Business League: A Different Type Of Tax-Exempt

You may have heard about business leagues.

One very much in the news recently is the National Football League, which has been considering giving up its tax-exempt status.

In the tax world, exempt entities obtain their exempt status under Section 501(c). There is then a number, and that number is the “type” of exempt under discussion. For example, a classic charity like the March of Dimes would be a 501(c)(3). When we think of tax-exempts, we likely are thinking of (c)(3)’s, for which contributions are deductible to the donor and nontaxable to the recipient charity.

The (c)(3) is about as good as it gets.

A business league is a (c)(6). So is a trade association.

Right off the bat, payments to a (c)(6) are not deductible as contributions. They are, however, deductible as a business expense- which makes sense as they are business leagues. You and I probably could not deduct them, but then again you and I are not businesses.

There are some benefits. For example, a (c)(6) has virtually no limit on its lobbying authority, other than having to pro-rate the member dues between that portion which represents lobbying (and not deductible by anybody) and the balance (deductible as a business expense).

There are requirements to a (c)(6):

(1)  There must be members.

a.     The members must share a common business interest.

                                                              i.     Members can be individuals or businesses.

                                                            ii.     If membership is available to all, this requirement has not been met. This makes sense when you consider that the intent of the (c)(6) is to promote shared interests.

(2)  Activities must be directed to improving business conditions in a line of business.

a.     Think of it as semi-civic: to advance the general welfare by promoting a line of business rather than just the individual companies.

b.    This pretty much means that membership must include competitors.

c.     Sometimes it can be sketchy to judge. For example, the IRS denied exemption to an organization whose principal activity was publishing and distributing a directory of member names, addresses and phone numbers to businesses likely to require their services. The IRS felt this went too close to advertising and too far from the improvement of general business conditions.

(3)  The primary activities must be geared to group and not individual interests.

a.     The American Automobile Association, for example, had its application denied as it was primarily engaged in rendering services to members and not improving a line of business.

(4)  The main purpose cannot be to run a for-profit business.

a.     This requirement is standard in the not-for-profit world. You can run a coffee shop, but you cannot be Starbucks.

b.    For example, a Board of Realtors normally segregates its MLS activities in another – and separate – company. The Board itself would be a (c)(6), but the MLS is safely tucked away in a for-profit entity – less it blow-up the (c)(6).

(5)  Must be not-for-profit.

a.     Meaning no dividends to shareholders or distributions rights if the entity ever liquidates.

b.    BTW – and to clarify – a not-for-profit can show a profit. Hypothetically it could show a profit every year, although it is debatable whether it could rock the profit level of Apple or Facebook and keep its exemption. The idea here is that profits – if any – do not “belong” to shareholders or investors.

(6)  There must be no private inurement or private benefit to key players or a restricted group of individuals.

a.     Again, this requirement is standard in the not-for-profit world.

b.    This issue has been levelled against the NFL. Roger Goodell (the NFL Commissioner) has been paid over $44 million a year for his services. It does not require a PhD in linguistics to ask at what point this compensation level becomes an “inurement” or “benefit” disallowed to a (c)(6).

There is litigation around (4) and (6). The courts have allowed some business activity and some benefit to the members, as long as it doesn’t get out of hand. The courts refer to this as “incidental benefit.”

Which can lead to interesting follow-up issues. Take a case where the organization runs a business (within acceptable limits) and then uses the profit to subsidize something for its members. Can this amount to private inurement? The members are – after all - receiving something at a lower cost than nonmembers.

Let’s take a look at a recent application. I think you know enough now to anticipate how the IRS decided.

(1)  The (c)(6) members are convenience stores and franchisees of “X.”

(2)  Revenues will be exclusively from member fees.

(3)  One-quarter of member fees will be remitted annually to the national franchisee (that is, the franchise above “X”)

(4)  Member franchisees will elect the Board.

(5)  The (c)(6) will educate and assist with franchise policies.

(6)  The (c)(6) will facilitate resolution between members and executives of “X.”

How did it go?

The IRS bounced the application.

Why?

We could have stopped at (1). There is no “line of business” happening here. Members are limited to franchisees of “X.” Granted, “X” participates in an industry but “X” does not comprise an industry. 

