In a recent Technical Advice Memorandum (TAM), the IRS determined that a major source of revenue for a 501(c)(6) trade association was unrelated business income and therefore taxable.

The trade association’s purpose was to promote a particular sport within a region.  Individuals can only play the sport at sports facilities that charge a fee to play.  The trade association sold discount coupons for use of such facilities.

In the TAM, the IRS listed the requirements for a Section 501(c)(6) organization:

(1)    It must be an association of persons having a common business interest,

(2)    Its purpose must be to promote that common business interest,

(3)    It must not be organized for profit,

(4)    It should not be engaged in a regular business of a kind ordinarily conducted for a profit,

(5)    Its activities should be directed toward the improvement of business conditions of one or more lines of business as opposed to the performance of particular services for individual persons, and

(6)    Its net earnings, if any, must not inure to the benefit of any private shareholder or individual.

The Internal Revenue Code imposes a tax on income to a nonprofit organization derived from any unrelated trade or business regularly carried on.  An unrelated trade or business is any trade or business which is not substantially related to the organization’s exempt purposes.

The trade association argued that the discount coupon program is substantially related to its exempt purposes because it encourages more people to engage in the sport.

The IRS disagreed.  The question turned on whether the sale of coupons promotes general interest and involvement in the sport or if it constitutes the performance of particular services for individual persons or businesses.  The IRS concluded that the sale of coupons only benefited those facilities that chose to participate and not the sport as a whole and therefore the sale of coupons was basically an advertising service for individual businesses.

The IRS states, “Advertising campaigns . . . that name and promote specific businesses rather than the industry as a whole constitute the performance of particular services for individual persons” which is an unrelated trade or business.

We know of many 501(c)(6) organizations that promote their members by maintaining business directories, spotlighting their members on their web sites, etc.  These organizations need to be careful that their activities don’t start to look like the sale of advertising (or else pay tax on the revenue associated with those activities).  (Note that occasional highlighting of members such as for a special event is not a problem because the tax on unrelated business income only applies to a trade or business that is regularly carried on.)

The following are some examples of activities that have been found to be taxable as unrelated business income to a 501(c)(6):

• Advertising of products and services in an association journal, even if those products and services are related to the purpose of the organizations
• Promotions that mention particular businesses
• Promotion of members to the exclusion of non-members in the same industry when members and non-members meet similar standards
• Fee-based services for members and/or non-members that are similar to what might be provided by a commercial business
• Providing discounted parking for patrons of only certain businesses in a downtown area.

The following are some examples of activities that have been found to be substantially related and therefore not taxable as unrelated business income:

• Publication of educational information that incidentally promotes specific businesses
• Providing discounted parking for all visitors to a downtown area
• Sponsorship of tournaments to promote interest in a sport and sale of broadcasting rights to those tournaments
• Promotion of an entire industry or line of business such as Washington apples or the use of plywood as a building material.

Note that a nonprofit can lose its exempt status if a significant amount of its revenue is derived from and/or a significant amount of its resources is devoted to an unrelated activity.

A security is defined under federal law as

“any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.” 15 U.S.C. 77b(a)(1).

The leading case on the definition of a security is federal Supreme Court case SEC v. W.J. Howey Co. (1946).  Under the Howey test, a security is “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”

In Howey, the “scheme” in question was the sale of land containing fruit trees as well as “service contracts” to cultivate and market the crops, with an allocation of the net profits going to the purchaser.

The Howey Court noted that its definition of a security “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

The ninth circuit court of appeals distilled Howey’s definition into a three-part test: “(1) an investment of money (2) in a common enterprise (3) with an expectation of profits produced by the efforts of others.” SEC v. Rubera (2003).

The courts have rejected attempts to narrow the definition of a security.  As one opinion put it, “[I]n searching for the meaning and scope of the word ‘security’ . . . form should be disregarded for substance and the emphasis should be on economic reality.”

The “investment of money” prong of the Howey test “requires that the investor ‘commit his assets to the enterprise in such a manner as to subject himself to financial loss.’”

