When I was a younger person with numerous pretensions and abundant spare reading time, if asked for my favorite to work to revisit regularly, I probably would have cited some bleak French or Russian literature that I may have read one and a half times (generous) but nonetheless decided was core to my personality.

Having traded (some of) those pretensions and (nearly all of) that spare reading time and attention span for the life of a nonprofit tax lawyer, the answer now might be Revenue Ruling 67-4:  a 56-year old one-page-long ruling about when publishing counts as an educational activity for 501(c)(3) purposes.  Life comes at you fast, etc.

Revenue Ruling 67-4 is not even mentioned in the 501(c)(3) application-denial ruling that caught my eye this week.  But it easily could have been.  And I think it pairs neatly with something that is cited: the commerciality doctrine, as articulated in Living Faith, Inc. vs. Commissioner, a 32-year old tax case about a religious health food store.

So, join me in a discussion of these two great works of “literature”, and the 501(c)(3) publisher that never was.

The History Lesson:  Publishing as Charitable Activity

Let’s start with what Rev. Rul. 67-4 says, which is that for publishing to be a 501(c)(3) activity, all of the following must be true:

(1) the content of the publication is educational,

(2) the preparation of material follows methods generally accepted as ‘educational’ in character,

(3) the distribution of the materials is necessary or valuable in achieving the organization’s educational and scientific purposes, and

(4) the manner in which the distribution is accomplished is distinguishable from ordinary commercial publishing practices.

This test has been applied in other contexts too, like documentary filmmaking, where the activity itself educates, but where there are also many media companies doing the same exact thing and making money from it, especially in the post-Netflix content boom,.  The first three prongs of the test are often easy to satisfy – people rarely publish things that you could not argue is educational in some way or another.  It’s the fourth prong that should slow organizations down.

What I like about the last prong and Revenue Ruling 67-4 is that it tells nonprofits to set a higher bar for themselves.  Just doing good in the same way that any other actor in the free market would is not enough – you have to do something differently.  Try a little harder.  In exchange for this tax exemption and access to deductible contributions and foundation grants, do something different than what you would do if you were just trying to make as much money as you possibly could in the free market.  An implicit rejection of capitalism and binding tax guidance for education nonprofits, all in one.  Great stuff.

History Lesson:  The Commerciality Doctrine

Which leads us to an amalgam of rulings, rejections, and revocations that many nonprofit lawyers hate, but I not so secretly love:  the commerciality doctrine.  Basically:  it’s OK for charities to make money, even make a profit you can use for other charitable activities, but if there are commercial actors doing the same kind of work, you just need to be… you know… not like them… somehow.  

Vague?  Definitely.  But I think aligned with our intuition that charities are supposed to be different than businesses, and reasonable if we want to be at least a little judicious about how our society hands out tax benefits.

There are many places to go for the commerciality doctrine, but the IRS in this most recent ruling went to Living Faith, a Seventh Circuit case about Seventh-day Adventists that created a nonprofit to house a chain of vegetarian restaurants and health food stores.  Their argument:  “the vegetarian and health food stores help our members practice their religion, which requires healthy living.”  The stores are also managed by Seventh-Day Adventists.  While franchised under a larger secular chain of stores, the Adventists incorporated some of their religious practice into the restaurant and stores (books on sale, staff prayer sessions, etc.) that they owned and operated as their ‘charitable activity’. 

The IRS, the tax court, and ultimately the appellate court all agreed that the nonprofit had a “substantial commercial purpose” and thus did not qualify.  And that’s an important point:  being a nonprofit is not just about “having the right purposes”.  It’s also about “not having the wrong purposes.”  And operating a commercial business for its own sake is a disqualifying purpose if it is substantial.  In a sense, that is what the commerciality doctrine is about.

To skip to the takeaway, Living Faith was cited by the IRS in the recent ruling as the “best contemporary explanation of the commerciality doctrine” and cited the relevant factors resulting in revocation as:

1.     The organization sold goods and services to the public.

2.     The organization was in direct competition with for profit businesses.

3.     The prices set by the organization were based on pricing formulas common to retail food businesses.

4.     The organization utilized promotional materials and "commercial catchphrases" to enhance sales.

5.     The organization advertised its services and food.

6.     The organization did not receive any charitable contributions

Now, both the court in Living Faith and the IRS would agree that any one of those factors on its own can be fine.  Even multiple of them.  And we can all probably think of examples as nonprofits that have many if not all of them, but nevertheless persist in exempt status.  But put them all together, and the IRS applies its own version of the “you know it when you see it” test for identifying nonprofits that should really be taxed like for-profits.

The Denied Nonprofit Publisher:

Many lawyers and nonprofits dislike the commerciality doctrine test because it’s subjective and can be applied inconsistently.  You can add to that list the founders of the organization in PLR 202342018 after the IRS applied the commerciality doctrine to reject their 501(c)(3) tax-exemption application:

• The nonprofit applicant was formed after the death of “Y, a spiritual author and teacher, founder of the T.” (T being not-so-helpfully defined as a “Movement” for purposes of the anonymous ruling). 

• Y’s estate remains the owner of all of Y’s books and related works during his lifetime.  The Y estate licensed the rights to the nonprofits to publish the works, in exchange for a royalty payment tied to the number of sales.

