Determination 1329020: IRS revokes an online university’s exemption for private inurement

View official IRS release (PDF)

Plain-English summary

The IRS revoked an online university’s exemption under IRC § 501(c)(3), effective January 1 of the redacted year. The determination found that three officers benefited from repeated payments, including housing, gifts, personal purchases, and reimbursements that lacked adequate substantiation. The IRS treated the payments as private inurement and excess-benefit transactions, noting that the organization engaged in more than 60 such transactions and had not established safeguards to prevent them. The organization was required to file Form 1120 for the affected years.

Ruling snapshot

• Question: Should the organization’s IRC § 501(c)(3) status be revoked because its net earnings inured to the benefit of its officers?
• Outcome: Revocation, effective January 1 of the redacted year, with Form 1120 filing required for the affected periods.
• Key authorities: IRC §§ 501(c)(3), 170, 4958, 6104(c), 7428; Treas. Reg. §§ 1.501(c)(3)-1(a)(1), 1.501(c)(3)-1(c)(2), 1.501(c)(3)-1(f)(2)(ii), 1.62-2, 53.4958-3, 53.4958-4, and 53.4958-7.

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
TEGE EO Examinations Mail Stop 4920 DAL
Dallas, Texas 75242

TAX EXEMPT AND

GOVERNMENT ENTITIES

DIVISION

Date: January 7, 2013
Release Number: 201329020

Rel Date: 7/19/2013
elease Date: 7/19/ Taxpayer Identification Number:

LEGEND

ORG - 0 cats Person to Contact:
Fganizatczon name Employee Identification Number:

7% - Date Address ~ address Employee Telephone Number:

Officer-1-3 1%, 274? g 34 (Phone)

Officer (Fax)

ORG

ADDRESS

CERTIFIED MAIL — RETURN RECEIPT

Dear

This is a final adverse determination regarding your exempt status under section 501(c)(3) of the
Internal Revenue Code. Our favorable determination letter to you dated February 3, 20XX is
hereby revoked and you are no longer exempt under section 501(a) of the Code effective January
1, 20XX.

The revocation of your exempt status was made for the following reason(s):

Organizations described in IRC 501(c)(3) and exempt under section 501(a) must be both organized
and operated exclusively for exempt purposes. You must establish that you are operated
exclusively for exempt purposes and that no part of your net earnings inures to the benefit of
private shareholders or individuals.

Your earnings have inured to the benefit of three of your officers, Officer-1, Officer-2, and Officer-

3. This inurement totaled $ during the years 20XX, 20XX, and 20XX. This is a substantial amount
   of inurement, and violates section 1.501(c)(3)-1(c)(2) of the Treasury Regs. Given the routine and
   continuvus nature of the inurement, this warrants revocation of your 501(c)(3) status effective
   January 1, 20XX.

Contributions to your organization are no longer deductible under IRC §170 after January 1, 20XX.

You are required to file income tax returns on Form 1120. These returns should be filed with the
appropriate Service Center for the tax year ending December 31, 20XX, and for all tax years
thereafter in accordance with the instructions of the return.

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 Internal Revenue Code.

If you decide to contest this determination under the declaratory judgment provisions of section
7428 of the Code, a petition to the United States Tax Court, the United States Claims Court, or the
district court of the United States for the District of Columbia must be filed before the 91° Day
after the date this determination was mailed to you. Please contact the clerk of the appropriate
court for rules regarding filing petitions for declaratory judgments by referring to the enclosed
Publication 892. You may write to the United States Tax Court at the following address:

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 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 contact the person whose name and telephone number are
shown in the heading of this letter.

Sincerely,

Nanette M. Downing
Director, EO Examinations

a) Department of the Treasury Date:

Internal Revenue Service July 24, 2012
IRS Tax Exempt and Government Entities Division Taxpayer Identification Number:
100 SW Main Street

Portland, OR 97204

Form:

Tax year(s) ended:

ORG
ADDRESS Person to contact / ID number:

Contact numbers:

Manager's name / ID number:

Manager's contact number:

Response due date:

Certified Mail - Return Receipt Requested
Dear

Why you are receiving this letter
We propose to revoke your status as an organization described in section 501(c)(3) of the Internal Revenue
Code (Code). Enclosed is our report of examination explaining the proposed action.

What you need to do if you agree

If you agree with our proposal, please sign the enclosed Form 6018, Consent to Proposed Action — Section
7428, and return it to the contact person at the address listed above (unless you have already provided us a
signed Form 6018). We'll issue a final revocation letter determining that you aren't an organization described in
section 501(c)(3).

After we issue the final revocation letter, we’ll announce that your organization is no longer eligible for
contributions deductible under section 170 of the Code.

If we don't hear from you

If you don't respond to this proposal within 30 calendar days from the date of this letter, we’Il issue a final
revocation letter. Failing to respond to this proposal will adversely impact your legal standing to seek a
declaratory judgment because you failed to exhaust your administrative remedies.

Effect of revocation status
If you receive a final revocation letter, you'll be required to file federal income tax returns for the tax year(s)
shown above as well as for subsequent tax years.

What you need to do if you disagree with the proposed revocation
If you disagree with our proposed revocation, you may request a meeting or telephone conference with the
supervisor of the IRS contact identified in the heading of this letter. You also may file a protest with the

Letter 3618 (Rev. 6-2012)
Catalog Number 34809F

IRS Appeals office by submitting a written request to the contact person at the address listed above within 30
calendar days from the date of this letter. The Appeals office is independent of the Exempt Organizations
division and resolves most disputes informally.

