Market-rate consulting fails exemption tests

Plain-English summary

An organization sought section 501(c)(3) status for mediation, quality-management consulting, hospital-accreditation preparation, internal auditing, and services involving veterans and older people. It planned to charge competitive market rates, serve both exempt and for-profit clients, and pay its president more than $200,000 annually, plus possible bonuses and other employee payments. The IRS found that the consulting and auditing activities had a substantial commercial purpose and competed with for-profit providers. It also found that the compensation arrangements served the private interests of the president and potential employees, so it denied exemption under section 501(c)(3).

Ruling snapshot

• Question: Did the organization operate exclusively for exempt purposes and serve public rather than private interests under section 501(c)(3)?
• Outcome: Denied
• Key authorities: IRC § 501(c)(3); Treas. Reg. § 1.501(c)(3)-1; Rev. Ruls. 69-266, 71-529, 72-369, 74-587, and 76-419

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Release Number: 201535019
Release Date: 8/28/2015
Date: June 5, 2015

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

Employer Identification Number:

LEGEND:

B = President
Q = Date
T = State

UIL:

501.36-01
501.33-00

Dear Applicant:

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 incorporated on date Q, in the state of T.

Article 5 of your Articles of Incorporation states you are organized for the provision of
mediation services; quality management consulting; hospital accreditation preparation
services; miscellaneous uplifting services for the elderly veterans of military service; and
research and development services. Your amended Articles of Incorporation state you
are organized exclusively for charitable, religious, educational, and scientific purposes.

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Your narrative description of activities states you will provide mediation services, quality
management consulting, hospital accreditation preparatory services, and miscellaneous uplifting
services for the elderly and veterans of military services. Further, you will provide internal
auditing services. Your consulting services target proactive risk management for patients,
health care facilities, and health care providers. You work to improve the safety of patients
through patient safety initiatives as mandated under the Patient Safety and Quality Improvement
Act of 2005. You explain that the patient safety act applies to both non-profit and for-profit
organizations. You will provide consulting services to individuals and organizations regardless of
their tax-exempt status. You will not refuse to assist any organization that strives to improve its
quality of patient care. You will offer free introductory consultations to potential clients. You will
operate throughout the continental United States and globally. You state that the bulk of
services provided will be delivered by your president.

You claim that all management and consulting services provided under the auspices of the
Patient Safety Act are tax exempt qualified services because they are the propagation of a
government program.

You indicate you provide services to any organization that strives to improve its quality of patient
care.

You will participate in research activities to facilitate economic development of small veteran
owned businesses in need. Activities may include clinical studies, academic reviews,
contributing to ongoing studies, or providing general business consulting services. You claim
this lessens the burden of government. You will conduct fundraising through solicitation of
vehicles, boats, planes, or similar donations; foundation grant solicitations; and government
grant solicitation. You are currently receiving your funding from B, your president; who is your
only officer. You will charge fees for services. You price services with market circumstances in
mind and strive to remain competitive by the quality of service provided and not by underpricing
or undercutting competitors. Your fee structure depends on the nature of the project and the
level of expertise required. You charge approximately $350 per hour for consulting services.
Consulting services are billed at the remuneration rate of the consultant providing the services.
Auditing fees are determined based on the core competencies required and the auditor’s salary
determined using a salary survey.

Your expenses include contributions, compensation for your president, occupancy, depreciation,
and other program service expenses. B will receive compensation over $200,000 per year
(over $340 per hour for services rendered). You explain B operated in prior years with yearly
compensation in arrears as a collectable debt. In addition to salary payments, you will provide
performance bonuses not to exceed approximately $100,000 per annum. You may make
interest free educational, career improvement or other technical loans to officers, directors, or
employees. Further, you will award revenue based payments when an employee participates in
auditing, streamlining or process improvement activities where the client agrees to pay a
percentage of money saved. The employee will receive approximately 3% of the proceeds if the
employee is the originator of the account. Revenue based payments will not exceed the
amounts statutorily allowed by law.

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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(a)(1) of the Income Tax 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(c)(1) of the regulations provides that an organization will be regarded as
"operated exclusively" for one or more exempt purposes only if it engages primarily in activities
that 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(d)(1)(ii) of the regulations provides that in order to be exempt under
section 501(c)(3) of the Code, an organization must be both organized and operated exclusively
for exempt purposes unless it serves a public rather than a private interest. To meet this
requirement, it is necessary for an organization to establish that it is not organized or operated
for the benefit of private interests.

