"Pay-what-you-want" café foundation loses 501(c)(3) status as a substantial commercial business

Plain-English summary

The IRS revoked a foundation's 501(c)(3) exemption because its main activity was running "pay-what-you-want" cafés that looked and operated like ordinary restaurants rather than a charity. To be exempt, an organization must be operated exclusively for charitable purposes, and a single substantial nonexempt (commercial) purpose defeats exemption no matter how many charitable purposes also exist. Here the foundation's cafés were open to the general public seven days a week in areas that were not economically depressed, competed with nearby eating places, posted suggested menu prices, and collected receipts (often at or above retail) from customers without any showing of need; the foundation kept no records identifying how much of what customers paid was a true gift versus payment for a meal. The foundation was controlled by a related for-profit whose employees were its officers and directors, and most of its support came from that for-profit rather than the public. Relying on cases like B.S.W. Group, Airlie Foundation, and Better Business Bureau (a substantial commercial purpose defeats exemption), the IRS concluded that providing food to a non-charitable class for a fee is not charitable and that the café operation was a substantial unrelated commercial business. Exemption was revoked effective January 1 of the year in issue, contributions are no longer deductible under section 170, and the organization must file Form 1120. The document bundles the Appeals Office final adverse determination and the Form 886-A examination report.

Ruling snapshot

• Question: Should a foundation's 501(c)(3) exemption be revoked where its primary activity was operating commercial-style "donation" cafés serving the general public for a fee?
• Outcome: revocation (effective January 1 of the year in issue; substantial nonexempt commercial activity; Form 1120 required)
• Key authorities: IRC §§ 501(c)(3), 170, 512-513; Treas. Reg. § 1.501(c)(3)-1(c), (d), (e); Rev. Ruls. 67-246, 72-369; B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352; Airlie Foundation v. IRS, 283 F. Supp. 2d 58; Better Business Bureau v. United States, 326 U.S. 279; Easter House v. United States, 12 Cl. Ct. 476

Full text (IRS public release)

Scanned document; transcription proofread from IRS OCR. A few obvious scan misreads were corrected (for example, "TAX will do everything" restored to "TAS will do everything" and "uniess" to "unless"), and OCR bullet markers rendered "e" were restored to bullets; wording is otherwise verbatim, including the Form 886-A page furniture, and redacted identifiers and figures appear as the IRS released them.

Internal Revenue Service Department of the Treasury
Appeals Office
San Jose Appeals, MS-7100 Employer Identification Number:
55 S. Market St., Suite 440
San Jose, CA 95113

Person to Contact:
Date: December 20, 2018

Number: 201911010
Release Date: 3/15/2019

UIL: 501.36-00
501.36-01

Certified Mail

Dear

This is a final adverse determination that you do not qualify for exemption from federal income tax under
Internal Revenue Code (the “Code”) Section 501(a) as an organization described in Section 501(c)(3) of
the Code.

We have hereby revoked the favorable determination letter to you dated July 1,20XX and you are no
longer exempt under Section 501(a) of the Code effective January 1, XX.

We made the adverse determination for the following reason(s):

You are not operated exclusively for charitable or other exempt purposes, as required by
section 501(c)(3) of the Code. Your primary activity was operating community located
in former locations, and

. Providing food and drink to
members of the general public absent a showing of need is not a charitable purpose under
section 501(c)(3). In addition, open to the general public during
commercial business hours and accepting retail cost or greater in payments from individuals
receiving the food items indicates a substantial non-exempt commercial purpose. Also, this
activity was and through the
operation of similar in appearance and operation to the , rather than
through donations or other support indicating community oversight from the general public,
further showing that the operations of the were for substantial non-exempt private
rather than public purposes.

Contributions to your organization are not deductible under section 170 of the Code.

You're required to file Federal income tax returns on Forms 1120, U.S. Corporation Income Tax Return.
Mail your form to the appropriate Internal Revenue Service Center per the form’s instructions. You can
get forms and instructions by visiting our website at www.irs.gov/forms-pubs or by calling 800-TAX-FORM
(800-829-3676).

