Wednesday September 27, 2023
Article of the Month
Understanding Charitable Class Guidance
Charities exist for a variety of reasons but at their core, it is to help others. Nonprofits must meet certain regulatory standards to enjoy tax-exempt status, including requirements for serving a charitable class. IRS regulations, case law and past revenue rulings can help organizations distinguish what constitutes a charitable class. This information can be helpful for donors and professional advisors in understanding how to structure charitable gifts.
This article will discuss the requirements charities must meet to qualify as a nonprofit and maintain tax-exempt status by ensuring charities serve a charitable class. This article will examine the March 2023 IRS Technical Guide TG 3-3: Exempt Purpose, Charitable IRC 501(c)(3) and will further analyze what a charitable class is, what comprises a charitable class, along with some examples of a qualified charitable class.
Common law developed the concept of charity before the term was incorporated in the Internal Revenue Code (IRC). On March 20, 2023, the IRS published a revised technical guidance on the topic of exempt purposes under Sec. 501(c)(3). While the technical guide is not precedent or legal authority, it can be revelatory to understand the IRS' position in assessing a nonprofit's tax-exempt status. When determining if an organization's activities are charitable, the IRS' analysis will not be limited solely to interpretations under Sec. 501(c)(3). However, the IRC explains that charitable purpose is used in its generally accepted legal sense. Reg. 1.501(c)(3)-1(d)(2).
An organization must be both organized and operated exclusively to further exempt purposes to achieve and maintain tax-exempt status under Sec. 501(c)(3). Exempt purposes are defined in Sec. 501(c)(3) as religious, charitable, educational, scientific, testing for public safety, literary, fostering national or international amateur sports competition and the prevention of cruelty to children or animals. The IRC explains that a tax-exempt purpose also includes relief of the poor and the distressed or underprivileged; advancement of religion, education or science; maintenance or creation of public buildings, monuments or works; lessening the burdens of government; and furthering social welfare. Reg. 1.501(c)(3)-1(d)(2). These categories have changed over time since the regulations were adopted.
Regulation 1.501(c)(3)-1(c)(1) provides that an organization will be regarded as operated exclusively for one or more exempt purposes if it engages primarily in activities which accomplish one or more exempt purposes specified in Sec. 501(c)(3). Ordinarily, a charity's activities will qualify for exemption under multiple tax-exempt purposes. Ensuring that a nonprofit maintains its tax-exempt status is crucial to permit donors to claim a charitable income tax deduction for charitable contributions.
Defining a Charitable Class
A charitable class is a group of beneficiaries that may receive assistance from a charitable organization. A charitable class must be large enough that the potential beneficiaries cannot be individually identified or must be sufficiently indefinite that the community, rather than a pre-selected group of beneficiaries, benefits when a charity provides assistance. Rev. Rul. 67-367, 1967-2 C.B. 188. For donors who wish to create scholarship-type charitable gifts, the charitable class must be sufficient to not provide a private benefit or inurement to donors or their families.
A nonprofit organization that provides assistance to a single identifiable individual or individuals from one family is generally not qualified as a charitable class because the class is too limited. See Wendy L. Parker Rehab. Found., Inc. v. Comm'r, 52 T.C.M. 51 (1986). Conversely, many nonprofits provide a benefit to a group of individuals in a city, county, or state because the potential beneficiaries cannot be individually identified.
A charitable class or charitable group may include groups consisting of the poor, elderly, handicapped, distressed or youth. Reg. 1.170A-4A(b)(2)(ii). However, creating a charitable class is not limited to these categories. The poor are individuals who are at or below the poverty line. Seniors who are at least 62 years old fit the definition of the elderly. Handicapped individuals are diagnosed with a physical and/or mental handicap. The category of distressed includes victims of a disaster. Youth is defined as anyone under the age of 18. IRS Pub. No. 5781.
