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.
Why?
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.
Oh, oh.
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.
