Back-health nonprofit is denied exemption for benefiting related insiders

Plain-English summary

A nonprofit proposed teaching a proprietary muscle-management program intended to reduce back pain. A related for-profit company owned by the nonprofit's president held the program's intellectual property and sold the books, apps, and other materials the nonprofit would purchase and promote. The program's creator served as the nonprofit's paid secretary and consultant, and most of the board was related or otherwise connected to the president. The nonprofit projected that most early revenue would compensate the president and secretary, and it did not provide requested details about pricing, duties, hours, revenue, and other operations. The IRS found that the nonprofit was effectively a market for the related company's products, produced private benefit and inurement for the two insiders, and had a substantial nonexempt commercial purpose. It denied section 501(c)(3) status because the organization failed the operational test and did not adequately substantiate its activities and finances.

Ruling snapshot

• Question: Does a nonprofit teaching and selling a related for-profit company's proprietary back-health program qualify under section 501(c)(3)?
• Outcome: denied
• Key authorities: IRC § 501(c)(3); Treas. Reg. § 1.501(c)(3)-1(a), (c), and (d); Rev. Rul. 80-287; Better Business Bureau of Washington, D.C. v. United States, 326 U.S. 279 (1945); Church by Mail, Inc. v. Commissioner, T.C. Memo. 1984-349

Full text (IRS public release)

Department of the Treasury
Internal Revenue Service

P.O. Box 2508
Cincinnati, OH 45201

Date: January 9, 2017

Release Number: 201714031 Employer ID number:

Release Date: 4/7/2017
Contact person/ID number:

Contact telephone number:
Form you must file:

Tax years:

UIL: 501.32-00, 501.33-00, 501.36-00

Dear

This letter is our final determination that you don’t qualify for tax-exempt status under Section 501(c)(3) of the
Internal Revenue Code (the Code). Recently, we sent you a proposed adverse determination in response to your
application. The proposed adverse determination explained the facts, law, and basis for our conclusion, and it
gave you 30 days to file a protest. Because we didn’t receive a protest within the required 30 days, the proposed
determination is now final.

Because you don’t qualify as a tax-exempt organization under Section 501(c)(3) of the Code, donors can’t
deduct contributions to you under Section 170 of the Code. You must file federal income tax returns for the tax
years listed at the top of this letter using the required form (also listed at the top of this letter) within 30 days of
this letter unless you request an extension of time to file.

We’ll make this final adverse determination letter and the proposed adverse determination letter available for
public inspection (as required under Section 6110 of the Code) after deleting certain identifying information.
Please read the enclosed Notice 437, Notice of Intention to Disclose, and review the two attached letters that
show our proposed deletions. If you disagree with our proposed deletions, follow the instructions in the Notice
437 on how to notify us. If you agree with our deletions, you don’t need to take any further action.

We’ll also notify the appropriate state officials of our determination by sending them a copy of this final letter
and the proposed determination letter (under Section 6104(c) of the Code). You should contact your state
officials if you have questions about how this determination will affect your state responsibilities and
requirements.

Letter 4038 (Rev. 7-2014)
Catalog Number 47632S

If you have questions about this letter, you can contact the person listed at the top of this letter. If you have
questions about your federal income tax status and responsibilities, call our customer service number at
1-800-829-1040 (TTY 1-800-829-4933 for deaf or hard of hearing) or customer service for businesses at
1-800-829-4933.

Sincerely,

Jeffrey I. Cooper
Director, Exempt Organizations
Rulings and Agreements

Enclosures:

Notice 437

Redacted Letter 4036, Proposed Adverse Determination Under IRC Section 501(c)(3)
Redacted Letter 4038, Final Adverse Determination Under IRC Section 501(c)(3) - No Protest

Letter 4038 (Rev. 7-2014)
Catalog Number 47632S

Department of the Treasury

Internal Revenue Service
P.O. Box 2508
Cincinnati, OH 45201
Date: November 15, 2016
Employer ID number:
Contact person/ID number:

Contact telephone number:

Contact fax number:

Legend: UIL:

B = Date of formation 501.32-00
C = State 501.33-00
D = Program 501.36-00
F = LLC

G = Secretary

H = President/Director
j dollars = Amount
k dollars = Amount

Dear

We considered your application for recognition of exemption from federal income tax under Section 501(a) of
the Internal Revenue Code (the Code). Based on the information provided, we determined that you don’t qualify
for exemption under Section 501(c)(3) of the Code. This letter explains the basis for our conclusion. Please
keep it for your records.

