Navigating The Tax Code On Your Own

 

I received a phone call recently from the married daughter of a client. I spoke with the couple – mostly the son-in-law – about needing an accountant. They had bought property, converted property to rental status and were selling property the following (that is, this) year.

It sounds like a lot. It really isn’t. It was clear during our conversation that they were well-versed in the tax issues.

I told them: “you don’t need me.”

They were surprised to hear this.

Why would I say that?

They knew more than they gave themselves credit for. Why pay me? Let them put the money to better use.

Let’s take an aside before continuing our story.

We - like many firms - are facing staffing pressure. The profession has brought much of this upon itself – public accounting has a blemished past – and today’s graduates appear to be aware of the sweatshop mentality that has preceded them. Lose a talented accountant. Experience futility in hiring new talent. Ask those who remain to work even harder to make up the shortfall. Be surprised when they eventually leave because of overwork. Unchecked, this problem can be a death spiral for a firm.

Firms are addressing this in different ways. Many firms are dismissing clients or not accepting new ones. Many (if not most) have increased minimum fees for new clients. Some have released entire lines of business. There is a firm nearby, for example, which has released all or nearly all of its fiduciary tax practice.

We too are taking steps, one of which is to increase our minimum fee for new individual tax clients.

Back to the young couple.

I explained that I did not want to charge them that minimum fee, especially since it appeared they could prepare their return as well as I could. 

They explained they wanted certainty that it was done right.

Yeah, I want that for them too. We will work something out.

But I think there is a larger issue here.

The tax Code keeps becoming increasingly complex. That is fine if we are talking about Apple or Microsoft, as they can afford to hire teams of accountants and attorneys. It is not fine for ordinary people, hopefully experiencing some success in life, but unable – or fearful - to prepare their own returns. Couple this with an overburdened accounting profession, a sclerotic IRS, and a Congress that may be brewing a toxic stew with its never-ending disfigurement of the tax Code to solve all perceived ills since the days of Hammurabi.

How are people supposed to know that they do not know?

Let’s look at the Lucas case.

Robert Lucas was a software engineer who lost his job in 2017. He was assisting his son and daughter, and he withdrew approximately $20 grand from his 401(k) toward that end.

Problem: Lucas was not age 59 ½.

Generally speaking, that means one has taxable income.

One may also have a penalty for early distribution. While that may seem like double jeopardy, such is the law.

Sure enough, the plan administrator issued a Form 1099 showing the distribution as taxable to Lucas with no known penalty exception.

Lucas should have paid the tax and penalty. He did not, which is why we are talking about this.

The IRS computers caught the omission, of course, and off to Tax Court they went.

Lucas argued that he had been diagnosed with diabetes a couple of years earlier. He had read on a website that diabetes would make the distribution nontaxable.

Sigh. He had misread – or someone had written something wildly inaccurate about – being “unable to engage in any substantial gainful activity.”

That is a no.

Since he thought the distribution nontaxable, he also thought the early distribution penalty would not apply.

No … again.

Lucas tried.

He thought he knew, but he did not know.

He could have used a competent tax preparer.

But how was he to know that?

Our case this time was Robert B. Lucas v Commissioner T.C.M. 2023-009.

A Brief History of Limited Partner Self-Employment Tax

 

There is a case going through the courts that caught my eye.

It has to do with limited liability companies (LLCs). More specifically, it has to do with LLC members.

LLCs started coming into their own in the 1990s. That gives us about 35 years of tax law to work with, and in many (if not most) cases practitioners have a good idea what the answers are.

There is one question, however, that still lingers.

Let’s set it up.

Before there were LLCs there were limited partnerships (LPs). The LPs will forever be associated with the tax shelters, and much of the gnarliness of partnership taxation is the result of Congress playing whack-a-mole with the shelters.

The LPs tended to have a similar structure.

(1)  Someone set up a partnership.

(2)  There were two tiers of partners.

a.    The general partner(s) who ran the show.

b.    The limited partner(s) who provided the cash but were not otherwise involved in the show. It is very possible that the limited was a well-to-do investor placed there by a financial advisor. The limited partner was basically investing while hoping for a mild/moderate/lavish side dish of tax deduction goodness.

The liability of the limited partners in the event of disaster was capped, generally to the amount invested. They truly were limited.

A tax question at this point was:

Is a limited partner subject to self-employment tax on his/her share of the earnings?

This question was not as simple as it may sound.

Why?