For your protest to be valid, it must contain certain specific information including a statement of the facts, the
applicable law, and arguments in support of your position. For specific information needed for a valid protest,
please refer to page one of the enclosed Publication 892, How to Appeal an IRS Decision on Tax-Exempt Status,
and page six of the enclosed Publication 3498, The Examination Process. Publication 3498 also includes
information on your rights as a taxpayer and the IRS collection process. Please note that Fast Track Mediation
referred to in Publication 3498 generally doesn’t apply after we issue this letter.

You also may request that we refer this matter for technical advice as explained in Publication 892. 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 on a technical advice memorandum issued by the Exempt
Organizations Rulings and Agreements office, no further IRS administrative appeal will be available to you.

Contacting the Taxpayer Advocate Office is a taxpayer right

You have the right to contact the office of the Taxpayer Advocate. Their assistance isn’t a substitute for
established IRS procedures, such as the formal appeals process. The Taxpayer Advocate can't reverse a legally
correct tax determination or extend the time you have (fixed by law) to file a petition in a United States court.
They can, however, see that a tax matter that hasn't 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:

Interiin! Revenue Service
Office of the Taxpayer Advocate

For additional information

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,

yal *
Nanette M. Downing
Director, EO Examinations

Enclosures:

Report of Examination
Form 6018

Publication 892
Publication 3498

Letter 3618 (Rev. 6-2012)
Catalog Number 34809F

Form 886 A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Petiod Ended
ORG, formerly CO-1 20XX, 20X°X,
20XX

LEGEND ;
ORG ~ Organization name XX - Date Address - address City - city
State - state President - president Vice-President - vice president
Secretary - secretary CPA - CPA Founder - founder RA-1 - 1%* RA

CO-1 through CO-11 - 1° through 11° COMPANIES

Issue

Should ORG’s 501(c)(3) status be revoked on the grounds that its net earnings inured
to the benefit of its president, vice-president, and secretary?

Facts

ORG, formerly known as CO-1 (“ORG”), is an online university. Its corporate office is
located at Address, City, State. It offers degrees in and

. Its enrollment was approximately 200 students during the years under
examination. ORG also conducts live training seminars approximately 30 times
throughout each school year. These seminars are held in locations throughout the
United States and Canada.

During the years under examination, ORG’s president and vice-president were
President and Vice-President (husband and wife), respectively. ORG’s board secretary
was Secretary.

ORG filed with the IRS a Form 1023, Application for Recognition of Exemption Under
Section 501(c)(3) of the Internal Revenue Code, on May 13, 20XX. On February 3,
20XX, the IRS issued a ruling letter to ORG, recognizing it as a tax-exempt public
charity under section 501(c)(3) of the Internal Revenue Code (“Code”), effective April
26, 20XX.

On April 28, 20XX, ORG filed a Plan of Conversion with the State of State to convert
back to for-profit status as of June 1, 20XX. The State of State certified this
conversion. According to a valuation prepared by CO-2 ORG’s value was appraised to
be zero. This was primarily due to ORG’s outstanding debt of $$ to CO-3 (“CO-3”).
President owns % of CO-3’s stock. At conversion, the debt was extinguished in
exchange for ORG’s stock. ORG formally changed its name from CO-1 to ORG on
December 13, 20XX.

The examining IRS agent contacted ORG president President on December 8, 20XX
and advised him of the audit of ORG’s year 20XX Form 990. The agent mailed the
audit letter to ORG on December 10, 20XX. The agent conducted the field audit at the
City office of ORG’s representative, CPA, CPA on January 10, 20XX. CPA was
replaced as representative by CPA, CPA, on March 2, 20XX.

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, formerly CO-1 20XX, 20XX,
, 20XX

Background of ORG

ORG operated as a for-profit corporation from 19XX until 2OXX. ORG was incorporated
in City, State on December 13, 19XX. It was a correspondence school organized to
train individuals in various self-improvement techniques developed by its founder,
Founder. Founder is the father of President.

CO-3 was ORG’s predecessor. It was incorporated November 12, 19XX as a for-profit
State corporation. All of the rights, title and interest in programs, training, books,
recordings and videos were held either by CO-3 or Founder, personally. Ownership of
CO-3 passed from Founder to President in 20XX.

According to ORG’s meeting minutes dated September 18, 20XX, ORG’s board voted
unanimously to remove Founder from his position as president of the board of ORG.
President was voted to take the position as president.

Following Founder’ termination, he demanded that ORG and CO-3 cease using his
registered marks, name and likeness. ORG and CO-3, however, continued to use his
marks, name and likeness in their print advertisements and on their web sites. As a
result, President brought suit against ORG, CO-3, President, and Vice-President.
Founder was granted a Motion for Temporary Restraining Order on March 6, 20XX.

Forms 990 and Payments to Officers
ORG’s Forms 990 for the years under examination reported as follows:
Figure 1: Forms 990
20XX 20XX 20XX

Date Filed 7/17/20XX 4/21/20XX 5/17/20XX
Revenues

Contributions and grants

Program service revenue

Investment income

Other revenue
Total Revenue

Expenses

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

Form 8 86 A "Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG, formerly CO-1 20XX, 20XX,
20XX

Grants, assistance to government
Grants, assistance to individual
Compensation to officers
Other salaries and wages
Pension plan contributions
Other employee benefits
Payroll taxes

Legal

Accounting

Other

Advertising and promo

Office expenses

Information technology
Occupancy

Travel

Conferences and Meetings
Depreciation

Insurance

Other 4

Total Expenses

Excess (deficit)

20XX 20XX 20XX
Assets
Cash
Accounts Receivable
Receivables from officers
Inventories
Prepaid expenses
Land, buildings, equipment
Other.assets
Total Assets

