When A Good Cause Is Not Enough

Let’s talk about the tax issues of tax-exempt entities. It sounds like a contradiction, doesn’t it?

It actually is its own area of practice. Several years ago I was elbow-deep working with nonprofits, and I attended a seminar presented by a specialist from Washington, D.C. All he did was nonprofits. At least he was in the right town for it.

There are the big-picture tax-exempt issues. For example, a 501(c)(3) has to be publicly-supported. You know there is a tractor-trailer load of rules as to what “publicly supported” means.

Then there are more specialized issues. One of them is the unrelated business income tax. The concept here is that a nonprofit cannot conduct an ongoing business and avoid tax because of its exemption. A museum may be a great charitable cause, for example, but one cannot avoid tax on a chain of chili restaurants by having the museum own them.

That is not what museums do. It is unrelated to “museum-ness,” and as such the chili restaurants will be taxed as unrelated business income.

Sometimes it can get tricky. Say that you have a culinary program at a community college. As part of the program, culinary students prepare meals, which are in turn sold on premises to the students, faculty and visitors. A very good argument can be made that this activity should not be taxed.  

What is the difference? In the community college’s case, the activity represents an expansion of the underlying (and exempt) culinary education program. The museum cannot make this argument with its chili restaurants.

However, what if the museum charges admission to view its collection of blue baby boots from Botswana? We are now closer to the example of culinary students preparing meals for sale. Exhibiting collections is what museums do.

I am looking a technical advice memorandum (TAM) on unrelated business income. This is internal IRS paperwork, and it means that an IRS high-level presented an issue to the National Office for review.

Let’s set it up.

There is a community college.

The community college has an alumni association. The association has one voting member, which is a political subdivision of the state.

The alumni association has a weekly farmers market, with arts and crafts and music and food vendors. It sounds like quite the event. It uses the parking areas of the community college, as well as campus rest rooms and utilities. Sometimes the college charges the alumni association; sometimes it does not.

The alumni association in turn rents parking lot space to vendors at the market.

All the money from the event goes to the college. Monies are used to fund scholarships and maintain facilities, such as purchasing a computer room for the library and maintaining the football field.

OBSERVATION: The tax Code does not care that any monies raised are to be used for a charitable purpose. The Code instead focuses on the activity itself. Get too close to a day-in-and-day-out business and you will be taxed as a business. Granted, you may get a charitable deduction for giving it away, but that is a different issue.

From surveys, the majority of visitors to the farmers market are age 55 and above.

There was an IRS audit. The revenue agent thought he spotted an unrelated business activity. The file moved up a notch or two at the IRS and a bigwig requested a TAM.

The association immediately conceded that the event was a trade or business regularly carried on. It had to: it was a highly-organized weekly activity.

The association argued instead that the event was its version of “museum-ness,” meaning the event furthered the association’s exempt purpose. It presented three arguments:

(1) The farmers market contributed to the exempt purpose of the college by drawing potential students and donors to campus, helping to develop civic support.

(2) The farmers market lessened the burden of government (that is, the college).

(3) The farmers market relieved the distress of the elderly.

The IRS saw these arguments differently:

(1) Can you provide any evidence to back that up? A mere assertion is neither persuasive nor dispositive.

COMMENT: The association should have taken active steps – year-after-year – to obtain and accumulate supporting data. It may have been worth hiring someone who does these things. Not doing so made it easy for the IRS to dismiss the argument as self-serving.

(2) At no time did the community college take on the responsibility for a farmers market, and the college is the closest thing to a government in this conversation. Granted, the college benefited from the proceeds, but that is not the test. The test is whether the association is (1) taking on a governmental burden and (2) actually lessening the burden on the government thereby.  As the government (that is, the college) never took on the burden, there can be no lessening of said burden.

COMMENT: This argument is interesting, as perhaps – with planning – something could have been arranged. For example, what if the college sponsored the weekly event, but contracted out event planning, organization and execution to the alumni association? 

