DATELINE: December 23, 2008, Chicago
On September 16, 2008, the IRS threw down the gauntlet when it released Determination Letter 200851031, which was made available to the public last Friday. The revocation of exempt status contains two helpful lessons for exempt organizations. But of far greater importance, the ruling looks...
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to relative expenditures on grants in assessing whether the organization continues to qualify for Section 501(c)(3) status. By taking that direction, the IRS is headed down a dangerous road that should make tax practitioners and the exempt organizations community very nervous.
The organization originally provided vocational skill development and training services. It then transferred its job training contracts and related assets to another nonprofit that provided job training services. It then devoted its remaining assets to a new activity, grantmaking.
What is disturbing about the ruling is the fact that the IRS decided to revoke the organization’s exempt status because the organization's administrative expenses were too high relative to its grants. In the year before revocation, the organization made grants equal to just 26% of its total expenditures. Forty-four (44%) of the organization’s assets were paid to the organization’s executive director as salary and the remaining 30% were devoted to general overhead. During a four-year lookback period, only 13% of expenditures were devoted to grants, with the remainder devoted to compensation and overhead.
We acknowledge that those numbers are superficially troubling, but depending on the facts, one might be able to argue that the organization was in the start-up phase of its new activity. Moreover, as we have pointed out before, we don’t believe in absolutes when it comes to numbers. Suppose this organization was looking for a cancer researcher to fund. Now suppose after careful research, it funded one researcher who had been turned down by everyone else. Finally, suppose this researcher used the organization’s grant money to find a cure for all cancer. Admittedly a bit fanciful, but the hypothetical points out why there should not be absolute percentages of acceptable overhead and compensation.
The ruling does not state whether the compensation and overhead expenses were legitimate, well-intended, or effective. All we are told is that the percentage devoted to these expenses was too high. The more pertinent question is whether the expenditures resulted in effective grantmaking, but the IRS isn’t authorized to ask those questions, nor is it in a position to make that judgment. That points out the fundamental flaw with PLR 200851031: The ruling reflects a view that inputs are highly correlated with outcomes. That isn’t necessarily so. We can envision one grantmaker incurring far more in overhead than another one. That means the first grant maker has less money for actual grants, but it is possible that the first grantmaker’s grantees will put the grants to much better use than the second grantmaker’s grantees. The IRS is falling into the same trap as those who believe $500,000 in compensation to the executive director is automatically a problem. In the ruling, the IRS fails to articulate whether the compensation and overhead expenses were reasonable ones.
This ruling should make all tax-exempt organizations very nervous. Would the organization have retained its Section 501(c)(3) status had it expended 42.45676678% of its money on grants, or is 56.4568124064% the breakpoint between tax-exempt and taxable status?
We suspect that there were sufficient facts to warrant revocation, but the better approach would have been to use the tools aimed at excessive compensation and inurement. The IRS first should have invoked the intermediate sanctions. Then it should have relied on recently finalized Regulation Section 1.501(c)(3)-1(f)(2)(ii) to characterize the level of excess benefit as sufficient private inurement to warrant revocation. That regulation provides:
(ii) Determination of whether revocation of tax-exempt status is appropriate when section 4958 excise taxes also apply.
In determining whether to continue to recognize the tax-exempt status of an applicable tax-exempt organization (as defined in section 4958(e) and § 53.4958-2) described in section 501(c)(3) that engages in one or more excess benefit transactions (as defined in section 4958(c) and § 53.4958-4) that violate the prohibition on inurement under section 501(c)(3), the Commissioner will consider all relevant facts and circumstances, including, but not limited to, the following -- (A) The size and scope of the organization's regular and ongoing activities that further exempt purposes before and after the excess benefit transaction or transactions occurred; (B) The size and scope of the excess benefit transaction or transactions (collectively, if more than one) in relation to the size and scope of the organization's regular and ongoing activities that further exempt purposes;
(C) Whether the organization has been involved in multiple excess benefit transactions with one or more persons;
(D) Whether the organization has implemented safeguards that are reasonably calculated to prevent excess benefit transactions; and (E) Whether the excess benefit transaction has been corrected (within the meaning of section 4958(f)(6) and § 53.4958-7), or the organization has made good faith efforts to seek correction from the disqualified person(s) who benefited from the excess benefit transaction.
If the IRS could not make the case that a portion of the salary and overhead constituted excess benefit, then that suggests that the expenses were reasonable and related to the grantmaking activity. When there is a clear regulatory solution, the IRS should use it rather than relying on an unprincipled analysis. Moreover, by failing to invoke the intermediate sanctions, it would appear that the insiders were able to keep the excess benefits the IRS believes they received. Had the IRS used the prescribed remedy, it could have captured the excess benefits and returned them to the charitable sector.
The ruling holds the following noteworthy lessons:
Form 990—Answer All Questions Completely. According to the IRS, the organization failed to answer Question 79 on its Form 990 correctly. That question asks whether the organization engaged in a liquidation, dissolution, termination, or substantial contraction during the year. The organization also apparently did not indicate that it engaged in new activity that hadn’t previously been reported to the IRS, as required by Question 76. The IRS noted that both of those questions required detailed explanations and descriptions of the changes. Although the failure to answer these questions may not have been decisive to the IRS’s revocation, it appears to have been a consideration.
Form 990-Repeat Information When Asked for the Same Information. As part of the Form 990 filing, the organization did include a reworded statement of its exempt purpose which made reference to the new grantmaking activity. This statement apparently was not made in response to Question 76. The IRS seemed unwilling to treat the disclosure as being responsive to Question 76. As 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.
The ruling had one other notable aspect. The IRS orignally granted Section 501(c)(3) status despite the fact that the organizational documents provided that the organization could engage in any lawful act permitted under the state's nonprofit corporation act. That strikes us as too broad of a purposes clause because the clause permits the organization to engage in activities that go well beyond those that would be permissible under Section 501(c)(3). It is surprising to us that the IRS did not require the purposes clause to be modified as a condition to the original determination of Section 501(c)(3) status.
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