Issues
Do you qualify for exemption under Section 501(c)(3) of the Code? No, for the reasons stated below.

Facts

You were incorporated on B in the State of C. Your stated purposes, in part, are to act and operate as a
charitable organization in lessening the burdens of government, providing relief to the poor and distressed or
underprivileged, and promoting social welfare by health and wellness intervention to teach muscle management
for a healthy back.

You teach muscle management with a program which detects muscle asymmetry and teaches therapeutic
stretching exercises to heal chronically injured muscles and reduce back pain. You teach core muscle exercises
to tone the back muscles so that they can then be strengthened and conditioned to make the back healthy and
more strain resistant.

F is a for-profit organization that holds the intellectual property, a program called D, which you use for training
purposes. The program name, D, is also included in your name and is also an integral part of the name of F.

F will train the D instructors, personal trainers and group exercise instructors which will work with your
students in private. You will teach students, coaches and health teachers the D program. The program teaches

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optimal therapeutic stretching techniques to rehabilitate core muscles of the back and neck and keeps muscle
movement symmetrical.

G is your Secretary and a paid consultant. G is the individual that developed the D program. H is your
President and a director. G and H are brothers. Your Treasurer is H’s sister. One of your directors is a work
associate of H. You have one governing body member, a director, unrelated to the others.

You provided what was purportedly your website address on your initial application. The website has copyright
information in the name of F at the bottom of each page. It discusses the D program and indicates that it was
designed to help people avoid needless reoccurring lower back pain, upper back pain, and shoulder and neck
pain due to muscle strain. It further indicates that D was the first new scientific breakthrough for back pain in
100 years. The website gives locations and times for private consultations and classes. G wrote a book
promoted by you and also for sale on the site. Later, when asked about your website, you said that it belongs to
F. The website states that F has been operational for almost ten years.

The for-profit company F is owned by H. You said in your initial application that you will purchase books, e-
books and phone apps from F. You later said that you own all rights to the intellectual property and therefore
will have direct control over wholesale distribution. Per our request, you provided clarification regarding this
discrepancy. You said that you will buy books, e-books and apps from F at wholesale prices. You further
indicated that G owns the copyright and since his position on the board is Secretary/Consultant, he will be
donating his royalties for intellectual properties to you. You said you have a contract with G, but you did not
provide a copy.

You said that F has an exclusive license agreement with G. You said you are not planning to interact with for-
profit entities, except F, to purchase material for classes and managing online sales. You further restated there
will be no activities which benefit the for-profit entity. The only benefit for F is that it will realize the possible
cost reduction in buying teaching materials in larger quantities. There will be no payments for services to F. F
will not be compensating H when he teaches for you.

When asked how you are distinguishable from F from the public’s perspective you indicated, “The non-profit
customers will have a code to purchase materials at wholesale costs.”

The website, which you state belongs to F, indicates that the classes are j dollars per class, which includes the D
program Book/DVD. When asked about how much you will charge for classes, you said class fees are k
dollars, which is more than the class offered by F (according to their website). You said the fee includes a book
or e-book and a phone app. The fee pays the instructor and includes the wholesale prices for the class material.
You said you are not collecting fees at this time.

H has been teaching classes through F and promoting the book that was written by G. When asked for a list of
duties for each compensated individual, including the number of hours each individual works for both you and
any other entity, you said that H will be managing both F and you. G is a consultant for both organizations.
There are no other individuals working for both you and F. The details we requested regarding the hours
worked and duties performed were not provided.

