Educational purposes include “instruction or training of individuals to improve or develop their capabilities; or instruction of the public on subjects useful to the individual and beneficial to the community.”1 This definition of “educational” encompasses professional or occupational training regarding business capabilities.2 The regulation gives the following four examples of educational organizations:
In clearing the hurdles to obtain exemption, a potentially tax-exempt nonprofit must choose one of eight charitable purposes.3 The broadest category is charitable, with the many missions discussed in Chapter 4. A narrower standard, with more fully developed criteria, exists for the educational organizations considered in this chapter as regards the content of the subjects presented and materials used. An entity focused on controversial issues of social concern, such as abortion, fairness of the income tax system, or universal health care, must present information in an unbiased fashion.
The Internal Revenue Service (IRS) regulation defining “charitable” organizations says:
The fact that an organization, in carrying out its primary purpose, advocates social or civic changes or presents opinion on controversial issues with the intention of molding public opinion or creating public sentiment to an acceptance of its views does not preclude such organization from qualifying under IRC §501(c)(3) so long as it is not an “action” organization.4
The same regulation, in defining “educational” organizations, instead says:
An organization may be educational even though it advocates a particular position or viewpoint so long as it presents a sufficiently full and fair exposition of the pertinent facts as to permit an individual or the public to form an independent opinion or conclusion. On the other hand, an organization is not educational if its principal function is the mere presentation of unsupported opinion.5
This regulation was held to be unconstitutionally vague in the Big Mama Rag, Inc., case in 1980.6 The IRS had argued that the newspaper, in celebrating the cause of lesbians, failed to present a “full and fair exposition of the facts” as required by the regulations. The court noted that the regulations do not make clear what groups are advocacy groups that must meet this test, nor do they provide any objective standard for distinguishing facts from opinions.
Without answering the questions posed by the D.C. Circuit in 1980, the IRS, in November 1986, issued a ruling outlining a methodology test for identifying impermissible advocacy.7 The presence of any of the following factors indicates that the method used by the organization to advocate its viewpoints or positions is not educational:
The methodology test was designed to “eliminate or minimize the potential for any public official to impose his or her preconceptions or beliefs in determining whether the particular viewpoint or position is educational.” It is the method used by the organization to communicate its viewpoint or position to others, not the viewpoint itself that will be tested. The IRS continues to apply this methodology test, which was condoned by the Tax Court, in confirming denial of exemption for The Nationalist Movement, a pro-white Mississippi organization advocating social, economic, and political change.8
An organization that espouses a particular viewpoint concerning issues that may be the subject of legislation or political debate, such as welfare, abortion, or guns, must first test its methodology for making a sufficient presentation of facts. A parallel, but different, issue is whether it is an action organization whose purposes can be accomplished only through the passage of legislation.9 If legislative advocacy is the organization's primary mission, it may not qualify for (c)(3) exemption. Electioneering is also strictly prohibited for a (c)(3) organization. Ask whether its purposes can be accomplished only through the passage of legislation by persons it plans to help to get elected. The House Ethics Committee investigation of Representative Newt Gingrich's work with the Abraham Lincoln Opportunity Foundation and the Progress and Freedom Foundation during 1997 focused on these issues. Were the contents of the foundation programs biased? Were the foundations created to advance the private interests of Gingrich and the Republican Party? The information gathered by the committee was turned over to the IRS for examination. Some were surprised that exempt status was not eventually revoked.10
Schools, like churches and hospitals, occupy a privileged category of §501(c)(3) organizations that are classified as public charities because of the activity they conduct rather than the sources of their revenue. An educational organization is a school if its primary function is the presentation of formal instruction with the following attributes:11
The following educational organizations have been ruled to be schools:
The term “school” includes primary, secondary, preparatory, and high schools, and colleges and universities. Schools publicly supported by federal, state, and local governments qualify for this category by definition, and in most cases also qualify as governmental units.14 A school possessing this duality might seek recognition of (c)(3) qualification to facilitate fund-raising. When the state school has tax-exempt status, however, it is subject to the organizational and operational tests.15 Advisors for a school can test its qualification for this category by studying the IRS examination guidelines for colleges and universities developed for use by the IRS's specialists.16 Factors considered by the IRS to determine that a school can continue to qualify can also be used as a reference for organizations seeking recognition as a school. The IRS addressed the special issues involved in the qualification of charter schools in its year-2000 training materials.17
