7.25.3  Religious, Charitable, Educational, Etc., Organizations (Cont. 2)

7.25.3.11 
Health

7.25.3.11.2 
Other Healthcare Organizations—Traditional

7.25.3.11.2.2  (02-23-1999)
Activities Pursuant to Applicable Statute

  1. Public Law 104–121, section 105, enacted on March 29, 1996, terminates payments as well as Medicare/Medicaid coverage, effective Jan. 2, 1997, for SSA beneficiaries whose disabilities are based on drug addiction or alcoholism. Termination of their payments and insurance benefits will not result if drug addiction or alcoholism is not material to the beneficiaries’ disabilities.

  2. Section 205(j)(4)(B) of the of the Social Security Independence and Program Improvements Act of 1994 (P.L. 103–296) defines the term qualified organization to include any community based non-profit agency. In 20 CFR 404.2040a of the Code of Federal Regulations, SSA defines community based non-profit agency as:

    1. a non-profit social service agency;

    2. that is "community-based," i.e., it is located within its service area, comprised of one or more neighborhoods, city or county locales;

    3. that is bonded or licensed in the state in which it serves as representative payee, regularly provides representative services concurrently to at least five beneficiaries, and is not a creditor of the beneficiary; and

    4. a nonprofit social service organization founded for religious, charitable or social welfare purposes that is tax-exempt under IRC 501(c).

  3. Representative payee organizations (RPOs) first must use the payments from SSA to pay for the basic needs (such as food and shelter) of the beneficiaries. Then, they may use the excess to pay for other needs such as

    • clothing,

    • medical expenses not covered by Medicare or Medicaid, or

    • recreation.

  4. RPOs are compensated for providing such services to SSA RPOP beneficiaries, by deducting a fee set by statute and SSA regulations from each beneficiary’s SSA funds.

7.25.3.11.2.3  (02-23-1999)
Rationales for Exemption

  1. RPOs may qualify for exemption under IRC 501(c)(3) on two rationales:

    • providing relief to the poor and distressed;

    • lessening the burdens of government.

  2. Relief of the Poor and Distressed — RPOs assist a class of individuals who are mentally or physically debilitated. By managing, monitoring, and providing funds that pay for their basic necessities of living, a RPO relieves the poor and distressed and, therefore, are furthering IRC 501(c)(3) or IRC 501(c)(4) purposes.

  3. Lessening the Burdens of Government — Rev. Rul. 81–276, 1981–C.B. 128 holds that a professional standards review organization qualifies for exemption under IRC 501(c)(3) because it is lessening the burdens of government. The ruling reasons that the organization assumes the government’s burden of reviewing the professional activities of health care practitioners and institutions to ensure they are appropriate recipients of Medicare and Medicaid reimbursement. Similarly, a PRO, by assisting the SSA ensure that public funds are used to provide necessities of life to SSA beneficiaries, may lessen the burdens of government.

  4. A RPO’s operations may be distinguished from the organization held to be engaged in a trade or business ordinarily carried on for profit in Rev. Rul. 72–369, 1972 C.B. 245. Rev. Rul. 72–369 describes an organization regularly providing managerial and consulting services to unrelated charities for a fee no more than its cost. It concludes that the organization does not qualify for exemption because it is only providing services of a ordinary commercial nature. A PRO is distinguishable from a commercial trade or business organizations because it provides services that may not be available through commercial channels to all eligible beneficiaries of the SSA RPOP, regardless of the potential fees.

7.25.3.11.2.4  (02-23-1999)
Requirement to Serve Public Rather Than Private Interests

  1. A RPO must otherwise satisfy the requirements for exemption under IRC 501(c)(3), including the requirement in Reg. 1.501(c)(3)–1(d)(1)(ii) to be operated for the benefit of public rather than private interests.

  2. Many RPO’s are organized in a manner that raise the issue whether the organization primarily serves the private interests of those who control it rather the public interests of the SSA. Facts that suggest private interests may be served include:

    1. The RPO was created and is controlled by one or two people, who are also the sole or controlling employees.

    2. If there are other employees, they are related to the controlling individual(s).

    3. The board of directors is comprised of controlling individual(s) and related persons.

    4. Expenses consist primarily of compensation or rent to those individuals who control the organization.

  3. The presence of the following factors suggest that a RPO is organized and operates for public rather than private purposes:

    1. Services are provided to all eligible SSA RPOP beneficiaries without regard to the amount (and corresponding RPO service fee) of the benefit that an eligible beneficiary may receive;

    2. The governing body is comprised primarily of community members who do not have a financial interest in the RPO’s activities;

    3. The governing body has exclusive authority to determine compensation of employees and other parties that perform major services for the RPO;

    4. Any members of the governing body who are also compensated for services provided to the RPO are not eligible to vote on board decisions involving their compensation;

    5. The governing body and key employees have experience or background in social services;

    6. Officials of the RPO represent that the organization will follow the operational requirements of the SSA, including fulfilling the duties described in SSA publications and regulations.

  4. The criteria are not unique to RPO’s, and have long been applied to a variety of organizations seeking recognition of exemption. For example, the requirement that such an organization be governed by a board of directors representative of the community served, rather than by "insiders" with a financial interest in the organization’s activities, is consistent with published precedents. In the health care area, health care providers and similar organizations are required to have a "community board" rather than a governing body dominated by financially interested individuals. See, e.g., Rev. Rul. 69–545, 1969–2 C.B. 117; compare Rev. Rul. 55–656, 1955–2 C.B. 262 (community nursing bureau qualified for exemption under IRC 501(c)(3)), with Rev. Rul. 61–170, 1961–2 C.B. 112 (private duty nurses’ registry did not qualified for exemption under IRC 501(c)(3) and distinguished from community nursing bureau on basis that public control and support of latter demonstrated operation for public benefit).

7.25.3.11.3  (02-23-1999)
Digests of Precedent Rulings

  1. Hospitals—A non-profit organization whose purpose and activity are providing hospital care is promoting health and may, therefore, qualify as organized and operated in furtherance of a charitable purpose if it meets the other requirements of IRC 501(c)(3) Rev. Rul. 69–545, 1969–2 C.B. 117.

  2. Medical staff of hospital—A nonprofit organization formed by a medical staff of an exempt hospital to carry on a charitable program of benefit to the hospital is described in IRC 501(c)(3). Rev. Rul. 69–631, 1969–2 C.B. 119.

  3. Clinic to aid drug victims—A nonprofit organization operating a clinic to aid victims of hallucinatory drugs and providing information concerning such drugs is described in IRC 501(c)(3). Rev. Rul. 70–590, 1970–2 C.B. 116.

  4. Medical society; local—A city medical society exempt under IRC 501(c)(6), that primarily directs its activities to the promotion of the common business purposes of its members may not be reclassified as an educational or charitable organization under IRC 501(c)(3). Rev. Rul. 71–504, 1971–2 C.B. 231.

  5. Rehabilitation program, former medical patients—An organization providing a residence facility and therapeutic "group living program" for individuals recently released from a medical institution is described in IRC 501(c)(3). Rev. Rul. 72–16, 1972–1 C.B. 143.

  6. Home health care—A nonprofit organization, a qualified "home health agency" as defined in 1861(c) of the Social Security Act, formed to provide low cost home health care for people of a community may qualify for exemption as an organization described in IRC 501(c)(3). Rev. Rul. 72–209, 1972–1 C.B. 148.

  7. Rural health center—An organization formed and supported by residents of an isolated rural community to provide a medical building and facilities at a reasonable rent to attract a doctor who would provide medical services to the entire community is promoting the health of the community and thus exempt as a charitable organization under IRC 501(c)(3). Rev. Rul. 73–313, 1973–2 C.B. 174.

  8. Medical specialty board—A medical specialty board that devises and administers written examinations to physicians in a particular medical specialty and issues certificates to successful candidates is exempt from tax as a business league under IRC 501(c)(6), but is not exempt as an organization described in IRC 501(c)(3). Rev. Rul. 73–567, 1973–2 C.B. 178.

  9. Medical information retrieval system; donated body organs—A nonprofit organization that operates a free computerized donor authorized retrieval system to facilitate transplantation of body organs upon a donor’s death qualifies for IRC 501(c)(3) exemption. Rev. Rul. 75–197, 1975–1 C.B. 156.

  10. Trust used to satisfy hospital’s malpractice claims—A trust created by an exempt hospital for the sole purpose of accumulating and holding funds to be used to satisfy malpractice claims against the hospital, and from which the hospital directs the bank-trustee to make payments to claimants qualifies for exemption under IRC 501(c)(3). Rev. Rul. 78–41, 1978–1 C.B. 148.

