Family control and private benefit defeat exemption

Plain-English summary

An unincorporated association sought recognition as tax-exempt under IRC § 501(c)(3) for housing and services for people with developmental disabilities. Its bylaws described two related individuals as equal owners, gave the owners continuing control over the board and major financial transactions, and allowed them to convert the organization into a publicly traded company. The governing document also failed to limit the organization to exempt purposes or dedicate its assets to an exempt purpose upon dissolution. The IRS found that the family ownership and control created private inurement and private benefit, while zero budgets and incomplete application schedules left the proposed operations insufficiently described. The organization did not protest the proposed adverse determination, so the IRS made the exemption denial final.

Ruling snapshot

• Question: Did the association qualify for exemption under IRC § 501(c)(3)?
• Outcome: Denied
• Key authorities: IRC §§ 170, 501(c)(3), 6104, 6110, and 7428; Treas. Reg. §§ 1.501(a)-1(c) and 1.501(c)(3)-1

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION

Contact Person:

Number: 201504017
Release Date: 1/23/2015 Identification Number:

Contact Number:

Date: 10/27/14
Employer Identification Number:

Required To Be Filed:

UIL: 501.32-00; 501.32-01; 501.33-00 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.

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: 9/28/14 Contact Person:
Identification Number:
Contact Number:
FAX Number:

Employer Identification Number:

LEGEND: UIL:
B = Name 501.32-00
C = Name 501.32-01
D = Name 501.33-00
E = Name

x = 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
described below.

Facts

You were formed via the adoption of Bylaws as an unincorporated association on date x. Your
Bylaws state B and D are your owners, each holding a 50% ownership interest. B and D have
the right “...to open revolving accounts and in debt [sic] the company in any manner that will be
beneficial to its growth.” B and D as owners shall have the option to change the company to a
publicly traded company.

The Bylaws also state that until a board of directors is appointed all decisions and legal affairs
will be handled by the owners. After a board is formed, your members will handle all the day to

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day aspects of each company attached to the parent company. Even after the board is formed,
all funds and major transactions must be approved in writing by your owners. Payroll checks,
fund transfers and real estate purchases must be approved by the owners and checks initiated
and signed by the owners unless otherwise stated.

The Bylaws continue by stating that the owners shall have the right to appoint three members to
the corporate board. These members can be appointed at any time that the owner desires.
The Bylaws further indicate B as President, C as the Treasurer, and D is the Secretary.

The attachment to your Form 1023 states you are family business. B, C, D and E are related. D
is the mother of B, C and E. The attachment also states B is the executive director, E is the
secretary of the company, and C is the trustee of the company.

You said each individual will have a team of individuals that will help create an Individual
Service Plan (ISP). Each ISP outlines and authorizes those specific services to meet those
needs. Individuals’ needs are reassessed at least annually. You provide therapeutic and
assistive services to your clients. You set realistic goals with the help of your therapeutic staff:
to improve speech, enhance walking abilities, feed themselves, and perform their own personal
care. You plan on providing computing training and a literacy program based on each
individual’s needs.

You provide housing for your clients with developmental disabilities. The criteria for housing is
that it is certified for clients with developmental disabilities. Your housing is considered
affordable to a significant segment of the elderly or handicapped population. Your community
“...has average house rates less than $70,000 which estimates the affordability of housing for
our clients.”

Your plan is to sustain a grant to help supplement the cost of maintaining the criteria of the
business when a resident is unable to pay their regular charge. Most of your clients will be
receiving state funding through Medicaid.

You will provide daily living skills, including meal preparation, laundry, house cleaning, home
maintenance, money management, and appropriate social interactions. Self-care skills include
bathing, showering dressing, toileting [sic], eating, and taking prescribed medications.

You also submitted a Schedule A with your Form 1023 indicating you are a church with around
30 members. You did not provide the necessary attachments. You also submitted a Schedule F
with your Form 1023 showing you are providing housing to the handicapped but again did not
provide attachments.

You provided proposed budgets of all zeros for four consecutive, unspecified years on your
Form 1023. You asked us to select the correct public charity classification.

Law

Section 501(c)(3) of the Code describes corporations organized and operated exclusively for
charitable purposes no part of the net earnings of which inures to the benefit of any private

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shareholder or individual.

Section 1.501(a)-1(c) of the regulations provides that the terms “private shareholder or
individual” in Section 501 refer to persons having a 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 be exempt as an
organization described in section 501(c)(3) of the Code, an organization must be both organized
and operated exclusively for one or more of the purposes specified in such section. If an
organization fails to meet either the organizational test or the operational test, it is not exempt.

Section 1.501(c)(3)-1(b)(1)(i) of the regulations provides that an organization is organized
exclusively for one or more exempt purposes only if its articles of organization:

(a) Limit the purposes of such organization to one or more exempt purposes; and

(b) Do not expressly empower the organization to engage, otherwise than as an
insubstantial part of its activities, in activities that in themselves are not in furtherance
of one or more exempt purposes.

Section 1.501(c)(3)-1(b)(4) of the regulations provides that an organization is not organized
exclusively for one or more exempt purposes unless its assets are dedicated to an exempt
purpose, either by an express provision in its governing instrument or by operation of law

Section 1.501(c)(3)-1(c)(2) of the regulations provides that an organization is not operated
exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the
benefit of private shareholders or individuals as defined in Section 1.501(a)-1(c).

