In PLR 202511016, the IRS revoked the IRC Section 501(c)(3) tax-exempt status of an organization under examination, finding it had not conducted charitable activities, other than maintaining donated property for several years and therefore failed to meet the operational test for exemption under IRC Section 501(c)(3).

Background

Under IRC Section 501(c)(3), entities organized and operated exclusively for charitable purposes qualify for federal income tax exemption. Treas. Reg. Section 1.501(c)(3)-1(c)(1), which the IRS cited in its revocation letter, regards an organization as "operated exclusively" for one or more exempt purposes only if it engages primarily in activities that accomplish one or more of the exempt purposes in IRC Section 501(c)(3).

An IRC Section 501(c)(3) organization can qualify as a public charity under IRC Section 509(a)(2) (the public charity status of the organization in PLR 202511016) if it receives less than one third of its financial support from gross investment income and net unrelated business taxable income, and more than one third from a combination of contributions, membership fees, and gross receipts from activities related to its exempt functions. If an IRC Section 501(c)(3) organization fails to meet either the IRC Section 509(a)(2) public support test or another public charity test, then it is a private foundation.

Ruling

The IRS determined that the organization did not qualify for tax exemption under IRC Section 501(c)(3) because it had not engaged in any charitable activities for several years. The IRS noted that the organization's directors had dealt with personal health issues during the years under exam, and that the COVID-19 pandemic restricted the organization's activities, During the years examined, the organization's only activity was maintaining donated property, which the IRS determined was insufficient to meet the operational requirements set forth in IRC Section 501(c)(3). The IRS directed the organization to submit Forms 1120, U.S. Corporation Income Tax Return, for its prior and current tax years.

The IRS set forth an alternative position in its ruling, stating that the organization should be reclassified as a private foundation if its IRC Section 501(c)(3) status is sustained on appeal. In explaining this alternative position, the IRS concluded the organization no longer qualifies as an IRC Section 509(a)(2) publicly supported organization, as it has not met the public support test under IRC Section 509(a)(2), nor does it qualify as any other type of public charity.

Implications

The revocation demonstrates the need for tax-exempt organizations to actively engage in charitable activity to ensure adherence to the IRC Section 501(c)(3) operational test. Charitable activity is a necessity throughout a charitable organization's existence. When an IRC Section 501(c)(3) organization reduces or materially changes its activity, it may no longer qualify as tax-exempt. As this IRS revocation letter highlights, it is important for organizations to maintain at least some level of tax-exempt activity every year, rather than ceasing exempt activity for one or more years.

This revocation letter also illustrates how strictly the IRS may apply the IRC Section 501(c)(3) operational test. Here, the organization was engaged in some activity — maintenance of donated property (though the redacted ruling does not explain what kind of donated property) — so it was at least partially active and not fully dormant. Nevertheless, the IRS determined that such property maintenance wasn't sufficiently charitable to meet the operational test.

This revocation letter also illustrates how strict the operational test rules are. Unlike other failures for which the IRS can grant penalty abatement for reasonable cause, like late-filed Form 990-series returns, the IRC Section 501(c)(3) operational test does not contain any reasonable-cause abatement provisions or exceptions. While noting the challenges faced by the organization from the COVID-19 pandemic and directors' health issues, the IRS didn't find these facts to be relevant in determining whether the organization met the IRC Section 501(c)(3) operational test.

An IRC Section 501(c)(3) organization like the one in PLR 202511016 that ceases, or significantly curtails, its activity also risks failing public charity tests and becoming a private foundation, particularly if it is a publicly supported charity under IRC Sections 509(a)(1) or 509(a)(2) and curtails its fundraising activity. A publicly-supported IRC Section 501(c)(3) organization on the precipice of tipping to private foundation status could save its public charity status if it were to (i) obtain a significant donation from a publicly supported charity, which would be 100% includible as public support, (ii) become a supporting organization under IRC Section 509(a)(3), or (iii) reclassify a large donation or donations from its prior five years as an unusual grant or grants, if applicable. Organizations that cease charitable activity and fail the operational test, however, will fail to qualify as either a public charity or private foundation.