The organization tried to clean-up its application after being rejected but it was too little too late.

The organization was not promoting the industry as a whole. It rather was promoting the interest of the franchisee-owners. 

Nothing wrong with that. You just cannot get a tax exemption for it.

How To Lose All Of Your Auto Deduction

I am not a fan of dumb.

And I am reading big dumb.

The IRS wanted over $22 thousand in taxes and $4,000 in penalties. There were several issues, but there was one that racked up the money.

What do you need if you want to claim auto expenses on your tax return?

Answer: some kind of record, like a log.

There is a reason for this. It is not random, chaotic or unfathomable.

The reason has two parts:

(1)  There was a very famous case decided in the 1930s concerning George Cohan. George was a playwright, a composer, a singer, actor, dancer and producer. He was very famous. He was also a terrible record keeper. Given his day job, he spent a ton of money schmoozing people. He deducted some of those expenses on his tax return, as he had to wine and dine to maintain his recognition, connections and earning power. Problem was: he kept lousy records. One had to – essentially – take his word for the expenses.

The Court, knowing who he was, thought it believable that he had incurred significant entertainment expenses. The Court simply estimated what they were and allowed him a deduction.

Ever since, that guesstimate has been referred to in taxation as the “Cohan rule.”

Problem was: everything can be abused. What started out as common sense and mitigation for George Cohan became a loophole for many others.

(2)  Congress got a bit miffed about this, especially when it came to travel, transportation and entertainment expenses. These expenses can be “soft” to begin with, and the Cohan rule made them gelatinous. Congress eventually said “enough” and passed Code Section 274(d), which overrides the Cohan rule for this category of expenses.

BTW, “transportation” is just a fancy tax-word for mileage.

The tax-tao now is: no records = no mileage deduction. Forget any Cohan rule.

Now, you do not need to record every jot and tittle as soon as you get in the car. Records can include your Outlook calendar, for example. You could extend the appointment by mileage from MapQuest and (probably) have the IRS consider it adequate. The point is that you created some record, at or near the time you racked up the mileage, and that record can be reasonably translated into support for your deduction.

Enter Gary Roy.

He was a consultant in Los Angeles. He worked out of his home and drove all over the place for business. He must have made a couple of bucks, as he purchased an Aston Martin Vantage.

This is not a car you see every day. Chances are the last time you saw an Aston Martin was in a James Bond movie.

You know he deducted that car on his tax return.

There are multiple issues in the case, but the one we want to talk about is his car. Roy appeared before the Court and straight-facedly claimed that he kept a mileage record for the Aston. He presented a sheet of paper showing mileage at the beginning of the year and mileage at the end of the year. He helpfully added the description “business use” so the Court would know what they were looking at.

As far as he was concerned, this was all the record-keeping he needed, as the car was 100% business use.

I want to be sympathetic, I really do. I suppose it is possible that he did not understand the rules, but I read in the decision that he used a tax preparer. 

COMMENT: To whom he paid $250. Given that there were complexities in his tax return – the business and a gazillion-dollar car, for goodness’ sake – he really, really should have upgraded on his tax preparer selection.

Roy had no chance. That stretch of tax highway has a million miles on it, and he missed the pavement completely.

Without the Cohan rule, the Court was not going to spot him anything. He just got a big zero. That is what Section 274(d) says. 

And is what Congress wanted back when.

Worst case scenario for Mr. Roy.

Someone Fought Back Against Ohio – And Won

I admit it will be a challenge to make this topic interesting.

Let’s give it a shot.

Imagine that you are an owner of a business. The business is a LLC, meaning that it “passes-through” its income to its owners, who in turn take their share of the business income, include it with their own income, and pay tax on the agglomeration.

You own 79.29% of the business. It has headquarters in Perrysville, Ohio, owns plants in Texas and California, and does business in all states.

The business has made a couple of bucks. It has allowed you a life of leisure. You fly-in for occasional Board meetings in northern Ohio, but you otherwise hire people to run the business for you. You have golf elsewhere to attend to.

You sold the business. More specifically, you sold the stock in the business. Your gain was over $27 million.

