In a recently released ruling, the Internal Revenue Service (“IRS”) determined that a Section 501(c)(3) membership association’s certification program generates taxable unrelated business income to the association. The ruling — a private letter ruling (PLR 200439043, June 28, 2004) issued by the IRS addressing the particular facts of one organization — provides valuable insight into the IRS’ approach regarding certification program revenue received by 501(c)(3) organizations, and could have a significant impact on a large number of professional membership associations. The impact may be more far-reaching than the mere imposition of unrelated business income tax (“UBIT”), and may result in the wholesale reshuffling of certification activities – as well as related study guides, educational seminars, and other programs that support the certification function – into affiliated Section 501(c)(6) entities.
Background
In general, most membership organizations — whether trade associations or professional societies — qualify as tax-exempt organizations under Section 501(c)(6) of the Internal Revenue Code. Section 501(c)(6) is reserved for organizations that operate primarily for the benefit of a line of business or profession. However, many professional societies, particularly those in the medical and scientific fields, have been able to qualify for recognition under Section 501(c)(3) of the Internal Revenue Code in the past. (It appears as though the IRS at present is far less likely to recognize an individual membership organization as exempt under Section 501(c)(3) than in the past.) Membership organizations that qualify under Section 501(c)(3) do so because they have been able to demonstrate to the IRS that they are organized and operated exclusively for one or more publicly beneficial purposes. Thus, the primary beneficiary of the activities of a 501(c)(3) organization should be the public; the primary beneficiary of the activities of a 501(c)(6) organization should be a line of business or profession. While it is more difficult to qualify under Section 501(c)(3), such status often is viewed as preferable to Section 501(c)(6) status — donations to 501(c)(3) organizations are tax-deductible as charitable contributions; many government and private sector grants are limited to 501(c)(3) organizations; and state and local sales, use and property tax exemptions generally are limited to certain 501(c)(3) organizations, for example.
In the past, even medical and scientific membership organizations that otherwise would have had little difficulty qualifying for Section 501(c)(3) status usually were not successful if a substantial portion of their activities included the offering of some type of professional certification program. For example, the IRS released a technical advice memorandum in 1986 refusing to allow an educational organization to convert from Section 501(c)(6) to Section 501(c)(3) status. That refusal was based, in large part, on the organization’s operation of a certification program, which the IRS determined was “designed and operated to achieve professional standing” for the professionals who are certified and “to enhance the respectability of those who have been certified.”
Further, a 1973 IRS revenue ruling addressed whether a medical specialty board qualified for tax-exempt status under Section 501(c)(3) when a primary activity of the organization was to administer written examinations and issue certificates to individual members of the particular medical specialty who passed such examinations. According to the IRS: “Although some public benefit may be derived from promoting high professional standards in a particular medical specialty, the activities of the board are directed primarily to serving the interest of the medical profession. Under these circumstances, the board is not organized and operated exclusively for charitable purposes. … Accordingly, the board is exempt from Federal income tax under section 501(c)(6) of the Code, but is not exempt under section 501(c)(3).”
Recent Private Letter Ruling
While it is clear that the IRS consistently has taken the position that an organization that is seeking recognition under Section 501(c)(3) will not be successful if a substantial portion of the activity is certifying professionals, until now, it has not been clear how the IRS would treat a 501(c)(3) organization that: (1) had a certification program that did not constitute a substantial portion of its overall activities; (2) instituted a certification program subsequent to being recognized by the IRS as exempt under Section 501(c)(3); and/or (3) offered educational and training programs and publications (for a fee) to help prepare individuals for the certification exam, and perhaps in connection with recertification as well. This recent PLR sheds some critical light on these questions.
The organization at issue in the new PLR was one that was organized for “scientific and educational purposes for the advancement of the theory and practice of certain disciplines, and their allied branches and related arts and sciences.” (While PLRs are public documents, they are only released in redacted form; thus, any information that might serve to disclose the identity of the taxpayer is omitted.)
The organization has a number of different activities and boards, one of which oversees a membership society; the membership society is, in effect, a subdivision of the 501(c)(3) organization, but is part of the same legal entity. The membership society created a certification program with four basic qualification requirements: (1) exam-based testing; (2) experience-based qualifications; (3) minimum continuing professional education; and (4) compliance with a code of conduct. As part of the program, the organization was planning to offer various workshops and educational programs, an online study guide, a book of sample questions, and a specific training curriculum. Additionally, in order to apply for certification, candidates must either: (1) be a member of the membership society or an equivalent professional association; or (2) be registered as a professional with a state.
The IRS analyzed the factual situation and determined that the program is very similar to the one described in the medical specialty board revenue ruling — the primary beneficiary of the certification program is the profession represented by the organization, and the public benefits only incidentally from the program. Further, the IRS determined that the seminars and study guides developed in conjunction with the certification examination, while educational, are “designed primarily to assist candidates in passing the examination.”
