Organization Loses Exemption Over Rental Activities

Person to Contact: * * *

This is a final determination that your exempt status under section 501(c)(3) of the Internal Revenue Code is revoked. The recognition of your exemption under Internal Revenue Code section 501(c)(3) is revoked effective as of January 1, 20XX for the following reason(s):

You have failed to demonstrate that you are operated exclusively for exempt purposes within the meaning of section 501(c)(3) of the Internal Revenue Code, as a substantial part of your operations are to further non-exempt purposes. You have also failed to demonstrate that your operations meet the requirements of section 509(a)(2) of the Internal Revenue Code, as your primary source of support is rental income.

Contributions to your organization are no longer deductible under section 170 of the Internal Revenue Code effective as of January 1, 20XX.

You are required to file Federal income tax returns on Form 1120. These returns should be filed with the appropriate Service Center for the year ending December 31, 20XX, and for all subsequent years.

Processing of income tax returns and assessment of any taxes due will not be delayed should a petition for declaratory judgment be filed under section 7428 of the Internal Revenue Code.

If you decide to contest this determination in court, you must initiate a suit for declaratory judgment in the United States Tax Court, the United States Claim Court or the District Court of the United States for the District of Columbia before the 91^st day after the date this determination was mailed to you. Contact the clerk of the appropriate court for the rules for initiating suits for declaratory judgment. Please contact the clerk of the respective court for rules and the appropriate forms regarding filing petitions for declaratory judgment by referring to the enclosed Publication 892. Please note that the United States Tax Court is the only one of these courts where a declaratory judgment action can be pursued without the services of a lawyer. You may write to the courts at the following addresses:

The Taxpayer Advocate Service (TAS) is an independent organization within the IRS that can help protect your taxpayer rights. We can offer you help if your tax problem is causing a hardship, or you've tried but haven't been able to resolve your problem with the IRS. If you qualify for our assistance, which is always free, we will do everything possible to help you. Visit taxpayeradvocate.irs.gov or call 1-877-777-4778.

If you have any questions, please contact the person whose name and telephone number are shown in the heading of this letter.

Sincerely yours,

After we issue the final revocation letter, we'll announce that your organization is no longer eligible for contributions deductible under section 170 of the Code.

For your protest to be valid, it must contain certain specific information including a statement of the facts, the applicable law, and arguments in support of your position. For specific information needed for a valid protest, please refer to page one of the enclosed Publication 892, How to Appeal an IRS Decision on Tax-Exempt Status, and page six of the enclosed Publication 3498, The Examination Process. Publication 3498 also includes information on your rights as a taxpayer and the IRS collection process. Please note that Fast Track Mediation referred to in Publication 3498 generally doesn't apply after we issue this letter.

You also may request that we refer this matter for technical advice as explained in Publication 892. Please contact the individual identified on the first page of this letter if you are considering requesting technical advice. If we issue a determination letter to you based on a technical advice memorandum issued by the Exempt Organizations Rulings and Agreements office, no further IRS administrative appeal will be available to you.

Thank you for your cooperation.

Sincerely,

* * * * *

 

 

 

 

ISSUES

 

* * *, ("EO", Exempt Organization), was granted exemption from Federal income tax under Section 501(c)(3) of the Internal Revenue Code. It was further described in section 509(a)(2), as a publicly supported organization in determination Letter 391 dated 02-09-19XX. The EO provided an updated Tax Exemption Letter dated 11-14-20XX. The organization was exempt under Section 501(c)(3) and classified as a public charity under Section 509(a)(2) of the Internal Revenue Code.

The EO filed with the IRS Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code on 11-05-19XX.

The Declaration of Trust (the Trust) Creating * * *, * * *, * * * dated 01-10-19XX, was filed for record in the Misc. Deed Records of Volume XX, Page XXX.

The Trust was created exclusively for public, charitable and educational purposes; "* * *".

