(a) Charter, Constitution, or Instrument

To receive IRS approval of exempt status, an organization must be created with properly executed documents filed and approved by appropriate state officials. A formless aggregation of individuals cannot be exempt, nor can a partnership.¹⁴ The IRS determination procedures generally assume two types of organizational documents:¹⁵

1. Articles of incorporation or association, or a trust instrument.
2. Rules of governance under which the exempt organization is operated, usually bylaws.

Bylaws alone are not an organizing document for a nonprofit corporation, but merely the internal rules and regulations of the organization. For trusts and unincorporated associations, the charter or constitution and bylaws are often combined into one document. The language required for creation of a nonprofit corporation in some states may not include the certain provisions required for federal tax exemption. IRS Publication 557, Tax-Exempt Status for Your Organization, contains sample documents with language that satisfies the tests and can be studied to ensure that proper provisions are included.¹⁶

A charter that is defective because it does not contain the four required components listed in the introduction cannot be cured by the organization's bylaws. The IRS routinely requires revision of deficient articles prior to issuing a determination of (c)(3) exempt status and customarily grants exemption retroactively to the original incorporation date. A defective charter is also not overcome merely because the organization's activities are actually charitable; likewise, an acceptable charter cannot overcome nonexempt activity.

IRS policy requires dissolution, inurement, purpose, and political action clauses of a proposed (c)(3) organization to contain the literal term “501(c)(3).” Descriptive language limiting the activity solely to charitable purposes, without specifically mentioning (c)(3), may be acceptable, but other language may not be.¹⁷ The Tax Court disagreed with this policy in Colorado State Chiropractic Society.¹⁸ A charitable organization, in the court's opinion, need not satisfy the organizational test solely by language in its corporate articles. Other factual evidence in addition to the charter, such as the bylaws, can be considered in determining passage of the test. Nevertheless, in the author's experience, the IRS continues to require specifically limiting language in the incorporation documents.

The IRS does not ordinarily question the validity of the corporate status of an organization that has satisfied the formal requirements for such status under the law governing its creation.¹⁹ However, as noted earlier, the minimum requirement for establishing a nonprofit organization in some states, such as Texas, is deficient by federal standards. The range of activities permitted a nonprofit corporation by a state may be broader, meaning that a charter granting all powers provided under a state's nonprofit corporation act may not qualify.²⁰

Because many nonprofit organizations have similar names, it is very useful to investigate name availability before the documents are submitted to the state. Unlike a business corporation, a nonprofit may not necessarily be required to use the words “corporation,” “company,” or “incorporated.” A trust instrument need not necessarily be registered with the state in which the nonprofit is established, but must contain the four operating rules specified in the regulations and listed at the beginning of this chapter.

(b) Dissolution Clause

Specific language in the nonprofit's charter must describe the manner in which its assets will be distributed in the event of dissolution. Assets may not be returned to contributors, directors, or any non-501(c)(3) organization or spent for non-501(c)(3) purposes.²¹ It is not sufficient to say that the assets will be dedicated to “nonprofit purposes,” as nonprofit purposes include activities that are broader than the eight specific (c)(3) purposes. Remaining assets at the time of dissolution must be either expended for one or more exempt (c)(3) purposes or given to another (c)(3) organization or the federal, state, or local government. To avoid any questions from the determination group, the tax code section should be specifically mentioned by number. The 2004 IRS Continuing Professional Education (CPE) text had a still-useful article that contains specific questions about two charter provisions: purpose clause and dissolution clause. There is no mention of language that prohibits use of assets for private purposes, prohibits participation in influencing an election, or limits lobbying activity.²²

Some state statutes make these provisions automatic unless otherwise stated in the corporate charter. The IRS has a list identifying states whose dissolution clauses qualify.²³ Even so, specific mention in the charter is advisable to avert IRS challenges to the charter when the application exemption is filed.

(c) Inurement Clause

Qualifying organizational documents must not permit distribution of any part of the organization's net earnings to its directors, officers, or trustees, or to any private individual.²⁴ Although IRC §503 applies only to §501(c)(17) and (18) organizations, it is instructive to study its list of the types of insider transactions that are still essentially prohibited for §501(c)(3) organizations.²⁵ The five prohibited transactions listed in §503(b) as causes for revocation of exemption are:

1. Lending any part of its income or corpus without receipt of adequate security and reasonable rate of interest.
2. Paying any compensation in excess of a reasonable allowance for salaries or other compensation for personal services actually rendered.
3. Making any part of its services available on a preferential basis.
4. Selling any substantial part of its securities or other property for less than an adequate consideration in money or money's worth.
5. Engaging in any other transaction that results in a substantial diversion of its income or corpus to the EO's creator, substantial contributors, family members, or controlled corporations of such persons.

In other words, a (c)(3) organization cannot use its assets to benefit its insiders. Chapter 20 defines insiders, considers the vague difference between private inurement and private benefit, and thoroughly outlines the criteria used to evaluate transactions to identify inurement. Chapter 22 discusses a variety of business transactions and associations between one exempt organization and another and between an exempt organization and private individuals or businesses, and presents the standards under which such relationships might be deemed to represent impermissible inurement. The IRS has issued private letter rulings which find that a nonprofit organization controlled by a board made up of related parties, or in some cases, one individual, or one lacking bylaws or “written policies setting forth the duties and responsibilities of your trustees” fails the “organizational test” and cannot qualify for tax exemption.²⁶ The production and promotion of concerts presenting the work of the organization's creator was admittedly educational and reputedly also included collaborating artists. Workshops, private lessons, master classes, and teaching residencies related to contemporary art music presented to the public were not enough to gain tax exemption for an organization created by an individual musician. The IRS found that the work advanced the artist's career and was the “single substantial activity.” Possibly the opinion was influenced by the fact that the creator was a board member and could not be removed. Maybe one should add “enhancing the Executive Director's reputation to private inurement to any discussion of noncharitable purposes.”²⁷

(d) Purpose Clause

Organizational documents must limit the purposes of the exempt organization to one or more of the eight specific purposes in the following list. To qualify under §501(c)(3), an exempt organization must also operate exclusively for one of these purposes. The only permitted purposes are:

1. Religious
2. Charitable
3. Scientific
4. Testing for public safety
5. Literary
6. Educational
7. Fostering national or international amateur sports competition
8. Preventing cruelty to children or animals

Ideally, the charter will describe one or more of the eight, such as charitable, charitable and scientific, or scientific and educational, along with the qualifier “as defined in (or within the meaning of) §501(c)(3) of the Internal Revenue Code.” Words having similar meaning to those in the preceding list cannot be used unless they are so qualified. The term eleemosynary may mean charitable but is not acceptable. “Civic welfare,” although listed as a charitable pursuit in the regulations, also does not, standing alone, qualify under (c)(3)—although such words are suitable under (c)(4). Also, combining permissible with impermissible purposes is not acceptable.²⁸ The IRS provides the following examples:²⁹

ACCEPTABLE: “Organization created to serve charitable and educational purposes within the meaning of IRC 501(c)(3).” It is also acceptable “to grant scholarships to deserving junior college students residing in Gotham City.”

