Private Letter Rulings - Charity Operating Candy Shop Loses Exempt Status
GiftLaw Note:
Org was granted tax-exempt status and had only one individual in charge. An IRS agent (Agent) was tasked with examining the tax-exempt operation of Org. Agent requested copies of Org’s Articles of Incorporation, Bylaws, IRS Determination Letter and Application for exempt status. Org could not provide any of these documents. In fact, most records of Org had been lost, stolen or destroyed in a water leak. When asked what its exempt purpose was, Org stated that its purpose was to help poor people via cash stipends. Org could not provide any records substantiating this claim. Agent discovered a news article that revealed Org’s address was actually that of an ice cream and candy shop and that this was Org’s only activity. The issue under consideration was whether Org’s exempt status should be revoked.
Under Sec. 501(c)(3), exempt organizations must be organized and operated exclusively for exempt purposes with no part of their earnings benefitting private interests. In addition, under Sec. 1.6001-1(a) and (c), exempt organizations are required to keep permanent records of their activities. Here, the Service determined that Org was not organized or operated exclusively for an exempt purpose. The sole activity of Org was the operation of an ice cream and candy shop. Such activities constitute an unrelated trade or business. In addition, Org could not provide any documentation or records to substantiate its exempt activities or the losses of its records. The Service also expressed great concern that Org had one sole officer in charge, which created a potential for abuse. Therefore, the Service revoked Org’s exempt status.
Under Sec. 501(c)(3), exempt organizations must be organized and operated exclusively for exempt purposes with no part of their earnings benefitting private interests. In addition, under Sec. 1.6001-1(a) and (c), exempt organizations are required to keep permanent records of their activities. Here, the Service determined that Org was not organized or operated exclusively for an exempt purpose. The sole activity of Org was the operation of an ice cream and candy shop. Such activities constitute an unrelated trade or business. In addition, Org could not provide any documentation or records to substantiate its exempt activities or the losses of its records. The Service also expressed great concern that Org had one sole officer in charge, which created a potential for abuse. Therefore, the Service revoked Org’s exempt status.
1/9/2015 (9/15/2014)
Dear * * *:
This is a final adverse determination regarding your exempt status under section 501(c)(3) of the Internal Revenue Code (the Code). Our favorable determination letter to you dated January 2001 is hereby revoked and you are no longer exempt under section 501(a) of the Code effective January 1, 20XX.
You have failed to establish that you are operated exclusively for exempt purposes within the meaning of Internal Revenue Code section 501(c)(3), and that no part of your net earnings inure to the benefit of private shareholders or individuals. You failed to respond to repeated reasonable requests to allow the Internal Revenue Service to examine your records regarding your receipts, expenditures, or activities as required by I.R.C. sections 6001, 6033(a)(1) and Rev. Rul. 59-95, 1959-1 C.B. 627.
Contributions to your organization are no longer deductible under IRC § 170.
* * *
ISSUE
Whether or not the * * *, qualifies for exemption under Section 501(c)(3) of the Internal Revenue Code?
FACTS
The organization was granted exemption in January 20XX. The original name of the organization which was granted exemption was * * *. The organization was granted exemption under 170(b)(1)(A)(vi) foundation status. An organization described in Internal Revenue Code 170(b)(1)(A)(vi) is one that normally receives a substantial part of its support from government units, direct or indirect contributions from the general public, or a combination of these sources.
The Agent requested that the organization provide copies of its Articles of Incorporation, Bylaws, IRS Determination Letter, and Application for exempt status. The organization was unable to provide any such documents.
During the interview the Agent asked questions regarding the organization purpose and according to the organizations President * * * the organization purpose is to help poor people. When asked how the organization completes its purpose, * * * replied that the organization gives poor people cash stipends. There was no other form of assistants to the poor. There were also no records to prove that the funds were actually distributed to poor people.
As part of the internal controls examination the Agent was able to determine that the organization had only one individual in charge. A review of the 20XX/12 Form 990-EZ (Part IV -- List of Directors) the organization list * * * as the President, Treasurer, Clerk, and Director of the organization. During the interview with the Agent was able to confirm that in fact * * * was the sole officer in charge.
* * * has not filed any Forms 990-T, to report any unrelated business income. It was also noted the organization never filed Form 940, 941, 1099, and W-2's.
During the examination of the organization, the Agent was able to identify the following issues:
ISSUE 1
During the examination of tax year 20XX, the Agent sent several Information Document Requests (IDR's). The IDR's were issued with specific requests about the organization and its operations. A total of six IDR's were sent certified mail and were received by the Organization. Contact with the Organization's current President * * * was established and a field examination date of December 12, 20XX was agreed upon.