(3) While the market did provide a venue for the elderly to gather and socialize, that is not the same as showing that the market was organized and worked with the intent of addressing the special needs of the elderly. 

COMMENT: Perhaps if the association had done things specifically for the elderly – transportation to/from retirement homes or free drink or meal tickets, for example – there would have been an argument. As it was, the high percentage of elderly was a happenstance and not a goal of the event.

There was no “museum-ness” there.

And then the association presented what I consider to be its best argument:

(4) We charged rent. Rent is specifically excluded as unrelated business income, unless special circumstances are present – which are not.

Generally speaking, rent is not taxable as unrelated business income unless there is debt on the property. The question is whether the payments the association received were rent or were something else.

What do I mean?

We would probably agree that leasing space at a strip mall is a textbook definition of rent. Let’s move the needle a bit. What would you call payment received for a hospital room? That doesn’t feel like rent, does it? What has changed? Your principal objective while in a hospital is medical attention; provision of the room is ancillary. The provision of space went from being the principal purpose of the transaction to being incidental.

The IRS saw the farmers’ market/arts and craft/et cetera as something more than a parking lot. The vendors were not so much interested in renting space as they were in participating (and profiting) from a well-organized destination and entertainment event. Landlords provide space. Landlords do not provide events. 

The IRS decided this was not rent.  

You ask why I thought this was the association’s best argument? Be fair, I did not say it was a winning argument, only that it was the best available.

The alumni association still has alternatives. Examination requested the TAM, so there will be no mercy there. That leaves Appeals and then possibly going to Court. A Court may view things differently.

And I am unhappy with the alumni association. I suspect that the farmers’ market went from humble origins to a well-organized, varied and profitable event. As a practitioner, however, I have to question whether they ever sought professional advice when this thing started generating pallet-loads of cash. Granted, the activity may have evolved to the point that no tax planning could save it, but we do not know that. What we do know is that little – if any – planning occurred. 

Why Audit Veterans Organizations?

I suppose that any examination of an exempt organization by the IRS nowadays is going to be viewed in harsh light.

What got me thinking about this is the controversy concerning IRS audits of veterans organizations. While it hasn’t garnered the attention of the 501(c)(4) imbroglio, there has nonetheless been harsh criticism. U.S. Senator Moran (Kansas) for example has stated:

On the heels of Americans' anger over revelations that the IRS intentionally targeted certain groups, it has been brought to my attention that the IRS is now turning their sights toward our nation's veterans. The IRS seems to be auditing veteran service organizations by requiring private member military service forms. If a post is unable or not willing to turn over this personal information, it is possible they could face a fine of $1,000 per day.

I am deeply concerned about this revelation and will insist on answers. This policy ... deserves, at a minimum, a thorough look to make certain the IRS is not overstepping bounds of privacy and respect for our nation's heroes."

For its part, the House Veterans Affairs committee has threated to investigate what the IRS is up to.

So why would the IRS – in a time of budget restraints – be auditing these groups?

A couple of reasons come to mind:

•  The IRS has to audit exempt groups occasionally, if only in the interest of enforcing tax compliance among all exempt groups.

• Veterans organizations have unique tax requirements that are relatively easy to run afoul of.

Reason (1) is easy to understand, even if we would rather have a root canal than undergo a tax audit. Reason (2) is a bit more involved.

Tax-exempt organizations come in multiple flavors, depending on what the organization does. For example, a veterans organization could qualify as a social welfare group – that is, a 501(c)(4) – given its purpose of promoting patriotism, championing the issues of veterans, assisting needy and disabled veterans and conducting social and recreational activities among its membership.   

Let’s go a step further, and you will understand how the sausage of tax law comes to be.

Let’s say the veterans organization buys a building. Let’s say it puts a kitchen and bar in said building. We may now have a social club under Sec 501(c)(7), the same as a college fraternity or private golf course. Had you and I gotten together and built our own golf course, our activity (of playing golf) would not be taxable. The tax Code acknowledges this and allows for larger groups to do what you and I could have done together if only we were multibillionaires. There could be tax consequences if we did other things, but let’s keep our discussion general.

