The United States (US) Internal Revenue Code (IRC) exempts from federal income taxation certain organizations operated exclusively for charitable and other exempt purposes. An organization seeking tax exempt status must apply for recognition as such before the Internal Revenue Service (form 1023). An interesting question is whether e-commerce sites operated for charitable purposes can obtain federal tax exempt status. The Internal Revenue Service (IRS) will consider the IRC rules and apply some tests to determine whether an organization qualifies for this exemption. In a 2004-Private Letter Ruling, the IRS held that a publishing e-commerce site did not qualify for tax exemption because it was not exclusively operated for a charitable or exempt purpose.
The IRC § 501(c) lists those federal income taxation exempted organizations (28 in total), i.e., credit unions; religious, educational, and charitable institutions; non-profit organizations; fraternal beneficiary societies; recreational club organizations; mutual insurance companies; and veterans organizations, among others. An important requirement to qualify for tax exemption under § 501(c) is that no part of the corporation, trust, or association benefits can inure to a private shareholder or individual. Indeed, the organization must serve a public interest rather than a private interest benefiting a family, shareholder, or individual. The organization must be created and "operate exclusively" for one or several of the exempt purposes described by the law. IRC § 1.501 (c)(3)(1)(a). However, the exempt purpose cannot be an insubstantial part of the organization's activities. A 501(c) organization may involve in trade or business if that is required to carry on the organizations' one or more exempt purposes. Thus, can a website created and operated to sell goods for the benefit a charity or non-profit cause be tax exempted? Or can a website selling advertising and giving its profits to non-profit organizations qualify for a 501(c) status?
The IRS reviews tax exempt status in a case-by-case basis. Thus, the company's articles of incorporation and specific facts are determinative in each case. Private Letters Rulings are powerful tools to be used by attorneys and those seeking 501(c)-status but, obviously, they are not controlling law. IRS Private Letter Ruling 200508017, November 9, 2004, ruled on the application of 501(c)-status by an e-commerce company that served as the advertising portal for merchants and whose proceeds were given to non-profits organizations.
The applicant for tax exempt status was company M.com, an e-commerce Internet website that served as portal for online merchants. M.com posted banners, links, and other promotional items to attract purchasers for those merchants advertising in its site. Vendors in M.com agreed to donate a percentage of their proceeds from the sale of goods and services to non-profit organizations selected by the purchaser of the goods or services. M.com's article of incorporation also noted that they were incorporated for any or all lawful business for which non-profit corporations may be incorporated under the laws of state X.
Purchasers went to M.com site, bought goods or acquired services, and selected a non-profit organization. M.com received a commission from the merchant's sale. This commission was managed by four "affiliate management" companies that every quarter distributed them to M.com, which in turn gave its commission to the participant non-profit organizations. M.com acted as an advertiser for the merchants and the affiliate management companies were "pay-for-performance" network advertising agencies. They gathered information about M.com's purchasers and distributed the vendor's commission to M.com. How did M.com survive if its commission was given to non-profit organizations? M.com stated in his tax exempt application that it derived financial support from sponsorship, special fundraising events, and the sale of promotional items. Some of M.com directors were employed by the affiliate management companies and provided their services to M.com without compensation.
The IRS analyzed this corporate structure and determined that M.com does not qualify for tax exempt status under § 501(c). The IRS applied the so-called Organizational and Operational Test to reach its conclusion. The Organizational Test requires that the articles of incorporation of a tax exempt organization limit its purpose to one or more exempt purposes specified in § 501(c). M.com's articles of incorporation stated that the corporation was to perform any lawful charitable purpose recognized by its state. Thus, M.com's articles of incorporation violated this Organizational Test for lack of specificity. In applying the Operational Test, the IRS first analyzed whether M.com's primary purpose was an unrelated trade and business. The IRS concluded that M.com was operated for the primary purpose of carrying on an unrelated trade or business and it did not operate exclusively for an exempt purpose specified in § 501(c). Hence, the IRS recognized, M.com fell within the feeder provision of IRC § 502. This section states that an organization conducting an unrelated trade and business and giving all its proceeds to charitable purposes does not qualify for tax exempt status under 501(c). Second, and within the Operational Test analysis, the IRS inquired on the private benefit requirement. The IRS held that M.com provided substantial, no incidental, benefits to private parties. Although M.com donated its vendors' commissions to charity, those donations were insubstantial compared to M.com's substantial benefits from their advertisers.
This Private Letter Ruling is an accurate example of tax exempt corporate structures being transferred to the online world. Off-line tax exempt corporate structures are complex in nature- specially offshore structures- and it is interesting to see how they are now playing their role in cyberspace- Cyberspace Tax Puzzles.