IRS denies exemption to a commercial consignment store that offered limited job training

Plain-English summary

The IRS denied an organization’s application for exemption under § 501(c)(3). The organization planned to operate a public consignment store and provide limited job training to people with special needs. The IRS concluded that the store was operated commercially, that consignors received more than an insubstantial private benefit, and that the organization had not established that its founder would not benefit from the operation. The IRS therefore found that the organization did not operate exclusively for exempt purposes.

Ruling snapshot

• Question: Did the proposed consignment-store organization qualify for exemption under § 501(c)(3)?
• Outcome: Denied, the IRS concluded that the organization did not qualify for exemption.
• Key authorities: IRC §§ 501(c)(3), 170, 502, 513, 6104(c), 6110, and 7428; Treas. Reg. §§ 1.501(c)(3)-1(c)(1), 1.501(c)(3)-1(d)(1)(ii)-(iii), 1.501(c)(3)-1(e)(1), 1.502-1(a), and 1.513-1(d)(2).

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Number: 201330038 Contact Person:

Release Date: 7/26/2013
Identification Number:

Contact Number:

Date: March 30, 2013
Employer Identification Number:

Form Required To Be Filed:
Tax Years:

UIL: 501.36-00; 501.36-01

Dear

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

Because you do not qualify for exemption as an organization described in Code section
501(c)(3), donors may not deduct contributions to you under Code section 170. You must file
Federal income tax returns on the form and for the years listed above within 30 days of this
letter, unless you request an extension of time to file. File the returns in accordance with their
instructions, and do not send them to this office. Failure to file the returns timely may result in a
penalty.

We will make this letter and our proposed adverse determination letter available for public
inspection under Code section 6110, after deleting certain identifying information. Please read
the enclosed Notice 437, Notice of Intention to Disclose, and review the two attached letters that
show our proposed deletions. If you disagree with our proposed deletions, follow the

instructions in Notice 437. If you agree with our deletions, you do not need to take any further
action.

In accordance with Code section 6104(c), we will notify the appropriate State officials of our
determination by sending them a copy of this final letter and the proposed adverse letter. You
should contact your State officials if you have any questions about how this determination may
affect your State responsibilities and requirements.

2

If you have any questions about this letter, please contact the person whose name and
telephone number are shown in the heading of this letter. If you have any questions about your
Federal income tax status and responsibilities, please contact IRS Customer Service at
1-800-829-1040 or the IRS Customer Service number for businesses, 1-800-829-4933. The
IRS Customer Service number for people with hearing impairments is 1-800-829-4059.

Sincerely,

Holly O. Paz
Director, Exempt Organizations
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: March 20, 2013 Contact Person:
Identification Number:
Contact Number:
FAX Number:
Employer Identification Number:

LEGEND: UIL:

B = Executive Director/Founder/President

C = Name of Organization 501.36-00

O = State 501.36-01

Q = Date

Dear

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

Issues

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

Facts

You were incorporated on Q in State O. Your original purpose in pertinent part is to
primarily support C financially and provide job training for individuals with special needs.
You amended your articles of incorporation to include section 501(c)(3) purposes.

B is your founder, Executive director, president and secretary. You have two other

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individuals on your governing body. One serves as your accountant and treasurer.
The third is an unpaid director who attends meetings as necessary.

C is a non-profit organization providing educational services to special needs
individuals. B works full time at C as a career instructor. B intends to take a leave of
absence from C to open and operate you. B’s hobbies include garage sales and
consigning clothing.

Your primary activity is the operation of a consignment store open to the public. B will
handle all aspects of the business and may chose to employ others to help with the day
to day aspects of operating the store. B will recruit consignees for the store, manage
all future employees and provide job training to individuals with special needs. The
store is located in a strip mall and will be open to the public. Currently you have store
hours from 10am to 6pm on Monday and Tuesday and from 11am to 5pm Wednesday
through Saturday.

About % of the store merchandise is acquired through consignment from individuals.
Your consignment contract provides that the consignor receives % of the sales price
and you retain the remaining %. The merchandise is priced at % of the cost to
purchase the item new. Merchandise not sold within the contract period, two months
from the date of consignment must be picked up by the consignor or the merchandise
will become your property.

