Contract With Related For-Profit Entity Disqualifies Exemption

By Robert Vuillemot, J.D., Pittsburgh

Editor: Michael Dell, CPA

Exempt Organizations

In Letter Ruling 201235021, the IRS ruled that an organization founded to facilitate charitable donations through a website and mobile phone application failed to establish that it operated exclusively for exempt purposes because a portion of the donations that it received were paid to a related for-profit entity that designed and operated the organization’s technology.


The organization was a state nonprofit corporation established to facilitate donations to existing charities. The organization intended to do so through a giving system on its website and a mobile phone application. The website and mobile application contained information on various charities and allowed users to make donations. The organization originally had three directors: B, its chairman, and C and D.

The organization entered into a contract with LLC, a for-profit entity owned by B, C, and D, to provide hardware, software, and administrative services for operating the organization’s online giving system and mobile phone application. In return, LLC was originally entitled to receive 20% of the donations, reduced when donations reached certain levels. The remaining amount (at least 80%) of donations would go to the designated charitable organizations. The organization stated that the 20% fee reflected a below-market rate, but it presented no evidence to support this assertion.

Following its original exemption application, the organization submitted additional information indicating that C and D were no longer on its board and that B was no longer on the LLC board (although B remained an owner of LLC). The organization also amended its contract with LLC, replacing the tiered fee structure with a flat 8% rate (with 5% going to LLC and the remaining 3% to be used by the organization for administration and marketing).

Ruling and Analysis

The IRS ruled that the organization had failed to establish that it operated exclusively for exempt rather than private purposes, and, accordingly, it failed to qualify for tax exemption under Sec. 501(c)(3). To qualify for exemption, the IRS explained, organizations must ensure that none of their earnings inure in whole or in part to the benefit of any private persons. The IRS concluded the organization operated to benefit LLC and its shareholders, B, C, and D.

The IRS also found that neither the original nor the amended contract was negotiated at arm’s length. At the time of the original contract, B , C , and D were on the boards of both the organization and LLC . Although the organization stated that the 20% paid to LLC was below market rate, it presented no documentation to substantiate the claim. Furthermore, the IRS noted that the contracts did not include any cap on the amount LLC could earn for its services, enabling it to receive unlimited income through the arrangement. The IRS also noted that the organization did not submit any comparable fee quotes for the services to be provided by LLC .

The IRS called the arrangement “tantamount to a joint venture” between the organization and LLC and its members—with more than an insubstantial benefit going to the latter. Although the boards of the organization and LLC were ultimately disentangled, B remained a member of LLC, and the amended contract continued to provide an improper private benefit to B. By failing to establish that the contract and amended contract were negotiated at arm’s length, the IRS concluded, the organization had failed to prove it was operated exclusively for charitable purposes.


Given the facts, the adverse determination in this case should come as no surprise; however, the ruling does illustrate that the IRS continues to closely scrutinize arrangements between nonprofit organizations seeking recognition of tax-exempt status and for-profit organizations owned by insiders of the nonprofit organization.

Therefore, it is recommended that existing tax-exempt organizations and new organizations seeking tax-exempt status make sure that any such arrangements are fully disclosed and documented and reflect fair market value terms negotiated at arm’s length. Organizations should also have a robust conflict-of-interest policy to help ensure that transactions with organizational insiders (or entities they control or influence) are fully vetted and approved only when they are in the best interest of the organization.


Michael Dell is a partner with Ernst & Young LLP in Washington, D.C.

For additional information about these items, contact Mr. Dell at 202-327-8788 or

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

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