The search for value often requires turning over a lot of stones and thinking creatively about structures and capital. In the search, an entrepreneur or investor often comes across an array of tax-exempt entities and considers whether they might be untapped potential resources. Whether it’s a new business idea that might fill a social need or a valuable opportunity to associate with a trusted brand, the nonprofit sector can present appealing options, even while investors lack an understanding of the real limitations of these entities.
But while the strictures on public charities and private foundations (the Internal Revenue Code Section 501(c)(3) class of entities) are fairly well known, other tax-exempt forms are less well understood. Specifically, the entities qualifying under Section 501(c)(4) have drawn a lot of attention as social welfare organizations – those civic leagues and organizations described as “operated exclusively for the promotion of social welfare” and for “the general welfare of the people of the community” under Treasury regulations.
What attracts the attention of both for-profit and nonprofit (i.e., 501(c)(3)) organizations is the ability of 501(c)(4) organizations to engage in some practices that are prohibited for 501(c)(3) entities, such as conducting an unlimited amount of lobbying and engaging in political campaign activities. In both cases, the activity is permitted to 501(c)(4)s provided that it’s not the primary purpose of the organization. However, identifying the primary purpose of an organization’s activities remains an inquiry that is based on all the facts and circumstances, and popular perception often overlooks this requirement.
Similar to the wider allowance of political and lobbying activity, the 501(c)(4) form has also historically had more flexibility in what qualified as a purpose that promoted social welfare and the good of the community. Once a qualifying community benefit is established, its exemption, for the most part, is not jeopardized by undertaking other activities as long as that social welfare purpose is the primary function of the organization. Much of this is predicated on the lack of a firm definition of “social welfare” and the broad explanation that these organizations provide for “common good and general welfare” and “civic betterments and social improvements” along the lines described in regulations. While the standard for tax-exempt status is to operate “exclusively” for the promotion of social welfare, the practice has been to define “exclusively” as being met when the organization is primarily engaged in activities that promote the common good and general welfare of people in the community. As a result, some organizations take a liberal interpretation of what is covered by the social welfare umbrella for purposes that would otherwise most likely fail to qualify as tax-exempt under Section 501(c)(3), and then they cobble together other activities that are generally beneficial but sometimes overly narrow in those they benefit.
In fact, this broad construction approach needs to be closely examined if a component of a proposed or existing business relationship is based on a 501(c)(4) relationship where the benefit to the community resembles activities that would normally be the domain of non-tax-exempt (i.e., for-profit) businesses. One common example comes from organizations claiming a social welfare purpose because they serve the “promotion of health” by offering health care, pharmaceutical or health-related services outside an organization that otherwise qualifies as a 501(c)(3). Other examples might be the provision of services to members, even members that are nonprofits, and to individuals who resemble a customer base more closely than the community as a whole.
A hypothetical example might include an entrepreneur who develops a database and tracking system to manage the maintenance and upkeep of real estate holdings. The entrepreneur decides to put the software services in a 501(c)(4), making it available to low- and moderate-income housing units, many of which are maintained and operated by nonprofit organizations. He or she reasons that the organization benefits the community because it makes it possible to improve the maintenance and upkeep of low-income housing. Maybe our entrepreneur also licenses the services to for-profit real estate managers for a higher fee, funneling the licensing profits back into the development of more features that benefit both nonprofit and for-profit housing managers. While the purpose of the organization may be meritorious, the facts, only slightly embellished here, mirror a revenue ruling explicitly determining that the organization did not qualify for 501(c)(4) status.
Unlike in the for-profit sector, what makes a purpose or activity one that serves the community goes beyond just meeting a market need. The key principle is that the organization’s activities provide a benefit to the community at large, as opposed to a group of members or select individuals. As a result, many goods and services that provide a market benefit to those individuals whose needs are met by those things being provided will not meet the threshold set for a community benefit in the context of a tax-exempt organization. Recent tax determinations and court cases have rejected tax-exempt organizations when the benefit included providing health care coordination services, pharmaceuticals, management consulting and software services. In many of these cases, the IRS has increasingly taken the position that the “exclusive” requirement more closely resembles the standard applied to 501(c)(3) organizations than the more-malleable popular perception that 501(c)(4) organizations have gained.
In the run-up to an election year, the usual focus for 501(c)(4) organizations is on the amount of political activity these organizations engage in. While these organizations’ political activities have recently drawn the attention of the House Committee on Ways and Means, business investors should also be aware that these organizations also crop up in conjunction with organizations and individuals interested in the seemingly greater capacity of these organizations to engage in activities that are tangential to or only loosely qualify as a social welfare purpose.
This trend in recent denials and decisions against 501(c)(4) organizations because they represent typical business purposes may signal increased attention to the social welfare purposes of 501(c)(4)s. As always, business transactions that involve or relate to tax-exempt entities require both close scrutiny and assistance from counsel with significant tax-exempt experience.
Meet the Author
Jennifer Gniady co-chairs Stradley Ronon’s nonprofit & religious organizations practice group, bringing together more than two dozen lawyers across a broad range of legal disciplines to serve these unique clients. She has spent more than 15 years counseling nonprofit organizations on how to respond to threats, solve problems and plan for the future. Her clients include charities, religious organizations, associations, schools and organizations promoting the arts, media, science and technology.