Contributions to quasi-governmental public-private partnerships.

AuthorKim, Alexis J.

If a taxpayer donates property to his or her local church, there is little doubt the donation is deductible and the church's income is exempt from tax. However, the IRS generally will not list a church as a qualified charity because a church is not required to file an application to be recognized as a tax-exempt organization. Similarly, a donation to a local municipality or county government is clearly deductible to the donor, and the government entity will not pay federal income tax even though the IRS does not include the entity in its exempt organization database. However, unlike a church, a government entity's income is not exempt from tax under Sec. 501(a). Instead, its taxation is governed by Sec. 115, which operates entirely differendy from Sec. 501(a). This distinction is important for many reasons, not the least of which is the effect it has on the donor of property to the entity.

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Now consider a taxpayer who wishes to donate property not to a government agency or entity but to a quasi-governmental organization set up under state or local law and intending to be governed by Sec. 115. Will the entity be a qualified charitable donee under Sec. 170? How can the donor get reassurance that the donation will be deductible? How can the entity be sure its income will be entirely free from income tax?

These questions can be answered by delving into one of the lesser-known sections of the Code, Sec. 115, which excludes from gross income any income derived from essential governmental functions and accruing to a state or political subdivision. This is a very short Code provision that taxpayers and practitioners often overlook. Treasury has not even issued regulations under Sec. 115. While it is clear that a state government, county, or municipality is presumed to derive all income from exercise of governmental powers and thus is immune from federal taxation, it is less than clear how semi-independent nonstock, not-for-profit corporations, created by the exercise of governmental power under state law, are treated.

A group of recently issued private letter rulings addresses the application of both Sec. 115 and Sec. 170 for county land bank organizations that were created under a special state statute to abate community deterioration in the wake of the 2008 economic recession and subsequent national foreclosure crisis. (1) These rulings provide a road map that other similar quasi-governmental organizations should follow if they would like to organize themselves as Sec. 115 government instrumentalities and wish to obtain a private letter ruling. These rulings also demonstrate the differences between being organized as a Sec. 501(c)(3) charity and a pure government instrumentality under Sec. 115. (2)

This article describes the requirements for an organization to meet Sec. 115(1), highlighting the differences from Sec. 501(a), provides an explanation of Sec. 115 and Sec. 170 for donors, and, finally, provides guidance and recommendations for structuring a quasi-governmental organization to meet Sec. 115(1), whether or not the entity seeks a private letter ruling. Through this article, donors will gain a better understanding of how a Sec. 115(1) organization can receive tax-deductible donations without having an IRS determination letter, and quasi-governmental agencies will secure a framework to use, in conjunction with tax counsel, during formation and ongoing operations, to comply with Secs. 115 and 170.

Comparing government instrumentalities and those applying for tax exemption under Sec. 501

The options available to a quasi-governmental entity to avoid tax are to (1) exclude all income under Sec. 115; (2) apply for tax-exempt status under Sec. 501(a); or (3) exclude some income under Sec. 115 and simultaneously apply for tax-exempt status under Sec. 501(a) as a hybrid organization. However, the IRS will not issue rulings on the Sec. 115 issue unless all of the entity's activities qualify as essential governmental functions. (3)

To receive a ruling that it is a government instrumentality under Sec. 115, (1) the entity must derive all its income from activities in furtherance of governmental purposes; (2) all the entity's income, if not used direcdy for those purposes, must accrue to another government instrumentality; and (3) any private benefit the entity provides must be no more than incidental to the public benefit it provides. (4) These requirements are somewhat in contrast to the more familiar requirements for a quasi-governmental entity to gain tax exemption via Sec. 501(a), usually as a Sec. 501(c)(3) charitable organization or possibly as a Sec. 501(c)(4) social welfare organization. The strongest commonality between the requirements under Sec. 115 and Sec. 501(a) is the private benefit prohibition. An organization exempt under Sec. 501(a), however, may engage in activities that are outside the scope of its charitable or other exempt purpose so long as these activities do not comprise a substantial part of the organization's activities or revenue, while a pure Sec. 115 entity may only engage in essential governmental functions.

