Internal Revenue Service
Revenue Ruling
Rev. Rul. 76-441
1976-2 C.B. 147
Section 501
IRS Headnote
For-profit school converted to nonprofit school. An otherwise qualifying
nonprofit organization that purchases or leases at fair market value the
assets of a former for-profit school and employs the former owners, who are
not related to the current directors, at salaries commensurate with their
responsibilities is operated exclusively for educational and charitable
purposes. An organization that takes over a school's assets and its
liabilities, which exceed the value of the assets and include notes owed to
the former owners and current directors of the school, is serving the
directors' private interests and is not operated exclusively for
educational and charitable purposes.
Full Text
Rev. Rul. 76-441
Advice has been requested whether the nonprofit organizations described
below, which otherwise qualify for exemption from Federal income tax under
section 501(c)(3) of the Internal Revenue Code of 1954, are operated
exclusively for charitable and educational purposes.
Situation 1.
X is the successor nonprofit organization to a former for-profit school. X
purchased all of the for-profit school's personal property and leased the
land and buildings from the former owners of the for-profit school. The
personal property was purchased at fair market value and the rental of the
leased facilities is at a fair market rental.
The former owners of the for-profit school are employed by X to reside at
the school on a 24 hour basis and provide supervision and care of the
students. The salaries paid to the former owners are commensurate with
their responsibilities and are reasonable compensation for their services.
None of X's officers or directors is related by blood or marriage to the
former owners, nor is any of them a business associate of the former
owners.
Situation 2.
Y, a nonprofit organization, received all of the stock in a for-profit
school as a gift. Y dissolved the for-profit school and assumed all of its
liabilities, including notes owed to the former owners. The financial
information indicates that the liabilities of the for-profit school
exceeded the fair market value of its assets. Y's Board of Directors is
composed of the former owners of the stock of the for-profit school.
Section 501(c)(3) of the Code provides for the exemption from Federal
income tax of organizations organized and operated exclusively for
charitable and educational purposes, no part of the net earnings of which
inures to the benefit of any private shareholder or individual. Section
1.501(c)(3)-1(d)(1)(ii) of the Income Tax Regulations provides that an
organization is not organized and operated exclusively for one or more
exempt purposes unless it serves a public rather than a private interest.
Thus, to meet this requirement, it is necessary for an organization to
establish that it is not organized or operated for the benefit of private
interests such as designated individuals, the creator or his family,
shareholders of the organization, or persons controlled, directly or
indirectly, by such private interests.
In Situation 1, X purchased the former school's personal property at fair
market value in an arm's length transaction and is paying a fair rental
value for the use of the land and buildings. X has also established that it
pays the former owners of the for-profit school reasonable compensation for
their services.
Accordingly, X has established that it is operated to serve a public rather
than a private interest. Therefore, X is operated exclusively for
educational and charitable purposes and qualifies for exemption from
Federal income tax under section 501(c)(3) of the Code.
In Situation 2, however, the Directors of Y benefitted in their individual
capacities from Y's acceptance of a transfer of the stock in the for-profit
school and its assumption of all the pre-existing liabilities thereof in
connection with its subsequent liquidation. Since these liabilities
included the notes owed to such directors and the liabilities of the
for-profit school exceeded the fair market value of its assets, the
nonprofit school is substantially serving the directors' private interests
in honoring them. The directors were, in fact, dealing with themselves and
will benefit financially from the transaction. Therefore, Y is not operated
exclusively for educational and charitable purposes and does not qualify
for exemption from Federal income tax under section 501(c)(3) of the Code.
Even though an organization considers itself within the scope of Situation
1 of this Revenue Ruling, it must file an application on Form 1023,
Application for Recognition of Exemption, in order to be recognized by the
Service as exempt under section 501(c)(3) of the Code. The application
should be filed with the District Director of Internal Revenue for the
district in which is located the principal place of business or principal
office of the organization. See sections 1.508-1(a) and 1.501(a)-1 of the
regulations.