We'll make this letter and the proposed adverse determination letter available for public inspection under
Code section 6110 after deleting certain identifying information. We have provided to you, in a separate
mailing, Notice 437, Notice of Intention to Disclose. Please review the Notice 437 and the documents

attached that show our proposed deletions. If you disagree with our proposed deletions, follow the
instructions in Notice 437.

If you decide to contest this determination, you may file an action for declaratory judgment under the
provisions of section 7428 of the Code in either:

• United States Tax Court,
• The United States Court of Federal Claims,
• The United States District Court for the District of Columbia.

You must file a petition or complaint in one of these three courts within 90 days from the date we mailed
this determination letter to you. Contact the clerk of the appropriate court for rules and the appropriate
forms for filing petitions for declaratory judgment. You can write to the courts at the following addresses:

United States Tax Court
400 Second Street, NW
Washington, DC 20217

US Court of Federal Claims
717 Madison Place, NW
Washington, DC 20005

U. S. District Court for the District of Columbia
333 Constitution Ave., N.W.
Washington, DC 20001

Note: We will not delay processing income tax returns and assessing any taxes due even if you file
petition for declaratory judgment under section 7428 of the Code.

Please refer to the enclosed Publication 892, How to Appeals an IRS Determination on Tax -Exempt
Status, for more information about the Appeals process.

You also have the right to contact the Taxpayer Advocate Service (TAS). TAS is an independent
organization within the IRS that can help protect your taxpayer rights. TAS can offer you help if your tax
problem is causing a hardship, or you've tried but haven't been able to resolve your problem with the IRS.
Advocate assistance, please contact the Taxpayer Advocate for the IRS office that issued this letter. You
If you qualify for TAS assistance, which is always free. TAS will do everything possible to help you. Visit
www.taxpayeradvocate.irs.gov or call 877-777-4778.

TAS assistance is not a substitute for established IRS procedures, such as the formal appeals process.
TAS cannot reverse a legally correct tax determination, or extend the time fixed by law that you have to
file a petition in a United States Court.

If you have any questions, contact the person at the top of this letter.

Sincerely,

Appeals Team Manager

Enclosure: Publication 892

cc:

Date:
March 23, 2017

In Reve ervi we at
ternal Revenue Service Taxpayer Identification Number:

Tax Exempt and Government Entities
IRS Exempt Organizations Examinations

Ai) Department of the Treasury

Suite 101 Form:
2850 NE Independence Ave.
Lee’s Summit, MO 64064 Tax Year(s) Ended:

Person to Contact / |D Number:

Employee ID:
Contact numbers:
Telephone:
Fax:
Manager’s Name / ID Number:

Employee ID:
Manager's Contact Number:

Response Due Date:
Certified Mail — Return Receipt Requested
Dear

Why you are receiving this letter

We propose to revoke your status as an organization described in section 501(c)(3) of the
Internal Revenue Code (Code). Enclosed is our report of examination explaining the proposed
action.

What you need to do if you agree

If you agree with our proposal, please sign the enclosed Form 6018, Consent to Proposed
Action — Section 7428, and return it to the contact person at the address listed above (unless
you have already provided us a signed Form 6018). We'll issue a final revocation letter
determining that you aren’t an organization described in section 501(c)(3).

After we issue the final revocation letter, we’ll announce that your organization is no longer
eligible for contributions deductible under section 170 of the Code.

If we don't hear from you

If you don’t respond to this proposal within 15 calendar days from the date of this letter, we'll
issue a final revocation letter. Failing to respond to this proposal will adversely impact your legal
standing to seek a declaratory judgment because you failed to exhaust your administrative
remedies.

Effect of revocation status
If you receive a final revocation letter, you'll be required to file federal income tax returns for the
tax year(s) shown above as well as for subsequent tax years.

What you need to do if you disagree with the proposed revocation

Letter 3618 (Rev. 6-2012)
Catalog Number 34809F

If you disagree with our proposed revocation, you may request a meeting or telephone
conference with the supervisor of the IRS contact identified in the heading of this letter. You also
may file a protest with the IRS Appeals office by submitting a written request to the contact
person at the address listed above within 15 calendar days from the date of this letter.