  11. Health care facility; Christian Science—An otherwise qualifying nonprofit organization that operates a health care facility for patients under the care of Christian Science practitioners, receives its income principally from contributions, patients, fees, medicare, medicaid, and health insurance qualifies for exemption as an organization described in IRC 501(c)(3). As funds permit, the organization accepts patients who are unable to pay. Rev. Rul. 80–114, 1980–1 C.B. 115.

  12. Hospital—Organization formed to construct, maintain, and operate or lease—An otherwise qualifying nonprofit organization that was created to construct, maintain and operate or lease a public hospital and related facilities for the benefit of a city and the surrounding communities is operated exclusively for charitable purposes and qualifies for exemption. Rev. Rul. 80–309, 1980–1 C.B. 183.

  13. Hospitals—A nonprofit hospital that is not required to operate an emergency room where a state or local health planning agency has found that this would unnecessarily duplicate emergency services and facilities that are adequately provided by another medical institution in the community is described in IRC 501(c)(3). Amplifies Rev. Rul. 69–545, supra. Rev. Rul. 83–157, 1983–2 C.B. 94.

  14. Recruitment incentives—A nonprofit hospital may pay recruitment incentives to a physician without jeopardizing its exempt status provided the transactions further charitable purposes, do not result in inurement, do not result in the hospitals serving a private rather than a public purpose, and do not constitute an illegal activity. Rev. Rul. 97–21, 1997–18 I.R.B. 8.

  15. Joint ventures—A nonprofit hospital that transfers substantially all of its assets to a joint venture with a for-profit entity may continue to qualify as an IRC 501(c)(3) organization if the facts and circumstances indicate that the organization’s participation in the joint venture furthers a charitable purpose and the transaction is structured so that the organization is not operating for the private benefit of its for-profit partners. Rev. Rul. 98–15, 1998–12 I.R.B. 6.

7.25.3.12  (02-23-1999)
Instrumentalities

  1. There is no provision in the Internal Revenue Code that imposes a tax on the income of governmental units. The term "governmental units" refers to the states and their political subdivisions. The income of governmental units is not generally subject to federal income taxation. However, the income of a separately organized entity, that is, an organization that is not an integral part of a state government or a political subdivision, is subject to tax unless a Code exemption or an exclusion applies.

  2. The term "instrumentality" of a governmental unit does not appear in IRC 501. It is referenced, however, in the Code sections applying the FICA and FUTA employment taxes

7.25.3.12.1  (02-23-1999)
IRC 501(c)(3) Exemption

  1. A wholly owned state or municipal entity which is separately organized and not an integral part of the state or local government itself, and which is organized and operated exclusively for purposes described in IRC 501(c)(3) may qualify for exemption from federal income tax under IRC 501(a) as an organization described in IRC 501(c)(3). Rev. Rul. 60–384, 1960–2 C.B. 172.

7.25.3.12.1.1  (02-23-1999)
Organizational Requirements

  1. Reg. 1.501(c)(3)–1(b) requires that an organization’s enabling document set forth purposes that limit it to exclusively serving one or more exempt purposes. Nevertheless, where an organization is established pursuant to a state statute, its stated purposes satisfy the organizational test by sufficiently describing its operations.

  2. To be considered a separately organized entity, an organization must establish that it is either a corporation, a trust, or an association. A review of the organization’s creating documents will normally disclose the nature of its formal structure, that is, whether it is in form a corporation, a trust, or an association.

7.25.3.12.1.2  (02-23-1999)
Corporations

  1. A corporation is a legal entity, created under the authority of the non-profit laws of a state. It is regarded as having an existence completely separate and apart from that of its creators and constituents.

  2. The separate organization requirement is generally met if the entity is incorporated under state non-profit corporation law. This is because by definition a corporation is a legal entity, created under the authority of the laws of a state, which is regarded as having an existence completely separate and apart from that of its creators and constituents. Accordingly, if the instrumentality in question is in substance and in form a corporation, it must be considered a separately organized entity.

7.25.3.12.1.3  (02-23-1999)
Trusts

  1. A trust is an arrangement created either by a will or by an inter vivos declaration where trustees take title to property to protect or conserve it for the beneficiaries under the ordinary rules applied in chancery or probate courts. Reg. 301.7701–4(a). If the purpose of an arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit, then it is a trust.

    Example:

    O is a trust, created under the will of X, to provide college scholarships for graduates of public schools in County C. The trust instrument appoints the public school board in County C as trustee of the trust. Under the trust provisions, the County C school board invests trust principal and uses the income therefrom to provide scholarships. The organization is a trust as defined in Reg. 301.7701–4(a).

7.25.3.12.1.4  (02-23-1999)
Associations

  1. IRC 7701(a)(3) states that the term "corporation" includes associations. Thus, any entity that is a "corporation" for federal tax law purposes will be considered separately organized, even if it is not incorporated under state law.

  2. Reg. 301.7701–2 lists six characteristics that are ordinarily found in a pure corporation, which, taken together, distinguish it from other organizations. As adapted to fit unincorporated nonprofit bodies, these corporate characteristics are: (i) associates, (ii) an objective by the associates to carry on the activity for which the organization was formed, (iii) continuity of life, (iv) centralized management, (v) limited liability, and (vi) free transferability of interests. The presence or absence of these characteristics will depend upon the facts in each individual case. Thus, an organization will be treated as an association if it more nearly resembles a corporation than a partnership or trust and, therefore, may be considered to be an organization distinct from its creator.

  3. Entities considered "separately organized" include colleges and universities; hospital, housing, or development authorities; public library boards; water or park districts; public school athletic associations; charitable trusts; and organizations created by inter-governmental agreement.

  4. Specific examples of separately organized entities, which have continuity of life and centralized management, as well as associates (their board members) who have an objective to carry on each organization’s activity separate and apart from the general activity of the government, are:

    1. Pursuant to a statute of State A, several county and municipal governments in A entered into an intergovernmental cooperation agreement providing for the creation of M. M’s purpose is to provide special education services to students in schools in counties and municipalities which are parties to the agreement. The services M provides are required by federal law. M is governed by a board of directors composed of one representative of each member government. The board annually assesses member governments, proportionately based on population of each county or municipality, an amount needed to fund M’s activities. The members may, by majority vote, provide for the dissolution of M. Upon dissolution, any funds remaining after payment of M’s liabilities will be returned to the school fund of each governmental unit which has participated in M’s activities, proportionately to assessments paid by the unit.

    2. N is a public hospital authority, created by a county in State B, pursuant to B statute. The statute provides that any county in B may create such an authority by vote of the county legislature. Under the statute, management of N’s facilities is vested in a board of governors. N’s initial governing board was named in the legislative enactment creating it; thereafter, N’s board members are appointed by the county executive with the approval of the county legislature. N receives an annual appropriation for its activities from the county legislature, as well as fees for patient services. State law authorizes N to issue bonds to construct new facilities. N may be dissolved, pursuant to statute, by vote of the county legislature. Upon dissolution, any facilities N owns become the property of County B, and any funds remaining after payment of N’s debts are transferred to a County Hospital Fund, to be used in providing health care services to residents of County B.

  5. Rev. Rul. 62–66, 1962–1 C.B. 84, describes an organization that is not separately organized. It holds that a committee created by executive order of the governor of a state as an official state agency, to educate the public about the purposes and activities of the United Nations as an instrument of world peace, does not qualify for exemption under IRC 501(c)(3). Rev. Rul. 62–66 concludes the organization is an "integral part" of the State government, and therefore, under Rev. Rul. 60–384, not described in IRC 501(c)(3).

7.25.3.12.2  (02-23-1999)
Powers Other Than Those Described in IRC 501(c)(3)

  1. Rev. Rul. 60–384 provides that even though a wholly-owned state or municipal instrumentality may be a separately organized entity, it is not entitled to IRC 501(c)(3) exemption if it has powers other than those described in IRC 501(c)(3). Where an instrumentality exercises substantial regulatory or enforcement powers in the public interest, it will not qualify. Powers of regulation or enforcement are powers which are possessed by governmental agencies such as school boards and boards of health and welfare. These powers are referred to as sovereign powers. The three acknowledged sovereign powers are the police power, the power to tax, and the power of eminent domain. The presence of either the police power or the power to tax, if substantial, will disqualify a separately organized government entity from exemption under IRC 501(c)(3).

