Internal Revenue Manual - 4.76.3 Public Charities (Cont. 1)

Part 4. Examining Process
Chapter 76. Exempt Organizations Examination Guidelines
Section 3. Public Charities (Cont. 1)

4.76.3.11
Inurement, Private Benefit and Excess Benefit Transactions (IRC § 4958)

4.76.3.11.3 (04-01-2003)
Private Benefit

The private benefit standard does not derive its authority from the portion of the statute prohibiting inurement of net earnings. Rather, it is based on the operational test in IRC § 501(c)(3) requiring an organization to operate exclusively for exempt purposes. However, "operated exclusively" has two meanings, both of which are contained in Treas. Reg. § 1.501(c)(3)-1(c)(1). It provides that an organization will be regarded as operated exclusively only if it engages "primarily" in activities that accomplish one or more exempt purposes such as those specified in IRC § 501(c)(3) and that it will not be so regarded if more than an "insubstantial" part of its activities does not further an exempt purpose.
Furthermore, Treas. Reg. § 1.501(c)(3)-1(d)(1)(ii) holds that an organization is not organized or operated exclusively for one or more exempt purposes unless it serves a public rather than a private interest. Therefore the activities of an organization exempt under IRC § 501(c)(3) must benefit the general public in a way that distinguishes it from a for-profit corporation, the latter of which serves shareholders (private interests). Serving the public is a basic tenet of the law of charity whose purpose is to ensure that those who constitute the "public" benefit equally.
Treas. Reg. § 1.501(c)(3)-1(d)(1)(ii) goes on to specify the organization must establish it is not organized or operated for the benefit of private interests, "such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests. " If the organization's founder, his family, or persons in control ("insiders" ) benefit in some way (typically economically, which involves net earnings), it would result in the inurement proscription. Consequently, it can be said that all inurement is also private benefit.
On the other hand, if other individuals or entities not classified as insiders receive a benefit that does not further the organization's exempt purposes, the result is "private benefit." The beneficiaries are not insiders who are in control, but they benefit in some manner that is not considered public either. Thus, it can be said that not all private benefit is inurement.
To identify and develop the issue, the examiner must analyze whether the benefit conferred is classified as inurement (recipient is an insider) or as private benefit (recipient is an outsider). This is a functional test of sorts. The examiner must look to the reality of who is in control of the organization and its operations from within, rather than a person's or entity's place on an organizational chart. An insider can be the founder, his family, an employee, a board of directors member, a related corporation, or even a fund-raiser. On the other hand, an outsider can be a specified individual, a class of individuals, a for-profit corporation, a joint venture, or a fund-raiser. Consider the court's finding in the following cases.

Example:

United Cancer Council v. Commissioner, 165 F.3d 1173 (7th Cir. 1999). The court reversed and remanded the Tax Court's ruling to uphold revocation of an organization exempt under IRC § 501(c)(3) based on inurement. It found nothing in the facts to support the fund-raisers seizing control of the exempt organization, thereby becoming an insider, triggering the inurement provision, and destroying exemption. The court stated there was no diversion of charitable earnings to board members or other insiders. The court pondered a different argument: suppose the exempt organization paid the fund-raiser twice as much as it actually charged for its services, so half of the annual fund-raising expense was like a gift to the fund-raiser. Then it could be argued the organization was operated substantially for the private benefit of the fund-raiser. The court suggested applying the tax law in this way could address the problem of a charitable organization's expenditures that are extravagant but do not inure to the benefit of insiders. "That in fact is the IRS's alternative ground for revoking the exemption."

Example:

Redlands Surgical Services v. Commissioner , 113 T.C. 47 (1999), aff'd, 242 F.3d 904 (9th Cir. 2001). At issue was whether Redlands Surgical Services should be recognized as exempt from Federal income tax based on its activities. The entity was a wholly owned subsidiary of an exempt health care system. It participated as co-general partner with a for-profit corporation; the latter was general partner of a partnership that operated an ambulatory surgery center. The organization argued it met the operational test under IRC. § 501(c)(3) because its surgery center activities furthered exempt purposes by promoting health and providing access to surgical care for the community based on medical need, not the ability to pay. The Service contended that it was not operated exclusively for charitable purposes because it operated for the benefit of private parties and failed to benefit a broad cross-section of the community. Based on all the facts and circumstances, the court held that the organization had ceded effective control of the partnerships' and the surgery center's activities to for-profit parties, conferring significant private benefits on them. Therefore, it was not operated exclusively for charitable purposes within the meaning of IRC. § 501(c)(3)

Example:

