IRS Asserts Commerciality Doctrine

For many years, courts have applied the commerciality doctrine in determining whether organizations were operated in accordance with Sec. 501(c)(3). A new case indicates that the doctrine is still viable.

Facts

Airlie Foundation, DC DC, 9/24/03, involved an interesting organization that had long battled the IRS. The organization operates a conference center outside of Washington, DC. Its purpose is to conduct scientific research, primarily by sponsoring meetings of scientists, administrators, scholars and others. At one time, it had been granted exempt status. However, in 1988, the IRS revoked that status due to inurement to its founder and commercial operations. In 1993, a district court finally upheld the IRS determination, solely on the basis of inurement; see Airlie Foundation, 826 FSupp 537 (DC DC 1993), affd, 55 F3d 684 (DC Cir. 1995).

In 1999, the foundation reapplied for Sec. 501(c)(3) status under a new administration. The Service again held that the conference center was operated for commercial purposes and denied the application in 2002. The foundation filed for a declaratory judgment against the IRS in the case at issue.

Analysis

The court found that the IRS was correctthe foundation operated the center in a commercial manner. The foundation argued that it often subsidized the use of the center, either completely or by granting discounts and that it did not operate in the same manner as nearby commercial conference facilities. To support its contention, it showed that in 1999, it fully subsidized 4.75% of events and partially subsidized another 12.5%. However, the facts also showed that 3040% of the events were of a private or corporate nature. Another 20% were held by government agencies and the balance by nonprofit or educational entities. The foundation showed that its profit margins were below those of its taxable competitors.

The court looked to the organizational and operational tests to determine whether the foundation qualified for Sec. 501(c)(3) status. It clearly met the organizational test by virtue of the language in its organizing documents. However, the operational test requires that the foundation operate primarily to accomplish its exempt purposes. The commerciality doctrine provides that operating in a commercial manner will violate the operational test. Among the factors that courts consider are competition, the extent of below-cost services and charitable donations, pricing policies and the level of advertising.

Applying these factors to the foundation, the court found that while discounts were granted in more than 17% of the events, resulting in below-cost services, the balance of the events were priced in a commercial manner. Further, the foundation maintained a commercial website, paid significant advertising and promotional expenses and competed regularly with commercial conference centers in the area.

Conclusion

This case clearly shows that commercial activities represent a threat to exempt organizations. It is not enough that they under-price the competition; to operate in a noncommercial manner, organizations must provide services at substantially below cost, preferably to charitable recipients. While they can charge, the operations must clearly demonstrate an exempt purpose.

From Harvey J. Berger, Vienna, VA