What suffices for “educational,” to garner IRS approval of Section 501(c)(3) status? Apparently, the IRS looks askance on educational filmmaking that involves commercial overtones and private intellectual property ownership.
The IRS recently denied tax exemption[1] to an organization known as Aegis for Dreams Foundation. Following in the footsteps of Hamilton and Lincoln, the Foundation intends to educate the public about America’s founding fathers through the arts. In its IRS Form 1023 tax-exemption application, the Foundation articulated a squarely educational purpose: to produce a historically accurate film to exhibit in high schools and at other public events. Rejecting the application, the IRS concluded that the Foundation provided impermissible private benefits to its Founder and that its methods for producing and displaying the film were too commercial to qualify for tax exemption. Did the IRS err in its reasoning? What can other nonprofits learn, both in terms of initial tax-exemption application and ongoing Section 501(c)(3) qualification? This article evaluates the IRS’s analysis and provides responsive recommendations for educational nonprofits and their leaders.
Aegis for Dreams
The Foundation holds licensing rights to a screenplay, Aegis for Dreams,[2] that dramatizes the relationship between Alexander Hamilton and George Washington against the backdrop of the Revolutionary War. Matthew Ryan is the screenplay’s author, the Foundation’s sole contributor, and its sole trustee. Ryan’s screenplay is marked by its historical accuracy. Unlike fictionalized Revolutionary War stories such as Revolution or The Patriot, the film draws more than forty percent of its dialogue directly from the historical record. The remainder of the dialogue and events are rooted in Ryan’s extensive primary source research.
The Foundation’s sole operational activity is to finance the making of the film through charitable contributions and then to produce and exhibit the film for public education. It intends to donate any proceeds received from film screenings to charities serving children and soldiers. The Foundation hopes to raise approximately $30 million from wealthy investors in order to finance a highly professional film production (think Hollywood blockbuster).
IRS Denial – Too Much Private Benefit, Too Commercial?
The IRS denied the Foundation’s Form 1023 Application for Recognition of Exemption for two key reasons.
First, the IRS took issue with the fact that Ryan retains the copyright and certain merchandising rights in the Aegis screenplay. In the IRS’s view, once the film was produced and screened, Ryan would impermissibly benefit from the Foundation’s operations. In addition, licensing rights to the screenplay will revert to Ryan if the Foundation cannot raise sufficient funding within a certain time period. As the IRS reasoned, this arrangement constitutes further evidence that the Foundation impermissibly serves Ryan’s private interests, which is incompatible with Section 501(c)(3) status.[3]
Second, the IRS determined that the Foundation has a substantial nonexempt commercial purpose, which also defeats Section 501(c)(3) qualification. Section 501(c)(3) requires tax-exempt organizations to operate “exclusively” for exempt purposes (i.e., primarily), such as charitable or educational purposes. Accompanying regulations to Section 501(c)(3) clarify that that organizations must not devote more than an “insubstantial part” of their activities to non-exempt or commercial purposes in order to qualify for exemption.
Here, the IRS determined that the Foundation planned to operate for non-exempt purposes because it hopes to produce and promote Aegis in a manner similar to an ordinary commercial film company. The IRS further noted that even though the Foundation had educational purposes, it planned to fund, produce, promote, and distribute the film to wide audiences. Because the Foundation planned to show the film in for-profit theaters (in addition to schools and other venues), the IRS viewed the Foundation as competing with for-profit filmmakers.
The IRS’s Flawed Reasoning - Determining “Educational” and “Commercial”
The IRS’s denial shows debatable legal reasoning. As an overarching matter, the Foundation’s stated purpose falls squarely within the IRS’s definition of “educational.” The Treasury Regulations define “educational” as either (1) “the instruction and training of the individual for the purpose of improving or developing his or her capabilities” or (2) “the instruction of the public on subjects useful to the individual and beneficial to the community.”[4] The Foundation fits into the second prong because it aims to educate the public on American history.
Allowing the Regulation’s exempt educational organization examples guide our legal analysis, we find that the Foundation aligns with Example 2, “an organization whose activities consist of presenting public discussion groups, forums, panels, lectures, or other similar programs. Such programs may be on radio or television.” The Foundation aims to use the medium of film to educate the public on the Revolutionary War through public screenings and discussions. Notably, Ryan distinguished the screenplay’s educational value from films produced primarily for entertainment, which—unlike Aegis—often sacrifice historical accuracy to increase profits and appeal to a wider audience. Because Aegis is motivated by educational purposes rather than profits, its focus is on historical accuracy rather than marketability.
Additionally, the IRS’s determination that the Foundation operated for commercial purposes erroneously focused almost exclusively on the Foundation’s means of producing and distributing the film—not the film’s educational ends. This approach represents a core problem with the IRS’s analytical method, known as the “commerciality doctrine.”[5] In focusing on the means that organizations employ, the IRS undervalues (or ignores entirely) the tax-exempt nature of their ultimate purposes.