The Appeals office is independent of the Exempt Organizations division and resolves most
disputes informally.

For your protest to be valid, it must contain certain specific information including a statement of
the facts, the applicable law, and arguments in support of your position. For specific information
needed for a valid protest, please refer to page one of the enclosed Publication 892, How to
Appeal an IRS Decision on Tax-Exempt Status, and page six of the enclosed Publication 3498,
The Examination Process. Publication 3498 also includes information on your rights as a
taxpayer and the IRS collection process. Please note that Fast Track Mediation referred to in
Publication 3498 generally doesn’t apply after we issue this letter.

You also may request that we refer this matter for technical advice as explained in Publication

892. Please contact the individual identified on the first page of this letter if you are considering
requesting technical advice. If we issue a determination letter to you based on a technical
advice memorandum issued by the Exempt Organizations Rulings and Agreements office, no
further IRS administrative appeal will be available to you.

Contacting the Taxpayer Advocate Office is a taxpayer right

You have the right to contact the office of the Taxpayer Advocate. Their assistance isn't a
substitute for established IRS procedures, such as the formal appeals process. The Taxpayer
Advocate can't reverse a legally correct tax determination or extend the time you have (fixed by
law) to file a petition in a United States court. They can, however, see that a tax matter that
hasn't been resolved through normal channels gets prompt and proper handling. You may call
toll-free 1-877-777-4778 and ask for Taxpayer Advocate assistance. If you prefer, you may
contact your local Taxpayer Advocate at:

Internal Revenue Service
Office of the Taxpayer Advocate

For additional information

If you have any questions, please call the contact person at the telephone number shown in the
heading of this letter. If you write, please provide a telephone number and the most convenient
time to call if we need to contact you.

Thank you for your cooperation.
Sincerely,

Maria Hooke
Director, EO Examinations

Enclosures:

Report of Examination
Form 6018
Publication 892
Publication 3498

2 Letter 3618 (Rev. 6-2012)
Catalog Number 34809F

Schedule or
Form 886-A EXPLANATION OF ITEMS Exhibit No.
Name of Taxpayer Year Ended
December 31,
20XX
Issues:
Whether 501(c)(3) tax-exempt status should be revoked

because of the existence of a substantial nonexempt activity.

Facts: Operations:

“hereafter referred to as the Foundation” was granted
exemption under Section 501(c)(3) of the Internal Revenue Code from January 10, 20XX, the
date that they incorporation with the State of

Initially, the Foundation activities consisted of organizing and implementing campaigns for
contributions and soliciting requests for donations. The contributions were then directed toward
providing assistance to organizations and programs that missions fell within the following
categories: Health and Welfare, Education, Culture and Arts, Civic and Community.

During tax year 20XX the Foundation’s activities consisted of the following:

• To provide contributions to exempt organizations throughout the United States for the
following activities: health and welfare, education, cultural and arts, and civic and
community.

To assists in procuring food and feeding America through a network of food banks.

To run , a program that consists of which operate similar to a
traditional . Customers are encouraged to take what they need and
make a suggested donation in return for the food and drinks received.

• To provide a job training program at the for high-risk individuals
between the ages of and __ that are referred by local non-profit organizations to the
Foundation.

Contributions/Assist in Procuring Food and Feeding America

During tax year 20XX the Foundation made grants and other assistance of $ to other
charitable organizations.

- Operations of Facilities

is a program that consists of which operate similar to traditional
. The are located in areas that are not economically depressed and
compete with other eating facilities that are located in the areas. The were
located in ; and . The were open seven days a
week. The menus at the Foundation’s include all of the of
a traditional . Please refer to Exhibit I.

The request suggested donations for the food and drinks that are provided,
and will accept whatever the customer wants to pay. The customers are not required to make
any payments in return for the food and drinks provided. The suggested donations are listed on
the menu board. Approximately, percent of the customers pay more than the value of

1|Page

Schedule or
Form 886-A EXPLANATION OF ITEMS Exhibit No.
Name of Taxpayer Year Ended
December 31,
20XX

the meal, percent of the customers pay the value of the meal and _ percent of the
customers pay less than the value of the meal. Customers that pay more than the suggested
menu price are not advised of the amount that should be treated as a contribution. When the

were initially opened it was estimated that they served over people each
week. During the 20XX tax year the Foundation received $ in receipts for the sale of
food and drinks items provided at the

Job Training Program

During the tax year ending Dec. 31, 20XX . had individuals
graduate from their job training program. - graduates,

- graduates and - . During the years , , and

the job training program has had _high-risk individuals graduate. The program provides
training for youth so they can get jobs in the food service industry.