    1. U is a public housing authority incorporated under a statute giving it power to conduct examinations and investigations, take sworn testimony at hearings, issue subpoenas requiring attendance of witnesses or production of books and papers, and issue commissions to examine witnesses not attending hearings. Through these means, it collects information and makes it available to other agencies to use in enforcing planning, building, and zoning ordinances. U does not qualify for exemption because its investigatory powers are beyond those permitted under IRC 501(c)(3). Rev. Rul. 74–14, 1974–1 C.B. 125.

  2. Compare Rev. Rul. 74–15, 1974–1 C.B. 126, in which a public library organized as a separate entity under a State statute has the authority to certify the tax rate needed for its operation to the rate-making authority. The library was held to qualify for exemption under IRC 501(c)(3). Since the State statute conferred only a limited power upon the public library to determine the tax rate necessary to support its operations, the power regarding the tax rate was not a regulatory or enforcement power within the meaning of Rev. Rul. 60–384.

  3. There is no distinction between the power to recommend or certify a tax rate, the power to determine a tax rate, and the power to "levy," "assess," or "impose" a tax. The regulatory or enforcement power lies with the power to collect, not the power to certify or levy a tax rate. Thus, if an organization has the power to collect the tax, it will be disqualified from being recognized as exempt.

  4. Certain limited powers do not disqualify if they do not indicate purposes beyond those qualifying as "exclusively" exempt under IRC 501(c)(3).

    Example:

    V a state university, has a police force to regulate traffic, motor vehicles, and speed limits on campus and to issue citations, impose fines, and arrest persons to detain them until city police arrive. Because V’s police powers are not substantial and are limited to its campus, they do not disqualify it from exemption under IRC 501(c)(3).

    1. Although Rev. Rul. 77–165, 1977–1 C.B. 21, dealing with qualification as a political subdivision under IRC 103, does not address IRC 501(c)(3) exemption, it is relevant, as organizations without "substantial sovereign powers" in the IRC 103 context also lack "powers other than those described in IRC 501(c)(3)" under Rev. Rul. 60–384.

  5. Although the power of eminent domain is indisputably a governmental power, it is not necessarily a power of regulation or enforcement within the meaning of Rev. Rul. 60–384, and may not disqualify a separately organized government entity from exemption.

    1. Rev. Rul. 67–290, 1967–2 C.B. 183, describes a public hospital corporation organized under a statute giving it power to acquire property essential to its purposes by eminent domain. Because its eminent domain power is limited to acquiring property for its charitable purpose, and such a limited power is commonly bestowed on non-governmental entities, the hospital corporation qualifies for exemption under IRC 501(c)(3). The ruling reasoned that the limited power of eminent domain is not a "regulatory" or "enforcement" power of the type described in Rev. Rul. 60–384.

  6. If the power of eminent domain is combined with other powers to give an organization purposes broader than those described in IRC 501(c)(3), then the organization does not qualify for exemption. For example, if an organization, in addition to condemning property by the power of eminent domain, has the power to conduct investigations, hear testimony and take proof under oath, issue subpoenas, and recommend standards of maintenance and requirements of applicable health and safety ordinances and zoning, it does not qualify.

7.25.3.12.3  (02-23-1999)
Dissolution Provisions

  1. Many instrumentalities have language in their governing instrument providing that upon dissolution, all remaining assets will be distributed to a state or any political subdivision thereof to satisfy IRC 115 requirements. This raises a potential problem, as Reg. 1.501(c)(3)–1(b)(4) requires that upon dissolution assets be distributed to the Federal government, or to a State or local government, for a public purpose. However, if the organization has been created by a state statute, local ordinance, or similar enabling vehicle, and there is no indication that upon dissolution the assets will be distributed for private use, then it can be considered to satisfy the dissolution requirements without explicitly including the phrase "for a public purpose," which would normally be required.

7.25.3.12.4  (02-23-1999)
Application Consideration: Exempt Status

  1. Exhibit 7.25.3–1, "INSTRUMENTALITY" EXEMPTION APPLICATION Checksheet for Organizations Closely Affiliated with Government, provides a checksheet of factors to assist in a determination whether an organization qualifies under IRC 501(c)(3).

7.25.3.12.5  (02-23-1999)
Application Consideration: Late Filers

  1. Applications from wholly-owned state or municipal instrumentalities frequently involve "late filers" , i.e., organizations not filing within the 15-month period set by Reg. 1.508–(a)(2). Although there is no special exception to the notice requirement for government entities, they can request relief from the filing deadline pursuant to Reg. 301.9100–1, Reg. 301.9100–2, and Reg. 301.91003 in the same manner as other applicants.

7.25.3.12.6  (02-23-1999)
IRC 115 Exclusion

  1. IRC 115(1) provides that gross income does not include

    1. income derived from the exercise of any essential governmental function, and

    2. accruing to a state or any political subdivision thereof.

  2. Factors to consider in determining whether income is excluded under IRC 111 are described in Rev. Rul. 57–128, 1957–1 C.B. 311.

    1. An organization seeking exclusion from income tax may request a ruling under IRC 115. The procedures for requesting a ruling are set out in Rev. Proc. 98–1, 1998–1 I.R.B. 11, or its successor.

  3. The fact that an organization’s income may be excluded under IRC 115(1), does not preclude it from also qualifying for exemption under IRC 501(c)(3).

7.25.3.12.7  (02-23-1999)
Employment Tax Requirements

  1. As of January 1, 1984, service performed in the employ of an organization exempt from federal income tax under IRC 501(a) as an organization described in IRC 501(c)(3) is liable for FICA tax requirements (social security and medicare taxes) on remuneration of $100.00 or more paid to each employee during a calendar year.

  2. Under IRC 3306(c)(8), service performed in the employ of an organization exempt from federal income tax under IRC 501(a) as an organization described in IRC 501(c)(3) is excepted from FUTA tax requirements.

  3. Unless covered under an agreement entered into under section 218 of the Social Security Act, under IRC 3121(b)(7), service in the employ of states, political subdivisions, and their instrumentalities is generally excepted from FICA tax requirements. However, under IRC 3121(u)(2), wages of any employees not covered under a section 218 agreement, but who are hired after March 31, 1986, are subject to the medicare portion of the FICA taxes. Further, under IRC 3121(b)(7)(F), regarding services performed after July 1, 1991, the wages of any employees not covered under a section 218 agreement and who are not members of a retirement system of the state, political subdivision, or instrumentality, are subject to FICA tax requirements (social security and medicare taxes).

  4. Under IRC 3306(c)(7), service in the employ of states, political subdivisions, and their instrumentalities is excepted from FUTA tax requirements.

  5. As previously noted, the term "instrumentality" is important in the Code sections applying the FICA and FUTA employment taxes. Therefore, when issuing a favorable determination letter to an organization as being exempt from federal income tax under IRC 501(a) as an organization described in IRC 501(c)(3), where the organization appears to be sufficiently connected and controlled by a political subdivision that it is likely to be an instrumentality, the specialist should include specialized language applicable to instrumentalities as provided by IRM 7.21.1, EO Automated Processing Procedures, (formerly 7690, Exhibit 300–26).

  6. Any questions that the organization may have as to whether it is an instrumentality of a state or a political subdivision for FICA or FUTA tax purposes should be addressed to the Office of the Chief Counsel (Tax Exempt/Government Entities), located in National Headquarters.

7.25.3.12.8  (02-23-1999)
Return Requirements

  1. IRC 6033 requires any organization exempt from federal income tax under IRC 501(a) to file an annual information return (Form 990), unless excepted, either by statute or pursuant to exercise of the Commissioner’s discretionary authority.

  2. Reg. 1.6033–2(g)(1)(v) provides that an organization that is exempt from tax under IRC 501(a) and that is a state institution, the income of which is excluded from gross income under IRC 115, is not required to file an annual information return.

    1. An organization may request a ruling that it meets the requirements of Reg. 1.6033–2(g)(1)(v) from the Washington POD.

  3. Certain governmental units and affiliates of governmental units are excepted from the requirement to file Forms 990 pursuant to exercise of the Commissioner’s authority in Rev. Proc. 95–48, 1995–2 C.B. 418. The entities covered are:

    1. Governmental unit

    2. Affiliate of a governmental unit described in IRC 501(c)(3) that has a ruling or determination letter

    3. Affiliate of a governmental unit described in IRC 501(c)(3) that does not have a ruling or determination letter from the Service.

  4. A governmental unit is defined as a state or local governmental unit defined in Reg. 1.103–1(b) and either

    1. it is entitled to receive deductible charitable contributions under IRC 170(c)(1), or

    2. it is an Indian tribal government or political subdivision thereof under IRC 7701(a)(40) and IRC 7871.