Then you received a notice from Ohio. They congratulated you on your good fortune and … oh, by the way … would you send them approximately $675,000?

Here is a key fact: you do not live in Ohio. You are not a resident. You fly in and fly out for the meetings.

Why does Ohio think it should receive a vig?

Because the business did business in Ohio. Some of its sales, its payroll and its assets were in Ohio.

Cannot argue with that.

Except “the business” did not sell anything. It still has its sales, its payroll and its assets. What you sold were your shares in the business, which is not the same as the business itself.

Seems to you that Ohio should test at your level and not at the business level: are you an Ohio resident? Are you not? Is there yet another way that Ohio can get to you personally?

You bet, said Ohio. Try this remarkable stretch of the English language on for size:

ORC 5747.212 (B) A taxpayer, directly or indirectly, owning at any time during the three-year period ending on the last day of the taxpayer's taxable year at least twenty per cent of the equity voting rights of a section 5747.212 entity shall apportion any income, including gain or loss, realized from each sale, exchange, or other disposition of a debt or equity interest in that entity as prescribed in this section. For such purposes, in lieu of using the method prescribed by sections 5747.20 and5747.21 of the Revised Code, the investor shall apportion the income using the average of the section 5747.212 entity's apportionment fractions otherwise applicable under section 5733.05, 5733.056, or 5747.21 of the Revised Code for the current and two preceding taxable years. If the section 5747.212 entity was not in business for one or more of those years, each year that the entity was not in business shall be excluded in determining the average.

Ohio is saying that it will substitute the business apportionment factors (sales, payroll and property) for yours. It will do this for the immediately preceding three years, take the average and drag you down with it.

Begone with thy spurious nonresidency, ye festering cur!

To be fair, I get it. If the business itself had sold the assets, there is no question that Ohio would have gotten its share. Why then is it a different result if one sells shares in the business rather than the underlying assets themselves? That is just smoke and mirrors, form over substance, putting jelly on bread before the peanut butter.

Well, for one reason: because form matters all over the place in the tax Code. Try claiming a $1,000 charitable deduction without getting a “magic letter” from the charity; or deducting auto expenses without keeping a mileage log; or claiming a child as a dependent when you paid everything for the child – but the divorce agreement says your spouse gets the deduction this year. Yeah, try arguing smoke and mirrors, form and substance and see how far it gets you.

But it’s not fair ….

Which can join the list of everything that is not fair: it’s not fair that Firefly was cancelled after one season; it’s not fair that there aren’t microwave fireplaces; it’s not fair that we cannot wear capes at work.

Take a number.

Our protagonist had a couple of nickels ($27 million worth, if I recall) to protest. He paid a portion of the tax and immediately filed a refund claim for the same amount. 

The Ohio tax commissioner denied the claim.

COMMENT: No one could have seen that coming.

The taxpayer appealed to the Ohio Board of Tax Appeals, which ruled in favor of the Tax Commissioner.

The taxpayer then appealed to the Ohio Supreme Court.

He presented a Due Process argument under the U.S. Constitution.

And the Ohio Supreme Court decided that Ohio had violated Due Process by conflating our protagonist with a company he owned shares in. One was a human being. The other was a piece of paper filed in Columbus.

The taxpayer won.

But the Court backed-off immediately, making the following points:

(1)  The decision applied only to this specific taxpayer; one was not to extrapolate the Court’s decision;

(2)  The Court night have decided differently if the taxpayer had enough activity in his own name to find a “unitary relationship” with the business being sold; and

(3)  The statute could still be valid if applied to another taxpayer with different facts.

Points (1) and (3) can apply to just about any tax case.

Point (2) is interesting. The phrase “unitary relationship” simply means that our protagonist did not do enough in Ohio to take-on the tax aroma of the company itself. Make him an officer and I suspect you have a different answer. Heck, I suspect that one Board meeting a year would save him but five would doom him. Who knows until a Court tells us?

With that you see tax law in the making.

By the way, if this is you – or someone you know – you may want to check-out the case for yourself: Corrigan v Testa. Someone may have a few tax dollars coming back.

Testa, not Tesla

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.