Did you know there was a time when people WANTED to pay into social security?

Let’s do WAYBAC machine.

When first implemented, social security only applied to certain W-2 workers.

This was an issue. There was a significant tranche of workers, such as government employees and self-employeds, who did not qualify. Enough of these excluded workers wanted (eventual) social security benefits that Congress changed the rules in 1950, when it introduced self-employment (SE) taxes. FICA applies to a W-2 worker. SE taxes apply to a self-employed worker. Both FICA and SE are social security taxes.

Congress also made all partners subject to SE tax: general, limited, vegan, soccer fan, whatever.

This in turn prompted promoters to peddle partnerships for the primary purpose of paying self-employment tax.

It sounds crazy in 2023, but it was not crazy at the time. During the 1950s the SE rate varied between 2.25% and 3.375% and the wage base from $3,600 to $4,200. Take someone who had never paid into social security. Getting an annual partnership K-1 and paying a little bit of SE tax in return for a government-backed lifetime annuity sounded appealing. The value of those benefits likely far exceeded the cost of any SE taxes.

It was appealing enough to catch Congress’ attention.

In 1977 Section 1402(a)(13) entered the tax Code:

There shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments … to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of renumeration for those services.”

You see what Congress did: they were addressing the partnerships gaming the social security system. One could earn social security benefits if one was involved in business activities, but not if one were just an investor – that is, a “limited” partner.

But things change.

Social security tax rates kept going up. The social security wage base kept climbing. Social security was becoming expensive. Rather than opt-in to social security, people were trying to opt out.

And businesses themselves kept changing.

Enter the LLCs.

Every member in an LLC could have “limited” liability for the entity’s debts. How would that play with a tax Code built on the existence of general and limited partners? LLCs introduced a hybrid.

Taxwise, it was problematic.

In 1994 the IRS took its first shot. It proposed Regulations that would respect an LLC member as a limited partner if:

(1) The member was not a manager of the LLC, and

(2) The LLC could have been formed as a limited partnership, and, if so, the member would have been classified as a limited partner.

It was a decent try, but the tax side was relying very heavily on the state law side. Throw in 50 states with 50 laws and this approach was unwieldy.

The IRS revisited in 1997. It had a new proposal:

         An individual was a limited partner unless

(1) He/she was personally liable for partnership debt, or

(2)  He/she could sign contracts for the partnership, or

(3) He/she participated in partnership activities for more than 500 hours during the year.

Got it. The IRS was focusing more on functional tests and less on state law.

I was in practice in 1997. I remember the reaction to the IRS proposal.

It was intense enough that the politicians got involved. Congress slapped a moratorium on further IRS action in this area. This was also in 1997.

The moratorium is still there, BTW, 26 years later.

And now there is a case (Soroban Capital Partners LP v Commissioner) coming through and returning attention to this issue.

Why?

Sure, there have been cases testing the SE tax waters, but most times the numbers have been modest. There has been no need to call out the National Guard or foam the runways.

Soroban upped the ante.

Soroban is challenging whether approximately $140 million (over several years) is subject to SE tax.

Soroban also brings a twist to the issue:

Can a partner/member wear both hats? That is, can the same person be a general partner/member (and subject to SE tax) and a limited partner/member (and not subject to SE tax)?

It is not a new issue, but it is a neglected issue.

We’ll return to Soroban in the future.

Reorganizing A Passive Activity

 

I am looking at a case that stacks a couple of different tax rules atop another and then asks: are we there yet?

Let’s talk about it.

The first is something called the continuity of business doctrine. Here we wade into the waters of corporate taxation and - more specifically - corporate reorganizations. Let’s take an easy example:

Corporation A wants to split into two corporations: corporation B and corporation C.

Why? It can be any number of things. Maybe management has decided that one of the business activities is not keeping up with the other, bringing down the stock price as a result. Maybe two families own corporation A, and the two families now have very strong and differing feelings about where to go and how to get there. Corporate reorganizations are relatively common.

The IRS wants to see an active trade or business in corporations A, B and C before allowing the reorganization. Why? Because reorganizations can be (and generally are) tax-free, and the IRS wants to be sure that there is a business reason for the reorganization – and avoiding tax does not count as a business reason.

Let me give you an example.

Corporation A is an exterminating company. Years ago it bought Tesla stock for pennies on the dollar, and those shares are now worth big bucks. It wants to reorganize into corporation B – which will continue the exterminating activity – and corporation C – which will hold Tesla stock.

