Adverse Rulings from the IRS Exempt Organizations Division. How Can Your Organization Learn from Others’ Mistakes?
On July 1, 2022, the IRS, Director of Exempt Organizations issued an array of final adverse determinations with respect to organizations seeking exemption under 26 U.S.C. sections 501(c)(3), 501(c)(4), and 501(c)(7). In these Private Letter Rulings, the IRS Exempt Organizations Division denied tax-exempt status to the organizations. A common theme runs through all the Rulings: The organization applying or under review for tax exemption failed the organization test and/or the operational test applicable to the requirements for the exemption sought.
Private Letter Rulings are not binding on any taxpayer except the taxpayer to whom the Ruling is directed. But, the Rulings are instructive and give an idea of the organizational and operational criteria that the IRS Exempt Organizations Division needs or wants to see in order to grant tax exemption. Due care should be taken with applications for tax exemption. The exemption, if available, is a privilege, not a right, and the IRS is not shy to deny that privilege when appropriate based on the organization or operations of the applying entity.
For additional information on legal and tax issues facing tax-exempt and nonprofit organizations, search this Freeman Law Insights blog for topics such as:
Three-Part blog on Tax Exemption and Unrelated Business Income Rules
Can Nonprofits Fundraise for Other Nonprofits?
What is a Section 509(a)(3) Supporting Organization?
Representing Texas Nonprofit Corporations
Below is a Freeman Law Insights Summary of those recent IRS Private Letter Rulings:
| PLR 202226011 | |
| Organization Type: 501(c)(3) | 26 U.S.C. § 501(c)(3): organized and operated exclusively for charitable, religious, educational, etc. purposes, no part of the net earnings of which inures to the benefit of any private shareholder or individual.
Treas. Reg. § 1.501(c)(3)-1: an organization must be both organized and operated primarily for one or more of the purposes specified in section 501(c)(3). If an organization fails to meet either the organizational test or the operational test, it is not exempt. Purposes: (a) Religious, (b) Charitable, (c) Scientific, (d) Testing for public safety, (e) Literary, (f) Educational, or (g) Prevention of cruelty to children or animals. |
| Adverse Determination | Does not qualify for tax exemption under section 501(c)(3).
Failed organizational and operational tests of section 501(c)(3). Contributions to the organization are not deductible under section 170. |
| Notable Deficiencies in Organization or Operations | Failed to meet the public support test of section 509(a)(2) of the Code, which generally requires that 33 1/3% of support come from the public or governmental sources or other sources specifically listed.
Public support is measured using a 5-year computation period that includes the current and four prior tax years (including short years). Primary source of income were funds contributed by its closely affiliated organization exempt under section 501(c)(6) of the Code and dental premiums by “non-qualified persons.” Assets were not dedicated to an exempt purpose, and more than an insubstantial part of the organization’s activities were not in furtherance of an exempt purpose. Failed the operational test. The organization was formed solely to provide benefits to specific members of the related 501(c)(6) organization and other related individuals. Thus, the organization was formed to serve private, not public interests. |
| PLR 202226012 | |
| Organization Type: 501(c)(7) | 26 U.S.C. § 501(c)(7): provides for exemption for clubs organized for pleasure, recreation, and other non-profitable purposes, substantially all of the activities of which are for such purposes and no part of the net earnings of which inures to the benefit of any private shareholder. |
| Adverse Determination | Does not qualify for tax exemption under section 501(c)(7).
Issue as framed by the IRS: “Whether the [Organization] is an organization described in . . . Section 501(c)(7), when consistently gross receipts from the use of club facilities and services by the public exceeds the 15 percent limitation provided for such organizations.” |
| Notable Deficiencies in Organization or Operations | Failed the support test applicable to section 501(c)(7).
