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Saturday May 23, 2015

Private Letter Ruling

Charitable Trust Loses Exempt Status

GiftLaw Note:
Trust sought tax-exempt status under Sec. 501(c)(3). Trust was organized and operated for the primary purpose of, among others, providing low-income housing and preserving holiday traditions. Trust’s primary activity will be the operation of a 200 unit apartment complex for low income housing. When transferred, the complex had preexisting tenants. Trust does not plan to break these existing leases, but instead will enter into new lease arrangements with qualified tenants as the existing leases expire. Trust also plans to conduct annual Christmas activities on private property its trustees own. The trustees will not charge for use of the property. Trust will coordinate with local vendors to provide Christmas activities and each vendor will charge a small fee to the public. The issue before the Service was whether Trust qualified for exemption under Sec. 501(c)(3).

Sec. 501(c)(3) organizations must be organized and operated exclusively for exempt purposes with no part of their net earnings inuring to the benefit of any private shareholder or individual. In order for an organization to establish that it is operated exclusively for exempt purposes, it must submit a detailed statement of its proposed activities. Here, the Service determined that Trust failed to provide details establishing it will operate for exempt purposes. First, Trust did not provide information showing that the residents of the 200 unit apartment complex are low income and meet the requirements of Rev. Rul. 96-32. Additionally, Trust failed to provide information on the income levels of the tenants or how many units were occupied by low income tenants. Second, the application failed to show that the transfer of the 200 unit apartment complex to Trust did not result in private inurement to Trust’s founders. Third, Trust failed to show how its Christmas activities, which are social and recreational in nature, fulfilled an exempt purpose. Therefore, the Service denied Trust’s application for exempt status.
PLR 201519033 Charitable Trust Loses Exempt Status
5/8/2015 (2/11/2015)

Dear * * *

We considered your application for recognition of exemption from federal income tax under Section 501(a) of the Internal Revenue Code (the Code). Based on the information provided, we determined that you don't qualify for exemption under Section 501(c)(3) of the Code. This letter explains the basis for our conclusion. Please keep it for your records.

ISSUES


Do you qualify for exemption under section 501(c)(3) of the Code? No, for the reasons described below.

Does your inability to adequately establish operations as exclusively charitable preclude you from exemption under section 501(c)(3) of the Code? Yes, for the reasons described below.

FACTS


You were created as a charitable trust that was funded on P. The trust document states that you were organized and operated exclusively for charitable purposes and your primary purposes consist of providing low-income housing, preserving holiday traditions, providing volunteer support for charitable community events, environmental protection, and land preservation.

Your founders, who also serve as your trustees, are husband and wife. They do not receive compensation from you.

Your primary activity will be the operation of a two hundred unit apartment complex for low income housing. You will not participate in government housing programs but will follow HUD Guidelines to determine the low-income housing income limits and maximum rents that may be charged.

You own M, a 200 unit apartment complex in N where your low income housing activities will take place. The building was donated to you by O, a limited liability company owned by your trustees. The building has an estimated gross value of $t. There is a $r loan on the building that you assumed along with other associated liabilities such as utilities, insurance, and property maintenance. You declined to provide a certified appraisal for the value of the apartment building at the time of transfer due to cost. You did not provide any documentation on the value of the building or on its transfer. Your other estimated operating expenses to be $x. That amount includes maintenance, repairs, and supplies, general property expenses, payroll expenses, general turnover costs such as renovation, cleaning, and repairs, utilities, advertising, taxes, insurance, and administrative expenses.

You stated that it is illegal to break a lease, so you will honor the existing lease contracts that were in place at the time the building was transferred. Once those units vacate, you will place qualified tenants in the units. You did not provide any detail on the number of residents of the apartment building who are currently low income tenants.

Your other activities include:

  • Helping families identify and cope with apraxia,
  • Acquiring land for the development of affordable housing,
  • Coordinating exempt activities with the community activities of Q, and
  • Conducting Christmas activities to keep the Christmas spirit alive.

Your Christmas activities are held on private property owned by your trustees that includes a living Christmas tree farm with a 100 foot Santa balloon. The trustees will not charge you for use of the property to promote the Christmas spirit. You will coordinate with local vendors to provide Christmas activities that will include a train ride through a Christmas tree farm, arts and crafts workshops, apple cider and hot chocolate, pony rides, and petting zoos. A small fee will be charged to the public by each of the participating vendors for the activities with prices ranging from $* * * to $* * *. There is no obligation that visitors purchase any goods or services to enjoy the festivities and holiday lights.

LAW


Section 501(c)(3) of the Internal Revenue Code provides for the exemption from federal income tax of organizations organized and operated exclusively for charitable, educational, scientific, or other specified exempt purposes, no part of the net earnings of which inures to the benefit of any private shareholder or individual.