Liabilities
Accounts Payable
Deferred revenue
Other liabilities
Total Liabilities
Net Assets

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

Form 8 86 A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG, formerly CO-1 20XX, 20XX,
20XX

Amorig iiie disbursements ORG made during the years under examination were the

following:
Figure 2 — Payments 20XX
Date Check Amount Payee
1/41XX $$ CO-4
2/6/XX $$ CO-4
3/7/XX $$ CO-4
4/11XX $$ President
4/21XX $$ CO-4
4/9/XX $$ President
4/18/XX $$ Vice-President
4/211XX $$ Vice-President
4/28/XX $$ Vice-President
5/71XX $$ CO-4
195R28/XX $$ President
5/31/XX $$ President
6/3/XX $$ CO-4
6/23/XX $$ President
7/1IXX $$ CO-4
8/6/XX $$ CO-4
8/15/XX $$ Vice-President
9/2/XX $$ Vice-President
Q9/2/XX $$ Vice-President
9/4/XX $$ CO-4
9/9/XX $$ President
9/26/XX $$ CO-5
9/29/XX $$ Vice-President
10/3/XX $$ CO-4
10/17/XX $$ Vice-President
10/18/XX $$ President
11/5/XX $$ Vice-President
11/5/XX $$ CO-4
11/25/XX $ President
12/2/XX $$ CO-4
Figure 3— Payments 20XX
Date Check Amount Payee
1/5/XX $$ CO-4
1/26/XX $$ President

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, formerly CO-1 20XX, 20XX,
20XX

2/4IXX
2/27IXX
oo Bf3/IXX
3/41XX
3/25/XX
3/31/XX
4/3/XX
4/13/XX
5/5/XX
6/3/XX
6/11/XX
6/27/XX
718IXX
TI2Z4IXX
8/5/XX
8/XX/XX
8/27/XX
9/1/XX
9/29/XX
10/21/XX
12/18/XX
12/18/XX

Date

2/3/XX
3/8/XX
5/5/1XX
6/1/XX
6/15/XX
8/4/XX
8/26/XX
9/24/XX
10/26/XX

$$ CO-4

$$ President

$$ CO-4

$$ President

$$ Vice-President
$$ Vice-President
$$ CO-4

$$ President

$$ CO-4

$$ CO-4

$$ President

$$ President

$$ CO-4

$$ Vice-President
$$ CO-4

$$ Vice-President
$$ President

$$ Vice-President
$$ President

$$ Vice-President
$$ President

$$ Vice-President

Figure 4— Payments 20XX
Check Amount Payee

$$ Vice-President
$$ Vice-President
$$ President
$$ Vice-President
$$ Vice-President
$$ President
$$ Vice-President
$$ President
$$ Vice-President

Secretary’ City Apartment

The payments to CO-4, in 20XX and 20XX, were for ORG board secretary Secretary’
apartment at Address in City, State. ORG did not report these payments as
compensation to Secretary on its own Forms 990, or on Secretary’ Forms W2.

Form 886-Arev.4-68)

Department of the Treasury - Internal Revenue Service

Page: -5-

Form 8 86 A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG, formerly CO-1 20XX, 20XX,
20XX

The revenue agent asked ORG, in Information Document Request (“IDR”) #3, issued
March 16, 20XX, the following question regarding these payments:

Question: What was the reason for not including the value of the City
apartment in the W2 of Secretary as a fringe benefit?

ORG’s response to IDR #3, received May 16, 20XX, included the following answer to
the above question:

Answer: We did not include the value of the City apartment in the W2 of
Secretary due to an oversight. We would be issuing a 1099 for this.

On December 13, 20XX, Secretary sent the agent an email regarding the $$ in
apartment payments in the year 20XX, which stated as follows:

Unfortunately, | was unable to locate the email correspondence via my old
laptop as the PC was non-functional. | had hoped to find the email stating
that | was accepting the position with the information included that
housing was a condition of employment. As such, for now, | have paid the
$$ to ORG and have attached evidence of this.

Attached to the email was a scanned check written by Secretary to ORG for $$, and a
scanned letter from ORG, signed by President, acknowledging receipt of the check.

On February 8, 20XX, Secretary sent the agent an email regarding the $$ in apartment
paymenis in the year 20XX, which stated as follows:

ORG did not report the payment to me of the apartment | resided in as
compensation. As | stated in my earlier correspondence with you, as well
as, via telephone, provision of housing was offered by the university as
part of my original offer of employment. | also indicated to you previously,
that the correspondence which references this is unavailable.

There is no discussion in ORG’s Board Meeting minutes of paying for Secretary’
apartment as part of her compensation or as a condition of her working for ORG.

Payments to President and Vice-President
The agent requested source documents (e.g. invoices or receipts) to support the

paymeriis made to President and Vice-President in 20XX via IDRs #2 and #3. ORG did
not initially provide any source documents.

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

Form 886 A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG, formerly CO-1 20XX, 20XX,
20XX

With respect to check # for $ ORG stated that $ of this went to President “for his 20"
anniversary gift in 20XX, to be included i in his 20XX payroll’. ORG stated that the other
$ went to Vice-President “for her 10" anniversary gift in 20XX, included in her 20XX
payroll’.

Regarding the $ payment to CO-5, ORG’s explanation was as follows:

The payment to CO-5 was classified as consulting fee due to the styling,
makeup and other tips they were giving us during the big public relations
push to increase marketing. Once we understood the styling tips there were
(sic) no need for their services anymore. Their services include hair
maintenance and make up services. These were for the benefit of President,
President and Lead Trainer.

