The Tax Court recently upheld the IRS’ revocation of exempt status of a 501(c)(3) organization formed for the purpose of fostering national and international sports competition, because of private inurement and private benefit issues with the fundraising structure. It is likely that many organizations apply a similar structure—which allowed members to fundraise in order to offset their cost assessment—and should take time to examine whether they may need to modify their practices.
Private Inurement and Private Benefit
As background, 501(c)(3) organizations are exempt from federal income taxation, and are eligible to collect tax-deductible contributions. However, these benefits do come with some restrictions, one of which is the prohibition on private inurement. A 501(c)(3)’s income and assets cannot be distributed to (or used for the benefit of) an “insider,” which includes founders, directors, officers, members, key employees, family members of any of the previous individuals, and certain related organizations. While there are certain exceptions, such as for reasonable compensation, this is an issue that always requires careful attention.
In addition, a 501(c)(3) organization is subject to a similar but separate prohibition against private benefit of individuals apart from insiders—the organization must operate for public, rather than private purposes, and cannot benefit private parties more than incidentally. When looking at this issue, the IRS generally considers both the amount of private benefit, and whether it is a necessary result of the activity that benefits the public. The classic examples are the organization that cleans up a public lake; while this benefits nearby landowners to a degree, this benefit is permissible because it is minor in comparison to the overall public benefit and is a necessary result of the activity that benefits the public. However, in contrast, an organization that maintains a park usable only by homeowners of a certain neighborhood would be impermissibly benefiting those private owners and wouldn’t qualify for 501(c)(3) status.
In Capital Gymnastics Booster Club, Inc. v. Commissioner, T.C. Memo 2013-193 (Aug. 26, 2013), the 501(c)(3) involved had about 240 member families. Parents were responsible for paying directly to Capital Gymnastics an annual dues payment of $40 to offset Capital Gymnastics’ nominal operating expenses such as annual corporate fees, insurance premiums, and production costs for the organization’s annual handbook, and an assessment of $600 to $1,400 per year per child to pay each athlete’s competition costs. This assessment covered the athlete’s estimated meet entry fees and the coaches’ travel costs (including transportation, lodging, and meals). Capital Gymnastics did not allow athletes to compete unless their assessment was paid in full, including any late fees. The record shows no conferring of “scholarships” nor any other relaxation of this requirement.
Parents could pay the assessments in cash, but the organization also had an arrangement where parents could fundraise and receive “points” that would reduce the amount they had to pay out of pocket. The points were awarded in proportion to the fundraising profit generated by the family. The organization was clear about not allocating any raised money to families who did not themselves fundraise. The IRS did not contest that the organization’s mission of fostering amateur sports competition is a qualifying purpose within the meaning of Section 501(c)(3), nor that fundraising generally is a permissible activity under for 501(c)(3) organizations. However, the IRS did object to the fact that almost all of the organization’s fundraising proceeds were earmarked to benefit those individuals who raised the funds. The IRS contended that this dollar-for-dollar arrangement constitutes inurement and private benefit in violation of Section 501(c)(3) because the methodology furthers private interests rather than the team or the organization as a whole
The Tax Court distinguished the circumstances at hand from situations such as a school band’s sale of candy, in which fundraising is a tiny fraction of an organization’s activities, and pointed out that fundraising was a primary activity of Capital Gymnastics. In addition, the court pointed out that the organization did not provide scholarships for those who could not afford to pay the assessment, nor did it require all members to perform fundraising; rather, the fundraising activities were options that allowed parents to offset assessments that were viewed as “serious parental obligations.” All in all, the court held that the benefits conferred by Capital Gymnastics were substantial—parents were able to fundraise under the name of Capital Gymnastics and reduce the amount they otherwise would have to pay as a cash assessment, and those parents received 93 percent of the fundraising profits. In contrast, in other cases where member benefit from an organization’s activities was held to be permissible, those members were receiving around 2 percent of the overall benefit.
Interestingly, the court took time to note that it was not criticizing the fundraising structure as being unfair or inefficient—the structure simply does not comply with 501(c)(3) requirements. This is important because many other organizations could very well take a similar approach by concluding that allowing members to fundraise and offset their own obligations is just and a fair way to reduce an obligation without benefitting “free riders.” Yet doing so could very well cost them their exempt status.