Contract with related for-profit entity disqualifies exemption.

• Author: Vuillemot, Robert

In Letter Ruling 201235021, the IRS ruled that an organization founded to facilitate charitable donations through a website and mobile phone application failed to establish that it operated exclusively for exempt purposes because a portion of the donations that it received were paid to a related for-profit entity that designed and. operated the organization's technology.

Facts

The organization was a state nonprofit corporation established to facilitate donations to existing charities. The organization intended to do so through a giving system on its website and a mobile phone application. The website and mobile application contained information on various charities and allowed users to make donations. The organization originally had three directors: B, its chairman, and C and D.

The organization entered into a contract with LLC, a for-profit entity owned by B, C, and D, to provide hardware, software, and administrative services for operating the organization's online giving system and mobile phone application. In return, LLC was originally entitled to receive 20% of the donations, reduced when donations reached certain levels. The remaining amount (at least 80%) of donations would go to the designated charitable organizations. The organization stated that the 20% fee reflected a below-market rate, but it presented no evidence to support this assertion.

Following its original exemption application, the organization submitted additional information indicating that C and D were no longer on its board and that B was no longer on the LLC board (although B remained an owner of LLC). The organization also amended its contract with LLC, replacing the tiered fee structure with a flat 8% rate (with 5% going to LLC and the remaining 3% to be used by the organization for administration and marketing).

Ruling and Analysis

The IRS ruled that the organization had failed to establish that it operated exclusively for exempt rather than private purposes, and, accordingly, it failed to qualify for tax exemption under Sec. 501(c)(3). To qualify for exemption, the IRS explained, organizations must ensure that none of their earnings inure in whole or in part to the benefit of any private persons. The IRS concluded the organization operated to benefit LLC and its shareholders, B, C, and D.

The IRS also found that neither the original nor the amended contract was negotiated at arm's length. At the time of the original contract, B, C, and D were on the boards of...