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Saturday July 23, 2016

Private Letter Ruling

Charity Unable to Substantiate Expenses Loses Exemption

GiftLaw Note:
Organization (Org) applied for and was granted tax-exempt status. Org’s purpose is to provide assistance to municipalities home to endangered species. The Service examined Org’s activities to determine that it was operating for exempt purposes. Org could not substantiate that meal expenses were used for exempt purposes. Cable and Internet expenses were for a personal residence and Org did not provide an exempt purpose to validate those expenses. Org also had vehicle expenses but did not have a vehicle in its asset log. In addition, Org’s founder also made personal loans to Org, but there were no contemporaneous loan documents to substantiate the loan terms. Bank statements provided to the Service indicated that expense receipts did not always match the timing and amount of withdrawals from Org’s account.

Organizations seeking tax-exempt status under Sec. 501(c)(3) must show that they are both organized and operated exclusively for exempt purposes with no part of their net earnings inuring to the benefit of a private individual. Under Reg. 1.501(c)(3)-1(d)(ii), the exempt organization has the burden of proof to show it is not organized or operated for the benefit of private interests, such as designated individuals, the creator, shareholders of the organization or persons controlled directly or indirectly by such private interests. Here, the Service found that Org’s expenses for meals, cable and other expenses were for the benefit of a private person and not the general public. Org could not substantiate that many expenses were made for exempt purposes. In addition, Org provided the Service with receipts that did not always reconcile with withdrawals from Org’s account. In the Service’s view, Org lacked an accountable plan substantiating which expenses and withdrawals were for exempt purposes and which were for private interests. Therefore, the Service revoked Org’s exempt status.
PLR 201627002 Charity Unable to Substantiate Expenses Loses Exemption
7/1/2016 (3/31/2016)

Dear * * *:

* * *

ISSUES


Whether ******** should have their exemption revoked for creating private benefit and inurement to a disqualified person of the exempt organization?

FACTS


******** is an applicable 501(c)(3) established in ********, ******** in October 20 of 19XX. ******** was granted their exemption on October of 19XX. The purpose of ******** is to provide assistance to various municipalities around ******** that have ******** that are home to an endangered species list that lives only in ******** in the ******** area. ******** protects and ******** inventories the ********.

******** paid for items that benefited ********. ******** has failed to substantiate the exempt purpose of these expenditures as requested in the issued to ******** on March 13 20XX. A listing of the largest items noted is as follows.

Meals: In 20XX food was purchased ******** times for a total of $ ********. These purchases occurred evenly throughout the year. In 20XX food was purchased times for a total of $ ********. ******** provided bank statements showing these expenditures, but ******** was issued several ******** on requesting substantiation for the business and tax exempt purpose of said purchases, but to date has failed to provide the requested information therefore these purchases are deemed to be personal in nature benefiting ******** personally.

Cable: ******** purchased cable and internet for ******** personal residence in the years 20XX and 20XX. The total expense for each year was $ ******** for 20XX and $ ******** for 20XX. ******** was issued ******** requesting substantiation for the business and tax exempt nature of these expenses, however to date this information has not been provided. Therefore due to the personal nature of these expenses it is deemed to be benefiting ******** personally.

Vehicle expenses: In 20XX ******** paid $ ******** for ******** fees, $ ******** in gas, and $ ******** in vehicle repairs. In 20XX ******** purchased $ ******** in gas and ******** in vehicle repair. ******** has no vehicle listed in the asset log that it provided from ******** sent on December 5, 20XX.

All transactions provided by ******** were either cash withdraws or debit card purchases. This agent did not observe any transactions that were checks in the records for the three years under exam.

******** was issued on March19, 20XX requesting explanation and source of the deposits. ******** stated that the amounts deposited were personal loans made to the EO from him. Agent noted that no contemporaneous loan documents were available to substantiate the terms of the loan. The loan from the officer was determined to not be a bona fide debt. The organization did not maintain proper substantiation to support and verify the expenses and advances that made up the total balance due to the officer such as a written promissory note, repayment schedule, maturity date for the loan, or an interest rate for the loan.

All disbursements in the bank statements provided by ******** are debit card transactions or cash transactions.

******** provided the Service with bank statements and envelopes with receipts in them. The receipts did not match the dollar amounts of the envelopes. The receipts inside the envelopes were not always from the immediate period that the cash withdraw was made. The receipts were from as much as a year before and half a year later in the same envelope. There was no accountable plan in place at ********. Most transactions were cash transactions or reimbursements of purchases.

The Bylaws of ******** state in ******** Prohibition against Private Inurement: No part of the net earnings of this corporation shall inure to the benefit of, or be distributable to, its members, directors, or trustees, officers, or other private persons, except that the corporation shall be authorized and empowered to pay reasonable compensation for services rendered and to make payments and distributions in furtherance of the purposes of this corporation.