The IRS went on to determine that even though the activities of the certification program do not accomplish a Section 501(c)(3) exempt purpose, the activities constitute an insubstantial part of the total activities of the organization. Thus, the certification program will not jeopardize the organization’s tax-exempt status, but it does constitute an unrelated trade or business, subjecting the revenues derived from the program to the federal tax on unrelated business income. Further, the IRS determined that the sale of study guides and the offering of exam preparatory courses were a part of the overall certification program, and, thus, income from such activities also would be subject to UBIT.
What Does It Mean?
A PLR, by its very terms, states that it is directed only to the organization that requested it; the Internal Revenue Code makes clear that PLRs may not be used or cited as precedent. Thus, this PLR should not be interpreted to mean that the IRS will never treat a 501(c)(3) organization’s certification program as related to its exempt purposes. However, PLRs are helpful in providing insight into the IRS’ positions on key issues affecting trade and professional associations. This PLR indicates that many 501(c)(3) associations may need to reconsider how they handle certification and related educational and training activities – and in what legal entity they are “housed.”
While much of the PLR reiterates past precedent — that is, the IRS generally will not allow an organization to maintain Section 501(c)(3) status if a substantial portion of its overall activities is the operation of a certification program — it also made clear that the IRS will treat certification program income received by a 501(c)(3) organization as taxable to the organization when the certification activities are insubstantial. Further, this PLR indicates clearly that the IRS will include in its calculation of certification program revenue the income that an organization receives from the sale of study guides and from educational programs that are “designed primarily to assist candidates in passing” a certification examination.
Possible Approaches
Going forward, a 501(c)(3) organization that engages in or seeks to engage in certification activities has a number of options. Specifically:
Background
In general, most membership organizations — whether trade associations or professional societies — qualify as tax-exempt organizations under Section 501(c)(6) of the Internal Revenue Code. Section 501(c)(6) is reserved for organizations that operate primarily for the benefit of a line of business or profession. However, many professional societies, particularly those in the medical and scientific fields, have been able to qualify for recognition under Section 501(c)(3) of the Internal Revenue Code in the past. (It appears as though the IRS at present is far less likely to recognize an individual membership organization as exempt under Section 501(c)(3) than in the past.) Membership organizations that qualify under Section 501(c)(3) do so because they have been able to demonstrate to the IRS that they are organized and operated exclusively for one or more publicly beneficial purposes. Thus, the primary beneficiary of the activities of a 501(c)(3) organization should be the public; the primary beneficiary of the activities of a 501(c)(6) organization should be a line of business or profession. While it is more difficult to qualify under Section 501(c)(3), such status often is viewed as preferable to Section 501(c)(6) status — donations to 501(c)(3) organizations are tax-deductible as charitable contributions; many government and private sector grants are limited to 501(c)(3) organizations; and state and local sales, use and property tax exemptions generally are limited to certain 501(c)(3) organizations, for example.
In the past, even medical and scientific membership organizations that otherwise would have had little difficulty qualifying for Section 501(c)(3) status usually were not successful if a substantial portion of their activities included the offering of some type of professional certification program. For example, the IRS released a technical advice memorandum in 1986 refusing to allow an educational organization to convert from Section 501(c)(6) to Section 501(c)(3) status. That refusal was based, in large part, on the organization’s operation of a certification program, which the IRS determined was “designed and operated to achieve professional standing” for the professionals who are certified and “to enhance the respectability of those who have been certified.”
Further, a 1973 IRS revenue ruling addressed whether a medical specialty board qualified for tax-exempt status under Section 501(c)(3) when a primary activity of the organization was to administer written examinations and issue certificates to individual members of the particular medical specialty who passed such examinations. According to the IRS: “Although some public benefit may be derived from promoting high professional standards in a particular medical specialty, the activities of the board are directed primarily to serving the interest of the medical profession. Under these circumstances, the board is not organized and operated exclusively for charitable purposes. … Accordingly, the board is exempt from Federal income tax under section 501(c)(6) of the Code, but is not exempt under section 501(c)(3).”
Recent Private Letter Ruling
While it is clear that the IRS consistently has taken the position that an organization that is seeking recognition under Section 501(c)(3) will not be successful if a substantial portion of the activity is certifying professionals, until now, it has not been clear how the IRS would treat a 501(c)(3) organization that: (1) had a certification program that did not constitute a substantial portion of its overall activities; (2) instituted a certification program subsequent to being recognized by the IRS as exempt under Section 501(c)(3); and/or (3) offered educational and training programs and publications (for a fee) to help prepare individuals for the certification exam, and perhaps in connection with recertification as well. This recent PLR sheds some critical light on these questions.
The organization at issue in the new PLR was one that was organized for “scientific and educational purposes for the advancement of the theory and practice of certain disciplines, and their allied branches and related arts and sciences.” (While PLRs are public documents, they are only released in redacted form; thus, any information that might serve to disclose the identity of the taxpayer is omitted.)
The organization has a number of different activities and boards, one of which oversees a membership society; the membership society is, in effect, a subdivision of the 501(c)(3) organization, but is part of the same legal entity. The membership society created a certification program with four basic qualification requirements: (1) exam-based testing; (2) experience-based qualifications; (3) minimum continuing professional education; and (4) compliance with a code of conduct. As part of the program, the organization was planning to offer various workshops and educational programs, an online study guide, a book of sample questions, and a specific training curriculum. Additionally, in order to apply for certification, candidates must either: (1) be a member of the membership society or an equivalent professional association; or (2) be registered as a professional with a state.