What the regulations call “noneducational” activities must be incidental. A recognized university can operate a museum or sponsor concerts and remain a school. A museum's art school, however, does not make the museum a school.18
Meaning of Regular. All three “regular” elements must be present to achieve recognition as a school: regular faculty and curriculum, enrolled students, and facility where educational activities are regularly carried on. A home-tutoring entity providing private tutoring was held not to be an educational organization for this purpose.19 Likewise, a correspondence school was not approved under this section because it lacked a physical site where classes were conducted.20
The word curriculum was loosely construed in a ruling that permitted an elementary school to qualify despite the fact that it had no formal course program and espoused an open-learning concept.21 However, leisure learning classes may not present a sufficiently formal course of instruction to qualify as a school. Lectures and short courses on a variety of general subjects not leading to a degree or accreditation do not constitute a curriculum.22 Also, invited authorities and personalities recognized in the field are not considered to be members of a regular faculty.23
The duration of the courses was not considered a barrier for an outdoor survival school whose classes lasted only 26 days, but were conducted with regular teachers, students, and course study, despite the fact that part of the facilities it used were wide-open spaces.24
An organization that originally qualified as a school because it operated a charter school lost its exempt status when it changed its mission to leasing buildings to unrelated charter schools. The IRS said an entity charging rentals at below-market rates “may” be exempt. Though the rents charged in this instance were somewhat less than prevailing market rates, the entity had accumulated significant funds, indicating it lacked donative intention for the activity. The ruling also noted that the entity did not have any independent directors.25
College and University Compliance Check. The IRS sent a very comprehensive 33-page compliance questionnaire to 400 schools in 2008. They requested data about organizational structure, activities, endowments, international activity, executive compensation, and governance issues. Details about geographical location, number of students, tuition rates, related organizations, and unrelated business income were also requested. Thirty-four examinations were conducted by the IRS.26
IRC §529,27 entitled “Qualified State Tuition Programs,” exempts organizations established for prepaid tuition plans and exempts their investment income, except such organizations may be subject to tax on unrelated income from an active business.28 To qualify, the program must be established or maintained by a state or instrumentality of a state29 to allow persons to purchase tuition credits and to contribute to an account established to pay the qualified higher education expense of a designated beneficiary. Such expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible education institution.
Student Housing. The provision of student housing sounds like a charitable activity, and indeed the IRS has said so in the past. A number of IRS rulings over the years have agreed:
In 2008 and 2011, lack of involvement and any control on the part of a college(s) was said to render a nonprofit unqualified for §501(c)(3) exemption.33 Keeping in mind that a private letter ruling does not necessarily apply in other situations, the facts and circumstances in two rulings indicated lack of charitable purpose. One organization, established to create limited liability companies to build and operate each housing facility, was essentially found to provide financing and development services. Neither the schools from which students would be drawn nor the communities in which they were located had any involvement in the housing projects. Coordination with student affairs or other evidence of affiliation with the school was absent, indicating a lack of educational mission.
Schools must adopt and practice, in good faith, policies prohibiting racial discrimination. A statement expressing its racially nondiscriminatory policy must be included in its charter, bylaws, or other governing instrument or be effective by resolution of its governing body. School brochures, catalogs, websites, and other printed and electronic matter used to inform prospective students of the school's programs must contain a policy statement as it relates to admission applications, scholarships, and program participation.34 Statistical records of the racial composition of the student body must be maintained to evidence the existence of the nondiscrimination policy.35
Schools filing Form 990 must complete Schedule E to inform the IRS that it has met these requirements.36 The nondiscrimination policy must be made known, or publicized, to all segments of the general community served by the school. A school that, in fact, has currently enrolled students of racial minority groups in meaningful numbers (not specifically set out by IRS) is excused from the media publicity requirement. Form 5578 is due to be filed by schools that are not required to file Form 990, primarily including church schools that qualify as an integrated auxiliary of a church. Some denominations file this form on behalf of their schools.
