Determination 1315027 denies exemption to an administrative-services organization

Plain-English summary

The IRS denied exemption under IRC § 501(c)(3) to an organization formed to provide management, human resources, finance, health-record, information-technology, property, transportation, and purchasing services to unrelated tax-exempt organizations. The organization planned to charge its members the cost of those commercially available services plus an administrative fee. The IRS concluded that the organization was primarily carrying on an unrelated trade or business, rather than performing a charitable function. It also ruled that providing services at cost was not enough to establish a charitable activity under the facts presented.

Ruling snapshot

• Question: Did the administrative-services organization qualify for exemption under IRC § 501(c)(3)?
• Outcome: Denied, the organization did not qualify under the stated facts.
• Key authorities: IRC §§ 101, 170, 501(a), 501(c)(3), 513, 6110, and 7428; Treas. Reg. §§ 1.501(c)(3)-1(a)(1), 1.501(c)(3)-1(c)(1), and 1.501(c)(3)-1(e)(1).

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION

Release Number: 201315027 Contact Person:

Release Date: 4/12/2013 [illegible]

Date: January 16, 2013 Identification Number:

UIL 501.03-00 [illegible]

[illegible] Contact Number:

[illegible] (***) [illegible]

[illegible] 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 § 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 § 501(c)(3), donors
may not deduct contributions to you under § 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 § 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.
IRS Customer Service number for people with hearing impairments is 1-800-829-4059.

Sincerely,

Holly O. Paz
Director, Rulings and Agreements

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: November 16, 2012 Contact Person:
Identification Number:
UIL 501.03-00, 501.03-30 [illegible]
Contact Number:
[illegible]
FAX Number:
(***) [illegible]
Employer Identification Number:
Legend:
State [illegible]
Date 1 [illegible]

[illegible]

Corporation
Corporation 2
LLC

Date 2

[illegible]

[illegible]

[illegible]

Dear

We have considered your application for recognition of exemption from Federal income tax
under Internal Revenue Code § 501(a). 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 were incorporated under the laws of State on Date 1. Your Articles of Incorporation state
that you are organized for charitable, religious, educational, and scientific purposes within the
meaning of § 501(c)(3). Your specific purposes include acting as an administrative services
organization to provide management and other support services that promote, support, and
benefit organizations qualifying under § 501(c)(3), including, without limitation, Corporation 1
and Corporation 2, hereafter referred to as the Initial Members, collectively. The Initial Members
are unrelated to one another. Additional § 501(c)(3) organizations may become members only
upon the unanimous approval of the Initial Members and must meet the qualifications set forth
in your Bylaws. Your Articles contain a prohibition on inurement and provide that upon
dissolution all remaining assets shall be distributed to your members provided that each is then
qualified as an organization under § 501(c)(3).

A predecessor organization, LLC, was formed on Date 2 but never operated. As the process of
making LLC operational moved forward, it was determined that a limited liability company was
not the best form for facilitating the contemplated purposes. As a result, a Plan of Merger was

[illegible]

adopted, you were incorporated, and the merger took immediate effect on Date 1, your date of
incorporation.

The information provided in Form 1023 indicates you were designed to provide your Initial
Members and other area tax-exempt organizations desiring to use your services the benefit of
collaborating and sharing a variety of management and related administrative services, thereby
gaining efficiencies and economies of scale and allowing the participating organizations to focus
on their respective missions, goals and programs. Specific services contemplated include four
core service areas: human resources; finance/accounting and electronic health record
development/management; information technology; and support services. In particular:

• The Finance Department will provide: financial reporting; development of management
tools; monthly reconciliation of general ledger accounts; payroll processing; accounts
payable; billing for reimbursements; internal budgets and budgets for grant proposals;
contract negotiation and the setting of reimbursement rates; review of fiscal policies and
procedures and monitoring of internal controls; oversight of annual audits and site visits
from funders, coordination of tax reporting; procurement of insurance including property
insurance, professional/general liability, workers compensation, and D&O; and treasury
functions and management of cash flow.

