IRS Creeping Back With Erroneous Ruling About Governance

• Published date: 01 March 2018
• DOI: http://doi.org/10.1002/npc.30439
• Date: 01 March 2018

Bruce R. Hopkins’ NONPROFIT COUNSEL

5

March 2018

THE LAW OF TAX-EXEMPT ORGANIZATIONS MONTHLY

Bruce R. Hopkins’ Nonprofit Counsel DOI:10.1002/npc

media professional that its directors have met through

years of networking.

The organization is governed by three directors,

including X and Y; all are involved in the “performance

promotion” business. X and Y own and operate several

performance media for-profit companies. One of these

companies is W, which markets this organization’s activi-

ties. In order for persons to make submissions for the con-

tests, they must use the online resources of W. W earns

commissions in connection with these transactions. W’s

staff screens applicants to identify finalists, whose entries

will then be screened at live events by judges represent-

ing media and broadcast companies, selecting a winner.

The organization advised the IRS that the sharing of W’s

portal is “for efficiency and to save resources.”

Analysis

The IRS, conceding that this organization’s contests

“bring attention to artistic works,” ruled that the tax

exemption it sought is defeated by the private benefit

doctrine. Private benefit was seen flowing to W, the

contest participants, and X and Y as owners of W. The

organization was said to structure its contests to benefit

X and Y.

The IRS focused on the fact that participants in

the contests must enroll through W’s portal and then

become subject to W’s terms of service and fees. The IRS

observed that this organization’s activities “will enable W

to increase users on its portal, have intellectual property

loaded and controlled through its portal and expose

contest participants to distributors that will generate

commissions for W.” [20.12]

Commentary: The IRS went far beyond the bounds of

common sense and the law in this case. Sure, the con-

test participants are privately benefited, but that is the

context of the way the exempt function program works.

This type of unavoidable private benefit is no different

than a student gaining an education from an exempt

school or an individual regaining health because of the

interventions of an exempt hospital. The Tax Court held

(in the American Campaign Academy case, not cited in

this ruling but summarized in the July 1989 issue) that

this is the type of primary private benefit that is not pre-

cluded by the private benefit doctrine. ◆

As far as any unwarranted private benefit to X and Y

is concerned, the analysis should have been undertaken

pursuant to the private inurement doctrine. There, the

test is whether the economic benefit to them was rea-

sonable. The ruling is silent on that point. A tax-exempt

organization that purchases services from a company

controlled by insiders is not engaging in private inure-

ment if the compensation involved is reasonable. Thus,

this ruling as to private benefit is erroneous.

The benefit to W, however, is unwarranted private

benefit, under the est case (not cited either but sum-

marized in the June 2006 issue) because the contest

participants are locked in to use of W’s portal, resulting

in the flow of commissions to that company. ◆

IRS CREEPING BACK WITH

ERRONEOUS RULING ABOUT

GOVERNANCE

In the foregoing ruling, the nonprofit organization

involved has a governing board of three individuals, two

of whom are married—gasp!—to each other. This board

structure has appeared in recent rulings, with the IRS

mercifully not bringing up the matter of governance.

That practice has stopped with this ruling.

The IRS first ruled, without any stated factual support

for the conclusion, that X and Y are “indistinguishable”

from W. Then, the IRS ruled that X and Y have not

established that the nonprofit organization will not be

operated for the benefit of X and Y through W. If the

IRS had applied the correct body of law (see above), that

issue would have been resolved.

Then, the IRS reverted to its mantra on governance,

writing that “operating under the control of one person

or a small, related group suggests [note that word] that

an organization operates primarily for non-exempt pur-

poses.” That is not the law, no matter how many times

the IRS proffers the statement.

Usually, in support of its misstatement of the law,

the IRS cites the Bubbling Well Church case (summarized

in the June 2014 issue). Not so in this ruling. Instead,

for this proposition, the IRS relied on Rev. Rul. 61-170.

This revenue ruling, however, does not support the IRS’s

“suggestion.”

The revenue ruling concerned the issue as to whether

an association composed of professional private-duty

nurses and practical nurses, where the organization’s pri-

mary activity was operation of a nurses’ registry to afford

greater employment opportunities for its members, was

eligible for tax-exempt status as a charitable entity. The IRS

ruled that the organization was precluded from exemp-

tion by reason of the private benefit doctrine, in that it

was providing personal employment services principally

for the benefit of its members. The IRS stated: “Public

participation in the management and support of [this]

organization is negligible. This is shown by the fact that

it draws its support primarily from members and is con-

trolled by a board of trustees composed of professional

nurses, without public participation of any kind.” Note

that the foregoing statement is merely one of fact about

this particular organization. Yet the IRS makes it appear

that this element of “public participation” is a general

prerequisite for tax exemption (which is not the law).

The IRS contrasted this “professional society” with

a “community nursing bureau,” which maintained a

register of qualified nursing personnel for the benefit of