Nonprofit Organizations Update Summer 2007

ARNSTEIN & LEHR LLP Attorneys at Law

Nonprofit Organizations Update About our Nonprofit Practice Group Arnstein & Lehr LLP provides legal services to trade associations, professional societies, public charities, private foundations, fraternal organizations, group insurance trusts, political action committees, schools, hospitals, medical staffs, "captive" insurance companies, and other organizations exempt from federal income tax under Section 501(c) of the Internal Revenue Code. The Firm's attorneys help such clients deal with a wide array of issues, including: •

Corporate and trust formation and maintenance

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Development of bylaws

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Obtaining and maintaining federal and state tax exemptions

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Avoiding and minimizing unrelated business income taxes

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Registrations and annual filings with attorneys general and other government officials

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Proper conduct of organization elections

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Avoiding antitrust problems

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Fund raising campaigns, including use of professional fundraisers

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Self-dealing, inurement and intermediate sanctions

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Relations with subsidiary groups, including group tax exemptions

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Protection of intellectual property

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Charitable gaming

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Limitations on political and legislative activity

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Professional ethics matters

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Public and member disclosure requirements

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Deductions for donors

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Nonprofit mailing permits

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Partnerships and joint ventures with forprofits

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Employment issues

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Insurance issues

IRS Outlines Safe Harbor for Tax-Exempt Campaign Groups Failing to Report Information About Contributors In Revenue Procedure 2007-27, published in March, the Internal Revenue Service outlined a safe harbor Section 527 tax-exempt campaign groups can utilize in showing that there is "reasonable cause" for failing to report the addresses, employers and occupations of contributors on IRS Form 8872. Federal law requires Section 527 groups to list the names and addresses of all contributors, and the occupations and employers of individual contributors, on that form, with a possible penalty of 35% of each contribution for which disclosures have not been made. But the IRS is allowed to waive the penalty if groups can show "reasonable cause." The IRS has noted that the safe harbor does not apply in cases where a group has failed to report contributor names on Form 8872. However, the IRS also points out that it can waive penalties outside of the safe harbor if it finds that failure to report any required information was nonetheless due to reasonable cause. The safe harbor includes the following terms: 1. All fund raising solicitations, by or on behalf of a group, must clearly and conspicuously request contributor names, addresses, and the occupation and employer for individual contributors. Each solicitation must also state that the group is required to report the information by law, subject to penalties for nondisclosure. 2. Within 30 days of receiving a contribution without the required information, a group must request that information in writing or orally, with a written record of the request. The information request can thank the donor, but cannot address any other subject, and it must include the group's legal reporting responsibilities, as well as either a pre-addressed return envelope or postcard or, for oral or electronic requests, a mailing or Internet address. 3. If contributors do not respond by the due date for a group's filing of Form 8872, the group must "fill in the blanks" itself, provided the group has the required information on file. 4. If a group receives any missing or corrected contributor information, it must file an amended Form 8872 within 30 days, but no later than two business days before an election (unless the contribution is received fewer than 2 days before an election). 5. A group must disclose all required information on Form 8872 with respect to at least 85% of the total dollar amounts of contributions received during the calendar year.