Employees

The Foundation had workers that were compensated for related services
and the Foundation paid total compensation of $ for the workers during tax
year

Foundation Controlled by Related For-profit

The Foundation is controlled by the members of a related for for-profit organization,

. All of the officers and directors of the Foundation are employees of . The
worker’s compensation were paid by and then was reimbursed by the
Foundation for the compensation that was paid. The Foundation does have some volunteers,
the volunteers are not permitted to handle food or collection monies, the volunteers are
restricted to cleaning tables, windows and floors.

During tax year ending December 31, 20XX, the Foundation had the following revenues:

$ - — Donated of , ; and, property and equipment.

$ - — Cash: ;

$ - — Receipts for food and drinks items from the general public.

$ — Vendor support contributions.

$ - Donation Boxes at for-profit facilities.

The majority of the Foundation’s support is from the related for-profit organization.

The activities are operated at a loss, even though they receive donations of , ;
and, property and equipment from . It was stated that the

activity was started because the Foundation intended to make a profit from the receipts
obtained from the food and drinks that were provided at the

LAW:

2|Page

Schedule or
Form 886-A EXPLANATION OF ITEMS Exhibit No.
Name of Taxpayer Year Ended
December 31,
20XX

Section 501(c)(3) of the Code provides for the exemption from federal income tax of
organizations organized and operated exclusively for charitable purposes.

Section 1.501(c)(3)-1(d)(2) of the Income Tax Regulations provides that the term ‘charitable’ is
used in section 501(c)(3) of the Code in its generally accepted legal sense, and includes the
lessening of the burdens of government.

An organization described in section 501(c)(3) of the Code, must, among other requirements, be
organized and operated exclusively for certain purposes.

Section 1.501(c)(3)-1(a)(1) of the Income Tax Regulations states: "In order to be exempt as an
organization described in section 501(c)(3), 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."
Section 1.501(c)(3)-1(c)(1) of the regulations states: "An organization will be regarded as
‘operated exclusively for one or more exempt purposes only if it engages primarily in activities
which accomplish one or more of such exempt purposes specified in section 501(c)(3). An
organization will not be so regarded if more than an insubstantial part of its activities is not in
furtherance of an exempt purpose.

Section 1.501(c)(3)-1(d)(1)(ii) of the regulations state that: "An organization is not organized and
operated exclusively for one or more of the purposes specified. . .unless it serves a public rather
than a private interest. Thus, to meet the requirements. . . 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 or his family, shareholders of the organization, or persons
controlled directly or indirectly, by such private interests." Section 1.501(c)(3)-1(e)(1) of the
regulations states: "An organization may meet the requirements of section 501(c)(3) although it
operates a trade or business as a substantial part of its activities, if the operation of such trade
or business is in furtherance of the organization's exempt purpose or purposes and if the
organization is not organized or operated for the primary purpose of carrying on an unrelated
trade or business, as defined in section 513. In determining the existence or nonexistence of
such primary purpose, all the circumstances must be considered, including the size and extent
of the trade or business and the size and extent of the activities which are in furtherance of one
or more exempt purposes."

Treasury Regulation 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 of such exempt purposes specified in section 501(c)(3).
An organization will not be so regarded if more than an insubstantial part of its activities is not in
furtherance of an exempt purpose.

Section 170 of the Code provides for allowance of deductions for charitable contributions,
subject to certain requirements and limitations. To the extent here relevant a charitable
contribution is defined 105 by that section as "a contribution or gift to or for the use of" certain
specified types of organizations. To be deductible as a charitable contribution for Federal
income tax purposes under section 170 of the Code, a payment to or for the use of a qualified
charitable organization must be a gift. To be a gift for such purposes in the present context

3|Page

Schedule or
Form 886-A EXPLANATION OF ITEMS Exhibit No.
Name of Taxpayer Year Ended
December 31,
20XX

there must be, among other requirements, a payment of money or transfer of property without
adequate consideration.

