Exemption denied for organization benefiting founder's business

Plain-English summary

An organization sought recognition under IRC § 501(c)(3) to develop hydroponic technology intended to address hunger. Its founder held a pending patent and owned a related for-profit company that manufactured, marketed, and distributed a commercial version of the technology. The IRS concluded that the organization's research and fundraising substantially benefited the founder and his company, causing private inurement and serving private rather than public interests. After the organization did not protest the proposed adverse determination, the IRS issued a final denial of tax-exempt status.

Ruling snapshot

• Question: Did the organization operate exclusively for exempt purposes without private inurement or substantial private benefit?
• Outcome: Denied
• Key authorities: IRC §§ 170 and 501(c)(3); Treas. Reg. § 1.501(c)(3)-1; Rev. Rul. 65-1; Rev. Rul. 69-632

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Release Number: 201443021
Release Dates: 10/24/2014
Date: July 29, 2014

Contact Person:

Identification Number:

UIL Code: 501.32-00

Contact Number:

Employer Identification Number:

Required To Be Filed:

Tax Years:
All

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,

Tamera Ripperda
Director, Exempt Organizations

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: June 4, 2014

Contact Person:
Identification Number:
Contact Number:
FAX Number:
Employer Identification Number:

LEGEND:

B = Name
C= Website Name
N = Company Name
O = State
P = Date
Q = Date
T = Device
x=Number
y dollars=Amount

UIL:

501.32-00
501-32-01
501.33-00

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
described below.

Facts

Prior to your formation, your founder and only director, B discovered a new
development in current hydroponics technology in which he has a patent pending called

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the T system; the T system is a soilless growing process, which can run without
conventional power and can aid in growing food in impoverished regions of the world
where fertile soil and clean water is scarce. You demonstrated the T technology to a
horticulture expert who advised you that global starvation cannot be solved in one
lifetime but the use of your technology can prove it is possible. The expert suggested
you shrink the system into a commercially viable stand-alone system and use the
proceeds to fund the larger system. B formed you to further the research and
development of the T system and to obtain benefactors to invest in his invention.

You were incorporated in the State of O on P. Your Articles of Incorporation state “The
specific purpose of this corporation is to eliminate world hunger”. After review of O’s
Secretary of State website, it was found that you are not in good standing. Since your
formation, 80% of your time has been dedicated to prototyping and working with the
manufacturer to bring the stand-alone T to market. You have been working closely with
an engineer and marketing agent to stand alone T which is being manufactured
overseas. B has a for-profit company, N which markets and distributes the T stand-
alone system.

You currently use the website, C and have a link to N’s website for purchasing the T
stand-alone system. You stated that you do not want the public to make any distinctions
between you and N and that you want the general public to look at the entities as being
symbiotic because you want people to know that when they purchase the T stand-alone
system from N, the proceeds are going directly to building food machines to feed the
starving.

The website also states that for every x systems sold, N will donate a stand-alone
system to you to get it to the places that need it most. In addition, N will donate x% of its
sales to you for the development of the T farm system. The web site C further states:
“N has the best tool in the world and but B needs your help in getting there. By
donating, you help in the packaging and shipping of T to regions of the world that can
use T to grow their own food”.

Once a prototype of the T farm system is completed, it will be tested in a hostile region
of the world. Two expert scientists/horticulturists have committed verbally to getting the
machine working at its optimal ability.

The T stand-alone systems are publicized through the website C, wholesale vendors
and home and garden shows.

Besides using his personal resources, B has borrowed funds from private investors to
finish the stand-alone T system through N and has spent about y dollars for injection
molds, website design, engineering, and legal fees.

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You wrote you have had zero income for the past 3 years and have not filed any annual
returns. You subsequently were automatically revoked for not filing your annual returns
for a consecutive three-year period.

Law

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

Section 1.501(c)(3)-1(c)(1) of the Income Tax 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). 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 Income Tax 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 provides 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 subsection, 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)(5)(iii) of the regulations provides that scientific research will be
regarded as in the public interest:

a) If the results of such research (including any patents, copyrights, processes or
formulas) resulting from such research are made available to the public on a
nondiscriminatory basis;

b) If such research is performed for the United States or any of its agencies or
instrumentalities or for a state or political subdivision there of;

c) If such research is directed toward benefiting the public.

In Rev. Rul. 65-1, 1965-1 C.B. 226, the Service considered an organization, which
promotes and fosters the development and design of machinery in connection with a
commercial operation, and in connection therewith has the power to sell, assign, and
grant licenses with respect to its copyrights, trademarks, trade names, or patent rights.

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The Service concluded that the organization does not qualify for exemption from federal
income tax under section 501(c) (3) of the Internal Revenue Code of 1954.

Revenue Ruling 69-632, 1969-1 C.B. 120, a nonprofit composed of members of a
particular industry to develop new and improved uses of existing products of the
industry is not exempt under section 501(c)(3) of the Code. The association’s members
select research projects in order to increase their sales by creating new uses and
markets for their product. The primary purpose of the association’s research is to serve
the private interests of its creators, rather than the public interest.