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Federal Law Prohibiting Intentional Damage to Computers Found Constitutional as Applied to Attack on Nonprofit's Computer Network Connected to Internet The U.S. Court of Appeals for the Eighth Circuit has found that it was not unconstitutional to apply a federal statute prohibiting the intentional causing of damage to protected computers in the case of an individual who was fired from his job at the Midland Division of the Salvation Army and then proceeded to launch an attack on the organization's computer network that cost the organization over $19,000 to repair. The attack included deleting files, shutting down a computer-operated phone system, erasing files, inserting files with obscenities directed toward the organization and sending organization employees pop-up messages on their computers indicating that "Trotter was here." John Larkin Trotter essentially admitted committing the attack on the organization's computer system at trial of this matter, when he was charged with intentionally causing damage to a protected computer without authorization, in violation of 18 U.S.C. §1030(a)(5)(A)(i). But he reserved the right to challenge the constitutionality of that statute as applied to him. The statute prohibits a person from knowingly causing "the transmission of a program, information, code, or command, and as a result of such conduct, intentionally caus(ing) damage without authorization to a protected computer." A "protected computer" is defined, in pertinent part, as a computer "which is used in interstate or foreign commerce or communication." Trotter's constitutional challenge to the statute, which was brought to the Eighth Circuit, involved his contention that the statute was overly broad in its application to him, because the Salvation Army is a nonprofit organization, and so, he said, was not involved in "interstate commerce," except to the extent that "[n]early all computers [these] days are used someway in interstate commerce through the [I]nternet or private networks." But the Eighth Circuit found that the Salvation Army's status as a nonprofit had no bearing on whether the statute was constitutional, because the statute focused on the characteristics of the computer or computer network attacked, not the entity using the computer or computer network. In this case, the Eighth Circuit found that the Salvation Army's computers were connected to the Internet and the computers were thus part of "a system that is inexorably intertwined with interstate commerce." In addition, Trotter had admitted that the computers were used to communicate with other computers in other states, so that the Salvation Army's

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computer system was clearly "used in interstate…commerce or communication." Thus, enactment of the statute was clearly within Congress's constitutional power to regulate interstate commerce, and application of the statute to Trotter was likewise constitutional. IRS Report on Executive Compensation Released The Internal Revenue Service has issued a report on an Executive Compensation Compliance Initiative undertaken in 2004 by the Exempt Organizations Office of the Tax Exempt/Government Entities Division. The project involved sending compliance check letters to over a thousand organizations and examining Form 990 and related returns for many other entities, including both private foundations and publicly supported organizations. According to the recently released report, there were "significant reporting errors and omissions" by tax-exempt organizations in specific areas, particularly excess benefit transactions and transactions with disqualified persons, as well as potential compliance issues related to loans made to officers. Many of the organizations surveyed had failed to initially file schedules detailing compensation paid to officers or employees. On the other hand, the IRS reported that its study did not evidence widespread concerns other than reporting. High compensation amounts were found in many cases, but the Service found that they were generally substantiated based on appropriate comparability data. IRS Issues Interim Guidance Concerning Excise Taxes on Nonprofits Participating in Tax Shelters The Internal Revenue Service has issued interim guidance concerning when tax-exempt organizations will be considered a "party" to a "prohibited tax shelter transaction." The federal Tax Increase Prevention and Reconciliation Act of 2005 imposed an excise tax on tax-exempt entities for the tax year in which they become a party to such a transaction. According to the recently issued IRS interim guidance, a taxexempt entity will be considered a "party" to a "prohibited tax shelter transaction" if it facilitates a transaction because of its tax-exempt, tax-indifferent or tax-favored status. The only other circumstance in which a tax-exempt entity will be considered a "party" is if it is identified in published guidance, by type, class or role, as a party to a prohibited tax shelter transaction.

The IRS guidance also addresses the amount and timing of net income and proceeds attributable to a transaction, which would determine the amount of excise taxes due, if any. Among other things, the IRS notes that net income and proceeds attributable to a transaction and allocated to a tax year ending on or before August 15, 2006 will not be subject to the new excise tax. For tax years including August 16, 2006, allocations will be made based on two short tax years, one ending on August 15, 2006 and the other beginning on August 16, 2006.

Even apart from the above factors, the Tax Court found that the nonprofit's activities would not qualify as "educational" under the generally accepted use of that term. Furthermore, the Tax Court noted the organization's acknowledgment in its application that it would engage in legislative and political activities generally not allowed for Section 501(c)(3) entities.