During the initial meeting, * * * was unable to provide any documentation that had been requested with the initial contact letter. In the initial IDR the Agent requested information that would help verify the amounts listed on the organizations Form 990-EZ for calendar year 20XX. When the Agent asked * * * about the Organizations financial records, * * * stated that all of the financial records from 20XX - 20XX were destroyed by water and were discarded. When the Agent asked * * * about the current year (20XX) records, * * * stated that the current year records were stolen out of a vehicle. Prior to the examination date did * * * not mention to the Agent, that there was going to be issues gathering the financial records.
After the initial meeting the Agent prepared and certified mailed IDR #4 dated December 17, 20XX requesting the following: * * *;
1) A written statement, signed under penalties of perjury, regarding the water damage events leading to the loss of their 20XX-20XX books and records
2) Provide a written statement from the landlord of confirming the water damage event.
3) Provide a police report confirming the loss of their 20XX records from the car break in.
The IDR had a response due date of January 23, 20XX and a response has not been received to date.
A second request for a response to IDR#4 was sent certified mail on January 24, 20XX to the Organization with a revised response due date of February 7, 20XX. The certified letter was signed for and received. To date, the Agent has not received any of the information requested above.
ISSUE 2
During the initial interview * * * revealed to the Agent that the organization did not have its own bank account. * * * stated that she used her personal bank account for the Organization's financial transactions.
The agent prepared and mailed certified mail IDR#5 requesting the following information:
1. Provide the Organization's bank statements and/or the name of the bank where the financial dealings of the Organization were handled.
The IDR had a response due date of January 23, 20XX and a response has not been received to date.
A second request for a response to IDR#5 was sent certified mail to the Organization on January 24, 20XX with a revised response due date of February 7, 20XX. The certified letter was signed for and received. To date, the Agent has not received any of the information requested above.
ISSUE 3
The Organization * * * appears to have other activities that are not consistent with its exempt purpose and for which the organization was granted exemption.
During the year under examination * * * the Program rented and operated out of a store front on * * *. According to the * * * news article dated September 5, 20XX that address is the location for an ice cream and candy shop, called * * *.
According to * * * the only activity the organization was involved in was the operation of the candy shop. It was also noted that all of the revenue generated was from the sale candy and other related items. The operation of a candy shop is not consistent with its exempt purposes. The Organization has not provided any information to support its exempt purpose or its activities.
ISSUE 4
* * * states she performed an intake interview for those individuals looking for help and that all payments made to these individuals were in the form of cash stipends. It is also noted that * * * is the only one who decides who gets these cash stipends and there is no independent board to review these payments.
When the Agent requested the above intake interview sheets, * * * stated all of the organizations records were destroyed from a large water leak that happened in January 20XX and all past records were thrown out.
According to the * * * news article dated September 5, 20XX, * * * is quoted as saying (see attached article): "* * *"
This statement and the lack of intake interview sheets leads the Agent to believe that there were no such intake interviews being conducted as indicated by * * * during the interview on December 12, 20XX..
LAW
Internal Revenue Code Section 501(c)(3) exempts Federal income taxes from organizations that are organized and operated exclusively for religious, charitable, etc. purposes where no part of its net earnings inure to the benefit of any private shareholder or individual and no substantial part of its activities involve the carrying on of propaganda or otherwise attempting to influence legislation.
Section 1.501(c)(3)-1(a) of the Income Tax Regulations provides that "in order to be exempt as an organization described in Section 501(c)(3) of the Code an organization must be both organized and operated exclusively for one of more purposes specified in such section. If any organization fails to meet either the organizational or operational test it is not exempt."
Treas. Reg. § 1.501(c)(3)-1(c)(1). It provides that an organization will be regarded as operated exclusively only if it engages "primarily" in activities that accomplish one or more exempt purposes such as those specified in IRC § 501(c)(3) and that it will not be so regarded if more than an "insubstantial" part of its activities does not further an exempt purpose.
Under Federal Tax Regulation, § 1.6001-1(a) & (c)
Returns and Records: a) In general, Except as provided in paragraph (b) of this section, any person subject to tax under subtitle A of the Code (including a qualified State individual income tax which is treated pursuant to section 6361(a) as if it were imposed by chapter 1 of subtitle A), or any person required to file a return of information with respect to income, shall keep such permanent books of account or records, including inventories, as are sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by such person in any return of such tax or information.
c) Exempt organizations. In addition to such permanent books and records as are required by paragraph (a) of this section with respect to the tax imposed by section 511 on unrelated business income of certain exempt organizations, every organization exempt from tax under section 501(a) shall keep such permanent books of account or records, including inventories, as are sufficient to show specifically the items of gross income, receipts and disbursements. Such organizations shall also keep such books and records as are required to substantiate the information required by section 6033.