The ******** of ******** provides ******** monitoring on the side and is paid directly for ******** services.

LAW


Section 501(c)(3) of the Code exempts from federal income tax organizations organized and operated exclusively for charitable, educational, and other exempt purposes, provided that no part of the organization's net earnings inures to the benefit of any private shareholder or individual.

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.

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(d)(ii) of the regulations provides that an organization is not organized or operated exclusively for one or more exempt purposes unless it serves a public rather than a private interest. Thus, it is necessary for an organization to establish that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests.

Section 1.501(c)(3)-1(d)(1)(ii) of the regulations states that an organization is not organized or operated exclusively for exempt purposes unless it serves a public rather than a private interest. The regulation places the burden of proof on the organization to demonstrate that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled directly or indirectly by such private interests.

Section 1.501(c)(3)-1(d)(2) of the regulations provides that the term "charitable" is used in section 501(c)(3) of the Code in its generally accepted legal sense, and includes the promotion of education.

The presence of a single substantial nonexempt purpose can destroy the exemption regardless of the number or importance of exempt purposes. Better Bus. Bureau v. United States, 326 U.S. 279. 283, 90 L.Ed. 67, 66 S. Ct. 112 (1945); Am. Campaign Acad. v. Commissioner, 92 IC. 1053, 1065 (1989); see also Old Dominion Box Co., Inc. v. United States, 477 F2d. 340 (4th Cir. 1973), cert. denied, 413 US 910 (1973) ("operating for the benefit of private parties who are not members of a charitable class constitutes a substantial nonexempt purpose"). When an organization operates for the benefit of private interests, such as designated individuals, the creator or his family, or persons directly or indirectly controlled by such private interests, the organization by definition does not operate exclusively for exempt purposes. Am. Campaign Acad. v. Commissioner, supra at 1065-1066.

In B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352 (1978), the courts ruled the organization did not qualify for exemption under IRC section 501(c)(3) because it was not operated exclusively for charitable, educational, or scientific purposes.

In order to be recognized as exempt under IRC section 501(c)(3), the organization is prohibited from:

1) Permitting its net earnings to inure to the benefit of private individuals or operating in a way where more than an insubstantial part of its activities further private versus public purposes

2) Engaging substantially in legislative activity

3) Participating or intervening in any political activity

Treas. Reg. section 1.501(c)(3)-1(c)(2) states that an organization is not exclusively operated for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals.

Treas. Reg. section 1.501(a)-1(c) defines a "private shareholder or individual" as "persons having a personal and private interest in the activities of an organization."

If the private benefit to an individual or a group of individuals is greater than the public benefit, the private benefit is considered substantial. A substantial private benefit can result in revocation of exempt status.

Even a small amount of private inurement is fatal to exemption. In Spokane Motorcycle Club v. U.S., 222 F. Supp. 151 (E.D. Wash. 1963) , net profits were found to inure to private individuals where refreshments, goods and services amounting to $825 (representing some 8% of gross revenues) were furnished to members.

Regs. 1.501(c)(3)-1(d)(1)(ii) states that the burden of proof is upon the organization to establish that it is not organized or operated for the benefit of private interests. This requirement applies equally to inurement and private benefit issues. While it is difficult to prove a negative, the organization is certainly in a better position than the Service to know the detailed facts surrounding its formation and operation. Therefore, in an exemption application case the organization is required to furnish the Service with the documents setting forth its purposes and rules of operation as well as a detailed explanation of its operations. See Rev. Proc. 84-46, 1984-1 C.B. 541.

Baird v. Commissioner, 25 T.C. 387 (1955) provides that the extent to which the borrower controls the corporation is a factor that can indicate whether a loan is a bona fide debt.

United States v. Title Guarantee & Trust Co., 133 F.2d 990 (6th Cir. 1943) provides that the maturity date of the loan can indicate whether a loan is a bona fide debt.

Thielking v. Commissioner, T.C.M. 1987-227 provides that whether the note provides for interest or not can indicate whether a loan is a bona fide debt.

In John Marshall Law School and John Marshall University v. United States, 228 Ct.Cl. 902 (1981), 81-2 U.S.T.C. 9514 involve classic channeling of an organization's net earnings to those in control. The court sustained the Service's revocation of the school's exempt status based on inurement. The court found inurement existed when the school provided the following to family members who were its officers:

* Interest free loans
* Unsecured loans
* Payments for non-business travel
* Payments for non-business entertainment
* Personal health spa membership

In United Cancer Council, Inc. v. Commissioner, 165 F.3d 1173 (1999), the appeals court stated the inurement clause of IRC section 501(c)(3) interprets the phrase "private individual or shareholder" as an insider of the charity.

