(a) General Rules

Basically, a tax-exempt organization will be a nonprofit corporation, trust (inter vivos or testamentary), or unincorporated association.² Exempt charitable and social welfare organizations may be formed as limited liability companies,³ although the IRS has suggested that this form of entity may be inappropriate for exempt social clubs.⁴ Some provisions of the Code, however, mandate, in whole or in part, the corporate form,⁵ and other Code provisions (particularly in the employee plan context) mandate the trust form for exempt organizations.⁶ Throughout the categories of exempt organizations are additional terms such as clubs, associations, societies, foundations, leagues, companies, boards, orders, posts, and units, which are not terms referencing legal forms. For tax purposes, an organization may be deemed a corporation even though it is not formally incorporated.⁷

The federal tax provision that describes charitable organizations provides that an organization described in that provision must be a corporation, community chest, fund, or foundation; only the first of these terms has any efficacy in law. An unincorporated association or trust can qualify under this provision, presumably as a fund or foundation or perhaps, as noted, as a corporation.⁸ A partnership cannot, however, be tax-exempt as a charitable organization.⁹

An organization already exempt from federal taxation may establish a separate fund or like entity that is itself an exempt organization.¹⁰ The attributes of this type of fund include a separate category of exemption (e.g., an educational research and scholarship fund established by a bar association),¹¹ a separate governing body, and separate books and accounts.¹² A mere bank deposit cannot, however, amount to a requisite fund.¹³

For purposes of the rules concerning charitable organizations, an organization tax-exempt by reason of those rules may be a unit of government¹⁴ or a foreign organization,¹⁵ or may conduct all or part of its activities in foreign countries.¹⁶

The formalities of organization of an entity may have a bearing on the tax exemption. This is the case not only in connection with the sufficiency of the governing instruments,¹⁷ but also, and more fundamentally, with regard to whether there is a separate organization in the first instance. An individual may perform worthwhile activities, such as providing financial assistance to needy students, but will receive no tax benefits from his or her beneficence unless he or she establishes and funds a qualified organization that in turn renders the charitable works, such as scholarship grants. One court observed, in the process of denying a charitable contribution deduction, that the federal tax law makes no provision for a charitable deduction in the context of personal ventures, however praiseworthy in character. The court noted that “[t]here is no evidence of such enterprise being a corporation, community chest, fund, or foundation and little information, if any, as to its organization or activities.”¹⁸ Assuming the organization is not operated to benefit private interests, its tax exemption will not be endangered because its creator serves as the sole trustee and exercises complete control,¹⁹ although state law may limit or preclude close control.

A “formless aggregation of individuals” cannot be tax-exempt as a charitable entity.²⁰ At a minimum, the entity—to be exempt—must have an organizing instrument, some governing rules, and regularly chosen officers.²¹ These rules have been amply illustrated in the cases concerning so-called personal churches.²²

Among the nontax factors to be considered in selecting an organizational form are legal liabilities in relation to the individuals involved (the corporate form can limit certain personal liabilities), local law requirements, necessities of governing instruments, local annual reporting requirements, organizational expenses, and any membership requirements.²³ Federal law other than the tax laws may also have a bearing on the choice, such as the organization's comparable status under the postal laws.²⁴

(b) Check-the-Box Regulations

In general, the classification of an entity as a particular type of organization can have significant federal tax consequences. Although this is an issue principally for for-profit entities, there are some ramifications in this area for tax-exempt organizations.

(a) Statement of Purposes

In meeting the organizational test, a charitable organization's purposes, as stated in its articles of organization, may be as broad as, or more specific than, the particular exempt purposes, such as religious, charitable, or educational ends. Therefore, an organization that, by the terms of its articles of organization, is formed for “literary and scientific purposes within the meaning of section 501(c)(3) of the Internal Revenue Code” shall, if it otherwise meets the requirements of the organizational test, be considered to have met the test. Similarly, articles of organization stating that the organization is created solely to “receive contributions and pay them over to organizations which are described in section 501(c)(3) and exempt from taxation under section 501(a) of the Internal Revenue Code” are sufficient for purposes of the organizational test. If the articles of organization state that the organization is formed for “charitable purposes,” the articles ordinarily will be adequate for purposes of the organizational test.⁵⁹

Articles of organization of charitable entities may not authorize the carrying on of nonexempt activities (unless they are insubstantial), even though the organization is, by the terms of its articles, created for a purpose that is no broader than the specified charitable purposes.⁶⁰ Thus, an organization that is empowered by its articles to “engage in a manufacturing business” or to “engage in the operation of a social club” does not meet the organizational test, regardless of the fact that its articles of organization may state that the organization is created for “charitable purposes within the meaning of section 501(c)(3) of the Internal Revenue Code.”⁶¹

In no case will an organization be considered to be organized exclusively for one or more tax-exempt charitable purposes if, by the terms of its articles of organization, the purposes for which the organization is created are broader than the specified charitable purposes. The fact that the actual operations of the organization have been exclusively in furtherance of one or more exempt purposes is not sufficient to permit the organization to meet the organizational test. An organization wishing to qualify as a charitable entity should not provide in its articles of organization that it has all of the powers accorded under the particular state's nonprofit corporation act, since those powers are likely to be broader than those allowable under federal tax law.⁶² Similarly, an organization will not meet the organizational test as a result of statements or other evidence that its members intend to operate only in furtherance of one or more exempt purposes.⁶³

An organization is not considered organized exclusively for one or more exempt charitable purposes if its articles of organization expressly authorize it to (1) devote more than an insubstantial part of its activities to attempting to influence legislation by propaganda or otherwise;⁶⁴ (2) directly or indirectly participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of or in opposition to any candidate for public office;⁶⁵ or (3) have objectives and engage in activities that characterize it as an action organization.⁶⁶ The organizational test is not violated, however, where an organization's articles empower it to make the expenditure test election (relating to expenditures for legislative activities⁶⁷) and, only if it so elects, to make direct lobbying or grassroots lobbying expenditures that are not in excess of the ceiling amounts prescribed by that test.⁶⁸ The organizational test, however, does not require that references be made in the organizational document to the prohibitions on private inurement, substantial private benefit, substantial lobbying, and political campaign activities.

The organizational test requires that the articles of organization limit the purposes of the entity to one or more exempt purposes. Exempt purposes are described in the statute,⁶⁹ and include purposes such as charitable, educational, religious, and scientific. These purposes are also enumerated in the tax regulations in explication of the term charitable,⁷⁰ and include purposes such as advancement of religion, lessening the burdens of government, and promotion of social welfare. There is no requirement in the law that the statement of purposes, when exempt purposes are referenced, expressly refer to IRC § 501(c)(3).