• The Human Resources & Training Departments will provide centralized services for all
human resource needs including: recruitment; applicant tracking and processing; benefit
management & tracking; employee documentation; time and labor tracking; payroll
processing; HR consultation; employee training; and training management and
maintenance.

• The EHR Development/Management Department will provide: maintenance of clinical
records, EHR implementation and maintenance; report customization; ad hoc reporting;
assigning caseloads, access and permissions; forms customization and creation of new
forms; producing required reports; providing user support for medical records;
responding to ROIs; assistance during audits; and claims based billing.

• The Information Technology Department will: support the infrastructure of advanced
communications, data storing and data sharing technology; support fiber and broadband
computer networks; provide professionals to ensure system security, network
administration, database management and software and hardware support; provide a one-
stop Helpdesk support system; provide continuing professional development to IT staff;
the goal to utilize advances in technology to reduce costs and increase productivity,
security and outcomes.

• The Property Management/Transportation/Purchasing Department includes: the
Maintenance Department providing HVAC; plumbing; painting; repair work; light
electrical work; locksmith and other services to be determined; the Transportation
Department overseeing a combined fleet of 60+ vehicles and providing fleet
maintenance; recordkeeping; coordination of trips and funder documentation; and the
Purchasing Department using the combined purchasing power of the members to

[illegible]

aggressively negotiate to obtain the most favorable pricing.

To implement your activities, you state you will enter into two different contracts with each of
your Initial Members. The first contract will be a management services agreement pursuant to
which each member will purchase certain management services. Secondly, you will enter into
employee leasing agreements with your Initial Members to lease employees from each member
to conduct your operations. Until your operations become firmly established, the amount to be
paid by the Initial Members under the management services agreement will, in the aggregate,
equal the amounts to be paid to each of the members under the employee leasing agreements.
You expect that cost efficiencies generated over time will allow excess income to be passed
back to the members.

You further state that all services you will provide to the Initial Members would be carried on
directly by them in the absence of your management services agreements. At the time of your
application, you had not expanded services to other organizations. However, you indicated that
contracts with other § 501(c)(3) organizations will be negotiated such that payments are
calculated and paid either at the cost of the goods or services provided, or at cost plus a
reasonable administrative fee.

You will not engage in fundraising. You state that your sole source of revenue once you are
fully operational will come from gross receipts. Gross receipts are categorized as follows:

• In-kind Occupancy Costs: rent, including utilities and building maintenance costs, which
will be donated by Corporation 2 for the space you occupy.
o Rent will be charged based on square footage at fair market value; you will use an
analysis of similar space in the local real estate market.

• Administrative Services: revenue relating to services provided for finance/accounting,
human resources, electronic health record development/management, information
technology, and support services.
o Fees will be charged based on cost plus an administrative fee.

• Property Maintenance Services: revenue relating to service provided for property
maintenance, repairs, renovations, project management, etc.
o Fees will be charged at $[illegible] per hour which is based on cost plus a small
administrative fee.

You state that all fees are based on cost plus an administrative fee not to exceed the fair market
value. All fee schedules are approved by your board of directors.

Your expenses include those for occupancy; depreciation and depletion; professional fees; and
disbursements to or for the benefit of members (i.e., employee leasing costs). You list computer
software and leasehold improvements as your depreciable assets. You also list expenses for
software maintenance fees; software subscription fees; insurance; operating expenses; and
bank fees. You explain that operating expenses are for office supplies such as stationery,
envelopes, postage, computer supplies, website maintenance, and meeting costs.

[illegible]

Your Bylaws provide that you shall have not less than three and not more than eleven directors.
All directors shall be elected by majority vote of Initial Members. Directors shall not receive
compensation for their services. You listed six members on your Board.

• President/CEO: also President/CEO of Corporation 1 and receives compensation from
Corporation 1; will have primary management responsibility over you; will spend [illegible]
of working time on your matters. You have agreed to reimburse Corporation 1 for [illegible]
of compensation.

• Treasurer: also serves as COO of Corporation 1 and receives compensation from
Corporation 1.