A private school that adopted a nondiscrimination policy in connection with seeking application for recognition of its exemption as an educational organization was later denied exemption when information revealed that in fact it did discriminate—it failed the good-faith test. The Tax Court denied tax exemption for Calhoun Academy because the “clear and convincing evidence” indicated that the school operated in a discriminatory fashion.37 The school was established concurrently with court-ordered desegregation plans. Although the community in which it was located was 50 percent black, no black student had ever been admitted. The school argued, unsuccessfully, that none had applied. Although the school had been in existence for 15 years, the nondiscrimination policy was implemented only in connection with the exemption application. The court noted that a school could qualify for tax-exempt status without establishing that it took the specific affirmative acts set forth in the IRS procedures, if, in fact, it operates in a racially nondiscriminatory manner.
The Bob Jones University Museum was determined to be qualified for exemption despite its affiliation with the non-tax-exempt Bob Jones University.38
The IRS, during the 1990s, was accused of discriminating against gay and lesbian groups seeking recognition of exemption. The Lambda Legal Defense and Education Fund representatives wrote to the commissioner of Internal Revenue at the time to complain about discriminatory treatment by “front-line agents” who initially deal with applications when gay- and lesbian-oriented groups apply for tax-exempt status. Marcus S. Owens, the director of the Exempt Organizations Division at the time, responded by scheduling visits by himself and with other IRS officials to field offices to brief agents on the importance of professionalism, impartiality, and fairness in dealing with all organizations.39
IRC §501(k) states that “providing care of children away from their homes” is an educational, and therefore exempt, purpose if:
Whether such an organization created by a consortium of employers can qualify for exemption is an unanswered question. Providing day care referrals and assistance information to the general public, however, has been treated as a service that is ordinarily a commercial activity. Counseling parents and caregivers about day care was found not to be, per se, an educational or charitable activity. In an entity where 98 percent of its revenues came from charges for its services, the IRS refused to grant tax-exempt status as an educational institution.42
IRC §501(f) was added to the Code to sanction pooled investing by educational institutions. To qualify, the organization must be:
Organizations that present instructional materials or training on a less formal basis than a school can qualify as tax-exempt educational organizations if they operate to benefit the general public rather than a particular business entity. Discussion groups, retreat centers, apprentice training programs, and the many other types of educational programs in the following list are exempt if they can prove they provide the requisite instruction for the benefit of individuals:
Computer users' groups are not exempt if their membership is limited to persons using a particular type of computer,58 but they may qualify as business leagues.59
An educational organization affiliated with or focused on a particular line of business or product must carefully adhere to the private inurement standards.60 The list of qualifying organizations found in the regulations defining educational organizations does not include instruction and training to improve and develop professional or business skills. Business groups conducting classes and sharing information are eligible for exempt status as educational organizations as long as two significant characteristics are present:
Foundations established to support the educational programs of social fraternities and sororities61 may be treated as qualifying educational organizations so long as they do not provide impermissible private benefit to the club members. Support granted for scholarships, tutoring, and other specific academic programs unquestionably promotes an educational purpose. Traditionally, the club members have been considered a sufficiently broad charitable class. The troublesome issue is whether the foundation can grant funds to improve the club's facilities. An early ruling found that structural improvements to a fraternity house granted private inurement to the club.62 Where the improvement primarily served an educational purpose, such as the construction or renovation of a library or study room, the IRS later opined that the educational benefit could outweigh the private benefit.63 The 1999 IRS training text commented that this issue was still unsettled, but provided no criteria for measuring the relative benefit.64
The exemption applications of two foundations affiliated with a fraternity treated favorably in late 2001 were based on a “similar benefit” standard.65 The foundation may “provide grants for facilities, services, or goods for the benefit of the members” of the fraternity house if “the benefit is similar to those provided” at the affiliated universities. In other words, if the school normally provides funding to fraternities to provide computers, study rooms, and the like, the foundation can also. Though not stated, this criterion implies that such grants benefit the school rather than the club. This distinction implies that a foundation benefiting a fraternity located on a campus that does not provide such support would not qualify for exemption.