  5. An affiliate of a governmental unit described in IRC 501(c)(3) that has a ruling or determination from the Service that:

    1. its income from IRC 501(c)(3) activities is excluded under IRC 115;

    2. it is entitled to receive deductible charitable contributions under IRC 170(c)(1) on the basis that they are "for the use of" governmental units; or

    3. it is a wholly owned instrumentality of a state or political subdivision for employment tax purposes.

  6. An affiliate of a governmental unit that is described in IRC 501(c)(3) that does not have a ruling or determination from the Service, but:

    1. it is either operated, supervised, or controlled by governmental units, or by organizations that are affiliates of governmental units, or the members of its governing body are elected by the public at large, pursuant to local statute or ordinance;

    2. it possesses two or more affiliation factors listed in section 4.02 of Rev. Proc. 95–48; and

    3. its filing of Form 990 is not otherwise necessary to the efficient administration of the internal revenue laws.

7.25.3.12.9  (02-23-1999)
Information Letter

  1. A state or municipal organization that inquires about its exempt status should be informed in writing that it may qualify for exempt status under IRC 501(c)(3) only if it is organized as a separate entity and if it otherwise meets the organizational and operational tests of IRC 501(c)(3), including the absence of governmental powers.

  2. The information letter should further advise the organization that the gross income of a state or municipal entity may not be subject to tax under IRC 115. The letter should refer to Rev. Proc. 98–1, 1998–1 I.R.B. 10, or its successor, and advise that a ruling may be requested from the Washington POD using the address indicated in the revenue procedure.

  3. IRM 7.25.3-2 contains a pattern letter for use in responding to such inquiries.

7.25.3.12.10  (02-23-1999)
Native American (Indian) Tribal Governments

  1. Before 1983, Native American tribal governments were not considered state or local governments under the Code. Although tribal governments were not subject to tax (Rev. Rul. 67–284, 1967–2 C.B. 55), the favorable consequences available to private parties entering into transactions with state governments did not apply to similar transactions with Native American tribal governments. For example, a bequest to a Native American tribe could not be deducted for estate tax purposes under IRC 2055(a)(1).

7.25.3.12.10.1  (02-23-1999)
Current Law

  1. In 1983, Congress sought to equalize this treatment by enacting IRC 7871. IRC 7871(a) provides that, for certain specified federal tax purposes, an Indian tribal government shall be treated as a State. The term "Indian tribal government" is defined in IRC 7701(a)(40) as a governing body of any tribe, band, community, village, or group of Indians, or (if applicable) Alaska Natives, that is determined by the Secretary of the Treasury, after consultation with the Secretary of the Interior, to exercise governmental functions. Neither IRC 7701(a)(40) nor 7871 defines the term "governmental function." Nevertheless, the relevant legislative history indicates that Congress considered the term "governmental function" to be synonymous with the term "sovereign powers."

  2. IRC 7871(d) provides that for the purposes specified in IRC 7871(a), a subdivision of an Indian tribal government shall be treated as a political subdivision of a State if (and only if) the Secretary of the Treasury determines (after consultation with the Secretary of the Interior) that such subdivision has been delegated the right to exercise one or more of the substantial governmental functions of the Indian tribal government.

  3. Neither IRC 7701(a)(40) nor 7871 define the term "political subdivision." The legislative history provides that it is intended that essentially equivalent criteria be used in making determinations as to delegations of sovereign powers by Indian tribal governments to their subdivisions and delegations of sovereign powers by states to their political subdivisions. The determination of an entity’s status as a political subdvision of an Indian tribal government is therefore to be based on the same criteria as have traditionally been applied to states and their political subdivisions under IRC 103. Reg. 1.103–(b) defines a "political subdivision" as either a municipal corporation, or a division of government that has been delegated the right to exercise one of the three sovereign powers.

  4. Rev. Proc. 83–87, 1983–2 C.B. 606, lists Indian tribal governments that are treated similarly to states for federal tax purposes, including IRC 7871 and 7701(a)(40).

  5. Rev. Proc. 84–36, 1984–1 C.B. 510, lists subdivisions of Indian tribal governments that are treated as political subdivisions of states for the same specified purposes under the Internal Revenue Code that are noted in Rev. Proc. 83–87.

  6. Rev. Proc. 84–37, 1984–1 C.B. 513, provides guidance how a governmental unit of an Indian tribe or a political subdivision of an Indian tribal government not included among those listed in Rev. Proc. 83–87 and Rev. Proc. 84–36, can request a determination qualifying it for treatment as a state or a political subdivision of a state for purposes of IRC 7871 and 7701(a)(40).

  7. An entity listed in Rev. Proc. 83–87 and treated similarly to a state for federal tax purposes, or listed in Rev. Proc. 84–36 and treated as a political subdivision of a state, is not subject to federal income tax on amounts derived from performing its tribal functions. This non-tax treatment is derived from the Service’s long-standing position, set forth in Rev. Rul. 67–284. Under this revenue ruling an Indian tribal government is not a taxable entity, i.e., it will not qualify for exemption as described under IRC 501(c)(3), rather, it is simply not taxed.

  8. Tribal governments and their political subdivisions are not the only Native American organizations that may apply for recognition of exemption. The Service has processed applications from a variety of Native American related organizations, including: a tribal corporation organized under section 17 of the Indian Reorganization Act of 1934; a separately organized entity created under state law by a tribal government; a separately organized entity created by a tribal government recognized by a particular State but not the federal government; and a tribal government believed to qualify for treatment as a state or a political subdivision of a state for purposes of IRC 7871 and 7701(a)(40).

  9. A Native American tribal corporation organized under section 17 of the Indian Reorganization Act of 1934, is treated as a tribal government under federal tax law, i.e., is not a taxable entity. It does not qualify for exemption as described under IRC 501(c)(3), but is simply not taxed.

    1. Rev. Rul. 94–16, 1994–12 I.R.B. 4, in clarifying Rev. Rul. 81–295, 1981–2 C.B. 15, held that an Indian tribal corporation organized under section 17 of the Indian Reorganization Act of 1934 shares the same tax status as the Indian tribal government. Therefore, any income earned by such a corporation, regardless of the location of the business activities that produced the income (either on or off the tribe’s reservation), is not subject to federal income tax.

  10. A separately organized entity created under state law by a tribal government to conduct specific activities may qualify for exemption from federal income tax if it otherwise meets the organizational and operational tests of IRC 501(c)(3), including the absence of substantial sovereign powers.

    1. Rev. Rul. 94–16, 1994–12 I.R.B. 4, in amplifying Rev. Rul. 67–284, 1967–2 C.B. 55, held that a corporation organized by an Indian tribal government under state law does not share the same tax status as the Indian tribal government for federal income tax purposes. Therefore, any income earned by such corporation, regardless of the location of the business activities that produced the income (either on or off the reservation), is subject to federal income tax.

    2. The corporation will qualify for exemption if it conducts charitable and educational activities as a corporation separate from the tribe. Such activities may include tribal history research, cultural activities, and self-help projects for tribe members who are located in areas of economic blight and living on incomes below the poverty level.

    3. These charitable and educational activities are often conducted by an organization as part of an effort to be recognized as an Indian tribe by the federal government. As obtaining tribal recognition usually entails historical documentation, but not political or legislative activity, this activity will not disqualify an organization from obtaining recognition under IRC 501(c)(3).

  11. A separately organized entity created by a tribal government that is recognized by a particular State but not the federal government may qualify for exemption from federal income tax if it otherwise meets the organizational and operational tests of IRC 501(c)(3), including the absence of substantial sovereign powers.

  12. If an application from an Indian tribal government is denied under IRC 501(c)(3), but it appears that the entity will qualify for treatment as a state or a political subdivision of a state for purposes of IRC 7871 and 7701(a)(40), the denial should advise that a formal determination of status as a state or a political subdivision of a state for purposes of IRC 7871 and 7701(a)(40) may be requested pursuant to Rev. Proc. 84–37, supra.

7.25.3.13  (02-23-1999)
Financial Support of Other Organizations

  1. Many charitable foundations do not engage in active charitable undertakings themselves, but rather assist the work of religious, charitable, educational, or similar organizations by contributing money to them.

7.25.3.13.1  (02-23-1999)
Grant Making Organizations

  1. Grant-making organizations are sometimes controlled by corporate and individual taxpayers who use them as channels for their charitable contributions. Some have very large endowments and make grants totaling millions of dollars annually. This indirect form of charitable activity provides a basis for recognition of exemption under IRC 501(c)(3). Rev. Rul. 67–149, 1967–1 C.B. 133.