Section 512(a) defines “unrelated business taxable income” as the gross income from any
“unrelated trade or business’ regularly carried on by the organization as computed in the manner
provided in section 512.

The term “unrelated trade or business” is defined in section 513(a) of the Code as any trade or
business the conduct of which is not substantially related (aside from the need of such
organization for income or funds or the use it makes of the profits derived) to the exercise or
performance by such organization of its exempt functions.

Section 513(a) of the Code provides that the term “unrelated trade or business” means, in the
case of any organization subject to the tax imposed by section 511, any trade or business the
conduct of which is not substantially related (aside from the need of such organization for income
or funds or the use it makes of the profits derived) to the exercise or performance by such
organization of its charitable, educational, or other purpose or function constituting the basis for its
exemption under section 501.

Section 513(c) of the Code provides that for the purposes of this section the term “trade or
business’ includes any activity that is carried on for the production of income from the sale of
goods or the performance of services.

Taxpayer's Position:

The Foundation believes that since the only request donations in return for the food and
drinks that the are charitable in nature.

Government's Position:

The Foundation primary activity is to operate in affluent areas, the provided food
and drinks to the general public, and at times to persons in need. The were not operated
primarily for the purpose of providing food and drinks to individuals in need. The activities

are substantial, the Foundation had workers that were employed to operate the
during tax year 20XX. The job training activities are insubstantial in nature since there were very
few participants, during tax year 20XX and oO over a year period.

The Foundation has posted suggested menu prices in the . The customers are requested
to pay suggested menu prices for the food and drink items, but the Foundation does not require
the customers to pay anything for the food and drinks. The Foundation did not provide any
specific documentation to show when the customers paid more than the suggested meal price.
Therefore, there was not anything documentation provided to show how much of the food and
drinks revenues should be considered a contribution.

The Foundation was also set-up for the purpose of accepting donated items from a
for-profit organization. donated of , , property and equipment
and cash. It was determined that most of the support during the tax year was from donations

4|Page

Schedule or
Form 886-A EXPLANATION OF ITEMS Exhibit No.
Name of Taxpayer Year Ended
December 31,
20XX
made by . The employees of control the Foundation, the officers and

directors of the Foundation are employees of

Revenue Ruling 67-246 clarifies Section 170 of the Code that provides for allowance of
deductions for charitable contributions, subject to certain requirements and limitations. To be
deductible as a charitable contribution for Federal income tax purposes under Section 170 of
the Code, a payment to or for the use of a qualified charitable organization must be a gift. To be
a gift for such purposes in the present context there must be, among other requirements, a
payment of money or transfer of property without adequate consideration.

In Rev. Ruling 72-369, an organization was formed to provide managerial and consulting
services for section 501(c)(3) organizations to improve the administration of their charitable
programs. The organization enters into agreements with unrelated section 501 (c)(3)
organizations to furnish managerial and consulting services on a cost basis. This revenue ruling
stated that: An organization is not exempt merely because its operations are not conducted for
the purpose of producing a profit. To satisfy the ‘operational test,’ the organization's resources
must be devoted to purposes that qualify as exclusively charitable within the meaning of section
501(c)(3) of the Code and the applicable regulations. Providing managerial and consulting
services on a regular basis for a fee is a trade or business ordinarily carried on for profit. The
fact that the services in this case are provided at cost and solely for exempt organizations is not
sufficient to characterize this activity as charitable within the meaning of section 501(c)(3) of the
Code. Furnishing the services at cost lacks the donative intent element necessary to establish
this activity as charitable.

In B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352 (1978), the Tax Court held that an
organization did not qualify for exemption under section 501(c)(3) of the Code because it was
primarily engaged in an activity that was characteristic of a trade or business and ordinarily
carried on by for-profit commercial businesses. The Tax Court stated: "We must agree with the
Commissioner that petitioner's activity constitutes the conduct of a consulting business of the
sort which is ordinarily carried on by commercial ventures organized for profit."