Tax Code Requirements
To maintain tax-exempt status under Sec. 501(c)(3), an organization must be organized and operated exclusively for exempt purposes set forth in Sec. 501(c)(3), known as the organizational and operational tests. Both tests include prohibitions against any of the distributions or earnings inuring to private shareholders or individuals. If an organization fails to meet either the organizational or operational test, it will not qualify for tax-exempt status under Sec. 501(c)(3).
For an organization to operate exclusively for exempt purposes, an organization must serve a public interest. If an organization operates for the benefit of a private interest such as the organization's founder or the founder's family, then the organization does not operate exclusively for exempt purposes. Reg. 1.501(c)(3)-1(d)(1)(ii). If the facts and circumstances demonstrate that a private benefit rather than a public interest is being served, tax-exempt status may be at risk.
In Regulation 1.501(c)(3)-1(d)(1)(iii) Example 1, the Service provides an example of an educational organization whose purpose was to study history and immigration. However, the focus of the organization's study in history was specific to the genealogy of one family for the purpose of publishing a history related to that particular lineage. A major objective of the organization's research was identifying and locating living descendants of that family to allow the descendants to connect with one another. The Service notes that the interests here primarily serve a private rather than a public interest. Therefore, tax-exempt status for this organization would be denied.
Prohibition Against Private Benefits
A charity that provides a private as opposed to a public benefit will adversely affect the organization's tax-exempt status. An organization is not organized or operated exclusively for one or more charitable purposes unless it serves a public rather than a private interest. Thus, to meet the public benefit requirement, it is necessary for an organization to establish that it is not organized or operated for the benefit of private interests, such as designated individuals, the creator of the organization or the creator's family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests. Reg. 1.501(c)(3)-1(d)(1)(ii).
In Regulation 1.501(c)(3)-1(d)(1)(iii) Example 2, the Service offers an example of an art museum with a principal activity of exhibiting art by a group of local artists. All art exhibited by the museum is offered for sale at prices set by the artists and each artist's exhibited work is under a consignment agreement with the museum. When the art is sold, the museum retains 10% of the selling price while the artist keeps the remaining 90%. Under these circumstances, the artists are directly benefiting from the museum exhibiting the art. As such, the museum's primary activity of promoting the art of local artists is in violation of the restriction on private benefits set out in Reg. 1.501(c)(3)-1(d)(1)(ii).
Indefinite Rather than Preselected Beneficiaries
A charitable class must be large enough that the potential beneficiaries cannot be individually identified or sufficiently indefinite that the community, rather than a pre-selected group of people, benefits when a charity provides assistance. Rev. Rul. 67-367, 1967-2 C.B. 188. In Wendy L. Parker Rehab. Found., Inc. v. Comm'r, the family of Wendy Parker established a foundation to assist coma victims such as Wendy. The charitable class was sufficiently large, however, it was determined that 30% of the foundation's income was earmarked towards Wendy's needs. The foundation was subsequently denied tax-exempt status due to the private inurement enjoyed by the child of the founder of the organization. Tax-exempt status will be denied if specifically identified and preselected individuals receive substantial benefits from the organization. Donors must keep this in mind when creating scholarships or other grantmaking planned gifts. Professional advisors should be aware of these rules to help steer donors toward the correct gift structure and prevent private benefit type gifts.
Serving a Charitable Class
As donors look to make gifts that benefit certain groups of people, charitable class definitions may be particularly relevant for professional advisors to ensure a valid charitable class is being served by the gift. Examining a few different examples can help clarify what the Service may deem an eligible charitable class.
Educational Scholarships, Grants and Awards
Academic scholarships, grants and awards are frequently tailored to specific charitable classes, while still being sufficiently broad to not run afoul of an organization's exempt purpose. Educational refers to (i) the instruction or training of the individual for the purpose of improving or developing his or her capabilities, or (ii) the instruction of the public on subjects useful to the individual and beneficial to the community. Reg. 1.501(c)(3)-1(d)(3). Organizations are able to place certain limits or restrictions on the award of scholarships without adversely affecting their tax-exempt status.