With respect to check # for $, ORG stated that $ of it went to two employees’ payroll,
and the other $ went to Vice-President for “personal” purposes. ORG stated that this
amount was “to be included in her 20XX payroll’.

On October 11, 20XX, the agent sent reports to President and Vice-President,
proposing excise taxes on excess benefit transactions (“EBTs”), as described in Code
section 4958, for the year 20XX disbursements shown in Figure 2, above.

On January 17, 20XX, CPA responded to the reports on behalf of the President and
Vice-President’. The response had attached to it five “employee expense reports’,
none of which are legible. It also had attached about 30 receipts, many of which are
also not legible. The response included the following statements:

Taxpayers will agree to reimburse the Company for $ for the watch that was
purchased for Vice-President.

Taxpayers will agree to reimburse the Company for the $$ 20" Anniversary
gift to President.

The response argued that the $$ payment to CO-5 was justified because, at the time,
President was having to make TV appearances to talk about RA-1 (a former ORG
student) and the deaths at his State sweat lodge, in an effort to save ORG’s public
image. The examining agent later viewed footage of President’ TV appearances,
includivig one on the CO-6 show.

kK Ok Kk

"CPA also represented the President and Vice-President in their Code section 4958 examinations until March 20XX,
when they appointed CPA as their representative.

Form 886-A cev.4-68) Department of the Treasury - Internal Revenue Service
Page: -7-

Form 8 86 A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG; formerly CO-1 20XX, 20XX,
20XX

The response argued that the $$ of the $$ from check ## that went to Vice-President
was included in her reported 20XX compensation prior to the examining agent's
January 10, 20XX initial audit appointment, and that it should therefore not be included
in EBTs.

Finally, the response went on to state that the President and Vice-President could only
produce $$ of the requested receipts’. It argued, however, that all of the remaining
disbursements to the President and Vice-President were for reimbursements of travel
expenses related to conducting ORG’s exempt activities, and that the per diem for the
dates and locations of this travel amounts to $$ for President and $$ for Vice-President.
The response argues that these per diem amounts, when added to the receipts, comes
to $$ ($$ + $$ + $$) and that, compared to this amount, the disbursements made to the
President and Vice-President in the year 20XX were reasonable.

On March 26, 20XX, the agent requested source documents to support the
disbursements to the President and Vice-President in 20XX and 20XX (in Figures 3 and
4) via IDRs #6 and #7. On May 10, 20XX, ORG responded by providing a CD with a
number of receipts and invoices. Many of these receipts are either illegible or bear no
relationship to carrying out ORG’s exempt activities. For example, ORG submitted, in
support of checks # and #, two receipts from CO-7, a luxury watch dealer in City, State
and City, State. The receipts reflect the purchase of four Rolex watches; two “Oyster”
models, one “Yachtmaster’, and one “Submariner”, totaling $$. For check #, ORG
submitted $$ in receipts from CO-8, CO-9, and the CO-10 boutique in City. In support
of check #, ORG produced a receipt for a $$ CO-11 men’s bag.

The agent reviewed ail legible receipts that could conceivably be related to ORG’s
exempt activities, and subtracted them from the corresponding disbursements in
Figures 3 and 4. The detailed analysis of valid and invalid receipts is attached as
Exhibit A. The results are as follows:

Figure 5 — Unsubstantiated Payments 20XX
Unsubstantiated

Date Check Payee Amount Valid Receipts Payments
4/1/XX President $$ $ - $$
4/9/XX President $$ $ - $$
4/18/XX Vice-President $$ $ - $$
4/21/XX Vice-President $$ $ - $$

kk ok *& ,

• The agent found that the legible receipts only totaled $$ which included $$ in hotel receipts. The $$ CO-5 invoice
  was discussed separately and so presumably was not included in the $$.

Form 886-A rrev.4-68) Department of the Treasury - Internal Revenue Service
Page: -8-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG, formerly CO-1 20XX, 20XX,
20XX
4/28/XX Vice-President $$ $ - $$
5/28/XX President $$ $ - $$
5/31/XX President $$ ($$) $ -
6/23/XX President $$ ($$) $$
8/14/XX President $$ ($$) $ -
8/15/XX Vice-President $$ $ - $$
9/2i/XX Vice-President $$ $ - $$
9/2/XX Vice-President $$ $ - $$
9/9/XX President $$ $ - $$
9/26/XX President $$ ($$) $ -
9/29/XX Vice-President $$ $ - $$
10/16/XX President $$ ($$) $ -
10/17/XX President $$ ($$) $$
10/18/XX President $$ ($$) $$
11/5/XX Vice-President $$ $ - $$
11/25/XX Vice-President $$ $ - $$
11/25/XX President $ $ - $
Secretary' apartment $ $ - $
$$
Figure 6 — Unsubstantiated Payments 20XX
nN Unsubstantiated
Date Check Payee Amount Valid Receipts Payments
1/26/XX President $$ ($$) $$
2/271XX President
3/4/XX President
3/25/XX Vice-President
3/31/XX Vice-President
4/13/XX President
6/11/XX President
6/27/XX President
TI241XX Vice-President
8/10/XX Vice-President
8/27/XX President
9/1/XX Vice-President
9/29/XX President $$ $ - $$
10/21/XX Vice-President $$
12/18/XX President $$
12/18/XX Vice President $$

Secretary apartment

Form 886-Acrev.4-68)

Department of the Treasury - Internal Revenue Service

Page: -9-

Form 8 86 A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG, formerly CO-1 20XX, 20XX,
20XX

Figure 7 — Unsubstantiated Payments 20XX

Unsubstantiated
Date Check Payee Amount Valid Receipts Payments
2/3/XX Vice-President $$
3/8/XX Vice-President $$
5/5/XX President $$
6/1/XX Vice-President $$
6/15/XX Vice-President $$
8/4/XX — President $$
8/26/XX Vice-President. $$
9/24/XX President $$
10/26/XX Vice-President $$
Law

Internal Revenue Code

Section-601(c)(3) of the Internal Revenue Code provides for exemption from Income
Tax for 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, 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.

