(a) General Principles

Tax-exempt charitable status is available for an organization solely on the ground that it relieves individuals who are distressed. The IRS considered the tax treatment of a nonprofit hospice that operated on both an inpatient and an outpatient basis to assist persons of all ages who have been advised by a physician that they are terminally ill in coping with the distress arising from their medical condition.³³ Thus, the classification of the organization as a charitable entity was predicated on the fact that the hospice “alleviat[ed] the mental and physical distress of persons terminally ill.” What the IRS did, as noted, beginning with three rulings issued in 1979,³⁴ was change the phraseology from poor and distressed to poor or distressed.

The IRS sometimes refers to individuals who are distressed as being needy. In a ruling, the IRS observed that “basic need[s]” include “nutrition, safety, shelter, or minimum income.”³⁵ This observation was made in the context of determining that “fill[ing] a gap in journalism which…ignores the less-than-affluent economic class”—known as relational journalism—does not rise to the level of addressing such a basic need.

(b) Disaster Relief Programs

The confusion inherent in the interplay between relief of the poor and relief of the distressed, as meanings of the term charitable, is vividly reflected in the IRS's policies with respect to disaster relief programs. Part of this confusion pertains to the eligibility of individuals for these programs' assistance; they need not be financially distressed but may be emotionally or physically distressed.

For many years, the IRS approved, as tax-exempt functions of charitable organizations, disaster relief and hardship programs, including those where the potential beneficiaries are employees (and perhaps also former employees) of related companies or other organizations, and the employees' families, where the potential recipients constituted a charitable class (that is, were distressed individuals).³⁶ In these situations, any private benefit³⁷ to the beneficiaries or any related entities was deemed by the IRS to be incidental and thus to not adversely affect the grantor's exempt status.³⁸ In the late 1990s, the IRS reversed this policy, concluding that company-related disaster and emergency relief programs were not exempt charitable functions and entailed private inurement³⁹ to the sponsoring company in the form of promotion of a loyal and stable employee base.⁴⁰

This was the status of the IRS's policy on disaster relief programs in the tax-exempt organizations context at the time of the terrorist attacks on September 11, 2001. Considerable confusion, including misunderstanding of applicable federal tax law, ensued as to who was eligible for monetary relief and/or services provided by charitable organizations in the immediate aftermath of the attacks. This turmoil was compounded by the IRS's proclamations that, to be eligible for this aid, an individual must demonstrate a financial need. That, however, is not the law; the standard is whether the beneficiaries are distressed, as that term is defined in the federal tax law.⁴¹

Legislation enacted in 2001 introduced rules for provision of assistance by charitable organizations to individuals who are victims of terrorism.⁴² Pursuant to this enactment, charitable organizations that make payments to individuals by reason of the death, injury, wounding, or illness of an individual incurred as a result of the terrorist attacks in 2001 or as the result of an attack involving anthrax in late 2001 are not required to make a specific assessment of need for the payments to be considered made for charitable purposes. The grantor organization must make the payments in good faith using a reasonable and objective formula that is consistently applied.

A qualified disaster means a disaster that results from a terroristic or military action, a presidentially declared disaster, an accident involving a common carrier, and any other event that the IRS determines is catastrophic.⁴³ The legislative history stated that the IRS is expected to reconsider its ruling position in connection with disaster relief programs in light of this paradigm.

The IRS returned to this matter of disaster relief programs provided by charitable organizations by means of a publication issued in 2005.⁴⁴ Disaster programs of company-sponsored charities may be treated as charitable activities, according to this guidance, where (1) the awards are paid to “needy and distressed persons” pursuant to appropriate standards; (2) the charitable organization's program does not relieve the company of any legal obligation, such as an obligation under a collective bargaining agreement or written plan to provide insurance benefits; and (3) the company does not use the program to recruit employees, induce employees to continue their employment, or otherwise follow a course of action sought by the company. The destruction of an employee's home by fire or medical emergency attributable to a health condition does not constitute an eligible disaster.

This publication states that “providing aid to relieve human suffering that may be caused by a natural or civil disaster to relieve an emergency hardship is charity in its most basic form.” Distributions may be made to individuals who are “financially or otherwise distressed.” The publication states that “[p]ersons do not have to be totally destitute to be needy; they may merely lack the resources to obtain basic necessities.” Adequate records to support this basis on which assistance is provided must be maintained.⁴⁵ A program to distribute forms of short-term emergency assistance requires less documentation concerning establishment of the need of disaster victims for assistance than the distribution of forms of long-term aid. Thus, in the face of an immediate disaster, the provision of a “drug rescue and telephone crisis center or recovery to a person lost at sea or trapped by a snow storm would not require a showing of financial need, since the individual requiring these services is distressed irrespective of the individual's financial condition.” By contrast, individuals “may not require long-term assistance if they have adequate financial resources.”⁴⁶

The IRS ruled that a private foundation providing financial assistance to victims or families of victims of a natural disaster, violence, or terrorist acts of war; victims of discrimination, social injustice, or persecution; and artists was making qualifying distributions⁴⁷ as long as the assistance was confined to “impoverished individuals with desperate financial needs.”⁴⁸ The IRS approved exemption for a fund to provide emergency assistance to current and former employees of an affiliated group of exempt health care providers.⁴⁹ The IRS ruled that a financial assistance program was not a charitable undertaking because a substantial portion of the charitable class to be aided consisted of employees of a related for-profit corporation, thus causing unwarranted private benefit and self-dealing involving the private foundation that would be conducting the program.⁵⁰

(a) Initial Evolution of Exemption Law

The IRS has, from the outset, resisted the notion that nonprofit credit counseling agencies are, in general, eligible for tax-exempt status as charitable (and/or educational) organizations. The most the agency was willing to concede was that these entities are so exempt when they confine provision of their services to low-income individuals (who are members of a charitable class⁵¹) who have financial problems and provide debt counseling without charge;⁵² when they provide the public with information on budgeting, buying practices, and the sound use of consumer credit;⁵³ and/or when they provide free or nominal-cost debt management plans (DMPs) for a small percentage of clients. Otherwise, the IRS was of the view that these agencies, if they are to be exempt at all, are properly classified as social welfare organizations, in that their activities contribute to the betterment of the community as a whole.⁵⁴

Initially, it appeared that courts would take a broader view. For example, a court ruled that the IRS cannot condition a credit counseling organization's tax status solely on the extent to which it provides assistance to the indigent.⁵⁵ This court held that the classification of these organizations as exempt charitable entities cannot be made dependent on whether they confine their assistance to low-income individuals or provide their services without charge. Credit counseling organizations were found to be entitled to recognition as charitable and educational organizations as long as they can demonstrate that they satisfy at least one of the definitions of the term charitable⁵⁶ or qualify as educational organizations.⁵⁷ The IRS decided, at the time, not to pursue this matter in the courts, being of the view that “further litigation of this issue would be futile.”⁵⁸

The IRS, beginning in 2002, renewed its efforts to revoke or deny recognition of tax exemption of nonprofit credit counseling agencies, working in tandem with the Federal Trade Commission.⁵⁹ Congressional hearings encouraged the IRS in this regard.⁶⁰ Relying heavily on the private benefit doctrine⁶¹ and the commerciality doctrine,⁶² the IRS started making the argument that contemporary credit counseling organizations are substantially different from their predecessors.⁶³ Adverse rulings in this context became the norm; they continue to be issued, although less frequently, inasmuch as tax exemption for these entities outside the statutory criteria has essentially been eradicated.⁶⁴ The IRS's policies in this regard are being extended to nonprofit organizations that assist homeowners in refinancing their mortgages⁶⁵ or that provide foreclosure-related services.⁶⁶

(b) Statutory Criteria for Exemption

An organization that has provision of credit counseling services⁶⁷ as its substantial purpose may not be tax-exempt⁶⁸ under the general requirements unless it also (1) provides credit counseling services tailored to the specific needs and circumstances of consumers; (2) does not make loans to debtors (other than loans without fees or interest) and does not negotiate the making of loans on behalf of debtors; (3) provides services for the purpose of improving a consumer's credit record, credit history, or credit rating only to the extent that these services are incidental to provision of credit counseling services; and (4) does not charge a separately stated fee for services for the purpose of improving a consumer's credit record, credit history, or credit rating.⁶⁹ The organization may not refuse to provide credit counseling services to a consumer due to the inability of the consumer to pay, the ineligibility of the consumer for DMP enrollment, or the unwillingness of the consumer to enroll in a DMP.⁷⁰ Also, the organization must establish and implement a fee policy that requires that any fees charged to a consumer for services be reasonable, allows for the waiver of fees if the consumer is unable to pay, and, except to the extent allowed by state law, prohibits charging any fee based in whole or in part on a percentage of the consumer's debt, the consumer's payments to be made pursuant to a DMP, or the projected or actual savings to the consumer resulting from enrollment in a DMP.⁷¹ Further, the organization's governing body must have certain characteristics.⁷² Moreover, the organization may not own more than 35 percent of the voting power of a corporation, the profits interest of a partnership, or the beneficial interest of a trust or estate that is in the business of lending money, repairing credit, or providing DMP services,⁷³ payment processing, or similar services.⁷⁴ Finally, this type of organization may not receive any amount for providing referrals for DMP services and may not pay for referrals of consumers.⁷⁵

