A recent IRS private letter ruling (PLR 202306009) should serve as a reminder that nonprofit organizations could lose their tax-exempt status for payments made to a related for-profit organization if they are not operating at arm’s length. In this instance, the charity had contracted with a management services organization (MSO) operated by a former officer and his wife without seeking competitive bids.

Unfortunately, the PLR is heavily redacted, with such things as the names of the parties, all identifying information and the terms of the management services contract at issue having been removed from the ruling. The absence of these details makes it hard to analyze the specifics of the ruling beyond the IRS finding that the nonprofit’s decision to contract with an MSO operated by the charity’s founder, and executive director and his wife, without seeking competing bids cost the organization its §501(c)(3) status despite the board’s claim it looked at the terms of similar agreements before agreeing to the contract.

Charity provided foster care services
The unnamed charity provides foster care services that include child placement, counseling and training, and the IRS acknowledged that it was pursuing a qualifying charitable purpose. However, after operating for several years, the founder and executive director of the charity and his wife formed a for-profit MSO to provide services to the charity and, possibly, to other organizations. The MSO was organized as an S corporation that listed the wife as the sole director.

The charity’s board approved the agreement between the charity and the MSO. While the board looked at comparable arrangements and performed market research, it did not engage in a competitive bidding process. The length of the agreement was redacted from the ruling, as was the compensation provided to the MSO. However, it did say that the contract was initially for a below-market amount due to the charity’s inability to pay, but was subsequently increased twice.

Despite the heavy redactions, the IRS clearly found the charity pays “a substantial amount of money” to the MSO, which pays salaries and distributions to the founder and his wife, along with their trusts. It also states that, without the contract in question, the MSO would not be a going concern.

IRS applies organizational, operational tests
The IRS applied an organizational and an operational test to the charity before concluding it should lose its exempt status. The IRS said the charity passed the organizational test because it was organized to provide for placing children in foster homes, adoption services, and counseling and training to foster parents. However, the IRS found it failed the operational test because part of the charity’s earnings inured to the benefit of private shareholders or individuals and provide a private benefit rather than serving the public’s interest.

In making its decision, the IRS found the charity’s circumstances were similar to those addressed by the U.S. Court of Appeals for the 9th Circuit’s ruling on Church by Mail v. Comm’r, No. 84-7663 (9th Cir. 1985). In that case, the court found the key operational question was not whether a charity’s contractual payments to a related for-profit organization were excessive, but rather the entire enterprise is carried out in a manner whether the for-profit organization benefits substantially, despite the fact the charity may be furthering an exempt purpose.

The IRS also made the following findings:

• At the time the management agreement was negotiated, the founder and his wife both held a personal and private interest in the activities of both organizations.
• Since its incorporation, the MSO has been controlled by the executive director and his wife (the IRS cited their ownership share, but the information was redacted).
• The minutes of the board meeting where the contract was approved showed the executive director had considerable input into the terms of the agreement.
• The contract was not an arm’s length transaction.
• The terms of the contract gave the MSO substantial control over the charity’s operations.
• The MSO’s focus on strategic planning and the growth of the charity’s operations, which increased the for-profit organization’s revenue because it was paid a percentage of the charity’s gross revenue.
• The charity was the MSO’s primary client.

The IRS concluded by saying that, as long as the management agreement was in place, the charity will not qualify for an exemption.