It is important to emphasize that a charitable organization created by a fraternity or sorority classified as a social club under § 501(c)(7) must develop policies and procedures to maintain separation of the two entities, to assure that the (c)(3) charity does not provide private benefits to club members. A traditional college fraternity that provided housing and fellowship to its student members was found not to qualify as a fraternal organization operating under the lodge system as provided in IRC §501(c)(10) to enable it to avoid tax on its investment income reported as unrelated business income.66
Performing arts organizations presenting music, drama, poetry, film, and dance are classified as cultural and, thus, as educational organizations. Symphony orchestras, theaters, public television and radio, and other performing groups easily gain exempt status if they meet the basic organizational and operational tests. Although most charge admission for performances, such arts organizations are characteristically charitable because they receive a significant portion of their revenues from voluntary contributions. The few rulings on the subject (that these organizations will be ruled exempt) follow:
Co-production of performances or recordings with commercial businesses must be carefully planned by a tax-exempt arts organization. As with all organizations qualifying under §501(c)(3), a performing arts organization must not operate to yield benefit to private individuals. In planning a project with a commercial entity, the terms must be designed to promote performing arts with only incidental benefit, if any, to the co-producers. An exempt television production company, for example, was found to be advancing its own exempt purposes in entering into a joint venture to develop children's programming for a commercial network.73 Permissible joint venture activities are explored in Chapter 22, including the famous Plumstead Theatre case.
Organizations that collect and exhibit objects of a literary, artistic, historic, biological, or other educational nature for the general public qualify as exempt educational organizations. Again, this type of cultural nonprofit is a prototypical charity because admission charges commonly cover a small portion of a museum's budget, with contributions and endowment income providing the lion's share. There are only a few rulings on this type of educational organization, but the IRS has ruled that the following activities qualify:
The Bob Jones University art gallery was found to be exempt despite the revocation of the school's exempt status by the Supreme Court because the university was racially discriminatory.83 The school art gallery leased the museum facility from the school and operated the facility with artwork on loan from the school. The museum was open to the public free of charge, and some 80 percent of its 20,000 annual visitors had no connection with the school. The museum's major support comes from contributions.84 In finding that the museum itself qualified for tax exemption, a court overruled the IRS on all of its following arguments:
An art museum or gallery that sells the works of art it exhibits must overcome a presumption that it is operating a business rather than serving a purely educational purpose that would entitle it to exemption. The question is whether the sale of an object off the exhibition walls or in the museum gift shop enhances the visitor's educational experience and thereby contributes to the accomplishment of its educational purposes. The answer varies depending on whether the object is an original work of handicraft or work of fine art, or instead a reproduction or replica of an object displayed in a museum exhibition or contained in the organization's collection of art. The latter items are considered to advance the educational mission (to continue the learning by taking a representation of a museum object home). The former, instead, are deemed to simply allow the organization to raise money—a nonexempt objective. An organization may not continue to qualify for tax-exempt status if its unrelated business activity is more than insubstantial (commonly thought to equal about 10 to 15 percent). The many museums and art centers that have gift shops should study the special section of Chapter 21 that focuses on museum sales and the need to distinguish the items sold between those that advance the mission and those that the IRS deems do not.
Publishing projects have been a subject of controversy with the IRS. The two issues most debated have been controversial subject matter and commercial activity. It is not sufficient that the subject matter of the published work be religious, cultural, scientific, or educational. An exempt publishing company must also distinguish itself from a commercial one so as to evidence that it is not operating an unrelated business. The factors that identify an educational publication program are:85
Organizations distributing educational materials free87 or at a nominal price88 indisputably operate in a noncommercial manner. However, publishing a foreign-language magazine on a subscription basis at a price and through channels used by commercial publishers is not an exempt activity.89 A section on the unrelated business aspects of publishing is provided in Chapter 21.