There are many other permissible functions of a charitable organization that are not formally recognized as exempt purposes in the Code or the regulations that nonetheless have been recognized as exempt functions (generically) in IRS revenue rulings and court decisions (and thus satisfy the operational test).⁷¹ Purposes of this nature include promotion of health, promotion of the arts, operation of a school, and protection of the environment. Inasmuch as functions of this nature are not exempt functions (as technically defined), they cannot stand alone in a statement of purposes. That is, for the organizational test to be satisfied, one of two statements must be in the articles of organization: (1) If the document contains a purpose that is not an exempt purpose, it should expressly limit the organization's purposes to those described in IRC § 501(c)(3), or (2) if the document contains a purpose that is not an exempt purpose, and that purpose is not contrary to exempt purposes, the document should include a “notwithstanding” clause.⁷²

An overly broad statement of purposes cannot be cured by a provision stating that the organization's activities will be confined to those described in IRC § 501(c)(3). Again, this is because activities are considered in connection with the operational test, while the organizational test is concerned with purposes. Also, despite the rules of law governing charitable entities, there is nothing in the organizational test that requires reference to the private inurement doctrine,⁷³ limitation on attempts to influence legislation,⁷⁴ or the prohibition on political campaign activities in the articles of organization.⁷⁵

It is the view of one court, however, that the organizational test entails a “purely…factual inquiry” and that it is not required to “myopically consider only” articles of incorporation or another creating document; in the case, an organization was found to qualify as a charitable organization meeting the organizational test because of suitable language in its bylaws.⁷⁶

The law of the state in which an organization is created is controlling in construing the terms of its articles of organization.⁷⁷ An organization that contends that the terms have, under state law, a different meaning from their generally accepted meaning must establish the special meaning by clear and convincing reference to relevant court decisions, opinions of the state attorney general, or other evidence of applicable state law.⁷⁸

An organization that would be classified as a private foundation⁷⁹ if it were recognized as a charitable entity does not satisfy the organizational test by virtue of having complied with the special governing instrument provisions applicable only to private foundations.⁸⁰ In so ruling, the IRS considered a case where an organization's articles of incorporation lacked the requisite provision requiring the distribution of its assets for charitable purposes on dissolution. The state law under which the organization operates had not been construed to assure dedication of assets to charitable purposes,⁸¹ although the state had a statute that mandates reference to the various private foundation rules in the foundation's articles of incorporation on all private foundations formed in the state.⁸² The IRS reasoned that a private foundation is a charitable organization, yet an organization cannot be so classified where its governing instrument fails to include a dissolution clause, and the special governing instrument provisions apply only to private foundations. Also, the IRS reviewed the legislative history of the private foundation rules, which makes it clear that these rules comprise requirements that are in addition to the general tax exemption requirements.⁸³

(b) Dissolution Requirements

An organization is not organized exclusively for one or more tax-exempt charitable purposes unless its assets are dedicated to an exempt purpose.⁸⁴ An organization's assets will be considered dedicated to an exempt purpose, for example, if, on dissolution, the assets would, by reason of a provision in the organization's articles of organization or by operation of law, be distributed for one or more exempt purposes, or to the federal government, or to a state or local government, for a public purpose or would be distributed by a court to another organization to be used in a manner that in the judgment of the court will best accomplish the general purposes for which the dissolved organization was organized.⁸⁵ A charitable organization does not, however, meet the organizational test if its articles of organization or the law of the state in which it was created provide that its assets would, on dissolution, be distributed to its members or shareholders.⁸⁶ Consequently, exemption as a charitable organization will be denied where, on dissolution of the organization, its assets would revert to the individual founders rather than to one or more qualifying charities.⁸⁷ Likewise, the IRS will likely revoke a charitable organization's exemption for removal of a dissolution clause, with the revocation retroactive to the date the clause was deleted.⁸⁸ A charitable organization's assets may, on dissolution, be transferred for charitable purposes without necessarily being transferred to a charitable organization.⁸⁹

The dedication-of-assets requirement contemplates that, notwithstanding the dissolution of a charitable entity, the assets will continue to be devoted to a charitable purpose (albeit a substituted one). Under the cy pres rule, a state court, in the exercise of its equity power, may modify the purpose of a charitable trust or place the funds of a charitable corporation in a new entity.⁹⁰ Organizations that are organized for both tax-exempt and nonexempt purposes fail to satisfy the organizational test.⁹¹

The IRS published guidelines for identification of states and circumstances where an express dissolution clause for charitable organizations is not required. Basically, these guidelines are a function of the type of organization that is involved. For example, the IRS has determined that the cy pres doctrine in any jurisdiction is insufficient to prevent an inter vivos charitable trust or an unincorporated association from failing, and thus that an adequate dissolution clause is essential for satisfaction of the organizational test. By contrast, the law of several states applies the cy pres doctrine to testamentary charitable trusts and the law of a few states applies the doctrine to nonprofit charitable corporations.⁹² Consequently, from the standpoint of the IRS, an organization in a jurisdiction where the cy pres doctrine is inapplicable must have an express, qualifying distribution or liquidation clause to satisfy the organizational test.⁹³

Most other categories of tax-exempt organizations are not subject to federal tax law dissolution requirements. Consequently, there is almost no law on the subject outside the charitable context. In one instance, however, an organization was denied recognition of exemption as a social welfare entity because it was not promoting the common good and general welfare of a community,⁹⁴ with the IRS citing the organization's dissolution clause, which left its assets to its members, as “further illustrat[ing]” that it was not serving a “wider community.”⁹⁵ In another instance, the IRS approved dissolution of an exempt labor organization⁹⁶ by transfer of all or substantially all of its assets to another exempt labor organization having similar purposes, noting that relevant state laws were complied with, permission of a state attorney general was not required, and no compensation was paid to any director or officer of either organization in connection with the dissolution.⁹⁷ The dissolution rule in the exempt voluntary employees' beneficiary association⁹⁸ setting provides that prohibited inurement does not occur if amounts distributed to members are determined on the basis of objective and reasonable standards that do not result in unequal payments to officers, shareholders, or highly compensated employees.⁹⁹ The IRS applied this rule in connection with dissolution of an exempt teachers' retirement fund¹⁰⁰ where the fund's plan of dissolution, involving transfers to its members, appeared to be in accordance with the “plain and ordinary” meaning of the teachers' retirement fund rules and the VEBA regulation, so that private inurement did not occur in connection with the distribution, and the exemption of the fund would not be imperiled.¹⁰¹

(c) Mission Statements

As part of the redesign of Form 990,¹⁰² the IRS is placing considerable emphasis on mission statements, particularly those of public charities. Thus, the return requests, in two instances, a description of the filing organization's mission.¹⁰³ An organization may thus have a mission statement in addition to a statement of purposes. A mission statement should not, of course, be inconsistent with the purposes statement.¹⁰⁴

(d) Board Composition

The IRS has developed a policy, predicated on the private benefit doctrine,¹⁰⁵ that an organization, particularly one striving to qualify as a public charity, cannot qualify for tax-exempt status if it has a small board or a board wholly or principally composed of related individuals.¹⁰⁶ Traditionally, of course, this has been solely a matter of state law; most states require a governing board consisting of at least three persons.

The optimum size of a governing board of a nonprofit organization depends on many factors, including the type of organization involved, the nature and size of the organization's constituency, the manner in which the directors are selected, and the role and effectiveness of an executive committee (if any).¹⁰⁷ In some instances, particularly in connection with trusts, an institutional trustee may be involved.

(e) Rules for Limited Liability Companies

The IRS concluded that an LLC¹⁰⁸ with two or more members that are charitable or governmental entities¹⁰⁹ can qualify for tax exemption as a charitable organization itself, if it satisfies 12 conditions.¹¹⁰ They are:

1. The LLC's organizational documents must include a specific statement limiting its activities to one or more exempt (charitable) purposes.
2. The organizational language must specify that the LLC is operated exclusively to further the charitable purposes of its members.
3. The organizational language must require that the LLC's members be charitable organizations, governmental units, or wholly owned instrumentalities of a state or political subdivision of a state.
4. The organizational language must prohibit any direct or indirect transfer of any membership interest in the LLC to a transferee other than a charitable organization, governmental unit, or instrumentality.
5. The organizational language must state that the LLC, interests in the LLC (other than a membership interest), or its assets may only be availed of or transferred to, directly or indirectly, any nonmember (other than a charitable organization, governmental unit, or instrumentality) in exchange for fair market value.
6. The organizational language must guarantee that, on dissolution of the LLC, the assets devoted to the LLC's charitable purposes will continue to be devoted to charitable purposes.
7. The organizational language must require that any amendments to the LLC's articles of organization and operating agreement be consistent with the general organizational test applicable to charitable organizations.
8. The organizational language must prohibit the LLC from merging with, or converting into, a for-profit entity.
9. The organizational language must require that the LLC not distribute any assets to members who cease to be charitable organizations, governmental units, or instrumentalities.
10. The organizational language must contain an acceptable contingency plan in the event one or more members cease at any time to be a charitable organization, a governmental unit, or an instrumentality.
11. The organizational language must state that the LLC's exempt members will “expeditiously and vigorously” enforce all of their rights in the LLC and will pursue all legal and equitable remedies to protect their interests in the LLC.
12. The LLC must represent that all its organizing document provisions are consistent with state LLC laws, and are enforceable at law and in equity.