Section 1.501(a)-1(b)(1)(iii) of the Income Tax Regulations provides, generally, that an organization described in section 501(c)(3) of the Code shall submit a detailed statement of its proposed activities as part of its application for exemption.

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

Section 1.501(c)(3)-1(c)(1) of the Income Tax Regulations 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 of such exempt purposes specified in section 501(c)(3) of the Code. 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)(2) of the Income Tax Regulations provides 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. Section 1.501(a)-1(c) defines the words "private shareholder or individual" in Code section 501 as referring to persons having a personal and private interest in the activities of the organization.

Section 1.501(c)(3)-1(d)(1)(ii) of the Income Tax Regulations provides that an organization is not organized or operated exclusively for one or more exempt purposes under Code section 501(c)(3) unless it serves a public rather 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.

Revenue Ruling 70-585 held that an organization providing housing to low-income families is exempt under section 501(c)(3) of the Code.

Revenue Ruling 76-441 described two situations in which a for-profit entity was converted to a non-profit entity. In situation 1 the organization was granted exemption because it established the conversion from for-profit to non-profit served a public and not a private interest. In situation 2 the organization was denied exemption because the founders benefitted from the transfer of the property to the non-profit entity because the non-profit entity assumed the liabilities of the for-profit entity.

Revenue Procedure 96-32, 1996-1 C.B. 717, sets forth a safe harbor under which organizations that provide low-income housing will be considered charitable as described in section 501(c)(3) of the Internal Revenue Code because they relieve the poor and distressed. The revenue procedure also describes the facts and circumstances test that will apply to determine whether organizations that fall outside the safe harbor relieve the poor and distressed. An organization must establish that at least (a) 75 percent of its units are occupied by low-income families, and (b) either 20 percent of the units are also occupied by very low-income residents or 40 percent of the units are occupied by residents whose incomes do not exceed 120 percent of the area's very low income limit. In addition, the housing is affordable to beneficiaries. In the case of rental housing, this requirement will ordinarily be satisfied by the adoption of a rental policy that complies with government-imposed rental restrictions or otherwise provides for the limitation of the tenant's portion of the rent charged to ensure that the housing is affordable to low-income and very low-income residents. The organization may not further the private interests of individuals with a financial stake in the project resulting from real property sales, development fees or management contracts.

Section 4.03 of Revenue Procedure 2014-9, provides, in part, as follows:

Exempt status will be recognized in advance of operations if proposed operations can be described in sufficient detail to permit a conclusion that the organization will clearly meet the particular requirements of the section under which exemption is claimed. (1) A mere restatement of purposes will not satisfy this requirement. (2) The organization must fully describe the activities in which it expects to engage, including the standards, criteria, procedures, or other means adopted or planned for carrying out the activities, the anticipated sources of receipts, and the nature of contemplated expenditures. (3) Where the organization cannot demonstrate to the satisfaction of the Service that it qualifies for exemption pursuant to the Section of the Internal Revenue Code under which exemption is claimed, the Service will generally issue a proposed adverse determination letter or ruling.

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

In Kenner v. Commissioner, 318 F.2d 632 (7th Cir. 1963), and Cleveland Chiropractic Practical College v. Commissioner, 312 F. 2d 203, 206 (8th Cir. 1963) the conditional language of section 501(c)(3) of the Code and the burden of proof placed upon the taxpayer is considered. In general, an organization that applies for recognition of exemption has the burden of proving that it clearly meets all the requirements of the particular section of the Code under which it has applied. The taxpayer must clearly demonstrate its right to exemption.

New Dynamics Foundation v. United States, 70 Fed. Cl. 782 (2006), the organization failed to establish an administrative record that showed it was operated for exclusively exempt purposes. The court held that exemption from federal income tax is not a right; it is a strictly interpreted matter of legislative grace and the burden rests with the applicant to prove that it is entitled to exempt status.

In Founding Church of Scientology v. United States, 412 F.2d 1197, 1200, 1202, 188 Ct. Cl. 490 (Ct.Cl 1969), the organization has the burden of providing sufficient documentation or other substantive information regarding its activities and operations, which would establish entitlement to tax exempt status, including establishing that its net earnings will not inure to the benefit of private individuals and that it will not serve private interests.

In Mercantile Bank & Trust Company v. United States, 441 F.2d 364 (8th Cir. 1971), the court stated that "Special benefits to taxpayers, such as tax exemption status, do not turn upon general equitable considerations but are matters of legislative grace. The taxpayer has the burden to show that it comes within the statutory provision allowing the deduction or exemption comes squarely within the terms of the laws conferring the benefit sought."

In Salvation Navy v. Commissioner, T.C.M. 2002-275 (2002), the Tax Court found that one of the reasons why the organization did not qualify for exemption from federal income tax was because it could not prove that it was not organized to serve the private interests of its founder.