The focus of the inquiry is on what the purchasers were offered or promised.  “The test [for determining whether an instrument is a security] . . . is what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.”

What does it mean to create an expectation of profits?  The Supreme Court defined profits as “either capital appreciation resulting from the development of the initial investment . . . or a participation in earnings resulting from the use of investors’ funds.”

The promised return may be fixed or variable and may be marketed as low-risk or “guaranteed.”

Courts have frequently examined the promotional materials associated with an instrument in determining whether it is a security.  If the materials promise things like great returns or guaranteed income, the court will almost certainly find the instrument to be a security, and therefore subject to federal securities regulations.

There are some exemptions to this requirement.  One of the most commonly used is the 25102(f) exemption (named, creatively enough, after the section of the code where it is found).

The following are the requirements for the offer and sale of a security to be eligible for the 25102(f) exemption:

• The offering can be made to an unlimited number of Excluded Purchasers
  • Excluded Purchasers include banks, officers and directors of the company, a person that works for the company that has executive level duties and authority, and accredited investors

• The offering can be made to a maximum of 35 purchasers who do not meet the definition of an Excluded Purchaser, if they meet one of the following requirements
  • Have a preexisting personal or business relationship with the company and/or its principals; or
  • Have the ability to protect their interests due to their financial experience or the fact that they have experienced professional advisors

• All purchasers must state that they are purchasing for their own account and not for re-sale
• The offering of the security may not be advertised to the public

The term “preexisting personal or business relationship” includes any relationship consisting of personal or business contacts of a nature and duration such as would enable a reasonably prudent purchaser to be aware of the character, business acumen and general business and financial circumstances of the person with whom such relationship exists.

In addition, the company must make a simple filing with the Department of Corporations.

This is a very basic summary — please do further research or work with a lawyer before attempting to use this exemption!

Note also that the company still must qualify for a federal exemption from securities registration – see our earlier blog post on federal exemptions.

Since many of us do not pay this tax, the state legislature adopted Assembly Bill x4-18 (Stats. 2009, Ch. 16) which requires “qualified purchasers” to register with the BOE and report and pay use tax.

A “qualified purchaser” means a business that meets all of the following conditions:

• Receives at least $100,000 in gross receipts from business operations per calendar year.
• Not required to hold a seller’s permit or certificate of registration for use tax.
• Not a holder of a use tax direct payment permit.
• Not otherwise registered with the BOE to report use tax.

A qualified purchaser may register for a use tax account by completing the BOE-404-A, Use Tax Registration, and mailing it to the BOE,

Board of Equalization
Tax Source Group, MIC: 007
PO Box 942879
Sacramento, Ca 94279-0007

There is no fee to register.

For more information, click here.

Equal Exchange purchases coffee and cacao from farmer cooperatives throughout the world and processes it into products that it sells to retailers.  All products meet rigorous standards for fairness and sustainability.

All of the employees of Equal Exchange (with the exception of new employees that have not completed an initial probationary period) own voting shares in the business.  Only employees may own voting shares.  The employees elect the board, with each employee having one vote.

To become a worker-owner at Equal Exchange, you are required to buy your ownership share, which currently costs $3,250 (the amount is adjusted for inflation each year).  To ensure that all employees can afford to buy their share, Equal Exchange offers a four-year no-interest loan for share purchase.  When employees leave, they must sell their share back to the cooperative.

In addition to voting rights, the employees are entitled to a share of the profits.  At the end of each year, 40% of the after-tax profits (or losses) are allocated to the workers.  Last year, each worker’s share was approximately $5,000.  The remaining profits stay in the company as retained earnings.

The company has been profitable every year but one for the last twenty years.

When the company needed to bring in outside capital, it created a second class of shares – a non-voting share.  These shares were originally priced at $25 (the price was increased to $27.50 after demonstrating a track record for paying reasonable returns).  After an initial offering to friends and family, the company sought out accredited investors to purchase shares in private offerings.

In exchange for their investment, the non-voting shareholders receive an annual preferred dividend (paid before the workers receive their patronage dividend).  The board decides each year how much the dividend will be, with a target of 5%.  Most investors choose to reinvest their dividend in non-voting shares.  The investors may redeem their shares after five years.  The shares are non-transferrable.