7.25.3.13.2  (02-23-1999)
Indirect Support of Charity

  1. An organization that owns and leases a building to the member agencies of a community chest may be providing a form of indirect support of charitable activities. If rentals are at rates substantially below fair rental value, the organization may qualify for recognition of exemption. Rev. Rul. 69–572, 1969–2 C.B. 119.

7.25.3.13.3  (02-23-1999)
Support of Charity Through Non-exempt Organizations

  1. Some charitable organizations make distributions to nonexempt organizations. These funds must be used for specific projects that further the purposes of the charitable organization.

  2. The charitable organization must retain discretion and control over the use of the funds and maintain records establishing that the funds are used for charitable purposes. An organization’s failure to document that funds distributed to nonexempt organizations or persons were used for exempt purposes could, if substantial, cause the organization to be operated for a substantial nonexempt purpose. Rev. Rul. 68–489, 1968–2 C.B. 210.

7.25.3.14  (02-23-1999)
U.S. Department of Agriculture Child and Adult Care Food Program

  1. Organizations created to assist in the implementation of the United States Department of Agriculture Child and Adult Care Food Program (USDA CADFP) may qualify for exemption under IRC 501(c)(3) as charitable organizations under the rationale that they lessen the burdens of government. The USDA CADFP is authorized under Section 17 of the National School Lunch Act, as amended, at 42 U.S.C. § 1766.

  2. The CACFP provides assistance to states through grants-in-aid and other means to initiate, maintain, and expand nonprofit food service programs for children or adult participants in nonresidential programs that provide care. In most states, the CACFP is administered by state agencies under USDA guidelines.

  3. The CACFP supports public institutions, private entities exempt under IRC 501(c)(3), and proprietary family day care providers. However, non-exempt family day care providers may participate in the program only under the sponsorship of a "sponsoring organization" that is tax-exempt, or "moving towards that status" by filing an application for recognition of exemption with the Service.

7.25.3.14.1  (02-23-1999)
Sponsoring Organization Responsibilities

  1. A "sponsoring organization" is responsible for:

    1. Submitting applications for participation or renewal in CACFP on behalf of sponsored day care providers

    2. Accepting final administrative and financial responsibility for program operations with respect to sponsored day care providers

    3. Monitoring the program at all facilities under its sponsorship

    4. Maintaining records required by USDA

    5. Acting as "fiscal intermediary" for food service funds between the state agency and the sponsored day care provider

  2. A "sponsoring organization" must:

    1. Conduct pre-approval visits to each provider

    2. Verify that the proposed food services do not exceed the providers capability

    3. Provide training for the providers in their responsibilities under CACFP

    4. Review operations to assess compliance with CACFP at least three times a year

  3. Sponsoring organizations receive the following payments under the CACFP program:

    1. Payment for meals (which they must pay over to sponsored providers at a rate established by law;

    2. Administrative payments, which may be the actual expenditures for cost of administering the program or the amount of administrative costs approved by the state agency

    3. One-time start-up payments to develop or expand successful CACFP operations in day care homes.

7.25.3.14.1.1  (02-23-1999)
Private Interest Considerations—One-Person Organizations

  1. Many "sponsoring organizations" applying for recognition of exemption are essentially one-person operations:

    1. The principal serves as an officer and director.

    2. The principal’s compensation is the organization’s primary expense.

    3. Other board members and employees may be members of the principal’s family.

  2. Operating under the control of one person or a small, related group suggests that an organization operates primarily for non-exempt private purposes, rather than exclusively for public purposes. See, e.g., Rev. Rul. 69–545, 1969–2 C.B. 177; compare Rev. Rul. 55–656, 1955–1 C.B. 262 (community nursing bureau qualified for exemption under IRC 501(c)(3)), with Rev. Rul. 61–170, 1961–2 C.B. 112 (private duty nurses; registry distinguished from community nursing bureau on basis that public control and support of latter demonstrated operation for public vs. private benefit).

  3. Sponsoring organizations may raise many of the same issues as Representative Payee Organizations discussed in IRM 7.25.3.11.2.4.

7.25.3.14.1.2  (02-23-1999)
Provider Control

  1. Sponsoring organizations may also be created and controlled by the day care providers they sponsor, to enable the providers to participate in CACFP. As with employee-dominated sponsoring organizations, provider-dominated sponsoring organizations may not be operated exclusively for exempt public purposes.

7.25.3.14.1.3  (02-23-1999)
Selective Sponsorship

  1. Organizations that refuse to sponsor state-licensed or federally-qualified day care providers that meet program requirements, because of their income or education levels, are not operated exclusively to further exempt purposes.

7.25.3.14.1.4  (02-23-1999)
Multiple Sponsorship Organizations Under Single Control

  1. One example of an abusive arrangement that operates primarily for private, non-exempt interests is where an Individual forms multiple sponsoring organizations to increase the amount of reimbursement received under CACFP.

7.25.3.14.2  (02-23-1999)
Exemption Criteria

  1. To qualify for exemption under IRC 501(c)(3), a sponsoring organization must meet the following criteria:

    1. A governing body comprised primarily of community members with no financial interest in its activities (in other words, persons other than organization employees, sponsored day care providers, or related parties).

    2. Members of the governing body should not vote on decisions concerning their compensation or that of a related party.

  2. Examples of an IRC 501(c)(3) exemption include—

    1. Decisions about compensation of employees and other parties providing services to the organization should be made by the governing body.

    2. No person receiving compensation for services under CACFP may receive compensation for services from any other sponsoring organization.

    3. Accept any qualified day care provider, consistent with its capacity to provide services to sponsored providers.

7.25.3.15  (02-23-1999)
Scientific Organizations

  1. Organizations may be described IRC 501(c)(3) if they are organized and operated exclusively for "scientific" purposes.

  2. "Scientific" is not defined in the Code, regulations, or any published rulings. However, a dictionary defines science as "a branch of study that is concerned with observation and classification of facts and especially with the establishment … of verifiable general laws chiefly by induction and hypotheses." Webster’s New Third New World Dictionary.

  3. An organization engaged in surveying scientific and medical literature and abstracting and publishing it free of charge was held to be exempt because it was engaged in the advancement of education and science. Rev. Rul. 66–147, 1966–1 C.B. 137.

  4. In another case, an organization carrying on research and disseminating knowledge in the field of the social sciences was held to be educational and scientific. It performed a substantial part of its research under contract from government agencies and devoted the proceeds to additional research. It performed no contract research for private individuals or organizations. Rev. Rul. 65–60, 1965–1 C.B. 231

7.25.3.15.1  (02-23-1999)
Public Versus Private Purposes

  1. The regulations provide that a scientific organization, as with other organizations described in IRC 501(c)(3), must be organized and operated in the public interest, as the purposes specified in IRC 501(c)(3) are limited to public purposes. This means that organizations that primarily pursue business purposes or that serve substantial private interests are not entitled to exemption under IRC 501(c)(3).

  2. Rev. Rul. 69–632, 1969–2 C.B. 120, holds that an organization composed of members of an industry to develop new and improved uses for products of the industry was not an exempt scientific organization because the primary purpose of the association’s research is to serve the private interests of its creators, rather than the public interest.

  3. An organization engaged in nonprofit research on human diseases, developing scientific methods for treatment, and disseminating its results through physicians’ seminars was held to be exempt as an educational organization in Rev. Rul. 65–298, 1965–2 C.B. 163. It planned to make the results of its research, including patents, formulas, etc., generally available to the public. The organization derived its financial support primarily from the donations and registration fees of the participants in its seminars.

7.25.3.15.2  (02-23-1999)
Scientific Research as an Exempt Purpose

  1. Scientific organizations generally engage in some form of "research." However, not all research is "scientific" and not all scientific research is carried on in the public interest.

    1. An association composed of the members of a particular industry was not exempt under IRC 501(c)(3) in Rev. Rul. 69–632, 1969–2 C.B. 120. The association sponsored research projects to develop new and improved uses for the industry’s products. Although patents and trademarks resulting from the research were licensed royalty free, the primary beneficiaries of the association’s research program were the members of the industry.

    2. On the other hand, however, an engineering society formed to engage in scientific research in the areas of heating, ventilating, and air conditioning for the benefit of the general public was held exempt under IRC 501(c)(3) in Rev. Rul. 71–506, 1971–2 C.B. 233.

  2. Reg. 1.501(c)(3)–1(d)(5)(i) provides that the determination of whether research is "scientific" does not depend on whether such research is "fundamental" or "basic" as contrasted with "applied" or "practical."

