An organization must be both "organized" and "operated" exclusively for one or more of these purposes to qualify for exemption.

A.  Organizational Test

B.  Operational Test

C.  The Meaning of "Exclusively"

D.  Unrelated Business Income Tax

A. In General

An important exception to the rule against inurement necessarily exists to permit an organization to provide compensation to insiders as well as third parties for rendering goods and services needed to accomplish its exempt purposes. World Family Corp. v. Commissioner, 81 T.C. 958, 968 (1983); Broadway Theatre League of Lynchburg, Va. v. United States, 293 F. Supp. 346, 355 (W.D. Va. 1968). This exception is strictly construed, however, and any compensation paid must be reasonable in light of the services actually performed or goods supplied. Senior Citizens of Missouri, Inc. v. Commissioner, 56 T.C.M. (CCH) 479, 482 (1988). Furthermore, the reasonableness standard applies both to the amount of compensation and to the manner in which the amount is determined. Thus, inurement may result not only if compensation in question is excessive in light of the services performed, but also it was not determined by an objective standard with reference to the interests of the organization as a whole, rather than those of the recipient. In United Cancer Council, the Tax Court found that the fundraiser’s earnings -- $4 million in fees as well as income from exploiting its co-ownership rights to the organization’s mailing list – exceeded reasonable compensation despite the fact that they were permitted by a bargained-for contract.

2. The "Commerciality" Doctrine

In applying the operational test discussed above, some courts have applied what has come to be called as the commerciality doctrine. In a variety of factual contexts, courts have determined that because of the "commercial" manner in which an organization carries out its activities, it is operated substantially for nonexempt commercial purposes rather than for one or more of the specified exempt purposes.

C.  Intermediate Sanctions

While the gravest consequence of private inurement is the possible revocation of an organization’s exempt status, Congress has recognized that revocation is an extreme sanction that may be disproportionate to the degree of inurement occurring in some cases. Section 4958 of the Code, added in 1995, accordingly provides intermediate sanctions in the form of penalty taxes on "excess benefit transactions," although the legislative history expressly contemplates that these taxes may be imposed "in lieu of, or in addition to, revocation.

An excess benefit transaction subject to tax is one in which a "disqualified person" receives an economic benefit whose value exceeds the value of the consideration received by the organization. This includes in particular the payment of unreasonable compensation to a "disqualified person," defined as any person, whether or not an employee, who was in a position to exercise substantial influence over the affairs of the organization at any time during the previous five-years, or a family member of such a person.

Under Section 4958(a), the disqualified person is personally liable for a tax equal to 25 per cent of the "excess benefit" -- i.e., the difference between the value of the compensation received and the value of the services rendered -- while the officers, directors, or other "organization managers" who approved the arrangement are personally liable for a separate tax equal to 10 per cent of the excess benefit. Furthermore, if the excess benefit is not "corrected" before those taxes are imposed, then the disqualified person will be subject to an additional tax under section 4958(b) in the amount of 200 per cent of the excess benefit. "Correction" for this purpose entails undoing the excess benefit to the extent possible and also taking any additional measures necessary to place the organization in a financial position not worse than it would have been if the highest fiduciary standards had prevailed.

A. Lobbying

To qualify for exemption under Code section 501(c)(3), the statute provides that "no substantial part of the [organization's] activities" may consist of "carrying on propaganda or otherwise attempting to influence legislation (except as otherwise provided in subsection (h)))." Generally, the substantiality of prohibited lobbying is measured in the same manner as any nonexempt purpose under the operational test. Section 501(h) provides, however, that most section 501(c)(3) organizations (other than churches and church affiliated organizations) may elect certain specified safe harbors for lobbying expenditures without endangering their exempt status.

