On September 16, 2008, the IRS released Determination Letter 200851031 – a revocation letter of 501(c)(3) exempt status for the applicant organization’s failure to pass both the organizational and operational tests required of 501(c)(3) organizations by the Department of the Treasury.

Regarding the organizational test, the IRS cites the organization’s failure to amend its Articles of Incorporation. The organization's Articles state that its primary exempt purpose is “providing vocational skills development and rehabilitation services to individuals with physical and/or mental handicaps.” However, its new primary activity was “a minor grant award program” that the IRS determined did not accomplish “[the organization’s] stated purposes for which it was organized and for which exemption had been authorized.”

The IRS’s assessment of the operational test is more complex, with the IRS engaging in a three-part analysis of the organization’s expenditures:

  1. Whether the organization’s activities are primarily directed at one or more exempt purpose
  2. Whether such exempt program expenditures are substantial when compared to the overall expenditures of the organization
  3. Whether the organization’s expenditures are directed toward accomplishing a purpose that benefits the public in some significant way and not to further the interests of private interests

The IRS determined that the organization failed on all three parts. The IRS concluded that the grants did not qualify as being in furtherance of one or more exempt activities because the distributions were given to “other unrelated organizations to use in conducting their own program of exempt activities.”  [This conclusion makes little sense to me.  Grantmaking does not qualify as being in furtherance of an exempt purpose? - Ed.)  Administrative costs played a large factor in the second and third parts of the test because the grantmaking activities only attributed for 13% of total expenditures over a four-year look-back period while salaries counted for 37% and general overhead at 50%. 

Attorney and CPA Jack Siegelof Charity Governance Consulting LLC interprets the IRS’s latter analysis of absolute numbers as troubling. Siegel states that this ruling “should make all tax-exempt organizations very nervous” and reflects the IRS’s mistaken view “that inputs are highly correlated with outcomes.” Siegel finds the notion that there can be absolute percentages of acceptable overhead and compensation to be problematic because organizations engaged in different activities (e.g. research) or in different phases (e.g. a new start-up) will incur costs specific to their situation. Instead, he believes that the pertinent question is whether the compensation and overhead expenditures were “legitimate, well-intended, or effective.” Thus, the IRS’s pure numbers approach is inherently flawed because “the IRS isn’t authorized to ask those questions, nor is it in a position to make that judgment.” Siegel is clear to state his issue is not with the revocation itself but that “the better approach would have been to use the tools aimed at excessive compensation and inurement” such as intermediate sanctions and excess benefit regulations.

While Siegel raises valuable insight about the potential flaws of the IRS’s approach to the operational test, it is important to note that the 6-page explanation of the revocation also points to a handful reporting errors by the organization. Among such issues include the organization’s failures:

  • to amend its stated purpose to accurately reflect the transition to providing grants “for projects that promote education for children and families.” Instead, the organization assumed this would be covered by its current overly broad purpose phrase that “… the corporation shall have the power to engage in any lawful act or activity for which non-profit corporations may be organized under the general corporation of [the State].”
  • to notify the IRS on Form 990 of its material change to its program (ceasing its job training center altogether) that occurred halfway through the fiscal year
  • to disclose on Form 990 the details in transferring its program to another agency
  • to properly answer Form 990 Question 76 (“Did the organization engage in any activity not previously reported to the Service?”) and Question 79 (“Was there a liquidation, dissolution, termination or substantial contraction during the year?”)

It is also worth mentioning that the IRS stated the organization’s new grantmaking purpose, if properly amended, “would most likely qualify as an activity permitted by IRC §501(c)(3)” under the organizational test. Additionally, although the organization defended its operational costs, stating “[it] believes that the costs incurred were both necessary and reasonable to accomplish its new exempt purpose,” the IRS’s omission to fully address this argument other than to point to expenditure percentages may have been another consequence of the organization’s failure to report all changes and relevant information to begin with. Although it cannot be said with any certainty whether full disclosure would have prevented the revocation, it appears the organization had missed opportunities to be proactive.

Thus, regardless if one agrees with Siegel’s criticism of the IRS’s approach to the operational test, Siegel highlights two important lessons that parties from any point of view should consider:

  • Form 990 – Answer All Questions Completely. Not only did the IRS state that the organization failed to answer Question 76 and 79, but also noted that both questions require detailed explanations and descriptions of the changes.
  • Form 990 – Repeat Information When Asked for the Same Information. The IRS did not treat the organization’s reworded purpose statement that had referenced the new grantmaking activity as responsive to Question 76 because it was mentioned elsewhere within Form 990 rather than specifically in response to Question 76.

Thus, Siegel suggests “[a]s a matter of prudent practice, organizations should respond completely to each question as if it were the only question on the return.  As an alternative, an organization that wants to rely on a response to one question when responding to another should use clear cross-references.”

Organizations must remember that failure of either the organizational or the operational test will result in a revocation of 501(c)(3) exempt status. Organizations are in the best position to know what changes are occurring, what costs are legitimate, and what information to provide to avoid ambiguities that will trigger IRS concerns and uncertainty as to whether the organization is operated exclusively for one or more exempt purposes. Even if the operational test is flawed, as Siegel suggests, this should not prevent an organization from meeting its legal reporting responsibilities and taking precautionary steps to protect its tax-exempt status. Outwardly troubling numbers without an explanation seem like a deadly combination for any organization regardless of how reasonable or well-founded they may actually be.

The IRS revocation letter of 501(c)(3) exempt status (Determination Letter 200851031) is available here.

Jack Siegel’s article, “IRS REVOKES GRANTMAKER’S 501(c)(3) STATUS BECAUSE ITS OVERHEAD WAS TOO HIGH: WHERE IS THE LINE BETWEEN EXEMPT AND TAXABLE FOUNDATIONS?” on the Charity Governance Blog, is available here.

- Emily Chan