In addition, if a credit counseling organization is to qualify as a tax-exempt charitable entity, it may not solicit contributions from consumers during the initial counseling process or while the consumer is receiving services from the organization. Also, the aggregate revenues of the organization derived from payments of creditors of consumers of the organization and that are attributable to DMPs generally may not exceed 50 percent of its total revenues.⁷⁶ In addition, if a credit counseling organization is to qualify as an exempt social welfare entity, it must apply for recognition of exempt status.⁷⁷

(a) Hospital Law in General

The most common example of a type of tax-exempt organization established and operated for the promotion of health is a nonprofit hospital.¹¹² Law has accreted over the decades as to the requirements for exemption for these hospitals. Additional statutory requirements for exemption in this context were enacted in 2010.¹¹³

To qualify for tax exemption as a charitable organization, however, a nonprofit hospital must demonstrate that it serves a public rather than a private interest.¹¹⁴ The Supreme Court observed that “[n]onprofit hospitals have never received these benefits [tax exemption and eligibility to receive deductible contributions] as a favored general category, but an individual nonprofit hospital has been able to claim them if it could qualify” as a charitable entity.¹¹⁵ The Court added: “As the Code does not define the term charitable, the status of each nonprofit hospital is determined on a case-by-case basis by the IRS.”¹¹⁶

The initial position of the IRS in this regard was published in 1956, in which the IRS set forth requirements for tax exemption, including a rule requiring patient care without charge or below cost.¹¹⁷ At that time, the IRS stated that a hospital, to be charitable, “must be operated to the extent of its financial ability for those not able to pay for the services rendered and not exclusively for those who are able and expected to pay.”¹¹⁸ This approach (the charity care standard) was a reflection of the charitable hospital as it once was—a health care provider emphasizing care more for the poor than for the sick.

Today's tax-exempt hospital provides health services for its community, funded by patient care revenue and charitable contributions. Prepayment plans cover hospital expenses for much of the citizenry, and reimbursement programs under Medicare and Medicaid have substantially reduced the number of patients who lack an ability to pay, directly or indirectly, for health care services. Because of these changes in the health care delivery system, in 1969 the IRS modified its 1956 position by recognizing that the promotion of health is inherently a charitable purpose and is not obviated by the fact that the cost of services is borne by patients or third-party payors.¹¹⁹ Under the 1969 ruling, to be tax-exempt, a hospital must adhere to a community benefit standard; that is, it must promote the health of a class broad enough to benefit the community and must be operated to serve a public rather than a private interest.¹²⁰ In practical terms, this means that the emergency room must be open to all and that hospital care is provided to all who can pay, directly or indirectly. The hospital may generate a surplus of receipts over disbursements and nonetheless be exempt. The requirement that health care must be provided free or at reduced costs was abandoned.

Other factors that may indicate that a hospital is operating for the benefit of the public include control of the institution by a board of trustees composed of individuals who do not have any direct economic interest in the hospital; maintenance by the hospital of an open medical staff, with privileges available to all qualified physicians, consistent with the size and nature of the facilities; a hospital policy enabling any member of the medical staff to rent available office space; hospital programs of medical training, research, and education; and involvement by the hospital in various projects and programs to improve the health of the community. These and similar factors are of particular help in the qualification for tax exemption of hospitals that do not operate an emergency room, either because other institutions provide emergency care sufficient to adequately serve the community or because the hospital is a specialized institution (e.g., an eye hospital or cancer center) that offers medical care under conditions unlikely to necessitate emergency care.¹²¹

For tax purposes, the term hospital includes federal government hospitals; state, county, and municipal hospitals that are instrumentalities of governmental units; rehabilitation institutions; outpatient clinics; extended care facilities; community mental health or drug treatment centers; and cooperative hospital service organizations,¹²² if they otherwise qualify. The term does not, however, include convalescent homes, homes for children or the aged, or institutions whose principal purpose or function is to train handicapped individuals to pursue a vocation;¹²³ nor does it include free clinics for animals.¹²⁴

The term medical care includes the treatment of any physical or mental disability or condition, whether on an inpatient or an outpatient basis, as long as the cost of the treatment is eligible for deductibility¹²⁵ by the person treated.¹²⁶

A four-entity reorganization resulted in formation of a federally qualified health center (FGHC) as that term is defined in the Medicare and Medicaid law. A tax-exempt hospital transferred nine of its primary-care medical practices to a related supporting organization,¹²⁷ which thereafter began operating as an FQHC. A title-holding company¹²⁸ merged into the supporting organization. A for-profit company that provided support services to the hospital dissolved; the supporting organization absorbed its assets and liabilities. Noting that the FQHC will adopt a charity care policy and will have a board of directors that will be community controlled, the IRS ruled that the supporting organization remained tax-exempt as an organization that promotes health.¹²⁹

(b) Additional Statutory Requirements for Hospitals

To be tax-exempt, nonprofit hospitals are required to meet additional statutory requirements that were enacted in 2010.¹³⁰

(c) Hospital Clinical Departments and Funds

Incorporated clinical departments of teaching hospitals associated with medical schools can be tax-exempt, charitable entities. For example, a court ruled that a professional corporation consisting of four departments of a medical school, which provided academic and clinical instruction for medical students, research, and administrative services for the benefit of the school and a teaching hospital, was exempt as a charitable, educational, and scientific entity in that it, in part, “delivers health care to the general public.”¹⁵³

On the basis of this and prior court decisions,¹⁵⁴ this type of corporate collective of physicians is tax-exempt, even though it generates fees for the performance of medical care services and pays the resulting earnings to individuals who are its stockholders. In these instances, of course, it is the close nexus with a medical school and teaching hospital that provides the underlying basis for the tax exemption.¹⁵⁵

Occasionally the IRS will rule that an organization is a tax-exempt charitable entity because it is carrying out an integral part of the activities of another charitable organization.¹⁵⁶ The IRS used this rationale to find that a trust created by an exempt hospital to accumulate and hold funds for the settlement of malpractice claims against the hospital, and from which the hospital directed the trustee to make payments to claimants, is a charitable organization for federal tax purposes.¹⁵⁷

(d) Medical Research Organizations

Charitable organizations that promote health include medical research organizations that are “directly engaged in the continuous active conduct of medical research in conjunction with a hospital.”¹⁵⁸ The term medical research means the conduct of investigations, experiments, and studies to discover, develop, or verify knowledge relating to the causes, diagnosis, treatment, prevention, or control of physical or mental diseases and impairments of humans. To qualify, the organization must have the appropriate equipment and professional personnel necessary to carry out its principal function.¹⁵⁹ Medical research encompasses the associated disciplines spanning the biological, social, and behavioral sciences.

This type of organization must have the conduct of medical research as its principal purpose or function¹⁶⁰ and be primarily engaged in the continuous active conduct of medical research in conjunction with a hospital that itself is a public charity. The organization need not be formally affiliated with a hospital to be considered primarily engaged in the active conduct of medical research in conjunction with a hospital. There must be, however, a joint effort on the part of the research organization and the hospital pursuant to an understanding that the two organizations will maintain continuing close cooperation in the active conduct of medical research.¹⁶¹ An organization will not be considered to be “primarily engaged directly in the continuous active conduct of medical research” unless it, during the applicable computation period,¹⁶² devoted more than one-half of its assets to the continuous active conduct of medical research or it expended funds equaling at least 3.5 percent of the fair market value of its endowment for the continuous active conduct of medical research.¹⁶³ If the organization's primary purpose is to disburse funds to other organizations for the conduct of research by them or to extend research grants or scholarships to others, it is not considered directly engaged in the active conduct of medical research.¹⁶⁴

(e) Homes for Aged

Another well-recognized health care provider is the home for the aged. Until 1972, the chief basis for tax exemption for a home for the aged as a charitable entity was that free or below-cost services must be provided, in conformance with the early IRS view of hospitals.¹⁶⁵ This approach was abandoned in that year and replaced with a requirement that the exempt charitable home for the aged be operated so as to satisfy the primary needs of the aged: housing, health care, and financial security.¹⁶⁶

The need for housing is generally satisfied if the home “provides residential facilities that are specifically designed to meet some combination of the physical, emotional, recreational, social, religious, and similar needs” of the aged. As for health care, that need is generally satisfied where the home “either directly provides some form of health care, or in the alternative, maintains some continuing arrangement with other organizations, facilities, or health personnel, designed to maintain the physical, and if necessary, mental well-being of its residents.” Satisfaction of the financial security need has two aspects: The home must (1) maintain in the residence “any persons who become unable to pay their regular charges” and (2) provide its services “at the lowest feasible cost.”

