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Overthinking the Play Call

In a Private Letter Ruling released on February 13, the IRS denied an open source software project’s 501(c)(4) exemption application using a rationale sure to invite Monday morning quarterbacking. Rather than simply denying the application on the straight up the middle basis that the open source software project was carrying on a business with the general public in a manner similar to organizations which are operated for profit (See Treas. Reg. § 1.501(c)(4)-1(a)(2)(ii)), the IRS instead chose a pass route that brings into question whether any open source software project could qualify for exemption.

Software issues under the Internal Revenue Code have always been challenging, and in 2013 the public press reported that exemption applications for open source software projects had landed on the IRS watch list. Last year, the word came out that the IRS was denying 501(c)(3) status on many of these projects, and in January a couple of the denial private letter rulings were released (201505040 and 201505041).

Section 501(c)(4) which describes organizations not organized for profit but operated exclusively for the promotion of social welfare has often been called a “catch all” provision for those types of organizations that may not qualify under Section 501(c)(3) but who still may have a nonprofit social benefit. Indeed, as the IRS was scrutinizing open software organizations seeking 501(c)(3) status, exemptions were being issued to other open software organizations under Section 501(c)(4). Now, with the release of Private Letter Ruling 201507025 (02/13/2015), has the IRS signaled a view that certain open source software can never qualify?

The Private Letter Ruling involves an organization that intended to research, develop, and distribute, free of charge, server side and client side software software that facilitates uncensored and secure communications by human rights activists, journalists, and civil society. The organization intended to charge fees to service providers to help them deploy secure communications services and maintain regular security audits, but the fees are not intended to generate a profit. Technical and consulting services for 501(c)(3) or (4) organizations would be at cost or for free.

In denying the exemption, the IRS identified three reasons: (i) developing and distributing open source software does not promote social welfare within the meaning of 501(c)(4); (ii) the world is not a community within the meaning of 501(c)(4); and (iii) the organization’s primary activity is selling software services at cost which is a trade or business ordinarily carried on for profit.

On the third point, the IRS noted that there were numerous private companies providing royalty free software under open source licenses and that the organization would be paid to develop the software and paid for installation, customization, and consultation services. In the view of the IRS, each of those services was a trade or business ordinarily carried on for profit, whether conducted together or carried on alone. That in and of itself was enough to deny the exemption and was the safe play call.

Instead, the IRS expanded on its view of open source software. First, the IRS rejected the argument that open source software provided a social welfare community benefit by maintaining that the nature of open source software was the same as any commercial software development activity. In doing so the IRS dismissed the precepts of open source software (viz., distributed without charge, open licensing) as merely providing a competitive advantage over commercial software. That approach gives no credence to the social welfare aspects of the open source software at issue (software that helps promote the freedom of the press and the free exchange of information) and is a blanket indictment against all open source endeavors.

Second, the IRS chose to narrowly define the community requirement in the context of open source software. An essential component of 501(c)(4) status is that the organization promotes the social welfare of a “community” and in the past, this community requirement has been viewed as part of a private benefit prohibition to ensure that an organization does not benefit select individuals. In this private letter ruling, the IRS maintained that “community” must reference to a geographical area ordinarily identified as a governmental unit citing to a Revenue Ruling involving homeowner’s associations. Since users of the open source software could be all over the world, there was no “community” in the view of the IRS as the world is not a governmental unit. Again, on this basis, it is unlikely that any open source software project (except one perhaps that was designed to benefit a discernable class?) could qualify for 501(c)(4) status. The inconsistency should be obvious.

These two interpretations of open source software were unnecessary in the context of denying the organization its 501(c)(4) status, and will be the source of second-guessing by practitioners in the years to come. Sometimes the best call is the safest one.

Posted in Tax Exempt.