The Wrong Way to Add a Charitable Arm to a For-Profit Business
I often receive inquiries from entrepreneurs who are looking to add a philanthropic component to an existing for-profit business, such as by forming a nonprofit as a charitable arm or subsidiary of their business or starting a corporate foundation. These ideas are usually well-intentioned. However, mixing business and charitable activities too closely can make IRS approval of 501(c)(3) status an uphill battle.
It is admirable when successful businesspeople decide to give back to the community and use their talents and resources for philanthropic purposes. It is also understandable that many entrepreneurs are drawn to charitable activities that are related to the areas in which they have built thriving for-profit businesses. They are more likely to see the societal needs and philanthropic opportunities in these areas because this is where they spend most of their time and energy. Moreover, people that form nonprofits usually want to focus on activities in which they already have expertise.
The problem is that the IRS tends to view charities that are too intertwined with the for-profit businesses of their founders as being formed, at least in part, for the purpose of benefiting the business. This perception often leads to Form 1023 applications being rejected or 501(c)(3) status being revoked upon a subsequent audit, even if the organization otherwise has valid 501(c)(3) purposes.
These kinds of organizations usually fit the description of one or more of the following models:
An organization that raises money to provide a portion of the goods or services of a related business to the public for free or a reduced price.
An organization whose activities rely heavily on goods or services from a related business.
An organization whose activities are otherwise too similar to the founder’s business.
Before discussing these models in more depth, it is necessary to provide a brief overview of the some of the relevant legal requirements of 501(c)(3) status (note, this is not an exhaustive overview of all the 501(c)(3) requirements, just the rules that are most relevant to this discussion).
Background Law
To qualify for 501(c)(3) status, an organization must be both organized and operated exclusively for 501(c)(3) purposes, such as charitable, religious, educational, scientific, or certain other specified purposes. In this context, “exclusively” means that a 501(c)(3) organization cannot engage in more than an “insubstantial” amount of activities that do not further the organization’s 501(c)(3) purposes, as measured by the time and effort required by the organization’s staff, the overall portion of the organization’s revenue and budget, and other factors.
Additionally, the Board members and other people who create or run a 501(c)(3) organization (as well as certain family members, business partners, and related businesses) are prohibited from being paid excessive compensation or otherwise siphoning the organization’s income or assets for personal use. This concept is embodied in the “private inurement” and “excess benefit transaction” (also known as “intermediate sanctions”) rules. These rules are typically monitored and enforced through an organization’s conflict of interest policy, which generally specifies a process to ensure that the organization’s insiders or (sometimes referred to as “interested persons” or “disqualified persons”) do not receive more than fair market value in any financial transaction with the organization.
While the private inurement and excess benefit transaction rules govern dealings involving those who hold leadership positions within the organization, the broader “private benefit rule” provides that that the assets and activities of a 501(c)(3) organization must not be used to benefit the interests of any private individual, business, or non-charitable entity, except to the extent such benefit is incidental to the organization’s 501(c)(3) purposes. In other words, an organization that has an otherwise valid 501(c)(3) purpose will not qualify for 501(c)(3) status if its programs benefit private persons more than incidentally.
For purposes of the private benefit rule, “incidental” means that any benefit to a private party must be minimal in relation to the organization’s benefits to the public, and inherent in the nature of the activities that further proper 501(c)(3) purposes. For example, providing resources to a “charitable class” (such as the poor) is considered an incidental private benefit.
In analyzing organizations whose activities are intertwined with those of a for-profit business, the IRS has frequently cited several key cases that relied primarily on the private benefit rule:
est of Hawaii v. Commissioner, 71 T.C. 1067 (1979) involved an organization formed to provide training, seminars, lectures on intrapersonal awareness and communication using a proprietary set of methods and techniques called “est” or "Erhard Seminars Training.” To use this teaching method, the organization had to enter into a detailed royalty agreement involving two unrelated for-profit companies that owned the rights. The agreement specified the tuition, frequency, and the manner in which the seminars were to take place, and provided that 50% of the revenue from the seminars would be paid to one of companies. The Tax Court ruled that that the IRS properly denied the organization’s 501(c)(3) status because the organization’s existed only to serve the interests of the for-profit rights holders. Although the for-profit companies were not related to the nonprofit through Board or officer overlap, the court noted that this was not sufficient to overcome the “private benefit” problem. Similarly, the court noted that it was irrelevant whether the fees paid by the organization were reasonable or excessive.
