IRS denies reinstatement because scholarships benefit a related business

Plain-English summary

An organization sought reinstatement of its § 501(c)(3) exemption after an earlier revocation for failing to file Form 990 for three consecutive years. It proposed scholarships for youth programs, but its directors were closely tied to a for-profit company that was the only program provider. The company set fees to remain profitable, solicited applications, and selected recipients; one director owned it, and two other directors worked for it. The record showed only one scholarship, selected and funded by an outside foundation, while the recipient still had to pay most of the related company's fee. The IRS concluded that the organization served private interests, produced inurement and private benefit, and had a substantial nonexempt commercial purpose. Because no protest was filed, the adverse determination became final, and contributions were not deductible under IRC § 170.

Ruling snapshot

• Question: Did the organization qualify for § 501(c)(3) exemption despite its control by insiders tied to its sole for-profit program provider?
• Outcome: Denied
• Key authorities: IRC § 501(c)(3); Treas. Reg. §§ 1.501(c)(3)-1(a), (c), and (d)

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION
Release Number: 201451045 Contact Person:
Release Date: 12/19/2014
Date: September 24, 2014 Identification Number:
UIL Code: 501.32-00 :
501.33-00 Contact Number:
501.33-01
Employer Identification Number:
Form Required To Be Filed:
Tax Years:
Dear

This is our final determination that you do not qualify for exemption from federal income tax as
an organization described in Internal Revenue Code 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.

Since 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.

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, you should 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.

Letter 4038(CG) (11-2005)
Catalog Number 47632S

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,

Director, Exempt Organizations

Enclosure

Notice 437
Redacted Proposed Adverse Determination Letter

Redacted Final Adverse Determination Letter

Letter 4038 (CG) (11-2005)
Catalog Number 47632S

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

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION
Date: June 26, 2014 Contact Person:
Identification Number:
Contact Number:
FAX Number:
Employer Identification Number:
Legend: UIL Numbers:
B= 501.32-00
C= 501.33-00
D= 501.33-01
F=
G =
H=
J=
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

Does the presence of inurement and private benefit preclude you from qualification
under Section 501(c)(3)? Yes, for the reasons described below.

Facts

You were incorporated in the State of B on C. You were previously granted exemption
under section 501(c)(3) of the Code more than 25 years ago. Your exempt status was

Letter 4036 (CG) (11-2005)
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revoked due to non-filing of Form 990 for three consecutive tax years. You have
requested reinstatement by submitting Form 1023, Application for Recognition of
Exemption on D.

You were formed to provide classroom and experiential summertime educational
opportunities to adolescents through the study of the scientific, historical, and cultural
features of specific regions of the world and the undertaking of challenging, active, small
group trips that place an emphasis on personal responsibility, group cooperation and
consideration for others. You subsequently amended your Articles of Organization to
indicate that you will not engage in any activity or exercise any power which would
deprive you of exemption under Section 501(c)(3) of the Internal Revenue Code.

You are governed by your board of directors. You identified F, G, and H as your
directors. F is the President and sole shareholder of J, a for profit company that was
incorporated 4 years after you were formed. G is F’s wife. Both G and H are employees
of J.

J is the only service provider for your programs at this time. There are no written
contract agreements with J. As the program evolves you will seek similarly qualified
service providers.

You award scholarships to qualified applicants to participate in programs which include
outdoor service, learning, and leadership programs for young adults up to age 19. The
current programs include summer camps in the US and trips to several foreign
countries. Per your application, you expected to award more than $60,000 in
scholarships in 2011. Donations from businesses and individuals will be accepted on
your future website, as well as on the website of J.

J serves as the third party to administer all of the program activities for the scholarship
recipients. Fees for the programs are determined by the staff of J. Fees are set at a
level to allow J to maintain profitability and to continue as a going concern. Students
unable to pay the required fee to J may qualify for financial aid through your scholarship
program. Financial aid awards cover 10% to 50% of the J program fee.

J solicits scholarship applications via its website. The selection process is based on
financial need. “The only condition is that the awardee participates in the program
identified in the application.” The qualified applicant information is provided to J's
current admissions team. J’s team selects scholarship recipients.

When asked to provide itineraries for your programs, you listed only one program. J's
charge to participate in that program was more than $4,000 per person. Because J is
currently your only provider, there are no written contract agreements with your
providers.