    1. However, the distinction between "fundamental" and "applied" research is important for purposes of the exclusion from unrelated business taxable income provided by IRC 501(c)(9).

7.25.3.15.2.1  (02-23-1999)
Research Incident to Commercial Operations

  1. Scientific research does not include activities of a type ordinarily carried on as an incident to commercial or industrial operations such as the inspection of products or the designing of equipment. Reg. 1.501(c)(3)–1(d)(5)(ii); Rev. Rul. 65–1, 1965–1 C.B. 226.

  2. Clinical testing of drugs for pharmaceutical companies is not scientific research as the regulations define the term. Rev. Rul. 68–373, 1968–2 C.B. 206, holds that clinical testing is an activity that is incidental to a pharmaceutical company’s commercial operations.

  3. Similarly, Rev. Rul. 65–1, 1965–1 C.B. 226, holds that an organization promoting the development of new machinery for a particular commercial operation and that had the power to sell, assign, or license the resulting patent rights did not qualify for exemption.

  4. In American Kennel Club, Inc. v. Hoey, Exrx., 148 F.2d. 920 (2nd Cir. 1945), the court held that the AKC is not an exempt scientific organization even though one of its activities is the compilation of data useful to geneticists and other scientists.

  5. In Dumaine Farms v. Commissioner, 73 T.C. 650 (1980), the Tax Court held that an irrevocable trust organized to operate an experimental model demonstration farm is exempt under IRC 501(c)(3). The Trust’s purpose is to demonstrate to local farmers and the general public the economic feasibility of experimental farming practices that will protect the area’s ecology and native wildlife. The Trust intends to keep the public and the farming community informed about its activities, which will be open to the public on a partially restricted basis. The Service had argued that the Trust’s articles empowered it to improve the quality of farming by operating a farm, a substantial nonexempt purpose; the farm served the commercial private interests of its creator; and it failed the "organizational" test because its articles did not describe in detail the manner of operation. However, the court held that the Trust’s agricultural activities were not commercially motivated, but were educational and scientific; the Trust’s articles made clear its intention to devote the farming activities exclusively in furtherance of exempt purposes; and the administrative record affirmatively demonstrated that the creator would not benefit privately from the activities. In interpreting Reg. 1.501(c)(3)–1(b)(1) (ii), pertaining to the "organizational" test, the Court stated that the fact that the Trust did not describe the manner of its operations in detail was inconsequential. In 1980–2 C.B.1, the Commissioner acquiesced in the holding on the operational requirements, but did not acquiesce in the holding on the organizational requirements,

7.25.3.15.2.2  (02-23-1999)
Research in the Public Interest

  1. Reg. 1.501(c)(3)–1(d)(1)(iii) provides that scientific research will be regarded as in the public interest:

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

    2. If such research is performed for the United States, or any of its agencies or instrumentalities, or for a State or political subdivision thereof;

    3. If such research is directed toward benefiting the public.

  2. Examples of research that meet the last criterion are:

    1. Research carried on for the purpose of aiding in the scientific education of college or university students;

    2. Research carried on for the purpose of obtaining scientific information, which is published in a treatise, thesis, trade publication, or in any other form that is available to the interested public;

    3. Research carried on for the purpose of discovering a cure for a disease; or,

    4. Research carried on for the purpose of aiding a community or geographical area by attracting new industry to the community or area or by encouraging the development of, or retention of, an industry in the community or area.

  3. Publication of research results is clearly not the only means by which scientific research can be in the public interest.

  4. Reg. 1.501(c)(3)–1(d)(5)(i) provide that "research" is not synonymous with "scientific." Its character depends on the purpose it serves, and it must be carried on in the public interest.

    1. A research organization, operated by a group of physicians specializing in heart defects, that investigates the causes and treatment of cardiac and cardiovascular conditions and diseases was recognized as exempt under IRC 501(c)(3) in Rev. Rul. 69–526, 1969–2 C.B. 115. The creators conducted medical practices apart from the organization’s research program, but the organization’s facilities were separately maintained and were used exclusively for the organization’s research program. Although some of the creators’ private patients were accepted for study, they were selected on the same criteria as the organization’s other patients. In this case the organization’s research was carried on in the public interest.

7.25.3.15.2.3  (02-23-1999)
Research Performed Under Contract

  1. Research that benefits the public within the meaning of Reg. 1.501(c)(3)–1(d)(1)(iii) will be regarded as carried on in the public interest even though such research is performed pursuant to a contract or agreement under which the sponsor or sponsors of the research have the right to obtain ownership or control of any patents, copyrights, processes, or formulae resulting from such research.

  2. Rev. Rul. 76–296, 1976–2 C.B. 141, distinguishes two situations involving scientific research undertaken pursuant to contracts with private industry.

    1. Commercially sponsored research that otherwise qualifies as scientific research under IRC 501(c)(3) constitutes scientific research carried on in the public interest if the results, including all relevant information, are timely published in a form available to the interested public, even though it is performed pursuant to a contract under which the sponsor has the right to obtain ownership of the patent.

    2. Research is not in the public interest, and constitutes unrelated trade or business within the meaning of IRC 513, if publication is withheld or delayed significantly beyond the time reasonably necessary to establish ownership rights. The organization will agree, on request, to forego or significantly delay publication of results of a particular project to protect the sponsor’s processes, technical data, or patent rights.

7.25.3.15.2.4  (02-23-1999)
Research Conducted Only for the Organization’s Creators

  1. Scientific research does not include activities ordinarily carried on incident to commercial or industrial operations such as the inspection of products or the designing of equipment. (Reg. 1.501(c)(3)–1(d)(5)(ii); Rev. Rul. 65–1, 1965–1 C.B. 226.) Thus, clinical drug testing for pharmaceutical companies is not scientific research as the regulations define the term. (Rev. Rul. 68–373, 1968–2 C.B. 206.) Clinical testing is an activity that is incidental to a pharmaceutical company’s commercial operations.

  2. Research is regarded as in the public interest if all patents or other resulting rights are made "available to the public." However, Reg. 1.501(c)(3)–1(d)(5)(iii) provides that research will be in the public interest even though the sponsor obtains patents or other resulting rights if:

    1. the research results are published;

    2. the research is done for the United States or a local government; or

    3. it is directed toward benefiting the public in some other way, such as to further the education of university students, to develop data for publication, to cure a disease, or to bring new industry to a community.

  3. Rev. Rul. 76–296, 1976–2 C.B. 141, discusses two situations involving commercially sponsored scientific research.

    1. In situation one, the results of the commercially sponsored projects, including all relevant information, are generally published in a form available to the interested public either currently, as developments in the project warrant, or within a reasonably short time after completion of the project. If patent rights are involved, publication is delayed pending reasonable opportunity to establish such rights, such as through the filing of application for patents. This type of research is regarded as carried on in the public interest even though it is performed pursuant to a contract under which the sponsor has the right to obtain ownership of the patent, and constitutes scientific research in the public interest within the meaning of IRC 501(c)(3).

    2. In situation two, the organization will agree, at the request of the sponsor, to forego publication of the results of a project to protect against disclosure of processes or technical data the sponsor wants to keep secret for various business reasons. The organization may also agree to delay publication of results if the sponsor, for business reasons, wants to protect its patent right under the project but wants to defer initiation of patent procedures so as to delay or control the timing of public disclosure of the results of the project. The research connected with these projects is not scientific research carried on in the public interest within the meaning of IRC 501(c)(3) as the research is withheld entirely or delayed significantly beyond the time reasonably necessary to establish patent or other ownership rights in the results of the research in order to accommodate the sponsor’s business interest in maintaining the secrecy of certain processes or to control the timing of public disclosure of the results.

7.25.3.15.3  (02-23-1999)
Testing for Public Safety

  1. Organizations that are organized and operated for the purpose of testing products for public safety are exempt under IRC 501(c)(3). However, IRC 170, 2055, 2106, and 2522 make no provision for the deduction of contributions, bequests, or gifts to an organization formed for this purpose.

  2. This provision was added to IRC 501(c)(3) to cover organizations that test consumer products to determine their acceptability for use by the general public. (S. Rept. No. 1622, 83rd. Cong., at page 310.) This was in response to Underwriters Laboratories, Inc. v. Commissioner, 135 F.2d 371 (7th Cir. 1943), cert. denied, 320 U.S. 756 (1943), which held that a testing laboratory was not exempt under IRC 501(c)(3) on the ground that its purpose was, in substantial part, to serve the interests of the manufacturers of electrical equipment.

  3. Rev. Rul. 65–61, 1965–1 C.B. 231, held that an organization engaged in establishing safety standards for pleasure boats, and testing boats and boating equipment for safety is exempt under IRC 501(c)(3).