Tax Court Upholds Denial of Educational Organization Exemption for Nonprofit Promoting Unsupported Conspiracy Theory

The Internal Revenue Service has revoked a federal income tax exemption under Section 501(c)(3) of the Internal Revenue Code for a nonprofit organization that provided shelter for homeless veterans. The organization had received its exemption in 1989 on the basis that it would provide a homeless shelter, but later structured its operations to serve only veterans.

The U.S. Tax Court has upheld a decision by the Internal Revenue Service denying tax-exempt status for the Families Against Government Slavery as an educational organization under Section 501(c)(3) of the Internal Revenue Code. The organization's governing documents stated that its purpose was to educate the public about "injustices to minority [A]mericans" and about "peacefully fight[ing] for freedom." But the IRS and the Tax Court found that the organization's primary activity was publicly promoting an unsupported conspiracy theory in a way that did not qualify as education. The Tax Court noted that the organization's activities consisted primarily of public protests or demonstrations made solely by the nonprofit's founder, in which he attempted to convince the public that the FBI kidnaps Hollywood celebrities and that law enforcement personnel and private gangs are joined in a conspiracy to kill, trap and enslave such celebrities and minorities "to gain more financial support" and to engage in activities described as "blood sport." In addition, the organization's documents alleged that government welfare and housing programs force minority women to participate in the above-alleged conspiracy. The IRS had requested the nonprofit to submit evidence supporting its claim for exemption, and the organization had submitted over 1,000 pages of what the Tax Court characterized as "nonsensical, emotionally charged, and incomprehensible allegations." Referring to published guidance from the IRS, the Tax Court noted that "educational" purposes do not include activities principally involving the presentation of unsupported opinion, and the Tax Court characterized the activities of the organization in this case as such because (1) the organization's viewpoints or positions were factually unsupported, (2) the organization distorted facts, (3) the nonprofit used inflammatory language and emotional and irrelevant statements, and (4) the organization failed to provide background information allowing the public to understand and evaluate its material.

IRS Revokes Tax Exemption of Nonprofit Providing Shelter for Homeless Veterans

In this case, the organization operated three homes that were used for homeless veterans, all of which were owned by the president and sole director and officer of the nonprofit. The IRS concluded that the nonprofit had made some expenditures related to operation of these shelters, including repairs, capital construction, food for the homeless and other miscellaneous costs. But the IRS revoked the organization's exemption because its net income had inured to the benefit of the president. The IRS noted that the organization did not maintain good internal controls or enter into arm's-length transactions. There were no contracts for rental or lease of the buildings owned by the president and used by the organization, and no other contracts regarding any payments to the president as compensation, although payments to the president were being made. Since the basis for the payments was unexplained, the IRS deemed them to be for a personal and private benefit and not for the benefit of the organization. Foundation's Termination of Educational Programs and For-Profit Founder's Subsequent Provision of Similar Programs Will Not Have Adverse Tax Consequences for Nonprofit In a pair of private letter rulings, the Internal Revenue Service has found that a private foundation would not suffer adverse tax consequences as a result of its terminating certain educational programs, even if its for-profit founder subsequently conducted similar programs, as long as the foundation transferred no property to its founder in connection with its cessation of the educational programs. The foundation's purpose was to create economic opportunities and revitalize neighborhoods across the United States, which it