NOT ACCEPTABLE: “MD, Inc., will operate a hospital [with no stipulation that the operation be charitable].” Nor is it acceptable to state that “ABC will conduct adult education classes” without also stating that the organization is formed exclusively for educational or charitable purposes.

An organization that has a substantial nonexempt purpose cannot qualify for exemption under (c)(3). Reciting detailed descriptions of the organization's purpose in its charter is not necessarily advisable. Such explanations are more suitably placed in the bylaws or mission statement. An organization's activities tend to evolve over the years and it is best to avoid the need to make formal charter changes that require approval by the state. Bylaws can normally be altered by the organization's governing body. Form 990, in Part VI, Question 4,³⁰ asks if any significant changes to the governing documents were made since the prior Form 990 was filed. In a departure from past instructions, changes are only described in Schedule O; actual changes are generally not submitted. The IRS Exempt Organizations Determinations does not issue letters indicating changes except for a name change, which has no impact on tax-exempt status.

(e) Political Activities

A charity's organizational documents must absolutely prohibit political campaign involvement and use the following language:

The organization shall not participate in, or intervene in activities (including the publication or distribution of statements) on behalf of or in opposition to any candidate for public office.³¹

A campaign management school organized to train individuals for professional careers in managing political races was denied exemption because it was formed to operate to benefit the Republican Party. Most of the school's graduates were associated with Republican candidates and committees supporting them. In its application for exemption, the American Campaign Academy stated it was an outgrowth of a National Republican Congressional Committee project and that its funding was provided solely by the National Republican Congressional Trust. The academy argued that it met all the definitions of a school and did not discriminate on the basis of political preference, race, color, or national or ethnic origins in its admission policies. The Tax Court agreed with the IRS that the facts—actual curriculum and admission applications—showed narrow partisan interests. The court found that the size of the class and number of Republican Party members did not transform the benefited class into a charitable class.³²

Nonpartisan voter registration drives do not constitute prohibited political activity if they are truly nonpartisan.³³ The fact that all candidates in the race are given a platform to discuss universal issues, rather than issues of concern to a particular political party, evidences an educational effort. When the facts indicate that an organization is formed to engage in nonpartisan analysis, study, and research and to conduct educational programs for voters, it may qualify for exemption.³⁴

Legislative lobbying should be limited by the following language: “No substantial part of the activities of the organization shall be the carrying on of propaganda, or otherwise attempting to influence legislation.”³⁵ Note the word “substantial.” A limited amount of lobbying can be conducted by a charity (except a private foundation). Different permissible limits apply to grassroots and direct lobbying efforts.³⁶

(f) Private Foundations

Enhanced requirements are placed on charities classified as private foundations. A private foundation generally is a nonprofit organization qualifying for tax exemption that receives its funding from investment income and/or donations of a limited number of people, usually a family or a particular individual.³⁷ A private foundation's charter, or laws of the state in which it operates, must specifically prohibit actions that would cause the imposition of excise taxes. The required language is automatically incorporated into a private foundation's charter in most states, and the IRS has issued a ruling listing those with approved requirements.³⁸ To be cautious, some counselors recommend inclusion of the prohibition against incurring excise taxes for all foundations, but they may not be necessary.

(g) Limited Liability Companies

A tax-exempt organization might form a single-member limited liability company (LLC) to isolate itself from the risks associated with conducting certain activities. The LLC can choose to seek its own independent recognition of tax exemption, or the single member can treat the LLC as a disregarded entity under the “check-the-box” rules.³⁹ When this form of organization was initially considered, the IRS was uncertain whether the LLC itself could be recognized as a charitable organization, particularly in those states which require that an LLC be formed for a business purpose. In 2001, however, the IRS announced it was willing to recognize exemption based on the LLC's representation that its charitable status is permitted under state law and that enforceable provisions are present in the organizational document.⁴⁰ The 12 specific provisions required for the LLC to be separately recognized as a §501(c)(3) entity follow:

1. A specific statement must limit the LLC's activities to one or more exempt purposes.
2. The LLC must be required to operate exclusively to further the charitable purposes of its members.
3. The LLC's members must be §501(c)(3) organizations, governmental units, or wholly owned instrumentalities of a state or political subdivision thereof.
4. Any direct or indirect transfer of any membership interest in the LLC to a transferee other than a §501(c)(3) organization, governmental unit, or instrumentality must be prohibited.
5. The LLC itself, interests in the LLC (other than a membership interest), or its assets may only be availed of or transferred to (whether directly or indirectly) any nonmember other than a §501(c)(3) organization, governmental unit, or instrumentality in exchange for fair market value.
6. The organizational documents must guarantee that upon dissolution of the LLC, its assets will be devoted to the LLC's charitable purposes.
7. Any amendments to the LLC's articles of organization and operating agreement must be consistent with §501(c)(3).
8. The LLC must be prohibited from merging with, or converting into, a for-profit entity.
9. The LLC may not distribute any assets to members who cease to be organizations described in §501(c)(3), governmental units, or instrumentalities thereof.
10. An acceptable contingency plan in the event that one or more members cease to be qualifying members must be provided. (Forfeiture of the nonexempt member's interest or sale of the interest to a qualifying member is allowed.)
11. The LLC's exempt members must expeditiously and vigorously enforce all of their rights in the LLC and pursue all legal and equitable remedies to protect their interests in the LLC.
12. The LLC must represent that all of its organizing document provisions are consistent with state LLC laws and are enforceable at law and in equity.

Rather than seeking separate recognition, the LLC can be treated as a disregarded entity and its tax-exempt status attributed to its parent member. In that situation, the LLC financial activity is reported on the member's Form 990.⁴¹ Without separate recognition, however, the LLC is not necessarily qualified to receive tax-deductible contributions itself, but may serve as agent for donations collected on behalf of another qualified organization. A Guide Sheet for LLCs issued in 2007 reduced some of the uncertainty while admitting that the rules are not entirely clear. An LLC that is not treated as a disregarded entity will be treated either as a partnership or an association taxable as a corporation.