Section 4958(c) defines the term “excess benefit transaction” as any transaction in
which an economic benefit is provided by an applicable tax-exempt organization directly
or indirectly to or for the use of any disqualified person if the value of the economic
benefit provided exceeds the value of the consideration (including the performance of
services) received for providing such benefit. For purposes of the preceding sentence,
an economic benefit shall not be treated as consideration for performance of services
unless such organization clearly indicated its intent to so treat such benefit.

Section 4958(e) defines “applicable tax-exempt organization” as an organization
described in either section 501(c)(3) or 501(c)(4) of the Internal Revenue Code or an
organization which was so described at any time during the five-year period ending on
the date of the excess benefit transaction.

Section 4958(f)(1) defines a “disqualified person” as (A) any person who was, at any
time during the five-year period ending on the date of such transaction, in a position to

Form 886-A rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -10-

Form 8 86 A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG, formerly CO-1 20XX, 20XX,
20XX

exercise substantial influence over the affairs of the organization, (B) a member of the
family of a disqualified person, and (C) a 35% controlled entity.

Section 4958(f)(6) of the Code defines “correction”, with respect to any excess benefit
transaction, as the undoing of the excess benefit to the extent possible, and taking any
additional measures necessary to place the organization in a financial position not
worse than that in which it would be if the disqualified person were dealing under the
highest fiduciary standards.

Treasury Regulations

Section 1.501(c)(3)-1(a)(1) of the Treasury Regulations (“Regs”) 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.

Section 1.501(c)(3)-1(c)(2) of the Regs 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(f)(2)(ii) of the Regs provides that, in determining whether to
continue to recognize the tax-exempt status of an applicable tax-exempt organization
described in section 501(c)(3) that engages in one or more excess benefit transactions
that violate the prohibition on inurement under section 501(c)(3), the Commissioner will
consider all relevant facts and circumstances, including, but not limited to, the following:

(A) The size and scope of the organization's regular and ongoing activities that further
exempt purposes before and after the excess benefit transaction or transactions
occurred;

(B) The size and scope of the excess benefit transaction or transactions (collectively, if
more than one) in relation to the size and scope of the organization's regular and
ongoing activities that further exempt purposes;

(C) Whether the organization has been involved in multiple excess benefit transactions
with one or more persons;

(D) Whether the organization has implemented safeguards that are reasonably
calculated to prevent excess benefit transactions; and

Form 886-A rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -11-

Form 8 86 A Department of the Treasury - Internal Revenue Service ~ Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG, formerly CO-1 20XX, 20XX,
20XX

(E) Whether the excess benefit transaction has been corrected (within the meaning of
section 4958(f)(6) and section 53.4958-7), or the organization has made good faith
efforts to seek correction from the disqualified person(s) who benefited from the
excess benefit transaction.

Section 53.4958-3(c)(2) of the Regs describes individuals having “substantial influence
over the affairs of the organization” (per Code section 4958(f)(1)) as including
presidents, chief executive officers, chief operating officers, or any person who,
regardless of title, has ultimate responsibility for implementing the decisions of the
governing body or for supervising the management, administration, or operation of the
organization. A person who serves as president, chief executive officer, or chief
operating officer has this ultimate responsibility unless the person demonstrates
otherwise. If this ultimate responsibility resides with two or more individuals (e.g., co-
presidents), who may exercise such responsibility in concert or individually, then each
individual is in a position to exercise substantial influence over the affairs of the
organization.

Section 53.4958-4(a)(4) provides that certain economic benefits are disregarded for
purposes of section 4958, including (i) Nontaxable fringe benefits. An economic benefit
that is excluded from income under section 132, except any liability insurance premium,
payment, or reimbursement that must be taken into account under paragraph
(b)(1)(ii)(B)(2) of this section, and (ii) Expense reimbursement payments pursuant to
accountable plans. Amounts paid under reimbursement arrangements that meet the
requirements of section 1.62-2(c) of this chapter.

Section 53.4958-4(c)(1) provides that an economic benefit is not treated as
consideration for the performance of services unless the organization providing the
benefit clearly indicates the intent to treat the benefit as compensation when the benefit
is paid. An applicable tax exempt organization is treated as clearly indicating its intent
to provide an economic benefit as compensation for services only if the organization
provided written substantiation that is contemporaneous with the transfer of the
economic benefit at issue. If an organization fails to provide this contemporaneous
substantiation, any services provided by the disqualified person will not be treated as
provided in consideration for the economic benefit for purposes of determining the
reasonableness of the transaction. In no event shall an economic benefit that a
disqualified person obtains by theft or fraud be treated as consideration for the
performance of services.

Section 53.4958-4(c)(3)(i)(A) provides that an organization’s reporting constitutes
contemporaneous substantiation to treat a benefit as compensation if the organization
reports the benefit as compensation on an original Federal tax information return with
respect to the payment (e.g., Form W-2 or 1099); or the recipient disqualified person

Form 886-A cev.4-68) Department of the Treasury - Internal Revenue Service

Page: -12-

Form 886 A Department of the Treasury - Internal Revenue Service Schedule No. ot
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG, formerly CO-1 20XX, 20XX,
20XX

reports the benefit as income on the person's original Federal tax return (e.g., Form
1040); or there is an approved written employment contract executed on or before the
date of the transfer indicating the benefit is compensation; or there is documentation by
the organization’s authorized body approving the transfer as compensation for services
on or before the date of the transfer; or there was written evidence in existence before
the due date of the applicable Federal tax return indicating a reasonable belief by the
organization that the benefit was a nontaxable benefit as described in Regs section
53.4958-4(c)(2).