Section 1.501(c)(3)-1(d)(2) of the regulations provides that the term ‘charitable’ is used in
section 501(c)(3) of the Code in its generally accepted legal sense. Such term includes relief of
the distressed.

In Revenue Ruling 69-266, 1969-1 C.B. 151, an organization was formed and controlled by a
medical doctor. The doctor transferred assets, including his medical practice, his home, and his
automobile to the organization. In return, the organization “hired” the doctor and charged
prevailing fees for services rendered. The Service held that the operation of the medical
practice did not differ significantly from the private practice of medicine for profit. In essence,
the organization was operated by its creator as an attempt to reduce his personal federal
income tax liability. Thus the organization’s primary function was to serve the private interests
of its creator rather than a public interest.

Revenue Ruling 71-529, 1971-2 C.B. 234, found that a nonprofit organization that provides
assistance in the management of participating colleges' and universities’ endowment or
investment funds for a charge substantially below cost qualifies for exemption under section
501(c)(3) of the Code. Membership in the organization is restricted to colleges and universities
exempt under section 501(c)(3) of the Code and its board of directors was composed of
representatives of the member organizations.

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Revenue Ruling 72-369, 1972-2 C.B. 245, found that an organization formed to provide
managerial and consulting services at cost to unrelated exempt organizations does not qualify
for exemption under section 501(c)(3) of the Code.

Revenue Ruling 74-587, 1974-2 C.B. 162, found that a nonprofit organization formed to relieve
poverty, eliminate prejudice, reduce neighborhood tensions, and combat community
deterioration through a program of financial assistance in the form of low cost or long-term loans
to, or the purchase of equity interests in, various business enterprises in economically
depressed areas is exempt under section 501(c)(3) of the Code.

Revenue Ruling 76-419, 1976-2 C.B. 146, found that a nonprofit organization that purchases
blighted land in an economically depressed community, converts the land into an industrial park,
and encourages industrial enterprises to locate new facilities in the park in order to provide
employment opportunities for low income residents of the area, is operated exclusively for
charitable purposes and qualifies for exemption under section 501(c)(3) of the Code.

An organization is not operated exclusively for charitable purposes, and thus will not qualify for
exemption under section 501(c)(3), if it has a single non-charitable purpose that is substantial in
nature. This is true regardless of the number or importance of the organization's charitable
purposes. See Better Business Bureau of Washington, D. C., Inc. v. United States, 326 U.S.
279 (1945), which held activities that were in part aimed at promoting the prosperity and
standing of the business community were held to serve a substantial non-exempt purpose.

B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352 (1978), describes an organization whose sole
activity was to provide consulting services for a fee to nonprofit organizations. It provided
qualified persons to perform research projects for its clients. The fees charged by the
organization were set at or close to cost but were not less than the organization’s full cost of
providing its service. The organization was denied exemption because it operated in a
commercial, nonexempt manner. The provision of managerial and consulting services on a
regular basis for a fee is a trade or business ordinarily carried on for profit. The court held that
the organization was not operated exclusively for charitable, educational or scientific purposes
within the meaning of section 501(c)(3) of the Code.

In Airlie Foundation v. Internal Revenue Service, 283 F. Supp. 2d 58 (D.D.C., 2003), the district
court relied on the "commerciality doctrine" in applying the operational test. The operational test
requires both that an organization engage "primarily" in activities that accomplish its exempt
purpose and that not more than an "insubstantial part of its activities" further a non-exempt
purpose. Because of the commercial manner in which the organization conducted its activities,
the court found that it was operated for a non-exempt commercial purpose, rather than for a tax-
exempt purpose. The court stated:

Among the major factors courts have considered in assessing commerciality are
competition with for profit commercial entities; extent and degree of below cost services
provided; pricing policies; and reasonableness of financial reserves. Additional factors
include whether the organization uses commercial promotional methods (e.g.,
advertising) and the extent to which the organization receives charitable donations.