• The nonprofit is also spending money to conduct quality control on Y’s works and renovate transcripts of Y’s works for another organization inspired by Y.

• There was some free distribution of the material to nonprofits affiliated with the mission.

I have no idea who “Y” is, but I could imagine why the applicant thought they were a qualifying organization, even if they looked at the Revenue Ruling 67-4.  They were producing educational work, presumably preparing it in an educational way, distributing them to raise awareness, and even did some things differently than a commercial publisher might (they were giving away the books in some cases and partnering with nonprofits). 

But that’s what makes the commerciality doctrine a helpful limit to protect the nonprofit sector.  Because, yes, in a way it’s “educational” – but 501(c)(3) can’t be as broad as “as long as someone is learning, that’s good enough.” We should be able to ask charities to do more than that.  And this nonprofit just looks and feels like a publishing arm for the estate.  The royalty arrangement will ensure they make just as much money as they did before – and perhaps more, because their nonprofit publisher is out there increasing the value of their work on a taxpayer-subsidized basis. Getting to the heart of the commerciality doctrine and the publishing test, the IRS noted that the nonprofit was formed by the for-profit publishing company that existed during Y’s life converting into a nonprofit.  A good reason to suspect that not much has changed. 

Whether you say the activity is too commercial or there is too much private benefit, the result is the same:  no tax-exemption if your primary objective is to do something other than educate. 

Lessons for Other Organizations

For organizations engaged or considering publication activities, I can reassure you by saying there are many ways to vary this activity in a way that likely would have earned the applicant tax-exempt status.  I’ll run through a few ideas, but there are surely more out there:

1.     Just donate the intellectual property and/or publish other people’s work too.  You still might have a commerciality issue, but the IRS was almost certainly focused on the fact that the nonprofit was doing all the work, with private individuals with a profit motive getting much of the benefit.  And the fact that they were only publishing the works of one author suggests that the benefit was probably the point of the arrangement.  While fair market value transactions between a public charity and a for-profit can be OK (and let’s assume that was the case), operating with the purpose of benefiting that for-profit is not OK.

2.     If you’re going to keep the intellectual property, don’t have the nonprofit do work and spend money to make it more valuable.  Similarly, not really a commerciality issue, but just a “what are you really doing here?” issue.  The IRS probably hated that the charity was spending its resources to improve work owned by someone else.  If the charity owned the work, that’s fine, both from an educational perspective (the work would be more educational) and a revenue-generating perspective (the charity could presumably generate more money to fund other activities).   But it didn’t own the work it was improving; the estate, with private beneficiaries did.  The charity is spending its money to increase the value of someone else’s asset.  That’s bad, especially when that someone else is your founder’s estate, which is presumably your insiders and their family.

3.     Make your noncommercial distribution as robust as your commercial distribution.  While there was some giving away of books here, that is generally not enough to fully distinguish yourself from a for-profit publisher.  Everyone gives away stuff from time to time on a promotional basis.  It is a lot more convincing if you conduct full programming around them and try to reach as broad an audience as possible. 

Another way to think about this:  when you’re operating as a market actor, scarcity is one way of creating value (the only way to get this book is to pay $29.99 – if there were lots of channels to get it for free, fewer people would pay).  But scarcity is the opposite of what an educational organization should want – their goal is to educate the general public.  Their revenue-generating interests need to balanced by the ultimate goal of getting the message out there and increasing public understanding.  There are a lot of ways to do it and if you can show that you are trying, you will probably be in a lot better shape than this applicant.

Closing Thoughts on the Commerciality Doctrine

To me, if there’s a problem with the commerciality doctrine, it is that it is not applied often enough.  If you follow the logic above, you would probably be left with a lot of questions about the state of our nonprofit sector.

• If we want educational organizations to operate noncommercially, why are the most funded and prestigious among them defined by selectivity, limiting those they serve primarily to the elite and offering admissions advantages that perpetuate their donors’ privilege? 

   

• Why have all of our nonprofit colleges, regardless of quality or licensure, been able to charge so much tuition, unconnected to outcomes, that we’ve buried so many millions of Americans in student debt?  Getting teenagers and noncreditworthy adults to sign off on tens or hundreds of thousands of dollars of debt, with little regard to prospect of return, seems sort of like a predatory commercial practice, no?

   

• Why is so much of our lower and middle class saddled with crushing medical debt, created often by nonprofit medical providers that are supposed to act differently and with a commitment to community benefit?

 

• Why do many donor-advised fund sponsors present themselves as the “charitable arm” of a specified investment bank, while marketing and operating their funds like “charitable checking accounts” that generate significant investment fees for the bank with anti-charitable incentives (the fewer the grants, the greater the fees)?

 

It is hard to square those situations with a doctrine that says charities can’t operate purely like commercial actors.  That is why the commerciality doctrine feels like a rule borrowed from a universe with a more robustly regulated nonprofit sector and a more logical tax system. One where the nonprofit sector has greater integrity and a reputation because it has a real commitment to carrying out its mission in a charitable way. 

I can understand why people may be frustrated when it pops up in rulings like the above – it doesn’t really belong in the nonprofit world that we actually live in.  Perhaps I just enjoy the escapism.