There are times when I read over the most recent batch of IRS 501(c)(3) denial rulings and shed a tear (figuratively speaking, of course) for the shattered dreams of well-intentioned but misguided applicants. This is not one of those times.

There was a batch of six IRS denial rulings that came across my desk, and I will probably cover at least a few of the other five eventually. But my penchant for schadenfreude drew me to the one that mentioned blatant partisan campaign intervention and prohibited benefits to a multi-level marketing company. And honestly, it’s much worse than that.

Let’s do a quick recap as an excuse to cover these two issues, one of which is as “black-and-white” as they come (electioneering) while the other (managing private benefit so that a relationship to an affiliated for-profit does not cost the 501(c)(3) its exempt status) is typically a very gray area and one that we spend a lot of time talking to clients about in order to get the balance right. But, honestly, I just wanted to share some insane facts.

Campaign Activity

Let’s get the easy issue out of the way. 501(c)(3)’s are subject to limits (or in the case of private foundations, a prohibition) on lobbying (i.e. communications to legislators, or the general public under certain circumstances, that reflects a view on specific legislation) and a strict prohibition on any electioneering (i.e. partisan activity supporting or opposing a candidate for elected office). If you applying for 501(c)(3) status to the IRS and you have plans to conduct candidate activity, you are making the reviewer’s job very easy — it’s a no.

Per the ruling, the applicant wanted to “engage in activities to express your views on social and political issues (so far: this is probably fine — most issue advocacy is not lobbying or electioneering, though it depends how it is done). For instance, you anticipate purchasing several cameras to express your views on social and political issues (cameras are nice…we might be OK if they stopped here and watched what they said on camera), which will include publishing videos online to express your political opinions (I’m starting to get worried, but there are versions of this that are OK, I really hope the next clause does not mention…) and holding public stances on political candidates (and there it goes…501(c)(3)’s need to stay away from stances on candidates — this is disqualifying in and of itself, regardless of their other crazy plans). You will publish opinion pieces online supporting or opposing political candidates and elected officials (digging the hole deeper...) . Additionally, you may coach political candidates who align with your mission as well as create online videos and canvass door-to-door on their behalf (And deeper still — I would have a hard time thinking of more obvious partisan campaign intervention than canvassing door-to-door).”

So, a very easy cautionary tale: if you want to do these things, create a 501(c)(4) — there is much more (but not unlimited) opportunity to get involved in support of political candidates there.

For-Profit Affiliate Issue

We could easily just stop there, but I spend a lot of time advising for-profit clients who want to set up a non-profit affiliate on how to make the relationship work and protect the 501(c)(3)’s exempt status, and this ruling gives us an entertaining excuse to talk about an example of how NOT to do it.

How to Think About It

In short, a for-profit operating side by side with a non-profit CAN work, BUT there is what I call a “micro” test and a “macro” test to think about (yes, I made these terms up, and yes they are bad, feel free to suggest better ones).

• The micro test is following the rules for transactions between a 501(c)(3) and its insiders or the entities they own. For private foundations, those are the very strict and highly limiting self-dealing rules under IRC Section 4941 (no transactions whatsoever, even favorable ones to the foundation, with a few limited exceptions). For public charities, those are the excess benefit transaction rules under IRC Section 4958 (to oversimplify, transactions between the for-profit and charity are generally OK, but the charity needs to always get a fair deal or better). In some ways, this is the easier test to satisfy when structuring a for-profit and non-profit affiliate relationship because there are relatively concrete rules to follow — figuring out what is a ‘fair deal’ can be challenging, but there are procedures to follow to comply (more on this in another post to come).

• The macro test refers to the requirement that, in order to maintain 501(c)(3) status, the organization must not provide “excessive” private benefit or have a non-exempt purpose (i.e. benefitting the for-profit affiliate) that is “substantial.”
  
  Obviously, these terms are vague and the “right” answer depends on all facts and circumstances. But to evaluate the macro test, you need to take a step back and look holistically at the two organizations and the intentions of the non-profit. Taking everything into account, the question for the applicant (like many a reality show contestant) is whether the non-profit is here for the “right reasons”? I would describe the “right reasons” as conducting a charitable activity the for-profit wants to happen and take advantage of a 501(c)(3)’s ability to attract funding from different sources, operate more tax-efficiently and/or generating some goodwill for their shared brand along the way. If the non-profit operates to help the for-profit make more money, it is here for the wrong reasons.

  One point here that I think is worth emphasizing, it is the charity that cannot have a purpose to benefit the for-profit or use its funds for a purpose other than a charitable purpose — the for-profit’s intentions in establishing or funding the charity are not under scrutiny — in other words there is nothing that prevents the for-profit from acting self-interestedly in deciding to set up an affiliate, the pressure is on the affiliate to operate like a 501(c)(3) (exclusively for charitable purposes) and avoid improper benefits. This is a nuanced distinction but a meaningful one, in my opinion — again, a topic for another post to come.
  