APPLICATION OF LAW


Section 501(c)(3) of the Code sets forth two main tests for an organization to be recognized as exempt. Section 1.501(c)(3)-1(a)(1) of the Regulations provides that in order for an organization to be exempt under section 501(c)(3), an organization must be both organized and operated exclusively for one or more of the purposes specified in such section. You have failed the operational test because you did not provide information to show that you are operated exclusively for 501(c)(3) purposes.

In order to establish its exemption, an organization must submit a detailed statement of its proposed activities as a part of its application for exemption. See Section 1.501(a)-1(b)(1)(iii) of the Regulations. You failed to provide the following items that are material to a determination of whether you satisfy the standards for exempt status:

  • Details to determine if your housing is currently operating as low income and fulfills a charitable purpose.
  • Details and documentation regarding the transfer of property to you that demonstrates the transaction did not lead to inurement to your trustees.
  • Details to determine if your Christmas activities further an exempt purpose under Section 501(c)(3) of the Code.

The IRS has statutory and regulatory authority to inquire about an applicant's proposed activities and other subjects material to its determination of whether the applicant meets the standards for exempt status. Rev. Proc. 2014-9. Accordingly, gaps in the administrative record may be resolved against you. See Rev. Proc. 2014-9, Section 4.03. Despite our request, you failed to respond to questions that were material to determining whether you satisfy the standards for exempt status. Your exemption request is similar to Kenner v. Commissioner, and Cleveland Chiropractic Practical College v. Commissioner, above. Here, the court held that an organization has the burden of proving that it clearly meets all the requirements of the particular section of the Code under which it has applied. Your application and response lacked sufficient information to show that you meet the requirements to be classified as an exempt organization under Section 501(c)(3) of the Code. Like the organization in New Dynamics Foundation v. United States, you failed to show that you are operated exclusively for exempt purposes.

Though providing low Income housing may fulfill an exempt purpose under Section 501(c)(3) of the Code, you have not shown that you engage primarily in activities that accomplish an exempt purpose. See Section 1.501(c)(3)-1(c)(1) of the Regulations. You are unlike the organizations described in Rev. Rul. 70-585. You did not provide information to show that the residents of your apartment building are low income and meet the guidelines set forth in Rev. Proc. 96-32. When your apartment building was transferred to you, there were already current tenants residing in the building. You did not provide information on the income levels of the tenants or how many units were occupied by low income residents. You only stated that it is illegal to break a lease so you have to honor the existing lease contracts that were in place at the time the building was transferred. Once those units vacate, you will place qualified tenants in the units. As stated above in Mercantile Bank & Trust Company v. United States, the burden of proof that the requirements for tax exemption are met falls upon you. By failing to provide information about the current residents of your apartment building, you have not carried your burden to demonstrate that your activities are exclusively in furtherance of exempt purposes.

You also failed to provide details and documentation regarding the transfer of property to you that demonstrates the transaction did not lead to inurement to your trustees. Your apartment building was donated by an LLC controlled by your founders who are also your trustees. The apartment building has a liability attached to it. You are unlike the organization in Situation 1 of Rev. Rul. 76-441. Your board is composed of the former owners of the apartment building. In that respect, you are similar to the organization in Situation 2 of Rev. Rul. 76-441. However, it is unclear whether the transfer of assets and liabilities was similar to that of Situation 2 since you declined to provide a qualified appraisal or other documentation on the property so we could determine if the assets transferred were greater than the liabilities. You only provided a statement indicating the value of the building and the outstanding loan amount. Charitable organizations cannot be operated to benefit insiders such as officers or directors. Per Section 1.501(c)(3)-1(c)(2) of the Regulations, 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. Like the organizations in Salvation Navy v. Commissioner and Founding Church of Scientology v. United States, you did not provide information to prove that you were not organized to serve the private interests of your founders who are also your trustees.

Section 1.501(c)(3)-1(d)(1)(ii) of the Income Tax Regulations provides that an organization is not organized or operated exclusively for one or more exempt purposes under Code section 501(c)(3) unless it serves a public rather 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. By not providing documentation about the transfer of the apartment building, you did not establish that you are not operated for the benefit of your trustees.

Per Section 1.501(c)(3)-1(c)(1) of the Regulations, 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) of the Code. You stated that your Christmas activities include train rides, arts and crafts workshops, pony rides, and petting zoos. These activities are social and recreational in nature, not charitable or educational. Like in Better Business Bureau of Washington, D.C., Inc. v. United States, your Christmas activities do not fulfill an exempt purpose under section 501(c)(3) of the Code.

CONCLUSION


You do not meet the requirements under Section 501(c)(3) of the Code because you failed to establish your activities are exclusively charitable and that you do not operate for the private interest of your founders. Accordingly, you do not qualify for exemption as an organization described in Section 501(c)(3) of the Code.

* * *

Sincerely,

Director, Exempt Organizations

Enclosure:
Publication 892

Published May 15, 2015

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