The section 501(h) election has a number of advantages for an eligible organization. First and foremost, of course, the election allows the organization to retain its exempt status (assuming that it otherwise continues to qualify) notwithstanding lobbying expenditures that would be considered "substantial" under the usual facts-and-circumstances test. Second, it replaces the IRS’s subjective determination of substantiality with an objective measure of lobbying activities, expressed in terms of the proportion between certain cash expenditures to influence legislation and expenditures to accomplish the organization’s exempt purposes. As defined in sections 4911(c) and (d), the safe harbor amounts exclude the lobbying activities of unpaid volunteers, as well as other activities that do not involve any expenditure of the organization’s funds, whether directly or indirectly. Third, the election lessens the impact of unusually high lobbying expenditures in any one taxable year, because the safe harbor test of whether the organization "normally" exceeds the applicable dollar ceilings is based upon the three preceding taxable years. If lobbying expenditures as defined do exceed the ceilings in a particular year, then an excise tax is imposed at the rate of 25 per cent of the excess. The Code provides, however, that the election is retroactive to the beginning of the taxable year in which it is made, whereas a voluntary revocation of the election takes effects only from the beginning of the next taxable year. This is intended to prevent organizations from avoiding the excise tax by shifting back and forth between the safe harbor election and the facts-and-circumstances test of substantiality in the light of their actual expenditures in a particular taxable year.

Lobbying activities may affect not only the organization’s own status but the ability of taxpayers to deduct their contributions to it. Although contributions to an organization exempt under section 501(c)(3) are generally deductible under section 170 up to a certain percentage of the taxpayer’s income, no deduction is allowed for out-of-pocket expenditures made for the purpose of influencing legislation. Where an organization conducts lobbying activities on matters of direct financial interest to a contributor, contributions to it generally are not deductible under section 170 to the extent that they also would not be deductible as trade or business expenses under section 162. This exclusion extends to the portion of membership dues allocable to lobbying activities, but it does not apply at all to local legislation.

2. Electioneering

Section 501(c)(3) further provides that an exempt organization may not "participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate or public office." Unlike the lobbying restriction, with its substantiality threshold, the electioneering prohibition is absolute. As in the case of prohibited private inurement, however, the Code provides intermediate sanctions against electioneering in the form of penalty excise taxes under section 4955. The initial penalty taxes under section 4955(a) comprise a tax imposed on the organization in the amount of 10 per cent of each political expenditure as well as a separate tax, equal to 2.5 per cent of each expenditure (with a maximum tax of $5,000 per expenditure) imposed on and payable by any organization manager who knowingly and willfully makes such an expenditure. Under section 4955(b), if a political expenditure is not "corrected" before the initial taxes are imposed, the organization is subject to an additional tax equal to 100 per cent of the expenditure, and any organization manager who refused to agree to all or part of the correction is subject to an additional tax of 50 per cent of the expenditure, up to a maximum tax of $10,000 per expenditure. "Correction" for this purpose is defined in section 4955(f) to mean recovery of all or part of the expenditure to the extent possible, plus the establishment of safeguards to prevent future political expenditures.

From the text and structure of Code section 501(c)(3), the courts and the IRS have derived two additional tests for exemption -- private benefit and public policy.

A. Private Benefit

B.  Public Policy

The IRS employs a "facts and circumstances" test in determining an organization's church status, looking at the following criteria:

  1. a distinct legal existence;
  2. a recognized creed and form of worship;
  3. a definite and distinct ecclesiastical government;
  4. a formal code of doctrine and discipline;
  5. a distinct religious history;
  6. a membership not associated with any other church or denomination;
  7. an organization of ordained ministers;
  8. ordained ministers selected after completing prescribed studies;
  9. a literature of its own;
10. established places of worship;
11. regular congregations;
12. regular religious services;
13. Sunday schools for religious instruction of the young; and
14. schools for the preparation of its ministers.

A church is a coherent group of individuals and families that join together to accomplish the religious purposes of mutually held beliefs. In other words, a church's principal means of accomplishing its religious purposes must be to assemble regularly a group of individuals related by common worship and faith. As stated by Tannenwald, J., concurring in Chapman [48 T.C. 358 (1967)]:

The word "church" implies that an otherwise qualified organization bring people together as the principal means of accomplishing its purpose. The objects of such gatherings need not be conversion to a particular faith or segment of a faith nor the propagation of the views of a particular denomination or sect. The permissible purpose may be accomplished individually and privately * * * but it may not be accomplished in physical solitude. * * * [48 T.C. at 367; emphasis in original.]