The IRS analyzed the factual situation and determined that the program is very similar to the one described in the medical specialty board revenue ruling — the primary beneficiary of the certification program is the profession represented by the organization, and the public benefits only incidentally from the program. Further, the IRS determined that the seminars and study guides developed in conjunction with the certification examination, while educational, are “designed primarily to assist candidates in passing the examination.”
The IRS went on to determine that even though the activities of the certification program do not accomplish a Section 501(c)(3) exempt purpose, the activities constitute an insubstantial part of the total activities of the organization. Thus, the certification program will not jeopardize the organization’s tax-exempt status, but it does constitute an unrelated trade or business, subjecting the revenues derived from the program to the federal tax on unrelated business income. Further, the IRS determined that the sale of study guides and the offering of exam preparatory courses were a part of the overall certification program, and, thus, income from such activities also would be subject to UBIT.
What Does It Mean?
A PLR, by its very terms, states that it is directed only to the organization that requested it; the Internal Revenue Code makes clear that PLRs may not be used or cited as precedent. Thus, this PLR should not be interpreted to mean that the IRS will never treat a 501(c)(3) organization’s certification program as related to its exempt purposes. However, PLRs are helpful in providing insight into the IRS’ positions on key issues affecting trade and professional associations. This PLR indicates that many 501(c)(3) associations may need to reconsider how they handle certification and related educational and training activities – and in what legal entity they are “housed.”
While much of the PLR reiterates past precedent — that is, the IRS generally will not allow an organization to maintain Section 501(c)(3) status if a substantial portion of its overall activities is the operation of a certification program — it also made clear that the IRS will treat certification program income received by a 501(c)(3) organization as taxable to the organization when the certification activities are insubstantial. Further, this PLR indicates clearly that the IRS will include in its calculation of certification program revenue the income that an organization receives from the sale of study guides and from educational programs that are “designed primarily to assist candidates in passing” a certification examination.
Possible Approaches
Going forward, a 501(c)(3) organization that engages in or seeks to engage in certification activities has a number of options. Specifically:
- The safest approach for a 501(c)(3) organization that is operating or plans to operate a certification program would be to establish a separate, affiliated 501(c)(6) organization that operates the certification program and related preparatory activities. This can be accomplished in a manner that does not result in the 501(c)(3) organization relinquishing all control over the certification activities: by contract and through the entities’ organizational documents, the 501(c)(3) entity can be authorized to appoint (and remove) the officers and board members of the affiliated 501(c)(6) organization, can reserve the right to approve all amendments to the 501(c)(6) entity’s articles of incorporation and bylaws, and can restrict the 501(c)(6) organization from operating independently of the 501(c)(3) entity without its consent. Moreover, the 501(c)(3) entity can lease staff, office space, and office services to the 501(c)(6) organization at fair market value, eliminating the need for the 501(c)(6) entity to do so on its own. The IRS has stated clearly that a properly-run certification program is very much consistent with Section 501(c)(6) status; thus, the organization should have little difficulty in having a related certification entity recognized as tax-exempt under Section 501(c)(6). Finally, housing the certification program in a separate legal entity has the added benefit of helping to insulate the 501(c)(3) organization’s assets from the not-insignificant potential liabilities that accompany the operation of most certification programs.
- The organization can take the position that its certification program activities are distinguishable from those in the PLR and other IRS rulings, and thus such activities are substantially related to and in furtherance of valid Section 501(c)(3) purposes. For example, organizations may argue that their certification programs are “lessening the burdens of government” (a valid Section 501(c)(3) purpose), although the IRS has proven reticent to recognize this argument absent some tangible manifestation from a government entity that the activity would otherwise be the responsibility of government were it not for the organization’s activities. As there is little favorable precedent from the IRS to guide an organization in this regard, this approach likely will carry with it significant tax risk and should only be undertaken with the assistance of experienced tax counsel.
- The organization may determine that its certification program activities, taken as a whole, are not substantial and that the organization may continue to operate the certification program but treat revenue from such activities as subject to the federal tax on unrelated business income. Many organizations’ certification programs are operated on a break-even basis; careful monitoring and documenting of applicable expenses could result in little to no net tax owed by an organization that follows this approach. The risk with this approach is making the determination as to whether or not the certification program is “substantial”; if the IRS determines it is substantial, the organization’s tax-exempt status likely would be revoked or converted to Section 501(c)(6). Again, this analysis should be undertaken with the assistance of experienced tax advisors, taking into account not only certification program fees, but also revenue from study guide sales and related training programs, for example.
Ultimately, any action taken by a 501(c)(3) association affected by this recent IRS ruling should be undertaken only after careful consideration of the available options, based on a weighing of all of the relevant risks and benefits of each approach.
For more information, contact Mr. Constantine at 202/344-4790 or geconstantine@venable.com.