The remaining % of your store’s merchandise is acquired by B from garage sales. B
purchases goods that she is confident can be sold for double the price paid.

Your job training program is an extension of programs offered by C. B instructs C on
the skills required. C guides the special needs individuals who practice skills at C. The
skill tasks include sorting, hanging items, stocking and labeling, pricing and janitorial
duties. The supervisors at C select special needs individuals to come to your store.
You have no set training schedule. The special needs trainees are welcome during the
hours you are open. B must be trained in C’s adult program before trainees will be
permitted to be with B without C’s staff present. The amount of time spent by trainees
varies from 30 minutes to a maximum of two hours per day. The maximum time spent
by any one individual was three hours per week. The number of trainees varies from
one to six.

B and your accountant are compensated for their duties. B and other board members
also initially received a % discount on merchandise purchased in your store. You
have since discontinued this practice. You hope to hire two other individuals at
minimum wage. Trainees are not compensated. However they do earn tickets that can
be redeemed for store merchandise. Once your sales reach a level where you can meet
your rent, utilities, pay a salary to B and your accountant you will be able to pay

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the special needs trainees.

Your projected income is entirely from merchandise sales. Approximately % of your
projected expenses are salaries and wages, approximately % occupancy and the
remainder contributions paid. You explain that after all expenses and salaries are paid
and you saved 2 years worth of operating costs any remaining profit will be given to C
on a quarterly basis.

Law

Section 501(c)(3) of the Internal Revenue Code exempts from federal income tax
organizations organized and operated exclusively for charitable or other exempt
purposes, no part of the net earnings of which inures to the benefit of any private
shareholder or individual.

Section 1.501(c)(3)-1(c)(1) of the regulations provides that an organization operates
exclusively for 501(c)(3) purposes only if it engages primarily in activities that
accomplish such purposes. It does not operate exclusively for 501(c)(3) purposes if
more than an insubstantial part of its activities does not further such purposes.

Section 1.501(c)(3)-1(d)(1)(ii) of the regulations states an organization is not organized
or operated exclusively for one or more of the purposes specified in subdivision (i) of
this subparagraph 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.

Section 1.501(c)(3)-1(d)(1)(iii) Example (2) of the regulations provides the example of
an art museum that exhibits and sells the art of unknown artists . The art is offered for
sale under a consignment agreement. Under the agreement when the art is sold the
museum retains a percentage of the proceeds to cover the costs and gives the rest to
the artist. The museum is governed by a board of trustees unrelated to the artists. The
artists in this situation directly benefit from the exhibition and sale of their art. As a result
the museum’s activity serves the private interest of these artists.

Section 1.501(c)(3)-1(e)(1) provides that an organization may meet the requirements of
section 501(c)(3) if it operates a trade or business that is in furtherance of its exempt
purposes but not if it is operated for the primary purpose of carrying on an unrelated
trade of business as defined in section 513 of the Code.

Section 1.502-1(a) of the Regulations provides that in the case of an organization
operated for the primary purpose of carrying on a trade or business for profit, exemption

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is not allowed under section 501 on the ground that all profits of such organization are
payable to one or more organizations exempt from taxation under section 501.

Section 502(b)(2) provides that the term ‘trade or business’ shall not include any trade or
business in which substantially all the work in carrying on such trade or business is
performed for the organization without compensation.

Section 1.513-1(d)((2) of the Regulations states that a trade or business is “related” to
exempt purposes only where the conduct of the business activities has causal
relationship to the achievement of an exempt purpose (other than through production of
income), and is substantially related for purposes of section 513 of the code only if the
casual relationship is a substantial one. Thus for the conduct of trade or business to be
substantially related to the purposes for which exemption is granted, the production of
goods or the performance of services must contribute importantly to the
accomplishment of those purposes.

Revenue Ruling 71-395 1971-2 C.B. 228 held that a cooperative art gallery formed and
operated by a group of artists for the purpose of exhibiting and selling their works does
not qualify for exemption under section 501(c)(3) of the Code.

