of material facts, (b) the facts subsequently
developed are not materially different from the facts and representations on which the ruling or
determination letter was based,(c) there has been no change in the applicable law, and (d) the
organization acted in good faith in reliance on the ruling or determination letter, the revocation
will be prospective. See Rev. Proc. 84-46, 1984-1 C.B. 541.

A ruling or determination letter recognizing exemption may be revoked or modified by (1) a
notice to the taxpayer to whom the ruling or determination letter originally was issued, (2)
enactment of legislation or ratification of a tax treaty, (3) a decision of the United States Supreme
Court, (4) issuance of temporary or final regulations, or (5) issuance of a revenue ruling, revenue
procedure, or other statement published in the Internal Revenue Bulletin. The revocation or
modification may be retroactive if the organization omitted or misstated a material fact, operated
in a manner materially different from that originally represented, or, in the case of organizations
to which section 503 applies, engaged in a prohibited transaction with the purpose of diverting
corpus or income of the organization from its exempt purpose and such transaction involved a
substantial part of the corpus or income of such organization. Where there is a material change,

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

Form 886-A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit

Name of Taxpayer Year/Period Ended

ORG December 31, 20XX

inconsistent with exemption, in the character, the purpose, or the method of operation of an
organization, revocation or modification will ordinarily take effect as of the date of such material
change. In cases where a ruling or determination letter was issued in error or is no longer in
accord with the holding of the Service, when section 7805(b) relief is granted (see sections 15
and 18 of Rev. Proc. 90-4), retroactivity of the revocation or modification ordinarily will be
limited to a date not earlier than that on which the original ruling or determination letter is
modified or revoked. See Rev. Proc. 90-27, 1990-1 C.B. 514

An educational day care center that enrolls children on the basis of family financial need and the
child’s need for the care and development program of the center qualifies for exemption under
Section 501(c)(3) of the Code. See Rev. Rul. 70-533, 1970-2 C.B. 112

The organization did not enroll children on the basis of family financial need, or the
child’s need for the care and development program of the center.

Section 501(k) of the code defines the term "educational purposes" to include the providing of
care of children away from their homes if--
(1) substantially all of the care provided by the organization is for purposes of enabling
individuals to be gainfully employed, and
(2) the services provided by the organization are available to the general public.

The organization does not provide substantially all of their care to enable individuals to be
gainfully employed. Nearly half of the clientele pays for their children(s) care out of pocket.
These individuals use the care as they see fit. Some may be putting their children in care so they
can attend school, do volunteer work, or simply a desire to socialize their children with others.
There is no guarantee that the children are enrolled so that the parents may work.

The children that receive their child care as paid for through the State of State normally either
have parents who are working, or attending school. (Those are the two requirements by the State
for the families to qualify for assistance paying for their childcare)

TAXPAYER’S POSITION

At a meeting with Founder on March 23, 20XX, she was agreeable to revoking the
exempt status of the organization back to the date of exemption. She had already started
the process with the State of State to switch her motto license to one of a sole
proprietorship in her own name.

GOVERNMENT’S POSITION

After review of the facts, and the relevant law and analysis, it is the government’s position that
the Exemption Determination was done so in error. The responses given to the items the

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

Form 886-A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit

Name of Taxpayer Year/Period Ended

ORG December 31, 20XX

Determinations Agent identified as issues needing further examination were not answered in a
way that supported the organization being granted tax exempt status.

It is also the government’s position that the organization operated in a manner materially
different from that originally represented in the application Form 1023.

CONCLUSION

Accordingly, the organization’s status as an organization described under section 501(c)(3)
should be revoked, because the organization was granted exemption in error. The effective date
of the revocation should be September 1, 19XX (revoking the Determination Letter) because the
organization operated in a manner materially different from that originally represented.

The 20XX Form 990 showed that the organization had a $ excess, in 20XX there was a $ deficit,
and the Form 990 for 20XX shows a $ excess. It was determined during the examination that
there were additional expenses of $ that were not reported on the 20XX Form 990. Had the Form
20XX been completed correctly the organization would have reported a $ deficit for 20XX.

The tax that would be due on a Form 1120 on the open statute years is immaterial; therefore
Forms 1120 are not being secured as a part of the revocation.

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