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In Asmark Institute, Inc. v. Commissioner of Internal Revenue, T.C. Memo. 2011-20, aff’d, 486
Fed. Appx. 566 (6th Cir. 2012), the appeals court upheld the Tax Court decision that Asmark
Institute is not entitled to exempt status under section 501(c)(3) of the Code because the
institute’s operations were commercial rather than charitable. Its activities consist mainly of
compliance services for a fee. The court also found that Appellant’s free services are relatively
small in relation to all of its services and are, in fact, tied in some manner to fee-based
membership. The court also found that the appellant’s largely fee-based business plan and its
competition within a for-profit market were also strong evidence of the predominance of their
nonexempt commercial purposes. The Tax Court concluded it was apparent from the record
that appellant’s consulting services are mainly associated with the fees appellant receives
through its various retainer agreements, membership agreements, and service packages. The
sale of services, including consulting services, is commonly considered to be a non-exempt,
commercial purpose.

In Harding Hospital, Inc. v. United States, 505 F.2 1068 6th Cir. (1974), the court held that an
organization seeking a ruling as to recognition of its exempt status has the burden of proving
that it satisfies the requirements of the particular exemption statute.

Application of Law

You are not described in section 501(c)(3) of the Code and section 1.501(c)(3)-1(a)(1) of the
regulations. You fail the operational test for exemption under 501(c)(3) because you are
operated in a commercial manner.

A substantial part of your activities are commercial. You provide internal auditing services,
quality management consulting, hospital accreditation preparatory services, and consultation
services to veterans and the elderly for a fee. Fees charged are at market rates. These services
are provided to individuals and organizations regardless of their tax-exempt status. You are in
competition with other individuals and organizations who provide similar services on a for-profit
basis. These facts demonstrate a commercial and substantially non-exempt purpose
inconsistent with section 501(c)(3) of the Code and Section 1.501(c)(3)-1(c)(1) of the
regulations.

You also operate for the private interest of B and potential employees, who are eligible for
revenue based payments and performance bonuses. Therefore, you are not organized or
operated exclusively as described in section 1.501(c)(3)-1(d)(1)(ii) of the regulations.

Your services are not designed for the relief of the poor and distressed, to lessen the burdens of
government, or the promotion of social welfare. Your services are not provided exclusively to
the poor, distressed or underprivileged nor are they directed to an economically depressed
community. Even though some of your services are directed to veterans or the elderly or are
provided in response to government programs, the manner in which you operate is commercial
and you are structured to benefit B. Therefore, your activities are not charitable as described in
section 1.501(c)(3)-1(d)(2) of the regulations.

Your fee-based service activities are similar to those described in Rev. Rul. 72-369 and in the

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court cases BSW Group, Inc., Airlie Foundation, and Asmark Institute. As in these four
situations, you operate in a commercial manner. You provide management and consulting
services to both for-profit and non-profit health care facilities. Your fees are not substantially
below cost. As stated above, you are operating a trade or business similar to and in competition
with commercial operations providing similar management and consulting services.

You are not similar to the organization described in Rev. Rul. 71-529 because you are not
providing services for a fee substantially below cost. You are also not similar to the
organizations described in Rev. Rul. 74-587 or Rev. Rul. 76-419 because you do not operate in
an economically depressed area or a distressed area. You provide management and
consulting services throughout the United States and globally. You provide services to any
organization that strives to improve its quality of patient care.

You are similar to the organizations in Better Business Bureau of Washington, D. C., Inc. and
Rev. Rul. 69-266 because you too have a substantial non-exempt purpose. The facts show you
operate for a substantial non-exempt commercial purpose and you also operate for the benefit
of B.

As in Harding Hospital, Inc. v. United States, you have the burden of proving that you satisfy the
requirements for tax exemption. You have failed to provide enough information to prove to us
that you are organized and operating in a manner appropriate under section 501(c)(3) of the
Code.

Conclusion

Based on the above facts and analysis, you do not qualify for exemption under section 501(c)(3)
of the Code because you are not operated exclusively for a 501(c)(3) purpose. The facts show
you operate for a substantial non-exempt commercial purpose as well as for the benefit of B.
Accordingly we conclude you do not qualify for exemption under section 501(c)(3).

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 (4th bullet) 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 protest and in any accompanying schedules and statements and, to the best of my

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knowledge and belief, they 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. To be represented 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. For more information about
representation, see 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 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 to you.
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 also 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 4034(CG) (11-2011)
Catalog Number 47628K