Section 53.4958-7(e) provides that when the applicable tax-exempt organization is no
longer described in section 501(c)(3), the disqualified person must make correction to
another organization described in sections 501(c)(3) and 170(b)(1)(A) (other than
sections 170(b)(1)(A)(vii) or (viii)) which has been so described for at least 60 months
ending on the date of correction. It further provides that the disqualified person must
not be a disqualified person with respect to the organization which receives the
correction, and that the organization receiving the correction amount must not allow the
disqualified person to make or recommend any grants or distributions by the
organization.

Section 1.62-2(b) provides that for purposes of determining “adjusted gross income,”
section 62(a)(2)(A) allows an employee a deduction for expenses paid by the
employee, in connection with the performance of services as an employee of the
employer, under a reimbursement or other expense allowance arrangement with a
payor. Section 62(c) provides that an arrangement will not be treated as a
reimbursement or other expense allowance arrangement for purposes of section
62(a)(2)(A) if—

(1) Such arrangement does not require the employee to substantiate the expenses
covered by the arrangement to the payor, or

(2) Such arrangement provides the employee the right to retain any amount in excess
of the substantiated expenses covered under the arrangement. '

(c) Reimbursement or other expense allowance arrangement—(1) Defined. For
purposes of sections 1.62—1, 1.62-1T, and 1.62—2, the phrase “reimbursement or other
expense allowance arrangement” means an arrangement that meets the requirements
of paragraphs (d) (business connection), (e) (substantiation), and (f) (returning amounts
in excess of expenses) of this section.

(2) Accountable plans—(i) In general. Except as provided in paragraph (c)(2)(ii), if an
arrangement meets the requirements of paragraphs (d), (e), and (f) of this section, all
amounts paid under the arrangement are treated as paid under an “accountable plan.”

mrt te

Form 886-A Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -13-

Form 886 A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG, formerly CO-1 20XX, 20XX,
20XX

(ii) Special rule for failure to return excess. If an arrangement meets the requirements of
paragraphs (qd), (e), and (f) of this section, but the employee fails to return, within a
reasonable period of time, any amount in excess of the amount of the expenses
substantiated in accordance with paragraph (e) of this section, only the amounts paid
under the arrangement that are not in excess of the substantiated expenses are treated
as paid under an accountable plan.

(3) Nonaccountable plans—(i) In general. If an arrangement does not satisfy one or
more of the requirements of paragraphs (d), (e), or (f) of this section, all amounts paid
under the arrangement are treated as paid under a “nonaccountable plan.” If a payor
provides a nonaccountable plan, an employee who receives payments under the plan
cannot compel the payor to treat the payments as paid under an accountable plan by
voluntarily substantiating the expenses and returning any excess to the payor.

(ii) Special rule for failure to return excess. If an arrangement meets the requirements of
paragraphs (d), (e), and (f) of this section, but the employee fails to return, within a
reasonable period of time, any amount in excess of the amount of the expenses
substantiated in accordance with paragraph (e) of this section, the amounts paid under
the arrangement that are in excess of the substantiated expenses are treated as paid
under a nonaccountable plan.

(4) Treatment of payments under accountable plans. Amounts treated as paid under an
accountable plan are excluded from the employee's gross income, are not reported as
wages or other compensation on the employee's Form W-2, and are exempt from the
withholding and payment of employment taxes.

(5) Treatment of payments under nonaccountable plans. Amounts treated as paid
under a nonaccountable plan are included in the employee's gross income, must be
reported:as wages or other compensation on the employee's Form W-2, and are
subject to withholding and payment of employment taxes (FICA, FUTA, RRTA, RURT,
and income tax). See paragraph (h) of this section. Expenses attributable to amounts
included in the employee's gross income may be deducted, provided the employee can
substantiate the full amount of his or her expenses (i.e., the amount of the expenses, if
any, the reimbursement for which is treated as paid under an accountable plan as well
as those for which the employee is claiming the deduction) in accordance with sections
1.274—-5T and 1.274(d)-1 or section §1.162—17, but only as a miscellaneous itemized
deduction subject to the limitations applicable to such expenses (e.g., the 80-percent
limitation on meal and entertainment expenses provided in section 274(n) and the 2-
percent floor provided in section 67).

(d) Business connection—(1) In general. Except as provided in paragraphs (d)(2) and
(d)(3) of this section, an arrangement meets the requirements of this paragraph (d) if it
provides advances, allowances (including per diem allowances, allowances only for

Form 886-A cev.4-68) Department of the Treasury - Internal Revenue Service
Page: -14-

Form 8 86 A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG, formerly CO-1 20XX, 20XX,
20XX

meals and incidental expenses, and mileage allowances), or reimbursements only for
business expenses that are allowable as deductions by part VI (section 161 and the
following), subchapter B, chapter 1 of the Code, and that are paid or incurred by the
employee in connection with the performance of services as an employee of the
employer. The payment may be actually received from the employer, its agent, or a
third party for whom the employee performs a service as an employee of the employer,
and may include amounts charged directly or indirectly to the payor through credit card
systems or otherwise. In addition, if both wages and the reimbursement or other
expense allowance are combined in a single payment, the reimbursement or other
expense allowance must be identified either by making a separate payment or by
specifically identifying the amount of the reimbursement or other expense allowance.