A home for the aged will qualify for tax-exempt status as a charitable organization, assuming it otherwise qualifies, if it operates in a manner designed to meet these primary needs of the aged. A home for the aged may, however, in the alternative, qualify under prior IRS rulings for exempt status if the home is primarily concerned with providing care and housing for financially distressed aged persons.¹⁶⁷

(f) Health Maintenance Organizations

Many tax-exempt health maintenance organizations provide health care services by means of facilities and programs, in adherence to standards of what is charitable comparable to those followed by exempt hospitals. It is a membership organization; its services are provided to members on a prepaid basis and to nonmembers on a fee-for-service basis. In most instances, the HMO handles emergency cases without regard to whether the patient is a member and annually provides care either free or at reduced rates to a limited number of indigent patients. Frequently, HMOs sponsor education programs and research efforts to study ways to deliver better health care services. The HMO governing board is usually elected by and from its membership.

The position of the IRS originally was that an HMO may qualify for tax exemption as a social welfare organization¹⁶⁸ but cannot qualify for exemption as a charitable organization, on the ground that the preferential treatment accorded its member-subscribers constitutes the serving of private interests and because the prepayment feature constitutes a form of insurance that is not a charitable activity. This position was rejected in court, however, in connection with one model of an HMO, where it was held that (1) the persons benefited by an HMO represent a class large enough to constitute a requisite community;¹⁶⁹ (2) the HMO meets all of the IRS criteria applied to determine charitable status for nonprofit hospitals;¹⁷⁰ and (3) while the risk of illness is spread throughout its entire membership, the HMO operates not for commercial purposes but for charitable purposes, and thus the risk-spreading feature¹⁷¹ is not a bar to designation of an HMO as a charitable organization.¹⁷²

Following the issuance of this court opinion, the IRS relented somewhat, agreeing that where an HMO possesses certain characteristics, it qualifies as a tax-exempt charitable entity.¹⁷³ Essentially, an HMO will qualify for charitable status in the eyes of the IRS when it operates primarily to benefit the community, rather than private interests. The IRS has determined, however, that certain HMOs cannot qualify as charitable organizations, because they are not operating for the benefit of a community. An IRS pronouncement distilled the key factors that, in the view of the agency, differentiate a tax-exempt HMO from a nonexempt HMO.¹⁷⁴

A federal court of appeals held that a nonprovider HMO does not qualify as a tax-exempt charitable organization.¹⁷⁵ The government won this case by distinguishing the facts from those in the prior litigation.¹⁷⁶ In the previous case, the HMO provided health care services itself, rather than arranging for others to provide that care. It employed physicians and other health care providers who were not affiliated with the HMO to provide health care services. It provided services to both subscribers and members of the general public through an outpatient clinic that it operated and through which it treated emergency patients, subscribers or not, regardless of ability to pay. It adjusted rates for and provided some free care to patients who were not subscribers. It offered public educational programs regarding health. The appellate court in the subsequent case held that a community benefit standard could be used; it went on to find, however, that the HMO did not provide any health services itself, it did not ensure that people who were not its subscribers had access to health care or information about health care, it did not conduct research, and it did not offer educational programs open to the public. In short, wrote the court, “it benefits no one but its subscribers.”¹⁷⁷

A court upheld the revocation by the IRS of the tax-exempt status of a nonprofit HMO, on the ground that it no longer provided the requisite community benefit.¹⁷⁸ One of the factors the court emphasized was the difference in treatment of the enrollees in the setting of premiums; the court inferred that this HMO was benefiting larger employers. Likewise, the composition of the HMO's board of trustees, “lacking in representation of the community at large, furthers the inference that [the HMO] predominantly served the private interests of the larger employers participating in its plans.”¹⁷⁹ The court concluded that the HMO “failed to show that it provides any community benefit that accomplishes a charitable purpose.”¹⁸⁰

(g) Integrated Delivery Systems

Another type of organization eligible for tax exemption as charitable organizations because they promote health is the integrated delivery system. Private determination letters (from the National Office of the IRS) recognizing the exempt status of these entities first appeared in early 1993.

An IDS is a health provider (or a component entity of an affiliated network of providers) created to integrate the provision of hospital services with medical services provided by physicians. Previously, these services were provided (and paid for by patients, their insurers, or government programs) separately; the hospital provided its services and facilities (such as diagnostic services, surgery, nursing, emergency care, room, and board), while physicians provided medical services to patients by means of private medical practices, admitting and treating patients in hospital facilities. In an IDS, an entity provides and bills for both hospital and physician services, either itself or by contract with another organization.

There are several models of a tax-exempt IDS. In one, a charitable organization obtains (by purchase, lease, license, stock transfer, or contribution) all of the assets needed to operate one or more hospitals, clinics, and physician offices. (There is concern on this point about the potential for forms of private inurement or private benefit,¹⁸¹ particularly in connection with leasing and licensing arrangements; the IRS prefers arrangements where the system's assets are purchased for fair market value and the IDS controls them.) It acquires the services of physicians, through direct employment or independent contract (the latter known as a professional services agreement). The organization is the provider of health care services—hospital and medical, inpatient and outpatient. It enters into all payor contracts, provides all nonprofessional personnel for the system, maintains all assets, and collects all revenues for services provided. Other models have the exempt IDS as a subsidiary of a hospital, hospital system, or clinic. Another type of IDS, which is jointly controlled by a health care provider and physicians, cannot qualify for exemption as a charitable entity because of the ownership and control by physicians.¹⁸²

Tax exemption for an IDS is tested against the community benefit standard. In this connection, the exempt IDS can minimize or eliminate duplication of tests, procedures, and treatments, resulting in greater efficiency and reduced costs to the public; provide increased accessibility to Medicare, Medicaid, and charity care patients; undertake research in primary care or areas of specialization that benefit the public; and conduct health education programs open to the public. The IRS expects (as it does in the exempt hospital setting) the governing board, and most committees and subcommittees, of an IDS to be independent (that is, not controlled by the physicians) and reflective of the community.

(h) Peer Review Organizations

Another category of organization posing problems with regard to eligibility for tax exemption as a charitable entity is the utilization and quality control peer review organization (PRO), which was authorized by statute in 1972.¹⁸³ PROs are qualified groups of physicians that establish mandatory cost and quality controls for medical treatment rendered in hospitals and financed under Medicare and Medicaid, and that monitor this care. PROs were conceived as part of a larger effort to curb the rising costs of health care, in this instance by minimizing or eliminating unnecessary services (those services termed overutilization) by assuring that payments under these governmental health care programs are made only when and to the extent that the health care services provided are medically necessary.

Congress views PROs as entities that act in the public interest, their chief purpose being to generally improve the quality of medical care in the United States and to obtain maximum value for every federal health dollar expended.¹⁸⁴ Assuming that the tax law requirements for tax-exempt charitable organizations are otherwise satisfied, this purpose would seem to clearly constitute a charitable activity, the rationales being the promotion of health, lessening of the burdens of government,¹⁸⁵ and/or promotion of social welfare.¹⁸⁶ There may, however, be a private purpose served by PROs, namely, enhancement of and establishment of confidence in the medical profession (even though, ironically, much of the medical community initially was bitterly opposed to the PRO concept).

PROs must be nonprofit organizations; they are reimbursed by the federal government for administrative costs. Members of a PRO must be licensed practitioners of medicine or osteopathy. The basic question with respect to tax-exempt charitable status is whether a PRO functions primarily to benefit the general public or to serve the interests of the medical profession. The inclination of the IRS is to treat certain health care organizations as business leagues rather than as charitable organizations.¹⁸⁷ The IRS recognized that incidental benefit to physicians will not defeat exemption as a charitable organization,¹⁸⁸ but also made it clear that, when the IRS concludes that a profession is itself receiving substantial benefit from an organization's activities, status as a business league is the likely result.¹⁸⁹ If, however, the activity primarily benefiting a profession is an incidental portion of a charitable organization's activities, the activity may be regarded as an unrelated business, leaving tax-exempt status undisturbed.¹⁹⁰ Prior to litigation, it was the position of the IRS that the public benefits flowing from physician peer review activities were overshadowed by the benefits ostensibly accorded physicians in their professional capacities, and thus that these organizations could not qualify as exempt charitable entities.