Because of conflict and confusion among the states as to the role of LLC articles of organization and operating agreements, the IRS is requiring that both documents separately comply with the first 11 of these conditions. The last one is met in a separate written statement from the organization.

An LLC that meets each of these 12 conditions can also qualify as a tax-exempt social welfare organization,¹¹¹ if it otherwise meets the requirements for that category of tax exemption. The IRS has yet to establish its position as to whether an LLC can qualify as any other type of exempt organization. The IRS appears to be of the view that a social club, to be exempt,¹¹² cannot be structured as a limited liability company, because the members, rather than the club itself, directly control the entity's assets.¹¹³

(a) Basic Rules

An organization, to qualify as a charitable entity, is regarded as operated exclusively for one or more tax-exempt purposes only if it engages primarily in activities that accomplish one or more of its exempt purposes.¹⁶¹ The IRS observed that, to satisfy this operational test, the organization's “resources must be devoted to purposes that qualify as exclusively charitable within the meaning of section 501(c)(3) of the Code and the applicable regulations.”¹⁶² An organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.¹⁶³ An organization is not considered as operated exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals.¹⁶⁴ An organization can be substantially dominated by its founder without, for that reason alone, failing to satisfy the operational test.¹⁶⁵ A court concluded, however, that an organization cannot qualify for tax exemption where one individual controls all aspects of the organization's operations and “is not checked” by any governing body.¹⁶⁶

An organization may meet the federal tax law requirements for charitable entities even though it operates a trade or business as a substantial part of its activities.¹⁶⁷ If the organization has as its primary purpose the carrying on of a trade or business, however, it may not be tax-exempt.¹⁶⁸ The core issue is whether the substantial business activity accomplishes or is in furtherance of an exempt purpose.¹⁶⁹ (The existence of an operating profit is not conclusive as to a business purpose.¹⁷⁰) Even though the operation of a business does not deprive an organization of classification as a charitable entity, there may be unrelated trade or business tax consequences.¹⁷¹

The operational test focuses on the actual purposes the organization advances by means of its activities, rather than on the organization's statement of purposes or the nature of its activities, in recognition of the fact that an organization may conduct a business in furtherance of a tax-exempt purpose and qualify as a charitable entity:

Under the operational test, the purpose towards which an organization's activities are directed, and not the nature of the activities themselves, is ultimately dispositive of the organization's right to be classified as a section 501(c)(3) organization exempt from tax under section 501(a)…[I]t is possible for…an activity to be carried on for more than one purpose…The fact that…[an] activity may constitute a trade or business does not, of course, disqualify it from classification under section 501(c)(3), provided the activity furthers or accomplishes an exempt purpose…Rather, the critical inquiry is whether…[an organization's] primary purpose for engaging in its…activity is an exempt purpose, or whether its primary purpose is the nonexempt one of operating a commercial business producing net profits for…[the organization].¹⁷²

This important distinction between activities and purpose is sometimes overlooked by the IRS and the courts. For example, in one case a court concluded that the operational test was not satisfied because the organization failed to describe its activities in sufficient detail in its application for recognition of exemption.¹⁷³

Although an organization might be engaged in only a single activity, that activity may be directed toward multiple purposes, both exempt and nonexempt. If the nonexempt purpose is substantial in nature, the organization will not satisfy the operational test.¹⁷⁴

Whether an organization has a substantial nonexempt purpose is a question of fact, to be resolved on the basis of all the appropriate evidence.¹⁷⁵ The U.S. Tax Court observed: “Factors such as the particular manner in which an organization's activities are conducted, the commercial hue of those activities, and the existence and amount of annual or accumulated profits are relevant evidence of a forbidden predominant purpose.”¹⁷⁶

An illustration of application of the operational test was provided by a case concerning the tax-exempt status of an organization granting scholarships to contestants in a beauty pageant, with a court finding that the payments were forms of compensation.¹⁷⁷ Another example of application of these rules is inherent in a court decision concluding that an organization that principally administered donor-advised funds¹⁷⁸ qualified as a charitable entity inasmuch as its “goal is to create an effective national network to respond to many worthy charitable needs at the local level which in many cases might go unmet” and its activities “promote public policy and represent the very essence of charitable benevolence.”¹⁷⁹ Still another example of these rules involved a court opinion concerning an otherwise qualifying school that was held to confer private benefit on its graduates, who were pursuing careers as political campaign professionals serving only candidates of one political party.¹⁸⁰

A court held that an organization could not qualify as a tax-exempt charitable entity, because of violation of the operational test, in that the organization's activities and those of its founder, sole director, and officer were essentially identical.¹⁸¹ The court wrote that the affairs of the organization and of this individual are “irretrievably intertwined,” so that the “benefits” of exemption would “inure” to him.¹⁸²

The operational test is used to apply the tests of commerciality and competition to charitable and other categories of tax-exempt organizations. Previously, the test had been used in conjunction with the exclusivity requirement¹⁸³ and the rules defining business for unrelated income taxation purposes.¹⁸⁴ This application of the commerciality doctrine has largely been by the U.S. Tax Court, where, for example, it denied exempt status, as a charitable and religious entity, to an organization associated with the Seventh-Day Adventist Church that, in advancement of Church doctrine, operated vegetarian restaurants and health food stores; the court wrote that the organization's “activity was conducted as a business and was in direct competition with other restaurants and health food stores” and that “[c]ompetition with commercial firms is strong evidence of a substantial nonexempt commercial purpose.”¹⁸⁵ Likewise, the Tax Court held that an organization that supported religious missionary work properly had its exemption revoked because it conducted a mail-order business in tape and electronic equipment as a substantial part of its activities and purposes,¹⁸⁶ and that an organization could not be exempt because it functioned the same as a purchasing, brokering, or consulting organization in the private sector.¹⁸⁷ The only prior opinion from the Tax Court that invoked the commerciality standard is one that looked at the issue from a somewhat different slant, in that the court wrote that the operational test is violated where the organization's “primary purpose is the nonexempt one of operating a commercial business producing net profits for” the organization.¹⁸⁸

The IRS, from time to time, denies recognition of tax-exempt status to organizations that, in the view of the agency, fail the operational test.¹⁸⁹ In one instance, the IRS ruled that an organization failed to qualify for exemption because the agency was unable to determine whether the entity would ever meet the operational test because the “timeframe” for the organization to “become operational is extremely indeterminate.”¹⁹⁰ By contrast, a charitable organization was allowed by the IRS to maintain its exempt status, even though it was a “dormant shell” (because it transferred all of its then assets for charitable purposes), inasmuch as additional funds were to be received by it and it had a plan to continue its charitable operations.¹⁹¹

On occasion, tax exemption of an organization will be revoked for inactivity (failure of an entity to operate at all).¹⁹²

(b) Activities Tests

The IRS sometimes references, in private letter rulings, an activities test, which it applies in determining whether a nonprofit organization qualifies for tax exemption. For example, the IRS cited this test in differentiating between traditional and nontraditional activities of exempt social clubs.¹⁹³ On occasion, this activities test is applied in addition to an operational test. As an illustration, the IRS, in denying recognition of exemption to an entity seeking to qualify as a telephone cooperative,¹⁹⁴ ruled that the organization did not satisfy the operational test because it was not operated as a cooperative, and it failed an activities test because its operations did not facilitate communication between its members and others.¹⁹⁵

(c) Quantification of Activities

The foregoing summary of the basic rules of the operational test have historically been applied on a facts-and-circumstances basis. This is because the federal tax law lacks a formal methodology for quantifying an organization's activities for the purposes of measuring the scope of each of them and ascertaining whether there is a sufficient combination of them to satisfy the requisite of primary activity.¹⁹⁶ To the extent that there has been much attention to this obvious omission in this analytic process, it has been in the area of legislative activities of public charities, where there is uncertainty as to how to measure the substantiality of legislative activities for the purpose of determining whether lobbying imperils an organization's tax exemption.¹⁹⁷ In that context, this unanswered question has been extant for decades: Is legislative activity measured in terms of expenditures of money or time, influence, outcomes, one or more other factors, or a combination of these elements?

