Over the years, I have advised tax-exempt organizations and served on nonprofit boards; I have seen and encouraged organizations to use strategies employed by businesses generally to increase effectiveness, efficiency and revenues. The mantra in the 80s and 90s was that nonprofits must “operate more like a business.” In recent years, with the decrease in contributions, dues and grants, nonprofits have looked to generating alternative sources of revenue to survive. In considering how these revenues will be treated for tax purposes, the analysis has generally revolved around whether the activity generating the revenue was related to achieving the tax-exempt purposes of the organization. Revenue from related activities was treated as non-taxable, and revenue from activities unrelated to mission was treated as taxable — simple enough.
However, it may not be so simple any more. In a number of recent rulings, the IRS has denied exemption to organizations whose purposes appear to be acceptable but whose operations have been viewed to be too much like that of a commercial for-profit enterprise. This has generally been referred to as the “commerciality doctrine.”
An example can be found in Private Letter Ruling 201204021 (January 27, 2012), which involved a nonprofit publisher of religious books that had many charitable attributes:
- It published and distributed Christian books and Bibles around the world.
- It used industry standards (i.e., fair market value) to price books competitively.
- 10 percent of the books were distributed free and damaged books were given away.
- 30 percent of its resources were devoted to providing pro bono services.
- It provided free literature to missionaries and pastors who served the poor and provided Bibles to incarcerated individuals.
The purported business-like attributes included:
- It paid authors a royalty and additional compensation for sales of television rights, radio rights, etc.
- It distributed its literature through retail shops, including chain stores.
- It marketed through advertising, sales representatives, media, catalogs, e-mail, etc.
- Its expenditures included salaries and wages, as well as occupancy and professional fees.
In Rev. Rul. 68-306, the IRS held that publishing and distributing a monthly newspaper carrying church news advanced religion. The newspapers were distributed through churches, and the revenues in that ruling did not cover expenses. In the private ruling, the IRS concluded that the religious publisher was not similar to the newspaper in Rev. Rul. 68-306, as it did not advance religion. The IRS rationale was that the publisher’s marketing and advertising was not limited to churches, its revenues covered its expenses, and its marketing and advertising was comparable to a commercial publisher.
The increased use of the IRS’s “commerciality doctrine” creates significant uncertainty regarding what activities are allowable. Here we have an organization that was distributing religious literature, some for cost and some donated. Presumably, the readers of the literature gained a better understanding of religion, which would appear to advance religion. The publishing and distribution operations seem in line with normal publishing industry practices so as to be efficient and to generate sufficient income to cover cost. Don’t most nonprofit organizations seek to operate in this way? The IRS pointed out that the organization competed with for-profit publishers. However, for-profit businesses do not generally donate their products or provide significant pro bono services. Likewise, in many areas there are nonprofit organizations that operate alongside for profit organizations, with colleges and hospitals being two obvious examples.
It appears that the true concerns of the IRS were not used as the exclusive basis for its ruling. These concerns centered on suspected private benefits to insiders. For example:
- The organization had previously been organized as a for-profit publishing company.
- Its primary distributor was a for profit publisher owned by one of its officers.
- It sold books authored by one of its officers.
The problem with these IRS concerns is that there is no per se prohibition against a nonprofit transacting business with its officers or directors, as long as the deals are at fair market value. There is no statutory or regulatory prohibition against having a small board of individuals who may be related or have some special relationship work with a nonprofit. Therefore, when faced with situations like these where there is no clear legal violation, the IRS seems to assert the rather murky “commerciality doctrine” to deny or challenge tax-exempt status. This analysis sets a very problematic precedent that can just as easily be applied to other organizations that don’t have the perceived problematic governance or private benefit practices but seek to operate efficiently. This could be a very slippery slope in the making for the IRS.
Of even greater concern is that some recent court decisions have embraced the “commerciality doctrine.” For example, in Asmark Institute v. Commissioner of Internal Revenue Service (July 2, 2012), the Sixth Circuit Court of Appeals (which has jurisdiction over Ohio and certain neighboring states) applied the commerciality doctrine to deny exemption to an organization that provided services to assist the agricultural industry to comply with governmental regulations. The organization asserted that its services were “educational” in nature.
The organization had formerly been a for profit company owned by the same three persons who served as the directors and officers of the nonprofit. It also operated out of space rented from a for profit company owned by these individuals. The organization’s business model was much the same as its for profit predecessor. Its revenue was comprised primarily of “membership dues,” which entitled its members to the services of the organization. It also provided other fee based services.
In concluding that the organization did not qualify for tax exemption, the Court cited the following factors:
- The organization was a successor to a for profit entity.
- The organization’s membership dues were, in fact, fees for services.
- The organization competed with for profit entities.
- The organization’s salary structure and lease arrangements with its officers and the for profit company they owned were questionable.
The Court concluded that the organization was not operated for charitable purposes because its “operations [are] commercial rather than charitable” and because the activities “consist mainly of compliance services for a fee.”
The Asmark case is a good example of bad facts making bad law. The organization’s activities were not clearly educational, and it conceded that its business model was just like its for profit predecessor. The organization also admitted that it converted to a nonprofit format solely to increase its revenues. Although the facts of the case are bad, the Court’s decision is written so broadly that it has the potential of being applied inappropriately. For example, the fact that the organization provided its services in exchange for a fee that was not unreasonable should not serve as a basis for finding that it operated too much like a for profit entity.
As noted previously, a huge percentage of 501(c)(3) organizations charge fees for their services. This does not convert them to for profit entities. Likewise, the fact that for profit entities provide similar services should not be used as a simplistic basis for identifying “commercial” activities. Many for profit entities engage in some of the same activities as non profits. They typically “cherry pick” and only do the part of the activities that is most profitable. It is essential to look at an organization’s full range of activities to determine if the organization is operated wholly in a commercial manner.
In summary, 501(c)(3) organizations must be aware of the IRS’s increased application of the “commerciality doctrine.” It is important for charities to document how each of their activities serve their mission and how their operations differ from for profit organizations that may do some of what they do. Care should also be taken to make sure that board minutes and other corporate documents reflect the organization’s intent to accomplish its charitable mission, rather than to accomplish its “business objectives.” The language used is very important.