The Declaration of Trust had VIII Parts:

Part V stated, in part, the "Restrictions and Limitations":

'The trust shall be irrevocable. In the event the Foundation does not qualify as an organization exempt from federal income tax under Section 501(c)(3) of the Internal Revenue Code of 1954 or the corresponding section of any subsequent Revenue Act, then the Board, acting by and through its duly elected Board of Directors, shall have the power to alter or amend the Trust, but only to the extent necessary to qualify the Foundation as an exempt organization under such Section. Any such alteration or amendment shall be by instrument in writing delivered to the Trustees and by them duly adopted. In the event, but only in the event, that the trust herein created shall be held by a final decree of a court of competent jurisdiction to be within the rule against perpetuities, the foregoing grant to the Trust Estate and any additional grant or grants shall be for a term ending twenty-one years after the death of the last to survive of the original Trustees hereinabove named, the same as if such grant or grants had been expressly made for such limited term, and at the expiration of such period the Trustees shall distribute the whole of the Trust Estate then remaining to such non-profit, permanent educational institutions as they may determine to be in the best position to carry out and subserve the original purposes of the Foundation, whereupon this trust shall terminate.

The EO provided a copy of its Articles of Incorporation filed with the Secretary of the State of on August 19, 19XX. The new name of the organization was * * *.

The EO provided a copy of its By-Laws dated August 25, 19XX. The name of the organization appears as * * *.

The Admin File was requested and obtained from the Records Unit, but no copy of the Articles of Incorporation or By-Laws were included.

The Office of the * * * of the State of * * * revoked the EO's exemption under Section * * * of the * * * Statute as of January 10, 20XX. The reason was that the EO did not provide an updated Determination Letter (After the Incorporation in 19XX) from the IRS. The EO provided to the Comptroller the IRS Determination Letter that indicated that the Federal exemption was granted to the unincorporated entity, the * * * and not the * * *.

The EO filed a Final Return by check marking 'Terminated" on its Form 990 for the year beginning 01-01-20XX and ending in 08-31-20XX. The return was dated 06-20-20XX and filed on time.

The Audit

The Form 990 for the year ending 12-31-20XX stated the EO's mission as 'The Trust was created exclusively for public charitable and educational purposes".

Present at the interview were * * * (the POA and CPA) and * * *, (the Bookkeeper). The interview and review of the books and records took place at the CPA's office as the EO did not have a place to conduct business.

The POA stated that the * * * had terminated its activities on 08-31-20XX, which was the subsequent year of this examination.

Public Support Test

The EO did not pass the Public Support Test. The EO failed to be a 509(a)(2) publicly supported organization as they received less than one-third support from gifts, grants, contributions, membership fees, and certain gross receipts. The EO received more than one-third support from net unrelated business taxable income.

The EO's total income was coming from $XX in donations and $XX,XXX from rental income. No other income was found. The total income was XX,XXX, making rental income, an unrelated business income, XX percent of the total support. It was a similar situation in the subsequent year.

The organization was not a 501(c)(3) further described in IRC Section 509(a)(2) as it failed the Public Support Test.

IRC Section 509(a)(2) organizations are supported primarily by exempt function income. Exempt function income is described as funds derived from an activity which is not an unrelated trade or business.

Organizations qualifying under Section 509(a)(2) normally receive not more than one-third of its support from gross investment income and more than one-third of its support from contributions, membership fees, and gross receipts from activities related to its exempt functions (subject to certain exceptions).

An organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.

Dual Test: Organizational and Operational Test.

The EO did not satisfy the Dual Test.

IRC 501(c)(3) requires an organization to be both "organized and operated" exclusively for one or more IRC 501(c)(3) purpose. If the Organization fails either the organizational test or the operational test, it is not exempt. Reg. 1.501(c)(3)-1(a)(1).

Organizational Test

The EO passed the Organizational Test.

The EO did not satisfy the Operational Test. The EO did not operate exclusively for one or more of the charitable or educational purposes. The EO served a private benefit rather than public interests. EO failed the operational test during the year under examination.

During the year under examination two activities were found to be performed by the EO.

• Rent of office space to for-profit businesses.

• Provide Scholarships to High School Students going to college in Real Estate and related fields.