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accomplished, among other things, through educational programs disseminating information to minority and underserved groups. The for-profit, which contributed to the foundation, also provided products and services to low and moderate-income Americans. Considering information presented by the nonprofit, the IRS noted that the foundation was terminating some of its educational programs because the foundation had determined that they were no longer an effective tool for delivering its educational message to the intended audience. The for-profit, however, had indicated that it might wish to sponsor or conduct similar programs, entirely with its own resources, and without any transfer of property from the nonprofit to the founder. Given there would be no transfer of property from the nonprofit to the founder, the IRS concluded that the proposed cessation of the foundation's educational programs, and the possible providing of similar programs by the founder, would not jeopardize the foundation's exempt status under Section 501(c)(3), as the foundation would continue to engage in other educational activities. In addition, the IRS concluded that the foundation would not be providing an impermissible private benefit to the founder, and the proposed activities would not involve the foundation and its sponsor in prohibited self-dealing. On the other hand, the IRS noted that the foundation would be continuing to provide a different educational program designed to offer educational information about a variety of issues, which would be directed to a broad public audience, with a particular focus on low- and moderate-income individuals, minorities, new immigrants, and other underrepresented groups. The founder indicated that it wished to engage in advertising activities in conjunction with the nonprofit's operation of that educational program. But the IRS declined to rule on whether the nonprofit would realize adverse tax consequences from such activities because the question of whether they might involve impermissible private benefit to the founder, or cause the nonprofit and its founder to engage in prohibited self-dealing, would depend upon the facts and circumstances existing at the time of those activities. Thus, the IRS concluded that it would be inappropriate to rule on that issue hypothetically. Nonprofit Operating Housing Project Denied Illinois Sales and Use Tax Exemption

to a nonprofit organization that operated a subsidized HUD Section 8 housing project and obtained a majority of its revenue from bingo operations, pull-tab games, rents and membership dues. Among other things, the Department noted that membership in the nonprofit was not available to an indefinite number of persons, the nonprofit had failed to establish that it had been designated as an exempt entity under Section 501(c)(3) of the Internal Revenue Code, and the organization's financial statements were incomplete. The Department addressed the organization's revenue sources, pointing out that, in each case, its revenue was received from people who paid money to the organization in return for a definite benefit they themselves would receive. With regard to the housing project, the Department noted that it appeared to be making money, and while the organization's bylaws indicated that it would not evict a tenant solely for non-payment of rent, the organization had failed to show that the bylaws provision would be implemented. Finally, the Department addressed the allegedly charitable nature of the organization's activities. Though the nonprofit gave money to certain organizations, it did not provide information about the charitable nature of those entities or how they were chosen for financial aid. IRS Proposes Revocation of Charity's Exempt Status Due to Former Officer's Questionable Expenditures The Internal Revenue Service, in a private letter ruling, has indicated that the exempt status of a charity under Section 501(c)(3) of the Internal Revenue Code should be revoked due to the questionable expenditures made by a former officer of the organization. Because of those expenditures, the IRS determined that the organization, which has been disbanded and has no assets, previously operated substantially for private benefit. Among the questionable expenditures by the former officer were payments to another now-dissolved organization for which he served as president, a payment to a financial institution for an individual's car, payments for telephone bills of unknown origin, and checks drawn either to cash or to another individual for "rents." In addition, the IRS pointed out that it had received no evidence the charity's assets were disposed of in the manner required for dissolution of a Section 501(c)(3) organization.

The Illinois Department of Revenue, in an administrative hearing decision, has denied a state sales and use tax exemption

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IRS Revokes Exemption for "Educational" Organization Engaged in Publishing The Internal Revenue Service has revoked the tax-exempt status under Section 501(c)(3) of the Internal Revenue Code previously held by an organization whose primary activity was producing a magazine, Flying Adventures: The Private Aircraft Owners/Passengers Travel & Lifestyle Magazine. The IRS found that the magazine could not justify the previously granted tax exemption on educational grounds because an average of 5% of the publication consisted of educational content, such as articles or other information relating to flying safety. In contrast, 25% of the publication consisted of paid advertising and 70% consisted of articles about various travel destinations, which were deemed to be primarily for entertainment purposes. Furthermore, the publication contained the following disclaimer: "We gotta tell you: This publication is NOT for navigational use. Pilots must make their own determination regarding safety. We are not responsible for data about advertisers, sponsors, reviews, editorial, airports, or safety messages. This publication is strictly for your entertainment value." A further ground for revoking the organization's exemption was its failure to provide documentation to substantiate the amount of $1,789,609 reported in its books as "Accounts Payable and Accrued Liabilities," which appeared to represent amounts owed to the founder and sole director and officer. It could not be determined that the fees charged by the founder to the organization, for which the organization had accrued liability, were reasonable, because the founder had not provided substantiating documentation for transactions listed as "development/creation," "loans," "automobile mileage reimbursement," "lease of personal aircraft," "lease of equipment," and "commissions." Furthermore, the founder had not demonstrated that the basis for his salary of $54,600 had been documented by the organization, and it appeared that interest rates charged to the organization by the founder were unreasonable, while transactions involving use of automobiles, personal aircraft and equipment were of a personal nature and for the benefit of the founder in violation of federal tax regulations. Scientific Research Organization Will Not Realize Adverse Tax Consequences from Focusing Research Efforts Toward Aiding Geographic Area, Attracting New Industry and Encouraging Development In a recent private letter ruling, the Internal Revenue Service has held that a nonprofit scientific research organization previously recognized as tax-exempt under Section 501(c)(3) of