Retired Teachers Legal Defense Fund, Inc. v. Commissioner, 78 T.C. 280 (1982). At issue was whether the organization was organized and operated exclusively for one or more exempt purposes within the meaning of IRC § 501(c)(3) or served private interests. Membership for a fee was open to any retiree of the New York City Teachers' Retirement System receiving a pension, of whom there were approximately 25,000. The organization argued that "benefit," as used in Treas. Reg. § 1.501(c)(3)-1(d)(1)(ii), is vague and contains no guidelines. The court disagreed, citing the Black's Law Dictionary definition as "advantage; profit; fruit; privilege; gain; interest." The court stated the organization ignored "private" as used in conjunction with "benefit" in the Treasury Regulations. The fundamental reason for granting an organization tax exemption is that it serves a public benefit...The [beneficiaries] of petitioner's organization and operation are the retirees of the system. Although approximately one-third of its members are poor and disabled, and although the term "charitable" includes "relief of the poor and distressed" , over two-thirds of its members do not fall within this classification. Thus, the organization was denied recognition as exempt under IRC § 501(c)(3).
The Treasury Regulations regarding the private benefit doctrine do not speak to net earnings but rather to exempt purposes, which are inferred from the type of activities it carries out and for whom. For example, a common private benefit issue involves a charitable organization's requiring a membership, and only those who pay to become members are granted the rights to its benefits. If it provides benefits only to the members who paid for these privileges, the result is a select group set apart from the public, and private benefit may result. However, if the organization provides the benefits (providing they are charitable) to anyone without a membership requirement, a special group does not exist. Thus, the organization's benefits serve the public, and there likely is no private benefit issue.
On the other hand, sometimes a public charity by its very nature benefits particular individuals in order to achieve its charitable purposes. The courts have recognized that a single activity can serve both an exempt and a nonexempt purpose. For example, an educational organization confers primary private benefit by instructing or training an individual for the purpose of improving and developing his or her capabilities. (See Bob Jones University v. United States, 103 S. Ct. 2017 and the cases cited therein.) A hospital confers private benefit on an individual patient through the process of health care. This type of private benefit is often referred to as "incidental " or "permissible." To be incidental, a private benefit must occur as a necessary result of the activity that benefits the public at large. In other words, the benefit to the public cannot be achieved without indirectly or unintentionally benefitting private individuals.
Even if a certain amount of incidental or permissible private benefit is allowed without jeopardizing exempt status, the issue sometimes arises of how much is too much. If an organization is carrying out its exempt purposes for the benefit of the public yet private benefit is present, the examiner must weigh all facts and circumstances.
Private benefit conferred by an activity must be balanced only against the public benefit conferred by that activity or arrangement, not the overall good accomplished by the organization. Therefore, the examiner must first identify how and to what degree the activity benefits the public, followed by determining if the private benefit is an unavoidable side effect of the activity. If the public benefit outweighs the indirect private benefit, it can be considered permissible. However, if an argument can be made that the activity's public benefit is subordinate to private benefit, then the private benefit can destroy exemption.

Example:

Sonora Community Hosp. v. Commissioner, 46 T.C. 519 (1966), aff'd, 397 F.2d 814 (9th Cir. 1968). The court considered whether more than incidental private benefit accrued to physicians from the activities of a hospital. Two doctors who previously had owned and founded the hospital facilities in question shared in the fees from the privately-operated laboratory and x-ray departments within the hospital, even though they performed no associated services. The Tax Court ruled this demonstrated that the hospital was operated to a considerable extent for the private benefit of the two founding doctors, rather than exclusively as a charitable organization. The court found it unnecessary to decide whether the arrangement constituted inurement of hospital net earnings to the doctors because it was satisfied the resulting private benefit was enough to prevent exemption.
The examiner also must be able to distinguish between private benefit issues and unrelated taxable business income issues. Unlike private benefit, unrelated trade or business does not normally jeopardize exempt status unless it rises to the level of questioning whether the organization is operated primarily for commercial or exempt purposes. As long it is primarily engaged in related activities, the organization's only consequence is a tax liability for its unrelated business income as imposed by IRC § 511. On the other hand, private benefit can result in revocation regardless of its insubstantiality. Therefore, it is important that the examiner properly identify the classification of a questionable activity.

4.76.3.11.4 (04-01-2003)
IRC § 4958 Intermediate Sanctions

An additional tax is imposed on the disqualified person if correction is not made within the taxable period. The primary objective of IRC § 4958 is to impose a sanction on the influential person involved rather than punish the organization itself by revoking its exempt status, providing it is properly carrying out its exempt purposes otherwise. The section is also meant to encourage correction of the excess benefit transaction.
It is worth emphasizing here that there is nothing to preclude the examiner from proposing assessment of excise taxes on the disqualified person under IRC § 4958 and proposing revocation of the exempt organization if that is his/her determination.
As the examiner will note, the wording and definitions of IRC § 4958 are based on private inurement, not private benefit, which is why making the distinction between the two is imperative to correctly identify the issue.

The taxes IRC § 4958 imposes are summarized as follows:

IRC Section	Rate	Imposed on...	For...
4958(a)(1)	25% ¹	Disqualified person	Engaging in excess benefit transaction
4958(a)(2)	10%²	Organization manager(s)	Knowingly participating in the transaction
4958(b)	200% ¹	Disqualified person	Failure to correct within the taxable period
¹ Percentage of the amount of the excess benefit not corrected
² Limited to $10,000

For rules relating to "abatement" of taxes on an excess benefit transaction that is corrected within the correction period (as defined in IRC § 4963(e)), See IRC §§ 4961(a), 4962(a) and the related Treasury Regulations. By providing for abatement, the Internal Revenue Code encourages the disqualified person to make correction of excess benefits.

Note:

This section is not meant to be all-inclusive on the issue of IRC § 4958 application but rather highlights important concepts for purposes of examination. See IRM 7.27.30 for an in-depth discussion of examination and safe harbor guidelines for taxes on excess benefit transactions.

