Case — Fun and games

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Image source: openclipart.org (public domain image)

Image source: openclipart.org (public domain image)

TL Case Summ

THE QUESTION

Does an organization that offers a recreational activity to achieve a charitable purpose qualify as a charitable organization?

THE DISPUTE

Taxpayer Says: It operates for charitable purposes because it provides relief for the poor, distressed, or underprivileged and promotes general welfare by encouraging community-minded sobriety.

Internal Revenue Service Says: More than an insubstantial part of the organization’s activities furthers nonexempt social and recreational interests because the organization offers gaming to anyone who is over 18 and sober. Gaming is recreational and the organization does not limit its services to a charitable class.

THE LAW

From Internal Revenue Code Section 501(a): A corporation that is organized and operated exclusively for charitable purposes, as described in section 501(c)(3), is exempt from Federal income tax unless exemption is denied under section 502 or 503.

From Internal Revenue Code Section 501(c)(3): Includes the following organizations: Corporations * * * organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition * * *, or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual * * *.

From Treasury Regulation 1.501(c)(3)-1(a)(1): To be exempt under section 501(c)(3), an organization must be both “organized” and “operated” exclusively for tax-exempt purposes. An organization must satisfy both tests to be exempt under section 501(c)(3).

From Treasury Regulation 1.501(c)(3)-1(c)(1): 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 the exempt purposes specified in section 501(c)(3).

From Treasury Regulation 1.501(c)(3)-1(d)(1)(ii): If an organization serves private rather than public interests, it also will not meet the operational test.

From Treasury Regulation 1.501(c)(3)-1(d)(2): The term “charitable” is used in section 501(c)(3) in its generally accepted legal sense and includes, but is not limited to: “[r]elief of the poor and distressed or of the underprivileged; * * * 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; * * * or (iv) to combat community deterioration and juvenile delinquency.”

From B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352 (1978): In this case, we framed the “critical inquiry” as “whether petitioner’s primary purpose for engaging in its sole activity is an exempt purpose, or whether its primary purpose is the nonexempt one of operating a commercial business producing net profits for petitioner.” The purpose of the activity, not the nature of the activity itself, is determinative.

From Better Business Bureau of Washington, D.C. v. United States, 326 U.S. 279, 283 (1945): A single substantial nonexempt purpose will disqualify an organization despite the importance of its exempt purpose.

THE CAUSE OF THE DISPUTE

To qualify as an organization exempt from income tax, the organization has to be organized and operated for purposes defined in the tax code as exempt. In general, this means the primary purpose of the organizations’ activities is an exempt one, rather than a nonexempt one of operating a commercial business producing net profits.

In this case, the organization, a Montana corporation, filed Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, in order to be recognized as a nonprofit organization.

In the application, the organization stated it was organized to provide alternative forms of entertainment to adult members of the [community] for the purpose of promoting adult sobriety. The organization would “achieve its directive by providing free and low cost tabletop gaming activities in a supervised[,] non-alcoholic, sober environment, along with access to gaming accessories that are provided without cost to the participants.”

Projects would teach participants how to develop relationships with retailers and game manufacturers and other gaming participants, create fair market access to trade and sales among members, and encourage and teach “positive activities that teach important life skills and work ethics.”

The organization also believed that the lack of initial investment by participants, along with lessons in how to play the games, would mean participants would eventually need to purchase materials the organization did not have and did not want to supply. In that regard, the organization would also help boost the overall market share of the industry by introducing new and motivated players into the environment. The Form 1023 also explained  the organization was dependent on donations from the gaming community and was largely a “mobile tutorial program” but hoped to secure long-term support so that it could obtain a permanent facility.

The organization’s web site stated it did not promote absolute abstinence from alcohol or drug use but “encourages community minded sobriety during otherwise prolific times of alcohol and drug use, particularly Friday and Saturday nights.” To encourage adult sobriety the organization offered two separate programs. One program was a tutorial on how to play the games, and the second program was “organized play.” The only requirement to join either the tutorial or the “organized play” programs were that the participant be at least 18 years of age and be committed towards sobriety during “gameplay.” Those failing to meet the requirements were not allowed to participate and did not receive any materials from the programs.

In June 2013, the IRS sent the organization a letter denying exemption. The IRS said the organization was not organized or operated exclusively for exempt purposes because (1) it failed to establish that it benefited a charitable class; (2) the nonexempt activities were more substantial than the exempt activities; and (3) it did not limit activities to addicts with a low income. The IRS said that a more than insubstantial part of the activities furthered nonexempt interests because the organization offered gaming to anyone over 18 and sober.

The organization contends that it operates for charitable purposes because it provides relief for the poor, distressed, or underprivileged and promotes general welfare by encouraging community-minded sobriety. In addition, the organization says the specific type of recreation should not matter, and it services a charitable class because its offerings are not competitive with the for-profit gaming industry.

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For the IRS.

We do not conclude that recreational therapy would not be an appropriate means of achieving a charitable purpose. We likewise do not conclude that the type of recreation–here gaming–should affect our analysis. We also accept the organization’s argument that its offerings are less attractive to those gaming participants who could afford to pay to play.

Nonetheless, we are unable to conclude on the administrative record that the organization is “operated exclusively” for one or more exempt purposes. Gaming in an alcohol-free environment may provide a therapeutic outlet to recovering addicts, and community-minded sobriety may benefit the community as a whole, but the question of tax exemption turns on whether there is a single substantial nonexempt purpose, notwithstanding the importance of the exempt purpose.

While it may be laudable, in the light of the administrative record in this case promotion of sober recreation is insufficient justification here for tax-exempt status under a statute that must be construed strictly. The decisive factor here is that the form of recreation offered as therapy also is offered by for-profit entities, and the organization even emphasized, in its application for tax exemption, that it would introduce new participants to that for-profit recreational market and “boost the overall market shares of the industry.” We also note that the organization received contributions of surplus materials from the industry.

While the organization itself does not profit from the recreation it offers and could not offer recreational gaming experiences that would compete in the for-profit recreational gaming markets, we conclude nonetheless that recreation is a significant purpose, in addition to the therapy provided, because of the inherently commercial nature of the recreation and the ties to the for-profit recreational gaming industry.

We therefore hold that the organization does not operate exclusively for charitable purposes within the meaning of section 501(c)(3). Because of our holding, we need not consider whether the organization was organized for tax-exempt purposes.

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