The IRS further ruled that S’s issuance of options for the purchase of stock in S to certain officers and employees of S under its stock option plan, and the issuance of stock options to S’s directors in payment of directors’ fees, where the value of the options and stock, based on fair market value, constitutes reasonable compensa- tion, will not adversely affect E’s tax-exempt sta- tus. This was seen as neither private inurement nor private benefit involving E, in that E and S are separate legal entities. The compensation to be paid to S’s directors, officers, and employees will be determined by a compensation consultant to help ensure that it is reasonable.

The IRS also ruled that a tax-exempt orga- nization “may cause shares of its taxable sub- sidiary to be issued as compensation [to the exempt organization’s employees] without con- travening the prohibition against [private] in- urement and private benefit, so long as the total compensation to be paid by [the exempt organi- zation] to an employee is reasonable.” This prac- tice was ruled to not adversely affect the exempt status of E.

The IRS final ruling was that the royalties to be paid to E by S will not constitute unrelated business income (by reason of IRC § 512(b)(2)), except to the extent the special rules concerning such income from controlled subsidiaries (IRC § 512(b)(13)) apply. [311 Commentary: This ruling provides a good case study as to how to establish the appropriate rela- tionship between a public charity and a for-proBt subsidiary, and how the IRS goes about analyzing the relationship from the standpoint of the law of tax-exempt organizations. 1 1

IRS RULES THAT EXPANDED WORK PROGRAM FOR DISABLED IS RELATED B USlN ESS

he IRS has ruled that a charitable organization’s T work activity program for its disabled clients is a related business and that its expansion will not violate the size and extent test (Priv. Ltr. Rul. 200225044).

Facts A public charity (PC) provides habilitative train- ing services for developmentally and physically disabled infants, children, and adults (“clients”); there are over 90 clients in its programs. These services are designed to enable individuals to prepare for a more independent life in the least restrictive environment while developing to their fullest potential in all areas. PC provides an integrated preschool program, educational ser- vices for school-age children (by means of con- tracts with local school districts), educational and work-related training for high school chil-

dren and adults, and supervised living programs for adults.

These programs are funded through tuition payments, public contributions, service contracts with federal and state agencies, and money gener- ated by PC’s clients in its work activity center. PC provides services to clients who are ineligible for governmental assistance and are otherwise unable to pay for the needed services.

The work activity center provides PC’s clients with the opportunity to learn work skills. PC contracts with local industries to assemble manu- facturing components. Clients receive habilitative training in a controlled work environment. They are paid wages. This center is a component of PC’s education and training program.

The work activity center functions as an as- sembly department of a local manufacturing in- dustry. The manufacturer delivers its inventory components to PC, the clients assemble these components into a finished product, and the manu- facturer picks up the finished products. The manu- facturer owns the fixtures and equipment used to assemble the finished goods.

About two years ago, PC’s largest contractor notified PC of changes in its corporate structure and operations. The contractor began requiring its vendors, including PC, to purchase and ware- house all parts required by present and future contracts. Thus, if PC were to continue to as- semble products for this manufacturer, it would be required to purchase and warehouse the com- ponent parts.

In order for PC to continue to provide work- related training services and jobs to its clients, a substantial monetary contract was required. PC is in a rural community: there are no other manu- factures available to fulfill this need. Without industry contracts, training opportunities for PC’s clients and billable services for training under government funding cannot exist. This would result in termination ofwork activity staff and loss of funding for overhead. Client wages enable many of the client families to provide necessary living expenses. Loss of this contract would seriously erode the ability of PC to provide work-related training to all clients.

With an increasing amount of PC’s financial resources coming from governmental sources, and the uncertainty of the federal and state programs’ continued strength, PC has been searching for ways to become more self-reliant (that is, less government-reliant) .

