Commerciality Doctrine: Denial of Exemption

Earlier this month, the IRS denied the exemption application of an organization whose articles stated that it would provide colleges and universities with the ability to engage in science and engineering studies and research in the submarine environment, including the ability to acquire by purchase, lease, gift, loan or by other means, vessels, vehicles and ancillary equipment pertaining to marine science and engineering; and provide advice and consulting services to such colleges and universities. The principal basis for the denial was because the organization failed the Operational Test applicable under IRC 501(c)(3) because its primary activities did not accomplish a 501(c)(3) exempt purpose. Further, it was operated in a manner not significantly distinguishable from a commercial enterprise. You can read PLR 201729022 for more details.

We’ve discussed the commerciality doctrine in a previous post, but the ruling in the application above sets forth the authorities that led to the denial of exemption, which are important in understanding how the commerciality doctrine can impact an organization’s 501(c)(3) status.


Section 501(c)(3) of the Code provides for the exemption from federal income tax organizations that are organized and operated exclusively for exempt purposes.

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

Treas. Reg. § 1.501(c)(3)-1(c)(1) provides that 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 exempt purposes specified in section 501(c)(3) of the Code. It is not operated for exempt purposes it more than an insubstantial part of its activities do not further an exempt purpose.

Treas. Reg. § 1.501(c)(3)-1(d)(1) states an organization may be exempt under section 501(c)(3) if it is organized and operated exclusively for one or more of the following purposes: religious, charitable, scientific, testing for public safety, literary, educational or prevention of cruelty to children or animals.

Treas. Reg. § 1.501(c)(3)-1(d)(2) provides that the term “charitable” is used in section 501(c)(3) in its generally accepted legal sense and includes relief of the poor and distressed or of the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening of the burdens of government; and promotion of social welfare.

Rev. Rul. 71-529, 1971-2 C.B. 234, held that an organization controlled by a group of exempt organizations and providing investment and management services for a charge substantially less than cost to that group qualifies for exemption under section 501(c)(3) of the Code.

In Rev. Rul. 72-369, 1972-2 C.B. 245, an organization was formed to provide managerial and consulting services for section 501(c)(3) organizations to improve the administration of their charitable programs. The organization enters into agreements with unrelated section 501(c)(3) organizations to furnish managerial and consulting services on a cost basis. The Service held that providing managerial and consulting services on a regular basis for a fee is a trade or business ordinarily carried on for profit and accordingly, was not exempt under section 501(c)(3) of the Code. Further the service stated that furnishing the services at cost lacks the donative element necessary to establish the activity as charitable. [Note also the implications to unrelated business income tax or UBIT.]

In Better Business Bureau of Washington, DC v. United States, 326 U.S. 279 (1945), the Supreme Court stated that the presence of a single non-exempt purpose, if substantial in nature, will destroy the exemption, regardless of the number or importance of truly exempt purposes.

In B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352 (1978), the court found that a corporation formed to provide consulting services did not satisfy the operational test under section 501(c)(3) of the Code because its activities constituted the conduct of a trade or business that is ordinarily carried on by commercial ventures organized for profit. Its primary purpose was not charitable, educational, or scientific, but rather commercial. In addition, the court found that the organization’s financing did not resemble that of the typical section 501(c)(3) organizations. It had not solicited, nor had it received, voluntary contributions from the public. Its only source of income was from fees from services, and those fees were set high enough to recoup all projected costs and to produce a profit. Moreover, it did not appear that the corporation ever planned to charge a fee less than “cost.” And finally, the corporation did not limit its clientele to organizations that were section 501(c)(3) exempt organizations.

In Airlie Foundation v. Commissioner, 283 F. Supp. 2d 58 (D.D.C., 2003), the court concluded that the Foundation was operated for a substantial non-exempt purpose. It based this conclusion on the manner in which the organization managed a conference center. “Among the major factors courts have considered in assessing commerciality are competition with for-profit commercial entities; extent and degree of below cost services provided; pricing policies; and reasonableness of financial reserves. Additional factors include, inter alia, whether the organization uses commercial promotional methods (e.g. advertising) and the extent to which the organization receives charitable donations.” Thus, the court looked at the business methods of the organization as a method of inferring whether its purpose was to serve the public or whether there was a substantial nonexempt purpose of operating a business for profit.

Consulting Services and Exemption

Despite the denial of exemption in this particular case and the authorities cited above, consulting services may be characterized as activities in furtherance of a charitable or educational purpose even if carried on for a reasonable fee. See, for example, PLR 201701002.

In this case, the Foundation’s technical assistance services are substantially related to the performance of its exempt functions. The services are part of the organization’s exempt data activities. The Foundation’s screening process ensures that it only undertakes projects that will provide valuable research and data to serve its charitable mission of improving the lives of low income children and their families. Performing the data analysis and interpretation services related to each project gives the Foundation access to new data and identifies new research questions related to its charitable mission. The Foundation makes the results of each project publicly available on its website. It also requires that its clients never sell the results of any project or use the results for any purpose other than the exempt purpose for which the Foundation agreed to provide its products or services; namely, to improve the lives of low income children and their families.


The Foundation is not like the organizations in B.S.W. Group, Inc. v. Commissioner and Rev. Rul. 72-369, because its technical assistance services have a primarily charitable purpose and differ from those available through commercial ventures. In B.S.W. Group, Inc., as in Rev. Rul. 72-369, the consulting services served the individual needs of the clients, but the services themselves were not inherently charitable, nor did they further the charitable purpose of the organization itself. In this case, the technical assistance services themselves further charitable purposes. Further, providing the technical assistance furthers the Foundation’s own charitable purposes because the Foundation uses resulting data and analysis for its own research and grantmaking purposes, in addition to assisting client social sector organizations to perform their own charitable activities. In addition, the Foundation’s services differ from those commercially available because the Foundation has access to raw data that is not available to commercial ventures and its activities are performed by employees of the Foundation who have developed particular knowledge and extensive understanding of issues facing low income children and their families in City metro region and perform such functions as part of other activities that further the Foundation’s exempt purposes. Finally, unlike the organization in B.S.W. Group, Inc., which did not appear to charge any fee less than cost, and the organization in Rev. Rul. 72-369, which charged fees at cost, the Foundation will determine on a case-by-case basis whether to charge a fee below cost to complete the project.

See also this analysis of PLR 201701002 from Loeb & Loeb.