Section 1.501(c)(3)-1(d)(1)(ii) of the regulations provides that an exempt organization must
serve a public rather than a private interest. The organization must demonstrate that it is not
organized or operated to benefit 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.” Thus, if an organization is operated to benefit private interests rather than for
public purposes, or is operated so that there is prohibited inurement of earnings to the benefit of
private shareholders or individuals, it may not retain its exempt status.

Revenue Procedure 2014-9 , Section 4.01, provides that the Internal Revenue Service will
recognize the tax-exempt status of an organization only if its application and supporting
documents establish that it meets the particular requirements of the section under which
exemption from federal income tax is claimed. Section 4.03 provides that exempt status may be
recognized in advance of the organization’s operations if its proposed operations are described
in sufficient detail to permit a conclusion that it will clearly meet the particular requirements for
exemption pursuant to the section of the Code under which exemption is claimed. Section
4.03(2) states that the organization must fully describe all of the activities in which it expects to
engage, including the standards, criteria, procedures or other means adopted or planned for
carrying out the activities, the anticipated sources of receipts, and the nature of contemplated
expenditures.

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In Western Catholic Church v. Commissioner, 73 T.C. 196 (1979), the Tax Court held that
although separate requirements, the "private inurement" test and the "operated exclusively for
exempt purposes" test often overlap substantially. The petitioner's only activities were some
individual counseling and distribution of a few grants to needy individuals. The petitioner's
failure to keep adequate records and its manner of operation made it impossible to trace the
money completely, but the court found it clear that money passed back and forth between
petitioner and its director and his for-profit businesses. The Court Held that petitioner had not
shown it was operated exclusively for exempt purposes or the no part of its earnings inured to
the benefit of its officer.

In Basic Bible Church v. Commissioner, 74 T.C. 846 (1980), the Sixth Circuit court found that
although the organization did serve religious and charitable purposes, it existed to serve the
private benefit of its founders, and thus failed the operational test of section 501(c)(3). Control
over financial affairs by the founder created an opportunity for abuse and thus the need to be
open and candid, which the applicant failed to do.

Application of Law

You are not as described in Section 501(c)(3) of the Code because you are not organized and
operated for charitable purposes.

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

You do not meet the requirements in Sections 1.501(c)(3)—1(b)(1)(i) of the Income Tax
Regulations. Your formation document does not limit your purposes as required in Section
501(c)(3) of the Code; in addition, your formation document does not have a dissolution
provision as required by Section 1.501(c)(3)-1(b)(4), which also causes you to fail the
organizational test.

You are not described in Section 1.501(c)(3)-1(c)(2) of the Regulations because you are not
operated exclusively for exempt purposes since your net earnings inure to the benefit of private
shareholders or individuals as defined in Section 1.501(a)-1(c). This is evidenced by the fact
you are structured as a family business with B and D as 50% owners. Individuals holding an
ownership interest in you inures to their benefit.

You are not as described in Section 1.501(c)(3)-1(d)(1)(ii) of the Regulations because you are
serving the private interests of B and D. This is indicated by the following:

• The Bylaws state B and D are your owners;
• The owners shall have the right to appoint three members to the corporate board;
• The Bylaws state that until a board of directors is appointed all decisions and legal
  affairs will be handled by the owners;
• Even after the board is formed, all funds and major transactions must be approved in
  writing by your owners;
• Payroll checks, fund transfers and real estate purchases must be approved by the

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owners and checks initiated and signed by the owners unless otherwise stated.

You also do not meet the provisions in Revenue Procedure 2014-9 because you failed to
provide budgets as well as sufficient information about your operations. You submitted a
Schedule A with your Form 1023 indicating you are a church with around 30 members without
any attachments. You also provided a Schedule F with your Form 1023 showing you are
providing housing to the handicapped but again did not provide attachments.

Like the organization in Western Catholic Church v. Commissioner, the information you
submitted shows you are serving a private, rather than public interest, as described in Section
1.501(c)(3)-1(d)(1)(ii) of the regulations. Even if you did serve some level of charitable
purposes, you were formed a as a for-profit organization to benefit your founders, much like the
organization described in Basic Bible Church v. Commissioner, precluding you from exemption
under section 501(c)(3) of the Code.

Conclusion

Based on the facts presented above, we conclude, you are not organized and operating
exclusively for exempt purposes as required by sections 1.501(c)(3)-1(a)(1) and 1.501(c)(3)-
1(c)(1) of the regulations. You are operating a business which benefits B and D. You do not
serve a public rather than a private interest as required by section 1.501(c)(3)-1(d)(1)(ii) of the
regulations.

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 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

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during the appeal process, you must file a proper power of attorney, Form 2848, Power of
Attorney and Declaration of Representative, if you have not already done so. You can find more
information about representation in Publication 947, Practice Before the IRS and Power of
Attorney. All forms and publications mentioned in this letter can be found at www.irs.gov, Forms
and Publications.

If you do not file a protest within 30 days, you will not be able to file a suit for declaratory
judgment in court because the Internal Revenue Service (IRS) will consider the failure to appeal
as a failure to exhaust available administrative remedies. Code section 7428(b)(2) provides, in
part, that a declaratory judgment or decree shall not be issued in any proceeding unless the Tax
Court, the United States Court of Federal Claims, or the District Court of the United States for
the District of Columbia determines that the organization involved has exhausted all of the
administrative remedies available to it within the IRS.

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

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

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

Cincinnati, OH 45201

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

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