Letter 4036 (Rev. 7-2014)
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Additionally, when asked what portion of F’s overall revenue would be received through your activities you
said that the percentage of the for-profit’s overall sales are going to be determined by how many schools and
other non-profit organizations purchase classes and materials.

When asked if you share a physical space, address or employees with any for-profit organizations you said, “I
work out of my home at the present time. In the future there will need to be employees and instructors working
for both the LLC and non-profit.” No other information was provided.

You said the wholesale prices of the materials are about half of the regular general public price. The wholesale
price is the amount you will pay to obtain the materials for resale. When asked for the price that you will pay
for materials that will be purchased from F, you did not submit this information.

In your initial application you stated that you plan on seeking funds through email, personal, and website
solicitations as well as foundation and government grants. You provided projected financial data with your
initial application which included compensation for G and H. For the first two years of your operations, you
project that 70% of your total revenue will be used to compensate G and H. You anticipate that your revenue
will double in your third year of operations and that 45% of that revenue will be used to compensate G and H
with another 25% being allocated for an additional instructor.

We requested a specific breakdown of each type and amount of revenue you have received since your formation
and that you plan to receive. To this request you replied, “The non-profit will be soliciting grant money to teach
firefighters, police officers, school personnel and school athletic teams.” No additional information was
provided.

Law

Section 501(c)(3) of the Code provides, in part, for the exemption from federal income tax organizations
organized and operated exclusively for charitable, religious or educational purposes, no part of the net earnings
of which inures to the benefit of any private shareholder or individual.

Treasury Regulation Section 1.501(c)(3)-1(a)(1) states that, in order to be exempt as an organization described
in Section 501(c)(3) of the Code, an organization must be both organized and operated exclusively for one or
more of the purposes specified in such section. If an organization fails to meet either the organizational test or
the operational test, it is not exempt.

Treas. Reg. Section 1.501(c)(3)-1(c)(1) provides that an organization will be regarded as “operated exclusively”
for one or more exempt purposes only if it engages primarily in activities that accomplish one or more such
exempt purposes specified in Section 501(c)(3) of the Code. An organization will not be so regarded if more
than an insubstantial part of its activities is not in furtherance of an exempt purpose.

Treas. Reg. Section 1.501(c)(3)-1(c)(2) provides that an organization is not operated exclusively for one or
more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or
individuals.

Treas. Reg. Section 1.501(c)(3)-1(d)(1)(ii) provides an applicant must show that it serves a public rather than a
private interest and specifically that it is not organized or operated for the benefit of private interests, such as

Letter 4036 (Rev. 7-2014)
Catalog Number 47630W

4

designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly
or indirectly, by such private interests.

Rev. Rul. 80-287, 1980-2 C.B. 185, involved a nonprofit lawyer referral service that arranged, at the request of
any member of the public, an initial half-hour appointment for a nominal charge with a lawyer whose name was
on an approved list maintained by the organization. As a general rule, providing services of an ordinary
commercial nature in a community, even though the undertaking is conducted on a nonprofit basis, is not
regarded as conferring a charitable benefit on the community unless the service directly accomplishes one of the
established categories of charitable purposes. The organization's activities were directed toward assisting
individuals in obtaining preventive or remedial legal services and, as such, were not specifically designed to
confer a charitable benefit on the community. Although the lawyer referral service provided some public
benefit, a substantial purpose of the program was promotion of the legal profession.

Rev. Proc. 2016-5 provides that a favorable determination letter or ruling will be issued to an organization only
if its application and supporting documents establish that it meets the particular requirements of the section
under which exemption from federal income tax is claimed. The organization must fully describe all of the
activities in which it expects to engage, including the standards, criteria, procedures, or other means adopted or
planned for carrying out the activities, the anticipated sources of receipts, and the nature of contemplated
expenditures. Where the organization cannot demonstrate to the satisfaction of the Service that it qualifies for
exemption pursuant to the section of the Code under which exemption is claimed, the Service will generally
issue a proposed adverse determination letter.

