Organizations that are created to provide goods or services exclusively (or primarily) to Section 501(c)(3) organizations (or governmental entities) may think that this purpose is sufficient to also qualify them under tax law. However, providing commercial-type services exclusively to exempt organizations is not by itself an exempt purpose. Much more is required for qualification under the rules of Internal Revenue Code Section 501(c)(3) than just having a mission to assist charitable organizations.
An exemption under tax code Section 501(c)(3) requires that an organization be both organized and operated for one or more specified purpose. This means the organization must have a public, rather than a private, interest. An organization can operate a trade or business as a substantial part of its activities if the operation furthers its exempt purpose and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business.
The presence of a single non-exempt purpose, if substantial in nature, precludes exemption, regardless of the number or importance of exempt purposes.
An organization is not exempt simply because its primary operations are not carried on for profit. To demonstrate that furnishing goods or services is intended to achieve an exempt purpose, the IRS has maintained that they be provided at substantially below cost. For example, an organization providing investment services to the colleges and universities that controlled it at substantially below its cost was deemed qualified for Section 501(c)(3) status. (IRS Revenue Ruling 71-529)
This principle was approved by the U.S. Tax Court in two cases (B.S.W. Group, Inc., 70 TC 352 and IHC Health Plans, Inc., U.S. Court of Appeals, 10th Circuit, 325 F 3d 1188)
“Substantially below cost” means just that. The IRS has found an entity organized to provide managerial and consulting services to Section 501(c)(3) organizations at cost did not qualify for Section 501(c)(3) status because it did not have a recognized charitable purpose and was not controlled by the charities it served. (IRS Revenue Rulings 72-369 and 69-528)
In the IHC case, the organization sold services at a discount, which, in the court’s view, was insufficient to be a charitable purpose. The court stressed that “there is a qualitative difference between selling at a discount and selling below cost.”
In another case, a U.S. District Court upheld the IRS’s denial of the taxpayer’s application for exemption on the grounds that its charitable and educational activities were merely incidental to its primary activity of operating a conference center as a commercial business. (Airlie Foundation, U.S. District Court, D.C., 92 AFTR 2d 2003-6206) Airlie failed the substantially below cost test because it intended to make a small overall profit on the conference center even though it rented its conference center to some charitable organizations below cost.
The organization charged fees for its services:
Leasing property is not inherently an exempt purpose, even if the lessee is an exempt organization that needs the property in order to operate. Although the organization’s rents were slightly below market rates, they were above cost and allowed Y to accumulate a substantial surplus. Therefore, in revoking the organization’s exemption, the IRS concluded that the lease terms lacked the donative element for the leasing to be charitable, even if the lessees had been tax-exempt. (IRS Technical Advice Memorandum 201438034)
Keep in mind: “Substantially below cost” is a subjective term. The IRS has neither publicly indicated how an organization’s cost of goods or services can or should be calculated for this purpose, nor quantified what is meant by substantially.
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