Private Foundation Loses Exempt Status

 An IRS Warning to Private Foundation Directors

A private foundation recently had its exempt status revoked by the IRS.  This ruling (TAM 201438034) serves as a pointed reminder to private foundation directors that exempt status can be revoked if the IRS determines that organization materially changed its original charitable exempt purpose.


The Private Foundation’s Orginal Mission: A Private School

In the ruling, the foundation was originally granted exemption to operate a private school.  However, the foundation’s home state subsequently passed legislation permitting formation of charter schools.  Based on the limited facts in the ruling, it appears the foundation then switched gears. It stopped operating its own private school, and began to look for ways to facilitate the growth of charter schools in the area.

The Private Foundation’s “Evolved” Mission: A Landlord for Charter Schools

Over the years, the foundation became adept at locating, purchasing and renovating suitable properties for new school facilities.  Then the foundation would sell or, in most cases, lease the properties to organizations operating charter schools.

The foundation would take a piece of the deal or collect rents, in order to fund its continued operations.  Eventually, the foundation began to accumulate a cash surplus due to its success.  It used at least part of this surplus to fund a summer camp for kids.

The foundation’s rationale for switching gears was compelling:  it could serve a few hundred children as a private school or benefit 10,000 students in six states with the charter school program.

IRS Revokes Exempt Status

Yet, the IRS revoked its exempt status.  The basis for the revocation was that the foundation’s revised activities were not only substantially different from the original stated purpose in the exemption application, but they were in the end commercial activities.

The IRS commented that operating a school for a body of enrolled students is a well-recognized exempt purpose.  But, the purchase, sale, and lease of real estate is generally not.  Not helping the cause in this case is the fact that none of the foundation’s charter school “clients” were exempt organizations.

To the IRS, this case boiled down to:  the foundation was buying properties and then selling or leasing real estate to for-profit companies.  The IRS declared this activity non-exempt.

The fact that the foundation’s tenants and business partners were schools did not help the foundation’s case.  The IRS simply noted that they were non-exempt entities, and questioned whether these activities would constitute an exempt purpose even if the schools were exempt organizations.  The foundation tried to lean on the schools’ quasi-governmental status, these schools were not in fact operated or maintained by any government agency.

The IRS noted that it is acceptable for an exempt organization to carry on certain commercial activities that are incidental or an integral part of the exempt activity.  One (strange) example given in the ruling was a university that operates and maintains a power plant via its subsidiary.  However, the IRS found that the leasing activity carried on in this case was the primary activity and not an incidental activity and not integral to the stated primary purpose of the entity, which was to conduct a private school.

Or, the ruling noted, if an integral part of the exempt organization’s activities is to assist other exempt organizations by, for example, leasing at below market rates to the other entities, then such activities could be deemed reasonable and part of an exempt purpose.  That example did not match the facts here.

Competing With For-Profit Enterprises

What seemed to be a critical component in this case is the IRS belief that the foundation was competing with for-profit entities performing the same services for charter schools.  The IRS noted that exempt status cannot be used to achieve advantage over private enterprise.

In the end the private foundation exempt status was revoked.  Painfully, the revocation was retroactive several years all the way back to the time at which the private school had ceased to operate. Presumably there will be considerable income tax and/or penalties payable by this organization.

Lessons Learned

This ruling provides the following critical reminders to families operating private foundations:

  1. Any exempt organization that strays from its original exempt purpose should automatically re-evaluate its exempt purposes and perhaps consider submitting a revised form 1023.
  2. Exempt organizations that are engaged in “commercial” activities need to evaluate whether those activities are an integral part of the stated exempt purpose or alternatively an incidental activity.
  3. Specifically, exempt organizations engaged in buying, selling or leasing out real estate should carefully evaluate whether they are conducting commercial activities, and whether those activities can be considered an integral part of the stated exempt purpose or alternatively an incidental activity

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About Oakstone Law, PL

Oakstone Law PL was founded by Bob Kleinknecht. A member of the Family Trust Subcommittee, the Estate Tax & Trust Planning (ETTP) Committee and the Real Property, Probate & Trust Law (RPPTL) Section of the Florida Bar, Kleinknecht has 15 years’ experience.

Prior to founding Oakstone law, he spent more than eight years serving as a personal, in-house estate, tax and charitable planning attorney for a Forbes 400 family in New York and Florida. Before that he was an estate planning and estate settlement attorney with prominent firms in Boston and Washington, D.C. after beginning his career with a boutique firm in Naples, Florida.

Licensed in Florida and Massachusetts, Kleinknecht has developed a practice model that eliminates billing by the hour and offers a streamlined, customized client process supported by technology, security and a personal approach.

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