IRS insights and a warning from the state AG

NONPROFIT NEWS

In May, the IRS confirmed its continued suspicion of the development and distribution of open source software as a charitable or educational activity within the meaning of Section 501(c)(3) in a final denial of an application for exemption by an organization engaging in such activities. The IRS also recently issued two new Issue Snapshots on nuanced tax issues applicable to exempt organizations relating to the excess business holdings rules and the deductibility of gaming proceeds as a business expense for purposes of the unrelated business income tax rules. Finally, the California attorney general indicated that he may be focusing on nonprofits that operate in California and engage in impermissible political campaign activities, signaling that the IRS may not be the only regulatory body concerned with such activities.

Open Source Software: Charitable or Not?

While there are certain activities that it would be hard to deny are charitable in nature, others have proven more controversial. One such activity that the IRS has continued to view with suspicion is the provision of free and open source software.

At the end of April, the IRS issued a final adverse determination finding that an applicant for exemption under Section 501(c)(3) was not operated exclusively for exempt purposes within the meaning of Section 501(c)(3). One of the organization's stated purposes was to "encourage, support, and advance the education of the free and open source ... application to professional and hobbyist software developers" in a particular geographic region. The determination further stated that the software at issue is a "Free and Open source software (FOSS) project that is available to any person or organization for free .... As a result, [the application] is used by a wide range of organizations including schools, government organizations, corporations, and non-profit organizations."

The IRS stated that the organization was "formed to foster and support the development of, access to, and adoption of [the application] as an open source ... , which is not an exempt purpose." Because these activities related to the open source software represented more than an insubstantial part of the organization's overall activities, the IRS determined that the organization did not satisfy the operational test, which requires an organization exempt under Section 501(c)(3) to be operated primarily for one or more exempt purposes, and was therefore not qualified for exemption under Section 501(c)(3). The IRS also stated, "Although [the application] is available for free, the provision of goods or services to the public does not further a charitable purpose itself nor is [the application] directed toward benefiting a charitable class." It also went on to find that the organization served the private interests of its members and that its educational activities were incidental to its primary purpose of software development.

When it comes to the development of open source software, the IRS appears to be concerned with the possibility of abuse of such software, such as with it being used to primarily benefit private individuals or entities or with individuals financing ventures through exempt organizations under the guise of charitable activity, but which may actually be intended to benefit them directly. On several occasions, the IRS has found that the provision of open source software to everyone for free is not inherently a charitable or educational activity within the meaning of Section 501(c)(3) and that such activities essentially boil down to providing a product that may be used for whatever purpose individuals see fit. This latest denial appears to show that the concerns of the IRS with respect to open source software have not been alleviated.

CA Attorney General Crackdown on Political Activity

As I've written about in this column several times in the past, Donald Trump and the Republican Party have recently made repeated calls for a repeal or softening of the prohibition on organizations recognized as exempt under IRC Section 501(c)(3) intervening in political campaigns. Trump also signed the "Promoting Free Speech and Religious Liberty" executive order at the beginning of May, which the White House described (many think inaccurately) as stopping "the IRS from revoking a church's or nonprofit's tax-exempt status if it chooses to support a political cause." However, just because the landscape on political activity for 501(c)(3)s may (or may not) be changing at the federal level in the near future does not mean that such organizations should let down their guard on this issue.

In early May, California Attorney General Xavier Becerra announced his intent to pursue nonprofits that are believed to be abusing their nonprofit status for political purposes. During a press conference marking his first 100 days in office, Becerra stated "The last thing I think most people want to find out is that all these groups that are getting tax breaks because they are not-for-profit are actually going out there and influencing our political system." Becerra did not specify which nonprofit entities he was referring to, and it should be noted that some nonprofits exempt under sections of the Internal Revenue Code other than Section 501(c)(3) (for example, 501(c)(4) social welfare organizations) are permitted under federal tax laws to engage in in political activities.

Nonetheless, Becerra's comments may serve as a warning to nonprofit 501(c)(3) organizations operating in California that the IRS may not be the only regulatory entity they need to be concerned with if engaging in activities that violate the prohibition on campaign intervention. Becerra's position and public warning is consistent with the increased enforcement with respect to nonprofits we've generally seen from some state regulatory agencies in recent years, perhaps as a response to the decreased funding, and resulting decreased enforcement capacity, of the IRS.

New IRS Issue Snapshots

The IRS occasionally issues summaries on rules applicable to tax-exempt and government entities, referred to as Issue Snapshots. While the Issue Snapshots are intended as aids for IRS employees in reviewing technical tax issues and may not be relied upon as official pronouncements of law, they can be useful tools for private practitioners in this field on the nuanced issues addressed.

In April, the IRS released two new Issue Snapshots: one on IRC Section 4943 -- Tax on excess business holdings and one on Deductibility of Contributions From Gaming Proceeds as Section 162 Business Expenses for Calculation of Unrelated Business Taxable Income by an Exempt Organization.

Under IRC Section 4943, an excise tax is imposed on private foundations, donor advised funds, and certain IRC Section 509(a)(3) supporting organizations that retain excess business holdings in business enterprises, subject to certain exceptions. The excess business holdings rules were intended to protect against an individual retaining control of a business enterprise by establishing a private foundation and transferring significant ownership of the business enterprise to the private foundation.

Under IRC Section 511, a tax at the general corporate rate is imposed on the taxable income generated from unrelated businesses of most organizations that are exempt from taxation by reason of IRC Section 501(a). IRC Section 513(a) clarifies that "unrelated trade or business" in this context means "any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501," and lists certain exceptions. The second Issue Snapshot discusses the deductibility of contributions and expenditures an exempt organization makes from gaming proceeds as an ordinary and necessary business expense under IRC Section 162 when the organization is required (generally under applicable state law) to make such contributions to a charity in order to retain its gaming license.