Other 1326019: IRS denies exemption to a foundation that made insider loans

Plain-English summary

The IRS denied section 501(c)(3) exemption to a foundation that made charitable grants and loans but also routed funds to related for-profit businesses. The foundation's directors and family members owned or controlled the businesses, and the IRS found that the transactions provided private benefit and caused inurement. The IRS also concluded that, if exemption were granted, the loans would constitute self-dealing and jeopardizing investments. Contributions were not deductible, and the organization was required to file Forms 1120 for open tax periods and later years.

Ruling snapshot

• Question: Did the foundation qualify for exemption under section 501(c)(3) despite loans to related for-profit entities?
• Outcome: Denied
• Key authorities: IRC §§ 501(a), 501(c)(3), 170, 507, 4941, 4944, 4945, 7428, and 6110; Treas. Reg. §§ 1.501(c)(3)-1, 53.4941(d)-1, 53.4941(d)-2, and 53.4944-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury

Appeals Office .
312 Elm Street, Suite 2330 Taxpayer Identification Number:
Cincinnati, OH 45202 NUMBER

Person to Contact:

Number: 201326019
Release Date: 6/28/2013

UIL: 501.32-00
Date: April 5, 2013 501.33-00

NAME
ADDRESS

Certified Mail

NAME:

This is a final adverse determination regarding your exempt status under section 501(c)(3) of the Internal
Revenue Code (the “Code”). It is determined that you do not qualify as exempt from Federal income tax
under section 501(c)(3) of the Code.

You do not qualify for exemption under Section 501(c)(3) of the Code because you are not formed and
operated exclusively for charitable tax-exempt purposes. You were formed and controlled by disqualified
persons. Your operations inure to the benefit of private individuals and entities controlled by and
significantly influenced by disqualified persons and relatives. A substantial amount of your charitable
assets were used for private purposes. Therefore, you are not operated exclusively for exempt purposes
described in section 501(c)(3) of the Code and are not exempt.

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

You are required to file Federal income tax returns on Forms 1120 for all open tax periods and for all tax
years thereafter. File your return with the appropriate Internal Revenue Service Center per the
instructions of the return. For further instructions, forms, and information please visit www. irs.gov.

If you were a private foundation as of the effective date of the adverse determination, you are considered
to be taxable private foundation until you terminate your private foundation status under section 507 of
the Code. In addition to your income tax return, you must also continue to file Form 990-PF by the 15th
Day of the fifth month after the end of your annual accounting period.

Processing of income tax returns and assessments of any taxes due will not be delayed should a petition
for declaratory judgment be filed under section 7428 of the Code.

If you decide to contest this determination, you may file an action for declaratory judgment under the
provisions of section 7428 of the Code in one of the following three venues: 1) United States Tax Court,
2) the United States Court of Federal Claims, or 3) the United States District Court for the District of
Columbia. A petition or complaint in one of these three courts must be filed within 90 days from the date
this determination letter was mailed to you. Please contact the clerk of the appropriate court for rules for
filing petitions for declaratory judgment. To secure a petition form from the United States Tax Court, write
to the United States Tax Court, 400 Second Street, N.W., Washington, D.C. 20217. See also Publication
892.

You also have the right to contact the office of the Taxpayer Advocate. Taxpayer Advocate assistance is
not a substitute for established IRS procedures, such as the formal appeals process. The Taxpayer
Advocate 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 tax matters
that may not have been resolved through normal channels get prompt and proper handling. If you want

Taxpayer Advocate assistance, please contact the Taxpayer Advocate for the IRS office that issued this
letter. You may call toll-free, 1-877-777-4778, for the Taxpayer Advocate or visit www. irs.gov/advocate
for more information.

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

Sincerely Yours,

XKXXXKXKK

Appeals Team Manager

Enclosure: Publication 892

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

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Date: February 13, 2012 Contact Person:
Identification Number:
Contact Number:
FAX Number:

Employer Identification Number:

LEGEND: UIL: ;
501.32-00
C= Name of State 501.33-00
D= Date

E= Director

F= Director

G= Director

H= Director

J= Name of organization

K= Name of organization

L= Name of organization

M= Name of for-profit entity

N= Name of for-profit entity

O= Name of individual

P= Name of individual

Q= Name of individual

R= Family

S= Date

T= Name of for-profit entity

U= Name of foundation

V= Name of individual

We Date

x= $

y=$

z=$

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

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concluded that you do not qualify for exemption under Code section 501(c)(3). The basis for
our conclusion is set forth below.

Issue

Do you qualify for exemption under section 501(c)(3) of the Code? No, for the reasons
described below.

