One of the first big decisions that most nonprofit corporations make is in regards to filing for tax-exemption with the IRS. This decision is a big one. Section 501(a) of the Internal Revenue Code states that an organization that is described under section 501(c) is exempt from corporate income taxation. While most nonprofits immediately jump towards filing for tax-exemption under section 501(c)(3), there are 29 different categories of tax exemption under section 501(c) and each one comes with unique characteristics. Most importantly, filing for tax-exemption under the Internal Revenue Code will subject the nonprofit to operational restrictions that will regulate what your nonprofit can and cannot do. Therefore, whenever an organization is filing for tax-exemption, they need to be aware of the pros and cons to be sure that they are making the right decision for their nonprofit.
This is especially true for organizations that are planning on engaging in economic development activity. For the purposes of this blog post, economic development activity is defined as providing some type of assistance to a for-profit business. Economic development activities can take several different forms. It generally entails providing financial assistance, either through a low-interest loan, a facility or space for the operation of the for-profit business, equipment for a new for-profit business, or technical services. There are also several reasons why a tax-exempt nonprofit (TENP) may want to engage in economic development activity. The mission of many TENPs consists at least in part of revitalizing a community that has become blighted due to private and public disinvestment and encouraging private enterprises to return to the community. Providing start-up assistance to a for-profit business that plans to locate in the TENP’s target community can help the nonprofit further its mission while avoiding the responsibility and cost of actively maintaining and managing that operation. It can also be a source of potential revenue as the nonprofit may be able to obtain rental income from any for-profit business that uses space that has been redeveloped by the nonprofit.
However, whenever tax-exempt funds are being used to benefit a private individual, you can be assured that there are IRS regulations that you should be aware of. Let’s go through the three different categories of tax-exemption—501(c)(3), 501(c)(4), and 501(c)(6)—and weigh the pros and cons of each so that your nonprofit corporation can best judge which, if any, category of tax exemption makes the most sense for you.
As mentioned previously, most new nonprofit corporations immediately jump for the 501(c)(3) tax exemption. The reason for this is fairly simple: being a 501(c)(3) TENP provides serious fundraising benefits that no other category of tax-exemption provides. First, in regards to tax deductions for donors, only donations to 501(c)(3) organizations are tax deductible for the donor. This means that donors, in general, will more readily donate to a 501(c)(3) TENP rather than a nonprofit corporation that is exempt under any of the other categories of tax-exemption. Second, in regards to grants from private foundations, it is generally easier and preferable for foundations to issue grants to 501(c)(3) TENP. The two fundraising advantages described above are the primary reason why new nonprofit corporations desire to be 501(c)(3) organizations.
However, while being a 501(c)(3) organization comes with serious fundraising advantages, it also comes with serious operational restrictions.
All 501(c)(3) organizations must be operated exclusively for a one of the tax-exempt purposes described in section 501(c)(3). The two most common types of tax-exempt purposes under 501(c)(3) are charity and education. When a TENP operates to provide goods or services for private interests, who is receiving the services is an important question to answer. If the people receiving the goods or services are members of a charitable class—which generally means low-income individuals and their families—then the provision of those goods and services is clearly within the definition of charity. A common example are food bank operations. However, when a TENP operates to provide goods and services to private individuals that cannot be classified as low-income, then a closer analysis is required to determine whether the operation is charitable.
The IRS has said that a 501(c)(3) TENP can accomplish charitable ends through the use of individuals who are not themselves members of a charitable class. The theory behind recognizing such activities as charitable is that while the services provided are directly benefiting a private interest that is not a member of charitable class, the benefit to the general public outweighs the private benefit given to the private individual. In short, the benefit to the public outweighs the private benefit.
The natural question then becomes how does the IRS assess whether the public benefit outweighs the private benefit? Put another way, what must a 501(c)(3) do to make sure that its economic development activity is regarded as “charitable” by the IRS? To answer this question, the IRS utilizes a 3 factor test.
1.) Assistance must be targeted to aid an economically depressed or blighted area, and;
2.) Assistance must be targeted to benefit a disadvantaged group, such as minorities, the unemployed, or the underemployed, and;
3.) Assistance must be targeted to aid business that have actually experienced difficulty in obtaining conventional financing either because of the deteriorated nature of the area in which they were or would be located, or because of their minority composition, or to aid businesses that, or;
4.) Assistance must be targeted to aid a business that would locate or remain in an economically depressed or blighted area and provide jobs and training to the unemployed or underemployed from such area only if the economic development corporation’s assistance is available.
Looking at the factors above, most Detroit-based organizations will be able to make a very solid argument that their assistance is targeted to aid an economically depressed or blighted area given the City’s current state. However, the other three factors require a closer look.
In regards to the second factor, which requires that the assistance be targeted to benefit a disadvantaged group, the IRS has said that having the TENP require the for-profit business receiving assistance to train and hire for unemployed and underemployed residents of the community as being sufficient. While the benefit to a disadvantaged group may likely take other forms, the IRS probably wants to see some direct, tangible benefit directly tied to the assistance being provided to a private interest.