Revenue Ruling 73-127, 1973-1 C.B. 221 holds that a nonprofit organization that
operates a retail grocery outlet and allocates a small portion of its earnings to provide
on the job training to hard core unemployed individuals does not qualify for exemption
from income tax. It was ruled that although the nature of the job training in this case is
primarily on the job training and thus requires the existence of an operating business as
its campus, the size and manner of the operation of the store as a retail grocery outlet is
in itself an independent objective of the organization. It is conducted on a scale larger
than is reasonably necessary for the performance of the organization’s training program
and was not intended to, nor does it fact, serve solely as a vehicle for carrying out the
training program of the organization.

Revenue Ruling 73-128 1973-1 C.B. 222 held that an organization that is otherwise
qualified for exemption from income tax will not fail to qualify merely because its
education and vocational training of unemployed and under-employed individuals is
carried out through the manufacturing and selling of toy products.

Revenue Ruling 76-94, 1976-1 C.B. 171 holds that an exempt organization’s operation
of a retail grocery store as part of its therapeutic program for emotionally disturbed
youth, almost fully staffed by the adolescents, and on a scale no larger than is
reasonable necessary for the performance of the organization’s exempt functions, is not
unrelated trade or business under section 513 of the Code.

Revenue Ruling 76-152 1976-1 C.B. 151 held that a nonprofit organization formed by

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art patrons to promote community understanding of modern art trends by selecting for
exhibit, exhibiting, and selling art works of local artists, retaining a commission on sales
less than customary commercial charges and not sufficient to cover the cost of oper-
ating the gallery, does not qualify for exemption under section 501(c)(3) of the Code;
Rev. Rul. 71-395 clarified.

Revenue Ruling 80-106, 1980-1 C.B. 113, held an organization that operates a thrift
shop that sells items that are either donated or received on consignment and where
substantially all of the work in operating the thrift shop is performed without
compensation, and all profits are distributed to section 501(c)(3) organizations is not a
feeder organization described in section 502(a) of the Code and qualifies for exemption
as an organization operated for charitable purposes.

In Better Business Bureau v. United States, 316 U.S. 279 (1945), the Supreme Court
held that an organization was not organized and operated exclusively for charitable
purposes. The court stated that the presence of a single non-exempt purpose, if
substantial in nature, will destroy exemption regardless of the number or importance of
truly exempt purposes.

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.

In B.S.W. Group, Inc v. Commissioner, 70 T.C. 352 (1978), the Tax Court held that an
organization did not qualify for exemption under section 501(c)(3) of the Code because
it was primarily engaged in an activity that was characteristic of a trade or business and
ordinarily carried on by for-profit commercial business.

In Airlie Foundation v. I.R.S., 283 F Supp. 2d 58 (D.D.C. 2003), the District Court found that the
organization was formed principally to organize, host, conduct and sponsor educational and
other charitable functions at its facilities. The organization’s patrons were not limited to tax-
exempt entities, but included patrons of a private and corporate nature. The organization paid
significant advertising and promotional expenses and derived substantial income from the
weddings and special events held at its conference center. The court determined that the
organization’s activities competed with a commercial nature and purpose. The court concluded
that although the organization carried out a number of charitable and educational activities,
these were incidental to its primary purpose of operating a for-profit conference center.

Application of Law

You do not meet section 501(c)(3) of the Code because you are not operated
exclusively for a section 501(c)(3) purpose and because you failed to establish that your
earnings will not inure to the benefit of B. You do not operate your consignment shop in
a non-profit charitable manner. B controls your daily operations and may benefit from

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the profits of the consignment shop.

You are not as described in section 1.501(c)(3)-1(c)(1) because your primary activity is
the operation of a commercial business, specifically a consignment store. You are not
primarily charitable, because the training you provide to special needs individuals is
limited and clearly not your primary activity.

You are not as described in section 1.501(c)(3)-1(d)(1)(ii) of the regulations because
you failed to establish your operations will not serve the private interests of your creator,
B through her control and influence. B’s hobbies include garage sales and consigning
clothing. You have failed to establish that the operation of a store is charitable or more
than an extension of B’s hobbies.

You are similar to the example in Section 1.501(c)(3)-1(d)(1)(iii) of the regulations
because more than an insubstantial part of your operations serve private interests.
Specifically like the artists in the example who benefit from the sale of their artwork
consignors benefit by your sale of their merchandise.