To discourage exempt organizations from engaging in excessive nonexempt and commercial activities, Congress enacted Sec. 512, imposing a tax on unrelated business taxable income (UBTI) on most exempt organizations. Sec. 501(a) organizations must maintain detailed records of their activities and revenue sources and report them annually on a Form 990, Return of Organization Exempt From Income Tax. (5) If the organization engages in unrelated business activity that earns revenue, it will be subject to the unrelated business income tax (UBIT) and required to prepare and file a Form 990-T, Exempt Organization Business Income Tax Return, that separately tracks all UBTI. Exempt organizations are permitted to take various deductions against their UBTI; however, many organizations do pay UBIT annually. Engaging in excessive commercial activity can also risk organizations' exempt status under Sec. 501(a).

If an organization is a Sec. 115 government instrumentality with all of its income excludable under Sec. 115, it cannot engage in any activity beyond its governmental purposes and it is not subject to UBIT. The IRS thus has a vested interest in ensuring that an organization requesting a ruling on the status of its income as excludable under Sec. 115 is actually engaged solely in essential governmental functions; the IRS will not rule if there is even a small amount of income from activity other than essential governmental functions. (6) Once an organization receives the IRS ruling, it has no required annual federal tax filings such as the Form 990 or Form 990-T, and the IRS has no mechanism to monitor the ongoing activities of Sec. 115 entities. (7) It is in the best interest of a quasi-governmental entity to carefully implement a structure that complies with Sec. 115 so that it can avoid unnecessary returns or the imposition of tax through UBIT or as a fully taxable entity.

Given the option of relying on Sec. 115 or obtaining exempt status under Sec. 501(c)(3), it would, on its face, appear better to be a Sec. 115 organization. However, practical considerations might cause an entity to do otherwise. One benefit of being a Sec. 501(c)(3) exempt organization is that it will be automatically treated as an entity that can accept tax-deductible charitable contributions and included in IRS Publication 78, Cumulative List of Exempt Organizations, which is available on the IRS website and can be searched using the Select Check tool. (8) Inclusion on this list gives donors comfort that donations will be tax-deductible under Sec. 170. Although churches and political subdivisions are not listed and do not ordinarily apply for tax exemption, it is not a foregone conclusion that a quasi-governmental agency would qualify under Sec. 115 and Sec. 170. A government instrumentality under Sec. 115 must also meet a political subdivision test under Sec. 170 if it wishes to accept tax-deductible contributions. The political subdivision test under Sec. 170 is similar to the analysis under Sec. 115, with some additional factors given weight.

Government instrumentality status under Sec. 115 is highly preferable to being a Sec. 501(c)(3) exempt organization in many ways. An organization may operate as a Sec. 115 entity without obtaining a private letter ruling; however, many organizations wish to have confirmation from the IRS. This can be a particular concern if the organization wishes to accept donations from donors who want to take a tax deduction for the donation. When a potential donor approaches an organization, if he or she cannot find the organization listed on IRS Select Check, he or she will often request a copy of the determination letter or other documentation that the donation will be tax-deductible. Some quasi-governmental entities may opt to apply for exempt status under Sec. 501(a), but this adds the annual administrative burdens described above. If an organization that engages solely in governmental activities has any doubt as to whether it meets the definition under Sec. 115, it should request a private letter ruling rather than applying to be exempt under Sec. 501(c)(3) or (4). A disadvantage of requesting a private letter ruling is the large user fee, currently $28,300. (9) Arguably, the entity may recoup the high upfront cost of obtaining a ruling within the first few years by saving on fees and administrative expenses for Sec. 501(c) application and compliance. If, however, the organization has any income streams from or engages in any activities that may not be essential governmental functions, it would be better to apply for exemption as a Sec. 501(c)(3) or (4) organization and obtain a tax opinion from tax counsel with expertise in this area over which portion of income is excludable under Sec. 115. These two provisions are not mutually exclusive.

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