Do nonprofits that engage in online fundraising activity as their principal activity qualify for tax-exempt status under IRC Section 501(c)(3)? The IRS recently said no to three nonprofit applicants, denying their requests for tax-exempt status.[1] One applicant operated an online retail store, with profits from sales going to the charity of the buyer’s choosing. The other two applicants obtained most or all of their funding by charging fees for their fundraising services to nonprofit organizations.
Many nonprofit organizations that engage primarily in fundraising activities have historically qualified for Section 501(c)(3) status, including “Friends Of” organizations that send charitable funds raised to foreign programs, nonprofits that raise money for special causes such as medical research, and organizations that operate “donor advised funds” (DAFs) by which donors direct payments to other charitable organizations. What went wrong for the online fundraising organizations here?
The three IRS decisions have sparked dialogue in the nonprofit tax arena about whether fundraising by itself constitutes a qualified charitable activity for purposes of 501(c)(3). Here’s what all nonprofit leaders can learn from the IRS rulings.
First Key Requirement: Tax-Exempt Purpose
First, in all three denial letters, the IRS focused on the organizations’ substantial commercial activities, noting the absence of any other significant activities. To qualify as tax-exempt under Section 501(c)(3), an organization must be primarily “organized” and “operated” for certain purposes, such as religious, educational, or charitable purposes. The IRS asserts that raising money – by itself – is not inherently a religious, educational, or charitable activity. Consequently, the IRS and courts have consistently ruled that organizations engaging primarily in commercial activities will not qualify for tax-exempt status merely because they turn over their profits to charity.
With respect to the online fundraising activities at issue here, the IRS recognized that the funds might ultimately be used for 501(c)(3) purposes. The activities themselves, however, are commercial – namely, operating a fee-based online fundraising website or online retail store.[2]
The lesson for nonprofits here is simply: keep the main thing the main thing -- stay focused primarily on religious, charitable, or educational activities. For example, the tax-exemption applicants could have structured their purpose and activities to be more directly engaged in charitable activities related to particular causes for which they shared philanthropic affinities. The list is endless and full of possibilities. But online fundraising, alone, won’t cut it.
It may have been helpful as well if the applicants had not charged fees to other nonprofits for processing donations, as designated by donors. At least in the IRS’ view, such fees look fairly business-like. The applicants may have been successful if they structured their arrangements so that all donations initially went to them first, as a grant-making organization (like the “Friends Of,” cause-related, and DAF organizations mentioned above). The applicants could then have distributed the funds raised to the target nonprofits, minus costs for operating expenses for such efforts, without charging commercial-type fees. The resulting donations to the recipient nonprofits thus would be identical financially, but with vastly different tax consequences for the nonprofit tax applicants.
Second Key Requirement: Public Benefit
Second, the IRS determined that one applicant’s relationship with a for-profit entity involved a fatal “private benefit.” Without exception, qualified 501(c)(3) organizations must be operated for public benefit rather than private benefit. In tax parlance, the term “public benefit” means that the organization is broadly helping many (e.g., the American Cancer Society’s dedication to finding cancer cures, the ASPCA helping to prevent animal cruelty, or a local food pantry providing food supplies to needy families). The term “private benefit” connotes an impermissible financial advantage garnered by an individual or company through the nonprofit, such as contractual relationships or other personal enrichment to the nonprofit’s detriment. Substantial private benefit can destroy tax-exempt qualification. Consequently, nonprofits that engage private companies or individuals for fundraising activities need to be particularly sensitive to potential private benefit problems.
In the IRS decision at issue, the tax-exemption applicant and a related for-profit entity operated a social networking website that allowed charitable organizations to create profiles where they could update potential donors with pictures and comments about their activities. The for-profit company maintained these profiles, provided fundraising services to the organizations, and coordinated acceptance of donations. In return, the for-profit company took a percentage of each donation as its fee. The applicant created additional profiles for other nonprofit organizations that had never signed up for the for-profit’s services, facilitating donations to these organizations. The applicant advertised that organizations could take better advantage of their profiles by “claiming” them in order to use the for-profit’s services.
In denying tax-exempt recognition, the IRS determined that substantial benefit resulted to the for-profit entity through such arrangements. Essentially, it looked like the nonprofit was designed to funnel business to the for-profit. Perhaps most detrimental was the fact that the applicant’s governing board consisted entirely of the three owners of the for-profit, including two who were married to each other. The lack of an independent board created the perception – in the view of the IRS – that these individuals would make organizational decisions that privately benefit themselves, as opposed to the organization’s mission.
What are the lessons here? Most obviously, keep your distance! A nonprofit that seeks to enter into a long-term business relationship with a for-profit, through a contractual relationship or otherwise, ideally will have no overlapping directors, officers, or other key employees. If any such relationships exist, the nonprofit board members should scrupulously apply the organization’s conflict of interest policy, determine a “fair” price for services in the organization’s best interests, and otherwise avoid any actual or potential for-profit control of the nonprofit. In addition, the nonprofit should be continually attentive to other possible private benefits that could arise in connection with its charitable activities and therefore should be avoided.
Concluding Observations
The IRS’ refusal to recognize tax-exempt status in these cases may have been due to some aversion to innovative technology uses. Or maybe it signals a conservative drift for the IRS, in finding such activities too commercial and otherwise problematic because of for-profit connections. The legal analysis and final decisions issued in these rulings only apply with respect to the specific tax-exemption applicants, and are therefore not legally binding precedent to all exempt organizations. However, the lessons set forth concerning the limitations of fundraising as an exempt activity are important for any organization interested in developing creative online platforms and activities to benefit public charities.