Will this fly?

Probably not.

The continuity of business doctrine wants to see five years of a trade or business in all parties involved. Corporation A and B will not have a problem with this, but corporation C probably will. Why? Well, C is going to have to argue that holding Tesla stock rises to the level of a trade or business. But does it? I point out that Yahoo had a similar fact pattern when it wanted to unload $32 billion of Alibaba stock a few years ago. The IRS refused to go along, and the Yahoo attorneys had to redesign the deal.

Now let’s stack tax rules.

You have a business.

To make the stack work, the business will be a passthrough: a partnership or an S corporation. The magic to the passthrough is that the entity itself does not pay tax. Rather its tax numbers are sliced and diced and allocated among its owners, each of whom includes his/her slice on his/her individual return.

Let’s say that the passthrough has a loss.

Can you show that loss on your individual return?

We have shifted (smooth, eh?) to the tax issue of “materially participating” and “passively nonparticipating” in a business.

Yep, we are talking passive loss rules.

The concept here is that one should not be allowed to use “passively nonparticipating” losses to offset “materially participating” income. Those passive losses instead accumulate until there is passive income to sponge them up or until one finally disposes of the passive activity altogether. Think tax shelters and you go a long way as to what Congress was trying to do here.

Back to our continuity of business doctrine.

Corporation A has two activities. One is a winner and the other is a loser. Historically A has netted the two, reporting the net number as “materially participating” on the shareholder K-1 and carried on.

Corporation A reorganizes into B and C.

B takes the winner.

C takes the loser.

The shareholder has passive losses elsewhere on his/her return. He/she REALLY wants to treat B as “passively nonparticipating.” Why? Because it would give him/her passive income to offset those passive losses loitering on his/her return.

But can you do this?

Enter another rule:

A taxpayer is considered to material participate in an activity if the taxpayer materially participated in the activity for any five years during the immediately preceding ten taxable years.

On first blush, the rule is confusing, but there is a reason why it exists.

Say that someone has a profitable “materially participating” activity. Meanwhile he/she is accumulating substantial “passively nonparticipating” losses. He/she approaches me as a tax advisor and says: help.

Can I do anything?

Maybe.

What would that something be?

I would have him/her pull back (if possible) his/her involvement in the profitable activity. In fact, I would have him/her pull back so dramatically that the activity is no longer “materially participating.” We have transmuted the activity to “passively nonparticipating.”

I just created passive income. Tax advisors gotta advise.

Can’t do this, though. Congress thought of this loophole and shut it down with that five-of-the-last-ten-years rule.

This gets us to the Rogerson case.

Rogerson owned and was very involved with an aerospace company for 40 years. Somewhere in there he decided to reorganize the company along product lines.

He now had three companies where he previously had one.

He reported two as materially participating. The third he treated as passively nonparticipating.

Nickels to dollars that third one was profitable. He wanted the rush of passive income. He wanted that passive like one wants Hawaiian ice on a scorching hot day.

And the IRS said: No.

Off to Tax Court they went.

Rogerson’s argument was straightforward: the winner was a new activity. It was fresh-born, all a-gleaming under an ascendent morning sun.

The Court pointed out the continuity of business doctrine: five years before and five after. The activity might be a-gleaming, but it was not fresh-born.

Rogerson tried a long shot: he had not materially participated in that winner prior to the reorganization. The winner had just been caught up in the tide by his tax preparers. How they shrouded their inscrutable dark arts from prying eyes! Oh, if he could do it over again ….

The Court made short work of that argument: by your hand, sir, not mine. If Rogerson wanted a different result, he should have done - and reported - things differently.

Our case this time was Rogerson v Commissioner, TC Memo 2022-49.

Can You Really Be Working If You Work Remotely?

Have you ever thought of working remotely?

Whether it is possible of course depends on what one does. It is unlikely a nurse could pull it off, but could an experienced tax CPA…?  I admit there have been moments over the years when I would have appreciated the flexibility, especially with out-of-state family.

I am looking at a case where someone pulled it off.

Fred lived in Chicago. He sold his company for tens of millions of dollars.

COMMENT: I probably would pull the (at least semi-) retirement trigger right there.

He used some of the proceeds to start a money-lending business. He was capitalizing on all the contacts he had made during the years he owned the previous company. He kept an office downtown at Archer Avenue and Canal Street, and he kept two employees on payroll.