In Better Business Bureau of Washington. D.C. v. U.S., 326 U.S. 279, 283, 66 S. Ct. 112, 90 L. Ed. 67 (1945),
the Supreme Court held that the presence of a single non-exempt purpose, if substantial in nature, will destroy
the exemption regardless of the number or importance of truly exempt purposes.”

In Old Dominion Box Co. v. United States, 477 F. 2d 340 (4th Cir. 1973), cert. denied 413 U.S. 910 (1973), the
Fourth Circuit held that operating for the benefit of private parties constitutes a substantial nonexempt purpose.

In est of Hawaii v. Commissioner, 71 T.C. 1067 (1979), several for-profit est organizations exerted significant
indirect control over est of Hawaii, a nonprofit entity, through contractual arrangements. The Tax Court
concluded that the for-profits were able to use the nonprofit as an “instrument” to further their for-profit
purposes. Neither the fact that the for-profits lacked structural control over the organization nor the fact that
amounts paid to the for-profit organizations under the contracts were reasonable affected the court's conclusion
that the organization did not qualify as an organization described in Section 501(c)(3) of the Code.

Bubbling Well Church of Universal Love, Inc. v. Commissioner, 74 T.C. 531 (1980), provides that an
application for tax-exempt status “calls for open and candid disclosure of all facts bearing upon [an Applicant's]
organization, operations, and finances to assure [that there is not] abuse of the revenue laws.” Further, in the
absence of such disclosure, “the logical inference is that the facts, if disclosed, would show that the [Applicant]
fails to meet the requirements of [Section] 501(c)(3).”

In Church by Mail. Inc. v. Commissioner, T.C. Memo 1984-349, affd 765 F. 2d 1387 (9th Cir. 1985) the court
upheld that an organization operated for the substantial non-exempt purpose of providing a market for a for-
profit corporation was not exempt under Section 501(c)(3) of the Code. In this case, a non-profit organization
was formed to promote religion through the distribution of printed religious messages. The non-profit

Letter 4036 (Rev. 7-2014)
Catalog Number 47630W

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organization was related to a for-profit corporation that provided the printing and mailing services for the non-
profit organization. The for-profit corporation also provided similar services to others as part of its normal
commercial operations. The court determined that the non-profit organization was operated for the non-exempt
purpose of providing a market for the for-profit corporation’s services and that this non-exempt purpose would
preclude exemption under Section 501(c)(3) of the Code.

In International Postgraduate Medical Foundation v. Commissioner, TCM 1989-36 (1989), the Tax Court
considered the qualification for exemption under section 501(c)(3) of the Code of a nonprofit corporation that
conducted continuing medical education tours. The petitioner had three trustees: Mr. Helin, who was a
shareholder and the president of H & C Tours, a for profit travel agency, Mr. Regan, an attorney, and a third
director, who was ill and did not participate. The petitioner used H & C Tours exclusively for all travel
arrangements. There is no evidence that the petitioner ever sought a competitive bid. The Court found that a
substantial purpose of the petitioner was benefiting the for-profit travel agency. It concluded that: “When a for-
profit organization benefits substantially from the manner in which the activities of a related organization are
carried on, the latter organization is not operated exclusively within the meaning of section 501(c)(3), even if it
furthers other exempt purposes.” The court found that a substantial purpose of the applicant's operations was to
increase the income of H&C Tours. H&C Tours benefits from the distribution and production of brochures
which solicit customers for tours arranged by H&C Tours.

In New Dynamics Foundation v. United States, 70 Fed. Cl. 782, 798 (Fed. Cl. 2006), the U.S. Court of Federal
Claims held that the Service properly denied tax exempt status under Section 501(c)(3) to a nonprofit
corporation that was organized to promote and contribute to charitable causes. In reaching this conclusion, the
court stated, “It is well-accepted that, in initial qualification cases [any] gaps in the administrative record are
resolved against the applicant,” adding that courts “can draw inferences adverse to a taxpayer seeking exempt
status where the taxpayer fails to provide evidence concerning its operations, or where the evidence is vague or
inconclusive.”