Although purchasing and warehousing in- ventory would mean additional overhead for PC, it would also be the means to increase job opportunities for its clients and teach them new work skills to develop their capacities and in- crease their quality of life. Realizing that the

4/The NonproJt Counsel September 2002

loss of the work activity center would seriously jeopardize the financial stability of all of PC’s programs, its board approved these activities: purchasing land for expansion, constructing a warehouse, establishing a line of credit to facili- tate the purchase of the inventory, negotiating a new contract unit rate to offset costs of owning inventory and labor assembly costs, phasing in inventory to meet the major contractor’s re- quirements, and obtaining a written commit- ment from the contractor regarding the repurchase of any unused or obsolete parts [in recognition of PC’s inexperience with invento- ries). These efforts were implemented.

Law and Analysis It was conceded that this manufacturing work activity program is a business and that this busi- ness is regulurly curried on. Thus, the issue came down to whether the work activity program is a related business.

The work activity program was held by the IRS to be in furtherance of charitable and edu- cational purposes. Although the manufacture and sale of commercial items are not inherently exempt functions, the provision of vocational training and guidance to the unskilled and underemployed can qualify as a charitable pur- pose. The work activity was found to be a “means” to help develop PC’s clients. The expansion of the program was held to be consistent with exempt purposes.

PC was ruled to be in compliance with the size and extent test. That is, its work activity pro- gram-even in its expanded version-was found to be conducted on a scale that is reasonably necessary to accomplish its exempt purposes. The expansion of the program did not significantly change the nature of the training services offered by PC to its clients.

Thus, the IRS ruled that the revenue generated from PC’s expanded manufacturing work activity program will not be treated as unrelated business income. (26.41

IRS RULES THAT MUSEUM RESTAURANT AND GIFT SHOP GENERALLY RELATED BUSINESSES

he IRS has ruled that a museum can operate a T g ift shop and restaurant as related businesses, in that these facilities attract visitors to the mu- seum and produce income used to fund its opera- tions (Priv. Ltr. Rul. 200222030).

Facts M is a public charity, which has the following purposes: promote the interest of, and to educate, the general public in decoy carvings and baymen’s artifacts: acquire artifacts for display in its mu-

seum: and conserve natural resources and wild- life. M operates V as a re-creation of a 19th- and early 20th-century local maritime village, and as an extension of its original museum. M’s purpose in operating V is to preserve, present, and inter- pret the maritime history, heritage, and environ- ment of the local coastal area and the contributions of its baymen.

Arestaurant will be open toVs patrons and the public on a year-round basis, and will be staffed by volunteers and paid employees. The primary pur- pose of the restaurant is to provide patrons with a convenient eating place, and allow them more time to appreciate the exhibits and presentations at V.

A gift shop will also be staffed by volunteers and paid employees. It offers items such as minia- ture boats and lighthouses, books on maritime history, waterfowl decoy carving and finishing sup- plies and kits, and paintings portraying different aspects of the baymen’s life. It also sells clothing bearing the V logo, materials and supplies needed for classes offered at V, and various knickknacks and guest amenities.

The income from these activities will be used in furtherance of Ms activities in the operation of V.

Law and Analysis The operation of V was held to enhance M’s educa- tional purposes. Thus, V is furthering the exempt purposes of M and is a related business.

The gift shop and restaurant were found to attract visitors to V and produce income used to fund the operation of V. These activities were said to also help further M’s purposes. They, too, were ruled to be related businesses.

TheIRSwrote, ‘Todetermineifthe sale ofanitem by a museum is related to its exempt purpose, it is necessary to ascertain the museum’s primary pur- pose for selling the item.” If the purpose is “utilitarian, ornamental, a souvenir in nature, or only generally educational in nature,” the sale of the item is not substantially related. Where the primary purpose behind the production and/or sale of an item is to further the organization’s exempt purposes, the ac- tivity or activities are related businesses.

The factors to be considered in the context of gift-shop sales are the degree of connection be- tween the item and the museum’s collection, the extent to which the item relates to the form and design of the original item, and the accuracy of the representation relative to the article sold. Still another factor is the “overall impression conveyed by the article.” If the “dominant im- pression one gains from viewing or using the article relates to the subject matter of the original article, picture, or likeness, substantial related- ness would be established.”

Items that are “reproductions or adaptations of articles displayed in [the museum’s] collections

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