Fred called all the shots: when to make loans, how to handle defaulted loans. He kept over 40 loans outstanding for the years under discussion.

Chicago has winters. Fred and his wife spent 60% of the year in Florida. Fred was no one’s fool.

But Fred racked up some big losses. The IRS came a-looking, and they wanted the following:

                   Year                          Tax

                   2009                     $336,666

                   2011                     $  90,699

                   2012                     $109,355

The IRS said that Fred was not materially participating in the business.

What sets this up are the passive activity rules that entered the Code in 1986. The IRS had been chasing tax-shelter and related activities for years. The effort introduced levels of incoherence into the tax Code (Section 465 at risk rules, Section 704(b) economic substance rules), but in 1986 Congress changed the playing field. One was to analyze an owner’s involvement in the business. If involvement was substantial, then one set of rules would apply. If involvement was not substantial, the another set of rules would.

The term for substantial was “material participation.”

And the key to the dichotomy was the handling of losses. After all, if the business was profitable, then the IRS was getting its vig whether there was material participation or not.

But if there were losses….

And the overall concept is that non-material participation losses would only be allowed to the extent one had non-material participation income. If one went net negative, then the net negative would be suspended and carryover to next year, to again await non-material participation income.

In truth, it has worked relatively well in addressing tax-shelter and related activities. It might in fact one argued that it has worked too well, sometimes pulling non-shelter activities into its wake.

The IRS argued that Fred was not materially participating in 2009, 2011 and 2012. I presume he made money in 2010.

Well, that would keep Fred from using the net losses in those respective years. The losses would suspend and carryover to the next year, and then the next.

Problem: Sounds to me like Fred is a one-man gang. He kept two employees in Chicago, but one was an accountant and the other the secretary.

The Tax Court observed that Fred worked at the office a little less than 6 hours per day while in Chicago. When in Florida he would call, fax, e-mail or whatever was required. The Court estimated he worked 460 hours in Chicago and 240 hours in Florida. I tally 700 hours between the two.

The IRS said that wasn’t enough.

Initially I presumed that Barney Fife was working this case for the IRS, as the answer seemed self-evident to me. Then I noticed that the IRS was using a relatively-unused Regulation in its challenge:

          Reg § 1.469-5T. Material participation (temporary).

(a)  (7)  Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

The common rules under this Regulation are the 500 hours test of (a)(1), the substantially-all-the-activity test of (a)(2) and 100-hours-and-not-less-than-anyone-else test of (a)(3). There are only so many cases under (a)(7).

Still, it was a bad call, IRS. There was never any question that Fred was the business, and the business was Fred. If Fred was not materially participating, then no one was. The business ran itself without human intervention. When looked at in such light, the absurdity of the IRS position becomes evident.

Our case this time was Barbara, TC Memo 2019-50.

Self-Renting a Big Green Egg

Sometimes tax law requires you to witness the torture of the language. Other times it herds you through a sequence of “except for” clauses, almost assuring that some future Court will address which except is taking exception.

And then you have the laughers.

I came across an article titled: Corporation’s self-leasing rental expense deduction denied.”

I was curious. We tax nerds have an exceptionally low threshold for curiosity.

Before reading the article, I anticipated that:

(1)  Something was being deducted

(2)  That something was rent expense

(3)  Something was being self-leased, whatever that means, and

(4)  Whatever it means, the deduction was denied.

Let us spend a little time on (3).

Self-lease (or self-rental) means that you are renting something to yourself or, more likely, to an entity that you own. It took on greater tax significance in 1986 when Congress, frustrated for years with tax shelters, created the passive activity (PAL) rules. The idea was to separate business activities between actually working (active/material participation) and living the Kennedy (passive activity).

It is not a big deal if all the activities are profitable.

It can be a big deal if some of the activities are unprofitable.

Let’s go back to the classic tax shelter. A high-incomer wants to shelter high income with a deductible tax loss.

Our high-incomer buys a partnership interest in a horse farm or oil pipeline or Starbucks. The high-incomer does not work at the farm/pipeline/Starbucks, of course. He or she is an investor.

In the lingo, he/she is passive in the activity.

Contrast that with whatever activity generates the high income. Odds are that he/she works there. We would refer to that as active or material participation.

The 1986 tax act greatly restricted the ability of the high-incomer to use passive losses to offset active/material participation income.

Every now and then, however, standard tax planning is flipped on its head. There are cases where the high-incomer wants more passive income.