By contrast, the IRS recognized a health systems agency (HSA), an organization established by federal law¹⁹¹ to establish and maintain a system of health planning and resources development aimed at providing adequate health care for a specified geographic area, to be a tax-exempt charitable organization.¹⁹² Among the functions of the HSA is the establishment of a health systems plan after appropriate consideration of the recommended national guidelines for health planning policy issued by the U.S. Department of Health and Human Services (HHS). The agency receives planning and matching grants from the federal government. Finding the basis of the designation of the agency as a charitable entity to be the promotion of health, the IRS observed that, by “establishing and maintaining a system of health planning and resources development aimed at providing adequate health care, the HSA is promoting the health of the residents of the area in which it functions.”¹⁹³

The adverse position of the IRS regarding PROs was rejected by a court in a case involving PRO support centers.¹⁹⁴ The court held that Congress's principal purpose in establishing PROs was to ensure the economical and effective delivery of health care services under Medicare and Medicaid, and that any benefits that physicians and others may derive (including reimbursement for services, limitation on tort liability, or promotion of esteem for the medical profession) have only a “tenuous, incidental, and non-substantial connection with the [PRO] scheme.”¹⁹⁵ On this latter point, the court added that the PRO support centers did not engage in financial transactions “designed to benefit the members of the organizations or the organizations themselves, activities in the nature of a patient referral service, or other potential money-making activities designed to benefit members or participants.”¹⁹⁶

As a sidelight of this PRO decision, the court found it “difficult to reconcile” the position of the IRS against PROs and the ruling granting classification as tax-exempt charitable entities to HSAs. Said the court: “The similarity between HSAs and PROs and [PRO] support centers is obvious. [PROs] collect and analyze data, establish regional norms and criteria of care, and coordinate activities with HSAs and other federal state health planning entities.”¹⁹⁷

In the aftermath of these two court decisions,¹⁹⁸ the IRS revised its position concerning physician peer review organizations and concluded that, in certain circumstances, this type of entity is a tax-exempt charitable organization because it is “promoting the health of the beneficiaries of governmental health care programs by preventing unnecessary hospitalization and surgery.”¹⁹⁹ The IRS regards these factors as essential for exemption of a PRO as an exempt charitable entity: Membership in it is open by law to all physicians without charge; it is an organization mandated by federal statute as the exclusive method of assuring appropriate quality and utilization of care provided to Medicare and Medicaid patients; the composition of the board of directors of the PRO is not tied to any membership or association with any medical society; and the PRO has the authority to make final decisions regarding quality and utilization of medical care for purposes of payment under the Medicare and Medicaid programs. The fact that the activities of the PRO “may indirectly further the interests of the medical profession by promoting public esteem for the medical profession, and by allowing physicians to set their own standards for the review of Medicare and Medicaid claims and thus prevent outside regulation” was dismissed as being “incidental” to the charitable benefits provided by the organization.²⁰⁰

(i) Fitness Centers

Fitness centers and similar facilities, whether freestanding or operated by institutions such as hospitals, can be tax-exempt organizations (or programs), considered charitable in nature because they promote health. In this setting, the IRS once again applies the community benefit doctrine. Thus, when the health facility provides a benefit for the entire community the organization serves, operation of the facility is an exempt function.²⁰¹ By contrast, if the fees for use of a health club are sufficiently high to restrict use of the club's facilities to a limited segment of a community, the club operation will be a nonexempt one.²⁰²

In one instance, the IRS expressed the view that the standard as to tax exemption for a health club is whether its “operations promote health in a manner which is collateral to the providing of recreational facilities which advances the well-being and happiness of the community in general.”²⁰³ Similarly, a fitness center was held to be exempt inasmuch as it furthered the accomplishment of certain of the other programs of the health care organization that operated it (including an occupational and physical therapy program), its facilities and programs were specially designed for the needs of the disabled and the treatment plans of patients in other programs, its fee structure was designed to make it available to the public (its rates were comparable to those charged by similar fitness centers), and it offered a range of programs that focused on wellness.²⁰⁴ Likewise, a freestanding state-of-the-art cardiovascular rehabilitation and heart disease prevention center, which included a fitness facility, was found to be a related activity of an exempt hospital, with the IRS emphasizing the existence of a nutrition program and a scholarship plan for those who could not afford the programs and services of the center.²⁰⁵

The IRS's treatment of fitness and health centers as tax-exempt charitable functions that promote health extends to the most elaborate of facilities. In one instance, exemption was accorded a hospital-run sports and fitness center, the components of which included exercise rooms, racquetball and tennis courts, a two-pool aquatic area, an indoor track, tanning beds, a roller skating rink, and a juice bar. The agency held that the rehabilitation of hospital inpatients and outpatients in connection with treatment plans prescribed by physicians or other appropriate hospital personnel furthered the hospital's exempt purpose of serving the health care needs of the community involved.²⁰⁶ Likewise, the IRS ruled that an “integrated medical fitness facility” was a related business; this facility included 69,000 square feet of cardiovascular and strength training areas, an indoor multipurpose gymnasium, a walking track, three swimming pools, a sauna, steam rooms, four group exercise studios, a youth fitness area, locker rooms, and a healing garden.²⁰⁷

(j) Other Health Care Organizations

There are various other types of health provider institutions that qualify as exempt charitable organizations for federal tax purposes. These include entities such as preferred provider organizations, drug rescue centers,²⁰⁸ blood banks,²⁰⁹ halfway houses,²¹⁰ organizations that minister to the nonmedical needs of patients in a proprietary hospital,²¹¹ nursing bureaus,²¹² senior citizens centers,²¹³ organizations that provide private hospital rooms when medically necessary,²¹⁴ and Christian Science medical care facilities.²¹⁵

Moreover, recognition of tax-exempt status has been accorded to several types of organizations providing specialized health care services. Thus, for example, a home health agency that provides low-cost health care to patients in their homes can be an exempt charitable entity.²¹⁶ Similarly, an organization created to attract a physician to a medically underserved community by providing a medical building and facilities was ruled to be exempt, notwithstanding the fact that the physician charged for services provided and received some personal benefit (use of a building) under the arrangement.²¹⁷ Also, an organization was determined to be furthering the charitable purpose of promoting the health of its community where it built and leased a public hospital and related facilities to an exempt charitable association that operated the facilities for an amount sufficient only to retire indebtedness and meet necessary operating expenses.²¹⁸ Likewise, organizations that conduct medical research are frequently ruled to be exempt as charitable organizations, although these organizations may instead be considered as engaged in scientific research.²¹⁹ As another illustration, an organization that operated a free computerized donor authorization retrieval system to facilitate transplantation of body organs on the death of donors qualified as an exempt charitable organization engaged in the promotion of health.²²⁰ Still another example is an organization that provided services (such as housing, transportation, and counseling) for relatives and friends who traveled to the organization's community to visit and comfort patients at local health care facilities.²²¹ Further, an organization that provided medical care to indigent individuals through five medical clinics, including the funding of emergency room care and related inpatient care to the indigent, was ruled by the IRS to be promoting health.²²²

The IRS stated that the term charitable includes the promotion of public health, in ruling that an organization formed to provide individual psychological and educational evaluations, as well as tutoring and therapy, for children and adolescents with learning disabilities qualified as a tax-exempt, charitable organization.²²³ The organization's psychologists and other professionals administered tests designed to determine intellectual capacity, academic achievement, psychological adjustment, speech and language difficulties, and perceptual-motor abilities. Therapy was available through staff professionals specially trained in the various areas of learning disabilities.

Despite the efforts of the IRS to deny tax-exempt status to nearly all forms of referral services,²²⁴ a court held that an organization that operated a medical and dental referral service was a charitable entity because it promoted health.²²⁵ Users of the service (subscribers) paid the organization an annual fee and were provided an array of information concerning the availability of health-related supplies, equipment, and services at a discount. The service providers did not pay any fees to be listed with the referral service, although many made contributions to the organization. Other program activities of the organization were the publication of a health care newsletter, sponsorship of a community health fair, the provision of speakers, and the presentation of an annual conference for physicians and dentists. The court said that the referral service “serves its charitable purpose by providing a resource whereby subscribers can be made aware of and referred to medical specialists who can serve their health care needs” and that any financial benefit inuring to the referral service is merely incidental to the overall charitable purposes being served.²²⁶

Thus, there are various types of nonprofit organizations that promote health. Many of these entities, including hospitals, operate as members of a health care provider system. Generally, an aggregation of organizations, even where they have a common purpose (sometimes termed a system), cannot itself qualify for tax exemption as a charitable entity.²²⁷ Usually each organization must separately establish (if it can) a basis in law for its claim to exemption.²²⁸ In this context, at least, the IRS resists the concept of “exemption by attachment” or “derivative exemption.”²²⁹ Nonetheless, the eligibility of a supporting organization for exemption often is determined by the nature of its relationship with one or more supported organizations.²³⁰

(k) Regional Health Information Organizations

The National Office of the IRS, in 2009, began issuing exemption rulings to regional health information organizations (RHIOs). The essential purpose of an RHIO is to facilitate the exchange of electronic health records. This information sharing is and will be occurring among health care providers, physicians, insurers, and others in the health care system. The overall purpose of these records-exchange programs is promotion of health: improvement of the delivery of health care services and patient outcomes.

The federal government is promoting greater use of EHRs. This promotion was in President Bush's State of the Union address in 2006. The IRS, in 2007, issued a memorandum from the Director of the Exempt Organizations Division stating that the agency would not treat the benefits that a tax-exempt hospital provides to its medical staff physicians in the form of EHR software and technical support services as impermissible private benefit or private inurement if these benefits fall within the range of the EHR items and services that are permissible under the Department of Health and Human Services regulations promulgated in 2006.