The following chart shows the performance of the Equal Exchange non-voting shares compared to the S&P 500 over the last 10 years.

Equal Exchange set up its financial model so that, while workers and investors can benefit from company profits, no one can benefit from increases in share prices.  This brilliant innovation ensures that none of the company’s stakeholders will ever be tempted to sell out to Starbucks or Hersheys.  The way this was accomplished was to prohibit the transfer of shares and to include a “sellout protection clause” in the company’s formation documents.  This clause requires that if the company is ever sold, all of the capital gains will be donated to fair trade organizations.  The workers and investors cannot receive capital gains on sale.

Many cooperatives have a great deal of difficulty raising outside capital because few investors are willing to purchase non-voting shares.  Yet Equal Exchange has raised over $8 million by selling non-voting shares.  How did they do it?  A number of mechanisms give non-voting investors comfort that the interests of the voting shareholders (the employees) are aligned with their interests.

These mechanisms include the following:

• The highest paid employee at Equal Exchange can never be paid more than four times what the lowest paid employee receives – this ensures that Equal Exchange’s profits will not be diverted to pay outrageous salaries
• The worker-owners receive half of their patronage dividends in non-voting shares so they have an interest in paying a fair return to the non-voting investors
• The workers are required to invest their own capital in the company and share in profits as well as losses, giving them a meaningful stake in the success of the company
• The workers spend time visiting the farmers and learning about how the company operates, putting them in the best position to make decisions about how the company is run.

The only thing that was missing from the model was a way for the public to invest in Equal Exchange.  The cost to sell shares to the public is prohibitive (as discussed at length in previous blog posts).  To remedy this problem, Equal Exchange partnered with a bank to create a company-specific certificate of deposit.  Investments in the CD go to a line of credit that can be used by Equal Exchange as working capital.

For more information, see Equal Exchange’s web site (http://www.equalexchange.coop/index.php) and blog (http://eeinvest.wordpress.com/).

Tiburon created a special assessment district to pay for the cost of undergrounding utility lines.  Property owners in the district challenged the assessment as failing to meet the requirements of Proposition 218.

The court agreed for the following reasons:

1. Assessments must be based on relative benefit received by a parcel, not on the cost of providing the benefit to the parcel.

Tiburon divided the costs of the project unevenly between several zones within the district which resulted in some property owners paying a higher assessment for a similar benefit.

The court held that this method violates Proposition 218: “The critical inquiry . . . concerns the special benefits conferred on the property. Properties that receive the same proportionate special benefit pay the same assessment, without regard to variations in the cost of construction among the properties.”

2. No property that receives special benefit may be excluded from the assessment district.

Tiburon excluded certain parcels from the district even though they benefited from the project.  The court held that this violates the requirement of proportional assessments for all the benefitted parcels (in effect, the parcels in the district are subsidizing those that are not).

While the court acknowledged that “Any attempt to classify special benefits conferred on particular properties and to assign relative weights to those benefits will necessarily involve some degree of imprecision.”  However, the court felt that the problem with Tiburon’s district was not imprecision but inconsistent application.

For the entire text of the case, click here.

The most well known type of nonprofit is a public charity that conducts charitable and/or educational activities, is tax exempt, and is eligible to receive tax deductible donations.  If this is the type of nonprofit you wish to form, then your choices are straightforward – you would form a California nonprofit public benefit corporation (assuming you are forming it under California law) and apply for federal tax exemption under Internal Revenue Code Section 501(c)(3).  But if you want to form some other type of nonprofit, things can get a bit complicated.

California Classifications: Public Benefit versus Mutual Benefit

At the state level, it is necessary to choose from among several types of nonprofit corporation (there are other options as well such as unincorporated associations, but I will not cover those here).  The two most common types are the nonprofit public benefit corporation and the nonprofit mutual benefit corporation.

A public benefit corporation can be either one of the following:

(1)    organized primarily for religious (however, it is also possible to form a religious organization as a California nonprofit religious corporation), charitable, scientific, testing for public safety, literary, or educational purposes, or for the prevention of cruelty to children or animals; OR

(2)    a civic league or social welfare organization.