This matter came to the fore due to concerns about permissible political campaign activity by exempt social welfare organizations.¹⁹⁸ When proposing regulations concerning candidate-related political activity in this context (ultimately withdrawn), the government solicited comments from the public as to what proportion of an organization's activities must promote social welfare for an organization to qualify as an exempt social welfare entity and on how to measure the activities of organizations for these purposes.¹⁹⁹

The IRS occasionally considers this matter. For example, the IRS observed that a tax-exempt organization operated three contiguous shops, each of which was “approximately the same size,” but did not explain the basis for that conclusion.²⁰⁰ In another instance, the IRS accepted an organization's portrayal of its primary activities, expressed in terms of percentages of total activities, without discussion of the basis for the percentages.²⁰¹ An organization conducting formal education that entailed 13 percent of its functional expenses, 7 percent of its contributions, and 6 percent of its revenue, and involved 20 percent of its employees, was ruled to not constitute a qualifying organization for unrelated debt-financed income purposes.²⁰²

In a certainly troublesome and seemingly incorrect ruling, the IRS concluded, as to an organization that had been operational for at least three years, that it did not qualify for tax-exempt status as a social welfare organization because 100 percent of its expenditures were for political campaign activities in one year, even though it expended 100 percent of its volunteer time on exempt functions in the ensuing two years, because this organization did not make any exempt function expenditures in those two years.²⁰³

This development has enormous implications for the law of tax-exempt organizations. If a methodology is (somehow) developed that measures the activities of exempt organizations and if there is a definitive answer as to appropriate and required “proportions” of activities, these two elements are bound to be applicable in all exempt organizations settings. This will dramatically impact the primary purpose test. The outcome will directly affect the quantification of legislative and unrelated business activities.²⁰⁴ Overall, if the government issues proposals concerning the measurement and proportionality of exempt organizations' activities and they become law, much law and many practices in the exempt organizations area will be transformed.

(d) Action Organizations

An organization is not operated exclusively for one or more exempt charitable purposes if it is an action organization.²⁰⁵

An organization is an action organization if a substantial part of its activities is attempting to influence legislation.²⁰⁶ For this purpose, an organization is regarded as attempting to influence legislation if the organization contacts, or urges the public to contact, members of a legislative body for the purpose of proposing, supporting, or opposing legislation or if it advocates the adoption or rejection of legislation. The term legislation includes action by the U.S. Congress, a state legislature, a local council or similar governing body, or the public in a referendum, initiative, constitutional amendment, or similar procedure. An organization will not fail to meet the operational test merely because it advocates, as an insubstantial part of its activities, the adoption or rejection of legislation.²⁰⁷ Also, an organization for which the expenditure test election (relating to expenditures for legislative activities)²⁰⁸ is in effect for a tax year is not considered an action organization for the year if it avoids loss of tax exemption by reason of that test.²⁰⁹

An organization is an action organization if it participates or intervenes, directly or indirectly, in any political campaign on behalf of or in opposition to any candidate for public office. The phrase candidate for public office means an individual who offers himself or herself, or is proposed by others, as a contestant for an elective public office, whether the office is national, state, or local. Activities that constitute participation or intervention in a political campaign on behalf of or in opposition to a candidate include, but are not limited to, the publication or distribution of written or printed statements or the making of oral statements on behalf of or in opposition to the candidate.²¹⁰

An organization is an action organization if it has the following two characteristics: (1) Its main or primary objective or objectives (as distinguished from its incidental or secondary objectives) may be attained only by legislation or a defeat of proposed legislation, and (2) it advocates or campaigns for the attainment of this main or primary objective or objectives as distinguished from engaging in nonpartisan analysis, study, or research, and making the results thereof available to the public. In determining whether an organization has these characteristics, all the surrounding facts and circumstances, including one or more provisions in the articles of organization and all activities of the organization, are considered.²¹¹

Application of the operational test is, therefore, intertwined with the proscriptions on private inurement and on legislative and political campaign activities.²¹² In essence, however, to meet the operational test, an organization must be engaged in activities that further public rather than private purposes.²¹³

The entwining of the operational test with the other requirements of the federal tax rules governing charitable organizations was recognized by a court in a decision refusing to reclassify a health and welfare fund, which was tax-exempt as an employee beneficiary association,²¹⁴ as a charitable organization.²¹⁵ The court ruled against the organization on the ground that it was not operated exclusively for charitable purposes²¹⁶ and that its activities were furthering private interests²¹⁷ but cloaked its opinion in the mantle of the operational test. (The organization's activities consisted of operating child day-care centers—which the court implied was not a charitable activity²¹⁸—and providing services to members, and the organization charged the employees less tuition for the day-care services than it charged other parents.)

An organization deemed to be an action organization, other than because of more than merely incidental political campaign activities, though it cannot for that reason qualify as a charitable organization, may nonetheless qualify as a social welfare organization.²¹⁹

(e) Aggregate Principle

The activities of a partnership or other form of joint venture are often considered to be the activities of the partners; this is termed the aggregate principle.²²⁰ This principle applies for purposes of the operational test, in that the operations of a joint venture that includes a tax-exempt organization are attributed to the exempt organization when it is being evaluated pursuant to the test.²²¹

Thus, where a limited liability company that is taxable as a partnership had as its members a for-profit holding company wholly owned by a tax-exempt organization and a for-profit corporation, the IRS ruled that the holding company's activities are attributable to the exempt organization for purposes of assessing its ongoing qualification for exemption; since the holding company also is a limited liability company taxable as a partnership, the activities of the limited liability company are attributable to the holding company for purposes of determining whether the limited liability company's functions are substantially related to the accomplishment of the exempt organization's purposes.²²²

Some in the exempt organizations community are uncomfortable with the concept (or prospect) that all of the operations of a joint venture may be attributed to a tax-exempt organization in this setting, irrespective of the extent of the membership interest and/or the presence or absence of control. In this regard, some solace may be found in the IRS's observation, in the accountable care organization context,²²³ that if there is attribution of nonexempt functions of an ACO to an exempt participant, the participant's exempt status will not be jeopardized if the ACO's nonexempt activities “represent no more than an insubstantial part of the participant's total activities.”²²⁴

(a) Doctrine in General

Tax-exempt organizations are, nearly always, private—that is, nongovernmental—entities.²⁵⁴ Thus, the operations of exempt organizations are usually not subject to constitutional law principles.²⁵⁵ These principles, embedded in the U.S. Constitution and made applicable to the states by the Fourteenth Amendment to the Constitution, include free speech rights, due process, and equal protection. Consequently, whereas state action is subject to Fourteenth Amendment scrutiny, private conduct normally is not.

