Everyone assumes that a charitable organization is tax-exempt, but it isn’t always that simple.
To qualify as a 501(c)(3) exempt organization, an organization’s primary activity must suit its exempt purpose. Otherwise, the organization will not be afforded this special tax-exempt provision.
The “primary activity” question was the issue in a U.S. Tax Court case involving Zagfly Inc. and the reason the organization’s tax-exempt status was not approved. The U.S. Court of Appeals for the 9th Circuit recently confirmed the Tax Court’s opinion (Zagfly, Inc., CA-9, May 21, 2015).
Zagfly Inc. was organized as a California nonprofit corporation in March 2010. Its articles of incorporation stated: “The specific purpose of this corporation is to establish Internet platforms that will enable the general public to direct the proceeds of their activities to charitable causes.” This statement seems to indicate that the main purpose of the corporation was a charitable one.
Initially, Zagfly intended to create a website and sell flowers as part of an established network of florists. The profit from the sales of flowers would be donated to a customer’s charity of choice.
The brokering of sales of flowers between consumers and florists is an activity ordinarily carried on by commercial enterprises. Zagfly acknowledged it would be a newcomer in a saturated market and would be in direct competition with commercial flower brokers.
Zagfly had filed the necessary paperwork with the Internal Revenue Service to be considered for 501(c)(3) tax-exempt status. The IRS had not yet ruled on Zagfly’s application. It was up to the Tax Court to decide the matter.
An organization that qualifies as a corporation described in 501(c)(3) is not only exempt from federal income tax but is generally permitted the ability to solicit and accept donations that are normally deductible by donors against their federal income tax.
In applying the rules of 501(c)(3), the court felt that the primary activity of Zagfly Inc. was to operate a website through which its customers could purchase flowers at market prices from a network of florists. Zagfly intended to engage in this sales-based business, in direct competition with commercial flower brokers, on a regular and continuous basis with the ultimate aim of maximizing profits in the form of commissions paid on each transaction that it completed.
Thus, the court felt that Zagfly’s primary activity was not a charitable one, but rather it was a commercial activity that amounted to an unrelated trade or business. Because Zagfly would not be operated exclusively for an exempt purpose, it did not qualify as an organization that is exempt from federal income tax.