(a) Charitable Class

To be exempt as a charitable organization under (c)(3), an organization must operate to benefit an indefinite class of persons, referred to as a “charitable class,” rather than a particular individual or a limited group of individuals. It may not be “organized or operated for the benefit of private interests such as designated individuals, the creator's family, or shareholders of the organization or persons controlled, directly or indirectly, by such private interests.”⁵⁴ A trust established to benefit an impoverished retired minister and his wife, for example, cannot qualify.⁵⁵ Likewise, a fund established to raise money to finance a medical procedure, rebuild a house destroyed by fire, or provide food for a particular person does not benefit a charitable class. An organization formed by merchants to relocate homeless persons (“throw the bums out”) from a downtown area was found to serve the merchant class and promote their interests rather than those of the homeless or the citizens.⁵⁶ Similar to the decision in the Westward Ho case, the IRS ruled that undocumented aliens served by the proposed organization were not members of a charitable class, so the organization did not qualify for tax exemption. The IRS reasoning was that American workers also incidentally don't constitute a qualifying charitable class when similar facts exist. The criteria proposed by the applicant did not show objective evidence of poverty or distress for the aliens.⁵⁷ In explaining the meaning of the word charitable, the regulations also deem federal, state, and local governments to be a charitable class by stipulating that relieving their burdens is a form of charitable activity qualifying for §501(c)(3) exemption.⁵⁸ A financial assistance program formed by a for-profit security company to give aid to families of persons injured or killed on the job did not qualify for charitable exemption because the program provided a substantial private benefit that represented self-dealing by the company's private foundation. Another way to view this decision is that the program did not serve a broad enough charitable class.⁵⁹

A comparatively small group of individuals can be benefited as long as the group is not limited to identifiable individuals, but the distinction is not always clear. The class need not be indigent, poor, or distressed.⁶⁰ A scholarship fund for a college fraternity that provided school tuition for members was ruled to be an exempt organization.⁶¹ On the other hand, a trust formed to aid destitute or disabled members of a particular college class was deemed to benefit a limited class. The “general law of charity recognizes that a narrowly defined class of beneficiaries will not cause a charitable trust to fail unless the trust's purposes are so personal, private, or selfish as to lack the element of public usefulness.”⁶² Criteria for selection of eligible beneficiaries should be specified and used to choose eligible individuals—case histories, grade reports, financial information, recommendations from specialists, and the like—should be maintained.

It is not necessarily the size of the class but a limitation of the class to specified individuals that may indicate private benefit. This standard is not, however, necessarily applied consistently. For example, schools can have admission standards that, unless they result in discrimination,⁶³ cause them to serve a very narrow class of students. Similarly, hospitals are not absolutely required to serve those who cannot pay.⁶⁴ Victims of a disaster unquestionably represent members of a charitable class. The issue is, however, the type and extent of aid that can be given to individuals by a charitable organization. A “needy and distressed” test was provided by the IRS as guidance to those organizations handling the outpouring of support given in response to the September 11 disaster. This test was refined in Publication 3833, Disaster Relief: Providing Assistance Through Charitable Organizations, revised in December 2014 and still viable. Disaster plans of company-sponsored charities may be acceptable when the awards do not satisfy a legal obligation of the company and the plan is not used to recruit or retain employees.⁶⁵

Disaster relief was again the top item on the IRS website for charities and nonprofits in September 2005, as nonprofits and individuals sought information about aid to victims of Hurricane Katrina. The website emphasized the fact that disaster aid must be provided to a charitable class. Such a group must be “large or indefinite enough that providing aid to members of the class benefits the community as a whole.”⁶⁶ As an example, aid cannot be “limited to specific individuals, such as a few persons injured in a particular fire.” The publication distinguishes between providing aid to relieve immediate needs, such as food and clothing, and long-term needs, such as replacement of housing or earning capacity of a deceased person. The “needy and distressed” test and other criteria that the IRS expects to be applied by organizations providing disaster funding must be applied.⁶⁷ The criteria applied by a relief organization to objectively make distributions to individuals, financially or otherwise distressed, must be written and records maintained to support the basis on which assistance is provided.⁶⁸

A genealogical society tracing the migrations to and within the United States of persons with a common name was found to qualify as a social club, not a charity. Although there was educational merit in the historical information compiled, the private interest of the family group predominated.⁶⁹ If membership in the society is open to all and its focus is educational—presenting lectures, sponsoring exhibitions, publishing a geographic area's pioneer history—an organization may be classified as charitable.⁷⁰ In contrast, a society limiting its membership to one family and compiling research data for family members individually cannot qualify.⁷¹

A hospital providing medical care unquestionably performs a charitable service: the promotion of the health of its patients. When a for-profit company manages the hospital, however, the interests of private investors may be found to contravene tax-exempt status.⁷² To be recognized as a charity, such a hospital must show that there is not more than an insubstantial private benefit given to the investors. The hospital cannot convey “a priority right of beneficial interaction to a select and identifiable person or group,”⁷³ in a fashion similar to the way the American Campaign Academy program's to train political volunteers for the Republican Party advanced the narrow partisan interests of the party rather than its many students and party members.⁷⁴

A simple way to prove that an organization operates to benefit a charitable class is for the organization to make grants to one or more other §501(c)(3) public charitable organizations. Congress imposed such a system on private foundations in 1969 to constrain their grant-making freedom.⁷⁵ Private foundations can make grants to individuals and nonpublic entities for a charitable purpose, but only if they enter into a formal contractual agreement with the grant recipient or obtain IRS approval in advance for individual grant programs. Although there are no such formal rules for public charities, a similar burden to prove that grant funds reach a charitable class exists.

New Faith, Inc. lost its tax-exempt status for lack of evidence that it served a charitable class.⁷⁶ The organization operated canteen-style lunch trucks and argued that the food was provided to needy persons on a donation or “love offering basis.” The evidence found lacking by the court included:

• There was no record of the number of persons, if any, receiving food items for free or below cost nor of the number of customers who were impoverished or needy persons.
• No tally of sales below fair market value was maintained.
• Written statements of the organization did not show that food was offered to anybody free or below cost.