Electronic publishing is still a relatively unexplored area of activity for tax-exempt organizations. In its training materials, the IRS said, “In the past, Internet Service Providers (ISP) have usually been denied exemption because they are viewed as carrying on a trade or business for profit, or conferring an unmixed private benefit, or both.”90 “Providing communication services of an ordinary commercial nature in a community, even though the undertaking is conducted on a nonprofit basis, is not regarded as conferring a charitable benefit on the community unless the service directly accomplishes one of the established categories of charitable purposes.”91 Both of the IRS training course articles from which the previous quotes are taken should be carefully studied for an ISP seeking tax-exempt status. The articles conclude that exemption may be possible if the ISP is an adjunct or integral part of a university, public school, library system, or a local government. Accountability and control; dependence on government grants rather than user fees; and free use to students, library patrons, and the general public are said to be characteristics that evidence a charitable ISP. Such an ISP might also qualify as relieving the burdens of government.92 The training manual suggests that the IRS technician “peruse the ISP's home page to evaluate its exempt character as a source of public information and to see if ‘placards,’ ‘banners,’ and links to commercial sites constitute advertising that create unrelated business income.”93
Establishment of a tax-exempt organization's website for the purpose of disseminating information and linking to other sites presents a range of tax issues discussed in §§2.2(j) and 21.8(j).
As early as 1919, the Bureau of Revenue said that educational organization status may apply to an entity whose sole purpose is the instruction of the public, “but an association formed to disseminate controversial or partisan propaganda is not educational.” The American Birth Control League was found not to be educational in 1930. Judge Learned Hand opined that a purpose to change the law as an end in itself was not itself exempt, regardless of the problem of uncontrolled procreation. He thought “political agitation as such is outside the statute, however innocent the aim.”94
The IRS view in 1997 was that “an organization's mere dissemination of words or a viewpoint to the public does not necessarily benefit the public sufficiently to warrant the organization's tax exemption under §501(c)(3).”95 A methodology test applies to determine the educational nature of a program. To be educational, information must be useful to the individual and beneficial to the community. The materials presented must contain a sufficiently full and fair exposition of the pertinent facts about a subject, rather than an unsupported opinion.
The Tax Court denied exemption for The Nationalist Movement (TNM), a pro-white Mississippi organization advocating social, economic, and political change in the United States.96 Denial was not based on excessive lobbying or political activity, but instead on a finding that the organizational activities were neither educational nor charitable. The court found that the organization did not operate exclusively for an exempt purpose. The opinion quotes extensively from the organization's literature—newsletters, convention programs, and writings of the founder, Richard Barrett. The following quotations, from a fund-raising letter, epitomize the philosophy of the organization. The second quotation, from a TNM newsletter, served, in the court's opinion, to exemplify viewpoints unsupported by facts and therefore not educational.
The IRS unsuccessfully argued that the organization served the private interests of Barrett by “supplying a forum to express and promote his personal agenda.” The court found that “substantial domination of an organization by its founder does not necessarily disqualify the organization from exemption.” The court also noted no evidence that Barrett used the organization to further his political career. TNM argued that it operated social services programs that qualified as charitable (feeding the poor and pursuing public interest litigation). The records about these activities were “inconsistent” in the eyes of the court and did not enable TNM to prove that it operated “exclusively for charitable purposes.”
Most important, the court found that the messages presented through TNM's radio program and written materials failed the methodology test97 and were not educational. Because they were TNM's primary activity, the organization did not qualify for exemption. The court also found that the methodology test “is not unconstitutionally vague or overbroad on its face” and reduces the vagueness of the regulation.98 The criteria “tend toward ensuring that the educational exemption be restricted to material which substantially helps a reader or listener in a learning process.” The court essentially condoned the regulation it had earlier found unconstitutional by finding that viewpoints unsupported by facts were not educational. Because a significant portion of the organization's communications contained such materials, the organization was not educational, even if such presentations were not its principal function.99
Interesting and unique exemption issues arise when the training and information are transmitted by way of electronic bulletin boards and across the Internet using tweets, blogs, Facebook, and other social media systems. The IRS has issued modest guidance for those many entities using such communication tools. For what it called “computer-related organizations,” the IRS in 1996 compiled a list of rulings concerning computer users' groups and promised to update guidance on the issue. Advisors to formulators of such groups will want to carefully study this reference prior to seeking recognition of exemption or adopting new programs for existing organizations.100 You can visit the IRS website at www.irs.gov/charities for the EO CPE Text and other IRS publications.101
