DATELINE June 24, 2008, Chicago
The IRS is up to its new tricks again. In Determination Letter 200825046 (Release Date July 20, 2008), the IRS revoked the exemption of a charity that had received Section 501(c)(3) status as an arts organization that sponsors ballet performances. Apparently, the performances were funded with the proceeds from bingo games. This determination letter is not all that interesting until the phrase "commensurate in scope" appears. With TE/GE Commissioner Steve Miller recently referring in public comments to the commensurate-in-scope test, every tax professional who works in the exempt organizations arena is now...
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tasked with developing an understanding of what is at best an ethereal test.
Here are the basic facts: The charity entered into a contract with a company that operates bingo games. The promoter had virtually complete control over the bingo operation. Under the terms of an amended contract, the promoter was to receive a percentage of the gross revenue prior to player payouts. All expenses were then charged against the bingo account, with the charity receiving any surplus. The charity was guaranteed a minimum fee each month.
The relevant metrics for the two years in question are as follows:
Year |
Exempt Function Hours |
Bingo Hours |
Total Hours |
Exempt Function Percentage Hours |
Bingo Percentage Hours |
P |
12,545 |
3,320 |
15,865 |
79.1% |
20.9% |
Q |
12,431 |
15,033 |
27,464 |
45.3% |
54.7% |
Year |
Exempt Function Income |
Bingo Gross Income |
Total Income |
Exempt Function Percentage Income |
Bingo Percentage Income |
P |
$87,729 |
$242,047 |
$329,775 |
27% |
73% |
Q |
$97,815 |
$1,090,048 |
$1,187,863 |
8% |
92% |
At this point, we found ourselves terribly confused by the reference to "bingo gross income." Did this mean the gross income received before any expenses, including the promoter fee, or did this mean the charity's gross take? After reading that in Year Q, the charity only received .34% of the gross bingo income, we realized that "gross bingo income" meant before any expenses, including the promoter's fees. That means that in Year Q, the charity only received $3,725 from the bingo operation.
Superficially, the IRS has a legitimate point: The charity isn't getting a whole lot of income from the bingo operation. But we don't think it necessarily follows that the promoter is receiving too much in the way of fees from the bingo operation. After all, the promoter is responsible for the operation. The charity has no involvement other than lending its name. Moreover, we don't know what the payouts to players are. Nor do we know the fees received by the promoter. In short, the IRS simply doesn't provide sufficient numbers or relative relationships to permit us to conclude that the promoter is "wagging" the charitable "dog." We also would like to know the value of the volunteer hours, which GAAP would likely treat as income to the charity. We suspect that the IRS's income numbers don't include the value of those services. We wonder whether the IRS would reach the same conclusion if the volunteer hours represented the work of dancers who were performing for the company.
Now we don't mean to suggest that the IRS doesn't have a case for revoking the organization's tax-exempt status. We suspect, given some of the facts, that the IRS should have revoked exempt status. Forms 990 were not filed when they should have been. W-2s and W-3s apparently weren't filed. Although the charity was supposed to receive a portion of the bingo proceeds, the IRS examination:
revealed that the bingo promoter failed to distribute the required minimum of $ K per month. Under the terms of the contract, you should have received at least $ BB from the bingo operation for the year ended P, and you should have received at least $ CC from the bingo operation for the year ended Q. No records were provided to show that any bingo proceeds were deposited into the charity's bank account for the year ended P, and only $ DD was deposited in the year ended Q.
The IRS also has some favorable case law on its side. For example, it cites In Help the Children, 28 TC 1128 (1957), where the charity operated bingo games, but only contributed insubstantial portions of the gross bingo revenue to other charities. The organization raised $313,802.20 for 1953 and $306,309.85 for 1954 in gross bingo revenue. It only contributed $2,880 in 1953 and $3,873.20 in 1954 to charities. That certainly raises questions. It also cites P.L.L. Scholarship Fund, 82 TC 196 (1984), in which funds raised through bingo games were to be used for scholarships, but the court found private inurement.
We also understand the IRS's concern with the absence of a cap on the promoter's compensation, particularly when the compensation is based on gross rather than net numbers. The IRS cited Revenue Ruling 69-383, 1969-CB 113; Lorain Avenue Clinic v. Commissioner, 31 T.C. 141 (1958); and Birmingham Business College v. Commissioner, 276 F. 2d 476 (1960).
In short, we suspect if we knew all the facts, we would be inclined to agree with a determination that there was private benefit, private inurement, or a substantial nonexempt purpose and activity. The presence of any of these would have been more than sufficient to result in revocation of exempt status.
Unfortunately, the determination letter didn't stop there. It continued on, stating:
Based on the amount of gross bingo income that was distributed for charitable purposes, we have concluded that the amount of the proceeds received from your bingo activities to conduct charitable and educational programs is not "commensurate in scope" with the financial resources of your bingo operation. (See Revenue Ruling 64182, 19641 (Part 1) C.B. 186)
The reference to Revenue Ruling 64-182 is pointless. It does not define the commensurate-in-scope test. Even more troubling, the determination letter provides no further explanation as to why or how the commensurate-in-scope test applies in this situation. If the fees paid to the bingo promoter were reasonable, then they should not count as assets of the charity. To illustrate the potential problem, suppose a charity ran a grocery store in a low-income neighborhood and provided the food on a subsidized basis. Despite the subsidy, grocery stores have notoriously low margins, or high costs of goods sold. Is the IRS suggesting that the determination of whether the charity is using a sufficient portion of its revenue for charitable purposes should be based on gross receipts rather than gross income, which is traditionally calculated after reduction for cost of goods sold.
The EO division of the IRS might want to take a look at Treasury Regulation 1.61-3, which defines gross income as total sales, less cost of goods sold. Admittedly, that regulation is limited to manufacturing, merchandising, and mining businesses, but the principle reflected in by the definition is equally applicable here. In short, expenses may be too high—resulting in private benefit or inurement—but treating gross revenue before expenses as charitable assets for purposes of applying the commensurate-in-scope test is simply putting both hands on the scale.
In our view, the IRS is making a serious mistake by increasingly dragging out an undefined legal doctrine just to be able to say it is using it. At the end of the day, effective tax administration is a partnership between the IRS and tax practitioners. If the IRS believes that the commensurate-in-scope test has a legitimate role to play, it should first define the test. That way practitioners can begin to counsel clients by taking into account what the test requires. As currently used, the test is a nothing more than a talisman that is being tossed about as if there is a directive from the top to refer to it in every third determination letter. That accomplishes nothing.
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