Tuesday, November 23, 2010
As reported in Tax Notes Today, the IRS has determined that an organization primarily organized to operate a restaurant does not qualify for exemption under Code section 501(c)(3). The organization proposed to serve both members – whose payment of dues secured rights to buy food at a discount – and non-members, seat at least 1,000 patrons, and employ 100 people. The organization stated that it would also conduct charitable programs, including a tuition program, a job training program, a welfare to work program, and a homeless shelter program (among others). The IRS reasoned as follows in determining that the entity failed to qualify for exemption on grounds of its commercial nature and its conveyance of private benefit:
You are similar to the organization described in Rev. Rul. 73-127 [ruling that an organization operating a low-price retail grocery store in an impoverished area and using a portion of its earnings to train the unemployed did not qualify for federal income tax exemption] because the operation of the restaurant and the operation of the training and other charitable programs are two distinct purposes. Since the operation of the restaurant is the main part of your activities and is not a recognized charitable purpose, you are not organized and operated exclusively for charitable purposes. Your restaurant hours, prices, menu items and services are competitive to for-profit restaurants. Your restaurant is staffed by paid employees and trainees may be hired as your employees after their training. Your paid staff is mainly for the operation of the restaurant rather than for the training program or any charitable functions. Your restaurant operation is no different from those of for-profit restaurants; therefore, you are in competition with for-profit restaurants. Furthermore, you serve private benefits to your patron members and patron non-members by giving them discounts and tax deductibility benefits to lure them from your competitors.
Although the IRS surely reached the correct determination on the facts before it under existing case law, the last sentence from the excerpt appears to reflect a misunderstanding – by both the applicant and the IRS – of how the law applies to the facts set forth in the application. The applicant planned to inform members that “their meals are tax deductible on all menus, advertisements, brochures, consumer receipts and all marketing data,” and also that their dues would be tax-deductible. Further, although the applicant represented that its menu prices “are set consistent with market value and then discounted to fit a charitable organization,” it asserted that “the difference in the members and nonmember price of a meal, party, banquet, etc. is the charitable contribution for nonmember[s].” The applicant was clearly confused about the case law restrictions on the deductible portion of a quid pro quo contribution to charity; except in the case of modest benefits provided by a charity under limited circumstances (including certain benefits provided to dues-paying members), any charitable contribution deduction is generally limited to the excess of the transferred amount over the fair market value (not a discounted price) of what the transferor receives from the charity. Rather than correcting this misunderstanding of law, the determination letter erroneously assumes the reality of the asserted tax benefits (that’s bad enough), and then claims that they contribute to a finding of private benefit (even worse). To be sure, the organization may have planned to operate so as to confer unlawful private benefit, and the IRS properly recognizes this fact. But it could not have done so through making available a nonexistent charitable contributions deduction.
The determination letter is available electronically at 2010 TNT 224-19.