Tax exemption for RHIOs was given a significant boost by enactment of legislation in 2009²³¹ that recognized that facilitation of health information exchange and technology is important to improvement of the delivery of health care and reduction in the costs of health care delivery and administration. The conference committee report accompanying this legislation stated that, as a result of the incentives for health information technology provided in the legislation, it is expected that “nonprofit organizations may be formed to facilitate the electronic use and exchange of health-related information consistent with standards adopted by HHS, and that such organizations may seek exemption from income tax as an organization described in IRC sec. 501(c)(3).”²³² Consequently, if a tax-exempt charitable organization “engages in activities to facilitate the electronic use or exchange of health-related information to advance the purposes of the bill, consistent with standards adopted by HHS, such activities will be considered activities that substantially further an exempt purpose under IRC sec. 501(c)(3), specifically the purpose of lessening the burdens of government.”²³³

The conference report concluded with this observation: “Private benefit attributable to cost savings realized from the conduct of such activities will be viewed as incidental to the accomplishment of the nonprofit organization's exempt purpose.”²³⁴ That language was of considerable assistance to the IRS in enabling it to begin issuing favorable exemption rulings to qualified RHIOs.

(l) Health Insurance Exchanges

States are required, by the health reform legislation enacted in 2010,²³⁵ to establish health insurance exchanges, namely, American Health Benefit Exchanges for the individual market and Small Business Health Options Program Exchanges for the small employer market (those with no more than 100 employees), that will make available qualified health plans to individuals and employers who are eligible to purchase insurance through these exchanges. The exchanges can be operated by a governmental agency, a quasi-governmental entity, or a nonprofit organization established by a state.²³⁶

If a state elects to not establish an exchange, the federal government will operate one. A state may combine these two types of exchanges into one entity. The National Association of Insurance Commissioners and state insurance commissioners are heavily involved in securing funding for exchange planning and start-up activities.

The functions of these exchanges will be determined by the states based on minimum standards established by the legislation and after consultation with stakeholders. These functions include certification, recertification, and decertification of health plans as qualified health plans;²³⁷ maintenance of a toll-free hotline to respond to requests for assistance; maintenance of a website for enrollees and prospective enrollees to enable them to compare information regarding qualified health plans; use of a standardized format for presenting health benefit plan options in the exchange; establishment of, and electronic availability of, a calculator to determine the actual cost of coverage after application of any premium tax credit²³⁸ and any applicable cost sharing; granting of certifications as to exemptions from the individual mandate or penalty;²³⁹ transferring of information to the Department of the Treasury concerning exemptions from the mandate, employees eligible for the premium tax credit, and individuals who have changed employers or have ceased coverage under a qualified health plan during the year; provision of information to employers on employees eligible for the premium tax credit who cease coverage under a qualified health plan during the plan year; and establishment of a navigator program based on HHS standards and developed in collaboration with the states.

Plan offerings by means of these exchanges will be based on essential health benefits as defined by the HHS, on the basis of a list of services in the legislation. A state may expand this list of essential health benefits; if a state does so, however, it is responsible for paying the associated costs.

Qualified health plans are required to implement a payment structure that provides increased reimbursement or incentives for quality improvement activities. These plans are required to report periodically to the appropriate exchange activities undertaken to implement the payment structure. Beginning on January 1, 2015, unless an exception is authorized by the exchange on the basis of rules developed by the HHS, a qualified health plan may contract with only (1) a hospital with more than 50 beds if the hospital uses a patient safety evaluation system and implements a mechanism ensuring that each patient receives information about a comprehensive program for hospital discharge, or (2) a health care provider if the provider implements mechanisms required by the HHS to improve health care quality. There is an opportunity for hospitals to participate in development of guidelines for quality improvement and exceptions.

States are required to develop a secure electronic interface that allows for the exchange of information to determine consumers' eligibility for public program coverage, tax credits, and other subsidies. Coordination is required between enrollment in the exchanges and state-funded health programs, such as Medicaid and the Children's Health Insurance Program. An exchange may contract with a Medicaid provider for enrollment, eligibility, and coordination of qualified health plans in an exchange.

A state may pursue federal funding to establish, expand, or provide support for offices of health insurance consumer assistance or ombudsman programs and, as a condition of receiving the grant, impose reporting and data collection requirements. A state may establish a risk-adjustment mechanism to assess issuers whose actuarial risk for a year is less than the average actuarial risk of all enrollees in the state and to pay issuers whose actuarial risk for a year is greater than average. The law requires states to adopt adjusted community rating, and limits premium variation for group and individual health insurance.²⁴⁰

(m) Accountable Care Organizations

The health care reform legislation brought new law directing the HHS to establish a Medicare Shared Savings Program (MSSP) that promotes accountability for care of Medicare beneficiaries, improves the coordination of Medicare fee-for-service items and services, and encourages investment in infrastructure and redesigned care processes for high-quality and efficient health care service delivery.²⁴¹ Groups of health care service providers and suppliers that have established a mechanism for shared governance and that meet criteria specified by the HHS are eligible to participate as accountable care organizations (ACOs), which essentially are networks designed to reduce health care costs, under the MSSP.²⁴² ACOs will be rewarded with a share of the Medicare savings for providing quality care at a lower cost in relation to a spending benchmark.

(a) General Principles

The early position of the IRS toward cooperative venturing by or for charitable (including educational) organizations was relatively favorable. This is reflected in an IRS ruling concerning an organization that was created to construct and maintain a building to house member agencies of a community chest.⁴²² Citing the concept that the “performance of a particular activity that is not inherently charitable may nonetheless further a charitable purpose,”⁴²³ the IRS ruled that the organization was exempt as a charitable entity, emphasizing the low rental rates and the close relationship between its purposes and functions and those of the tenant organizations.⁴²⁴

The contemporary state of the law in this regard, however, is that these cooperative ventures are likely to be nonexempt entities, even where the venture is controlled by and performs a function for its members that each tax-exempt institution would otherwise have to undertake for itself without adverse tax consequences. The IRS has two exceptions to this policy, in that exemption as a charitable organization will be granted where the consortium conducts substantive programs that are inherently exempt in nature⁴²⁵ or where at least 85 percent of the organization's revenue is derived from outside sources (the donative element test).⁴²⁶ The agency bases its position on a passage in the regulations accompanying the federal tax rules pertaining to feeder organizations.⁴²⁷ The IRS policy toward cooperative ventures had, for many years, been rejected in the courts on nearly every occasion when it was considered,⁴²⁸ and Congress had legislated in this area, contravening the IRS's policy three times.⁴²⁹

The direction of the law regarding tax exemption for consortia began to shift as a result of consideration of the issue by the U.S. Tax Court. A 1980 case involved a cooperative hospital laundry service owned and operated by exempt hospitals. Finding the regulations under the feeder organization rules to have the force of law because of long-standing congressional awareness of them, and concluding that the legislative history of related statutes evidenced congressional intent to not allow exemption for hospital-controlled laundries, the court found that the hospital laundry service organization was a feeder organization and thus not exempt from taxation.⁴³⁰ Because of the emphasis placed on this legislative history, however, it was not clear whether consortia other than hospital laundry enterprises would receive like treatment by the Tax Court. Shortly after the Tax Court reached this decision, the Third,⁴³¹ Ninth,⁴³² and Sixth Circuit courts of appeal arrived at the same conclusion.⁴³³

Despite this policy, the IRS recognized the necessity and utility of cooperative endeavors in the field of higher education. Thus, the IRS stated that “[m]any activities normally carried on by colleges and universities can be more effectively accomplished through the combined efforts of a group of such institutions” and that these associations “aid and promote the educational endeavors of their members and interpret to the public the aims, functions, and needs of the institutions, with a view to better understanding and cooperation.”⁴³⁴ The IRS subscribed to this view in the intervening years.⁴³⁵

The IRS ruled that an organization whose members are educational (including some proprietary) institutions qualified as a tax-exempt charitable organization because it accredits these institutions.⁴³⁶ The rationale for exemption was that the organization advanced education and thus was charitable in nature;⁴³⁷ it engaged in activities that “support and advance education by providing significant incentive for maintaining a high quality educational program.”

Similarly, the IRS accorded charitable entity status to an organization controlled by a tax-exempt conference of churches, where its purpose was to issue mortgages to the churches to enable them to finance the construction of church buildings.⁴³⁸ The rationale for exemption was that the organization was advancing religion.⁴³⁹ The making of loans is not, of course, an inherently religious activity; rather, exemption was derived from the fact that the loans were made at lower than commercial interest rates to churches of the conference to enable them to construct buildings for religious purposes at reduced cost.

Also, the IRS granted recognition of tax-exempt charitable status to a consortium of counties located in the same state.⁴⁴⁰ This exemption was accorded on the ground that the organization's activities contribute to the “more efficient operation of county government.” Efficiency of operation is, as noted, one of the principal reasons for the establishment and operation of consortia.