A subset of this issue concerns designated funds. A charity must take responsibility and maintain dominion and control over the use of its funds. It cannot act as a conduit for funds directed to be paid to particular individual scholarships, medical emergency grants, a foreign organization, religious “deputies,” or other grant recipients for which a donor is not entitled to claim a contribution deduction if the payment is made directly to the ultimate recipient.⁷⁷ Another aspect of the issue is whether the organization accepting the conduit donations can qualify as a public charity or rather as a private foundation.

Serving both charity and an individual is also not permitted. A split-interest trust paying a fixed annual percentage of its income to its creator and the balance to a named charity is not exempt.⁷⁸ Nor is a trust paying a fixed annual sum for perpetual care of the creator's cemetery lot, with the balance paid to charities.⁷⁹

Dormancy: Inactivity is often deemed to be an indicator that an organization is not operating for a charitable or other tax-exempt purpose. Many private letter rulings are issued each year that revoke tax exemption for this reason. Inactivity, or no regular exempt program or financial activity, is the basis of the rulings. Words used in rulings may be “operations have not been conducted or planned or entity has not been operating in the manner and for a purpose significantly different from the manner of operation and purpose for which it was granted exempt status.”⁸⁰

How long is too long is not stated or clear. Typically such rulings do not disclose length of time the inactivity or dormancy has taken place. A good reason for the condition might be that the organization lost its funding and has been spending time (albeit unsuccessfully) raising money to enable it to recommence exempt activities. Maybe local licensing laws authorizing activity changed and reauthorization is expected in the next year. Prudence would dictate that an organization in such a situation should continue to file one of the Form 990s to disclose the reasons for its inactivity, so as not to be automatically revoked.⁸¹

When a Form 990-N is being filed electronically to signal less than $50,000 of revenue, caution is needed in answering the last item (8) on the form. It asks for “If applicable, a statement that the organization has terminated or is terminating (going out of business).” This response could lead to revocation of exemption. In some instances, filing of Form 990-EZ disclosing reasons for inactivity that one cannot disclose with an electronically filed 990-N may be useful.

(b) Amount of Charitable Expenditures

IRC §501(c)(3) does not generally require a specific amount of annual expenditures by a charitable organization, although the IRS may impose a commensurate test.⁸² Presumably, it is left to the contributors and supporters of an organization to require that their money be spent for worthy causes and to monitor the manner in which funds are expended. Some states have rules governing spending by nonprofit organizations to monitor particularly the level of administrative and fund-raising costs in relation to program costs.

A private foundation, partly because it is not scrutinized by public contributors, is subject to a minimum distribution requirement. At least 5 percent of the average annual value of its investment assets must be expended annually in making grants, conducting programs, or purchasing assets used in charitable activities.⁸³

A subset of this issue is the inurement test.⁸⁴ A nonprofit cannot qualify as a §501(c)(3) organization if more than an insubstantial amount of its expenditures are devoted to activities that do not advance its exempt purposes.⁸⁵

Additionally, the IRS has revoked exemption for organizations with no activity.⁸⁶ In this ruling and several others, they cite the section of the regulations entitled Primary Activities that says, “An organization will be regarded as ‘operated exclusively’ for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of such exempt purposes specified in section 501(c)(3). An organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.”⁸⁷

(c) Income Accumulations

There is no prohibition per se against a (c)(3) organization accumulating revenues in excess of its expenditures. Nonetheless, a criterion applied by the IRS to measure whether an organization operates exclusively for charitable purposes is the portion of its revenues actually expended on charitable projects. Where funds are accumulated, the organization has a burden of proving to the IRS and those from whom it is seeking financial support that its charitable purposes are better served by increasing its resources.

This issue arises particularly in connection with publicly funded charities—those organizations that annually raise funds to support their programs through donations or fees charged for services rendered (often both). When fund-raising efforts are unusually successful, operations are cost efficient, or for whatever reason an organization generates revenues in excess of expenses, these questions arise: Will the excess revenues jeopardize exempt status? Can the organization save the income? Must it spend it and, if so, how soon? Some profit—excess of revenues over expenditures—can be accumulated so long as the purpose for increasing fund balances is to better advance the charitable interests of the organization over a period of time. Acceptable reasons why funds might be accumulated include:

• To maintain sufficient working capital to ensure ongoing, continuous provision of charitable services. Working capital can be saved to protect against years when income declines due to loss of grants, lower donations, reduced investment income, and other uncontrollable outside forces. Ask how investors would view the accumulated funds. Liquid assets equal to one year's operating budget are thought by some to be a minimally reasonable amount of working capital, though some agencies may consider such an asset level too high.
• To replace obsolete equipment, to acquire a new building, or to establish a new program dedicated to charitable purposes. Saving funds until the organization can self-finance new or improvement projects may be prudent because it allows the organization to avoid indebtedness. In other instances, a sinking fund might be established to ensure that the organization meets its annual obligation to pay off the mortgage on a new building.
• To establish new programs or expand services for charitable constituents when the funds required exceed current available resources. Savings to self-finance expansion can be accumulated.

Another way to measure permissible net asset levels is to ask whether the amount of assets held represents a substantial nonexempt purpose. Ask why the organization is accumulating profits rather than using them to accomplish tax-exempt purposes.⁸⁸ The same test used to determine whether a for-profit has accumulated excess assets subject to the accumulated earnings tax can be applied to judge whether a charitable organization has excess net assets.⁸⁹ Plans for use of assets for charitable programs should be demonstrable, specific, and feasible.⁹⁰ Plans to use accumulations need not be immediate, but should be scheduled within a reasonable time depending on all the facts and circumstances relating to the future needs of the organization.⁹¹ A religious organization with a $500,000 annual budget, which accumulated more than $5 million and had no concrete plans for the funds, was found to have a substantial nonexempt purpose.⁹²

Spending standards for private foundations, however, are specified by the tax code that requires annual charitable spending of only 5 percent of the fair market value of investment assets each year.⁹³ The level is determined without regard to the actual annual return on investments; a foundation that is able to earn above 5 percent on its assets may accumulate its excess income.

(d) Commensurate Test

The commensurate test asks whether the organization's expenditures are proportionate in relation to its financial resources. The theory was espoused in 1964 in looking at what fraction of an organization's assets could be invested in unrelated business activities.⁹⁴ In addition to operating exclusively for charitable purposes, a charity's primary purpose must also be charitable. The distinction between the two tests is blurry, and no exact mathematical test is provided. It is sufficient to say that both must be satisfied to ensure maintenance of exempt status. The IRS scrutinizes fund-raising organizations with professional fund-raisers to see whether they receive an excessive portion of the funds they raise for the charity. State charitable regulators are also concerned and may have specific limitations on such payments.