P.L.L Scholarship Fund v. Commissioner, 82 T.C. 196 (1984) involved an organization formed to raise money to provide college scholarships. The organization’s fundraising efforts took the form of regularly scheduled bingo games at a particular lounge owned by two of the organization’s Board members. In fact, the organization’s Articles of Incorporation specified that holding bingo games at the lounge was to be the organization’s primary means of fundraising. The bingo games were operated by employees of the lounge, who also solicited the bingo players to purchase food and beverages. The Tax Court concluded that IRS properly denied the organization’s 501(c)(3) status because attracting people to visit the lounge and buy food and beverages was more than an insubstantial purpose of the organization. The court noted that the activities of the nonprofit and the lounge “were so interrelated as to be functionally inseparable.” Importantly, the court reached this conclusion even though the entities in this case were careful to keep their own separate accounting records.
Church by Mail Inc. v. Commissioner, 765 F.2d 1387 (9th Cir. 1985) involved a religious organization whose primary activity was the preparation, printing and mailing of various religious messages. The organization’s printing and mailing needs were serviced by a single company, which was owned by the same people who formed and ran the organization. The Ninth Circuit affirmed the denial of the organization’s 501(c)(3) status, noting that “the critical inquiry is not whether particular contractual payments to a related for-profit organization are reasonable or excessive, but instead whether the entire enterprise is carried on in such a manner that the for-profit organization benefits substantially from the operation of the Church.”
International Postgraduate Medical Foundation v. Commissioner, T.C. Memo 1989-36 (1989) involved an organization formed for the purpose of providing continuing medical education seminars to physicians in conjunction with travel tours in various foreign countries. The organization’s founder and Executive Director was also shareholder and President of a for-profit travel agency that exclusively handled the booking and logistics of the organization’s tours. The travel agency would bill their travel charges directly to the individuals participating in the tours, with a percentage of these fees paid back to the organization. The organization never solicited bids from any travel agency other than the one owned by its Executive Director and, in fact, was restricted in its ability to accept outside bids pursuant to an agreement between the two entities. The Tax Court ruled that a substantial purpose of the organization’s operations was to increase the income of the travel agency, and the IRS therefore properly revoked the organization’s 501(c)(3) status.
Analysis of the Three Models
1. An organization that raises money to provide a portion of the goods or services of a related business to the public for free or a reduced price.
In this model, a business owner (often a doctor, lawyer, educator, or app builder) sees a need and an opportunity to provide their goods or services to people who cannot afford them. Rather than simply providing the goods or services for free or a reduced price at the company’s expense, the business owner wants to create a charitable vehicle to raise contributions to make the initiative more financially feasible (the fundraising is often done in the name of providing “scholarships” to use the services). There are two main problems with this model.
First, while there may be a genuine need for these goods or services among a charitable class, the main effect of such an organization would be to shift money to the founder’s business. Thus, the IRS tends to view this type of organization as an attempt to use the benefits of 501(c)(3) status to subsidize a new source of customers for the business and has rejected similar applications for this reason. See, e.g., IRS Private Letter Ruling 202118022 (a nonprofit that provided funding for individuals without insurance to receive therapy treatment provided by the founder’s company).
Additionally, as in the est of Hawaii case, the charity would be, in effect, be utilizing only one for-profit entity to provide the goods and services to the public. This is strongly indicative of an arrangement that provides more than incidental private benefit.
2. An organization whose activities rely heavily on goods or services from a related business.
This model is similar to the first model discussed above, except in this model the organization typically has a more robust set of programs and activities that go beyond mere fundraising. Additionally, the involvement of the related business is somewhat less direct in this model since the business is providing their goods or services to the organization itself rather than to the public. However, this model usually has the same problems as the first model because the organization has little or no ability to pursue its program without using the services of the related business.
Church by Mail and International Postgraduate Medical Foundation illustrate classic examples of this model, as the programs of these organizations relied heavily on paid services that were provided solely by a related business (printing/mailing and travel agency services, respectively).
A similar more recent example is found in IRS Private Letter Ruling 201315029, in which the nonprofit organization edited, finalized, and packaged for sale certain educational video materials owned by its founder, who in exchange received royalties and other compensation. As with est of Hawaii, the organization in this ruling had no programs that were not solely reliant on the intellectual property of a for-profit business, and the business received a clear benefit through the compensation arrangement.