In 1969 Congress expanded the reach of the unrelated business income tax (UBT). UBT by definition relates to tax-exempt organizations, and it means that the organization has to pay tax on profitable business activities that are not in furtherance of its tax-exempt purpose.

What does that mean? Let’s go back to that golf course you and I built. Let’s say that we rent out our course to the PGA annually for a major tournament. We of course charge the PGA big bucks for using our course. We apply as a (c)(7), albeit a small one, considering it is only you and me. The IRS is not going to let us pocket all that money and not pay tax. Why? Because it is not our exempt purpose to rent our course to the PGA.

The veterans organizations became upset with the UBT. It was not even the kitchen and bar, truthfully, as much as it was the insurances – life, health and so on – that they were offering to their members. That was a big deal, and their insurance activity was now being pulled into the orbit of the UBT because of that (c)(4) or (c)(7) status.

Congress, thinking that the answer to everything problem is yet another law, passed Code section 501(c)(19): 

(19)  A post or organization of past or present members of the Armed Forces of the United States, or an auxiliary unit or society of, or a trust or foundation for, any such post or organization—

(A)  organized in the United States or any of its possessions,

(B)  at least 75 percent of the members of which are past or present members of the Armed Forces of the United States and substantially all of the other members of which are individuals who are cadets or are spouses, widows, widowers, ancestors, or lineal descendants of past or present members of the Armed Forces of the United States or of cadets, and

(C)  no part of the net earnings of which inures to the benefit of any private shareholder or individual.

And veterans organizations now had an escape clause from the UBT – as long as they could fit into (c)(19).

It worked well enough for long enough. And now it is starting to work less well.

Why?

It’s the math. Code section (c)(19) states that at least 75% of the members must be veterans  and substantially all other members  (generally defined as 90% or more) must be spouses, widows and descendants. Let’s go through the math. To start, at least 75% of the members must be veterans. Of the remaining, 90% or more must be related to a veteran. Doing the math, only 2.5% of the total membership (25% times 10%) may consist of non-veterans or persons unelated to a veteran.

That is a tight window.

Statistics show over 19 million veterans in the United States. More than 9 million are age 65 or over. Veterans are aging, and every year there are fewer of them. Those demographics are pushing on the percentage tests of (c)(19).

Let’s point out another problem.

How do you prove the 75%? I suppose you could (and probably should) obtain documentation from the veterans. The same could be said for proving the other 90%.  It would be business- standard procedure to keep files and maintain a policy and post signs that only members and families are admitted. I suppose we could boost documentation even more by requiring sign-in books, but you get the idea.

Is it intrusive? You bet. We are talking about IDs and proof of military service, for example. The IRS aggravated the matter recently by asking for DD 214 forms, which is the paperwork accompanying military discharge. The IRS had not routinely asked for this before, so many organizations were caught flat-footed. To exacerbate the matter, the IRS then threatened $1,000 per day penalties.

Cue the resentment and anger of organizations like the American Legion. These generally are not organizations that can easily accommodate drastic changes in tax rules. Many are small, reliant on volunteers and operating on a tight budget.  One cannot approach them as though one were dealing with the tax department of an Apple or Pfizer.

What is the answer? I don’t know. The 501(c) area is a motley of tax grab-bag accreted over the years. Some (c)’s can receive tax-exempt contributions; others cannot. Some organizations are (c)’s just by existing; others have to formally apply and get approval. Some do not pay income tax unless they get carried away and flat-out run a for-profit business. Others pay tax on income “not sufficiently related” to their exempt purpose, a standard sometimes bordering on the mystical. Some are huge, own buildings and have tens of thousands of employees. Others are tiny, have space donated and do everything through volunteers.

It is maddening, but they all have to be (at least in theory) auditable by the IRS.

And there is the rub.