4.76.3.11.4.1 (04-01-2003)
IRC § 4958 Definitions

As with IRC § 4941, becoming familiar with the terminology used in IRC § 4958 is crucial. Although worded similarly, each section has its own distinctive definitions. Listed below are some of the most important ones in IRC § 4958.
An excess benefit transaction is any economic benefit a disqualified person receives from an applicable exempt organization's net earnings as a result of prohibited inurement. Although IRC § 4958 does not define "economic," Treas. Reg. § 53.4958-4(a)-(1) describes the amount as all consideration and benefits exchanged between a disqualified person and the applicable tax-exempt organization and/or all entities the organization controls. Put simply, excess benefit means the value of the economic benefit the disqualified person received exceeds the value of consideration (cash, property, benefits, or services) the exempt organization received. Only the excess is subject to the initial and additional taxes imposed by IRC § 4958.
An applicable organization is one described in IRC § 501(c)(3) or (4) that was exempt any time in the five-year period before the excess benefit transaction occurred. This is called the "Lookback Rule," and the five-year period is called the "Lookback Period." If the transaction occurred before September 14, 2000, the Lookback Period begins on September 14, 1995 (the effective date of IRC § 4958) and ends on the date the excess benefit transaction occurred. The following are not applicable tax-exempt organizations:
- A private foundation
- A governmental entity not subject to taxation
- A foreign organization exempt under IRC §§ 501(3)(3) or (4) that receives substantially all support from sources outside the United States
- An IRC §§ 501(c)(3) or (4) entity whose exemption was never recognized
- An IRC §§ 501(c)(3) or (4) entity that was revoked (unless the revocation was based on private inurement or private benefit, which could include revocation based on the Lookback Rule).
A disqualified person is any person in a position to exercise substantial influence over the affairs of the organization at anytime in the Lookback Period. It is not necessary that the person actually exercise substantial influence, only that he/she is in a position to do so. Per Treas. Reg. § 53.4958-3, this includes persons who hold any of the following powers, responsibilities, or interests:
- Family members of the disqualified person
- Entities controlled by the disqualified person (owning more than 35 percent voting power)
- A voting member of the governing body
- A person with ultimate responsibility to implement the governing body's decisions, to supervise management, to carry out administration or operation of the organization, i.e., president, chief executive officer, chief operating officer
- A person with ultimate responsibility for managing the finances of the organization, i.e., treasurer, chief financial officer
- Persons with a material financial interest in a provider-sponsored organization
Other persons may or may not meet the definition of disqualified person. Treas. Reg. § 53.49-3(e)(2) gives facts and circumstances that are not all inclusive but tend to show a person does have substantial influence over the organization's affairs:
- The organization's founder
- A substantial contributor
- A person whose compensation is based on revenues from activities of the organization the person controls
- A person who has or shares authority to control a substantial part of the organization's capital expenditures, operating budget, or employees' compensation
- A person who manages activities that are a substantial portion of the organization's overall activities, assets, income or expenses
- A person who owns a controlling interest in a corporation, partnership or trust that is a disqualified person
- A person who is a non-stock organization controlled directly or indirectly by one or more disqualified persons.
A disqualified person is not:
- An IRC 501(c)(3) or (4) organization
- A employee of the organization who receives economic benefit of a specific amount within a taxable year, i.e. $85,000 in 2001, unless that employee is a family member of the disqualified person, someone who can exercise substantial influence (as described), or a substantial contributor to the organization
Treas. Reg. § 53.4958-3(e)(3) gives facts and circumstances that are not all inclusive but tend to show a person does not have substantial influence over the organization's affairs.
A foundation manager is defined in Treas. Reg. § 53.4958-1(d)(2) as any officer, director, or trustee of the organization, or any individual having powers or responsibilities similar to such persons, regardless of title. A person is an officer if its organizing documents (articles of incorporation, bylaws, or other) designate him/her, or if the person regularly exercises authority to make administrative or policy decisions for the organization.
An organization manager participates in an excess benefit transaction knowingly if he/she:
- Has actual knowledge of sufficient facts that the transaction would be an excess benefit transaction
- Is aware the transaction may constitute an excess benefit transaction and
- Negligently fails to make reasonable attempts to determine if the transaction is an excess benefit transaction or is aware it is
There are exceptions to knowing, even if a transaction is subsequently found to be an excess benefit transaction:
- The foundation manager relied on a professional's advice after making full disclosure of all relevant facts
- The foundation manager relied on the fact that the requirements for "rebuttable presumption" of reasonableness have been satisfied.
Willful means the participation was voluntary, conscious and intentional.
Reasonable cause means the organization manager exercised responsibility with ordinary business care and prudence.
If an organization meets three requirements, the transaction is presumed to be reasonable and at fair market value. This is called"rebuttable presumption" , and the requirements are:
- Advance approval by an authorized body
- The authorized body obtained and relied on appropriate comparative data before making the determination
- It concurrently documented the basis for its determination
The taxable period begins when the excess benefit transaction occurred and ends on the earlier of:
1. Mailing a notice of deficiency to the disqualified person regarding the 25% tax, or
2. Assessment of the 25% tax on the disqualified person.
IRC § 4958(f)(6) provides that an excess benefit transaction is "corrected" by undoing it to the extent possible and taking any additional measures necessary to place the organization into a financial position that is not worse than it would be if the disqualified person had acted under the highest fiduciary standards.
IRC § 4961 and Treas. Reg. § 53.4958-1(c)(2)(iii) outline circumstances under which the 25% tax may be abated and the 200% tax must be abated. By providing for abatement, the Internal Revenue Code encourages the disqualified person to make correction of excess benefits.

4.76.3.11.4.2 (04-01-2003)
Statute of Limitation Considerations

The period of limitations for assessing IRC § 4958 excise taxes against the disqualified person and foundation manager begins when the organization files its Form 990 for the period in which the excess benefit transaction occurred or when the Form 990 is due, whichever is later.
The period ends either three years or six years from that date.
Three Years - If the organization filed Form 990 for the period in which the excess benefit transaction occurred and adequately reported the excess benefit on the return, the period of limitations ends three years later.
Six Years - If the organization filed Form 990 for the period in which the excess benefit transaction occurred but did not adequately report the excess benefit transaction on the return, the period of limitations ends six years later.
Note: The Service has the burden of proof as to whether or not the organization's Form 990 was insufficient to apprise the Service of the existence and nature of an excess benefit transaction with a disqualified person and participation by an organization manager. Therefore, the examiner must consult with Area Counsel regarding whether or not the six-year limitations period applies.
Form 990 was not Filed- The period of limitations has not begun to run, so there is no statute date.
Extending the Period of Limitations - Liability for IRC § 4958 excise taxes is that of the disqualified person or foundation manager, each of whom is deemed a separate taxpayer. Therefore, the Service and each disqualified person or foundation manager may agree to extend the period of limitations by executing a separate Form 872. Each 872 relates to each person's own tax year, not the year of the organization. The examiner must be vigilant in recognizing that the period of limitations begins with the filing of Form 990, which may be a different tax year than that of the disqualified person or foundation manager.