The distinction between state action and private operations sometimes is not clear; as the Supreme Court observed, it is called on from time to time to “plot a line” between the two,²⁵⁶ noting that the fashioning and application of a precise formula for recognition of state responsibility is an “impossible task.”²⁵⁷ The courts' obligation in this setting is threefold: to “‘preserv[e] an area of individual freedom by limiting the reach of federal law’ and avoid[] the imposition of responsibility on a State for conduct it could not control,”²⁵⁸ as well as assure that constitutional law standards are invoked “when it can be said that the State is responsible for the specific conduct of which the plaintiff complains.”²⁵⁹

The determination as to whether the state action doctrine is applicable to a tax-exempt organization, by attributing its activity to a government, is made pursuant to a facts-and-circumstances test; the “criteria lack rigid simplicity.”²⁶⁰ The Court held, for example, that a challenged activity may be state action when it results from a state's exercise of “coercive power”;²⁶¹ when a state provides “significant encouragement, either overt or covert”;²⁶² when a private organization operates as a “willful participant in joint activity with the State or its agents”;²⁶³ when the “private actor” is controlled by an “agency of the State”;²⁶⁴ when it has been delegated a public function by a state;²⁶⁵ or when it is “entwined with governmental policies” or when government is “entwined in [its] management or control.”²⁶⁶

One of the principal Supreme Court cases involving the state action doctrine concerned the operation of a private restaurant located within a state-owned automobile parking facility; the restaurant refused service to an individual because of his race. The Court held that this exclusion of the individual was discriminatory state action in violation of the Equal Protection Clause.²⁶⁷ Another significant state action case had the Court considering the circumstances of an individual who, because of his race, was refused service as a guest in a dining room and bar by a fraternal lodge, which was a local branch of a national tax-exempt fraternal organization.²⁶⁸ In this instance, the conclusion was that the discriminatory guest policies of the lodge did not trigger application of equal protection principles because the state involved was not sufficiently implicated.

This background led the Court to the conclusion that the “character of a legal entity is determined neither by its expressly private characterization in statutory law, nor by the failure of the law to acknowledge the entity's inseparability from recognized government officials or agencies.”²⁶⁹ In one instance, a privately endowed college was held to be a state actor and enforcement of its private founder's limitation of admission to whites attributable to a state, because, consistent with the terms of the settlor's gift, the college's board of directors was a state agency established by state law.²⁷⁰ In another case, private trustees to whom a city had transferred a park were nonetheless state actors barred from enforcing racial segregation, because the park served the public purpose of providing community recreation and the “municipality remain[ed] entwined in [its] management [and] control.”²⁷¹ In still another instance, the doctrine was held inapplicable where a state university suspended one of its coaches in order to comply with the rules of a national association of colleges and universities.²⁷²

The law in this area significantly changed in 2001, when the Court, in another athletic association case, held that the nonprofit association was to be treated as part of a state's government and thus was bound by constitutional law principles.²⁷³ The association in this case was organized to regulate interscholastic sport among the public and private high schools in the state that were its members. The constitution, bylaws, and rules of this association set standards of school membership and the eligibility of students to play in interscholastic games. The Court majority wrote: “The nominally private character of the Association is overborne by the pervasive entwinement of public institutions and public officials in its composition and workings, and there is no substantial reason to claim unfairness in applying constitutional standards to it.”²⁷⁴

Consequently, where there is “public entwinement” in the management and control of ostensibly separate nonprofit entities, the state action doctrine is likely to apply to these tax-exempt organizations.

(b) Doctrine as Applied to Social Clubs

The U.S. Constitution, in the Fifth and Fourteenth Amendments, prohibits racial discrimination by government and government-supported private institutions. In general, private organizations may lawfully discriminate, absent applicability of the state action doctrine (or a transgression of the public policy doctrine).²⁷⁵

The relationship between the state action doctrine and tax exemptions for social clubs²⁷⁶ and other nonprofit organizations has been the focus of several cases. This relationship with regard to social clubs was the subject of a case in which a black individual, allegedly denied membership in a lodge of a fraternal organization solely because of his race, brought a class action to enjoin the granting of tax benefits to nonprofit fraternal organizations that exclude nonwhite individuals from membership.²⁷⁷ In this case, the court concluded that an exempt social club's policy of racial discrimination did not preclude exemption, although the exemption given to fraternal organizations²⁷⁸ required the absence of discriminatory practices. The rationale underlying this distinction in treatment turned on the peculiar manner in which social clubs are taxed; because they are taxed on all receipts other than exempt-function income, there is no state action type “benefit” but only a matter of defining appropriate subjects of taxation, whereas fraternal organizations, being taxed only on unrelated business taxable income, do receive a government benefit in that investment income goes untaxed.

In another social club case, involving claims of religious and racial discrimination, the fact of a lease by a city to a private club, of land underlying club-constructed and club-maintained dock facilities, was held to be insufficient to supply the requisite Fourteenth Amendment significant state involvement in the membership policies of the club.²⁷⁹ In another case a nonprofit swim club was held to not be a private club, enabling the court to explore whether it engaged in racial discrimination with respect to its guest policy.²⁸⁰ Still another organization was held to be a private club and thus not subject to antidiscrimination laws.²⁸¹

The Supreme Court held that a nonprofit, single-function (swimming) recreational club was not a private club and concluded that its racially discriminatory policies as to guests were violative of civil rights legislation.²⁸² Membership was largely keyed to a surrounding geographical area. The Court wrote: “When an organization links membership benefits to residency in a narrow geographical area, that decision infuses those benefits into the bundle of rights for which an individual pays when buying or leasing within the area.”²⁸³ The Court continued: “The mandate of [the civil rights law] then operates to guarantee a nonwhite resident who purchases, leases, or holds this property, the same rights as are enjoyed by a white resident.”²⁸⁴

(c) Doctrine and Other Exempt Organizations

The Supreme Court issued an opinion that looked like a state action case, in that a union, acting under authority of a federal statute as the exclusive bargaining representative of a craft or class of railway employees, having engaged in racial discrimination, was found liable for breach of the statutory duty to represent the interests of all of its members.²⁸⁵ The Court did not resolve this case on constitutional law grounds, stating: “The economic discrimination against Negroes practiced by the [union] and the railroad under color of Congressional authority raises a grave constitutional issue that should be squarely faced.”²⁸⁶

A federal court of appeals held that a private university was not subject to the dictates of the First Amendment or the Fifth Amendment (procedural due process) in connection with the firing of a teacher; government chartering of the institution, federal and local tax exemptions, and federal funding for certain of its programs and capital expenditures were held to not represent substantial governmental involvement to trigger application of the state action doctrine.²⁸⁷ Similarly, financial assistance to a private university by means of tax exemptions and student aid was held to be insufficient to render its actions as state action, in the face of a complaint that a suspended student had her First, Fifth, and Fourteenth Amendments rights violated.²⁸⁸ Another appellate court held that procedures followed in the expulsion of students by a private university were not subject to the requirements of due process and equal protection, despite a state statute undertaking to set policy for coping with campus demonstrations.²⁸⁹

A test in some federal circuits is that there must be a nexus between the questioned activity (not just the entity) and the governmental funding.²⁹⁰ Thus, a private hospital receiving Hill-Burton funds, having engaged in discriminatory conduct, was found to have violated the Fourth Amendment,²⁹¹ whereas a similarly funded hospital that denied a physician readmittance to the hospital staff was held to have not contravened the First, Fifth, Eighth, Ninth, and Fourteenth Amendments because the funding did not have a nexus with the employment and termination policies applied with regard to staff.²⁹² The receipt of Hill-Burton funds, plus financial and regulatory involvement by a state, by a private hospital was enough for a federal court of appeals to find state involvement in the hospital policy that was challenged.²⁹³