An IRC § 501(c)(7) organization may receive up to 35 percent of its gross receipts, including investment income, from sources outside its membership without losing its tax-exempt status. (a) Within the 35 percent, not more than 15 percent of the gross receipts should be derived from the use of a social club’s facilities or services by the general public. An exempt social club may receive up to 35 percent of its gross receipts from a combination of investment income and receipts from non-members, so long as the latter do not represent more than 15 percent of total receipts. (b) A social club may receive investment income up to the full 35 percent of its gross receipts if no income is derived from non-members’ use of club facilities. (c) Where a club receives unusual amounts of income, such as from the sale of its clubhouse or similar facilities, that income is not to be included in the 35 percent formula. The Unrelated Business Income (UBI) identified by the Organization on the 990/990-T returns exceeds the limitation of non-member income that is permissible from the use of social club facilities and services by the general public. And, the Organization’s facilities were open to the public. A social club that opens its facilities to the public is deemed to be not organized and operated exclusively for pleasure, recreation, and other nonprofitable purposes and is not exempt under section 501(a). There must be an established membership of individuals, personal contracts and fellowship. This Organization did not track and record member vs. non-member income as required for the exemption. Thus, the IRS presumes all the inventory/bar sales were made to the general public and Is considered non-member Income. |
PLR 202226014
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| Organization Type: 501(c)(4) | 26 U.S.C. § 501(c)(4) provides for the exemption from Federal income tax of civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare or legal associations of employees, the membership of which is limited to the employees of the designated person or persons in a particular municipality, and the net earnings of which are devoted exclusively to charitable, educational or recreational purposes.
Treas. Reg. § 1.501(c)(4)-1: An organization may be exempt if (i) it is not operated for profit and (ii) it is operated exclusively for the promoting of social welfare. Treas. Reg. Section 1.501(c)(4)-1(a)(2)(i) provides that an organization is operated exclusively for the promotion of social welfare if it is primarily engaged in promoting in some way the common good and general welfare of the people of the community. An organization embraced within this section is one, which is operated primarily for the purpose of bringing about civic betterments and social improvements. |
| Adverse Determination | Organization does not qualify for tax exemption.
Organization failed to promote the social welfare or provide a community benefit because it does not allow public access. |
| Notable Deficiencies in Organization or Operations | To qualify for exemption under IRC section 501(c)(4) (rather than the more common approach, section 501(c)(7), a homeowners’ association must: 1. serve a “community” which bears a reasonable recognizable relationship to an area ordinarily identified as governmental, 2. not conduct activities directed to the exterior maintenance of private residences, and 3. open its common areas or facilities it owns and maintains must for the use and enjoyment of the general public.
See Rev. Rul. 74-99, 1974-1 C.B. 132, modified Rev. Rul. 72-102. This organization is not “community” in organization or operation. It is a gated community; no one can get past the gate unless they are resident members or guests of the private country club. Members of the general public only have access only on limited occasions. The Organization did not primarily operate to promote social welfare within the meaning of Section 501(c)(4). And, the activities did not meet the provisions of Treas. Reg. section 1.501(c)(4)-1(a)(2)(i) because they were focused on providing services and amenities to the member homeowners and do not primarily promote civic betterment or social welfare. |
| PLR 202226015 | |
| Organization Type: 501(c)(7) | 26 U.S.C. § 501(c)(7) provides for exemption for clubs organized for pleasure, recreation, and other non-profitable purposes, substantially all of the activities of which are for such purposes and no part of the net earnings of which inures to the benefit of any private shareholder. |
| Adverse Determination | Does not qualify for tax exemption under section 501(c)(7).
IRS alludes that the organization might qualify for tax exemption under section 501(c)(4), subject to separate application for exemption. Issue as framed by the IRS in the PLR: “Whether the [Redacted Text] qualifies for self-declared tax-exempt status under Internal Revenue Code (IRC) Section 501(c)(7) when it derives significant income from a substantial, nontraditional ongoing business activity outside of its membership.” |
| Notable Deficiencies in Organization or Operations | Treas. Reg. section 1.501(c)(7)-1(a) provides that, in general, the exemption extends to social and recreation clubs supported solely by membership fees, dues and assessments. A club that engages in a business, such as making its social and recreational facilities open to the general public, is not organized and operated exclusively for pleasure, recreation and other non- profitable purposes, and is not exempt under section 501(a).