4.76.3.11.4.3 (04-01-2003)
Valuation

One of the most difficult jobs for the examiner is to determine if an excess benefit transaction has occurred. Obviously, part of making the determination is to know the value of the transaction itself, which will tell the examiner if it is excessive or not. In general, excess benefit transactions involve the transfer of property or payments for services. If the issue is property (including the right to use property), the Treasury Regulations provide that the value is fair market value for purposes of IRC § 4958. If the issue is compensation, the value is the amount that would ordinarily be paid for like services by like enterprises under like circumstances, otherwise known as "reasonable compensation" . IRC § 162 standards apply in determining reasonableness of compensation.
In the case of fair market value of property, the examiner may want to consider a referral to Engineering. This should be done as early in the development of the issue as possible. See IRM 4.75.13.
To determine if an excess benefit transaction has occurred, the examiner must take into account all consideration and benefits exchanged between a disqualified person and the applicable exempt organization as well as any entities it controls. However, virtually any economic benefits that are excluded from income under IRC § 132 also are disregarded for purposes of IRC § 4958. Treas. Reg. § 53.4958-4(a)(4).
Examples of economic benefits included in determining the value of services rendered and whether the compensation is reasonable or not are:
- Cash and non-cash compensation (salary, fees, bonuses, severance payments, deferred compensation)
- Payment of liability insurance premiums
- Other payments on behalf of the disqualified person (penalties, tax expenses, civil proceeding expenses, expenses resulting from an act or failure to act)
- Other compensatory benefits (expense allowances or reimbursements paid under anonaccountableplan, such as travel or auto expenses)
- Foregone or below-market interest on loans

4.76.3.11.4.4 (04-01-2003)
IRC § 4958 Issues

Though certainly not all-inclusive, the list below shows examples of transactions between an applicable exempt organization and disqualified person that could be IRC § 4958 issues:
- Payment of a disqualified person's personal expenses by the exempt organization
- Use by the disqualified person of the exempt organization's vehicles for personal reasons
- Use by the disqualified person of the exempt organization's real property for personal reasons
- Lease of property owned by the disqualified person to the exempt organization in exchange for rent
- Whether or not amounts received by the disqualified person from the exempt organization are loans
- Whether or not amounts received by the disqualified person from the exempt organization are loan repayments
- Payment of personal expenses for a disqualified person's family members
- Payment of expenses of a for-profit corporation owned by the disqualified person
- Amounts embezzled from an exempt organization by a disqualified person (Treas. Reg. § 53.4958-4(c)(1))
- Revenue-sharing arrangements between the exempt organization and disqualified person
- Transfer of assets from an exempt organization to a for-profit organization controlled by the disqualified person

4.76.3.11.4.5 (03-24-2009)
Hospitals Providing Financial Assistance to Staff Physicians Involving Electronic Health Records

The purpose of this subsection is to provide a directive for handling examination and exemption application cases involving hospitals that provide physicians who have staff privileges at those hospitals ("medical staff physicians" ) with financial assistance to acquire and implement software that is used predominantly for creating, maintaining, transmitting, or receiving electronic health records ("EHR" ) for their patients.
Many hospitals described in IRC 501(c)(3) plan to establish interoperable EHR systems to improve the effectiveness and efficiency of their medical care and to reduce medical errors. Some hospitals believe that their medical staff physicians need a financial incentive to acquire and implement EHR software that would allow the physicians to connect to the hospitals’ EHR systems. On August 8, 2006, the U.S. Department of Health and Human Services ("HHS" ) issued final regulations (see 42 C.F.R. Section 411.357 and 42 C.F.R. Section 1001.952) ("HHS EHR Regulations" ) that allow hospitals to provide, within specific parameters, EHR software and technical support services ("Health IT Items and Services" ) to their medical staff physicians without violating the federal anti-kickback law, 42 USC §1320a-7b, and physician self-referral law, 42 USC §1395nn.
We will not treat the benefits a hospital provides to its medical staff physicians as impermissible private benefit or inurement in violation of IRC 501(c)(3) if the benefits fall within the range of Health IT Items and Services that are permissible under the HHS EHR Regulations and the hospital operates in the manner described below.
A hospital that is otherwise described in section 501(c)(3) enters into Health IT Subsidy agreements with its medical staff physicians for the provision of Health IT Items and Services at a discount ("Health IT Subsidy Arrangements" ). These Health IT Subsidy Arrangements require both the hospital and the participating physicians to comply with the HHS EHR Regulations on a continuing basis. The Health IT Subsidy Arrangements provide that, to the extent permitted by law, the hospital may access all of the electronic medical records created by a physician using the Health IT Items and Services subsidized by the hospital. The hospital ensures that the Health IT Items and Services are available to all of its medical staff physicians. The hospital provides the same level of subsidy to all of its medical staff physicians or varies the level of subsidy by applying criteria related to meeting the health care needs of the community.
These procedures do not apply to a hospital that allows its earnings to inure to the benefit of one or more medical staff physicians through arrangements that are other than Health IT Subsidy Arrangements, because the hospital would not be considered to be described in section 501(c)(3).
For further information, see Q&A on Hospitals' Health IT Subsidy Arrangements with Medical Staff Physicians at Exhibit 4.76.3-12.