In the name of all that is holy, why?

Has to do with passive losses. Let’s say that you had $10,000 in passive losses in 2015. You could not use them to offset other income, so the $10,000 carried over to 2016. Then to 2017. They are gathering dust.

If we could create passive income, we could use those passive losses.

How to create passive income?

Well, let’s say that you own a company.

You rent something to the company.

Let’s rent your car, your office-in-home or your Big Green EGG XXL.

Rent is passive income, right? The tax on our passive income will be zero, as the losses will mop up every dollar of income.

That is the “self-rental” the tax Code is after.

But it also triggers one of those “except for” rules: if the self-rental results in income, the income will not qualify as passive income.

All your effort was for naught. Thank you for playing.

Back to the article I was reading.

There is a doctor. He is the only owner of a medical practice. He used the second story of his house solely for the medical practice. Fair be fair, he had the practice pay him rent for that second floor.

I have no problem with that.

The Tax Court disallowed the corporation a rent deduction.

Whaaat? That makes no sense.

The purpose of the passive/active/material participation rules is not to deny a deduction altogether. The purpose is to delay the use of losses until the right type of income comes around.

What was the Tax Court thinking?

Easy. The doctor never reported the rental income on his personal return.

This case has nothing to do with self-rental rules. The Court simply was not permitting the corporation a deduction for rent that its shareholder failed to report as income.

The case for the home gamers is Christopher C.L. Ng M.D. Inc.

Walk The Walk, Talk The Talk

We have another not-for-profit story.

Spoiler Alert: it failed.

Why did it fail?

Sometimes there is a great story, the churning of technical arcana and the tease of suspense.

This is not one of those times.

Our homespun protagonist this time is the Community Education Foundation. It had changed names several times over its life, but that appears to have been its last nom de jour.

It began life as a doe-eyed and enthusiastic 501(c)(3) back in 2001. It was going to change the world:

The …. is a conservative research and educational institute focusing on public policy issues that have particular impact on African Americans, Hispanic Americans, Asian Americans, Native Americans and heritage groups (the ‘Target Groups’).”

                COMMENT: “Heritage” groups?

Anyway …

The Foundation’s guiding principle is to encourage open inquiry about public policy issues that are of particular interest and educational values for the Target Groups and the public in general and to provide programs that highlight and educate the Target Groups and the public about these germane subjects and/or public policy issues.”

Wow. Good thing someone jumped on “educating” all those “target” groups on “germane” subjects.

The (c)(3) obviously had to do stuff to bring enlightenment to the benighted and wretched, including:

(1) Town hall meetings

(2) National workshops

(3) Congressional forums

(4) Billboards, radio, television, and other media, such as town criers, bodypainting and soothing rap music drifting through open car windows while waiting at a traffic light.

Fast forward. To 2012. Eleven years later. The IRS took a look at said (c)(3). It wanted to know how it was doing.

The IRS revoked the (c)(3).

Whoa. That seemed a bit strong.

What pray tell provoked such a response?

The Community Education Foundation had done nothing – zip, zero, the square root of nada – for 11 years.

The (c)(3) disagreed and took the matter to Tax Court.

It did have an argument: it turns out that it tried but failed to do some things in 2009 and 2010, including a “Presidential Inaugural Ball” to honor veterans.

COMMENT: I too have no idea what one has to do with the other.

The Tax Court pointed out the obvious: if you want to be a (c)(3), you have to …

·      Talk the talk, and

·      Walk the walk

In eleven years, the organization had performed none of the activities it had said it would when it applied for exempt status.

There was no walk to the talk.

The (c)(3) status was revoked.

Can A Coffee Shop Be Tax-Exempt?

I have been spending quite a bit of time over the last few days working on or reviewing not-for-profit returns.

It may surprise you, but – with a few exceptions – not-for-profit organizations are required to file paperwork annually with the IRS.

There is a reason for this: the tax Code recognizes some organizations as “per se” not-for-profit – churches are the classic example. Churches do not need to be told by the IRS that they are tax-exempt; they simply are. A large part of this is church:state separation, although church programs that begin to look uncannily similar to for-profit businesses are supposed to file an income tax return (known as Form 990-T) and pay tax.

Then we have the next tier: the education, charitable, scientific, etc. entities that also comprise not-for-profits. These are not “per se” and have to apply with the IRS to have their exempt status recognized. The application is done via either Form 1023 or Form 1024, depending upon the type of exempt status desired.