In regards to the third and fourth factor, it is important to note that only one must be satisfied. The third factor requires that assistance be targeted to aid a business that has experienced actual difficulty in obtaining financing either because of the area in which they are operating or seeking to operate or because of their minority composition. The word “actual” in this instance requires that the business show that they have tried to seek conventional financing from banking institutions and other sources, and have failed to obtain such financing. For some organizations, this can seem like a burdensome and unnecessary step.
Luckily, the fourth factor provides another way. If the assistance is targeted towards a business that will locate or remain in an economically depressed area and provide jobs and training for unemployed or underemployed people from that area, then such assistance should be regarded as charitable.
Let’s look at a real life example. In Revenue Ruling 76-419, the IRS considered whether a nonprofit organization that purchased blighted land in an economically depressed community, converted that land into a suitable space for a business, and induced a business to locate in the space through favorable lease terms that required employment training opportunities for unemployed and underemployed residents of the community was exempt under 501(c)(3). The IRS found that the activities of the nonprofit organization were charitable in that they combatted community deterioration by establishing new businesses, eliminated conditions of blight, and lessened neighborhood tensions that were caused by a lack of jobs in the area.
The 501(c)(4) category of tax-exemption is often the fall back category for nonprofit corporations that don’t quite fit within 501(c)(3) regulations or simply don’t want to be subject to the rather extensive and confusing regulations that come along with being a 501(c)(3) organization. A 501(c)(4) organization is defined as an organization not organized for profit but operated exclusively for the promotion of social welfare. IRS regulations have further defined social welfare to mean the promotion in some way of the common good and general welfare of the community. Therefore, the issues discussed above in regards to 501(c)(3) organizations providing a private benefit apply to 501(c)(3) organizations as well and the IRS will once again attempt to weigh the private benefit against the benefit to the public. Let’s look at some specific examples.
In certain cases, providing direct benefits to private individuals may be regarded as primarily benefiting the public because the benefits are being provided to a typically disadvantaged population. In Revenue Ruling 57-297, the IRS held that a nonprofit corporation that provided job training and rehabilitation services to elderly people was promoting the social welfare of the community based on the type of people it was serving.
In other cases, providing benefits to people or businesses that are not typically characterized as disadvantaged may also be found to promote social welfare. In Revenue Ruling 67-294, the IRS considered whether an organization that provided loans to business entities to encourage them to purchase and develop land and facilities in an economically depressed area for the purpose of alleviating unemployment was promoting social welfare. The IRS found that by encouraging a business to settle in an economically depressed area, the organization was operating to bring about civic betterment and social improvement and was therefore exempt under 501(c)(4). Similar to the analysis for 501(c)(3) organization’s above, tying the assistance to a for-profit business directly to a requirement that the business hire and train underemployed or unemployed individuals was an important part of the analysis.
501(c)(6) provides a corporate income tax exemption for business leagues which are not organized for profit and no part of the net earnings of which inure to the benefit of any private shareholder or individual.
So what is a business league? IRS regulations define it as “an association of persons having a common business, whose purpose is to promote the common business interest and not to engage in a regular business of a kind ordinarily carried on for profit. Its activities are directed to the improvement of business conditions of one or more lines of business rather than the performance of particular services for individual persons.
To determine whether an organization qualifies as a tax-exempt business league, the IRS utilizes a 7 factor test:
1.) Must be an association of persons having a common business interest and its purpose must be to promote this common business interest;
2.) Must be a membership-based organization as designated in its articles of incorporation and have a meaningful extent of membership support
3.) It must not be organized for profit
4.) No part of its net earnings may inure to the benefit of any private shareholder or individual;
5.) Its activities must be directed to the improvement of business conditions of one or more lines of business as distinguished from the performance of particular services for individual persons
6.) Primary activity must not consist of performing particular services for individual persons
7.) Its purpose must not be to engage in regular business of a kind ordinarily carried on for profit, even if the business is operated on a cooperative basis or produces only sufficient income to be self-sustaining
While many nonprofit organizations seeking to engage in economic development activity will be able to satisfy factors 1-4, satisfying 5-7 will likely prove impossible. In short, a 501(c)(6) organization cannot promote private interests. Instead, it must focus on improvement of business conditions as a whole which may entail attempting to influence legislation or promoting an industry as a whole to the public. However, the 501(c)(6) tax exemption will most likely be unhelpful for a nonprofit corporation hoping to engage in economic development activity.
In conclusion, 501(c)(3) and 501(c)(4) are likely to be applicable categories of tax-exemption for nonprofit corporations that are looking to become involved in economic development activities. If your nonprofit corporation is thinking about engaging in economic development activities, it is important to remember that the IRS will weigh the private benefits against the public benefits. To ensure that the public benefits outweigh the private benefits, some direct public benefit, such as a jobs training program and employment opportunities, should be directly tied to providing the private assistance.