The regulations are silent and contain no definition or criteria for qualification of a literary organization. Since literature is both educational and cultural, a literary organization can be exempt as educational or charitable. Most often at issue for a literary project is its relationship with those who create the literature. Do the programs advance the private interests of the writers? An organization established to encourage emerging writers by publishing their works in the small-press market must prove that it does not primarily benefit the individual writers, but instead promotes literature or culture in a global sense. The IRS expects the economic benefits received from the intellectual property created in connection with a program conducted by a tax-exempt entity will not provide unreasonable financial return to the writers. The creators may be given a portion, if not all, of the royalties, so long as the resulting compensation is reasonable. Examples of literary pursuits are publishing of literature, including poetry, essays, fiction, nonfiction, and all other forms of written compositions. Other examples include a sponsor of poetry readings, a literary workshop to teach writing skills, a critical journal of reviews, a committee to award a prize for excellence in literature (such as the Pulitzer Prize), and a preservation society for rare books.102
The IRS admitted in 1966 that the term “scientific” is not definable with precision.103 The regulations say only that “scientific” includes the carrying on of scientific research in the public interest. Further, they say, “Research when taken alone is a word with many meanings; it is not synonymous with scientific and the nature of particular research depends upon the purpose which it serves.” The determination as to whether research is scientific does not depend on whether such research is classified as fundamental, or basic, as contrasted with applied, or practical.104
The ambiguity in the meaning of “research” is addressed by very exact and specific standards for judging whether scientific research is conducted in the public interest and therefore qualifies as a tax-exempt activity. To be considered as conducted in the public interest, research—both fundamental and applied—must have the following characteristics:
Scientific research, to qualify as a charitable pursuit, does not include activities of a type ordinarily carried on incident to commercial or industrial operations, as, for example, the ordinary testing or inspection of materials or products, or the designing or construction of equipment, buildings, and the like.105 Drug testing to discover treatments and ultimately a cure for a disease that has “orphan” status under FDA regulations was deemed to be conducted for public benefit.106 Further, because the testing was related to discovering a cure for a disease, any benefit accruing to the owner of the intellectual property in the drug would be incidental. The testing essentially was deemed to be conducted in the public interest. The clinical tests to be conducted were of a type not normally conducted by commercial organizations because the likelihood of developing a marketable treatment is small and there are few potential customers. Tests were to be conducted by a variety of institutes and clinics selected by a steering committee based on recommendations of academic and medical scientists. The committee intended to investigate the effectiveness of new drugs and explore new uses or combinations of existing drugs. The testing program was not related to the drug manufacturers' obtaining FDA approval for uses of the drugs and the proposed clinical trials would not be incidental to any commercial operations as described in Rev. Rul. 68-373.
Retaining ownership or control of more than an insubstantial portion of the patents, copyrights, processes, or formulas resulting from an organization's research and not making them available to the public may disqualify the organization from exempt status.107 If granting an exclusive right is the only practical manner in which the patent can be utilized to benefit the public, such as in the case of research conducted for the government or for the purposes listed under the preceding standards, the information can be withheld.108 An exempt organization that performs research only for its non-§501(c)(3) creators cannot be classified as a §501(c)(3) organization.109
One court has suggested that this regulation can be understood in the context of distinguishing a commercial testing laboratory from a scientific research institute.110 The definition of scientific research would exclude the repetitive or relatively unsophisticated work done by commercial laboratories to determine whether items tested meet certain specifications, rather than the more sophisticated testing done to validate a scientific hypothesis. Scientific research was said to have three components:
The IRS has suggested that in differentiating between research and testing, it may be useful to refer to “research and development expenses” qualifying for tax credit under §174.111 In that situation, all costs are incident to the development of an experimental or pilot model, a product, a formula, an invention, or similar property, and the improvement of already existing property of these categories. The term does not include expenditures such as those for the ordinary testing or inspection of materials for products for quality control purposes or for efficiency surveys, management studies, consumer surveys, advertising, or promotion.