[D]espite the breadth of petitioners' broadcasting and publishing efforts, its associational aspects are much more than incidental. We hold that petitioner has sufficient associational aspects to be considered a church.³⁸

The public benefit necessary to warrant special tax benefits for churches flows not from a government subsidy for religion, which would be impermissible under the First Amendment to the United States Constitution,³⁹ but from the non-religious benefits accruing to society from organized religion -- morality, community and personal responsibility, benevolence, and so forth.⁴⁰ These public benefits flow from the associational aspects of organized religion, namely "join[ing] together" to implement in society at large the "religious purposes of mutually held beliefs" of "a cohesive group of individuals."

Under sections 501(b) and 511(a)(1) of the Code, an otherwise tax-exempt organization must pay tax, at regular corporate rates, on its "unrelated business taxable income" (UBTI). Unrelated business taxable income is defined in section 512(a)(1) and Treas. Reg. § 1.512(a)-1(a) as income derived from "any unrelated trade or business. regularly carried on" by the organization, less allowable deductions that are "directly connected" with such trade or business, and subject to certain "modifications" set forth in section 512(b). Interest and dividends, rents, royalties, and gains or losses from dispositions of property (other than stock or property held for sale to customers in the ordinary course of business), together with associated deductions, are expressly excluded from UBTI. Code sections 512(b)(1)-(3), (5). The scope of the royalty exclusion has been the focus of considerable litigation involving mailing list rentals and, more recently, "affinity credit cards" endorsed by universities and other exempt organizations as a fundraising device. The crucial distinction is a payment for the use of a name, logo, or list, which satisfies the definition of a royalty as payment for a valuable intangible property right, and compensation for promotional or other services, which does not qualify as a royalty.⁴¹

Notwithstanding those exclusions, sections 512(b)(4) and 514 provide that income from property must be included in the computation of UBTI to the extent that the acquisition of the property was debt-financed and at least 85 per cent of its use is unrelated to the organization’s exempt purposes. This rule does not apply to schools, universities, pension trusts, or title holding corporations described in section 501(c)(5).⁴² It was introduced in 1969 to prevent abusive "charitable bootstrapping" transactions that allowed stockholders to avoid capital gains on the sale of ongoing commercial businesses to charities.

An "unrelated trade or business" is one that is not substantially and causally related to the exercise or performance of the organization's exempt purpose, aside from the need for income or funds. Code section 513(a); Treas. Reg. §§ 1.513-1(a), (d)(2). Thus, charges for the performance of the exempt activities themselves do not constitute UBTI. Treas. Reg. § 1.513-1(d)(4)(i). The term "trade or business" in this context includes "any activity which is carried on for the production of income from the sale of goods or the performance of services" (Code section 513(c)) and that otherwise possesses the characteristics of a trade or business within the meaning of Code section 162, such as profit motive (see Treas. Reg. § 1.513-1(b)). Although the primary legislative purpose behind the UBTI provisions was to avoid giving exempt organizations an unfair competitive edge,⁴³ this definition may also reach activities that are not carried on commercially by non-exempt organizations. See Treas. Reg. § 1.513-1(b). Also, an activity does not lose its identity as a trade or business merely because it is carried on within a "larger complex" of activities that are related to the organization’s exempt purposes. Code section 513(c). This means, in particular, that the sale of advertising in a periodical published by an exempt organization may constitute an unrelated trade or business and give rise to UBTI, even if the editorial content of the periodical advances exempt purposes.⁴⁴

By itself, the conduct of an unrelated profit-making enterprise does not automatically subject an exempt organization to tax. Rather, section 512(a) limits the definition of UBTI to income derived from activities that are "regularly carried on," in the sense that they "manifest a frequency and continuity, and are pursued in a manner generally similar to comparable commercial activities of non-exempt organizations." Treas. Reg. § 1.513-1(c)(1). This means, however, that a short-term or occasional activity could still be "regularly carried on" if it would be handled the same way in a commercial context. Annual fundraising events such as auctions or dinners generally would not rise that level,⁴⁵ nor does the sale of advertising space in the program for an annual sporting event.⁴⁶ Although the IRS has attempted to treat income derived from corporate sponsorship of annual collegiate sporting events as UBTI, its position has been criticized on the ground that these events are not "regularly carried on," that the practice of recognizing donors does not constitute a trade or business, and that the sponsorship donations promote exempt purposes by enhancing the collegiate athletic and educational experience.

