The taxation of tax-exempts can sometimes be tricky.
The reason is that a tax-exempt can – depending on the facts – owe income tax. This type of income is referred to as unrelated business income, and the tax issue developed because Congress did not want tax-exempts to mimic the activities of for-profit companies while not paying tax.
There are certain areas – such as permitting third-party use of membership data – that can trigger the unrelated business tax.
Another would be the rental of real estate with associated indebtedness.
The organization will owe tax on these activities.
Then there is the worst-case scenario: the revocation of the tax-exempt status itself. Think Elon Musk putting Tesla in a 501(c)(3) – the IRS is going to blow-up that arrangement.
Let’s discuss a recent case that walked the revocation ledge.
There is an organization in New York. It is open to seniors from age 55 to 90. To become a member a senior must submit an application and application fee.
It appears to have four principal activities:
· To provide burial benefits for members and assistance to surviving family
· To provide information and referrals to seniors regarding burial as well as general concerns
· To provide organized activities for senior citizens
· To provide annual scholarships to needy, promising students
The organization charges fees as follows:
· An application fee of $100 for seniors age 55 to 70
· An application fee of $150 for seniors age 71 to 90
· A $30 annual fee
· A $10 fee every time a member dies
It doesn’t appear unreasonable to me.
There was an interesting and heartwarming twist to their activities: the organization would pay a separate amount directly to the family of a deceased member, pursuant to a Korean tradition. The organization paid, for example, $11 thousand directly to a funeral home and over $3,200 to the family of a deceased member.
Since we are talking about them, you know that the organization went to audit.
The IRS wanted to revoke their tax-exempt status.
The is an over-arching requirement that a tax-exempt be operated “exclusively” for an exempt purpose. There is some latitude in the “exclusive” requirement, otherwise de minimis and silly stuff could cost an organization its exemption.
Still, what did the IRS see here?
The first is that benefits were available only to members.
COMMENT: The organization had expressed an intent to include nonmembers, but as of the audit year that goal remained aspirational.
OBSERVATION: The organization had told the IRS of its intent to include nonmembers when it requested exempt status. Upon audit and failure to find nonmember benefits, the IRS argued that the organization had failed to operate in the manner it had previously represented to the IRS.
Second is that a member was required to pay dues. In fact, if a member failed to pay dues for 90 days after receiving written notice, the organization could terminate the membership and – with it – the requirement to pay any burial benefits.
COMMENT: Sounds a bit like an insurance company, doesn’t it?
Third is that the amount of burial benefits was based on the number of years the deceased had been a member. A member of 12 years would receive more than a member of 5 years.
The IRS brought big heat. The organization was organized in 1996, applied for exempt status in 1998 and was being audited for 2013.
OK, a reasonable number of years had passed since receiving exempt status.
The organization had reported over $2.3 million in revenues on their Form 990.
Sounds to me like they were doing well.
In 2008 they bought a condominium, paying over $800 grand.
You can begin to understand where the IRS was coming from. As operated, the organization was looking like a small insurance company. It was accumulating a bank balance; it had bought real estate. The IRS wanted to see obvious charitable activities. If the organization could swing $800 grand on a condo, then they could shake loose a few dollars and waive dues for someone who was broke. They were operating dangerously close to a private club. That is fine, but do not ask for (c)(3) status.
The organization had a remaining argument: there was no diversion of earnings or money. There couldn’t be, as no benefits occurred until someone passed away.
The Court however separated this argument into two parts:
(1) The earnings and assets of the organization cannot inure (that is, return to) to a member.
The organization successfully argued this point.
(2) There must be no private benefit.
This makes more sense if one flips the wording: there must be a public benefit. The Court did not see a public benefit, as the organization was not providing benefits to nonmembers or allowing for reduction or abatement of dues for financial need. Not seeing a public benefit, the Court saw a private benefit.
The organization was operating in a manner too close to a for-profit business, and it lost its tax-exempt status.
I get the technical issues, but I do not agree as vigorously as the Court that there was that much private benefit here. Society has an interest in promoting the causes and issues of senior citizens, and the organization – in its own way – was helping. By aiding seniors with government agencies, it was reducing the strain on social services. By assisting seniors with planning and paying for funeral services, it was reducing costs otherwise defaulting to the municipality.
One would have preferred a warning, an opportunity for the organization to right its course, so to speak. What happened instead was akin to burning down the bridge.
Still, that is how issues in this area go: one is working on a spectrum. The advisor has to judge whether one is on the safe or the non-safe side of the spectrum.
The Court decided the organization had wandered too far to the non-safe side.
Our case this time was The Korean-American Senior Mutual Association v Commissioner.