• Secretary: also serves as Chairman of the Board of Corporation 1.

• Chairman of the Board: also serves as the Chairman of Corporation 2.

• Director 1: also serves as President/CEO of Corporation 2 and receives compensation
from Corporation 2.

• Director 2: also serves as COO of Corporation 2 and receives compensation from
Corporation 2.

Each member has one vote on all matters coming before the members for action. Your Bylaws
do not contain any provision on membership qualifications other than naming the Initial Members
as such. You have adopted a Conflict of Interest Policy.

Law:

Section 501(a) provides that an organization described in subsection (c) is exempt from income
taxation.

Section 501(c)(3) provides for the exemption from federal income tax of organizations that are
organized and operated exclusively for charitable, scientific or educational purposes, or for the
prevention of cruelty to children, provided no part of the organization’s net earnings inures to
the benefit of any private shareholder or individual.

Section 1.501(c)(3)-1(a)(1) of the Income Tax Regulations provides that, in order to be exempt
as an organization described in § 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.

Section 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 § 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.

Section 1.501(c)(3)-1(e)(1) provides that an organization may meet the requirements of section
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

[illegible]

on an unrelated trade or business (as defined in § 513). 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.

Rev. Rul. 54-305, 1954-2 C.B. 127, concerns an organization whose purposes are to secure for
hospitals and other charitable institutions the advantages of cooperation in establishing uniform
standards as to quality and kind of supplies and the purchasing of the same, and to promote the
economical and efficient administration of hospitals and other institutions and to establish and
maintain a central purchasing agency. Any hospital or similar institution not conducted for profit
and engaged in charitable work is eligible for membership. The organization’s income is
derived from dues, cash discounts on purchases for members, and service charges. The ruling
states that the activities of the organization, the purchase of supplies and the performance of
related services for the several otherwise unrelated charitable organizations that constitute its
membership, cannot be termed charitable, but are ordinary business activities. The ruling holds
that a corporation organized and operated for the primary purpose of operating and maintaining
a purchasing agency for the benefit of otherwise unrelated members who are exempt from
federal income tax as charitable organizations is engaged in business activities which would be
unrelated activities if carried on by any one of the tax-exempt organizations served. Therefore,
the organization is not entitled to exemption under § 101, the precursor of § 501(c)(3).

Rev. Rul. 69-528, 1969-2 C.B. 127, concerns an organization formed to provide investment
services for a fee exclusively to organizations exempt under § 501(c)(3). The ruling states that
providing investment services on a regular basis for a fee is a trade or business ordinarily
carried on for profit. If the services were regularly provided by one tax-exempt organization for
other tax-exempt organizations, such activity would constitute unrelated trade or business.
Thus, the ruling holds that the organization is not described in § 501(c)(3) since it is regularly
carrying on the business of providing investment services that would be unrelated trade or
business if carried on by any of the tax-exempt organizations on whose behalf it operates.

Rev. Rul. 71-529, 1971-2 C.B. 234, concerns an organization formed specifically to assist §
501(c)(3) organizations to manage more effectively their endowment or investment funds.
Membership in the organization is restricted to colleges and universities exempt under §
501(c)(3). Its board of directors is composed of representatives of the member organizations.
Most of the operating expenses of the organization are paid for by grants from independent
charitable organizations. The member organizations pay only a nominal fee for the services
performed. These fees represent less than fifteen percent of the total costs of operation. The
ruling states that, by providing the services described above to its members, the organization is
performing an essential function for charitable organizations. By performing this function for the
organizations for a charge that is substantially below cost, the organization is performing a
charitable activity within the meaning of § 501(c)(3). Consequently, the ruling holds that the
organization qualifies for exemption under § 501(c)(3).