4.76.3.11.5 (04-01-2003)
Examination of Books and Records

The following are some suggested audit steps the examiner can take to identify and develop issues of inurement, private benefit, and intermediate sanctions:
Review Form 990 carefully for items that could indicate issues. (See Exhibit 4.76.3-10.)
Review salaries paid to those controlling the organization and to other key employees. To determine if they are reasonable consider factors such as:
- Duties performed
- Amount and type of responsibility
- Time devoted to duties
- Special knowledge and experience
- Individual ability
- Previous training
- Compensation paid in prior years
- Prevailing economic conditions
- Living conditions of the particular locality
- The type of activities carried out by the organization and its size.
Reconcile salaries paid by the organization to wages reflected on Forms W-2 of the employees. What was included in taxable income?
Request copies of employment contracts or compensation packages as deemed pertinent. Check the date and the specific compensation the organization intended to pay.
Review disbursements. Be alert for payment of expenses paid by the exempt organization to or for the benefit of an officer or employee that may not be reflected as wages on Form W-2.
Consider the status of the recipients to determine who meets the various criteria of an insider, an outsider, a disqualified person with respect to the organization.
Review other compensation amounts, including fringe benefits. Determine if they are excludable from the recipient's gross income under IRC § 132 or includible under IRC § 61. Look closely at such reimbursements as travel expenses. Was the payment made under a non-accountable plan? If so, determine if the amounts paid meet the ordinary and necessary requirements of IRC § 162. Was the amount included on Form W-2?
Determine if there were any sales or exchanges of property. If so, were there any insiders, disqualified persons, foundation managers involved? Was the sale or exchange at fair market value?
Analyze the composition of the organization's assets. Did an insider, disqualified person, foundation manager have personal use of any of them? For example, a vehicle may be used for personal and business travel. If personal use was involved, was an amount included on the Form W-2?
Analyze fund-raising agreements to determine if they are at arm's length. Consider the method of raising funds and whether such income is subject to unrelated business tax. Does the fund-raiser exercise control over the organization in any manner?
Determine if there are entities related to the exempt organization. Analyze the structure of any transactions between the related entities and the exempt organization. Are they at arm's length, fair market value, exclusive?
See Exhibit 4.76.3-11 for a list of steps to help identify and analyze excess benefit transactions subject to IRC § 4958 taxes.

4.76.3.12 (04-01-2003)
Legislative Activities Guidelines

IRC § 501(c)(3) states that no substantial part of the activities of an otherwise qualified organization may be the carrying on of propaganda or otherwise attempting to influence legislation. Organizations whose lobbying activities disqualify them from recognition of exemption under IRC § 501(c)(3) are action organizations. Treas. Reg. § 1.501(c)(3)-1(c)(3)(vi) provides that an organization is an action organization if it has the following characteristics:
1. Its primary objective (as distinguished from an incidental objective) can be attained only by legislation or defeat of proposed legislation and;
2. It advocates or campaigns for the attainment of its primary objective as opposed to engaging in nonpartisan analysis, study or research and making the results available to the public.
Example:

An organization was formed to assist the governor-elect of a state. It screened and selected appointive office applicants, prepared the party platform's legislative message and program for presentation to the legislature. Since the organization could accomplish its main purpose only through legislation, it was ruled an action organization. Rev. Rul. 74-117, 1974-117, 1974-1 C.B. 128.

4.76.3.12.1 (04-01-2003)
Direct Lobbying and Grass Roots Legislation

"Direct lobbying" is the attempt to influence legislation through communication with any member or employee of a legislative body, with a government official or other employee who can participate in formulation of the legislation. The key is that the communication's principal purpose must be to influence legislation.
"Grass roots lobbying" involves the organization's urging members of the public to contact legislators to support, oppose, or propose a piece of legislation. The examiner needs to determine if the organization is engaged in grass roots lobbying and if so, to what extent. He/she can perform audit steps such as interviewing its officers regarding any activities that further the entity's legislative interests, reviewing official minutes, publications and financial records, and considering the following;
1. Have there been paid articles and advertisements in newspapers or magazines that promote the organization's legislative interests?
2. Did the organization engage in commentaries through television, cable, radio or other public communications?
3. Did it publicize or disseminate its position on certain legislation in articles or publications?
4. Has it made direct mailings or internet campaigns that encourage the public to contact legislators regarding its position?
The examiner should analyze expenses to determine if the entity made disbursements for any of the following:
1. Contributions to organizations engaged in legislative activities.
2. Payments to lobbyists or other intermediaries on behalf of the organization itself or as a subordinate to a national regional or state parent organization.
  
  Note:
  
  Payments may be disguised as charges to legal, professional or advertising fees.
3. Dues to parent, state or national organizations for legislative activities. This activity might be attributed to the subsidiary organization via payment of dues.

4.76.3.12.2 (04-01-2003)
IRC § 501(h) Election and IRC § 4911 Excise Tax on Excess Lobbying Expenses

When there is strong evidence of legislative activity, the examiner will then determine whether the organization has made a lobbying election under IRC § 501(h) by filing Form 5768, Election to Make Legislative Expenditures. This election subjects the organization to the lobbying expenditures test of IRC § 4911. An eligible public charity, through an election, may choose to have its legislative activities measured by an expenditures test that sets relatively specific expenditure limits and lends more concreteness to the uncertain standards of IRC § 501(c)(3). The examiner will then analyze disbursements to determine if:
1. The sliding scale limits for nontaxable lobbying and grassroots expenditures have been exceeded. (The maximum lobbying nontaxable amount is $1,000,000.)
2. Affiliated organizations have included their disbursements in the total to determine if the nontaxable amounts have been exceeded.
3. Lobbying expenditures over a four year period exceed 150 percent of the lobbying nontaxable amount; or
4. Grass roots expenditures over a four year period exceed 150 percent of the grassroots nontaxable amount.
  
  Note:
  