We talking about the March of Dimes, Doctors Without Borders or your local high school boosters club.

One thing this tier has in common is that they have to explain to the IRS what their exempt purpose is.

And there are tax subtleties at play. For example, can your exempt purpose be less than 50% of what you do? What if it is more than 50% but you have a significant (but less than 50%) non-exempt purpose? What if you start out at a more-than-50% exempt purpose but – over time – your non-exempt purpose goes over 50%?

This becomes its own field of specialization. I have met practitioners over the years whose only practice is tax exempts.

I am looking at the IRS response to a recent exempt application. I will give you a few facts and flavor, and let’s see if you can anticipate the IRS decision on the matter.

(1)  A minister had an idea for a coffee shop. The shop would be separate from the church (hence the exempt application). Being separate however would allow (and maybe encourage) other churches and religious groups to participate.

(2)  The coffee shop would allow believers and non-believers to interact. There would be religious activities, but the activities would not be organized by the shop. They would instead be organized by the patrons. By the way, the shop could also be used for non-religious activities. One could leave a donation for the use of the space.

(3)  There are no similar businesses where the shop is located, hence it is not taking commercial opportunity from a profit-seeking business.

(4)  The shop affords a gathering space that is open late, as well as provide safe space for residents to gather.

(5)  The shop takes part in a job-skills training program to help underserved youth by placing them in an actual job for a six-week internship.

(6)  The shop participates in a project for the children of incarcerated parents. Patrons can share gifts with the kids, such as for their birthdays and Christmas.

(7)  The shop does not want to turn away anyone for inability to pay. There is a program where a customer can pay for a certain amount of coffee in advance. When a not-able-to-pay patron enters, he/she is served from those advance payments.

(8)  The shop sells coffee, teas, smoothies and so forth. There are also baked goods, as well as salads and desserts.

(9)  The shop roasts its own coffee, which is sourced directly from coffee farmers. This allows the farmers to earn more than other conventional means of distribution. The coffee is also available for sale, and there are plans to sell the coffee online in the future

(10)        The shop uses some volunteers, but its largest expense is (understandably) wages and related payroll costs.

(11)        The shop intends to give away its profits - that is, when it finally becomes profitable.

What do you think? Would you give this shop exempt status?

Here goes the IRS:

(1)  To be exempt, an organization must be both organized and operated exclusively for an exempt purpose. The test has two parts: the paperwork and what is actually going on.

(2)  The IRS has defined the word “exclusively” to mean “primarily.”

(3)  Hot on the heels of that definition, the IRS has also said that non-exempt activities must not be “more than an insubstantial part” of activities.

OBSERVATION: You can see the evolution of law here. A non-tax specialist would anticipate that an activity is exempt if the exempt activity is 51% or more of all activities. The flip side is that a non-exempt activity should be as much as 49%.

The IRS however states that a non-exempt activity cannot be “more than an insubstantial part” of all activities.

Does “insubstantial” mean as much as 49%?

If not, then the IRS is changing definitions all over the place.

(4)  The IRS has previously decided that the operation of a grocery store to provide on-the-job training to hardcore unemployed represented two purposes, not one. Each purpose has to be reviewed to determine whether it is exempt or not.

(a)  And now it gets tricky. If the store is staffed principally by a target group (or volunteers) AND the store is no larger than reasonably necessary for achieving the exempt purpose, the IRS has said that the store is exempt.

(b)  Conversely, if the store is not staffed by the target group (or volunteers) or larger than necessary, the IRS has said that the store is non-exempt.

(5)  While the coffee shop intends to donate its profits, its main activity is the operation of a coffee shop in a commercial manner.

(6)  And that activity is “more than insubstantial.”

The IRS rejected the application. The coffee shop will have to pay taxes.

Doesn’t it matter that they are giving away all profits? Isn’t there a vow-of-poverty-thing that one can point to?

And there is a key point about tax law in the world of exempts. Giving away money will not transform a for-profit activity into a not-for-profit activity. Granted, you may get a charitable deduction, but you will be taxable. The IRS has been steadfast on this point for many years. The activity itself has to be exempt, not just the monies derived from said activity. To phrase it differently, gigantic donations will not make Microsoft a tax-exempt entity.

The IRS decided the shop was too similar to a Starbucks or Caribou.    

And giving away any profits wasn’t enough to change the answer.

Does the shop do great work?

Yes.

Is it tax exempt?

Nope.