The commensurate test was used to challenge the exempt status of United Cancer Council, Inc. (UCC), a charity that solicited funds by mail. Out of more than $7 million raised during 1986, UCC spent less than $300,000 on patient services and research and paid the balance to its fund-raising counsel, Watson & Hughey.⁹⁵ A nonprofit whose sole purpose is to raise money for other organizations must devote or pay a sufficient amount of the money it raises to charitable purposes to qualify for exemption under §501(c)(3). Other aspects of its operations and policies may also be indicative of its charitable nature. In one instance, an entity organized to conduct an annual golf tournament agreed to the following IRS (arguably too strict) conditions to qualify for exemption:⁹⁶

• All net income was payable to other §501(c)(3) organizations.
• Recipient organizations were local charities chosen on the basis of their community involvement, use of the funds, and fund-raising ability.
• Grants would not be related to the recipient's volunteer efforts toward the annual event.
• Charitable aspects of the tournament were emphasized in publicity materials about the event.
• The mission statement was printed in the tournament program.
• New board members who better reflect charitable interests and broadly represent the community would be added to the board.

In meeting the commensurate test, the way in which the organization's revenues are expended, rather than their source, is determinative. A private foundation is recognized as exempt even though it expects to receive all of its income from passive investment sources.⁹⁷ The IRS says, “It is well established that organizations that do nothing but make contributions to other charitable organizations can qualify for exemption.”⁹⁸

(e) Business Activity

The receipt of unrelated business income can jeopardize an organization's exempt status. An organization that conducts a trade or business as a substantial part of its activities can be exempt only if the operation of the business furthers its exempt purpose; that is, it is related. The primary purpose of an organization exempt under (c)(3) must not be to carry on an unrelated trade or business.⁹⁹ What is meant by “substantial” is not numerically expressed, but instead measured by taking all of the facts and circumstances of the organization's operations into account. The size and extent of the trade or business in relation to the organization's exempt activity is determinative. The customary measure of primariness is the portion of the organization's overall budget produced by the business and the time expended by its managers on business versus charitable activities. The IRS has said it is likely the exempt status of an organization will be revoked where it regularly derives over one-half of its annual revenue from unrelated activities.¹⁰⁰ The regulations, however, provide no specific numerical percentage level.

The Second Circuit Court of Appeals thought one-third was excessive.¹⁰¹ Another court indicated that a safe level of unrelated income would be less than 20 to 25 percent of the organization's overall revenues.¹⁰² An organization working with mentally challenged children was allowed to retain its tax-exempt status despite the fact that more than 98 percent of its revenues and more than 95 percent of the expenditures pertained to a bingo operation.¹⁰³ Similarly, an organization operated to help needy women retained its tax exemption despite the fact that it gained about 65 percent of its revenues from operation of an unrelated tearoom and gift shop operated alongside a shop in which it displayed and sold goods made by the women.¹⁰⁴ Though confusing and sometimes difficult to apply, the fact that a quantitative test does not exist for determining the amount of permitted unrelated business activity allows an organization to be relatively aggressive in pursuing revenue-producing activities so long as its primary activity is charitable.¹⁰⁵ When an organization conducts activities beyond the scope of those described in its exemption application, the IRS expects disclosure of the changes on the annually filed Form 990 rather than submission of a new Form 1230. The IRS may, when changes are not so reported, choose to revoke its original approval. An entity approved for §501(c)(3) status based on proposed educational work was found to be providing commercial services and instead operating as a business. The original purpose was to be “a consulting business specializing in regulatory compliance for the agricultural industry; specifically, to provide compliance-related educational material[s], training and computer programs, and on-site inspection services to farms and farm retailers.” The IRS found that the services were paid for as part of member assessments to promote businesses located in a metropolitan area, with all members being for-profit businesses. The decision noted that their application for exemption, which had stated their purpose to be “a consulting business,” did not specify scaled fees for poor farmers, reducing the impact of pesticides on the environment, or other evidence of charitable motive. The fact that their “educational work” was provided to for-profit customers might have qualified for exemption, but the court concluded that the education work was tied to the fees members paid. There were no scaled fees or other evidence of charity. The fact that excessive salaries and high rent were paid to the principals, though not so stated, seemed to evidence a profit motive for the work performed. Exemption was revoked.¹⁰⁶

The operation of a trade or business that furthers, or is related to, an organization's exempt purposes is permitted. Proving that a business is related, rather than unrelated, may be necessary for an organization to achieve or maintain exempt status. In evaluating the relatedness of a business enterprise, the purpose toward which the activity is directed, rather than the nature of the activity itself, determines whether the activity serves an exempt purpose.¹⁰⁷ In other words, if a resale shop run by workers who have disabilities provides a livelihood for workers not otherwise able to support themselves, the fact that the shop is in business competing with commercial resale shops does not prevent relatedness. Consider Goodwill Industries: As a part of a job-training program, handicapped workers repair and refurbish furniture and other items for resale. The primary motivation is to provide training and livelihood for the disadvantaged workers (a charitable purpose), not to operate the stores. An unlimited amount of such related business activity is permitted.

The profit from business activity that is unrelated to the organization's exempt purpose is subject to income tax. Chapter 21 discusses the complex issue of permitted amounts of unrelated business activity, methods of calculating the tax, the many exceptions, and the commerciality test. Spinning excess business activity off into an independent subsidiary corporation saved the exemption application for the Ark Environmental Foundation U.S., Inc. Because a substantial part of its activity was the sale of environmentally friendly products, exempt status was initially denied in the key district. The national office, upon reconsideration, decided that if a truly separate subsidiary were created with a bona fide business purpose, exempt status would be available for the parent.¹⁰⁸

In considering the permissible level of business activity a tax-exempt organization can safely perform without endangering its exempt status, rulings have added helpful words to this somewhat vague definition in addition to the profit motive and commerciality test applied in identifying unrelated business income.¹⁰⁹ A business is broadly defined in the regulations to include any activity carried on for the production of income from the sale of goods or performance of services.¹¹⁰ It is important to study the older published rulings and newer private rulings for context in identifying such activities with a view to evaluating excessive business activity.¹¹¹

Texas A&M Professor Terri Helge conducted a study of §501(c)(3) exempt applications between 1/1/14 and 1/1/16.¹¹² She found that 91 percent of the IRS denials were based on consideration of the operational test focused on four factors:

• Substantial commercial activity (50 percent)
• Substantial private benefit (53 percent)
• Activities did not meet any specific tax code category (34 percent)
• Activities violated a “public policy” standard (2.4 percent)

(f) Importance of Sources of Support

The classic (c)(3) organization receives its financial support from voluntary contributions and from investment income produced from contributions it retains in an endowment or working capital fund. Its charitable nature is evidenced by its ability to attract such donations (one-way-street gifts) in support of its activities. The IRS applies support ratio tests in its determinations and examinations.¹¹³ Support coming from a limited group of donors may dictate or result in private foundation status. An absence of, or a limited amount of, donations may imply noncharitable status.