The EO's rental of its facilities was not an exempt activity, but the issuing of scholarships to high school students going to college was. The rental activity was the EO's primary activity. According to this analysis, the Operational Test was not satisfied.

Exempt Activities

The Form 990 described the most significant activities as been exclusively for public, charitable and educational purposes.

During the interview the Bookkeeper said that the primary activity of the organization was to provide scholarships to high school students pursuing a college degree in real estate and related fields. She said that the secondary activities were seminars to teach the elderly in how to do a will and a power of attorney. She added that there was training for realtors.

The EO had some exempt activity, the distribution of scholarships. The books and records showed scholarships and donations, but no other activities, exempt in nature, were found. The educational scholarships were awarded to high school students. The Criteria was for the student to be in the upper XX^th to XX^th percentile of their class (Not Top XX%). No other exempt activity was found during the audit for the year under examination.

The Profit & Loss Statement showed the organization's income and expenses as follows:

 

 

The rental income was an unrelated business activity, of commercial business in kind, and it was not in furtherance of a charitable, educational, etc., purpose as the organization had stated in its organizational documents and Form 1023.

Unlike Private benefit, unrelated trade or business does not normally jeopardize exempt status unless it rises to the level of questioning whether the organization is operated primarily for commercial or exempt purposes. As long it is primarily engaged in related activities, the organization's only consequence is a tax liability of its unrelated business income as imposed by IRC Section 511. On the other hand, private benefit can result in revocation regardless of its insubstantiality.

EO's Final Return

The EO filed a Final Return, Form 990, for the year beginning 01-01-20XX and ending 08-31-20XX. The return was dated 06-20-20XX.

The EO attached to the Form 990 for the year 20xx a "Statement Filed Pursuant to Treasure Regulation Section 1.368-3(a)." The Statement provides the names and EIN's of parties of reorganization. The parties were * * *.

The EO terminated on August 31, 20XX, according to a "Plan of Merger" document attached to the Form 990, dated August 15, 20XX. The Plan of merger was by and between * * * ("Acquired Corporation"), a non-profit corporation incorporated under the laws of the State of * * *, and ("Surviving Corporation"), a non-profit corporation incorporated under the laws of the state of * * *.

Schedule "N" of the Form 990, 20XX12 showed the merger as "All assets of the company were transferred pursuant to a tax free merger." The date of the distribution was 08-15-20XX; the Fair market value of asset(s) distributed or amount of transaction expenses was $XXX,XXX. The Method of determining FMV for asset (s) distributed or transaction expenses was "Book Value". The Name of the recipient was * * *.

During the interview, the POA stated that the EO had been advised by one of its Firm's former CPA on the Merger of the organizations by a "Tax Free Merger". It was further found that the organization receiving the assets in the merger was a for-profit organization. The POA was asked on this regards and he said that in fact it was a for profit corporation.

Section 1.501(a)-1(c) of the regulations defines the words "private shareholder or individual". The words private shareholder or individual in section 501 refer to persons having a personal and private interest in the activities of the organization.

Section 1.501(c)(3)-1(d)(1)(i) states that an organization may be exempt as an organization described in section 501(c)(3) if it is organized and operated exclusively for one or more of the following purposes:

Section 1.501(c)(3)-1(a)(1) of the regulations provides that in order to be exempt as an organization described in section 501(c)(3) of the Code, the organization must be one that is both organized and operated exclusively for one or more of the purposes specified in that section. If an organization fails to meet either the organizational or operational test, it is not exempt.

Section 1.501(c)(3)-1(c) of the regulations specifies that with regard to the primary activities within the operational test, an organization will be regarded as "operated exclusively" for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of such exempt purposes specified in section 501(c)(3). An organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.

Section 1.501(c)(3)-1(c)(1) of the regulations provides that an organization will not be regarded as operated exclusively for exempt purposes if more than an insubstantial part of its activities is not in furtherance of exempt purposes.

Section 1.501(c)(3)-1(c)(2) entitled distribution of earnings, provided that an organization is not operated exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals. For the definition of the words "private shareholder or individual", see paragraph (c) of § 1.501(a)-1.