Rev. Rul. 72-369, 1972-2 C.B. 245, concerns an organization formed to provide managerial and
consulting services for nonprofit organizations exempt under § 501(c)(3) to improve the
administration of their charitable programs. The organization enters into agreements with
unrelated nonprofit organizations to furnish managerial and consulting services on a cost basis.
The ruling states that the provision of managerial and consulting services on a regular basis for
a fee is a trade or business ordinarily carried on for profit. The fact that the services in this case
are provided at cost and solely for exempt organizations is not sufficient to characterize this
activity as charitable within the meaning of section 501(c)(3) of the Code. Furnishing the
services at cost lacks the donative element necessary to establish this activity as charitable.
Accordingly, the ruling holds that the organization’s activities are not charitable and, therefore,
the organization does not qualify for exemption under § 501(c)(3).

Analysis:

You were formed as an administrative services organization to provide management and
support services to organizations described in § 501(c)(3). Corporation 1 and Corporation 2 are
your Initial Members who, aside from their common membership in you, are unrelated. You will
enter into a management services agreement with each Initial Member under which the member
will purchase certain management services in the areas of human resources, finance and
accounting, information technology, and other support services, thereby enabling those Initial
Members to realize efficiencies and economies of scale. Fees for such services will be based
on cost plus an administrative fee.

Section 1.501(c)(3)-1(e) provides that an organization that is organized and operated for the
primary purpose of carrying on an unrelated trade or business does not meet the requirements
of § 501(c)(3). This principle is illustrated in Rev. Rul. 54-305, which stands for the proposition
that purchasing and related administrative support services that promote the economic and
efficient administration of charitable organizations are not charitable activities, but ordinary
business activities. If a charitable organization were to provide such services to other unrelated
charitable organizations, such activities would be considered an unrelated trade or business of
the provider. Thus an organization engaged solely in such activities would be deemed
organized and operated for the primary purpose of carrying on an unrelated trade or business,
and, consequently, would fail to meet the requirements of § 501(c)(3).

Correspondingly, if Corporation 1 were to provide administrative services to Corporation 2 for
a fee, such activities would constitute an unrelated trade or business of Corporation 1. Because
the provision of administrative services to your Initial Members and other unrelated charitable
organizations is your sole purpose and activity, we conclude that you are organized and
operated for the primary purpose of carrying on an unrelated trade or business, and do not
qualify for exemption under § 501(c)(3).

Our conclusion is buttressed by Rev. Rul. 69-528, in which it was held that if a tax-exempt
organization provides investment services for a fee to another unrelated tax-exempt
organization, such activity would constitute an unrelated trade or business. Thus, it was
reasoned that an organization formed for the sole purpose of providing such services is not
described in § 501(c)(3) because it is organized and operated for the primary purpose of
carrying on an unrelated trade or business.

Like investment services, the services you provide can be obtained from for-profit commercial
businesses. The provision of commercially-available services to unrelated exempt
organizations at cost is not a basis for exemption under § 501(c)(3). This proposition is
illustrated by comparing Rev. Rul. 71-529 with Rev. Rul. 72-369.

In Rev. Rul. 71-529, an organization formed to provide investment services to unrelated
colleges and universities was found to be engaging in charitable activities because the fees paid
by its members for such services were nominal, less than 15 percent of the total costs of
operations. By comparison, in Rev. Rul. 72-369, an organization formed to provide managerial
and consulting services at cost to exempt organizations for the purpose of improving the
administration of their charitable programs was found to be carrying on a regular commercial
trade or business. It was concluded that the organization does not qualify for exemption under
§ 501(c)(3) because the furnishing of commercially-available services at cost is insufficient to
establish the activity as charitable.

You will provide commercially-available services to other unrelated § 501(c)(3) organizations
either at cost or at cost plus a reasonable administrative fee. Thus, your activities, like those of
the organization described in Rev. Rul. 72-369, are not charitable.

Accordingly, you do not qualify for exemption as an organization described in § 501(c)(3) and
you must file federal income tax returns. Contributions to you are not deductible under § 170.

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 Service will consider the failure to protest as a failure to exhaust
available administrative remedies. 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

[illegible]

Columbia determines that the organization involved has exhausted all of the administrative
remedies available to it within the Service.

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:T:1
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,

Holly O. Paz
Director, Rulings and Agreements