The benefit to the business need not be a direct compensation arrangement to be problematic, as illustrated by P.L.L Scholarship Fund, in which the organization exclusively used the premises of the business to hold its programs. This case demonstrates that there can be impermissible private benefit if the nonprofit’s programs are operated in a way that provides a related for-profit business with substantial opportunities to market or upsell to the nonprofit’s users, donors, or customers.
IRS Private Letter Ruling 201405024 is a more modern example that illustrates this concept. The organization in this ruling generated course materials and other educational resources that schools and teachers could access for free for use in developing their specific course content. By itself, this is clearly an educational activity. The problem was that the materials created by the nonprofit were distributed exclusively on the website and tablet applications of a related for-profit business. The business did not charge fees to the nonprofit and was not permitted to charge the public for the nonprofit’s content. Nonetheless, the IRS denied 501(c)(3) because having the nonprofit’s content on the for-profit’s website and tablet applications brought more visitors and more potential sales to the business, thereby violating the private benefit rule.
3. An organization whose activities are otherwise too similar to the founder’s business.
I sometimes see a third model that is a slight variation on the first model. In this model, instead of raising money to directly subsidize access to the founder’s goods or services, the nonprofit appears to have its own activities that are very similar to the activities of the founder’s business. The nonprofit might have its own website or branding, but it is otherwise difficult to distinguish between the activities of the nonprofit and the business aside from perhaps being aimed at a different market segment.
The P.L.L Scholarship Fund case provides a strong indication that this type of organization is on tenuous legal ground from a 501(c)(3) qualification perspective, since the court concluded that the entities in that case “were so interrelated as to be functionally inseparable,” despite keeping separate accounting records.
The IRS has followed this approach in subsequent private letter rulings. For example, in IRS Private Letter Ruling 202041007 the IRS denied the 501(c)(3) status of an organization that provided training, mentoring, and community building programs for males in a manner that promoted “the same brand and overall vision” of the founder’s for-profit business, which appeared to engage in the online equivalent of these activities along with the sale of books, products, and other items.
Similarly, in IRS Private Letter Ruling 201714031 the IRS denied the 501(c)(3) status of an organization formed to teach a certain program of muscle management and therapeutic stretching exercises to heal chronically injured muscles and reduce back pain, which apparently were the same activities of the founder’s for-profit business. The IRS noted that the only way the two entities were distinguishable from the public’s perspective is that “[t]he non-profit customers will have a code to purchase materials at wholesale costs."
The main problem with this model is that it appears the IRS considers a related business to be inherently in a position to benefit from a nonprofit’s programs when the public cannot meaningfully distinguish between the activities of the two entities, usually by capturing a segment of the people served by the nonprofit or having special access to market the for-profit’s goods or services to these potential customers.
Planning Tip – A founder’s philanthropic and public recognition goals can often be just as fully achieved by simply donating funds or collaborating with an organization in the founder’s mission area of choice. Businesspeople should fully explore the possibility of working with an existing charity before starting down the burdensome and potentially tenuous path of forming a charity that is related to their business. From a legal, operational, and optics perspective, an independent and reputable charity will usually be in a better position to pursue collaborative projects with a for-profit business without raising the difficult issues that arise when the charity’s founder(s) and/or Board member(s) are owners of the business.
Conclusion and Recommendations
Two key lessons can be drawn from the models discussed above based on the relevant case law and IRS guidance.
First, confusion and opportunities for impermissible private benefit begin to surface when a nonprofit is formed to pursue activities that are too closely related to the business of its founder. Founders should instead try to differentiate the activities of their nonprofits as much as possible and work in areas that are not served in any respect by their businesses. For example, a nonprofit organization formed by the owner of a law firm would generally be well advised to avoid providing legal services in any way that has any involvement of the founder’s own law firm, focusing instead on an unrelated area such as providing college scholarships.
Second, nonprofits should not be entirely reliant on the goods or services of one or a handful of for-profit companies for their core programs, especially if those companies have a relationship with the organization such as shared Board members or officers. While an occasional business transaction with a founder or Board member may be permissible if proper conflict of interest procedures are followed, it is problematic when the organization is dependent on these transactions to carry out its mission. Instead, a nonprofit should be using a wide variety of vendors for its various functions. Most of these vendors should have no relationship to the organization, and the organization should document its efforts to seek estimates and proposals from multiple companies and hire the vendors that are most efficient and effective.
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