Section 1.6001-1(c) of the regulations requires that an exempt organization must maintain records sufficient to demonstrate that it is entitled to tax exempt status.

Section 1.6033-2(h)(2) of the regulations holds that an organization which is exempt from tax, whether or not it is required to file an annual information return, shall submit such additional information as may be required by the Internal Revenue Service for the purpose of inquiring into its exempt status.

In Bubbling Well Church of Universal Love, Inc. v. Commissioner, the tax court held that "where the creators control the affairs of the organization, there is an obvious opportunity for abuse, which necessitates an open and candid disclosure of all facts bearing upon the organization, operations, and finances so that the Court can be assured that by granting the claimed exemption it is not sanctioning the abuse of the revenue laws." Implicit in this determination is that the taxpayer has a responsibility to show through its "candid disclosure" of its activities and operations that it continues to qualify for exemption. The "Bubbling Well" opinion goes on to say that if such disclosure is not forthcoming, the logical inference is that the facts, if disclosed, would show that the organization fails to meet the requirements of 501(c)(3).

Rev. Rul. 72-369 states, in part, that in order for an organization to pass the operational test the organization's resources must be devoted to purposes that qualify as exclusively charitable. Section 508 of the Code provides Special Rules with respect to Section 501(c)(3) organizations.

Section 508(a)(1) of the code provides, with certain exceptions, that an organization organized after October 9, 1969, shall not be treated as an organization described in section 501(c(3) unless it has given notice to the Secretary or his delegate that it is applying for recognition of such status. If the notice is given after the time prescribed in the regulations, section 508(a)(2) provides that the organization shall not be treated as an organization described in section 501(c)(3) for any period before the giving of such notice.

Section 1.508-1(a)(2)(i) of the Income Tax Regulations provides that the required notice is filed by the submission of a properly completed and executed Form 1023 with 15 months from the end of the month in which the organization was organized.

Section 509(a)(2) of the Code specifies these type of organizations are supported primarily by exempt function income. Exempt function income is described as funds derived from an activity which is not an unrelated trade or business. This code section excludes from private foundation classification those publicly supported organizations that received more than one-third of support from gifts, grants, contributions, membership fees, and certain gross receipts but not more than one-third from gross investment income and net unrelated business taxable income.

Rev. Rul. 67-390 states that an exempt unincorporated organization or association and/or trust that incorporates and continues the operations which had qualified it for the exemption, must file an application for exemption to establish that the new entity qualifies for exemption under the Code and applicable regulations. When you create a corporation, even though it may be conducting the same activities and providing the same services as the unincorporated organization, you have created a new entity. Based on this Revenue Ruling, the organization must file an application for exemption to establish that the new entity qualifies for exemption under the Code and applicable regulations.

• The organization was not a 501(c)(3) further described in IRC Section 509(a)(2) as it failed the Public Support Test.

• The organization was not a 501(c)(3) as it failed the Operational Test.

• The EO did not operated exclusively for exempt purposes as required by IRC Section 501(c)(3). The EO's unrelated business activity was more than an insubstantial part of its activities. The organization was operated primarily for commercial purposes. It was not primarily engaged in exempt related activities.

• After incorporation in 19XX, the EO did not resubmitted to the IRS Form 1023 for exemption under Section 501(c)(3), as per Section 1.508-1(a)(2) of the Income Tax Regulations.

• The EO's assets were transferred to a for-profit organization. According to the EO's Trust and By-laws, the organization, if terminated, would dedicate its assets to a charitable organization. The EO violated the 501(c)(3) rules, the Declaration of Trust and its By-laws. The organization served a private benefit rather than public interests.

The EO did not qualify for exempt status for the year under examination and was not operated exclusively for charitable purposes within the meaning of IRC Section 501(c)(3), further described under Section 509(a)(2).

Forms 1120, US. Corporation Income Tax Return, should be filed for years 20XX and 20XX, and each year thereafter as long as the organization remains subject to Federal Income Tax.