Alternative Issues

If upon appeal exemption is granted, would your loan to a related for-profit entity, M, constitute
an act of self-dealing? Yes for the reasons described below.

If upon appeal exemption is granted, would your loans to M constitute a jeopardizing
investment? Yes, for the reasons described below.

Facts
You are a corporation formed on D under the laws of the state of C.

Your Certificate of Incorporation states the purposes for which you were formed are:

“To distribute funds to non-profit organizations who are tax exempt under section 501(c)(3) of
the Internal Revenue Code or the foreign equivalent to support their charitable and religious
activities.”

Your governing body is comprised of four individuals, each titled as director: E, F, G and H. All
four of your directors are related by blood/marriage as two of your directors are brothers and the
other two directors are their spouses.

You adopted non profit Bylaws listing general purposes and operational procedures. Article 5 of
your Bylaws outlines your Conflict of Interest policy and procedures regarding interested parties.

Under the activities description given in Form 1023 your stated activities will be the making of
contributions to other organizations, the nature of whose activities is such as to qualify them
under Internal Revenue Code 501(c)(3). This activity will be conducted by the directors of your
organization and will be funded by unsolicited contributions from individuals and/or closely held
corporations.

You indicated that directors will choose 501(c)(3) entities with no relationship to your foundation
to whom donations would be made. Records will be retained with the date, names and
addresses of the recipient organizations and the amount of the donation. Distributions will only
be made to exempt 501(c)(3) organizations in good standing and they will be selected by their
reputation as helping the community at large. Although your organizing document makes
reference to making distributions to foreign entities, you have indicated your intention to not
make any gifts to foreign organizations at this time.

Your correspondence provided further detail on your loan making activities. You will provide

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interest free short term loans to charitable organizations. You will also make long term loans to

for-profit entities. If a for-profit entity requests a loan it will be charged interest. You have stated
the purpose of the short term loans is to assist non profit organizations by providing interest free
working capital and help with their charitable activities. The loans made to for profit entities were
long term to generate interest income.

Loans were made to three charities (J, K and L) and one for-profit entity, M. M was not the end
user of the loan. You transferred the loan funds to M because M had obligated itself to lend the
money to N a for-profit LLC. After receiving the loan from you M entered into a loan agreement
with N for x dollars total. y dollars of that amount was advanced to N on S and z dollars was
advanced on W. V, an uncle to E and G, arranged for the financing of the transaction between
N and M. V is designated as a manager of N and signed the agreement between N and M.
Your loans to M were on Promissory Notes signed by E on behalf of the borrower M and were
not collateralized in any manner. The loan from M to N was secured by a mortgage on certain
real property.

M is partially owned by two of your board members, G and E. The majority owner of M is P, the
father of G and E. Total ownership by percentage is broken down as follows:

• ‘%
  OQ... cee cee eeee - %
  ree - %
  Qloc cece cena ees - %
  G woe cece eens - %
  Others......... - %

In total, the R family owns % of M with G and E owning %. Since P is the father of G
and E, disqualified persons own more than °% of M.

T is a corporation % owned and controlled by G and E and therefore ‘% owned by your
board. T, has contributed the majority of funds to you.

U is the second largest donor to you. U is a 501(c)(3) Private foundation and you indicated that
you have no relationship to U. However you did indicate that T has also made substantial
contributions to U.

Throughout the 20 _ fiscal year T donated approximately $: to you, and U donated y
dollars. E provided a loan to you which was repaid in full with no interest. Loan repayments to
you totaled approximately $

You made approximately $ in donations, $ in loans to other organizations, and the
loans to M.

On S, U gave y dollars to you. T gave what appears to be y dollars + % to U, 4 days later.

Ten days after receiving y dollars, you made a loan to M for the same amount. On the same
day, M entered into the agreement with N and made an initial distribution of funds for y dollars.
Thirty days later, T gave z dollars to you. On the same day another payment was made to M for

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z dollars under the agreement.

Law

Section 501(a) of the Internal Revenue Code of 1986 provides for the exemption from federal
income tax for organizations described in Section 501(c)(3). Such organizations are recognized
as exempt if they are organized and operated exclusively for religious, charitable, and
educational purposes.

Section 1.501(c)(3)-1(a)(1) of the Income Tax Regulations states that, in order to be exempt as
an organization described in section 501(c)(3) of the Code, 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) of the regulations 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 section 501(c)(3) of the
Code. 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(c)(2) of the regulations provides that an organization is not operated
exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the
benefit of private shareholders or individuals.

Section 1.501(c)(3)-1(d)(1)(ii) of the regulations states 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 requirement of this subdivision, 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.