  If the limits of c) or d) above are exceeded, the examiner will then consider revocation. (Note that once revoked, the organization cannot then apply for IRC § 501(c)(4) status.) There is no determination required, however, for the first, second, or third year of election as long as the expenditures are not over the ceiling amounts. If a ceiling amount is exceeded, the determination is recomputed using prior years, even if they were prior to an election. (Omit all years in which the organization was not exempt under IRC § 501(c)(3). See Treas. Reg. § 1.501(h)-3(b)(2)).
Should the organization exceed its limits for direct and/or grassroots lobbying expenditures, it will then be subject to an excise tax equal to 25% of the excess expenditures, as imposed by IRC § 4911(a). If the organization becomes liable for the excise tax imposed by IRC § 4911(a), the examiner will then attempt to securing a delinquent Form 4720, "Return of Certain Excise Taxes on Charities and Other Persons Under Chapters 41 and 42 of the Internal Revenue Code," and collect the tax due.
IRC § 4911(d)(2) specifies activities which are not considered to be influencing legislation:
1. Making available the results of nonpartisan analysis, study, or research.
2. Providing technical advice or assistance to a governmental body, a committee or other subdivision of it in response to a written request by the body or subdivision.
3. Appearances before, or communications to, any legislative body with respect to a possible decision of the body that might affect the organization's existence, powers, duties, tax exempt status, or the deduction of contributions to the organization.
4. Communications between the organization and its bona fide members about legislation or proposed legislation of direct interest to the organization and its members as long as the organization does not encourage the member to take commensurate action.
5. Certain communications with members or employees of legislative bodies.
The examiner should be aware that the following organizations are ineligible to make an IRC § 501(h) election:
1. Churches or conventions or associations of churches as described in IRC § 170(b)(1)(A)(i), including integrated auxiliaries, convention or association of churches,
2. Organizations described in IRC § 501(c)(3) that are affiliated with at least one church, convention or association of churches, or an integrated auxiliary (an "affiliated group" within the meaning of IRC § 4911(f)(2)),
3. Organizations that are public charities because they are a supporting organization described in IRC § 509(a)(3),
4. Organizations engaged in testing for public safety described in IRC § 509(a)(4),
5. Private foundations.
The election under IRC § 501(h) is effective beginning with the organization's taxable year in which it files Form 5768.

Example:

An eligible organization with a taxable year ending December 31, 2002 files Form 5768, making the IRC § 501(h) election on August 31, 2002. The organization's IRC § 501(h) election is effective for all taxable years beginning January 1, 2002. (A loss of exemption will automatically revoke the election.)
An organization's election may be revoked voluntarily or involuntarily. Voluntary revocation of election is made by filing a notice with the appropriate Service Center listed on Form 5768. Under IRC § 501(h)(6)(B), a voluntary revocation is effective beginning with the first taxable year after the taxable year in which the notice is filed, and the organization becomes subject to the "substantial part" test at that time.

4.76.3.12.3 (04-01-2003)
Nonelecting Organizations

If the examiner determines that the organization engaged in legislative activity but did not elect the provisions of IRC § 501(h), it will remain subject to the substantial part test.
A determination of whether or not an organization is substantially engaged in legislative activity is a question of facts and circumstances. (The courts have found that a percentage test is not the only measure of substantiality.)
Substantial is measured not only by the funds spent on the activity but by the time and effort expended as well. The examiner should consider:
1. The amount of effort expended by the organization's membership when they are urged to act. (Keep in mind that a single article in an organization's publication requesting legislative action might trigger thousands of members to contact their legislators, but the expense may be minimal.)
2. The time, effort and money expended on reaching or developing a position on whether to support or oppose particular legislation.
The examiner should also:
1. Analyze all direct and indirect expenses attributable to legislative activities.
2. Find out what the organization's definition of lobbying is and make sure it complies with the law.
3. Review time sheets or whatever activity report the organization uses to determine the time the staff spent on lobbying activities (in other words, check the organization's computation to make sure it is reasonable.)
  
  Note:
  
  Just because the dollar limits are high, the examiner should not ignore them. The organization may have misclassified disbursements for grassroots activities as exempt activities. Since the grassroots amount is only 25 percent of the lobbying amount, it is easier to exceed the grassroots amount. The examiner will solicit Form 4720 if either of the limits were exceeded.

4.76.3.12.4 (04-01-2003)
Exceptions to Revocation

Under IRC § 501(c)(3) there are certain circumstances where nonpartisan analysis, study, research, or discussion of matters pertaining to legislation, may be educational and do not constitute attempts to influence legislation. While the examiner may initially determine the organization is substantially engaged in legislative activity and revocation seems likely, the following rulings should be researched if applicable:
1. League of Women Voters of the United States v. United States,180 F.Supp. 379 (Ct. Cl.1960). The time spent discussing public issues, formulating and agreeing upon positions, and studying them in preparation for adopting a position was taken into account. It was compared to the other activities in determining the substantiality of the attempts to influence legislation. Research, discussion and other back-up activities may not always be considered part of attempting to influence legislation.
2. In Rev. Rul. 72-513, 1972-2 C.B. 246, .a school exempt under IRC § 501(c)(3) that made its staff available to serve on a school newspaper that published opinion on legislative and political matters was not attempting to influence legislation or participate in political activities. The process of gathering news, doing research, analyzing data, writing and editing material for the newspaper dealing with legislative and political topics furthered the education of the students.
3. In Rev. Rul. 64-195, 1964-2 C.B. 138, an organization conducted research on legislation and disseminated materials to the public. The ruling concluded, "it is clear that the instant organization does not participate in any way in the presentation of any proposed bills to the State Legislature or advocate either approval or disapproval of the proposed constitutional amendment by the electorate. Its primary activity in connection with court reform is the study, research, and assembling of materials on a nonpartisan basis and the dissemination of such materials to the public." The examiner should inquire about the purpose of the analysis, study or discussion. Ask if it furthers a partisan end, and will the organization be involved in advocating adoption or rejection of the legislation.
4. When a membership organization is involved, it is often necessary to determine whether a lobbying activity is attributable to the organization or is merely the act of the individual. On one hand, actions of a person in excess of his official authority should not be considered those of the exempt organization (i.e.; a school or a church) as a general rule. However, if the organization allows contempt for authority to go unpunished, it implies ratification of the act. When trying to determine if an individual 's acts may be attributed to an organization , there are no clear set of rules or guidelines. Relevant indicators include whether statements appear on the organization's official letterhead, whether the board of directors of the organization endorsed a questionable act, what are the organization's stated policies and intentions to support particular acts, and whether the organization tried to explain or disassociated itself from the act.