Further, it has long been the position of the IRS that an organization formed and operated for the purpose of providing financial assistance to organizations that are regarded as charitable is itself qualified for tax exemption as a charitable entity.⁴⁴¹

(b) Adjunct Theory

A federal court had occasion to reaffirm its original position concerning consortia,⁴⁴² stating that “[t]his court has held in the past that where one organization provides a service which is necessary and indispensable to the operations of another, the first will take on the tax status of the second.”⁴⁴³ Invoking an adjunct theory, the court added that “[t]hese cases clearly indicate that where one organization serves as a mere adjunct for a primary organization by providing services which are essential to the functioning of the primary organization and which would be normally performed by it, the adjunct will acquire the tax status of the primary company.”⁴⁴⁴

The adjunct theory was initially invoked by a federal court of appeals in 1934.⁴⁴⁵ The first application of this theory to adjunct entities of charitable organizations occurred in 1951. In that year, another federal appellate court reviewed the tax status of a corporation organized to operate a bookstore and restaurant on the campus of a tax-exempt college. Despite the fact that these operations were not inherently charitable or educational activities, the court of appeals invoked the rationale of the adjunct theory, writing that the “business enterprise in which [the] taxpayer is engaged obviously bears a close and intimate relationship to the functioning of the [c]ollege itself.”⁴⁴⁶ The appellate court concluded that this corporation was entitled to exemption as an educational organization.

The adjunct theory was subsequently espoused by a court, which concluded that a museum was a tax-exempt educational organization because it was an integral part of and a valuable adjunct to a public school system.⁴⁴⁷ At issue in this case was the availability of the pre-1969 additional charitable contribution deduction of 10 percent of a taxpayer's adjusted gross income for contributions to operating educational institutions that engage in the presentation of formal instruction.⁴⁴⁸ The court concluded that gifts to the museum qualified for the bonus charitable contribution deduction, even though the museum itself did not satisfy the statutory requirements, because it was an integral part of the school system and thus was clothed with the educational status of the system.⁴⁴⁹

The adjunct theory, however, does not have broad application. As a court stated, the “adjunct doctrine has developed in unique factual settings which when reconciled do not stand for a general principle capable of eroding the statutory limitations on exemptions.”⁴⁵⁰

(c) Cooperative Arrangements

One of the principal reasons that the government has opposed tax-exempt status for a consortium entity is the fear that an organization that is not formed and controlled by charitable entities will by its own choice confine its services to charitable entities and thereby itself acquire exempt charitable status, even where the provision of its services is in competition with commercial enterprises. Of course, this factual situation is easily distinguishable from the normal consortium arrangement, but this concern nonetheless persists.

The government's concerns in this regard were presumably largely alleviated by a court decision holding that an organization that planned to offer consulting services for a fee to a class of nonprofit (but not all tax-exempt) organizations did not qualify as an exempt charitable entity but was taxable as a business.⁴⁵¹ Nonetheless, the IRS reviewed the tax-exempt status of an organization whose members were exempt universities and municipal libraries; its operation of a computer network to facilitate exchange of information among its membership was ruled to be an exempt charitable function.⁴⁵² The IRS ruled that this organization could extend its services to private businesses in furtherance of its exempt information-sharing functions.⁴⁵³

The legislative history of the CommonFund provision⁴⁵⁴ stated that it applies only to cooperative organizations formed and controlled by the participating institutions themselves, rather than to private organizations furnishing the same services, even where those services might be made available only to educational organizations. Congress stated that, in enacting this statute, “it is not intended that any inference be drawn as to the exempt status of other organizations formed by educational institutions or by other charities on their behalf to carry out their normal functions in a cooperative manner.”⁴⁵⁵

Congress changed the law in this area in one respect in 1976.⁴⁵⁶ It had been the position of the IRS that income derived by a tax-exempt hospital from providing services to other exempt hospitals constitutes unrelated business income to the hospital providing the services, on the rationale that the provision of services to other hospitals is not an activity that is substantially related to the exempt purposes of the provider hospital.⁴⁵⁷ Congress acted to override this position in the case of small hospitals where an exempt hospital⁴⁵⁸ provides services only to other exempt hospitals, as long as each of the recipient hospitals has facilities to serve no more than 100 inpatients and the services are consistent with the recipient hospitals' exempt purposes if performed by them on their own behalf.⁴⁵⁹ This law change was implemented to enable a number of small hospitals to receive services from a single institution instead of providing them directly or creating an exempt organization to provide the services.

The U.S. Supreme Court held that a cooperative hospital laundry organization did not qualify for tax exemption as a charitable entity.⁴⁶⁰ Such an organization is, of course, a type of consortium. The Court ruled in opposition to exemption in this context, however, because the facts necessitated application of the rules concerning cooperative hospital organizations—a unique set of circumstances⁴⁶¹—and not because the tax law is generally in opposition to exemption for consortia. Thus, for example, a court held that an organization, operated on a cooperative basis, was entitled to exempt status as a charitable organization because it was controlled by its member exempt organizations (libraries) and provided indispensable program and administrative services to them.⁴⁶² The court stated that “where a group of tax exempt organizations forms a cooperative to provide services exclusively to those tax exempt organizations, and the services provided are necessary and indispensable to the operations of the tax exempt organizations, the cooperative is a tax exempt organization.”⁴⁶³

(a) General Principles

The IRS observed that its records indicate that “over 12,000 exempt organizations are listed as having fund raising as a major purpose,” adding that “it seems logical that there are tens of thousands of additional organizations that engage in fund raising programs to various degrees.”⁴⁶⁵ And that was written in 1982.

Indeed, it has been IRS policy since 1924 that a nonprofit organization that only carries on operations that involve receipt of contributions (and perhaps investment income) and distributions of its income to public charities is eligible to receive recognition of tax exemption as a charitable entity.⁴⁶⁶ This principle was restated in 1967, holding that an organization that meets this description qualifies for tax exemption as a charitable entity: “An organization was formed for the purpose of providing financial assistance to several different types of organizations which are exempt from Federal income tax under section 501(c)(3) of the Internal Revenue Code of 1954. It carries on no operations other than to receive contributions and incidental investment income and to make distributions of income to such exempt organizations at periodic intervals.”⁴⁶⁷

In a 1960s case considered by the IRS, a resulting technical advice memorandum stated that “[c]haritable organizations have traditionally engaged in fund raising activities as a means of raising funds to carry out their charitable purposes.” This TAM concluded: “The mere fact that an organization derives its income primarily from such fund-raising activity is not considered to defeat either the primary purposes or the substantial activity tests of section 1.501(c)(3)-1(c) of the Income Tax Regulations.”⁴⁶⁸

Another case reviewed by the IRS in the 1970s involved a “social fund raiser,” the objective of which was “to raise money for charity through members, family and friends sponsoring socials, lunches and dinners, and donations for the affairs to be given for various charitable organizations.” The entity owned a clubhouse where these events (including birthday parties) took place. In a TAM, the IRS wrote: “Many charitable organizations do not engage in active charitable undertakings themselves, but rather assist the work of religious, charitable, educational or similar organizations by contributing money to them,” adding that “[p]roviding financial assistance to such organizations is a charitable activity justifying exemption.”⁴⁶⁹

In another case from the 1970s, an organization ran a beer “kegger” for the benefit of local charities. The parties produced a considerable profit. The IRS ruled that the organization qualified for exemption as a charitable entity.⁴⁷⁰

An early version of the Exempt Organizations Handbook contained this observation: “Many charitable foundations do not engage in active charitable undertakings themselves, but rather assist the work of religious, charitable, educational, or similar organizations by contributing money to them. The foundation's funds may be dedicated to purposes, as broad as but no broader than, the purposes set out in IRC [§] 501(c)(3). These foundations are charitable in the broad sense of the word.”⁴⁷¹

A court observed: “It seems well settled that an organization need not engage in a functional charitable activity to be organized and operated for charitable purposes within the meaning of section 501(c)(3).…Such charitable purposes may be accomplished solely by providing funds to other exempt organizations.”⁴⁷²

Another court stated: “In determining whether an activity is organized for educational purposes and so exempt from social security taxes, the purposes for which it spends its income and not the means whereby it obtains income are conclusive.”⁴⁷³

(b) Application of Commensurate Test

Because the IRS and the courts regard grantmaking to charities as charitable activity, the IRS has concerns where the grantor organization is distributing what it regards as insubstantial amounts. The IRS has termed these entities “unproductive” fundraising organizations.⁴⁷⁴ The IRS measures this productivity by means of application of the commensurate test.

