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Section 501(c)(3) organizations that aren't actively engaged in some sort of charitable program (i.e. inactive entities) are at risk of having their tax-exempt status revoked by the IRS. This Alert summarizes a recent Tax Court decision and two IRS revocation letters that conclude an inactive organization does not meet the "operational test," which requires Section 501(c)(3) organizations to be engaged in charitable activities. It also discusses implications for large tax-exempt systems that may have inactive organizations within their control.

Community Education Foundation v. IRS

In Community Education Foundation v. IRS, T.C. Memo 2016-223, the Tax Court held that Community Education Foundation (CEF) ceased to qualify as a Section 501(c)(3) organization because its inactivity demonstrated a failure to operate exclusively for exempt purposes.

CEF was founded in 2001 and applied for recognition as a tax-exempt Section 501(c)(3) organization at that time. CEF's stated purpose was to encourage the open discussion of policy issues impacting African Americans, Hispanic Americans, Asian Americans, Native Americans, and heritage groups. To this end, it planned to sponsor town hall meetings, national workshops and congressional forums, and to engage in media outreach activities.

The IRS granted CEF's request for recognition under Section 501(c)(3) in 2001. However, in 2012, the IRS sent CEF a letter revoking that status due to the organization's failure to establish that it met the operational test requirements under Section 501(c)(3). In response, CEF admitted that it was inactive from 2001-2008, but stated that it attempted (but failed) to host various events in 2009 and 2010. Nonetheless, the IRS revoked CEF's exempt status due to (1) its failure to establish it was operated exclusively for exempt purposes, (2) its failure to maintain or produce any books or records on its finances or activities, and (3) its admitted significant period of inactivity.

CEF filed a petition for declaratory judgment with the Tax Court. The Tax Court noted that, in such an action, the organization bears the burden of proving that it is a Section 501(c) organization — including that it meets the requirements of being both organized and operated for exempt purposes. While CEF and the IRS disputed why the events that CEF stated it intended to organize in 2009 and 2010 never occurred, the Tax Court determined that it did not need to resolve that dispute to reach its holding. Instead, the court noted that CEF "did not over time meaningfully organize or allocate resources to any of the [planned charitable activities listed on its exemption application]." Accordingly, the court held CEF failed to satisfy the operational test and did not qualify as a Section 501(c)(3) organization.

IRS revocation letters PLR 201706021 and 201706022

In ruling 201706022, the IRS revoked the Section 501(c)(3) status of an organization that ceased activities due to lost funding but that was seeking to restart activities in the future. In this instance, those activities were of an educational nature and the organization operated a school before it lost its funding. After the funding loss caused the closure of the school, the organization leased some of its property so that it could generate rental income to maintain the property while it sought new funding to re-open as an educational facility. The organization was pursuing various ideas, including a collaborative partnership with another organization and an aerospace education program for youth. However, none of these programs had come to fruition. To this end, the organization asked the IRS to give it additional time and allow it to maintain its tax-exempt status while it sought more funding. The IRS declined the request and stated that the organization "cannot retain its exempt status simply because it might have a charitable purpose in the future" and that "[s]imply having discussions with others about proposed programs or activities does not constitute operating for a charitable or educational purposes." The IRS ruled that because the organization has no current exempt activities, the organization is not operated for exempt purposes under Section 501(c)(3).

In ruling 201706021, the IRS ruled that an organization failed to continue to meet the operational requirement under Section 501(c)(3) when it ceased to provide the charitable services for which it was formed. The organization in question was formed to provide services, including residential care, for individuals living with AIDS. To this end, the organization relied on contracts it had with the Department of Public Health to fund such services. Although the timeline is not clear due to redactions in the letter ruling, at some point the organization lost its contracts and could no longer provide the residential services. The organization leased its buildings to unrelated businesses while it attempted to attain more funding. However, ultimately, the organization stated it could not continue its charitable activities due to lack of funding. With the organization's agreement, the IRS revoked its exempt status for failure to meet the operational test.

Implications

In general, to be considered as operating exclusively for charitable purposes, an entity is required to engage primarily in activities that accomplish one or more exempt purposes as specified in Treas. Reg. Section 1.501(c)(3)-1(c). The regulations do not specifically address whether an organization with no activities can meet this "operational test," however, the recent IRS and Tax Court decisions noted indicate that such an organization cannot. Presumably, it is possible for an organization to be inactive temporarily, though the IRS and the courts have not provided a firm time limit on when an organization will cease to be operated exclusively for an exempt purpose.

Even if an inactive organization does not have its Section 501(c)(3) status revoked (or prior to that time), it may become a private foundation due to a lack of public support. If the entity meets the public support test as a supporting organization of another public charity, it can avoid reclassification as a private foundation. However, this may not prevent revocation of Section 501(c)(3) status if the entity remains inactive for too long. In two 2011 rulings, the IRS revoked the Section 501(c)(3) status of supporting organizations that were never active (PLRs 201103061 and 201108038).

Organizations occasionally keep a formerly active Section 501(c)(3) entity "on the shelf" for future use. Due to the recent IRS activity in this area, all tax-exempt organizations, particularly those that are responsible for multiple tax-exempt subsidiaries, are reminded about the operational test and should review whether controlled entities are actively operating a charitable program. If there are inactive entities, these should be evaluated to determine whether their public charity classifications and overall tax-exempt statuses are at risk.

Please contact your Ernst & Young LLP tax professional with any questions.

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RELATED RESOURCES

— For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg.

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