  4. In contrast, Rev. Rul. 68–373, 1968–2 C.B. 206 held that an organization engaged in clinical drug testing for pharmaceutical companies is not testing for public safety. The organization tests drugs before marketing to enable the companies to comply with Food and Drug Administration rules. This activity serves the private interest of the manufacturers rather than the public interest.

7.25.3.16  (02-23-1999)
Inurement, Private Benefit, and Intermediate Sanctions

  1. An otherwise qualifying organization will be disqualified for exemption if it excessively benefits private interests, either through inurement of its net earnings to certain "insiders" or by primarily benefiting the interests of persons who, though not "insiders" , do not comprise a charitable class.

  2. Inurement and private benefit are often incorrectly used interchangeably. This can cause confusion and lead to incorrect analysis. The critical distinction is that "private benefit" is broader than "inurement" . Thus, all inurement is private benefit, but not all private benefit is inurement.

  3. The distinction was given added significance by the addition of IRC 4958. The excise tax on "excess benefit transactions" imposed by that section was intended to provide an intermediate sanction short of revocation to transactions constituting inurement.

  4. Technical advice must be requested in any case in which the excise tax on intermediate sanctions is proposed or revocation of exemption because of inurement is an issue, including any case in which those issues are resolved through a closing agreement.

7.25.3.16.1  (02-23-1999)
Inurement—Benefits to Insiders

  1. IRC 501(c)(3) expressly forbids the inurement of net earnings to the benefit of a private shareholder or individual.

  2. Reg. 1.501(c)(3)–1(c)(2) clarifies that an organization is not operated exclusively for exempt purposes if its net earnings inure to the benefit of private individuals.

7.25.3.16.2  (02-23-1999)
Private Shareholder or Individual

  1. The words "private shareholder or individual" refer to persons having a personal and private interest in the activities of the organization. Reg. 1.501(c)(3)–1(c). It places the focus of the inurement proscription on those who, by virtue of a special relationship with the organization in question, are able to influence the expenditure of its funds or the use of its assets, rather than on the general public. See, for example, Church by Mail, Inc. v. Commissioner, 765 F.2d 1387 (9th Cir. 1985); est of Hawaii v. Commissioner, 71 T.C. 1067 (1979).

  2. IRC 501(c)(3) does not prohibit all dealings between a charitable organization and its founder or with those in controlling positions. An organization’s trustees, officers, members, founders, and contributors may, of course, receive reasonable compensation or fair market value for services or goods, or other expenditures in furtherance of exempt purposes.

  3. However, those in control may not, by reason of their position, acquire any of the charitable organization’s funds. If funds are diverted from exempt purposes to private purposes, exemption is in jeopardy.

  4. Dealings between a private foundation and certain closely related persons are restricted by Chapter 42 of the Code. These are discussed thoroughly in the section on private foundations.

7.25.3.16.3  (02-23-1999)
Insider Benefit

  1. The term "insider benefit" provides a good working definition of inurement.

  2. The use of the term "insider" serves to distinguish inurement from the broader concept of private benefit, discussed below.

  3. The use of the term "benefit" highlights the broad interpretation placed on the Code language of "net earnings." The "net earnings" reference goes beyond a narrow accounting definition of net income to encompass almost any use, other than in an arm’s-length transaction or as reasonable compensation, made of an organization’s assets by an insider.

  4. Where an exempt organization engages in a transaction with an insider and there is a purpose to benefit the insider rather than the organization, inurement occurs even though the transaction ultimately proves profitable for the exempt organization. The test is not ultimate profit or loss but whether, at every stage of the transaction, those controlling the organization guarded its interests and dealt with related parties at arm’s-length. See Leon A. Beeghly Fund v. Commissioner, 35 T.C. 490 (1960). (Inurement occurred when organization entered a transaction to benefit the stockholders of a particular business corporation, not to benefit the charity, even though corporation suffered no financial loss.)

  5. The treatment of a first contract between a third party professional fund-raiser and an exempt organization is discussed in United Cancer Council v. Commissioner, 165 F.3rd 1173 (7th Cir. 1999). The circuit court concluded that prohibited inurement cannot result from a contractual relationship negotiated at arm's length with a party having no prior relationship with the organization, regardless of the relative bargaining strength of the parties or the resultant control over the tax-exempt organization created by the contract terms.

7.25.3.16.4  (02-23-1999)
Examples

  1. Examples of unreasonable compensation:

    1. Those in control of an organization may not withdraw its earnings under the guise of salary payments. Birmingham Business College, Inc. v. Commissioner, 276 F.2d 476 (5th Cir. 1960).

    2. Compensation arrangements include a variety of benefits in addition to salary, such as welfare benefits, fringe benefits, and deferred compensation. Look to the total compensation to determine if it is reasonable.

    3. Rev. Rul. 69–383, 1969–2 C.B. 113, provides an example of a reasonable compensation arrangement.

    4. In an IRC 7428 action, The Church of the Living Tree v. Commissioner, T.C. Memo 1996–291 (1996), the Tax Court upheld the Service’s determination that the organization, whose secondary purpose was promotion of the (hand) papermaking industry, was not described in IRC 501(c)(3). The organization also provided rent-free facilities to the founder, although the founder received no compensation for his work with the organization. The Service had determined that promotion of the papermaking industry was a substantial non-exempt purpose and that the organization provided private benefit to the founder. The court ruled that the organization had not carried its burden of proof to show the Service’s determination was erroneous.

  2. Payment of excessive rent. Texas Trade School v. Commissioner, 30 T.C. 642, aff’d, 272 F.2d 168 (5th Cir. 1959).

  3. Deferred or retained interests. See Rev. Rul. 66–259, 1966–2 C.B. 214.

  4. Receipt of less than fair market value in sales or exchange of property. Sonora Community Hospital v. Commissioner, 46 T.C. 519 (1966).

  5. Inadequately secured loans.

    • Lowry Hospital Association v. Commissioner, 66 T.C. 850 (1976).

    • But see, Donald G. and Lillian S. Griswold v. Commissioner, 39 T.C. 620 (1962), acq., 1965–1 C.B. 4. (Numerous loans to insiders at current commercial rates that were secured by adequate collateral did not result in inurement.)

7.25.3.16.5  (02-23-1999)
Personal Grants

  1. Gifts by a charitable organization to friends and relatives of persons in control of the organization are personal in nature rather than public. The recipients are natural objects of the "donor’s" bounty. Therefore, by aiding them, the organization is serving the insider’s private purposes. This is true even though the recipients may be needy.

    1. Large part of a foundation’s funds used for scholarship grant to the son of a foundation trustee results in inurement of earnings. Charleston Chair Company v. United States, 203 F. Supp. 126 (E.D S.C. 1962).

  2. A private foundation that makes grants to friends and relatives of insiders may face penalties under Chapter 42 of the Code.

7.25.3.16.6  (02-23-1999)
Intermediate Sanctions

  1. The Taxpayer Bill of Rights 2 ( "TBOR2" ), P.L. 104–168, enacted July 30, 1996, created a series of new excise taxes, often referred to as "intermediate sanctions" . These "intermediate sanctions" include an excise tax equal to 25 percent of the excess benefit derived by a "disqualified person" (defined below); this tax is payable by those who are "disqualified persons" with respect to "excess benefit transactions." IRC 4958(a).

  2. A disqualified person is defined as any person who is in a position to exercise substantial influence over the affairs of the organization; it includes family members of such an individual, or a 35 percent controlled entity. IRC 4958(f)(1). In the legislative history of TBOR2, the Committee on Ways and Means pronounced that a person having the title of "officer, director, or trustee" does not automatically have the status of a disqualified person.

  3. The term "excess benefit transaction" means any transaction in which an economic benefit is provided by an organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit.

7.25.3.16.7  (02-23-1999)
Private Benefit

  1. To be charitable, an organization must serve a public rather than a private interest. Reg. 1.501(c)(3)–1(d)(1)(ii). The organization must demonstrate 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.

  2. A charitable organization can give money, goods, or services to individuals without losing its exempt status. Many forms of charity involve aid to individuals. Help to poor people and to deserving students are traditional examples. Instead, private benefit involves gifts to individuals to serve their private purposes.

  3. The private benefit restriction is not limited to benefits provided to insiders. Rather, the restriction applies to benefits provided to any individual, whether or not the individual is in a position to control or influence the organization. The private benefit restriction operates against all parties who receive a benefit not accorded the public as a whole.