In Airlie Foundation v. Internal Revenue Service, 283 F. Supp. 2d 58 (D.D.C. 2003), the District
Court found that that the organization was formed principally to organize, host, conduct and
sponsor educational and other charitable functions on its facilities. The organization's patrons
were not limited to tax-exempt entities, but included patrons of a private and corporate nature.
The organization paid significant advertising and promotional expenses and derived substantial
income from weddings and special events held at its conference center. The court determined
that the organization's activities competed with a number of commercial, as well as
noncommercial entities, which strongly evidenced a commercial nature and purpose. The court
concluded that although the organization carried out a number of charitable and educational
activities, these were incidental to its primary activity of operating a for-profit conference center.
The court stated: "While plaintiffs organizational purpose is exempt and the foundation operates,
in important respects, in an exempt fashion, there is a distinctive 'commercial hue’ to the way
Airlie carries out its business"

In American Institute for Economic Research v. United States, 302 F.2d 934 (Ct. Cl. 1962), the
Court considered the status of an organization that provided analyses of securities and

5|Page

Schedule or
Form 886-A EXPLANATION OF ITEMS Exhibit No.
Name of Taxpayer Year Ended
December 31,
20XX

industries and of the economic climate in general. It sold subscriptions to various periodicals
and services providing advice for purchases of individual securities. The Court noted that
education is a broad concept, and assumed for the sake of argument that the organization had
an educational purpose. The Court concluded, however, that the totality of the organization's
activities, which included the sale of many publications as well as the sale of advice for a fee to
individuals, was more indicative of a business than that of an educational organization. The
Court held that the organization had a significant non-exempt commercial purpose that was not
incidental to the educational purpose and that the organization was not entitled to be regarded
as exempt.

In United States v. American Bar Endowment, 106 S. Ct. 2426 (1986), the Supreme Court held
that an 501(c)(3) organization's insurance program constituted both the sale of goods and
performance of services and, therefore constituted a trade or business for purposes of the
computation of tax on unrelated business income. The court determined that the manner in
which the American Bar Endowment conducted the activity was like that of a for-profit insurance
broker.

The Foundation is providing dining services that are similar to those provided by commercial
businesses. The Claims Court in Easter House v. United States, 12 Cl. Ct. 476 (1987) held that
an organization that provided health services to unmarried mothers and their children as a part
of its adoption service did not operate exclusively for an exempt purpose since the health
services were provided only as a part of the adoption services that were similar to those
provided by commercial businesses.

The Foundation is involved in some other charitable activities besides the . But the

are the Foundation’s primary activity. The existence of a substantial nonexempt purpose,
regardless of the number or importance of exempt purposes, will cause failure of the operational
test. Better Business Bureau of Washington, D.C., Inc. v. United States, 326 U.S. 279 (1945).
Treasury Regulation 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 of such exempt purposes specified in section 501(c)(3).
An organization will not be so regarded if more than an insubstantial part of its activities is not in
furtherance of an exempt purpose. The providing of restaurant facilities to the general
public is not a charitable activity and not within the meaning of Internal Revenue Code
501(c)(3).

The Foundation has a substantial non-exempt activity and does not qualify under Section
501(c)(3) of the Internal Revenue Code. Providing food and drinks primarily to a non-charitable
class for a fee is not within the meaning of Section 501(c)(3) of the Internal Revenue Code. In
fact, the Foundation is conducting a commercial unrelated business that is substantial in nature.
Therefore, since the Foundation primary activity is to operate that serves the general
public, the Foundation is involved in a substantial nonexempt activity and the Foundation’s
501(c)(3) tax-exempt status should be revoked as of January 1, 20XX.

Conclusion:

6|Page

Form 886-A

EXPLANATION OF ITEMS

Schedule or
Exhibit No.

Name of Taxpayer

Year Ended

December 31,
20XX

The Foundation is not “operated exclusively” for one or more exempt purposes specified in
section 501(c)(3). Accordingly, the Foundation’s tax-exempt status is revoked effective January

1, 20XX.

7|Page