In Salvation Navy v. Commissioner, T.C.M. 2002-275 (2002), the court found that one of the
reasons why the organization did not qualify for exemption from federal income tax was
because it could not provide that its net earnings would not inure to the benefit of a private
individual which was its founder.

In Old Dominion Box Co. v. United States, 477 F2d 344 (4th Cir. 1973) cert. denied 413 U.S. 910
(1973), the court held that operating for the benefit of private parties constitutes a substantial
non-exempt purpose.

Leon A. Beeghly v. Commissioner, 35 T.C. 490 (1960), provided that where an exempt
organization engages in a transaction with a related interest and there is a purpose to benefit
the private interest rather than the organization, exemption may be lost even though the
transaction ultimately proves profitable for the exempt organization.

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In Better Business Bureau of Washington, D.C., Inc. v. United States, 326 U.S. 179, the
Supreme Court held that the presence of a single non-exempt purpose, if substantial in nature,
will destroy a claim for exemption regardless of the number or importance of truly exempt
purposes.

Law Regarding Alternative Issues

Section 53-4941(d)(1) of the regulations defines self-dealing as any direct or indirect transaction
described in §53.4941(d)-2. For purposes of this section, it is immaterial whether the
transaction results in a benefit or a detriment to the private foundation.

Section 53-4941(d)-2(c) indicates that the lending of money or other extension of credit between
a private foundation and a disqualified person shall constitute an act of self-dealing.

Section 53-4944-1(2) of the regulations indicates that an investment shall be considered to
jeopardize the carrying out of the exempt purposes of a private foundation if it is determined that
the foundation managers, in making such investment, have failed to exercise "ordinary business
care and prudence", under the facts and circumstances prevailing at the time of making the
investment, in providing for the long and short term financial needs of the foundation to carry out
its exempt purposes. In the exercise of the requisite standard of care and prudence the
foundation managers may take into account the expected return, the risks of rising and falling
price levels, and need for diversification within the investment portfolio.

Rev. Rul. 77-161, 1977-1 C.B. 358
This ruling held that a loan by a private foundation to a disqualified person constitutes an act of
self dealing but is not a taxable expenditure within the meaning of section 4945(d)(5) of the
Code. The private foundation made a loan to a disqualified person to generate income to be
used solely for the foundation's charitable purposes. The loan was made at a reasonable rate of
interest, adequately secured and otherwise met prudent investment standards.

Application of Law

You operate for the benefit of private interests by channeling funds from one related for-profit to
another related for-profit through you. The loans you provide to the related for-profit M are used
by it to operate its mortgage lending business thereby resulting in inurement to G and E its
owners. Therefore you are not operated exclusively for charitable purposes as described in
section 501(c)(3) of the code and fail the operational test under 1.501(c)(3)-1(a)(1) of the
regulations. Since your primary purpose is to operate for the benefit of insiders you also are not
as described in 1.501(c)(3)-1(c)(1) of the regulations.

You obtained funds from a related for-profit and then channeled these funds as a loan to
another related for-profit which is owned by your board members and their family members. As
a result your earnings inured to your directors and you operated for the benefit of private
interests such as your creators and their family. Therefore you are not as described in section
1.501(c)(3)-1(c)(2) and 1.501(c)(3)-1(d)(1)(ii) of the regulations.

As shown in Salvation Navy v. Comm. and Old Dominion v. U.S., the transactions conducted

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through you benefitted private interests. The loans that, in the normal course of business,
would have been made directly to M were directed through you. The transactions generated
charitable contributions, while still allowing access to the funds through loans to related for-profit
entities. The loans also served the private interests of the other for-profit M owned by G and E
and members of the R family by providing it funds to operate its business. The timing of the
transactions, the amounts and the fact that the loans were unsecured clearly demonstrate the
transactions were structured for the private benefit of insiders. In addition your investment in M
was made to satisfy an obligation of M to N which was an arrangement orchestrated by V an
uncle of E and G.

Similar to Leon Beeghly v. Comm., the loans you made to M were to satisfy an obligation M had
to provide funding to N. Although the loans to M would generate interest income for you the
purpose of these loans was to benefit the end user, N. M would also benefit from this
transaction by using the funds for its own business purposes and earning interest therefrom.

