Editor: Mark Heroux, J.D.
The name "economic development corporation" (EDC) is somewhat misleading. The name suggests that any organization designed to help a community's economy can be exempt from taxation. The reality is that EDCs are considered charitable organizations. Thus, EDCs should have a charitable mission. While there is no bright-line test for what qualifies as an EDC, the IRS's position is that EDCs must generally exist to help disenfranchised taxpayers in blighted communities. EDCs are well-advised to be aware of both the regulatory foundation for an exemption and the various IRS authorities on EDCs.
Sec. 501(c)(3) exempts from taxation institutions that are organized and operated for charitable purposes.Regs.Sec. 1.501(c)(3)-1(d)(2) states that the term "charitable" includes:
Relief of the poor and distressed or of the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening of the burdens of Government; and promotion of social welfare by organizations designed to accomplish any of the above purposes, or (i) to lessen neighborhood tensions; (ii) to eliminate prejudice and discrimination; (iii) to defend human and civil rights secured by law; or (iv) to combat community deterioration and juvenile delinquency.
While the phrase "economic development" does not appear in the regulation, it is through this language that EDCs are exempt from taxation.
The IRS's position on EDCs
The IRS stated in an informal memorandum:
The theory behind recognizing economic development corporations as exempt under IRC 501(c)(3) is that although services are provided directly to for-profit businesses, the ultimate good received by the general public outweighs the private benefit accorded to the direct beneficiaries. In light of this, the most important factual determination for the specialist to make is whether the activities of the incubator serve a public rather than a private interest consistent with Regs. 1.501(c)(3)-1(d)(1)(ii). . . .
Merely targeting assistance to an economically depressed area is not sufficient to overcome the private benefit derived by non-charitable business beneficiaries intended to serve as instruments to accomplish charitable purposes.
In developing economic development corporation cases under IRC 501(c)(3), the emphasis should be in having the organization provide information that shows the targeted area in which it will operate as one which is economically depressed. Federal, state or local designations of an area as depressed, or studies (including maps) are helpful. The organization also should be able to show its specific criteria used in determining whether businesses are eligible for its assistance and how such criteria relate to furthering public rather than private interests. [IRS Exempt Organization CPE Text, "Economic Development Corporations: Charity Through the Back Door" (1990), available at tinyurl.com/y967zwrg]
The IRS's informal memorandum also listed three factors for evaluating whether an EDC primarily accomplishes charitable purposes despite the element of private benefit: (1) whether the activity aids economically blighted or depressed areas; (2) whether the benefit is conveyed upon a disadvantaged group, e.g., unemployed or minority groups; and (3) whether the activity is necessary to ensure that a business remains in or locates to the economically blighted area.
It should be noted that the IRS's informal memorandum is not binding authority. It does, however, provide insight into how the IRS views EDCs. EDCs should be mindful of this standard when drafting marketing materials and descriptions of activities on a website. EDCs should also consider this standard when preparing activity descriptions on Form 1023, Application for Recognition of Exemption, and Form 990, Return of Organization Exempt From Income Tax. These represent some of the materials that would likely be reviewed in an IRS examination.
Revenue rulings involving EDCs
The IRS's informal memo relied heavily on three revenue rulings related to economic development corporations. In Rev. Rul. 74-587, the organization qualified for a tax exemption because it provided below-market loans to minority-owned businesses in blighted areas. Similarly, in Rev. Rul. 76-419, the organization qualified for a tax exemption because it purchased land in blighted areas, converted the land into an industrial park, and induced businesses to relocate to the park and hire local unemployed residents.
In Rev. Rul. 77-111, however, the tax exemption was denied because the organization provided assistance to businesses that were not owned by disadvantaged groups and did not experience difficulties as a result of their location in a blighted area. The organization's purpose was to increase business patronage in a deteriorated area predominantly inhabited by minorities. The organization used television and radio advertisements to encourage shopping in the area, created a speaker's bureau of local businesspeople to discuss the shopping environment with different groups, operated a telephone service providing transportation and accommodations information to prospective shoppers, and informed the news media of the area's problems and potential. The IRS determined that while the organization's activities served some charitable purposes under Sec. 501(c)(3), the organization's activities' "overall thrust [wa]s to promote business rather than to accomplish exclusively 501(c)(3) objectives." The organization provided assistance to businesses that were not minority-owned and that were not experiencing difficulty due to being located in a deteriorated section of the community. The IRS therefore ruled that the organization did not qualify as tax-exempt under Sec. 501(c)(3).
Rev. Rul. 77-111 suggests that the IRS does not believe organizations that promote gentrification should qualify as EDCs. Instead, the IRS's position appears to be that EDCs must provide assistance directly to disadvantaged groups.
EDCs and lessening the burdens of government
Charitable activity also includes activity designed to lessen the burdens of government (Regs. Sec. 1.501(c)(3)-1(d)(2)). To determine whether a government objectively considers an organization's activities to lessen its burden, the IRS considers (1) whether the governmental unit considers the organization's activities to be its burden and (2) whether these activities actually lessen the burden of the governmental unit (Rev. Rul. 85-1). Neither the fact that the government approves of an organization's activities nor the fact that the organization was created by statute are dispositive (Rev. Rul. 85-2; IRS General Counsel Memorandum 39,347 (March 15, 1985)).
General Counsel Memorandum 39,852 (July 1, 1991) involved a county's development corporation, which was created under state law and subject to the county's control. The development corporation promoted and developed commercial, industrial, and manufacturing enterprises aimed at increasing local employment. The development corporation was incorporated under a state statute providing for the financing of industrial projects via the issuance of revenue bonds. The development corporation's board of directors was subject to a political subdivision, which was authorized to issue bonds to finance development corporations. Because the development corporation was created by and subject to the control of a local government, the organization was exempt under Sec. 501(c)(3).
As is often the case in the tax-exempt world, there is a general lack of guidance regarding EDCs. While the IRS memorandum is not binding on taxpayers, it does offer valuable insight into how the IRS would evaluate an EDC in an examination. EDCs should document how they help disadvantaged groups specifically. EDCs should also document why the communities in which they operate are in need of assistance. Failure to do so could result in an EDC's losing its tax exemption.
Mark Heroux, J.D., is a principal with the National Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.