Pursuant to the commensurate test, the IRS assesses whether a charitable organization is maintaining program activities that are commensurate in scope with its financial resources.⁴⁷⁵ In the facts underlying an IRS 1964 pronouncement, the organization derived most of its income from rents. The organization, nonetheless, was successful in preserving its tax-exempt status as a charity because it satisfied the test by engaging in an adequate amount of charitable functions notwithstanding the extent of its rental activities.⁴⁷⁶

The IRS often combines application of the commensurate test with its consideration of the unrelated business rules, usually leading to a favorable outcome for the organization involved when the activity, considered by the organization to be fundraising, is protected from unrelated business income taxation by reason of a statutory exception.⁴⁷⁷ As the IRS has said, taken in conjunction with these exceptions, the “Service has often granted IRC 501(c)(3) exemption status to the typical fund raiser if there has been a sufficient turnover of funds to charity.”⁴⁷⁸

The IRS has said that, assuming the fundraising activity is not an unrelated business, tax exemption “cannot be legally denied under IRC [§] 501(c)(3)” if the agency “find[s] that the fund raising organizations through these events produce commensurately in scope with their financial resources.” “This is true,” the IRS added, “because a commensurately producing typical fund raising organization cannot be held to be organized or operated for the primary purpose of operating a trade or business for purposes of Reg. [§] 1.501(c)(3)-1(e).”⁴⁷⁹

If an organization engages in a form of fundraising but makes few or no distributions for charitable purposes, the organization cannot be exempt as a charitable entity, by reason of the commensurate test. For example, an organization conducted bingo games as its principal activity; its stated purpose was to conduct these games and provide financial assistance for the care of needy children and children's charities. The organization made grants to charitable entities that were insubstantial when compared to the gross receipts from the bingo games. A court held that this organization did not qualify for exemption as a charitable entity because it did not engage in any charitable activities and principally operated the bingo game business.⁴⁸⁰ Similarly, the IRS ruled that an organization conducting bingo games was not a charitable entity because it made no distributions for its ostensible exempt purpose, which was the making of scholarship grants.⁴⁸¹

In sum, rather than following a set percentage formula, a threshold factor of charitable giving should be fully analyzed in context with all the operative facts. The IRS's lawyers have also written:

The “commensurate test” does not lend itself to rigid numerical distribution formulas—there is no fixed percentage of income that an organization must pay out for charitable purposes. The financial resources of any organization may be affected by such factors as start-up costs, overhead, scale of operations, whether labor is volunteer or salaried, phone or postal rates, etc. In each case, therefore, the particular facts and circumstances of the fund-raising organization must be considered. Accordingly, a low payout percentage does not automatically mandate the conclusion that the fund-raising organization under consideration has a primary purpose that is not charitable. In each case, it should be ascertained whether the failure to make real and substantial contributions for charitable purposes is due to a reasonable cause.⁴⁸²

The IRS wrote that “[w]hether an organization is carrying on a real and substantial program reasonably commensurate in scope with its financial resources and capabilities is an essentially factual matter.” In the fundraising context, the IRS stated that a “threshold consideration rests on an organization's production of funds distributed for charitable use.”⁴⁸³

(c) Other Exemption Issues

As is the case in many aspects of the law, the general rules can be abused, leading, in this context, to denial of recognition of, or to revocation of, tax-exempt status. The abuses in the fundraising context include failure to meet the commensurate test (because of high administrative and fundraising expenses and/or inadequate distributions for charitable purposes), violation of the private inurement doctrine (such as payment of excessive compensation to a service provider that is an insider or other inappropriate involvement of this type of service provider), and application of the doctrine of commerciality.

For example, the private inurement doctrine was found violated where a nonprofit organization was formed to raise money for a scholarship fund, where the fundraising medium consisted of the conduct of bingo games in a cocktail lounge owned by a majority of the directors of the nonprofit entity. A court found that more than an insubstantial purpose of the nonprofit organization's activities was to attract customers, by way of the games, onto the premises of the lounge, expecting that they would purchase food and beverages while there, thus enhancing the profitability of the company operating the lounge. Tax exemption was denied in this instance.⁴⁸⁴ A similar holding concerned the case of a nonprofit organization seeking to raise money for charities by selling lottery tickets in a bar.⁴⁸⁵

In another instance, a nonprofit entity, operating a “networking and fund-raising” website, was denied recognition as a charitable entity by the IRS because its primary activity was advertising, which was considered commercial; the fact that a portion of the advertising revenue could be directed by users of the site to charities was deemed unavailing.⁴⁸⁶ Likewise, a nonprofit organization selling coffee and hot chocolate products online, enabling customers to designate a portion of the “fundraising proceeds” for charity, was denied recognition of exemption, primarily on the grounds of commerciality.⁴⁸⁷ Also, a nonprofit organization, formed to promote mobile giving and fundraising using other technology platforms to encourage charitable giving by younger donors, facilitating the distributions of contributions made by wireless mobile telephone customers to qualified charities, was denied recognition of exemption as a charitable entity largely because of private benefit provided to applications service provider companies and the participating wireless mobile telephone carriers.⁴⁸⁸ The same fate befell an organization operating a website enabling individuals to volunteer to perform services in exchange for charitable contributions, with the IRS portraying this entity as a “facilitator of commerce” between the service providers and recipients.⁴⁸⁹ Likewise, the IRS ruled that an organization was a “commercial fundraising service” that did not really engage in fundraising but merely facilitated the transfer of funds from donors to donees,⁴⁹⁰ that fundraising by means of an online raffle was a commercial activity because the tickets were too highly priced,⁴⁹¹ that an organization providing fundraising and marketing services to unrelated charitable entities could not be exempt because it was primarily engaged in commercial activity,⁴⁹² and an organization selling shirts online, that planned to donate them to the needy and make grants to charitable organizations, could not be exempt.⁴⁹³

It is the view of the IRS that fundraising activities by sports booster clubs, where the resulting payments directly benefit participating families rather than the organizations themselves, amount to a form of private inurement.⁴⁹⁴ The government was successful in causing a court to agree in a case of a gymnastics booster club that facilitated fundraising by parents of children in the sports program; the parents earned points, which were used to reduce amounts owed for assessments for the expenses of competitions.⁴⁹⁵ In this case, the court found that the fundraising practices caused private inurement to the participating parents⁴⁹⁶ and conferred unwarranted private benefit to the children participating in the athletic activities.⁴⁹⁷

(a) Environmental Protection

An organization established to promote environmental conservancy is a tax-exempt charitable entity.⁵²⁸ The IRS ruled that it is “generally recognized that efforts to preserve and protect the natural environment for the benefit of the public serve a charitable purpose.”⁵²⁹ The IRS, however, refused to classify an organization as an exempt charitable entity where it merely restricted land uses that did not change the environment, where the land lacked any “distinctive ecological significance,” and where any public benefit was “too indirect and insignificant.”⁵³⁰ The IRS declined to accord recognition of exemption to a nonprofit corporation that proposed provision of “residential solar energy systems” to low- and middle-income households in a county, because the organization failed to provide “credible studies or research” showing that use of these systems “would have a measurable, significant impact in preserving and protecting the environment.”⁵³¹ The IRS likewise did not recognize exemption of an alleged environment organization, finding that its program of mitigating carbon emissions was a nonexempt certification activity, with its selling of carbon offsets a commercial enterprise.⁵³²

Nonetheless, the position of the IRS that only land of “distinctive ecological significance” can qualify as a tax-exempt function holding of an environmental conservation organization was implicitly rejected by a court when it accorded classification as an exempt charitable organization to a model farm operated as a conservation project.⁵³³ Rather than focus on the nature of the land as such, the court emphasized the use of the land: The organization's “agricultural program seeks to demonstrate the commercial viability of ecologically sound farming techniques not yet practiced in the surrounding community.”⁵³⁴

This body of law is integrated with the rules in the charitable giving context pertaining to contributions of conservation easements.⁵³⁵ For example, the IRS ruled that a nonprofit organization newly receiving gifts of conservation easements and incapable of enforcing them, and facilitating tax avoidance by allowing improper charitable contribution deductions, was not entitled to recognition of exemption as an environmental protection entity.⁵³⁶ A similar situation occurred following observation by an IRS agent of illegal dumping, abandoned home appliances, and garbage on the ostensibly protected property, along with evidence of four-wheel-drive vehicles driven over sensitive wetlands and the development of recreational ponds.⁵³⁷ Indeed, an organization had its exempt status as a charitable organization revoked when the IRS discovered that its function of receiving gifts of conservation easements was not being undertaken for the protection of open space or natural habitats but was done for the purpose of generating “sizeable deductions” for the donors, who were clients of the organization's president, an accountant.⁵³⁸

(b) Promotion of Patriotism

The IRS concluded that the promotion of patriotism is a charitable objective. The ruling came in the case of a membership organization formed by citizens of a community to promote “civic pride in the community, state, and the country” by providing a color guard and conducting flag-raising and other ceremonies at patriotic and community functions.⁵³⁹ As authority for this position, the IRS stated that trusts created for the purpose of “inculcating patriotic emotions have been upheld as charitable, as have trusts for the purchase and display of a flag, and for the celebration of a patriotic holiday.”⁵⁴⁰

(c) Promotion of Sports

A court held that the promotion, advancement, and sponsoring of recreational and amateur sports is a charitable activity.⁵⁴¹ The organization involved owned and operated an amateur baseball team that played in a semiprofessional league, leased and maintained a baseball field used by its team and other teams, furnished instructors and coaches for a baseball camp, and provided coaches for Little League teams. The government's contention that the team was semiprofessional, and thus that the operation of it was a nonexempt activity, was rejected.⁵⁴² Where, however, the primary purpose of an organization is to promote recreational sports among adults, the entity does not provide instruction to youth, it lacks a regular program of teaching a sport and does not have a sports trainer, and/or it expends most of its funds on travel and meals for a team comprised of individuals 18 years of age or older, the organization will not qualify for exemption as a charitable entity.⁵⁴³