As in Better Business Bureau of Washington, D.C., Inc. v. United States, 326 U.S. 179, and
Sections 1.501(c)(3)-1(a)(1) and 1.501(c)(3)-1(c)(1) You are set up to operate for the non-
exempt purpose of receiving funding from a for-profit entity, turning around and providing loans
to another for-profit entity both of which are owned by your directors and their family. You
operate to serve the private interests of these for-profit entities and also allow your income to
inure to the benefit of your directors and family members by providing loans to for-profit
businesses that are owned by your directors and family members. Substantially all of your
income was used to provide loans to related for-profit entities, which represents a significant
non-exempt purpose.

Application of Law on Alternative Issues

The loans to M clearly constitute an act of self-dealing based on Section 53-4941(d)(1) and
Section 53-4941(d)-2(c) of the regulations. As in Revenue Ruling 77-161, you made a loan to
a disqualified person which resulted in an act of self dealing.

The loans made by you also constitute a jeopardizing investment as described in Section 53-
4944-1(2) of the regulations. Your loans to M were made to enable M to satisfy its obligation to
N without consideration of your long and short term needs to carry out your exempt purposes.
Also in making this investment you have failed to exercise the requisite standard of care and
prudence, taking into account the expected return, the risks of falling price levels and the need
for diversification of the investment portfolio. There was no diversification in your investments,
the loans were unsecured, all made to a single entity which was involved in mortgage lending.
Therefore it is clear that the required ordinary business care and prudence was not exercised by
you in making this loan.

Applicant’s Position

You indicated that the loans were never intended for M’s use but rather for unrelated third party
entities. The purpose of these loans, backed by mortgages on real property was to produce
interest revenue for your charitable purposes. The loans were channeled through M because
they had been providing mortgage loans for years and had the infrastructure necessary for

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making such loans relatively quickly. All interest on the loans has been remitted entirely to you.
Soon afterward you realized the problem of making loans through related entities. You
immediately discontinued the practice and make all loans directly to unrelated parties.

Service Response to Applicant’s Position

You provided funds to M so that they can make mortgage loans on real property. M is a for-
profit entity which is % owned by disqualified persons. Therefore in effect you financed M so
that they could operate their mortgage business which they have been conducting for years.
Therefore you operated for the private benefit of M and your earnings inured to the directors and
owners of M because they were able to use your funds to operate their business and to earn
profits therefrom. Your loans to M were unsecured. In addition, had you been exempt, the
loans made to M would constitute self-dealing and also a jeopardizing investment. You indicate
you now make loans directly to unrelated third parties. The making of loans to unrelated third
parties is not an exempt purpose. You did not provide any information as to the nature of these
loans and the purpose and terms of these loans.

Conclusion

Based on the above facts and law we conclude that you do not qualify for exemption under
Section 501(c)(3) of the Code because you are operating for a substantial non exempt purpose.
Your operations result in private benefit to for-profit organizations and your earnings inure to
your directors and family members who are owners of these for-profit businesses that contribute
to you as well as receive funds from you.

Conclusion-Alternative Issues

We further conclude that, if upon appeal exemption is granted, the lending of money to a related
company results in a self-dealing transaction. In addition the lack of requisite care and
prudence in making the purported investment in the related company indicates that the
investment would be a jeopardizing investment.

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. If your
statement does not provide a basis to reconsider our determination, we will forward your case to
our Appeals Office. You can find more information about the role of the Appeals Office in
Publication 892, Exempt Organization Appeal Procedures for Unagreed Issues.

Types of information that should be included in your appeal can be found on page 2 of
Publication 892, under the heading “Regional Office Appeal”. The statement of facts (item 4)
must be accompanied by the following declaration:

“Under penalties of perjury, I declare that I have examined the statement of facts presented in
this appeal and in any accompanying schedules and statements and, to the best of my
knowledge and belief, they are true, correct, and complete.”

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The declaration must be signed by an officer or trustee of the organization who has personal
knowledge of the facts.

Your appeal will be considered incomplete without this statement.

If an organization’s representative submits the appeal, a substitute declaration must be included
stating that the representative prepared the appeal and accompanying documents; and whether
the representative knows personally that the statements of facts contained in the appeal and
accompanying documents are true and correct.

An attorney, certified public accountant, or an individual enrolled to practice before the Internal
Revenue Service may represent you during the appeal process. If you want representation
during the appeal process, you must file a proper power of attorney, Form 2848, Power of
Attorney and Declaration of Representative, if you have not already done so. You can find more
information about representation in 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 appeal
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 the
applicable address:

Mail to: Deliver to:
Internal Revenue Service Internal Revenue Service
EO Determinations Quality Assurance EO Determinations Quality Assurance
Room 7-008 550 Main Street, Room 7-008
P.O. Box 2508 Cincinnati, OH 45202

Cincinnati, OH 45201

You may 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.

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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

Enclosure, Publication 892

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