A public benefit corporation may be tax exempt under one of two sections of the California Revenue and Taxation Code: 23701d or 23701f (these sections correspond with the two types described above).

California nonprofit public benefit corporations exempt under 23701d must meet the following requirements:

• no part of the net earnings may benefit any private shareholder or individual
• no substantial part of the organization’s activities may include influencing legislation
• the organization may not participate in political campaigns of candidates for public office
• upon dissolution, the organization’s assets must be donated to another nonprofit charity or government agency.

California nonprofit public benefit corporations exempt under 23701f must meet the requirements of an organization exempt from taxation under Section 501(c)(4) of the Internal Revenue Code (described below).  Its assets must be irrevocably dedicated to 501(c)(4) compliant purposes – this means that upon dissolution, the assets cannot be distributed to anyone for any other purpose.

Note that if you choose to form as a nonprofit public benefit corporation, you cannot easily convert to a mutual benefit corporation.  The only way to do such a conversion is to first ensure that all of the assets of the organization are donated to another nonprofit or government agency with exempt purposes.

California nonprofit mutual benefit corporations can be many types of organizations such as labor, agricultural, or horticultural organizations; fraternal orders; business leagues; chambers of commerce; social or recreational clubs; voluntary employees’ beneficiary associations; teachers’ retirement fund associations, homeowners associations, etc.

Federal Classifications: 501(c)(3) versus exemption under other sections of the Internal Revenue Code

Once you have chosen from among the options at the state level, you will need to decide under what federal code section you will apply for tax exemption.  Note that you do not need to apply for state or federal tax exemption.  Some organizations choose not to for various reasons.  For example, many medical marijuana collectives are formed as California mutual benefit corporations.  They do not apply for federal tax exemption because trafficking in marijuana is not legal under federal law.  Often they choose not to apply for tax exemption under state law either because they want to give back to the state by paying taxes.

If you do choose to apply for federal tax exemption, you have more than 25 classifications to choose from.  As noted above, the most well known federal classification is 501(c)(3) – a charitable or educational organization.  In this post I will describe two of the other most common options: 501(c)(4) and 501(c)(6).

An organization exempt under 501(c)(4) is known as a civic league  or social welfare organization.

It operates primarily to further the common good and general welfare of the people of the community.  Here are some examples from the IRS web site:

• An organization operating an airport that is on land owned by a local government, which supervises the airport’s operation, and that serves the general public in an area with no other airport,
• A community association that works to improve public services, housing and resi­dential parking, publishes a free commu­nity newspaper, sponsors a community sports league, holiday programs and meetings, and contracts with a private se­curity service to patrol the community,
• A community association devoted to preserving the community’s traditions, ar­chitecture, and appearance by represent­ing it before the local legislature and administrative agencies in zoning, traffic, and parking matters,
• An organization that tries to encourage in­dustrial development and relieve unem­ployment in an area by making loans to businesses so they will relocate to the area, and
• An organization that holds an annual festi­val of regional customs and traditions.

An organization exempt under 501(c)(6) is known as a business league or chamber of commerce.  The purpose of the organization must be to promote the common business interest of a group of persons.  It may not engage in a regular business of a kind ordinarily carried on for profit.  The organization must receive support from its members.

An organization does not qualify for exemption under section 501(c)(6) if any of its net earnings inures to the benefit of any member.  Members may nevertheless receive some kinds of benefits from the organization, such as newsletters and similar material.  Moreover, the profitability of the members’ individual enterprises may be enhanced by the successful promotion of the common business interest.

Both Section 501(c)(4) and (6) organizations may engage in political campaign activities on behalf of or in opposition to candidates for public office but the organization must ensure that its political campaign activities do not constitute the organization’s primary activity.  Also such activities are subject to a tax.

In general, section 501(c)(4) and(6) organizations may engage in an unlimited amount of lobbying, provided that the lobbying is related to the organization’s exempt purpose.