Under the commerciality doctrine analysis, the IRS weighs a wide-ranging, subjective list of factors to determine whether an organization has a “commercial hue.” If so, then the IRS deems the organization to be devoting more than an insubstantial part of its activities to commercial purposes and thus not qualified for tax exemption. Some of the most important factors in this analysis include:
- whether the organization competes with for-profit entities;
- whether the organization generates and accumulates profits;
- whether the organization employs market-rate pricing; and
- whether the organization employs business and marketing practices in a manner similar to for-profit entities.
Here, the IRS determined that the Foundation would compete with for-profit filmmakers per se because the Foundation planned to produce and distribute Aegis in a manner similar to for-profit entities. But as noted above, the IRS erred in one key respect: no commercial market exists for historically accurate Revolutionary War films. Aegis thus is not competing with any commercial film entities to produce this type of film. Since 2000, only one Revolutionary War-era feature film has earned a theatrical release (The Patriot), and that film was a work of historical fiction. Unlike Civil War and World War II films, Revolutionary War films have largely not proved profitable, as apparently Hollywood lacks the appetite to produce works depicting this era. The IRS’s means-focused analysis thus may ring a death knell for educational institutions that seek to fill in cultural gaps, by producing art that would otherwise go unmade by for-profit entities.
Out of Step on Developing Section 501(c)(3) Qualification?
The IRS’s view of what constitutes proper means by which a nonprofit may accomplish its exempt purposes often lags significantly behind developments in culture and society. The IRS’s initial rejection of all joint venture activities[6] in the historic Plumstead decision illustrates this type of delay. Likewise, the IRS has yet to acknowledge carbon emission reduction and other energy efficiency efforts as charitable as well as online-only religious congregations as churches. Likewise, the free distribution and use of open-source software continues to fall outside the scope of the IRS’s view of charitable and educational. When these new developing activities arise, the IRS tends to invoke the commerciality doctrine and deny exemption.
Notably, a significant private benefit concern undergirds the IRS’s adverse decision for the Foundation, as in such other tax-exemption matters. But by utilizing the commerciality doctrine and not analyzing the facts strictly under the private benefit doctrine, the IRS muddies the standards for both doctrines. The IRS’s legal analysis also calls into question whether the means by which a nonprofit seeks to accomplish its exempt purposes are nonexempt per se, or simply nonexempt because of the potential or presence of impermissible private benefit. For the Foundation, does displaying an educational movie at for-profit theaters, or utilizing similar practices to commercial theater companies, result per se in a nonexempt activity? Or, was it the other issues of potential private benefit that are the true source of the problem and not the activities? A more refined and logical analysis by the IRS could have answered these questions.
What’s Next & Lessons Learned
In December 2021, the Foundation filed a petition in the U.S. Tax Court to appeal the IRS’s denial. Perhaps greater clarity may result for educational nonprofits, particularly those seeking to develop films and other resources to address historical and cultural events.
In the meantime, nonprofits seeking to obtain or retain Section 501(c)(3) status should take great pains to not appear “too commercial” or in competition with for-profit entities. For example, the organization’s activities as described in the IRS Form 1023 tax-exemption application (or IRS Form 990 annual report) should be carefully supported by current IRS rulings and guidance addressing the subcategory of exempt activity under Section 501(c)(3), whether charitable, educational, religious, etc.[7] Even when the means or activities are novel, there should be components and elements that are supported by prior rulings. Additionally, it would be helpful to demonstrate a broad range of public support from the outset, without so much focus on any single founder’s initial funding—especially if the founder holds private ownership in related content.
Nonprofits thus should vigilantly avoid any perception of impermissible private benefit. Most cases involving the IRS’s denial or revocation of tax-exempt status on the grounds of commerciality also involve some sort of private benefit. Here, perhaps, the IRS would not have denied the Foundation’s application had they not surmised that Ryan stood to benefit personally from the success of the Aegis film. No matter the organization’s purposes, every nonprofit should ensure that its funds and organizational resources are primarily and demonstrably directed towards tax-exempt purposes—not private benefits.
[1] See Aegis for Dreams Foundation’s IRS adverse determination letter here.
[2] Learn more about the Aegis for Dreams historical feature film here. Merriam-Webster defines aegis as “the power to protect, control, or support something or someone.” Shortly after Washington’s unexpected death, Hamilton called him “… an Aegis very essential to me” in a letter penned to Tobias Lear on January 2, 1800.
[3] For further discussion, read our blog articles Promoting the Nonprofit Mission, Not Doling Out Business Favors and Public Charities and Private Benefit: How Much is Too Much?
[4] 26 CFR § 1.501(c)(3)-1 courtesy of Legal Information Institute at Cornell Law School.
[5] See our blog article, Would You Like Some “Commerciality” With Your Coffee? Structuring Tax-Exempt Business Activities Under Section 501(c)(3).
[6] See our blog article, Sharing Strengths: A Few Questions and Answers about Nonprofit Joint Ventures with For Profit Entities.
[7] See our blog article, A Walk Through the IRS Form 1023: Applying for Section 501(c)(3) Recognition.