The court further said a charity must not improperly pass its earnings to its founder, board members, their families, or anyone else described as an insider who is the equivalent of an owner or manager. The insider could be an employee such as an office manager.

GOVERNMENT'S POSITION


An organization recognized as tax exempt under IRC section 501(c)(3) is prohibited from permitting any of its net earnings to inure to the benefit of any private shareholder or individual. ******** records show several expenses that are inurement just like in John Marshall Law School and John Marshall University v. United States, 228 Ct.Cl. 902 (1981), 81-2 U.S.T.C. 9514 . These expenses meals, cable bills, payments and other expenses are for the betterment of a disqualified person and not for general public.

Regs. 1.501(c)(3)-1(d)(1)(ii) states that the burden of proof is upon the organization to establish that it is not organized or operated for the benefit of private interests. This requirement applies equally to inurement and private benefit issues. While it is difficult to prove a negative, the organization is certainly in a better position than the Service to know the detailed facts surrounding its formation and operation. Therefore, in an exemption application case the organization is required to furnish the Service with the documents setting forth its purposes and rules of operation as well as a detailed explanation of its operations. See Rev. Proc. 84-46, 1984-1 C.B. 541 .

It is the Government's position that the ******** has not provided any consistency in the information provided in this examination. In response to the Information Document Requests, ******** furnished several envelopes with receipts, total of ******** which never reconciled to the amounts withdrawn from the bank account. The receipts were from 8 months before the cash withdraw and up to 8 months after the cash withdraw. The receipts contained in the envelopes were for various expenses that were never proven to be for a business/tax exempt purpose and were dated for periods outside of the audit years. See the examples attached to this report. This is inconsistent with the meaning of an accountable plan and not proof of factual events for an ongoing concern. The receipts provided in envelopes were not labeled with information to discern their exempt purpose. To not have an accountable plan is to have a taxable event and that is what this agent sees in ********. Not only do we have a taxable event but we have inurement which is not allowed in Section 501(c)(3) organizations. Therefore it is the Governments position that should lose its exemption due to inurement and private benefit created on behalf of the of ******** Disqualified Person who controls the exempt organization. All purchases and decisions are made by the ******** of ********. Excess benefit transactions would not occur without ******** approval.

The amount of the benefit is not clear due to the intermingling of personal expenses and exempt organizations functional expenses. What was determinable was that there is a comingling of these expenses and that there were no controls or accountable plans to separate personal expenses from the exempt organizations business. The exempt organization did not report these amounts as compensation on an original or amended Form 990, Form W-2, or Form 1099 for the year ending December 31, 20XX, before the start of this examination; nor did any of the corporate officers report these amounts as compensation on an original or amended Form 1040 before the start of this examination. Furthermore, the EO did not establish that its failure to report these amounts as compensation was due to reasonable cause within the meaning of section 301.6724-1 of the regulations, nor did it provide any other written documentation demonstrating that it approved these payments in accordance with established procedures set forth in section 53-4958-4(c)(3)(ii) of the regulations. The payments are described in detail below and on the attached documents.

The ******** claims that certain payments received by the exempt organization were loans. As per United States v. Title Guarantee & Trust Co., 133 F. 2d 990 (6th Cir. 1943), Thielking v. Commissioner, T.C.M. 1987-227, and Baird v. Commissioner, 25 T.C. 387 (1955) the Government has a framework that must be followed to be bona fide as a true loan and not a contribution to an organization. These steps to disclose a bona fide debt such as including in the Form 990 that loans were created or a physical document signed contemporaneously that would state terms conditions and implied payback schedule were not provided. ******** did not document the transactions contemporaneously. The ******** of ******** did not even leave a paper trail to proof that the moneys were from the ******** of ********. The ******** of ******** states that ******** withdrew the cash from ******** personal account and deposited said cash into ******** account. It is the Government's position that there are no loans properly disclosed to the Government, nor any contemporaneous documentation to proof the origins of the funds that were received. The corresponding cash payments made to the ******** of ******** will be considered unreported income therefore, as per definition Section 4958 excess benefit transactions.

CONCLUSION


Regs. 1.501(c)(3)-1(d)(1)(ii) states that an organization is not organized or operated exclusively for exempt purposes unless it serves a public rather than a private interest. The regulation places the burden of proof on the organization to demonstrate that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or ******** family, shareholders of the organization, or persons controlled directly or indirectly by such private interests. Based on the foregoing reasons, ******** does not qualify for exemption under section 501(c)(3) and its tax exempt status should be revoked as of January 1 20XX.

******** should have their exempt status revoked due to lack of exempt purposes.

TAXPAYER'S POSITION


******** has indicated that it will agree with to revocation of its exemption.

Published July 15, 2016
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