A combined educational and scientific purpose may also qualify an organization for exemption, as the following examples illustrate:
Design and development of a patentable medical device, under a contract with a medical equipment company, was found not to qualify as scientific research, because the science was incidental to the commercial exploitation aspects of the activity. The organization obligated itself to license any patents for the device exclusively to the company in exchange for a royalty.116
Scientific research often results in valuable intellectual property capable of producing revenues. Two very different issues are involved when research results are sold or exploited for commercial dissemination:
A research project commissioned by commercial interests can only incidentally benefit its private sponsors. To evaluate this benefit, the proverbial facts and circumstances of a project are examined to determine the motivation for conducting the research. Importantly, the exploited research activity cannot constitute a substantial nonexempt activity without jeopardy to the organization's tax-exempt status. To reduce this possibility, organizations conducting commercial research should consider creating a separate nonexempt organization to conduct the business of selling the results.117
Private rulings requested by research organizations reflect interesting facts that can be studied to understand the IRS view of exploitation of the results of scientific research. For example, an organization was created to engage in research about the design of urban land and to educate the public on the need for improvement in the use and design of public urban open spaces. The facts provided a good forum for the IRS to find examples of excessive private interest.118 Eight specific urban design projects were reviewed and myriad models analyzed. Private interest was found to exist in three projects studying the public's use of private property. One project studied pedestrian flow through a building's government-mandated public space and ways to enhance the underutilized plaza. Even though the projects serving private property owners produced some 15 percent of its revenue and were subject to tax, the organization was found to qualify for exemption.
In another instance, an organization was originally created to conduct basic research in biotechnology to broaden the industrial base and foster job creation through the development of innovations. To become financially independent of state funding, the organization planned to focus on applied research to produce marketable technology that it could commercially license and exploit. Under the plan, its discovery research would be transferred to a university. The ruling also considered the sharing of intellectual property rights. The IRS said it preferred for the nonprofit to retain 100 percent of intellectual property rights based on the theory that any allocation of rights to individuals results in private inurement. However, the organization's federal research agreements required it to share royalties from patents with the inventors. One-third of revenues from licensing or other transfers of patents was allocated to the inventor employees. Further consulting fees were shared half and half or equally with the employees for services rendered during regular working hours. Individual scientists were allowed to retain all fees for consulting performed on their own time. An additional bonus system rewarded managers and senior scientists. Because the compensation arrangements were a result of arm's-length bargaining and the overall compensation was reasonable, the IRS determined that the royalty, fee sharing, and bonus system did not result in private inurement. The IRS determined that the entity could retain its tax-exempt status.119
Another organization received approval for a reorganization in which it spun off inventions and products into wholly owned taxable for-profit subsidiaries. The plan had several goals: (1) to commercialize technologies developed by the exempt's scientists and engineers, (2) to improve the transfer of technology from the exempt's labs into the public domain, (3) to stimulate economic development, (4) to provide entrepreneurial opportunities for the scientists, and (5) to separate the commercial activities from the basic research function.120
Special UBI Exclusions. When research results are commercially sold, the form of revenue payments received by the exempt organization is important. The unrelated business income tax rules modify, or exclude, income that is essentially derived from research programs conducted in the public interest. Using slightly different language from that found in the §501(c)(3) regulations defining exempt scientific work, the tax code specifically excludes the following:121
Instead, profits from research carried on for the following purposes would be treated as unrelated income, the receipt of which could jeopardize tax-exempt status:122
Royalty Exclusion. Revenues from research of a type not specifically excluded from the unrelated business income tax under the preceding rule may still be modified, or excluded, from unrelated business income tax under another exception. When the revenue is paid in the form of royalties in return for licensing intellectual property, the income is not subject to income tax.123 This exclusion recognizes the fact that the exempt organization entering into such a licensing agreement does not itself conduct the business in which the license is applied and financially exploited.
The regulations give only one example of an organization qualifying because it tests for public safety. Such an organization tests consumer products, such as electrical products, to determine whether they are safe for use by the general public.124 Other exempt programs might include testing for structural building strength against violent weather, such as hurricanes and tornadoes, or earthquakes. Testing boat equipment and establishing standards for pleasure craft were also ruled to be exempt activities.125
Similar to the scientific research constraints, testing must be performed to serve a public benefit, rather than the interests of private owners, such as drug manufacturers. This distinction is not always clear. In a published ruling, the IRS found that testing, research, and other work toward developing methods and safety certifications for shipping containers benefited the shipping industry and advanced international commerce and, therefore, were not exempt, despite the fact that the stevedores working with shipping containers constitute a charitable class whose safety is significant and worthy of testing.126 Similarly, a drug company's testing program prior to approval by the Food and Drug Administration was ruled to serve the manufacturer's private interest.127 A structural steel certification program operated by Quality Auditing Company failed to convince the IRS or the Tax Court that it qualified as charitable.128 There was no overt evidence that the government considers such testing to be its burden or responsibility. The quality inspection program was established by American Institute of Steel Construction, a business league, rather than by an express governmental program. There was no finding that the certification program actually promoted increased structural integrity and safety in steel buildings. Finally, it was determined that the program furthered the private interests of the industry members. League literature stated that the program is “intended to make the task of selecting qualified bidders more reliable.” The characteristics of scientific research as contrasted with those of testing activity were discussed.129
Perhaps because their funds are raised through the provision of services, these testing organizations do not qualify as charitable organizations eligible to receive deductible contributions under IRC §170(c), even though they do qualify as exempt under §501(c)(3). They are excepted from private foundation classification under §509 presumably because they are not funded with private donations.