Another variation on the state action theme is that some courts recognize a double state action doctrine, which is a “less onerous test for cases involving racial discrimination, and a more rigorous standard for other claims.”²⁹⁴ In one of these cases, which proved unsuccessful, an individual brought suit against 13 charitable foundations alleging racial discrimination against himself, his children, and his foundation, inasmuch as these foundations refused to hire him as a director, to provide scholarships to his children, and to make grants to his foundation.²⁹⁵

Another factor that can lead to a finding of state action is the mandatory presence of government officials on the board of a nonprofit organization. The Supreme Court held that the position of a state agency as trustee of an organization was sufficient, without more, to constitute state action.²⁹⁶ Noting that, in another case, the control by government officials was “less absolute and direct,” a court wrote that “even indirect governmental participation in the management of an organization is persuasive evidence of the existence of ‘state action’ where that participation is both substantial and other than neutral.”²⁹⁷ (The states' traditional parens patriae role with respect to charitable organizations does not alone transform actions by charities into actions by the state.²⁹⁸)

(d) Statutory Law

Congress concluded that it is “inappropriate” for a tax-exempt social club to have a “written policy” of discrimination on account of race, color, or religion. Accordingly, Congress, in 1976, enacted a rule that bars tax exemption for social clubs maintaining any of these types of discriminatory policies.²⁹⁹ It is the position of the IRS that this proscription on discriminatory practices does not extend to exempt social clubs that limit membership on the basis of ethnic or national origin.³⁰⁰

In 1980, Congress refined this requirement to allow tax-exempt social clubs that are affiliated with fraternal beneficiary societies³⁰¹ to retain tax exemption even though membership in the clubs is limited to members of a particular religion. Also, this law change allows certain alumni clubs, which are limited to members of a particular religion in order to further the religion's teachings or principles, to retain their exemption as social clubs.³⁰²

(a) Summary of Doctrine

The commerciality doctrine essentially is this: A tax-exempt organization (most likely, a public charity) is engaged in a nonexempt activity when that activity is undertaken in a manner that is commercial in nature. An activity is a commercial one if it has a direct counterpart in, or is conducted in the same or similar manner as in, the realm of for-profit organizations. (Having stated the essence of the doctrine, it must also be said that it is unevenly applied.)

The usual sanction for violation of the commerciality doctrine is denial of recognition of, or revocation of, tax-exempt status.

(b) Assumption Underlying Doctrine

The commerciality doctrine is largely predicated on the assumption that a nonprofit organization that is operating in the same manner as, and/or is directly competing with, a for-profit organization is thus a commercial entity and therefore is ineligible for federal tax exemption. The criteria for assessing operations in the same manner as for-profit companies principally are pricing formulas, hours of operation, marketing, officers' and employees' competence, use of employees, and lack of funding by charitable contributions and grants.

The biggest problem presented by this assumption is that it is inconsistent with reality. With the rise of for-profit companies' involvement in fields such as education and health, there are thousands of instances on an ongoing basis where nonprofit and for-profit entities are essentially operating in the same manner and/or are in competition (for example, hospitals, schools, theaters, and publishing entities).

(c) Origin of Doctrine

The doctrine was initiated long before Congress enacted the unrelated income rules in 1950. It was first mentioned, at the federal level, in 1924, by the U.S. Supreme Court.³⁰³ The case concerned a tax-exempt religious order that was operated for religious purposes, but that engaged in other activities that the government alleged destroyed the basis for its exemption; the order had extensive investments in real estate and stock holdings that returned a profit, as well as some incidental sales of wine, chocolate, and other articles. The Supreme Court found that the order was exempt as a religious entity, justifying its investment and business efforts by writing that “[s]uch [religious] activities cannot be carried on without money.”³⁰⁴

In this case, the Court did not articulate a commerciality doctrine. The Court characterized the government's argument as being that the order “is operated also for business and commercial purposes.”³⁰⁵ The Court rejected this characterization, writing that there is no “competition” and that while the “transactions yield some profit [it] is in the circumstances a negligible factor.”³⁰⁶ Thus, in this case, the Supreme Court did not enunciate the commerciality doctrine; however, by using the word in describing the government's position, the commerciality doctrine was born.

(d) Focus on Publishing

Courts' scrutiny of nonprofit publishing organizations provides telling applications of the doctrine. An entity that published religious literature in an effort to upgrade the quality of Bible teaching materials was held to be of a “nonexempt character” because of its commercial nature.³⁰⁷ By contrast, without referencing commerciality, a court held that an organization publishing a system for indexing library collections was tax-exempt,³⁰⁸ as was an organization that sold religious publications and charged admission fees to conclaves.³⁰⁹ Yet, an organization disseminating publications containing investment advice to subscribers was denied exemption as an educational entity.³¹⁰

Another court rejected the government's contention that the publication and sale of religious magazines, books, pamphlets, Bibles, records, tape recordings, and pictures amounted to commercial activity.³¹¹ This court was faced with another case involving the operation of alleged commercial enterprises, this time concerning a religious organization that conducted training projects. The court rejected the commerciality doctrine, with the observation that “we regard consistent nonprofitability as evidence of the absence of commercial purposes.”³¹²

Still another case involving a religious publishing organization was considered by a federal district court, which refined the commerciality doctrine by distinguishing between organizations that have commercial activities as a part of their overall activities and those that have commercial activities as their sole activity.³¹³ Organizations that retained their tax exemption in the prior cases were grouped in the first category;³¹⁴ the other organizations were placed in the second category. The court thus relied on the other cases³¹⁵ in concluding that the publishing company was not exempt. The nonexempt purpose³¹⁶ was portrayed as the “publication and sale of religious literature at a profit.”³¹⁷ The court said its conclusion could not be otherwise—”If it were, every publishing house would be entitled to an exemption on the ground that it furthers the education of the public.”³¹⁸

Another federal district court came to the identical result. A publisher of religious materials was denied tax exemption because it was “clearly engaged primarily in a business activity, and it conducted its operations, although on a small scale, in the same way as any commercial publisher of religious books for profit would have done.”³¹⁹ The fact that the organization's ultimate purpose was a religious one did not, for that court, confer exemption.

The next year, this opinion was reversed. The case was won before the appellate court on the ground that the organization did not have “operational profits.”³²⁰ The court concluded that the “deficit operation reflects not poor business planning nor ill fortune but rather the fact that profits were not the goal of the operation.”³²¹ Although the nonprofit organization involved in the case prevailed, this opinion went a long way toward establishment of the point that the existence of profit is evidence of commerciality.

An organization that disseminated sermons to ministers to improve their religious teachings was held to be tax-exempt.³²² The same court concluded that an entity that published and sold books written by its founder was not exempt.³²³ Another court decided that an organization publishing religious literature should be deprived of its exemption because it evolved into a “highly efficient business venture” with a “commercial hue,”³²⁴ although its similar decision in a subsequent case was reversed.³²⁵

(e) Other Applications of Doctrine

An organization that purchased and sold products manufactured by blind individuals was ruled to be tax-exempt because it alleviated the hardships experienced by these individuals.³²⁶ But an entity that benefited the poor by assisting in the operation of businesses that employ these individuals was denied exemption on the basis of the commerciality doctrine.³²⁷ An ostensibly religious organization failed to achieve exemption because the information it provided was no different from that furnished by a commercial tax service.³²⁸ An organization that assisted in the process of transfer of technology from universities and research institutions to industry was ruled to be operating in a commercial manner.³²⁹ An entity operating a religious retreat center, as an integral part of a conference of the United Methodist Church, was found to be exempt and commercial in nature because it did not compete with for-profit businesses.³³⁰

