Getting Grants for Yourself Not a Valid Exempt Purpose

Originally Published on forbes.com on July 9th,2011

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Americans of all ages, all conditions, and all dispositions, constantly form associations. They have not only commercial andmanufacturing companies, in which all take part, but associations of a thousand other kinds—religious, moral, serious, futile, extensive, or restricted, enormous or diminutive. The Americans make associations to give entertainments, to found establishments for education, to build inns, to construct churches, to diffuse books, to send missionaries to the antipodes; and in this manner they found hospitals, prisons, and schools. If it be proposed to advance some truth, or to foster some feeling by the encouragement of a great example, they form a society.

Democracy in America – Alexis De Tocqueville

One of the most gratifying things I have done in my career is help some small not-for-profits gain exempt status and deal with the various compliance issues they encounter.   The one I am proudest of is Just Detention International, which is dedicated to ending the sexual abuse of men, women and children in all forms of detention.  It’s not so small anymore although not nearly large enough for the enormity of the task in front of it.  It turns out that achieving some worthy object is not the only reason that people start not for profitorganizations.  You see there are all these grants out there.  Governments, foundations, whatever.  They are just dying to hand out money, but you might need to start a not-for-profit to get in on it.  Not to worry.  There are companies that can help you.  Such was the case of the founder of the anonymous organization described in PLR 201126037.  For convenience I’m going to call the organization ” Where’s The Freebies ?, Inc” (WTF).  Here are the basic facts on WTF:

Your board of directors consists of your founder, B, and a related individual. B is also the founder and owner of D, a for-profit business that engages in the sale of electrical materials, aggregates, supplies, and rental equipment. Through the company D, B began a process to obtain substantialgrant funding by entering into a contract with E, a for-profit grant company. In the contract, B agreed to pay E $7,500 for their service and requested a grant of $1,000,000.

I love oxymorons, which is why I named my blog “Passive Activities and Other Oxymorons’ (Had to shorten it for Forbes).  “For-profit grant company” is a beaut.  OK.  Here is our business plan.  We’ll give money away.  It will cost us on each transaction, but what we’ll do is give money to lots of organizations and that way we’ll make it up on volume.  Apparently that is not the way a “For-profit grant company” operates. It doesn’t make the grants.  It finds them and then takes a piece of them.  Actually, it takes it piece regardless:

The service provided by E, with this agreement is for research, letter writing, and grant writing. This service is for a consecutive twelve month period beginning on the date on this agreement or the date on the Client’s check, whichever date comes first. If E does not generate a grant within twelve months for the above mentioned client, E will provide a second consecutive twelve months of service at no additional charge. The total cost of this service is $7500.00 also referred as the “RETAINER” amount. The total grant amount awarded must be a minimum of $100,000.00, for the balance to be due. ………The retainer fee is non-refundable due to the nature of the services provided by E.

I can’t quite figure out the part about the balance not being due if they don’t get the $1,000,000 but the retainer being non-refundable, but I’m sure there is an explanation.

As things moved on, it turned out that E would be able to do a better job for B, if there was a not-for-profit getting a small piece of the action – 5%.  Hence was born WTF.  Of course forming WTF involved extra work:

During the contract period, B was told by E that in order to receive the grant funding, a non- profit organization would have to be formed to receive 5% of the grant. E told B that after the non-profit was formed, a grant in the amount of $450,000 would be released. B then entered into a second agreement with E to form you, and paid E an additional $6,200.

Of course there was another contract.  I think E may have some sharp lawyers working for it.  I found this part impressive :

I hereby understand and agree that E cannot provide me with tax advice. I further agree that I am not applying for non-profit status for the purposes of a tax shelter or tax avoidance purposes. I understand and agree that these services I am purchasing are not consumer purchases regulated under state/federal consumer fraud statutes nor are these services a product/service that can be returned for a refund. Therefore, all sales are final. I also understand and agree that E is not responsible for any illegal acts, misuse, or abuse of the corporation to be formed on my behalf.

I’m not sure of everything you need to run a “for-profit grant company”, but it looks like a refund department is probably not necessary.

It appears that the IRS insisted on speaking to B rather than letting E just handle everything.  It appears that B was a pretty honest straight-forward fellow:

Your application showed anticipated revenue of $600,000 annually from grants. Your projected expenses were substantially lower than anticipated revenue and showed that your main expenses were for compensation to officers and occupancy expense. When you were asked for more information regarding these expenses, you stated that the financial data was prepared by E, that you had no intention of paying salaries, and that you do not have a facility. However, you intend to use the non-profit funds you receive to reimburse B the $6200.00 that was spent in filing fees to create you.

You stated that you only applied for tax-exempt status under the instructions of E for the purpose of securing grant money for D. According to you, E said the IRS wants 5% of the grant money to go to non-profit organizations, and this could not be accomplished unless you were created. You made it clear during the application process that you were formed in order to enable D to receive grant funding. D will receive 95% of grants awarded, and you will receive the other 5%.

The IRS didn’t find much of an exempt purpose there, but the founder of WTF had an answer:

You stated you filed everything under the direction of E and the actual Form 1023 was completed by M. Your main purpose is to be a resource for people, small businesses and communities. You state you will provide financial resources to non-profit organizations in your area. You will fund projects that enhance the community, focusing on small businesses, children, families, health and education. You continued by stating your small businesses will benefit from your assistance by providing the support to grow and create jobs for individuals.

E and M (minion?) seem to have dropped out of the picture at this point and B just didn’t have the right answers.  WTF will not be getting exempt status:

You are not operating exclusively for exempt purposes as described in Section 1.501(c)(3)- 1(d)(1)(ii) of the Income Tax Regulations because you serve private interests, including benefiting the persons who created you. As explained above, the fact that 95% of the grant funding intended for you will go to D, clearly shows that your activities substantially serve private interests. Moreover, since your founder is also the owner of D, your activities directly benefit the person who created you.