  4. Although even a minimal amount of inurement results in disqualification of an exempt organization, private benefit will not jeopardize tax-exempt status if it is incidental to accomplishment of exempt purposes. However, an activity that primarily serves private interests may jeopardize exempt status if it is carried on to a degree that is more than an insubstantial part of the organization’s activities.

  5. Restrictions on membership, or other demarcations that restrict the class of persons served by an organization can result in the organization primarily serving private interests. In Columbia Park and Recreation Association, Inc. v. Commissioner, 88 T.C. 1 (1987), aff’d in unpublished opinion 838 F. 2d 465 (4th Cir. 1988), the court upheld denial of exemption under IRC 501(c)(3) to an organization formed to develop and operate utilities, systems, services, and facilities "for the common good and social welfare" for a private real estate development with a population of over 100,000 residents. The development was neither an incorporated city nor other form of political subdivision. The court considered this fact significant in concluding that the organization was "...merely an aggregation of homeowners and tenants bound together in a structural unit formed as an integral part of a plan for the development of real estate." As such, it lacked a "sufficient public element" to be a "community at large" in the charitable context.

7.25.3.16.7.1  (02-23-1999)
Incidental Private Benefit

  1. If an organization serves a public interest and also serves a private interest other than incidentally, it is not entitled to exemption under IRC 501(c)(3).

  2. To be incidental, the private benefit must be a necessary concomitant of the activity which benefits the public at large and accomplishes exempt purposes. In other words, the benefit to the public cannot be achieved without necessarily benefiting certain private individuals.

  3. Further, private interests must be benefited only to the extent necessary to accomplish exempt purposes. It is a facts and circumstances test in that public benefit from the organization’s activities must outweigh any individual benefit.

7.25.3.16.7.2  (02-23-1999)
Business Benefits

  1. Private benefit can result from grants, awards, scholarships, or research that create substantial benefits for particular business interests. Specific situations the Service has considered include:

    1. Research and development of new machinery to be used by particular commercial operations. Rev. Rul. 65–1, 1965–1 C.B. 226.

    2. Testing drugs for commercial pharmaceutical companies. Rev. Rul. 68–373, 1968–2 C.B. 206.

    3. Development of new and improved uses for existing products of an industry. Rev. Rul. 69–632 1969–2 C.B. 120.

    4. Testing cargo retainers. Rev. Rul. 78–426, 1978–2 C.B. 175.

    5. Medical peer review boards formed by a state medical association. Rev. Rul. 74–553, 1974–2 C.B. 168.

    6. Promotion and protection of the practice of law by a city bar association. Rev. Rul. 71–505, 1971–2 C.B. 232.

    7. Lawyer referral service. Rev. Rul. 80–287, 1980–2 C.B. 185.

  2. Activities that were in part aimed at promoting the prosperity and standing of the business community served a substantial private purpose. Better Business Bureau of Washington, D. C., Inc. v. United States, 326 U.S. 279 (1945).

  3. A group of local merchants formed an organization to construct and operate a public off-street parking facility in the central business district. The organization set up a free parking validation stamp system for the merchants’ customers. The organization served the merchants’ private interests more than incidentally by encouraging the public to patronize their stores. Rev. Rul. 78–86, 1978–1 C.B. 151.

7.25.3.16.7.3  (02-23-1999)
Employee Benefits

  1. An employee benefit organization funded and controlled by the employer may be operated to serve a business interest rather than an exclusively charitable purpose.

    1. A foundation paid the educational and medical expenses of young performers employed by the founder, who was in show business. These expenditures were a form of compensation to the employees and directly furthered the business interests of the founder. Horace Heidt Foundation v. United States, 170 F. Supp. 634 (Ct.CI. 1959).

    2. A trust created by an employer to pay pensions to retired employees relieves the employer of the burdens of the pension program. Also, payments to retired individuals are not in themselves charitable. Rev. Rul. 56–138, 1956–1 C.B. 202.

    3. A bequest to pay pensions to the retired employees of the testator’s private corporation relieves the employer corporation of paying all the compensation amounts. Rev. Rul. 68–422, 1968–2 C.B. 207. See also, Watson, exr. v. United States, 355 F.2d. 269 (3rd Circ. 1966).

  2. In an employee benefit fund supported by the employees themselves where benefits are awarded in the event of death, illness, or disability, without regard to financial distress, the organization is a sort of mutual benefit association, not a charity. This form of self-help serves the interests of the members, which is not a public purpose.

  3. A different result is possible where benefits to employees are not a form of indirect compensation and where benefits are awarded on truly charitable standards. See William B. Chase v. Commissioner, 19 T.C.M. 234 (1960) (Where organization granted scholarships on the basis of objective criteria to children of employees of related corporations, grants were not a form of indirect compensation to the employees.)

  4. A private foundation that grants scholarships to children of a particular employer should ensure that its program meets the requirements of IRC 4945(d)(3) and (g). If not, it may be subject to penalties.

7.25.3.16.7.4  (02-23-1999)
Member Benefits

  1. Nurses’ Registers.

    1. Maintaining an employment register primarily for the employment of members of a nurses’ association promotes the interests of its individual members. Rev. Rul. 61–170, 1961–2 C.B. 112.

    2. On the other hand, a community nursing bureau, operated as a community project, that maintains a register of all qualified professional and paraprofessional personnel for the benefit of hospitals, health agencies, doctors, and members of the community, was held exempt under IRC 501(c)(3) in Rev. Rul. 55–656, 1955–1 C.B. 149.

  2. A subscription "scholarship" plan for individuals designated by the subscribers serves private rather than public purposes. Rev. Rul. 67–367, 1967–2 C.B. 188.

  3. Bus transportation for members’ children attending a private school serves a private rather than a public interest. Rev Rul. 69–175, 1969–1 C.B. 149.

  4. Navigable waterways:

    1. A nonprofit corporation, formed to dredge a navigable waterway fronting the properties of its members, received contributions solely from its members in proportion to the value of their properties. Evidence showed that the waterway was little used by the general public but its navigability greatly affected the value of members’ properties. It was formed for private purposes of its members. Benedict Ginsberg v. Commissioner, 46 T.C. 47 (1966).

    2. On the other hand, an organization described in Rev. Rul. 70–186, 1970–1 C.B. 128, formed to preserve a lake as a public recreational facility and to improve the condition of the water in the lake, benefited the community as a whole. It was financed by lake front property owners, by members of the community adjacent to the lake, and by municipalities bordering the lake.

  5. An organization serves as a recruitment incentive for and provides aerial assistance to the Syracuse Air National Guard. It owns an airplane which it rents at low cost to its members. Its membership is restricted to members of the Syracuse Air National Guard and civilian employees, active and retired members of reserve military units, and personnel of the Federal Aviation Agency. The organization provides no classes or instructional materials, and employs no faculty. The court held that the private benefit to the members is substantial and not incidental to the public benefit of assisting the Syracuse Air National Guard. Syrang Aero Club v. Commissioner, 73 T.C. 717 (1980).

7.25.3.16.7.5  (02-23-1999)
Tax Avoidance

  1. Sometimes a business or professional person will transfer business and personal assets to a controlled nonprofit organization for the purpose of avoiding taxes. The individual will continue to carry on the business or profession as an employee of the transferee organization and will continue to enjoy personal assets such as a home and/or automobile. Transactions of this type are lacking in substance in the sense that the transferor is still, in effect, engaging in a business or profession in an individual capacity. Since the transferor operates the organization essentially as an attempt to reduce personal Federal income tax liability while still enjoying the benefits of earnings, the organization’s primary function is to serve the private interest of its creator rather than a public interest.

7.25.3.16.7.5.1  (02-23-1999)
Examples of Private Benefit from Tax Avoidance

  1. A doctor transferred assets, including his medical practice, to a nonprofit organization that he formed and controlled. The doctor was then "hired" to conduct "research programs" that consisted of the examination and treatment of patients charged at prevailing rates. In return for his services the doctor received a salary and other benefits. Rev. Rul. 69–266, 1969–1 C.B. 151.

  2. An organization, not affiliated with any particular charitable entity, offered free personal tax and estate planning to encourage donations to charitable organizations. Aiding individuals in their tax and estate planning and giving advice on legal methods of tax avoidance is a commercially available service, not a charitable activity in the generally accepted legal sense. Although funds may have ultimately been made available to charity as a result of the organization’s planning assistance to individuals, the benefits to the public were tenuous in view of the private purposes served by arranging individual’s tax and estate plans. Rev. Rul. 76–442, 1976–2 C.B. 148. See also Christian Stewardship Assistance, Inc. v. Commissioner, 70 T.C. 1037 (1978).


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