Application of law

You are not described in Section 501(c)(3) of the Code or Treas. Reg. Section 1.501(c)(3)-1(a)(1) because you
fail the operational test. Specifically, the facts show you are not operated exclusively for Section 501(c)(3)
purposes, but for the substantial non-exempt purpose of facilitating sales for the benefit of your governing body
members, G and H.

You are not operated exclusively for an exempt purpose as described in Treas. Reg. Section 1.501(c)(3)-1(c)(1).
Operating for the benefit of private parties, such as G and H, constitutes a substantial non-exempt purpose as
illustrated in Old Dominion. The presence of a single non-exempt purpose, if substantial in nature, will destroy
a claim for exemption regardless of the number or importance of truly exempt purposes. Treas. Reg. Section
1.501(c)(3)-1(d)(1)(ii).

You are similar to the organization described in International Postgraduate Medical Foundation. The majority of
your board is related. H owns the related for-profit entity, F, and G is the author of the materials promoted by
you. H and G benefit substantially from the manner in which your activities are conducted. Like the
organization described in this case, you are not operated exclusively for exempt purposes within the meaning of
Section 501(c)(3). Your activities inure to the benefit of G and H as described in Treas. Reg. Section
1.501(c)(3)-1(c)(2). G and H are both compensated and their salaries consume a large portion of your revenue.
Prior to your formation, F would sell the books, e-books and apps to the general public for a certain price. You

Letter 4036 (Rev. 7-2014)
Catalog Number 47630W

6

were formed to purchase those materials from F and resell them to those interested in your programs. G is the
author of the book, holds the copyright and is the one that designed the D program. Your promotion of the D
program, which benefits G and H directly, creates inurement, which causes you be precluded from exemption
under Section 501(c)(3) of the Code.

Like the organization described in Rev. Rul. 80-287, your activities directly promote and facilitate the sale of
products by a for-profit organization. You are similar to the organization in est of Hawaii because you are
dependent on one for-profit entity, F, for your operations. Without the materials you purchase from F, you
would have no program. You are similar to Church by Mail, because you provide a market for the for-profit
business and you are promoting the for-profit business.

According to Better Business Bureau, a single non-exempt purpose will destroy exemption. You have a
substantial non-exempt purpose of promoting the D program through the purchase of books, e-books and apps
from the related for-profit entity, precluding you from exemption. You are marketing the same program, D, as
the for-profit, F. You serve the same purpose as F, provide the same educational services, have a very similar
name and share a website with F. You and F are virtually indistinguishable. In fact, you indicated the only
difference between you and F, from the public’s perspective, is that the individuals buying materials through
you get a discount code to use at checkout.

We asked for specific details regarding your activities and financial data to which you provided vague
generalities, some contradictory information, and to some of our specific requests your response was silent. An
organization has the burden of proof to describe its activities to sufficient detail to permit the Service to
determine whether it meets the definition of the Code section under which exemption is sought. As explained
in Bubbling Well, when details regarding financial data and activities are sought and the organization does not
provide that information, the logical inference is that if the requested information was provided, the
organization would not qualify for exemption.

In addition, New Dynamics explains that in initial application cases, any gaps in the administrative record are
resolved against the applicant, especially in cases where the applicant fails to provide evidence concerning its
operations, or where the evidence is vague or inconclusive. You have failed to fully describe all of your
activities in which you expect to engage, including the standards, criteria, procedures, or other means planned
for carrying out the activities, the anticipated sources of receipts, and the nature of contemplated expenditures as
required by Rev. Proc. 2016-5. Therefore, you are not entitled to exemption under Section 501(c)(3) of the
Code.

Your position

You feel you qualify for exemption since none of the directors or officers will receive financial benefits outside
of a salary for services rendered. You will buy self-published teaching materials and resources wholesale
directly from the publisher. You also state that the phone apps and e-books will have a code that allows students
and teachers to download the products at wholesale costs.