Once these definitional issues are resolved, in order to determine the amount of its UBTI, an organization is required to allocate its expenses, including salaries, depreciation, and operating costs, between its exempt and non-exempt functions. An expense is deductible from UBTI if it is "directly connected" with the unrelated trade or business, meaning that it bears a "proximate and primary causal relationship to the carrying on" of that business. Code section 512(a)(1); Treas. Reg. §§ 1.512(a)-1(a) and (b). On the other hand, costs incurred in an exempt activity, or derived from an unrelated business activity that "exploits" an exempt activity, generally are not deductible. Code section 265; Treas. Reg. § 1.512(a)-1(d)(1). The organization has considerable leeway to make a "reasonable" allocation, notwithstanding disagreement from the IRS. Rensselaer Polytechnic Inst. v. Commissioner, 732 F.2d 1058 (2d Cir. 1984); Treas. Reg. § 1.512(a)-1(c).

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   ¹As interpreted, "exclusively" really means substantially; an incidental nonexempt  purpose will not disqualify an organization from exemption.  return to text

   ²In general, an organization meets the "organizational" test if its articles of incorporation limit its purpose to one or more exempt purposes and if they "[d]o not expressly empower the organization to engage, otherwise than as an insubstantial part of its activities, in activities which in themselves are not in furtherance of one or more exempt purpose." Treas. Reg. § 1.501(c)(3)-1(b)(1)(i). The articles may express the organization’s purposes in terms as broad as the language of section 501(c)(3), for example, by stating that the organization is formed "for literary and scientific purposes within the meaning of section 501(c)(3) of the Code" or even simply "for charitable purposes." Treas. Reg. § 1.501(c)(3)-1(b)(1)(ii). If, however, the organization is empowered by its articles to engage in a substantial nonexempt purpose, it fails the "organizational" test.  return to text

     ³"[I]n applying the organizational test, a court is not necessarily bound by the recitals in the certificate of incorporation, and in an appropriate case may look beyond the four corners of the creating instrument and consider extrinsic evidence:

'To grant or deny tax benefits to organizations upon a basis of recitations in a charter or certificate would not seem to accomplish what Congress was getting at. The issue of "organized," * * * is primarily a question of fact not to be determined merely by an examination of the certificate of incorporation but by the actual objects motivating the organization and the subsequent conduct of the organization.'"

Taxation With Representation v. United States, 585 F.2d 1219, 1222 (4th Cir. 1978), cert. denied, 441 U.S. 905 (1979) (emphasis added) (quoting Samuel Friedland Foundation v. United States, 144 F. Supp. 74, 85 (D.N.J. 1956).  return to text

    ⁴Treas. Reg. §1.501(c)(3)-1(c)(1).  return to text

     ⁵Goldsboro Art League v. Commissioner, 75 T.C. 337, 343 (1980), acq., 1986-2 C.B. 1; Federation Pharmacy Services, Inc. v. Commissioner, 72 T.C. 687, 691 (1979), aff'd, 625 F.2d 804, 807 (8th Cir. 1980).   return to text

    ⁶See, e.g., Linwood Cemetery Ass'n v. Commissioner, 87 T.C. 1314, 1327-28 (1986) ("'[T]he rendering of medical care is a charitable activity' in and of itself. . . ."); St. Joseph Farms of Indiana v. Commissioner, 85 T.C. 9, 22-23 (1985) ("[O]peration of schools, boys' homes and foreign mission facilities . . . fall within the category of what have traditionally been considered, in and of themselves, charitable activities").  return to text

     ⁷See, e.g., Living Faith, Inc. v. Commissioner, 950 F.2d 365 (7th Cir. 1991); B.S.W. Group, Inc. v. Commissioner, 70 T.C. at 356-57.  return to text

     ⁸Treas. Reg. §§1.501(c)(c)(3)-i(a)(1), 1.501(c)(c)(3)-1(c)(1).  return to text

     ⁹Better Business Bureau v. United States, 326 U.S. 279, 283 (1945).  return to text

    ¹⁰World Family Corp. v. Commissioner, 81 T.C. 958 (1983).  return to text

     ¹¹Orange County Agricultural Society, Inc. v. Commissioner, 55 T.C.M. (CCH) 602, 1604 (1988), aff'd 893 F.2d 647 (2d Cir. 1990).  return to text