Both types of organizations must ensure that no part of its net earnings benefit private individuals or businesses.  For example, the organization should never pay more than fair market value for any goods or services it receives from an individual or business.

In general, contributions to 501(c) organizations other than organizations described in section 501(c)(3) of the Code are NOT deductible as charitable contributions for federal income tax purposes.

First, the general rule is that any offering of equity or debt in a business is a security and must be registered with the federal Securities and Exchange Commission (SEC) and the securities law agency of all states where securities are being offered.  This process of registration is what is known as an Initial Public Offering (IPO) and is extremely expensive, so most growing businesses try to qualify for an exemption from registration (although, as we will see, even that can be difficult or expensive or greatly limit your ability to market the offering).

This is the first post in a series about basic securities law. This post summarizes some of the most commonly used exemptions under federal law, i.e. the SEC (state law exemptions will be covered in a future post).

To understand the exemptions from federal registration of a securities offering, it is first necessary to understand the concept of an “accredited investor.”

An accredited investor is defined by the SEC as follows:

• a charitable organization, corporation, or partnership with assets exceeding $5 million;
• a natural person with a net worth of at least $1 million; or
• a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year

(note there are some other ways to qualify as accredited, such as being a bank, but we have not listed those here – for the full definition of an accredited investor, click here).

The following are some of the most commonly used exemptions from the federal registration requirement:

1. The statutory private placement exemption (contained in Section 4(2) of the federal Securities Act) – may only be offered privately to a limited number of affluent/sophisticated investors, who must be provided with all material information about the company.  This exemption is typically only used for company insiders/founders because these people are most likely to have access to information about the company.

2. Reg D (short for SEC “Regulation D”) – this is actually 3 separate exemptions:

• Rule 504 is for offerings that do not exceed $1,000,000.  A Rule 504 offering can be made to an unlimited number of accredited and non-accredited investors.
• Rule 505 is for offerings that do not exceed $5,000,000.  A Rule 505 offering may be made to an unlimited number of accredited investors and up to 35 non-accredited investors.  If the investment is offered to even one non-accredited investor, a lengthy document called a prospectus or private placement memorandum must be prepared to provide relevant information about the business and the offering to prospective investors.
• There is no limit on the offering amount under Rule 506.  A Rule 506 offering may be made to an unlimited number of accredited investors and up to 35 non-accredited investors.  Unlike Rule 505, all non-accredited investors, either alone or with a purchaser representative, must be sophisticated - that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.

The following rules apply to all Reg D offerings:

1. The offering cannot be advertised to the general public – the offering can only be made to potential investors that have an existing relationship with the company (there is an exception to this rule – a 504 offering can be advertised to the public if state registration is completed).
2. The securities offered under a Reg D offering cannot be re-sold without additional compliance requirements being met.
3. A form must be filed with the SEC (Form D).

3. Reg A – this is similar to a full registration but was created by the SEC for small offerings – up to $5 million.  It somewhat easier to complete than a full registration but still can cost upwards of $20,000 – $30,000 in legal and accounting fees.

4. Intrastate exemption – this exemption is based on the premise that an offering that stays within a single state does not require federal regulation (it will be regulated by the relevant state).  The business must be incorporated and do a significant portion of its business in the same state where the offering takes place (for example, if you are incorporated in Delaware but located in California, you cannot use this exemption).  You must also take stringent measures to make sure all investors reside in your home state and do not sell their stock to anyone living outside that state.  Because the statute is somewhat vague about how to qualify for this exemption, the SEC created a “safe harbor” for compliance.  A safe harbor is a set of conditions that, if you comply with them, you can be assured that you will meet the requirements of an exemption.  However, it is not necessary to comply with the safe harbor conditions to comply with the exemption.  The conditions required to meet the safe harbor are as follows:

1. 80% of the company’s assets are located in the state in which the offering is made;
2. 80% of the company’s revenue comes from the state in which the offering is made; and
3. 80% of the proceeds from the offering will be used within the state in which the offering is made.

Note that even if you qualify for one of the above exemptions, you must still qualify for an exemption from registration with the securities law agency of every state in which you offer the securities.  State exemptions will be covered in a future post.