Vicarious Tax Exemption: Is Your “Non-Profit” At Risk of Being Taxed On Its Income?

As organizations are ramping up for 2016, it is increasingly important they have their administrative ducks in a row for the year to come.  This is especially true for tax-exempt organizations operating under a model using local chapters or affiliates (as opposed to wholly-owned organizations), and even more so if those local chapters or affiliates are relying on their central organization for tax-exempt status.  If the local chapter or affiliate does not comply with IRS regulations governing such a structure, it may lose its tax-exempt status and be taxed on its income as if it were a taxable corporation.

Excluding certain religious, and other eleemosynary organizations, tax-exempt organizations with at least $5,000 in annual gross receipts must register with the IRS.  However, if an organization desires to obtain tax-exempt status through its affiliation with an organization that has already registered as a tax-exempt organization, it can do so through one of two ways.  The safest of these two options requires the central organization to apply for a “group exemption.”  Alternatively, the central organization and its  affiliates/local chapters may rely on the judicially-developed “integral part doctrine”.

Group Exemption Letter

Group exemption letters are rulings or determination letters issued by the IRS to central organizations, recognizing on a group basis the exemption under Internal Revenue Code Section 501(c) of subordinate organizations on whose behalf the central organization has applied for recognition of exemption.  An exempt organization with subordinates can request a group exemption letter on behalf of those subordinate organizations, but must obtain its own exemption before or with the group exemption.  The benefits to an affiliate organization of a group exemption include:

  • Exclusion from filing Form 1023 (or Form 1024), Application for Recognition of Exemption;
  • The ability (but not the requirement) to be included in a group Form 990 return and thus avoid filing a separate Form 990;
  • Enjoyment of the goodwill resulting from affiliation with the central organization; and
  • Avoidance of the uncertainties of an advance ruling period from the IRS.

In addition to providing information about itself, the central organization must provide a myriad of information about the subordinates it wishes to include in its group exemption letter.  For purposes of applying for group exemption, a “subordinate organization” is a chapter, local, post, or unit of a central organization.  A central organization may be a subordinate itself, such as a state organization that has subordinate units and is itself affiliated with a national (central) organization.  A subordinate organization may or may not be incorporated, but it must have an organization document, such as articles of incorporation.

Integral Part Doctrine

Generally, separate entities must each qualify for tax exemption on their own.  However, several courts have recognized an exception to the general rule, referred to as the “integral part doctrine”.  Under this rule, if an organization’s sole activity is an “integral part” of an exempt affiliate’s activities, the organization may derive its exemption from its affiliate.  This provides a means by which an organization may qualify for exemption vicariously through a related organization, provided it is engaged in activities which would be exempt if the related organization engaged in them, and as long as those activities are furthering the exempt purpose of the related organization.

Unlike a group exemption letter, which requires a more proactive approach by the central organization with the IRS, the integral part doctrine holds that an entity may achieve tax-exempt status if its activities (1) are an integral part of another exempt organization, and (2) they further the exempt purpose of the other organization.  The integral part doctrine applies even though the separate organization’s activities do not by themselves justify exempt status.  The United States Tax Court has ruled, however, that an organization which incorporates separately (from the central organization) has to accept the consequences of its separate status, and may not benefit from a vicarious tax-exemption through the integral part doctrine.  In another case, the Tax Court concluded that in order for the organization to benefit from its tax-exempt affiliate, it must be under the supervision or control of such affiliate or otherwise limited in its purpose to advancing the interests of the exempt affiliate, and does not serve private interests.

Although operating as a tax-exempt organization under the integral part doctrine is more passive in nature than applying for a group exemption letter directly with the IRS, there is an audit risk.  There are steps an organization should consider to tip the scales in its favor if the structure of the organization is called into question.  Whether the integral part doctrine applies depends on the facts and circumstances surrounding the particular organization being questioned, and while the factors mentioned above are indicators, each taxpayer must analyze their core purpose, and how its affiliates interact with one another.

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