This Organization received substantial income from other than the social club’s business activities. Revenue Ruling 58-589, 1958-2 C.B. 266 states that a social club’s business activity will defeat exemption unless such activity is incidental, trivial or nonrecurrent, i.e., “insubstantial.” Revenue Ruling 69-220, 1969-1 C.B. 154: a social club that receives a substantial portion of its income from the rental of property and uses such income to defray operating expenses and to improve and expand its facilities is not exempt under section 501(c)(7). Revenue Ruling 66-149, 1966-1 C.B. 146: a social club as not exempt as an organization described in section 501(c)(7) where it regularly derives a substantial part of its income from non-member sources. A club that engages in nontraditional business activity can jeopardize its exempt status even when its gross receipts are within the permissible limits. |
| PLR 202226016 | |
| Organization Type: 501(c)(7) | 26 U.S.C. § 501(c)(7) provides for exemption for clubs organized for pleasure, recreation, and other non-profitable purposes, substantially all of the activities of which are for such purposes and no part of the net earnings of which inures to the benefit of any private shareholder. |
| Adverse Determination | Does not qualify for tax exemption under section 501(c)(7) and failed to protest that determination. |
| Notable Deficiencies in Organization or Operations | Main activity was the production and sale of [Redacted Text], and its other activities involve the leasing of property for income. More than a substantial amount of the activities are directed at non-recreational purposes.
No membership qualifications; participation criteria based solely on familial relationship. Zero membership income. Organization lacked a true membership; personal contact and comingling are not exempt under section 501(c)(7). Revenue Ruling 74-30 states that in order for a club to meet the requirements for exemption under IRC Section 501(c)(7), there must be an established membership of individuals, personal contacts, and fellowship. Furthermore, a commingling of members must play a material part in the activities of the organization. |
| PLR 202226018 | |
| Organization Type: 501(c)(3) | 26 U.S.C. § 501(c)(3): organized and operated exclusively for charitable, religious, educational, etc. purposes, no part of the net earnings of which inures to the benefit of any private shareholder or individual.
Treas. Reg. § 1.501(c)(3)-1: an organization must be both organized and operated primarily for one or more of the purposes specified in section 501(c)(3). If an organization fails to meet either the organizational test or the operational test, it is not exempt. Purposes: (a) Religious, (b) Charitable, (c) Scientific, (d) Testing for public safety, (e) Literary, (f) Educational, or (g) Prevention of cruelty to children or animals. |
| Adverse Determination | Does not qualify for tax exemption under section 501(c)(3).
Failed organizational and operational tests of section 501(c)(3). Contributions to the organization are not deductible under section 170. |
| Notable Deficiencies in Organization or Operations | Organization’s activities focused on equine activities which included equine speed events and horsemanship events. Revenue came from membership fees, registration fees, and sales of promotional items.
“Your equine and horsemanship events may have some educational value, but they further a recreational purpose which is not insubstantial.” Better Business Bureau of Washington, D.C., Inc v. United States, 326 U. S. 279 (1945): The presence of a single non-exempt purpose, if substantial in nature, will destroy the exemption regardless of the number and importance of truly exempt purposes. Organization’s recreational purpose of offering horsemanship competitions and shows outweighed any exempt purpose. There was no evidence that the Organization had any educational or other exempt element to the operations. |
| PLR 202226019 | |
| Organization Type: 501(c)(7) | 26 U.S.C. § 501(c)(7) provides for exemption for clubs organized for pleasure, recreation, and other non-profitable purposes, substantially all of the activities of which are for such purposes and no part of the net earnings of which inures to the benefit of any private shareholder. |
| Adverse Determination | Does not qualify for tax exemption under section 501(c)(7).
Issue as framed by the IRS: “Whether [Redacted Text] is organized and operated exclusively under Internal Revenue Code (IRC) §501(c)(7) as a social club?” |
| Notable Deficiencies in Organization or Operations | Organization’s Stated Purpose: The formation of a membership of women interested in promoting interest in cultural, intellectual, and civic activities, and to further such philanthropic work as the club may desire.
Failed the support test for exemption under section 501(c)(7). See above PLR 202226012 for summary of support test. Based on Form 990 and analysis of gross receipts, the Organization’s total income was from investments (trading securities). Sponsoring activities of a noncommercial nature can lead to denial or revocation if the activities are not similar to providing pleasure and recreation. Example, Rev. Rul. 63-190, 1963-2 C.B. 212: organization was held not to qualify for exemption under section 501(c)(7) where it provided its members with sick and death benefits. The conduct of a business “not traditionally carried on” by social clubs should preclude exemption. Characteristics of a business: solicitation of the general public, a recurring activity, and the conduct of an activity unrelated to the exempt function of a social club. |