The IRS ruled that an organization that furthers recreational and amateur sports is a charitable entity; in this instance, the organization provides youth with learning facilities and educational programs that promote character-development and life-enhancing values by means of the playing of golf. The organization operates an 18-hole golf course, provides lessons, and sponsors golf clinics and youth tournaments. The IRS ruled that the operation of the golf course and the other functions, in this context, had a substantial causal relationship to the achievement of exempt functions.⁵⁴⁴

(d) Public Interest Law

Organizations structured as public interest law firms—nonprofit entities that provide legal representation in matters involving a broad public interest under circumstances where the financial interests at stake would not normally warrant representation from private legal sources—can qualify as tax-exempt charitable organizations where they provide a “service which is of benefit to the community as a whole,” with “[c]haritability…also dependent upon the fact that the service provided by public interest law firms is distinguishable from that which is commercially available.”⁵⁴⁵ The recognition by the IRS that public interest law firms can be charitable in nature was significant, in that beforehand the agency would not recognize as exempt an organization operating in support of interests of a majority of the public since that segment of society does not constitute a charitable class.⁵⁴⁶

In guidelines containing criteria for these firms, the IRS stated that the engagement of public interest law firms in litigation “can reasonably be said to be in representation of a broad public interest rather than a private interest.”⁵⁴⁷ These guidelines “are not inflexible,” in that an organization will be given the opportunity to demonstrate that, under the particular facts and circumstances, adherence to the guidelines is not required in certain respects in order to ensure that the charitable organization's operations are “totally charitable.”

Litigation is considered to be in representation of a broad public interest if it is designed to present a position on behalf of the public at large on matters of public interest. This type of litigation includes class actions, in which resolution of the dispute is in the public interest, lawsuits for injunction against action by government or private interests broadly affecting the public, similar representation before administrative boards and agencies, and test suits where the private interest is small.

This type of litigation activity normally may not extend to direct representation of litigants in actions between private persons where the financial interests at stake would warrant representation from private legal sources. The organization may not attempt to achieve its objectives through a program of disruption of the judicial system, illegal activity, or violation of applicable canons of ethics. The policies and programs of the organization should be the responsibility of a board or committee representative of the public interest. The organization should not be operated in a manner that creates identification or confusion with a particular private law firm.

The organization may accept lawyers' fees in public interest cases if the fees are paid by opposing parties and are awarded by a court or administrative agency or approved by such a body in a settlement agreement. The organization may accept lawyers' fees in public interest cases if the fees are paid directly by its clients, if it adopts certain additional procedures concerning client-paid fees (see below). The likelihood or probability of a fee, whether court-awarded or client-paid, may not be a consideration in the organization's selection of cases.

The total amount of all lawyers' fees may not exceed 50 percent of the total cost of operation of the organization's legal functions. This percentage is calculated over a five-year period. Costs of legal functions include lawyers' and others' salaries, overhead, and costs directly attributable to the performance of the organization's legal functions. Staff lawyers and other employees are compensated on the basis of reasonable salaries that are not established by reference to fees received in connection with the cases they have handled.

Client-paid fees may not exceed the actual cost incurred in each case. These costs may be charged against a retainer, with any balance remaining after the conclusion of the litigation refunded to the litigant. Once having undertaken a representation, a public interest law firm may not withdraw from the case because the litigant is unable to pay the contemplated fee.

Other types of tax-exempt, charitable organizations engage in litigation activities in furtherance of their exempt functions. They are legal aid organizations,⁵⁴⁸ human and civil rights organizations,⁵⁴⁹ and still other organizations that attempt achievement of charitable goals by means of litigation.⁵⁵⁰

(e) Local Economic Development

A form of tax-exempt charitable organization is the local economic development corporation (LEDC). LEDCs engage in a variety of activities, including investment in local businesses; direct operation of job-training, housing, and other programs; business counseling; and encouragement to established national businesses to open plants or offices in economically depressed areas. A prime purpose of an LEDC is to alleviate poverty—clearly a charitable purpose.⁵⁵¹ By necessity, however, LEDCs render assistance to commercial business enterprises and make investments in businesses as part of their principal function. While these activities are not normally regarded as charitable in nature, there is authority for a determination that these LEDCs engage in charitable endeavors.

The IRS ruled that an organization is tax-exempt as a charitable entity (as promoting social welfare⁵⁵²) where it maintained a program of providing low-cost financial assistance and other aid designed to improve economic conditions and economic opportunities in economically depressed areas.⁵⁵³ The organization undertook to combat these conditions by providing funds and working capital to business corporations or individual proprietors who were unable to obtain funds from conventional commercial sources because of the poor financial risks involved. The IRS noted that “these loans and purchases of equity interest are not undertaken for purpose of profit or gain but for the purpose of advancing the charitable goals of the organization and are not investments for profit in any conventional business sense.”⁵⁵⁴

It is possible for an LEDC to qualify for tax exemption as a charitable entity even though it is licensed as a nonprofit small business investment company under the Small Business Investment Act (SBIC).⁵⁵⁵ An SBIC licensee is required to comply with certain regulations promulgated by the Small Business Administration (SBA) that set requirements as to the level of interest rates charged by a licensee and impose various restrictions on the degree of financial support that may be offered to a prospective recipient. The difficulty is that an SBA-regulated SBIC may be prevented from engaging in certain loan transactions in which it would otherwise be able to engage in furtherance of charitable purposes. Although a “narrower range of permissible transactions” is available to an SBIC than to non-SBA-regulated LEDCs, the IRS concluded that the SBIC “may still provide loans to businesses that cannot secure financing through conventional commercial sources, the operation of which businesses will achieve charitable purposes.”⁵⁵⁶ Thus, although this ruling does not mean that all SBA-regulated SBICs are automatically exempt LEDCs, it does not mean that the mere fact that the organization is subject to the SBA regulations does not preclude it from exemption.

Subsequently, the IRS distinguished the situation involved in its prior ruling from that where the primary purpose of the organization is to promote business in general rather than to provide assistance only to businesses owned by minority groups or to businesses experiencing difficulty because of their location in a deteriorated section of the community. Thus, the IRS denied classification as a tax-exempt charitable entity to an organization formed to increase business patronage in a deteriorated area mainly inhabited by minority groups by providing information on the area's shopping opportunities, local transportation, and accommodations, and to an organization the purpose of which was to revive retail sales in an area suffering from continued economic decline by constructing a shopping center in the area to arrest the flow of business to competing centers in outlying areas.⁵⁵⁷

A public charity constructed an “innovation and incubator center,” funded by commercial loans and government grants, to attract high-technology companies to a state for the purpose of creating employment opportunities and increase higher education in technology so as to build a skilled workforce. Small companies rent space at the center at below-market rates, thereby bringing more high-tech jobs into the area. Noting that the region where this center is located has been plagued by poverty, poor education, and low standards of living for over a century, the IRS ruled that this project furthers charitable purposes by providing economic development to this underprivileged area.⁵⁵⁸

(f) Other Charitable Organizations

The IRS ruled that the term charitable includes the “care of orphans.”⁵⁵⁹ The occasion was consideration of the tax status of an organization that arranged for the placement of orphan children living in foreign countries with adoptive parents in the United States. The agency also determined that “facilitating student and cultural exchanges” is a charitable activity.⁵⁶⁰

Although a federal court allowed an estate tax charitable contribution deduction for a bequest to a “public” cemetery because of the “important social function” it performed and the “concurrent lessening of the burden of the public fisc,”⁵⁶¹ the decision was overturned on appeal on the grounds that Congress has not enacted an estate tax counterpart to the income tax exemption provision for cemetery companies⁵⁶² and that the common-law definition of the term charity in the income tax context cannot be imported into the estate tax field.⁵⁶³ The appellate court was unable to discern why Congress elected to treat contributions to cemetery organizations differently for income and estate tax deduction purposes, regarding the matter as an “anomaly” that must be left to “congressional wisdom.”⁵⁶⁴ The attempt by the lower court to categorize public cemeteries as charities because the “maintenance of cemetery facilities by cemetery associations benefits the community both through its aesthetic effects and by the performance of a necessary social task”⁵⁶⁵ thus failed.

A court concluded that the purpose of “maintain[ing] public confidence in the legal system” through “various means of improving the administration of justice” is charitable.⁵⁶⁶ By contrast, a court refused to regard as charitable the object to “encourage, foster, promote and perpetuate outdoor activities.”⁵⁶⁷

One of the many ways to qualify as a tax-exempt charitable entity is to engage in activities consisting of the “erection or maintenance of public buildings, monuments, or works.”⁵⁶⁸ An organization sought recognition of exemption as a charitable entity with a program of development and distribution of open source software. The IRS declined to recognize exemption in this case because anyone can use the software for any purpose; the software was not considered the requisite “work.”⁵⁶⁹

An agricultural research organization is a type of public charity.⁵⁷⁰ This is an entity that is engaged in the continuous active conduct of agricultural research in conjunction with a land-grant college or university or non–land-grant college of agriculture.⁵⁷¹