Treas. Reg. § 1.6033-2(1)(2) provides, in part, ". . . that every organization which is exempt from tax, whether or not it is required to file an annual information return, shall submit such additional information as may be required by the Internal Revenue Service for the purpose of inquiring into its exempt status and administering the provisions of subchapter F, chapter 1 of subtitle A of the Code, IRC § 6033, and chapter 42 of subtitle D of the Code . . ."
IRC § 6033, Treas. Reg. § 1.6001-1(c) and Treas. Reg. § 1.6033-2(a)(1) and (i)(2) require any organization exempt from tax under § 501(a), to supply the Service with such information as is required by the revenue procedures and the instructions for Form 990, Return of Organization Exempt From Income Tax, and Schedules thereto, and to keep such books and records as are necessary to substantiate such information.
Rev. Rul. 59-95 states failure or inability to file the required information return or otherwise to comply with the provision of section 6033 of the Code and the regulations which implement it, may result in the termination of the exempt status of an organization previously held exempt, on the grounds that the organization has not established that it is observing the conditions required for the continuation of an exempt status.
Rev. Rul. 90-27 provides procedures with regard to applications for recognition of exemption from Federal income tax under Sections 501 and 521 with respect to revocation or modification of exemption rulings and determinations letters.
Church of Scientology of California v. C.I.R., 823 F.2d 1310, 92 A.L.R. Fed. 231 (9th Cir. 1987). (3) Payment of excessive salaries will result in finding of inurement as will distributions or unaccounted for diversions by one who has complete and unfettered control over organization's resources.
United Hospital Services, Inc. v. U.S., 384 F. Supp. 776 (S.D. Ind. 1974). An organization must exclusively perform essential public services in order to qualify as a charitable organization and to be exempt from federal income taxation.
The term 'unrelated trade or business' is defined in section 513 of the Code as any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its exempt functions.
Section 513(c) of the Code and section 1.513-(b) of the regulations provide that trade or business includes any activity which is carried on for the production of income from the sale of goods. An activity does not lose its identity as trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may not be related to the exempt purposes of the organization.
Rev. Rul. 79-360 describes the operation of health club facilities in a commercial manner by an organization exempt from tax under section 501(c)(3) of the Code, whose purpose is to provide for the welfare of young people, constitutes unrelated trade or business under section 513.
Rev. Rul. 79-361 describes the operation of a miniature golf course in a commercial manner by an organization exempt from tax under section 501(c)(3) of the Code, whose purpose is to provide for the welfare of young people, constitutes unrelated trade or business under section 513.
TAXPAYERS POSITION
GOVERNMENT'S POSITION
It is the government's position that * * * has failed the Operation test. As consistent with Section 1.501(c)(3)-1(a) of the Income Tax Regulations an organization is not exempt if it fails either the organizational or the operational test. The sole activity of the organization was the operation of a candy and ice cream shop. These activities represent carrying on a unrelated trade or business.
The Agent believes that the * * * Program is not operating for an exempt purpose for the following reasons.
1. Documentation to support the information reported on F990-EZ has not been provided.
2. Documentation to support the water damage and car thief that lead to loss of their books and records has not been provided.
3. Documentation regarding their purposes and operations has not been provided.
4. The substantial part of the organization revenue is from an unrelated business.
5. The organization 'fails' the public support test.
Taxpayer has burden to establish that it is entitled to tax exempt status; this is particularly true in this situations where there is great potential for abuse created by one individual's control. The lack of good internal controls may indicate the potential for diverted receipts, diverted assets, or other significant problems. To date, the Agent has not received any of the requested information, which would help determine if the above issues exist.
The Agent also sent out a letter detailing the interview responses from * * *, regarding the organization. In this letter the Agent requested that the statements, * * * made be reviewed for accuracy and requested that * * * respond to any conflicting statements. To this date * * * has not responded to this interview response letter and it is the view of the Internal Revenue Service that the statements in the letter are accurate without conflict.
Based on the above facts and law, it is the IRS's position that the organization has failed to meet the operational test required under Section 501(c)(3) of the Code and applicable regulations.
CONCLUSION
The Service has determined that the * * * is not operated exclusively for Section 501(c)(3) purposes for all years beginning on or after January 1, 20XX. Accordingly, the organization does not continue to qualify for exemption under Section 501(a) of the Internal Revenue Code for all years beginning on or after January 1, 20XX., 20XX.