A major commerciality doctrine case concerned a nonprofit organization that operated an adoption agency.³³¹ It was held that this organization could not qualify as an exempt charitable or educational entity because adoption services are not inherently exempt functions; the organization was cast as operating in a manner not “distinguishable from a commercial adoption agency,” because it generated substantial profits, accumulated capital, was funded entirely by fees, had no plans to solicit contributions, and had a paid staff.³³²

(f) Elements of Commerciality

A court concluded that the commerciality doctrine was the basis for denial of tax-exempt status, as a charitable and religious entity, to an organization associated with the Seventh-Day Adventist Church that operated, in advancement of church doctrine, vegetarian restaurants and health food stores.³³³ The court wrote that the organization's “activity was conducted as a business and was in direct competition with other restaurants and health food stores.”³³⁴ The court added: “Competition with commercial firms is strong evidence of a substantial nonexempt commercial purpose.”³³⁵

When this case was considered on appeal, the appellate court affirmed the lower court decision.³³⁶ The appellate court opinion detailed the factors that the court relied on in finding commerciality and thus offered the fundamental basis for contemporary explication of the commerciality doctrine. These factors were that (1) the organization sold goods and services to the public (this factor alone was said to make the operations “presumptively commercial”), (2) the organization was in “direct competition” with for-profit restaurants and food stores, (3) the prices set by the organization were based on pricing formulas common in the retail food business (with the “profit-making price structure loom[ing] large” in the court's analysis and the court criticizing the organization for not having “below-cost pricing”), (4) the organization utilized promotional materials and “commercial catch phrases” to enhance sales, (5) the organization advertised its services and food ($15,500 expended for advertising over two years), (6) the organization's hours of operation were basically the same as for-profit enterprises, (7) the guidelines by which the organization operated required that its management have “business ability” and six months of training, (8) the organization did not utilize volunteers but paid salaries (totaling $63,000 in one year and more than $25,000 in another year), and (9) the organization did not receive charitable contributions.

Subsequently, a federal district court denied tax-exempt status to an organization whose principal purpose was operation of a conference center, on the ground that there was a distinctly commercial hue associated with its operations.³³⁷ The commerciality doctrine as applied in this case was based on a close following of the foregoing appellate court decision.³³⁸ The court stated that among the “major factors” courts have considered in “assessing commerciality” are competition with for-profit entities, the extent and degree of low-cost services provided, pricing policies, and the reasonableness of financial reserves.³³⁹ Additional factors were said to include whether the organization uses “commercial promotional methods (e.g., advertising)” and the extent to which the organization receives charitable contributions.³⁴⁰ The conference center was portrayed as operated in a commercial manner, in part because its patrons were not confined to tax-exempt organizations and because the facility was used for weddings and similar events.

(g) IRS Ruling Policy

The IRS enthusiastically embraces the commerciality doctrine, utilizing its precepts in a wide variety of settings. (So have courts. A court applied the commerciality doctrine in the context of ascertaining whether a tax-exempt charitable organization should lose its exempt status because its fundraising costs are too “high.”³⁴¹ Further, it was held that an organization selling religious tapes was a nonexempt commercial organization,³⁴² and that an organization operating prisoner rehabilitation programs was not eligible for tax exemption because of commercial activities.³⁴³)

The IRS's policy of denying recognition of tax exemption to, or revoking the exempt status of, credit counseling and down payment assistance organizations entails frequent invocation of the doctrine.³⁴⁴ Other instances of IRS utilization of the doctrine in its rulings include denial of exempt status to an organization that facilitates the sale of health insurance for for-profit insurance companies;³⁴⁵ an organization that facilitates charitable contributions of boats and other items of tangible personal property to charitable organizations;³⁴⁶ an organization that established a center to provide rest and relaxation to caregivers of chronically and terminally ill individuals (because the services to be provided are akin to those provided by a commercial inn);³⁴⁷ an organization that provides management services to home health care agencies and home health care providers, and otherwise facilitates the provision of home health services, for a fee;³⁴⁸ an organization that maintained a golf course open to the public on a fee-for-service basis;³⁴⁹ an organization that provides paratransit or transportation services to health care organizations to assist their elderly and disabled clients, for fees that are not below cost;³⁵⁰ an organization that sells books and other religious products as part of a network involving a church that is expanding the distribution of religious materials (because, according to the IRS, it is operating in a manner comparable to that of a for-profit publisher);³⁵¹ an organization providing free Internet access throughout a state, primarily through wireless networking, in part because it is enhancing the interests of for-profit companies that facilitate Internet access by enhancing their ability to attract customers;³⁵² an entity functioning as an administrative services organization to provide support services that benefit and promote unrelated tax-exempt charitable organizations (because the services provided “can be obtained from for-profit commercial businesses”);³⁵³ an organization believing itself to be an incubator of small businesses and nonprofit organizations (which are often tax-exempt) but which the IRS held to be similar to for-profit consulting companies that charge fees for their services;³⁵⁴ an organization operating a fee-based health care cooperative in a commercial manner;³⁵⁵ an organization conducting raffles as a commercial business;³⁵⁶ an organization providing travel services to synagogues nationwide;³⁵⁷ an organization that functioned as a licensing agency for products devised by children in contests, where it served to further children's education and establish a social network to further children's education funding;³⁵⁸ and an organization that was said by the IRS to be competing with for-profit companies (although that point was not explained) and had an insubstantial amount of charitable gifts.³⁵⁹ A church attempted to create an exempt coffeehouse, to enable it to appear “truly concerned” about its community, but the IRS rejected the idea, taking the position that the enterprise was a commercial one, competing with for-profit coffee shops.³⁶⁰ Additional private letter rulings are being issued on this subject.³⁶¹

The commerciality doctrine is being applied in some of the cases involving the provision of commercial-type insurance.³⁶² For example, in one of these cases, the court wrote that the “various factors to consider in determining whether an organization promotes a forbidden nonexempt purpose” under the rules concerning charitable organizations include the “manner in which an organization conducts its activities; the commercial hue or nature of those activities; the competitive nature of the activities; the existence of accumulated profits; and the provision of free or below cost services.”³⁶³ The organization, the tax status of which was at issue in the case, was characterized by the court as existing “solely for the purpose of selling insurance to nonprofit exempt organizations at the lowest possible cost on a continued, stable basis”; the court continued with the observation that “[s]elling insurance undeniably is an inherently commercial activity ordinarily carried on by a commercial for-profit company.”³⁶⁴ The court added that, although the organization “may not possess every attribute characteristic of a mutual insurance company, it possesses a majority of the qualifying characteristics, which only further enhances the determination that…[it] is presumptively commercial in nature.”³⁶⁵ In another of these cases, a court concluded that a group of self-insurance pools had a “commercial hue.”³⁶⁶ For example, a court assumed that an activity labeled recreational was “inherently commercial” and decided on that basis that an organization providing recreational therapy could not qualify as a charitable entity.³⁶⁷

(h) Contemporary Perspective on Doctrine

The commerciality doctrine has become one of the IRS's most potent tools to invoke when denying recognition of, or revoking, tax exemption, particularly where the issue involved is status as a charitable organization. The IRS has pushed the doctrine beyond the boundaries of the elements of commerciality articulated by courts.³⁶⁸ Meanwhile, these elements are increasingly appearing quaint and even nonsensical today.