It is vital that scholarships do not confer any private benefits to shareholders or other individuals involved with the scholarship. For example, a nonprofit organization providing scholarships to needy students to continue their education is exempt from tax under Sec. 501(c)(3) if there is no monetary benefit to the donor and it fits the charitable class rules. Rev. Rul. 66-103, 1966-1 C.B. 134. It is also important to ensure that the potential pool of scholarship recipients is large enough that the community benefits rather than a pre-selected group of people. An organization established to assess achievements and provide awards to citizens of a particular state for educational purposes is exempt from tax as the organization was benefiting the whole community. Rev. Rul. 66-146, 1966-1 C.B. 136.
Assistance to the Elderly
Assisting the elderly with housing, health care and financial security may qualify as a charitable activity. One of the most common examples of assisting the elderly comes in the form of retirement homes. Many retirement homes are not exempt because they are supported by fees from their residents. However, the Service has shifted its position when it comes to retirement homes. Originally, the Service did not view assisted living facilities as having a charitable purpose unless such facilities were operated for the relief of poverty by offering services at rates that were "substantially less than the actual cost of the services furnished." Rev. Rul. 61-72, 1961-1 CB 188. However, the Service expanded its view on what constitutes as charitable when it comes to helping seniors in need.
In Revenue Ruling 72-124, 1972-1 C.B. 145, the Service found that exemption status under Sec. 501(c)(3) is no longer conditioned on whether an organization helps relieve the financial distress of senior individuals by providing care for them. Assisted living facilities do not need to provide direct financial assistance to the elderly to be considered charitable, since financial security is only one form of hardship to which seniors are specifically vulnerable. As such, an assisted living facility will qualify for exempt status so long as the facility satisfies the three primary needs of the elderly like providing housing, health care and financial security. Rev. Rul. 72-124.
Relief for the Sick and Disabled
Donors can make contributions to funds specifically allocated for assisting the sick or disabled so long as the fund benefits a charitable class and not predetermined individuals. Wendy L. Parker Rehab. Found., Inc. v. Comm'r, 52 T.C.M. 51 (1986). Assistance can come in many forms including providing inpatient and outpatient care to terminally ill patients. Rev. Rul. 79-17, 1979-1 C.B. 193. Relief can also include low-cost housing for those with physical disabilities, which may allow patients to remain in care in the event the individual becomes unable to pay monthly fees. Rev. Rul. 79-19, 1979-1 C.B. 195.
Assistance is not limited solely to those afflicted but includes relatives as well. An organization that provides counseling, housing and transportation to hospital patients' families and friends who travel to help the patients was considered a sufficient charitable class for the organization to obtain tax-exempt status under Sec. 501(c)(3). Rev. Rul. 81-28, 1981-1 C.B. 328.
Relief of the Poor and Distressed
Relief of the poor and underprivileged is listed as a charitable purpose. Reg. 1.501(c)(3)-1(d)(2). Assistance may consist of the necessities of life such as providing food, clothing and shelter. The IRS has held the position that poor and distressed beneficiaries consist of individuals unable to afford necessities of life. As such, low-income individuals are considered a valid charitable class. The IRS will identify low-income individuals and families based on income limits published by the Department of Housing Urban Development (HUD). IRS Pub. No. 5781.
The Service has examined a number of scenarios when it comes to providing housing to those in need. An organization formed to provide instruction and guidance to low-income families in need of adequate housing on how to build their own homes is exempt under Sec. 501(c)(3). Rev. Rul. 67-138, 1967-1 C.B. 129. According to IRS Publication 3833, relief can also come in the form of providing grants or assistance to those impacted by disasters, such as an organization's employees affected by a current disaster or future disasters.
A charity must serve a charitable class in order to achieve and maintain tax-exempt status. Charities should review the various examples cited in the regulations and look to scenarios the Service has examined as guidance when it comes to determining whether they are serving a charitable class. With this knowledge, donors and their advisors can feel confident that donors' qualified gifts are directed towards a valid charitable class and ensure the charity's tax-exempt status is protected. With their tax-exempt status safe, charities can focus on accomplishing their mission of helping others.
Published July 1, 2023