IRS Revokes Tax-Exempt Status in Affiliated Deals

Reviewing shared service agreements with related for-profit entities is essential for organizations seeking to protect their tax-exempt status. Many tax-exempt organizations, including healthcare systems, public charities, foundations, and educational institutions, maintain complex relationships with related for-profit corporations. These connections often involve shared services, leases, loans, or staffing arrangements. While such arrangements can provide valuable efficiencies, they also introduce compliance risks.

In recent years, the IRS has revoked tax-exempt status for organizations that failed to ensure related-party transactions were conducted at arm’s length. These determinations frequently are assessed using transfer pricing methodologies, underscoring the importance of structuring agreements carefully to withstand scrutiny and consulting transfer pricing specialists to review the transactions.

Why transfer pricing matters for tax-exempt organizations

Due to the tax differential between tax-exempt organizations and related for-profit entities, it is essential that transactions between the two occur at arm’s length, which generally means under terms similar to those between unrelated parties. If they are not, the IRS might see this as a misuse of charitable resources, leading to penalties or even revocation of exempt status.

For example, if a for-profit entity that overpays a tax-exempt related party for goods or services or sells its assets to a tax-exempt organization below market value, it could be viewed as providing a private benefit, which undermines the charitable purpose of the exempt organization. Such transactions also raise concerns about income shifting or avoiding tax obligations from the perspective of the for-profit entity.

To protect their tax-exempt status, exempt organization transactions with for-profit related parties should:

• Serve a legitimate business purpose
• Reflect fair market value
• Avoid excessive private benefit or inurement
• Be well documented and supported by a transfer pricing analysis

From a transfer pricing perspective, tax-exempt organizations should focus on two key areas: governance and compliance.

On the governance side, tax-exempt organizations should be able to demonstrate independence and oversight when transacting with for-profit affiliates. Weak governance can suggest conflicts of interest or excess benefit transactions, potentially leading to excise taxes or loss of tax-exempt status.

On the compliance side, transactions should be structured and documented appropriately, especially when they involve the allocation of income or expenses between related tax-exempt and for-profit parties. If the arrangement triggers unrelated business taxable income (UBTI), the need for proper compliance becomes even more critical for tax-exempt parties.

Case study: Recent IRS ruling revoking tax exemption due to related-party transactions

In Private Letter Ruling 202306009, the IRS reviewed a tax-exempt organization’s transactions with for-profit related parties under both an organizational and operational test. While the tax-exempt organization met the organizational test because its purposes were charitable, it failed the operational test by engaging in transactions that the IRS found resulted in private benefit.

The following are key facts that supported the ruling’s conclusion that there was private benefit and that tax-exempt status should be revoked:

• The tax-exempt organization contracted with a related for-profit management services company that was created by the tax-exempt organization’s founders without applying safeguards or engaging in a competitive bidding process for the services.
• The management services company’s fees were charged as a percentage of revenue. A percentage of revenue basis for pricing is likely to provide a service provider with higher remuneration than the more typical intercompany method of cost-plus pricing.
• The for-profit company had full operational control over the tax-exempt entity and derived all of its revenue from the tax-exempt related party. Although a transfer pricing analysis was submitted demonstrating that the service fees were below market, upon further review and analysis the IRS found the arrangement was not arm’s length and had led to an excess benefit for private individuals.

Best practices

To avoid outcomes similar to the ruling, tax-exempt organizations should adopt strong governance practices, including:

• Demonstrating a business rationale for related-party transactions
• Evaluating fair market value using appropriate pricing methods
• Obtaining competitive bids when possible
• Approving transactions with independent board oversight

From a compliance standpoint, transfer pricing documentation should include:

• The rationale for and structure of related-party transactions
• Economic and market comparables
• The transfer pricing method used and justification for why the chosen method is appropriate
• Supporting data and assumptions

Crowe observation

Maintaining contemporaneous documentation helps establish that the organization is not unduly enriching insiders or shifting value away from its charitable mission.

A continuous feedback loop between governance and compliance is essential. Governance frameworks should include policies for reviewing and approving related-party transactions. Compliance teams should regularly assess whether these transactions reflect current market conditions and adjust as needed.

Looking ahead

Losing tax-exempt status due to improperly structured related-party transactions can be costly and damaging. While engaging in transactions with related for-profit entities is not inherently problematic, tax-exempt organizations must ensure that these arrangements are carefully managed to comply with transfer pricing principles and maintain regulatory integrity. Tax-exempt organizations should be proactive in incorporating transfer pricing into their governance frameworks, applying arm’s-length standards consistently, and preparing the necessary documentation thoroughly. Doing so will protect the organization’s status, strengthen transparency, and uphold its charitable mission.