In P.L.L Scholarship v. Commissioner, 82 T.C. 196 (1984), an organization which
operated a bingo at a bar for the avowed purpose of raising money for scholarships was
denied exemption under Section 501(c)(3) because it was operating for private
interests. The board included the bar owners, the bar’s accountant, also a director of
the bar, as well as two players. A realistic look at the operations of these two entities,
however, shows that the activities of the organization and the bar were so interrelated
as to be functionally inseparable.

In Church by Mail, Inc. v. Commissioner, 765 F.2d 1387 (9th Cir. 1985), cert. denied,
497 U.S. 1005 (1990), the court held that when a for-profit organization benefits
substantially from the manner in which the activities of a related organization are carried
on, the organization is not operated exclusively for exempt purposes within the meaning
of section 501(c)(3), even if it furthers other exempt purposes.

Application of Law

You are not as described in section 501(c)(3) of the Code because you are not
exclusively operated for charitable or educational purposes.

You are not as described in Section 1.501(c)(3)-1(a)(1) of the Regulations because you
fail the operational test.

You do not meet the provisions of Section 1.501(c)(3)-1(c)(1) of the Regulations
because more than an insubstantial part of your activities is not in furtherance of an
exempt purpose. Providing funding to develop B’s patented technology into marketable
devices to be marketed, distributed and sold by N serves a substantial private purpose.

As described in section 1.501(c)(3)-1(c)(2) of the Regulations, you are not operated
exclusively for exempt purposes because your net earnings inure to the benefit of B.
For example, you were formed to fund the research and development of marketable
devices using B’s patented technology which will be sold by B’s for profit business, N. In
addition, your board consists of one person, B who controls all aspects of your
operations and has a for profit, business, N, who will benefit from your operations.

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You are not as defined in Section 1.501(c)(3)-1(d)(1)(ii) of the Regulations because you
are operating for the private interests of B and N. You are operating to confer the
advantages of tax-exempt status to B as shown by the fact that your tax exemption will
enable B to apply for grants to develop his inventions which are marketed and distributed
through N. Furthermore you stated you want the general public to make no distinctions
between you and N. This also demonstrates you are primarily serving private interests.

You do not meet the provisions of Section 1.501(c)(3)-1(d)(5)(iii) of the Regulations. Any
scientific research you are carrying on is not primarily conducted in the public interest.
Your activities of funding the research and development of B’s patented technology into
marketable products serves private interests.

You are like the organization in Revenue Ruling 65-1. Your activities of funding the
research and development of B’s ideas into products do not constitute "scientific
research" within the meaning of section 1.501(c)(3)-1(d)(5) of the regulations. In
addition, your purpose of obtaining grant money to develop B’s ideas is directed to
benefit B and N and any public purpose is incidental.

You are comparable to the organization in Revenue Ruling 69-632 because you were
formed to serve the private interests of your creator B. Although your activities may
result in new processes that benefit the public, this benefit does not overcome the
benefit to B and N which violates the absolute inurement prohibition.

You are also similar to the organization described in P.L.L Scholarship Fund. You and
N are controlled by the same individual, B. Your functions and management are so
interrelated with N that you are functionally inseparable from N because without you, N
is not able to obtain funding.

You are comparable to the organization in Church by Mail because you and N are
controlled by the same person. Moreover, N benefits substantially from your
operations.

Conclusion

You do not qualify for exemption under section 501(c)(3) of the Internal Revenue Code,
because you do not meet the operational test of Reg. 1.501(c)(3)-1(c)(1); you are not
operating exclusively for exempt purposes. Your net earnings inure to the benefit of B
directly as well as through N. You are also operated for the purpose of benefiting N, a
private related business and you serve a private rather than a public interest.

You have the right to file a protest if you believe this determination is incorrect. To
protest, you must submit a protest statement explaining your views and reasoning. You

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must submit the protest 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 protest 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.

Types of information that should be included in your protest statement can be found in
Publication 892. The protest statement must be accompanied by the following
declaration:

“Under penalties of perjury, I declare that I have examined this protest statement,
including accompanying documents and to the best of my knowledge and belief, the
statement contains all relevant facts and such facts are true, correct, and complete.”

Your protest will be considered incomplete without this statement.

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

Letter 4036 (CG) (11-2011)
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7

Please send your protest statement, Form 2848, and any supporting documents to the
applicable address:

Mail to:

Internal Revenue Service
EO Determinations Quality Assurance
Room 7-008
P.O. Box 2508
Cincinnati, OH 45201

Deliver to:

Internal Revenue Service
EO Determinations Quality Assurance
550 Main Street, Room 7-008
Cincinnati, OH 45202

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,

Tamera Ripperda
Director, Exempt Organizations

Enclosure: Publication 892

Letter 4036 (CG) (11-2011)
Catalog Number 47630W