4.76.3.12.5 (04-01-2003)
IRC § 4912 Excise Tax on Disqualifying Lobbying Expenditures

Effective for tax years beginning after December 22, 1987, IRC § 4912 imposes a tax of 5 percent on the lobbying expenditures of an organization whose tax exempt status was revoked due to a substantial amount of lobbying activity. The tax does not apply to the following:
1. Charitable organizations which have made the IRC § 501(h) election,
2. Churches or certain church-related organizations that are not eligible to make the IRC § 501(h) election,
3. Private foundations.
Tax imposed under IRC § 4912 is an excise tax described in IRC Chapter 41 (Public Charities). Organizations and individuals with a tax liability under this section should file Form 4720. (Such persons will be jointly and severally liable under the Internal Revenue Code.) IRC § 4912 is subject to deficiency procedures. Penalties relating to failure to file, failure to pay tax due, negligence and civil fraud may apply.
IRC § 4912 imposes a similar tax on any organization manager (basically its officers and directors) who permits the expenditure, knowing that it will jeopardize the organization's exempt status.

4.76.3.13 (04-01-2003)
Political Activities Guidelines

There is an absolute prohibition on all IRC § 501(c)(3) organizations from participating or intervening in any political campaign. Even an insubstantial amount of political activity can lead to the revocation of the organization's exempt status. Examples of political activity include:
1. Publication of written or printed statements or oral statements made on behalf of, or in opposition to a candidate for public office (Treas. Reg. 1.501(c)(3)-1(3)(iii));
2. Payments to a political candidate for speeches or other services;
3. Travel expenses of a candidate;
4. Expenses incurred in conducting polls, surveys, or other studies;
5. Preparing papers or other material for use by a candidate;
6. Expenses of advertising, publicity, and fund-raising for a candidate; and
7. Any other expense that has the primary purpose of promoting public recognition, or otherwise primarily accruing to the benefit of an individual.
A candidate for public office is defined as an individual who offers himself or herself or is proposed by others as a contestant for an elective public office, whether such office is national, state, or local. Treas. Reg. 1.501(c)(3)-1(c)(3)(iii)).

Note:

It does not matter if the candidate is not endorsed by a political party or if the office is not contested by a political party. In Rev. Rul. 67-71, 1967-1 CB 125, school board candidates were held to be candidates for public office despite the fact that no candidates were affiliated with any political party.
Attempting to influence the senate confirmation of an individual nominated to serve as a federal judge does not constitute intervention or participation in a political campaign within the meaning of IRC § 501(c)(3) because a federal judgeship is an appointive office rather than an elective one. Notice 88-76, 1988-27 I.R.B. 34.

Note:

However, such expenditures are subject to the tax imposed by IRC § 527(b) on political expenditures.

4.76.3.13.1 (04-01-2003)
Political vs. Educational Activities

While some activities and disbursements are obviously political in nature, others may initially appear political to the examiner but actually are educational. Certain "voter education" activities conducted in a non-partisan manner by an IRC § 501(c)(3) organization may not constitute prohibited political activity. Consider the following:
1. Rev. Rul. 86-95, 1986-2 C.B. 73 states that public forums do not constitute participation or intervention in any political campaign within the meaning of IRC § 501(c)(3). An IRC § 501(c)(3) organization conducted the public forums in a congressional district during a congressional election campaign. All legally qualified congressional candidates were invited to participate; they discussed topics that covered a broad range of issues of interest to the public. Questions were prepared and presented by a nonpartisan, independent panel; and each candidate received an equal opportunity to present his or her views on each issue discussed. The facts and circumstances established that both the format and content of the forums were presented in a neutral manner.
2. Rev. Rul. 78-248, 1978-1 C.B. 154, Situation 1 held an organization was exempt under IRC § 501(c)(3) that annually prepared and made generally available to the public a compilation of voting records of all members of Congress on major legislative issues involving a wide range of subjects. The publication contained no editorial opinion, and its contents and structure did not imply approval or disapproval of any Congressional members or their voting records.
3. Rev. Rul. 78-248, 1978-1 C.B. 154, Situation 2, an organization distributed a questionnaire to all candidates for governor in a particular state. The ruling held the organization to be exempt under IRC § 501(c)(3). The questionnaire solicited a brief statement of each candidate's position on a wide variety of issues which were published in a voter's guide made generally available to the public. Neither the questionnaire nor the voter's guide, in content or structure, evidenced a bias or preference with respect to the views of any candidate or group of candidates.
4. Rev. Rul. 80-282, 1980-2 C.B. 178 - An IRC § 501(c)(3) organization which monitored and reported on governmental activities and developments it considered to be of important social interest is not participating or intervening in any political campaign. It published and distributed a non-partisan newsletter to interested members and others, who numbered only a few thousand nationwide. The newsletter was politically non-partisan and consisted of congressional incumbents' voting records on selective issues, along with an expression of the organization's position on the issues. The publication occurred after congressional adjournment and was not geared to the timing of any federal election.
On the other hand, other voter education activities may indeed constitute political. Consider the following:
1. An organization that sent a questionnaire to candidates for major public offices and used the responses to prepare a voter's guide that was distributed during an election campaign. It was held not to be exempt under IRC § 501(c)(3) since some of the questions evidenced a bias on certain issues. Rev. Rul. 78-248, 1978-1 C.B. 154, Situation 3.
2. An organization that published and distributed to the public a voter's guide containing voting records of members of Congress on the single issue of land conservation was held not to be exempt under IRC § 501(c)(3) because the emphasis on one area of concern indicated a partisan purpose and constituted a proscribed political activity. Rev. Rul. 78-248, 1978-1 C.B. 154, Situation 4.
3. A bar association did not qualify under IRC § 501(c)(3) because its practice of rating and publishing the ratings of candidates for elective judicial office constituted intervention in a political campaign, although it comprised only a small portion of the association's total activities, was clearly in the public interest, and was conducted on a nonpartisan basis. The Association of the Bar of the City of New York v. Commissioner, 858 F.2d 876, 881 (1988).