Letter 4036 (CG) (11-2005)
Catalog Number 47630W

In all the years from 1/1/2007 to 12/31/12:

• Only one scholarship, covering less than 40% of the admission cost was offered,

• The recipient of the scholarship applied to and was selected by an outside
foundation;

• You received no income or contributions other than the scholarship paid by the
outside foundation toward the recipient’s cost;

• No financial information was available for any other applicants because only one
scholarship was offered.

Law

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

Income Tax Regulations (“Regulations”) § 1.501(a)-1(c) define a private shareholder or
individual as a person having personal and private interest in the activities of the
organization.

Section 1.501(c)(3)-1(a)(1) of the Regulations states that in order to qualify under
section 501(c)(3) of the Code, an organization must be both organized and operated
exclusively for one or more exempt purposes. If an organization fails to meet either the
organizational or operational test, it is not exempt.

Section 1.501(c)(3)-1(c)(2) of the Regulations states 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.

Regulation § 1.501(c)(3)-1(d)(1)(ii) also relates to operations of an organization by
stating: that an organization is not organized or operated exclusively for one or more of
the purposes specified unless it serves a public rather than a private interest. Thus, to
meet the requirement it is necessary for an organization to establish it is not organized
or operated for the benefit of private interests such as designated individuals, the
creator or his family, shareholders of the organization, or persons controlled, directly or
indirectly, by such private interests.

In Better Business Bureau of Washington D.C., Inc. v. United States, 326 U.S. 279
(1945), the Supreme Court held that the presence of a single non-exempt purpose, if
substantial in nature, will destroy the exemption regardless of the number or importance
of truly exempt purposes. The Court found that the trade association had an

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“underlying commercial motive” that distinguished its educational program from that
carried out by a university.

In est of Hawaii v. Commissioner, 71 T.C. 1067 (1979), several for-profit est
organizations exerted significant indirect control over est of Hawaii, a non-profit entity,
through contractual arrangements. The question for the court was not whether the
payments made to the for-profits were excessive, but whether they benefited
substantially from the operation of the applicant. The Tax Court concluded that the for-
profits were able to use the non-profit as an "instrument" to further their for-profit
purposes. Neither the fact that the for-profits lacked structural control over the
organization nor the fact that amounts paid to the for-profit organizations under the
contracts were reasonable affected the court's conclusion. Consequently, est of Hawaii
did not qualify as an organization described in section 501(c)(3).

In Church by Mail, Inc. v. Commissioner, T.C. Memo 1984-349, aff'd 765 F.2d 1387 (9th
Cir. 1985), the Court affirmed a Tax Court decision. Church by Mail sent out sermons in
numerous mailings. This required a great deal of printing services. A for-profit
company, controlled by the same ministers, provided the printing and the mailing. The
services were provided under two contracts. The contracts were signed by the two
ministers for both the organization and the for-profit company. The organization's
business comprised two-thirds of the overall business done by the for-profit company.
The court determined that there was ample evidence in the record to support the finding
that the organization was operated for the substantial non-exempt purpose of providing
a market for the services of the for-profit company. The Court of Appeals pointed out
that "the critical inquiry is not whether particular contractual payments to a related for-
profit organization are reasonable or excessive, but instead whether the entire

enterprise is carried on in such a manner that the for-profit organization benefits
substantially from the operation of the Church." Moreover, the ministers’ dual control of
both the Church and the for-profit company enables them to profit from the affiliation of
the two entities through increased compensation.

In Housing Pioneers, Inc. v. Commissioner, 58 F.3d (1995), the court affirmed the
judgement of the trial court that the organization was not entitled to tax-exempt status
as a corporation operated exclusively for charitable purposes within the meaning of
section 501(c)(3) of the Code. The court found that the organization's substantial
purpose of helping a for-profit business take advantage of its tax-exempt status was a
non-exempt purpose even if it had the effect of making housing more affordable.

In International Postgraduate Medical Foundation v. Commissioner, TCM 1989-36, the
Tax Court concluded that when a for-profit organization benefits substantially from the
manner in which the activities of a related non-profit organization were carried on, the
latter organization was not operated exclusively for exempt purposes within the
meaning of section 501(c)(3), even if it furthers other exempt purposes.

Letter 4036(CG) (11-2005)
Catalog Number 47630W

Application of Law

You do not meet the operational test under section 501(c)(3) of the Code because you
have not established that you are not operated for the benefit of private interests. On
the contrary, all members of your governing body profit from your existence. The facts
you provided show:

• All your current board members receive compensation from J;

• J is currently your exclusive service provider;

• You pay rates that insure J profits from providing those services; and

• Only applicants for J programs are eligible for your scholarships.