You are not as described in Section 1.501(c)(3)-1(e)(1) of the regulations because your
operation of a consignment shop is not exclusively in furtherance of 501(c)(3) purposes
but instead is a primary purpose to operate a business.

Even though you intend to turn over future profits to an exempt organization, as noted in
section 1.502-1(a), because your primary purpose is carrying on the business of
operating a consignment store, exemption is not allowed.

You are not as described in section 502(b)(2) because substantially all of the work
performed in the consignment shop is performed with compensation. B performs
substantially all the work and other employees will be hired and compensated in the
future.

You are not described in section 1.513-1(d)((2) of the Regulations because your
consignment sale business does not contribute importantly to the accomplishment of
exempt purposes. Instead the business is primarily operated to sell merchandise on
consignment. Trainees work a maximum of 2 hours out of an eight hour day and much
of the training is provided by C, not you. Accordingly, your focus is clearly on the sale of
merchandise, not training.

Like the organization in Revenue Ruling 71-395 you too are formed to exhibit and sell.
Like the artists, your consignors benefit from the sale of their merchandise. See also
Revenue Ruling 76-152.

You are similar to Revenue Ruling 73-127. You too operate a business on a scale

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larger than necessary for the accomplishment of a training program.

You are not similar to Revenue Ruling 73-128 because education and training are not
your primary activity. Instead your primary activity is the operation of a consignment
store in a commercial manner.

You are not similar to Revenue Ruling 76-94 because the manner in which your
consignment store is operated on a scale larger than necessary for the performance of
your limited training program.

You are not similar to Revenue Ruling 80-206 because substantially all the work
performed in your consignment shop is performed with compensation. In addition you
will not distribute any profit to C until you have saved two years worth of operating costs
and have paid all expenses and salaries.

You are similar to organization in the Better Business Bureau because you operate for
the substantial non-exempt commercial purpose of operating a consignment shop in a
commercial manner.

You are similar to Old Dominion Box because private parties, your consignors benefit
from your sale of their merchandise and that benefit is a substantial non-exempt
purpose.

You are similar to BSW Group because you too are primarily engaged in a business
ordinarily carried on by for profit commercial businesses.

You are similar to Airlie because the facts show your consignment shop business is
operated in a commercial manner. Your location and hours of operation are
comparable to similar businesses operating for a profit. The manner in which you
secure merchandise and price your merchandise is also comparable to similar
businesses. You operate with paid staff. Training is limited to 2 hours a day and your
involvement in the actual training of the individuals is limited as C conducts most of the
training for the individuals. Accordingly, operating in a commercial manner is your
primary activity.

Applicant’s Position

Currently you are not making enough to be able to pay the special needs individuals.
Once sales allow you to meet your budget that includes rent, utilities and salaries for B
and the accountant you will pay the special need individuals who are doing volunteer
training. You could have decided to be for-profit. However the special needs
individuals would not be able to volunteer in your store.

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You decided to be a non-profit separate from C because C has enough financial debt
without trying to fund a small business like you. B has spent her own savings to start
you and is currently making less than B would working at C.

You chose consignment instead of donation because people donate items that are not
nice enough for consignment and you wanted a nice environment for the special needs
individuals and B to work in.

Service Response to Applicant’s Position

Compensating the trainees in the future will not overcome the fact that you operate a
consignment store in a commercial manner as your primary activity. Likewise, the fact
that B is now making less money or spent her savings to start you does not overcome the
fact that you operate in a commercial manner. Your choice of consignment over
donation because you wanted a nice environment to work in does not demonstrate an
exempt purpose.

Conclusion

You do not qualify for exemption as an organization described in section 501(c)(3) for
the following reasons any one of which standing alone is sufficient cause for denial.

You operate in a commercial manner.

You operate for more than insubstantial benefit to consignors. You sell consignors
merchandise and share the proceeds from the sale with them.

You have failed to establish that B will not benefit from your operation.

Accordingly, we conclude you do not qualify for exemption under section 501(c)(3) of
the code.

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

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(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.”

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:

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Mail to: Deliver to:
Internal Revenue Service Internal Revenue Service
EO Determinations Quality Assurance EO Determinations Quality Assurance

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.

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, Exempt Organizations
Rulings and Agreements

Enclosure: Publication 892

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