The level of public support normally differs according to the type of organization. For example, a grant-making United Fund would receive the bulk of its revenues from donations; a university would receive a sizeable part of its revenues from student tuition (exempt function income). Chapter 11 details the definition of various categories of public charities and requirements for obtaining public status.

(g) Action Organization

An organization whose purposes can be accomplished only through the passage of legislation changing local, state, or federal laws is called an action organization and cannot qualify for exemption as a charity under (c)(3).¹¹⁴ When a substantial part of the organization's activity is attempting to influence legislation by propaganda or otherwise, it is considered an action organization. Attempting to influence legislation means:

• Contacting or urging the public to contact members of a legislative body (the Congress, any state legislature, local council, or similar governing body or the public in a referendum) for the purpose of proposing, supporting, or opposing legislation, or
• Advocating the adoption or rejection of legislation.

The test of whether an organization's legislative activity is substantial is applied subjectively, with no specific mathematical test. One early case applied a 5 percent limitation.¹¹⁵ In another case, the use of a percentage test was rejected and instead the balance of an organization's activities in relation to its objectives and circumstances was considered.¹¹⁶ Due to the uncertainty, Congress added an elective test containing percentage limitations for measuring permissible lobbying—the expenditure test of IRC §501(h).¹¹⁷

Another kind of action organization is one that participates or intervenes, directly or indirectly, in any political campaign on behalf of or in opposition to any candidate for public office—an activity prohibited for a (c)(3) organization. Chapters 6 and 23 discuss these rules in detail, including when to consider the formation of a (c)(4) organization.

(h) Feeders and the Integral Part Test

Each separately organized nonprofit organization must seek to qualify for exemption unless it is included in a group exemption.¹¹⁸ For legal and/or management reasons, an existing nonprofit may create another organization to conduct high-risk activities, to hold investment assets, or for a variety of other reasons. The new nonprofit can qualify for exemption if it performs essential services directly to or for its parent or affiliate or to the class of direct beneficiaries of the exempt activities of its parent.¹¹⁹ Such an entity is said to be an integral part of the parent. Services can be rendered to the natural constituency of its creator, such as the students and faculty of a university or the patients of a hospital. The affiliate can be exempt despite the fact that it makes a profit from its dealings with the parent organization. It cannot, however, be exempt if its activities would produce unrelated income in the hands of the parent.

The relationship between the related organizations is significant. Performing services for a group of similar, but unrelated, organizations is an unrelated activity.¹²⁰ The regulations say that “an exempt organization is not related to another exempt organization merely because they both engage in the same type of exempt activities.”¹²¹ Being an integral part essentially means to operate as a subsidiary of, although the nature of the control relationship is not stipulated. In one situation, the IRS asked whether the services are essential to the exempt functioning of the group.¹²² The word feeder is used to describe an organization that provides or conducts an unrelated business (provides its services or sells products to unrelated parties) and pays all or feeds its profits to one or more other exempt organizations. Feeder entities are specifically prohibited from exempt status by IRC §502. A separately incorporated nonprofit entity selling pharmaceuticals to a hospital's patients would qualify for exemption only if the nonpatient sales were insubstantial. It would have to prove that its primary purpose was to sell drugs to patients to be classified as an integral part.

An IRS ruling provided a good illustration of the type of relationship it expects to exist between organizations for the service provider to be considered an integral part. Provision of services by one member of a related group of organizations to others in the group is not treated as an unrelated activity if the services rendered are essential to the exempt functioning of the group so as to satisfy the integral part test. In the ruling, “College” provides a wide range of services, including campus security, telephone and mail service, steam plant, financial services, auditorium, faculty house used for meals and meetings, medical center, library, and interfaith fellowship center, to its related “small colleges around a library.”¹²³ Though each entity was legally separate, College's constitution and bylaws provide for a council made up of the presidents of each college in the group to provide policy guidelines on the administration and development of common programs and facilities. Thus, sufficient control and close supervision were exercised by the group in relation to College to satisfy the structural relatedness requirement to avoid classification of College as a feeder organization.

(i) International Activities

A tax-exempt organization is entitled to pursue its mission anywhere on Earth; the tax code imposes no geographic limitations. It is the motivation for conducting an activity, not its situs, that determines its character for tax purposes. So long as the fashion in which the activities are conducted meets the requirements outlined in Chapters 3 through 9, the location in which they take place is unconstrained. The tax home of a nonprofit organization, however, influences the deductibility of the payments it receives. For U.S. tax purposes, a qualifying charitable contribution is a “gift to or for the use of a State, a possession of the United States, or the United States or the District of Columbia” used exclusively for public purposes, or to a U.S.-based corporation, trust, or community chest, fund, or foundation¹²⁴ that satisfies the organizational and operational tests outlined in this chapter. A donation to a foreign charity is not deductible for U.S. tax purposes, but a donation to a U.S. charity that conducts foreign programs may be deductible. The charity that solicits gifts earmarked for foreign programs must retain the ultimate control over disposition of the funds to avoid a situation in which the donors are deemed to have made a gift to a foreign charity.¹²⁵ Private foundations that support foreign organizations that have no recognition as qualifying public charities must take additional steps to document such grants.¹²⁶

(j) The Internet and Tax-Exempt Organizations

Most exempt organizations use the Internet as a means of conveying and accomplishing their mission. Opportunities to provide links between an organization's website and other sites on the World Wide Web abound, making it important for tax-exempt organizations and advisors to familiarize themselves with the impact of using electronic communication systems on their tax-exempt status.

Exempt Status Issues. To obtain recognition and to maintain tax-exempt status, a nonprofit organization must be dedicated to and devote its primary energies to conducting activities that accomplish a qualifying exempt purpose. The standards for qualification under the different categories of §501(c) are well defined and documented in the Treasury Regulations, in Internal Revenue manuals, in countless published and private IRS rulings, and in court decisions discussed in Chapters 3 through 9 of this book. The IRS agrees that the offline standards apply in making determinations about the character of electronic communication activities on the Web. Logically, the tax code and regulations should be applied consistently without regard to the medium in which activities are conducted. The history of IRS consideration of this issue is instructive.