(3) Reimbursement requirement—(i) In general. If a payor arranges to pay an amount to
an employee regardless of whether the employee incurs (or is reasonably expected to
incur) business expenses of a type described in paragraph (d)(1) or (d)(2) of this
section, the arrangement does not satisfy this paragraph (d) and all amounts paid under
the arrangement are treated as paid under a nonaccountable plan. See paragraphs
(c)(5) and (h) of this section.

(ii) Per diem allowances. An arrangement providing a per diem allowance for travel
expenses of a type described in paragraph (d)(1) or (d)(2) of this section that is
computed on a basis similar to that used in computing the employee's wages or other
compensation (e.g., the number of hours worked, miles traveled, or pieces produced)
meets the requirements of this paragraph (d) only if, on December 12, 1989, the per
diem allowance was identified by the payor either by making a separate payment or by
specifically identifying the amount of the per diem allowance, or a per diem allowance
computed on that basis was commonly used in the industry in which the employee is
employed. See section 274(d) and section 1.274(d)—1. A per diem allowance described
in this paragraph (d)(3)(ii) may be adjusted in a manner that reasonably reflects actual
increases in employee business expenses occurring after December 12, 1989.

(e) Substantiation—(1) In general. An arrangement meets the requirements of this
paragraph (e) if it requires each business expense to be substantiated to the payor in
accordance with paragraph (e)(2) or (e)(3) of this section, whichever is applicable,
within a reasonable period of time. See section 1.274—5T or section 1.162-17.

(2) Expenses governed by section 274(d). An arrangement that reimburses travel,
entertainment, use of a passenger automobile or other listed property, or other
business expenses governed by section 274(d) meets the requirements of this
paragraph (e)(2) if information sufficient to satisfy the substantiation requirements of
section 274(d) and the Regs thereunder is submitted to the payor. See section 1.274—5.
Under section 274(d), information sufficient to substantiate the requisite elements of
each expenditure or use must be submitted to the payor. For example, with respect to

Form 886-A rev.4-68) Department of the Treasury - Internal Revenue Service
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Form 8 86 A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG, formerly CO-1 20XX, 20XX,
20XX

travel away from home, section 1.274—5(b)(2) requires that information sufficient to
substantiate the amount, time, place, and business purpose of the expense must be
submitted to the payor. Similarly, with respect to use of a passenger automobile or
other listed property, section 1.274—5(b)(6) requires that information sufficient to
substantiate the amount, time, use, and business purpose of the expense must be
submitted to the payor. See section 1.274—5(g) and (j), which grant the Commissioner
the authority to establish optional methods of substantiating certain expenses.
Substantiation of the amount of a business expense in accordance with rules
prescribed pursuant to the authority granted by section 1.274—5(g) or (j) will be treated
as substantiation of the amount of such expense for purposes of this section.

(3) Expenses not governed by section 274(d). An arrangement that reimburses _
business expenses not governed by section 274(d) meets the requirements of this
paragraph (e)(3) if information is submitted to the payor sufficient to enable the payor to
identify the specific nature of each expense and to conclude that the expense is
attributable to the payor's business activities. Therefore, each of the elements of an
expenditure or use must be substantiated to the payor. It is not sufficient if an employee
merely aggregates expenses into broad categories (such as “travel”) or reports
individual expenses through the use of vague, nondescriptive terms (such as
“miscellaneous business expenses”). See section 1.162—17(b).

(f) Returning amounts in excess of expenses—(1) In general. Except as provided in
paragraph (f)(2) of this section, an arrangement meets the requirements of this
paragraph (f) if it requires the employee to return to the payor within a reasonable
period of time the amount paid under the arrangement in excess of the expenses
substantiated in accordance with paragraph (e) of this section. The determination of
whether an arrangement requires an employee to return amounts in excess of
substantiated expenses will depend on the facts and circumstances. An arrangement
whereby money is advanced to an employee to defray expenses will be treated as
satisfying the requirements of this paragraph (f) only if the amount of money advanced
is reasonably calculated not to exceed the amount of anticipated expenditures, the
advance of money is made on a day within a reasonable period of the day that the
anticipated expenditures are paid or incurred, and any amounts in excess of the
expenses substantiated in accordance with paragraph (e) of this section are required to
be returned to the payor within a reasonable period of time after the advance is
received.

Government's Position

ORG’s 501(c)(3) status should be revoked, effective January 1, 20XX, based on the
substantial inurement evidenced by the payments shown in Figures 5, 6, and 7 above.
The examining agent has requested documentation and explanations for the above

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

Page: -16-

Form 8 86 A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG, formerly CO-1 20XX, 20XX,
20XX

payments. ORG, the President and Vice-President, and Secretary have provided what
documentation and explanations they could. The payments to or for these individuals
that have either been acknowledged as benefiting them, or that still remain
unsubstantiated total $ for 20XX, $ for 20XX, and $ for 20XX. This inurement violates
section 501(c)(3) of the Internal Revenue Code and section 1.501(c)(3)-1(c)(2) of the
Treasury Regulations.

The payments for Secretary’ City apartment constitute inurement and EBTs. They
benefited her through the provision of free housing. There was no contemporaneous
substantiation that it was ORG’s intent to treat these payments as compensation for
services.

The $$ from check ## constitutes inurement and an EBT to President.

It was not reported as compensation to President on any Form W2 issued to him, nor
on any of ORG’s Forms 990s filed prior to the December 20XX commencement of the
IRS examination. This payment should have been included in President’ year 20XX
Form W2, issued in January of 20XX. The President and Vice-President acknowledged
in the January 17" response that this $$ “gift” should be reimbursed.