Like est of Hawaii, a for-profit organization exerts significant control over you and can
benefit substantially from your operations.

You are similar to Church by Mail, Inc. because you are controlled by the same persons
who control the for-profit company which conducts your programs. Your directors
maintain dual control over both you and J. This enables them to profit from the affiliation
of the two entities through increased compensation.

Like Housing Pioneers, Inc., you are not entitled to tax-exempt status because you are
helping a for-profit business take advantage of your tax-exempt status. This is a non-
exempt purpose even if it has the effect of making your programs more affordable.

Just as in International Postgraduate Medical Foundation, when J, a for-profit
organization, benefits substantially from the manner in which your activities are carried
on, you are not operated exclusively for exempt purposes within the meaning of section
501(c)(3) even if you further other exempt purposes.

You are like Better Business Bureau of Washington D.C., Inc. because you have an
“underlying commercial motive.” This substantial nonexempt purpose has destroyed
your claim for exemption.

Applicant’s Position:

You were organized as a conduit by which J could reach underprivileged children to
provide them with the opportunity to participate in the programs offered by J. This can
only be accomplished by the provision of scholarships through your close connection
with J.

Letter 4036(CG) (11-2005)
Catalog Number 47630W

You differ from a for-profit organization because the applicants will not be expected to
pay full price for the programs conducted by J, and the fees are set by J at a level
above cost sufficient for J to maintain an acceptable level of profitability. The fees
charged by J are not based on an individual's ability to pay.

While J is currently the sole provider of these programs, numerous organizations other
than J, will provide similar programs in the future.

Any Board member offering their business services to this organization, that would
create a conflict of interest, would be excused from the meeting to discuss the proposal.

Service’s Response to Applicant’s Position:

Your close connection to J results in additional income to J through the funds you
secure and pass through to J. Your reduced fee structure continues to ensure J profits.

There is no evidence that you have ever directly funded any scholarships for
underprivileged children. Only one scholarship has been provided in your entire history.
You had no role in the selection process. Instead, a donor offered the scholarship,
selected the recipient and paid the funds to you.

You claim to focus on underprivileged children, but your only “scholar” was required to
raise 60% of J’s more than $4,000 fee. And, as shown above, you cannot provide a
history of having directly awarded any scholarships.

You do not maintain an arm's length relationship with J. Instead, J controls every aspect
of your operations, and you serve as conduit to your founder's for-profit company.

• J's founders, officers and directors serve as your governing body

• J solicits the scholarship applications via its website.

• J’s admission team identifies qualified applicants and selects scholarship
recipients.

• The recipient must participate in the program identified in the application.

• J is the only current provider of your programs.

• And, your conflict of interest policy cannot be enforced with respect to J because
all members of your board are insiders who profit from your relationship with J.

Conclusion

Based on the facts, we have concluded that you have not shown that you have or will
meet the operational test under section 501(c)(3) of the Code. Accordingly, you do not

Letter 4036 (CG) (11-2005)
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7

qualify for exemption as an organization described in section 501(c)(3) of the Code.
Contributions to your organization are not deductible under section 170 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 that 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, How to Appeal an IRS Decision on Tax Exempt
Status.

Types of information that should be included in your protest can be found on page 1 of
Publication 892, under the heading “Filing a Protest.” The statement of facts must be
declared true under penalties of perjury. This may be done by adding to the protest the
following signed 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 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

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to appeal as a failure to exhaust available administrative remedies. Code section
7428(b)(2) provides, in part, that a declaratory judgment or decree shall not be issued in
any proceeding unless the Tax Court, the United States Court of Federal Claims, or the
District Court of the United States for the District of Columbia determines that the
organization involved has exhausted all of the administrative remedies available to it
within the IRS.

If you do not intend to protest this determination, you do not need to take any further
action. If we do not hear from you within 30 days, we will issue a final adverse
determination letter. That letter will provide information about filing tax returns and other
matters.

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

Mail to: Deliver to:

Internal Revenue Service Internal Revenue Service

EO Determinations Quality Assurance EO Determinations Quality Assurance
Room 7-008 550 Main Street, Room 7-008

P.O. Box 2508 Cincinnati, OH 45202

Cincinnati, OH 45201
You may fax your statement using the fax number shown in the heading of this letter. If
you fax your statement, please call the person identified in the heading of this letter to
confirm that he or she received your fax.

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

Sincerely,

Director, Exempt Organizations

Enclosure, Publication 892

Letter 4036(CG) (11-2005)
Catalog Number 47630W