In 1974, the IRS approved exemption for a regional computer network for a consortium of colleges and universities because it advanced education.¹²⁷ In 1981, a computer network to exchange bibliographic information between libraries was also ruled to be a 501(c)(3) organization, even though some of its members were not tax exempt.¹²⁸ 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.¹²⁹ IRS technicians began to peruse the Internet Service Provider home pages 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 creates unrelated business income. The IRS in 1999 said, “Internet Service Providers (ISPs) 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.”¹³⁰

The IRS challenged the tax exemption of an organization that provided Internet services to the public which described itself as a community-based public-access information and communications nonprofit. A council of community representatives managed the program, and its services were provided primarily¹³¹ by volunteers. Nonetheless, providing 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, such as relieving the burdens of government. What did qualify as charitable was operation of the ISP to serve only low-income individuals and other charitable organizations on a substantially below-cost basis. By transferring the unrelated (full pay to general public) ISP to a for-profit subsidiary, the organization was allowed to maintain its tax-exempt status.¹³²

The IRS has approved exemption applications for Internet-related organizations, including a virtual educational organization that disseminates information and another that conducts fund-raising for other organizations totally via the Internet. Groups claiming exemption as Internet churches, however, have been granted tax-exempt status as religious or educational organizations, but not allowed church status. The IRS has said a church cannot operate in cyberspace because an online group cannot, in their view, meet an “associational” test in addition to meeting the 14-point test for church status. They apparently believe a regular congregation cannot exist electronically.¹³³ Similar to its position on Internet churches in a private ruling, the IR determined that a sorority could not qualify for exemption because “commingling and the promotion of fellowship are not a material part of your operations. Commingling is a necessary and material part in the life of an organization exempt under § 501(c)(7) and is deemed present if such things as meetings, gatherings, and regular facilities are evident.”¹³⁴ Again, the medium for accomplishing the charitable or other nonprofit mission should not, per se, deprive an organization of eligibility for exempt status. What is the reason religious worship services cannot be provided to a virtual congregation solely on the Internet? Why not an e-marriage? Why do spiritual ceremonies have to take place in a physical space?

Providing Information. The publication of information pertaining to the organization's mission and program activities for free on its own website is certainly an exempt activity. A site containing basic information about rate schedules, grant applications, deadlines, admission standards, locations, caregiver resumes, and any other information describing the services it provides simply replaces brochures and reports available on paper. Dissemination of information through the Internet to advance the accomplishment of exempt purposes is permitted. A site might also contain a bulletin board for constituent communication, such as a parent forum concerning child care issues. Linking the site to those of other tax-exempt organizations that contain reference materials, services, or resources pertaining to its exempt function is an exempt activity. For example, a child care provider can link its site to a mental health agency, to the school district, to the association of child psychiatrists, or to a child protective services agency. Links that might cause concern regarding exempt status or produce unrelated business income are discussed later in this section. Publishing information pertaining to legislation and elections on an organization's website will have different consequences to the different types of exempt organizations, as outlined in Chapter 23. Because information on a website is available for all to see, the rules pertaining to communicating with an organization's members will not necessarily apply.

Providing Services. Selling services and information that advance the mission to an organization's constituents on the Internet can be an exempt activity. A business league that sells legal forms to industry members to provide common conveyance documents that avoid controversies was allowed to do so electronically.¹³⁵ An organization that provides counseling, resource information, and transportation assistance to disabled and elderly people can do so through its website.¹³⁶ A legal aid society can provide advice and documents electronically.¹³⁷ Providing bibliographic information to libraries has been found to be an exempt function; by reference, such an exempt service can be provided on the Internet.¹³⁸ An entity formed to design wireless phone applications to facilitate collection and electronic transmission of donations to charities and to conduct educational conferences attended mostly by wireless carriers and businesses focused on collection of charitable donations through mobile technologies was denied exempt status despite the fact that no charges would be imposed. The expressed need for the organization was the unwillingness of wireless mobile carriers to provide administrative support to charitable organizations for this purpose. They proposed to help nonprofits to facilitate communications with donors, provide written contribution receipts, and maintain donor records.¹³⁹

The IRS continues to distinguish between services that accomplish a charitable purpose and those they deem to administrative and clerical commonly conducted by the business community and not unique to the charitable sector, particularly when it involves electronic media.¹⁴⁰ During 2014, they applied this opinion to refuse to approve exemption for an organization formed to provide information access to unserved and underserved business communities and to prevent business deterioration in minority communities through technology.¹⁴¹

Fees for Internet Activities. When information, goods, or consulting services are sold on an organization's website, however, the activity may or may not be considered exempt. For all categories of tax-exempt organizations, the character of revenues generated through a website and delivery of services in connection with electronic communication will depend on the relationship between the activity generating the revenue and accomplishment of the organization's exempt purposes.¹⁴² Any charges made by the organizations described in the preceding paragraph would represent exempt function revenues related to their mission. In considering other situations, the standards for defining relatedness under IRC §513 and the labyrinth of exceptions and modifications applied in calculating taxable income under IRC §512 can provide answers. Undoubtedly, the irregular activity exception will not normally apply to items available for sale on a site. Also, without question, using a website in a commercial fashion or providing Internet services to the general public constitutes unrelated activity. What constitutes exploitation for different types of exempt organizations, however, is determined by existing rulings and court decisions discussed in Chapters 3 through 9 and §21.8(j).

Links. The one issue unique to the Internet may be the capability of linking an organization's website instantly and without any charge to another website. Links can be considered from the vantage point of several different tax consequences.

Links that serve an exempt purpose. The child care provider previously mentioned would be making related links when it connects its site to a mental health agency, to the school district, to the association of child psychiatrists, or to the child protective services agency. Links to sites of sponsoring organizations that provide benefits to an agricultural association's members' businesses, as a part of its listing information on its own website, was found to serve an exempt purpose.¹⁴³

Links that create unrelated business income. Links to the sales pages of a business sponsor's site could create taxable advertising income, depending on the content of the linked site.¹⁴⁴ Sale of goods or services unrelated to the organization's objectives, including those fragmented from a group of related items, creates unrelated business income. Commissions or fees rebated to the organization from commercial business sites may produce related or unrelated income, depending on the type of items sold. An educational organization that sells its own publications through a link to Amazon.com receives related revenues for its share of the book sales. An organization dedicated to literacy that encourages reading might be allowed to treat the Amazon revenues as related. The rebate it receives because it prompted a visitor to its site to link to Amazon's site, however, is a commission that may be considered unrelated income. Some say such a link need not be related to the organization's mission. That view says the rebates are royalties eligible for exclusion from unrelated business taxable income (UBTI) for the use of the organization's intangible property—the visitors to its website.¹⁴⁵ They ask why a link is any different from a name on a mailing list, though to date the IRS has indicated that it expects such revenues should be treated as active business income.