The $ from check # constitutes inurement and an EBT to Vice-President. The January
17" response acknowledged that this was for the purchase of a watch for Vice-
President, and that it should be reimbursed.

The $$ from check ## constitutes inurement and an EBT to Vice-President.

It was not reported as compensation to Vice-President on any Form W2 issued to her,
nor on any of ORG’s Forms 990s filed prior to the December 20XX commencement of
the IRS examination. This payment should have been included in Vice-President’ year
20XX Form W2, issued in January of 20XX. In any event, ORG’s issuing of Vice-
President’ 20XX W2 in January 20XX came after the commencement of the IRS
examination. It therefore does not meet the contemporaneous substantiation
requirement of Regs section 53.4958-4(c)(3)(i)(A). ORG’s inclusion of this amount on
President and Vice-President compensation for the year 20XX is not a mitigating factor.

The rest of the unsubstantiated payments to President and Vice-President, shown in
Figures 5, 6, and 7 also constitute inurement and EBTs. They benefited the President
and Vice-President in the form of outright cash payments, mostly in $ denominations.
These payments were not part of an accountable plan. They failed, variously, sections
(d), (e), and (f) of Regs section 1.62-2. The shopping at CO-11 and other boutiques,
and purchases of multiple Rolex watches fail the section 1.62-2(d) business connection
requirement. And the rest of the unexplained excess reimbursements fail both the
section 1.62-2(e) and (f) substantiation and return of excess requirements.

Form 886-Acrev.4-68) Department of the Treasury - Internal Revenue Service
Page: -17-

Form 886 A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG, formerly CO-1 20XX, 20XX,
20XX

The argument in the January 17" response to the Code section 4958 reports that the
total of receipts should be added to the total of per diem is not logical. Reimbursement
arrangements are either “actual” or “per diem”. To the extent that ORG had a particular
reimbursement arrangement in place, it is clear, from the fact that it used “employee
expense reports”, that it was not based on per diem. It should be noted that this report
only cites the excess of reimbursements over what has been substantiated as having a
business connection. An employee would never be entitled to “reimbursement” of both
actual and per diem, as was suggested in the response. The unsubstantiated
payments in Figures 5, 6, and 7 thus constitute inurement and EBTs.

With respect to section 1.501(c)(3)-1(f)(2)(ii) of the Treasury Regs, the analysis of the
five factors set forth therein is as follows:

(A) The size and scope of the organization's regular and ongoing activities that further
exempt purposes before and after the excess benefit transaction or transactions

No evidence was gathered during the examination to suggest that there was any
fluctuation in ORG’s activities. Furthermore, due to the frequency of the payments at
issue, peing evenly spread throughout each year, no distinction can be made between
ORG's activities “before and after” these payments. The qualification of ORG’s
activities for 501(c)(3) status are not being challenged in this report. Thus, this factor
weighs neither in favor of, nor against, revocation.

(B) The size and scope of the excess benefit transaction or transactions in relation to
the size and scope of the organization's regular and ongoing exempt activities

ORG does not have any “ongoing” exempt activities. It voluntarily became a for-profit
entity on June 1, 20XX. Inasmuch as ORG's revenues reflect its exempt activities, its
revenues during the years under examination, while it was still exempt, was $. The
inurement and EBTs cited above total $, or about %. This is a significant amount of
inurement and EBTs, and weighs in favor of revocation.

(C) Wiether the organization has been involved in multiple excess benefit transactions
with one or more persons

ORG engaged in over sixty EBTs during the years under examination. These
transactions involved three different officers; President, Vice-President, and Secretary.
This weighs in favor of revocation.

(D) Whether the organization has implemented safeguards that are reasonably
calculated to prevent excess benefit transactions

Form 886-A ev.4-68) Department of the Treasury - Internal Revenue Service
Page: -18-

Form 8 86 A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG, formerly CO-1 20XX, 20XX,
20XX

ORG forfeited its own 501(c)(3) exemption June 1, 20XX. At issue, then, is whether its
exemption should also be revoked for the period of January 1, 20XX to May 31, 20XX.
It is evident that no safeguards were put in place to prevent EBTs from 20XX to 20XX,
or from 20XX to 20XX. On the contrary, President has even more unfettered control
over ORG’s assets, now that ORG is owned by his wholly-owned company, CO-3.
This factor weighs in favor of revocation.

(E) Whether the excess benefit transaction has been corrected (within the meaning of
section 4958(f)(6)), or the organization has made good faith efforts to seek correction
from those who benefited from the excess benefit transaction

As of the date of this report, ORG is no longer described in section 501(c)(3) of the
Internal Revenue Code. Repayments to ORG would not qualify as “correction” within
the meaning of section 4958(f)(6). Therefore, per Regs section 53.4958-7(e), any
correction to be made by the President and Vice-President or Secretary would have to
go to a different 501(c)(3) organization. As of the date of this report, no correction has
been made to such a 501(c)(3) organization. Therefore, applying this factor would
weigh in favor of revocation.

Taxpayer’s Position

ORG has not yet taken a position with respect to this report.
Conclusion

ORG’s earnings have inured to the benefit of three of its officers, President, Vice-
President, and Secretary. This inurement totaled $ during the years 20XX, 20XX, and
20XX. This is a substantial amount of inurement, and violates section 1.501(c)(3)-
1(c)(2) of the Treasury Regs. Given the routine and continuous nature of the
inurement, this warrants revocation of ORG’s 501(c)(3) status effective January 1,
20XX. ORG should file Form 1120, U.S. Corporation Income Tax Return, for the years
20XX and 20XX, and for the period ended May 31, 20XX. If the proposed revocation
becomes final, appropriate State officials will be notified in accordance with Code
section 6104(c).

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