    ¹²But see Orange County Agricultural Society, Inc. v. Commissioner, supra.  return to text

    ¹³Treas. Reg. § 1.501(a)-1(c).  return to text

   ¹⁴See, e.g., Enterprise Ry. Equip. Co. v. United States, 142 Ct. Cl. 192, 161 F. Supp. 590, 595 (1958).  return to text

    ¹⁵See, e.g., Lowry Hospital Ass'n v. Commissioner, 66 T.C. 850, 858 (1976).  return to text

    ¹⁶See, e.g., Ohio Furnace Co. v. Commissioner, 25 T.C. 179, 193 (1955).  return to text

    ¹⁷See, e.g., Texas Trade School v. Commissioner, 30 T.C. 642, 647 (1958), aff'd per curiam, 272 F.2d 168 (5th Cir. 1959).  return to text

   ¹⁸See American Institute for Economic Research v. United States, 302 F.2d 934, 938 (Ct. Cl. 1962), cert. denied, 372 U.S. 976 (1963) ("the services offered by plaintiffs are commonly associated with a commercial practice"); Scripture Press Found. v. United States, 285 F.2d 800, 806, n.11 (Ct. Cl. 1961), cert. denied, 368 U.S. 985 (1962); Easter House v. United States, 12 Cl. Ct 476, 486 (1987), aff'd w/o op., 846 F.2d 78 (Fed. Cir.), cert. denied, 488 U.S. 907 (1988) ("Plaintiff's competition [with other commercial organizations] provides its activities with a commercial hue."); B.S.W. Group, 70 T.C. at 358 ("Competition with commercial firms is strong evidence of the predominance of nonexempt commercial purposes.").  return to text

    ¹⁹See, e.g., Presbyterian and Reformed Pub. Co. v. Commissioner, 743 F.2d 148, 156-58 (3d Cir. 1984); Easter House, 12 Cl. Ct. at 485-86. return to text

    ²⁰Living Faith, 950 F.2d at 373-74. return to text 

   ²¹Hopkins, The Law of Tax Exempt Organizations, pp. 829-42 (6th ed. 1992); id. at 830 (The commerciality doctrine "rests in part upon untrue premises * * * and has crept into the law by actions of judges who, consciously or unconsciously, ignored the Internal Revenue Code and the underlying regulations, and developed law with these premises in mind.")  return to text

   ³⁴Most courts appear to have accepted the Service's 14 church criteria in toto. See Spiritual Outreach Society, 927 F.2d at 338; United States v. Jeffries, 854 F.2d 254, 258 & n.1 (7th Cir. 1988); Lutheran Social Service of Minnesota v. United States, 758 F.2d 1283, 1286-87 (8th Cir. 1985), aff'g 583 F. Supp. 1298 (D. Minn. 1984); Tennessee Baptist Children's Homes, Inc. v. United States, 604 F. Supp. 210, 212 n.4 (M.D. Tenn. 1984), aff'd on other grounds, 790 F.2d 534 (6th Cir. 1986); Williams Home, Inc. v. United States, 540 F. Supp. 310, 317 (W.D. Va. 1982); American Guidance Foundation, Inc. v. United States, 490 F. Supp. 304, 306 & n.2 (D. D.C. 1980); Church of the Visible Intelligence, 4 Cl. Ct. at 64. The Tax Court, while not accepting the 14 criteria as a determinative test, treats these criteria as "helpful in deciding what is essentially a fact test." Foundation of Human Understanding v. Commissioner, 88 T.C. 1341, 1357-58 (1987).   return to text

   ³⁵See, e.g., Foundation of Human Understanding, 88 T.C. at 1360-61; Church of Eternal Life and Liberty v. Commissioner, 86 T.C. 916, 924-25 (1986); Spiritual Outreach Society v. Commissioner, 58 T.C.M. (CCH) 1284, 1286-87. In affirming the Tax Court's decision in Spiritual Outreach Society, the Court of Appeals specifically declined to address the Tax Court's "associational" test, 927 F.2d at 338, finding that the organization failed to qualify as a church under the Service's published 14 criteria. 927 F.2d at 338-39.  return to text

   ³⁶Church of Eternal Life v. Commissioner, 86 T.C. at 924.  return to text