Who Benefits?

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Whether starting a new nonprofit or running a well developed one, leaders nonprofits should carefully evaluate their activities to ensure that they are, in fact, serving appropriate beneficiaries within the meaning of applicable exemption laws.  Consider the following cautionary tale involving a new section 501(c)(4) social welfare organization, which provides lessons for other tax-exempt organization as well.

The IRS recently denied an application for tax-exempt status, concluding that the entity was “not primarily engaged in promoting the common good and general welfare of the people of the community,”  as required under section 501(c)(4) of the Internal Revenue Code.  Accordingly, it did “not qualify for recognition of exemption.”

The applicant’s stated purposes certainly seemed to promote the requisite “common good and general welfare of the people of the community.”  According to applicant’s Articles of Incorporation, the organization’s purposes were as follows:

(a) To secure dental services to individuals and groups and their families through the design of dental service coverage products and active involvement in the provision of such products through independent professional service providers.

(b) To encourage, foster, and finance professional and scientific study and research in the general field of oral health; to make studies and conduct investigations designed to develop information pertaining to all aspects of dental service coverage plans; and to assist in the education of the public concerning the need for and advantages of oral health.

At first blush, such purposes seem to be well within the pale of the applicable legal standard  In its determination, the IRS acknowledged as much -- that the organization’s activities were activities were “intended to further the understanding of the demographics of dental disease and to incorporate such findings into the development of new, evidence-based dental benefits products.” 

So what was the problem?  The IRS went on to explain that although the organization’s activities might incidentally “redound to society” the intended beneficiaries were actually (1) another, closely-related corporation (corporation M) of which the applicant was a member, and (2) the other members of M. Applicant had entered into a License Agreement with M for the purpose of providing dental benefit products, exclusively to or through M and its member companies.  This, according to the ruling disqualified the applicant from tax-exempt status.  It was not enough that the applicant also engaged in public awareness building activities. According to the ruling, those activities did not constitute the organization’s primary activity.  The agency concluded the organization was essentially a privately devoted endeavor for the benefit of M and its member companies.

Lessons for Nonprofits

The IRS ruling provides two important lessons for exempt organizations:  First, it is not enough to merely state purposes that are consistent with applicable treasury regulations.  Second, organizations must be careful to evaluate agreements with closely related entities to guard against such entities do not receive impermissible benefits from the agreements. 

1.              It’s not enough to merely state exempt purposes.

The law in the above case provided that the applicant be “primarily engaged in promoting in some way the common good and general welfare of the people of the community.”   But the IRS found that applicant only played lip service to its notion of social welfare.  The applicant’s activities were primarily concerned with the betterment of the related organization of which it was a member.  The organization’s modicum of public awareness activities was not enough to disabuse the IRS of the perception that the organization primarily existed for the benefit of another closely related entity.  Organizational leaders must regularly evaluate the entity’s programming to ensure that the group’s activities match the purposes for which the organization states it exists.  Specifically, in addition to a proper statement of exempt purposes, the primary activities of the organization must be consistent with those purposes.

2.              Carefully evaluate agreements with closely related organizations and individuals.

Nonprofit organizations usually have key individuals or entities that play strategic roles in the organization’s formation and operations.  Such individuals and entities often provide valuable resources to the entity, sometimes in the form of funding or advantageous business relationships.  A not-for-profit food pantry, for example, might enter into a relationship with a produce company to obtain fresh fruits and vegetables at a reduced or at no cost.  Such a relationship would provide the pantry with important resources for programming without burdening what is likely the pantry’s very limited budget.  The produce company, on the other hand, might enjoy lower tax liability if it donates goods or services to the food pantry. Such mutually beneficial transactions are often conducted without negative tax consequences. 

However, if there is a close relationship between the nonprofit and the helping organization, nonprofit leaders should evaluate agreements with such organizations.  In the above case, the focus of the nonprofit’s activities was for the benefit of a closely related organization and its membership, of which the applicant was a part.  The applicant had executed an exclusive licensing agreement whereby only the closely related organization and its membership enjoyed the applicant’s beneficial services.  The IRS quickly concluded the organization did not exist primarily for the benefit of the general public, but rather for the benefit of the closely related organization and its members. 

Organizations should thus regularly evaluate agreements with closely related entities.  As noted above, such entities may play crucial roles in the organization’s success.  While certain incidental benefits may be permissible, the organization may not exist primarily for the closely related entity’s benefit.  Strong conflict of interest policies may mitigate the risk somewhat, but regardless the existence of such policies, the organization’s activities may not be principally for the benefit of the closely related entity. 

Finally, some tax-exempt entities will not be subject to such constraints; you should consult with a qualified attorney with experience in exempt organizations to determine which laws are applicable to your organization.