Links that represent nonexempt activity. A link that promotes the private interests of the organization's disqualified persons constitutes a nonexempt activity.¹⁴⁶ An example of such inurement occurs for a cancer treatment research group that links only to the clinic site of its creator, an oncologist. Linking a site of any category of exempt organization to privately owned business(es), if the activity it represents is substantial in relation to other organizational functions, could threaten an organization's exempt status. Whether an organization's exempt status is endangered by such link activity is measured by the standard that requires it to operate primarily for tax-exempt purposes. Links to a particular political party's site would be impermissible for (c)(3) and possibly (c)(4) organizations.¹⁴⁷ Unbiased links to all parties might be considered voter education rather than intervention in a political campaign. There is no specific limitation on electioneering by a labor union or business league, for example, so that links to a particular political candidate or party may be acceptable from a tax standpoint. The Federal Election Commission (FEC) sanctioned a site called DNet.org established by two 501(c)(3) organizations to provide nonpartisan information on candidates to encourage an online debate between candidates.¹⁴⁸

Links that cause penalties. Certain nonexempt function links could subject the organization to penalties. For a private foundation, the self-dealing and taxable expenditure sanctions would impose a penalty for impermissible links. The cost associated with links that constitute political expenditures would be reportable as taxable income on Form 1120-POL and also subject to either the §4955 or §4945 penalty and reported on Form 4720.¹⁴⁹ The IRS website contains minimal references to Internet postings, links, and social media activities such as Facebook, Twitter, and LinkedIn.¹⁵⁰

Other Internet Issues. There are a number of issues beyond the scope of this book that should be mentioned. Nonprofits conducting activities from a Web page should seek assistance in answering the following questions (among others the author is not qualified to suggest):

• Must any state sales tax be collected for sales of goods or products?
• Do the materials published on the organization's site, or sites to which it is linked, involve legal issues concerning intellectual property rights, invasion of privacy, or defamation of character issues, and so on?
• If contributions or memberships are solicited on the website, must the organization report its fund-raising activity in any states from which it receives donations? Should disclosures about the organization's financials be shown on the site?

Fund-Raising Issues. The donor solicitation disclosures rules apply to charities,¹⁵¹ civic welfare organizations,¹⁵² labor unions, and business leagues that seek donations, membership dues, and other forms of payments in support of (or to qualify for participation in) a tax-exempt organization's programs on the Internet. To be able to claim a deduction for a donation of $250 or more to a §501(c)(3) organization, the donor must have a written receipt. Such “contemporaneous substantiation” must reflect the amount of the payment and a statement reporting whether any goods or services were provided in connection with the gift—and if so, the worth of those goods or services. The disclosure of the value of benefits provided in a quid pro quo solicitation can be conveyed in electronic form.¹⁵³

(k) Governance

Led by Steve Miller, then-chief of the Tax-Exempt and Government Entities Division, the IRS in 2005 initiated an emphasis on improving the governance of tax-exempt organization. Form 990 was revised as the first governance queries appeared. New Part VI, Governance, Management and Disclosure, was added as part of an extensively expanded Form 990. The practices the IRS recommends organizations follow to achieve appropriate oversight of activities are embodied in Part VI. Most would agree that it is appropriate for a nonprofit organization—the very essence of which is to operate to benefit its constituents rather than those who control it—to have a conflict-of-interest policy. But the form implies that such a policy, plus other governance practices, is required. Though the IRS instructions reassure filers that “No” answers will not necessarily lead to examinations, some filers worry. It is important that each nonprofit required to file the Form 990 study this part to consider its existing policies in view of those the IRS considers necessary for governing a tax-exempt organization. The IRS Governance Project Guidesheet used by examiners can be used to learn the issues of concern.¹⁵⁴

The IRS EO FY 2017 Annual Report and FY 2018 Work Plan can be studied for results of information gathered with the Guidesheets. The principal factors they found associated with compliance for organizations reviewed included:

• Entity has a written mission statement.
• Comparability data were always used when making compensation decisions.
• Controls were in place to ensure the proper use of charitable assets.
• Form 990 was provided for review by the entire board of directors before filing.

Entities with control concentrated in one individual, or in a small, select group of individuals, were associated with noncompliance.¹⁵⁵

By 2009, the IRS accelerated its denial of exemption for organizations that are governed by the founder and his or her family members and, therefore, lack an independent, community-based board of directors.¹⁵⁶ This position is not necessarily supported by the tax laws, without evidence that the organization fails to operate to benefit its exempt constituents rather than those board members.

The IRS refined this position in 2012, saying the fact that an exempt organization has a “small and closely related board” alone is not enough to deny exemption. Other factors, such as insider compensation or other financial transactions providing private inurement, combined with a board controlled by persons involved, would indicate disqualification.¹⁵⁷ Note that it is traditional, and long permitted by the IRS, for private foundations to be governed by the founder(s) and family members.

The 2020 Form 990, Part VI, says “This Section B, Policies, requests information about policies not required by the Internal Revenue Code.”

(l) Economic Substance

Economic substance is a tax law doctrine under which a transaction must have an economic purpose aside from reduction of tax liability in order to be considered valid. The IRS applies this doctrine to determine whether tax shelters, or other strategies used to reduce tax liability, are “abusive” and in violation of tax laws. Courts over the years have been in conflict about its application. The doctrine was adopted into law as part of the Affordable Care Act and could have some impact on tax-exempt issues for nonprofit organizations.¹⁵⁸

The new code section essentially says that tax benefits are not allowable if the transaction does not have economic substance or lacks a business purpose. It also provides that, in the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if:

• The transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position, and
• The taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction.

As a result, enactment of §7701(o) resolved the longstanding conflict among various circuit courts of appeal regarding how the doctrine should be applied by codifying a two-part conjunctive test.

In addition, a strict liability penalty of 20 percent (40 percent for undisclosed transactions) can be imposed on any underpayment attributable to the disallowance of claimed tax benefits by reason of the application of the economic substance doctrine or failing to meet the requirements of any similar rule of law.¹⁵⁹