The IRS's expansive view as to the factors “indicative of commercial operations” is that they include “regular and ongoing … sales [to the public], competition with other [organizations], common retail pricing structures, marketing and advertising, and the reliance on sales and fees versus contributions.”³⁶⁹

The competition element is most troublesome, particularly when the lines of demarcation between nonprofit and for-profit organizations are, in some instances, blurring.³⁷⁰ Nonprofit organizations are becoming increasingly reliant on revenue in the form of fees for services. For-profit organizations are more concerned than ever about their public image and the extent to which they can provide assistance to their communities. For-profit organizations are entering domains of producing and providing services that were once the sole province of nonprofit organizations. Laws are changed to promote greater parity between the sectors, such as the Office of Management and Budget regulations, which require tax-exempt organizations pursuing government contracts to calculate tax revenues forgone. Management of nonprofit organizations is becoming more sophisticated.³⁷¹

The IRS provided a unique application of the commerciality doctrine, holding that a community foundation can, in furtherance of charitable purposes, sell grantmaking services to charitable organizations in its community, although the sales of administrative and clerical services were held to be nonexempt functions.³⁷² The IRS suggested that the purchasing charitable entities constituted a charitable class,³⁷³ a fact that trumped the “commercial nature of the service.” The IRS dismissed the matter of the charging of fees,³⁷⁴ stating that the fees would be reasonable.³⁷⁵

Two categories of charitable organizations continue to evolve: those that are supported largely by gifts (donative organizations)³⁷⁶ and those that are supported principally by exempt function revenue (service provider organizations).³⁷⁷ As this trend continues, it will force new pressures on the concept of tax exemption. New rationales for exemption may emerge. The battles that are building over the ground rules for exemptions for hospitals³⁷⁸ and credit unions³⁷⁹ should be appreciated from this perspective. The growth of the social enterprise movement is likely to exacerbate this phenomenon.³⁸⁰

The IRS is not content with the existence of the courts' factors evidencing (ostensible) commerciality. In one ruling, the agency came up with these items “demonstrating” the presence of commercial operations: free WiFi, existence of a website, and the provision of power outlets for use by the entity's patrons.³⁸¹ In another instance, the IRS ruled that the fact that an organization collected testimonials on its website was evidence that the entity was being operated in a commercial manner.³⁸² An organization was ruled to have violated the doctrine by establishing chapters and charging them operational fees.³⁸³ The IRS has stretched the doctrine to the point where it declares that tax-exempt organizations “should not duplicate services or facilities provided by commercial entities.”³⁸⁴

The IRS issues, on a regular basis, rulings finding commerciality because a nonprofit organization was competing with a for-profit company,³⁸⁵ engaging in sales activity (generation of fee-for-service revenue),³⁸⁶ engaging in marketing efforts,³⁸⁷ lacking in the use of volunteers,³⁸⁸ using comparable hours of operation,³⁸⁹ and failing to receive charitable contributions.³⁹⁰ The IRS is beginning to utilize the commerciality doctrine in defining an unrelated business.³⁹¹

Matters would be helped in this regard if the IRS based its adverse rulings on bodies of law other than the commerciality doctrine, such as the operational test,³⁹² the private inurement doctrine,³⁹³ the private benefit doctrine,³⁹⁴ and the unrelated business rules.³⁹⁵ The IRS occasionally does this.³⁹⁶ This also can happen with a court.³⁹⁷

(a) Concept of Social Enterprise

The nomenclature surrounding the social enterprise phenomenon is illuminating: business ventures, corporate partnerships, strategic partnerships, and cause-related marketing. This parlance is decorated with verbs such as leverage, develop (the mission), license, capitalize, and invest.

There is, of course, nothing new in the fact that tax-exempt organizations undertake related and unrelated businesses.³⁹⁸ What is different in the social enterprise setting is the underlying spirit or philosophy of entrepreneurialism. Its proponents see heavy reliance on contributors and grantors as arcane and confining. They disregard concern about traditional federal tax law constraints; rarely in the literature of social enterprisers is much written about the actual or potential impact of these business ventures on organizations' tax-exempt status or susceptibility to unrelated business income taxation. Instead, the emphasis is on business opportunities, asset base expansion, productivity incentives, employee training and advancement, and public relations. Terms heretofore uttered only in the for-profit sector now dominate the social enterprise lexicon: profit margin, return on investment, risk tolerance, capacity building, self-sufficiency, diversified revenue strategy, and the irrepressible new paradigm.

The thinking and actions of this form of entrepreneurialism dramatically clash with the commerciality doctrine.³⁹⁹ As discussed, that doctrine holds that a charitable organization's tax-exempt status is endangered when elements such as focus on the wants and needs of the public, profits, and marketing are taken into account by it, not to mention trained employees and decreased reliance on gifts and grants.

Social enterprise philosophy tends to eschew the use of for-profit subsidiaries.⁴⁰⁰ The attraction is to partnerships—not in the sense of discrete legal entities⁴⁰¹ but rather direct interrelationships with for-profit businesses, where the entities function in tandem (partner or form a strategic alliance) to advance charitable causes (missions), rely on in-kind gifts, engage in unique fundraising promotions, utilize technical assistance, and operate using other forms of mission alignment.

Public charities contemplating involvement in social enterprises may give consideration to doing so other than by directly partnering with a for-profit business. Alternatives include use of a supporting organization,⁴⁰² a for-profit subsidiary, or a limited liability company or other form of joint venture vehicle.⁴⁰³ Entrepreneurialism can have an adverse impact on tax-exempt and/or public charity status,⁴⁰⁴ cause application of the unrelated business rules, and/or attract forms of legal liability.

To date, the federal tax law has not dampened the enthusiasm or curbed the innovativeness of the structures of the social enterprise movement. This is somewhat surprising, given the robust expansion of the private inurement and private benefit doctrines,⁴⁰⁵ the potency of the intermediate sanctions rules,⁴⁰⁶ and the unrelated business rules.

(b) Program-Related Investments

Historically, the blending of charitable activity and potentially nonexempt functions (investing) has appeared in the private foundation rules concerning program-related investments, which do not constitute jeopardizing investments.⁴⁰⁷ This is because the primary purpose of a program-related investment is to accomplish one or more charitable purposes.⁴⁰⁸ Also, no significant purpose of the investment may be the production of income or the appreciation of property; no purpose of the investment may be for lobbying or intervention in political campaigns.⁴⁰⁹

Program-related investments constitute private foundation qualifying distributions⁴¹⁰ and are not subject to the excess business holdings restrictions.⁴¹¹ Where the investment is in an entity that is not a public charity, expenditure responsibility must be exercised by the foundation.⁴¹²

(c) Low-Profit Limited Liability Companies

As noted, an aspect of the social enterprise movement is the emergence of new forms of entities. The most common of these organizations to date, spawned because of the program-related investments rules, is the low-profit limited liability company (L3C). These organizations are the subject of state statute. These L3Cs are likely to be for-profit, taxable entities, with one or more taxable members. An L3C has as its primary purpose the accomplishment of one or more charitable purposes. The production of income is a permitted secondary purpose of an L3C.

The principal federal tax law issue in this regard is whether an investment by a private foundation in an L3C qualifies as a program-related investment. The requirements for qualification as an L3C are essentially identical to the preexisting law for these investments. An investment in an L3C, however, does not automatically mean that the investment is a program-related investment.

(d) B Corporations

B corporations are not a form of entity but are business corporations that are certified by the B Lab (a tax-exempt charitable entity) as companies working to solve social and environmental problems. To be certified, a corporation must meet performance and legal accountability standards and build constituencies.

(e) Benefit Corporations

Another type of hybrid or blended corporation is the benefit corporation, which is an entity that has socially responsible and business purposes. These corporations are formed by state statute; they elect to be this type of corporation, pursuing ends such as environmental preservation, promotion of health, and promotion of the arts and sciences. In determining what is in the best interests of a benefit corporation, its directors are to consider the effects of any action or decision on a variety of stakeholders, including its shareholders, employees, and customers, as well as community and societal aspects.

(f) Flexible Purpose Corporations

Efforts are under way in California to create a new type of corporation that has flexibility in combining profitability and social purposes—the flexible purpose corporation. This entity would have essentially the same characteristics as the benefit corporation.