501(c)(3) organizations, while exempt from tax, are certainly not exempt from IRS oversight. In fact, it is just the opposite—501(c)(3) organizations are heavily regulated by the IRS because they have the double benefit of tax exemption and the ability to accept tax-deductible contributions.

For organizations to gain and maintain 501(c)(3) status, there are many requirements and restrictions to contend with. To name just a few:

• The organization must be organized and operated for recognized 501(c)(3) purposes;
• The organization cannot lobby to more than an insubstantial degree, and cannot participate at all in partisan political activity;
• The organization cannot allow any inurement of its income or assets to its insiders (e.g., its officers, directors and others with substantial influence)—though it can compensate and participate in transactions on a reasonable and fair market value basis;
• It cannot be organized for the primary purpose of operating an unrelated trade or business; and
• It cannot further non-exempt purposes more than insubstantially.

This final restriction encompasses several different legal doctrines. Take, for example, the private benefit doctrine—a 501(c)(3) cannot benefit private parties (regardless of their relationship to the organization) through its activities to more than an incidental degree. It also encompasses the doctrine of commerciality, a somewhat murky area of the law where the IRS can take the position that an organization operates too similarly to a for-profit to qualify as tax-exempt under 501(c)(3).

To illustrate, the IRS recently denied an organization 501(c)(3) status largely on the basis of the commerciality doctrine. In the ruling (Priv. Let. Rul. 201411038), the applying organization sought to provide board training and other support services for small synagogues, as well as heritage mission trips to visit struggling congregations overseas. The organization charged for its services on an hourly basis (for training and other consulting) and at a package rate (for travel).

The IRS noted that the organization was providing services for cost and was operating in a manner similar to a trade or business operated for profit. It didn’t provide its services at substantially below cost (as is the case in a favorable IRS ruling), and as such its pricing structure lacked a donative element. The fact that its services were provided to exempt organizations was not enough qualify the activities as 501(c)(3) activities.

The organization made the case that it served smaller organizations that weren’t able to pay fees charged by other providers, and that its fees were modest in comparison. However, to the IRS the relevant question is not necessarily whether fees are lower than competitors, but whether services are provided below cost.

The commerciality doctrine can be perplexing, because it seems to reflect a presumption against fee-for-service organizations qualifying for 501(c)(3) status (except under narrow circumstances). Yet many types of traditional 501(c)(3) organizations like hospitals and schools operate on a fee-for-service basis—and they are certainly not providing services at substantially below cost. In addition, there is a public support test under section 509(a)(2) that is meant to be used by organizations that have fees as a main part of their revenue. With the social enterprise movement, there is an emphasis on organizations having a fee model and seeking to become less dependent on donations. At the same time, some lines between for-profits and nonprofits are blurring in terms of activities and populations served; marketing and promotion of activities; and more.  As such, the commerciality issue may continue to grow.

Becky Seidel will be speaking Thursday, May 2, on Obtaining and Maintaining Exempt Status at the Primer for Advising Nonprofit Organizations. Her presentation will discuss the commerciality doctrine, among other issues related to exemption.