You also stated that back pain is the number one cause of disability in the world. H personally instructs the D
program at schools in health classes and the physical education department and teaches patients at a medical
clinic. This educational program has the potential to help many individuals develop a healthy back for life and
prevent needless suffering and economic loss.

Letter 4036 (Rev. 7-2014)
Catalog Number 47630W

7

Our response to your position
You were formed to promote the business of F and to promote a book written by G. H owns F and you will be

purchasing books, e-books and apps from F. Both G and H are benefiting substantially from the promotion and
sale of the books, e-books and apps that will be purchased F.

Conclusion

You do not qualify for exemption under Section 501(c)(3) of the Code because you fail the operational test.
You conduct activities which are indistinguishable from the for-profit’s activities. Your activities further
substantial non-exempt purposes and cause inurement to G and H. Additionally, you failed to provide the
details we requested regarding your activities. Therefore, you are not exempt under Section 501(c)(3).

If you don’t agree
You have a right to file a protest if you don’t agree with our proposed adverse determination. To do so, you
must send a statement to us within 30 days of the date of this letter. The statement must include:

• Your name, address, employer identification number (EIN), and a daytime phone
number

• A copy of this letter highlighting the findings you disagree with
• An explanation of why you disagree, including any supporting documents
• The law or authority, if any, you are relying on

• The signature of an officer, director, trustee, or other official who is authorized to sign for the
organization, or your authorized representative

• One of the following declarations:

For an officer, director, trustee, or other official who is authorized to sign for the organization:
Under penalties of perjury, I declare that I examined this protest statement, including

accompanying documents, and to the best of my knowledge and belief, the statement contains all
relevant facts and such facts are true, correct, and complete.

For authorized representatives:

Under penalties of perjury, I declare that I prepared this protest statement, including
accompanying documents, and to the best of my knowledge and belief, the statement contains all
relevant facts and such facts are true, correct, and complete.

Your representative (attorney, certified public accountant, or other individual enrolled to practice before the
IRS) must file a Form 2848, Power of Attorney and Declaration of Representative, with us if he or she hasn’t
already done so. You can find more information about representation in Publication 947, Practice Before the
IRS and Power of Attorney.

We'll review your protest statement and decide if you provided a basis for us to reconsider our determination. If

so, we'll continue to process your case considering the information you provided. If you haven’t provided a

Letter 4036 (Rev. 7-2014)

Catalog Number 47630W

8

basis for reconsideration, we’ll forward your case to the Office of Appeals and notify you. You can find more
information about the role of the Appeals Office in Publication 892, How to Appeal an IRS Decision on Tax-
Exempt Status.

If you don’t file a protest within 30 days, you can’t seek a declaratory judgment in court at a later date because
the law requires that you use the IRS administrative process first (Section 7428(b)(2) of the Code).

Where to send your protest
Please send your protest statement, Form 2848, if needed, and any supporting documents to the applicable
address:

U.S. mail: Street address for delivery service:
Internal Revenue Service Internal Revenue Service

EO Determinations Quality Assurance EO Determinations Quality Assurance
Room 7-008 550 Main Street, Room 7-008

P.O. Box 2508 Cincinnati, OH 45202

Cincinnati, OH 45201

You can also fax your statement and supporting documents to the fax number listed at the top of this letter. If
you fax your statement, please contact the person listed at the top of this letter to confirm that he or she received
it.

If you agree

If you agree with our proposed adverse determination, you don’t need to do anything. If we don’t hear from you
within 30 days, we’ll issue a final adverse determination letter. That letter will provide information on your
income tax filing requirements.

You can find all forms and publications mentioned in this letter on our website at www.irs.gov/formspubs. If
you have questions, you can contact the person listed at the top of this letter.

Sincerely,

Jeffrey I. Cooper
Director, Exempt Organizations
Rulings and Agreements

Enclosure:
Publication 892

Letter 4036 (Rev. 7-2014)
Catalog Number 47630W