4.76.3.13.2 (04-01-2003)
Public Discussion of Political Issues

An organization that conducted public forums, lectures, and debates on controversial social, political, and international questions was held to be educational. Although the speakers were frequently controversial, the organization adopted an unbiased position. Rev. Rul. 66-256, 1966-2 C.B. 210.
An organization that operated a broadcasting station was not participating in political activities by providing reasonable air time equally available to all legally qualified candidates for election to public office in compliance with the Federal Communications Act of 1934. The organization neither endorsed a candidate nor any viewpoint expressed by a candidate. Rev. Rul. 74-574, 1974-2 C.B.161.
An organization formed to elevate the standards of ethics and morality in the conduct of political campaigns disseminated information concerning general campaign practices, furnished teaching aids to political science and civics teachers, and publicized its proposed code of fair campaign practices without soliciting the signing or endorsement of the code by candidates. It qualified as an educational organization under IRC § 501(c)(3). Rev. Rul.76-456, 1976-2 C.B. 151.

4.76.3.13.3 (04-01-2003)
Examination Procedures

Most organizations are aware of the prohibition. However, during the examination process, if the examiner finds evidence of political activity but no overt transactions, he/she may need to look at more subtle sources to substantiate the evidence. Some suggestions are:
1. Reading the organization's minutes and newsletters for mention of a political figure or a political event. (Note: some organizations maintain a publicity file.)
2. Review of the cash disbursements journal along with the corresponding cancelled checks to determine possible payments to politicians, political parties, political action committees (PACs), bogus trade associations, legal firms diverted to political trustee accounts as well as other organizations.
3. Review of agreements and contracts entered into by the organization to determine possible lending or sharing of equipment , facilities or employees.
  
  Example:
  
  Upon a review of the organization's minutes, the examiner notices a political figure is featured in the minutes. The agent makes a note of the month that the discussion takes place and reviews the cash disbursements for that month and the months following that date. Noting a questionable expenditure, the examiner then asks for the actual check, which was in the amount of $700, to determine the payee and to look at the endorsement. He/she then traces the payment to the general ledger to determine how it was recorded. Since there was an indication the payment was for services of an independent contractor, the examiner requests to see the person's contract with the organization and Form 1099.
4. Perusal of local newspapers for announcements regarding political events sponsored by the organization.
5. Testing expense reimbursements for any political contributions.
6. Checking supplier invoices for any evidence of overbilling (an excess may be used for political purposes)
7. Testing payroll accounts for evidence of any employees who may have worked on political campaigns on company time.
Although an organization may not be directly conducting any political activities themselves, an examiner may discover evidence of support for a political campaign through an affiliated organization. Typical conduits are organizations described in IRC § 501(c)(4), (5), or (6) because they are permitted to engage in some political activity. The organization may be making grants, lending equipment, facilities, employees, or members to these affiliates for political endeavors.

4.76.3.13.4 (04-01-2003)
Disqualification Under IRC § 501(c)(4)

Any organization (except for churches, conventions of churches, etc.) that ceases to qualify under IRC § 501(c)(3) by reason of participating in, or intervening in, any political campaign on behalf of, or in opposition to, any candidate for public office is precluded from exempt recognition under IRC §501(c)(4).

4.76.3.13.5 (04-01-2003)
Effect of IRC § 527

IRC §527 enables an IRC § 501(c) organization to set up a separately segregated fund to carry out the political activities of the IRC § 501(c) organization. The IRC § 501(c) organization is subject to tax on any amount that it spends on the selection, nomination, election or appointment of a candidate for public office but only to the extent of its net investment income. IRC § 527(f)(3).

Note:

IRC §527 was not intendedto affect the prohibition against IRC § 501(c)(3) organizations engaging in political activities. Thus, notwithstanding IRC 527, charities may not engage in political activities on behalf of, or in opposition to candidates for elective public office nor may they set up separately segregated to engage in such activities without endangering their IRC § 501(c)(3) status.

4.76.3.13.6 (04-01-2003)
Resolution of Political Activities and IRC § 4955

Depending on the facts and circumstances, engaging in political activity can result in:
1. The loss of exempt status.
2. The imposition of the IRC § 4955 tax.
3. Both the loss of exempt status and imposition of the IRC § 4955 tax.

Congress enacted IRC § 4955 in 1987, which subjected IRC § 501(c)(3) organizations that make political expenditures to an excise tax as follows:

IRC Section	Rate of Amount Involved¹	Imposed On	Act²
4955(a)₁	10%	Organization	Making political expenditures
4955(b)₁	100%	Organization	Not correcting the expenditure within the taxable period
4955(a)₂	2.5% (maximum of $5,000)	Organization Manager	Agreeing to make the expenditure, knowing that it is a political expenditure
4955(b)₂	50% (maximum of $10,000)	Organization Manager	Refusing to correct a political expenditure
¹ The taxable period begins on the date the expenditure is made, and ends on the date the 90 day letter is mailed for the first tier tax or the date of the first tier tax assessment, whichever comes first.
² The initial tax can be abated if the organization can establish that its making the expenditure was not willful and flagrant.

Under IRC § 4955(d)(2) certain expenditures of candidate-controlled organizations are considered political expenditures for the purpose of the tax imposed by IRC § 4955. A candidate-controlled organization is an organization formed primarily for the purpose of promoting the candidacy or prospective candidacy of an individual for public office or one that is effectively controlled by a candidate or prospective candidate for political purposes. An organization is effectively controlled by the candidate if the candidate "has a continuing, substantial involvement in the day-to-day operations or management of the operation." The expenditures of such an organization, amounts paid or incurred for any of the following purposes are considered political expenditures:
1. Amounts paid to or incurred by the candidate for speeches or other services,
2. Travel expenses of the candidate,
3. Expenses for conducting polls, surveys or other studies, or preparing papers or other materials for use by the candidate,
4. Expenses for advertising, publicity and fund-raising for the candidate,
5. Any other expense that has the primary effect of promoting public recognition or otherwise primarily accruing to the benefit of the candidate.
In general, the examiner should apply the IRC § 4955 sanction instead of proposing revocation,if, based on the facts and circumstances, the examiner determines:
1. The violation was found to be unintentional,
2. The expenditure involved a relatively small amount,
3. The organization corrected the violation and adopted procedures to assure that similar expenditure would not be made in the future. (If the organization makes a correction, the first tier tax may be abated.)