  Either way, my approach in these situations is to frame the structuring of the relationships and activities by thinking of several “dials” we can turn to get to the right balance of alignment between the entities (to make the for-profit comfortable funding and to prevent mission drift by the non-profit) and prevent excessive private benefit or inappropriate activity by the non-profit. Those dials include:

  • The activities: how much are they going to intersect? Will the non-profit be engaged in regular transactions with the for-profit? Will all of the non-profit’s constituents be for-profit customers? Or will they serve two entirely different regions or sets of constituents? The more the activities of the organizations intersect, the greater the risk — the more you set up “walls” between the two entities, the lower the risk.

  • The money: does money flow entirely from the for-profit to the non-profit? Or is money flowing regularly from the non-profit to the for-profit? Is money flowing from a common source (e.g. for-profit investors or customers)? In general, the only truly safe economic benefit to the for-profit affiliate is goodwill (people like the company more)— every tangible economic benefit adds some degree of risk, though there is a degree of incidental benefit to the for-profit is acceptable. The answer to this question will likely influence how you want to set the other dials (e.g. if there are going to be direct economic transactions between the two entities, the organization should strongly consider a majority independent Board for the non-profit).

  • The degree of for-profit control: does the for-profit appoint all of non-profit’s Board? A majority? A minority? One seat? No seats? There is legal flexibility here. If the other areas present little to no risk, full control is an option (see most company foundations). If the activities pose a greater risk, however, then the affiliate may want to sacrifice some or all control to perform better under this test.

  • Common branding: are the two organizations going to use a common brand (e.g. Acme, Inc. and Acme Foundation)? Or will there be additional steps to brand them as separate entities? A shared brand can work (and most company foundations have the company in their name), but if the other dials are set to “higher risk”, you might consider whether more clear separation of brands is desirable.

At some point, I’ll write a post about how to strike that balance correctly and more on how we can turn those ‘dials’, but let’s focus on a pretty clear example of what does NOT work. And, wow, does it not work.

How to Not to Do It (i.e. What this Applicant Did)

The applicant in this ruling was a “worldwide movement and lifelong collective of support toward better health, better wealth, and better happiness that serves community groups all over the world through multiple physical and online platforms to provide (1) free and donation-optional life coaching services and basic needs support and (2) support in cultivating healthy, happy, independent careers and lives beyond the timeframes of your programs, groups, and events.” (sounds charitable enough I guess…what could go wrong?). One of the applicant’s program will be “a habilitation home to serve poor and distressed individuals such as the homeless, the struggling, and for those in bad situations. During the first several weeks of (the program), the participants will take part in weekly sessions to enable them to use discourse among themselves to deal with conflict in order to become healed. Once healed, they begin the next phase.” (OK, this sounds more or less charitable, though ‘healed’ along with everything else makes this feel a bit… cult-y intense… wait, what was that about beginning the “next phase?” That sounds ominous).

If you have not guessed from the title of this post, the ‘next phase” is paying a fee to become an independent distributor for the affiliated multilevel marketing company that established and completely controls this nonprofit. Participants in the program live in the home free of charge but pay the normal fees up to the company typical of these pyramid schemes multilevel marketing arrangements. And don’t worry, if you were worried about whether these formally homeless or indigent participants would fail to pay this wonderful company their fees, the company’s interests are protected. Participants would actually need to deposit their sales into specific savings accounts to allow the residents to save up for obtaining their own housing, and the non-profit would have access to accounts and impose infractions for unauthorized withdrawals. (I wish I was making this up…)

Finally, in my favorite line from the ruling, the applicant represented that the program operated by the multilevel marketing was “the only and perfect way to achieve the goals of (the charity)”.

But wait, you might ask, why do these people have to work with this particular company? Shouldn’t a charity let its participants work with any company they want if it will help address their financial needs? Well, yes, you, I, and the IRS agree on this point. There are certainly ways to conduct activities where non-profit constituents may also end up engaging with the for-profit affiliate, but there is always some risk there… and it gets extremely risky if dealing with the for-profit is a requirement to receive the services of a non-profit. While you might believe that your company is the “only and perfect way” for the non-profit to achieve its mission, I would encourage organizations considering a for-profit and non-profit affiliate structure to come up with a better answer than that.

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At this point, you might be wondering whether your organization can learn anything from an organization that was planning on:

• Scooping up homeless and other indigent individuals;

• Putting them in a home together and brainwashing persuading them to pay to become salespeople for a multi-level marketing company,

• Charging them a fee for that initiation on top of the fees that all salespeople pay up the chain;

• Taking control of their finances and charging them money for non-compliance, and

• Having their conscripted army of indigent salespersons produce videos, op-eds, and go canvassing door-to-door to campaign in support of the company’s chosen candidates or in opposition to the company’s political enemies.

Honestly, I hope you knew this was not OK. But, this ruling is at least a reminder that (1) your organization cannot engage in partisan election activity, (2) the for-profit and non-profit affiliate relationship often involves some degree of risk and you need meaningful guardrails, and (3) it is crazy out there.