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the Internal Revenue Code will not realize adverse tax consequences by amending its articles of incorporation so as to allow it to focus the organization's research efforts toward aiding a geographic area, attracting new industry to the area and encouraging industrial development there. The nonprofit was originally formed to conduct scientific research for the understanding, measurement and prevention of problems caused by inadequate indoor environments. But it expanded the purpose clauses in its articles of incorporation to allow the organization to become a vehicle for attracting companies, generating new investments and bringing high-paying jobs to a particular geographic area by transforming the area into an innovative leader in the field of environmental research. The IRS stated that while the nonprofit would continue with its original scientific research into indoor environmental problems, it would make a greater effort to ensure that the results of its research would develop and encourage industry in the geographic area served by the organization. This change was characterized as a change in the emphasis of the nonprofit's mission, and the IRS concluded that substantially all research conducted by the organization or in the benefited geographic area would be "scientific" research "carried on in the public interest." In that regard, the IRS determined that the "scientific" character of the organization's research would not be changed by the fact that its amended articles of incorporation would allow it to focus its research efforts toward aiding the geographic area, attracting new industry to the area and encouraging industrial development there. Organization Under State's Business Corporation Statute Creates Presumption Against Entity's Entitlement to Exemption Under Internal Revenue Code Section 501(c)(4) The Internal Revenue Service has held that an entity organized under a state's business corporation statute was not thereby precluded from being considered exempt from federal income tax under Section 501(c)(4) of the Internal Revenue Code. However, the IRS ruled that such incorporation creates a presumption that an entity is not entitled to exemption under Section 501(c)(4). In this case, the entity argued that it was entitled to an exemption because it was actually operated in a manner that made it a charitable trust under applicable state law. Considering all of the facts and circumstances of this case, however, the IRS concluded that the organization could not be considered as "not organized for profit," within the meaning of Section 501(c)(4), based on the following factors:

(1) it was organized under its state's business corporation law; (2) neither the articles of incorporation nor the bylaws of the organization limited its business powers, particularly with respect to dividends; (3) the entity had stock that was held by a for-profit organization, to which it was required to distribute assets upon dissolution, and there were no apparent ownership or transfer restrictions with respect to the stock of the parent or the subsidiary, and (4) the organization could have incorporated under its state's nonprofit corporation statute, unlike an entity in a previously decided case that could not have been formed as a nonprofit corporation under its state's laws.

Church-Affiliated Nursing Home Facility Denied Property Tax Exemption The Connecticut Superior Court has held that a churchaffiliated nursing home facility was not entitled to a state property tax exemption because it was not used exclusively for charitable purposes, since it generated large amounts of money from private patients and provided rehabilitative services that were not exclusively for the elderly. In addition, the court found that the facility was not entitled to a religious property exemption because, while the facility had a large chapel on the premises, that chapel was merely incidental to the primary use of the facility as a nursing home.

If you would like further information about any of the topics mentioned in this publication, please contact James F. Gossett at [email protected] or 312.876.7833.

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