Charitable organizations, such as hospitals, schools, and research organizations that focus on public interest research, face some challenges in documenting the exempt purpose of such work. When funding comes from public sources, such as the National Institutes of Health, the issue does not arise. When the work is funded by commercial interests, the joint venture can be treated as a nonexempt activity that creates unrelated business income.130 Another concern such entities face can involve qualified tax-exempt bond financing. A bond issue with excessive private business use (PBU) loses its qualification under § 141(a)(1) for tax-free income tax treatment for its holders. An organization issuing such bonds must submit information to evidence continued qualification of the bonds on Form 990, Schedule H.131
The parenthetical qualification to this exemption category was added in 1976 to prevent athletic or social clubs from qualifying under §501(c)(3), while allowing charitable status to the Olympic and Pan-American Games. In a seemingly redundant provision, Congress in 1982 stipulated in §501(j) that certain qualified organizations are not subject to the restriction in the parentheses. Curiously, the definition of those organizations that qualify is identical to the words used in §501(c)(3). The regulations concerning the 1976 changes were withdrawn in 1984.
The most-often-cited case in this area involved the International E22 Class Association.132 The organization was established to formulate and enforce measurements of a particular type of racing sailboat used in international competition. In addition to setting the standard, the association sold tools to measure compliance during construction of the boats and during races. The IRS argued that such devices were athletic equipment and refused to grant the organization an exemption. The Tax Court disagreed, saying that the measurement tools were not facilities, as clubhouses, swimming pools, and gymnasiums are. “Equipment” means property used directly in athletic endeavors. The court was not aware of any athletic exercise, game, competition, or other endeavor in which the tools could be used.
Local amateur athletic groups, such as the Little League, need not necessarily qualify under this category. Such a group can instead qualify under the charitable category because it prevents juvenile delinquency and advances education.133 The IRS decided that a national high school athletic association created in 1942 could continue to be classified as a charitable and educational entity rather than be reclassified under §501(j). The organization coordinated the efforts of state high school associations by sponsoring meetings and conferences, setting activity rules, publishing educational materials, and serving as the national governing body.134 Promoting recreational sports for a limited membership, however, may not be an activity benefiting the requisite charitable class.135
Wayne Baseball, Inc., failed to convince the IRS or the Tax Court that its amateur baseball team qualified as a (c)(3) organization.136 The typical player on the team was over age 21, and the team included a few players with professional experience. Because the team offered no formal instructional training and did not sponsor coaching or other programs for youths, the IRS determined that the team operated to promote the social and recreational interests of its members, not the general public. An organization that functions to advance amateur baseball in its community as a whole can so qualify.137 A sports activity complex operated on a local level for adults could not qualify as fostering national or international amateur sports competition.138 The important distinction made in another ruling that found the entity not to qualify for exemption was the fact that the program was recreational. Only adults participated; there was no instruction or teaching for youth and no sports trainer. Most of the expenses were for travel and food for the team.139
This is another exemption category without explanation in the IRS regulations. Thankfully, a few published rulings provide guidelines, as the following examples of exempt activities indicate:
A troublesome activity might be the provision of veterinary services to individual pet owners. While it could be argued that such services prevent cruelty, there is an additional burden to prove the public usefulness of the effort. Certain treatments probably deserve and could gain charitable status, such as rabies control or neutering, but the absence of individual benefit ultimately has to be proven in order to obtain exemption.
18.118.20.90