Updated Form 1023 Tuesday, Mar 13 2018 

Earlier this year the IRS updated Form 1023, the application through which over 1.5 million entities have gained recognition of tax exempt status.  As discussed below, I consider the changes incorporated to be reasonable and largely welcome.

The most noteworthy changes included 1) a lowering of application fees (invariably a welcome development for applicants), 2) an increase in the information required on the EZ form, and 3) some updating to the full form, reflecting ten years of changes, and elimination of some obsolete items.

The change in fee structure is noteworthy because it is unusual for a government agency to actually lower a fee for a service.

Form 1023.  The full Form 1023 application fee was reduced from $850 to $600.  The previous option of paying $400 for an organization with $10,000 or less in annual revenue was rightly eliminated.  Three years ago when the EZ form was introduced for organizations with revenues under $50,000 a year at a cost of only $275, the $400 option was rendered meaningless except in the less common case of an organization not qualified to file the EZ form, such as a church.

Form 1023-EZ.  The application fee for Form 1023-EZ has remained the same at $275, despite the fact that the IRS has increased the amount of information required on the application, likely resulting in greater IRS review time.  Paradoxically this increase in information required is actually a welcome change to the short form.  The qualifications worksheet for the earlier EZ form was simply incorporated by reference, rather than incorporating the relevant, deciding qualifications into the body of the form.  It was too easy for unknowing applicants to simply check a box that they were qualified to use the EZ form, that they were properly formed, had proper purposes, etc.  The new format requires an applicant to expressly verify that the organization is not a church, school, or hospital (for which the EZ form is inappropriate) before making application.  It also requires an applicant to iterate in words the main purpose for which the nonprofit organization was created.  Not all legal purposes qualify an entity for tax exemption.

Frankly, I believe that the IRS could have beneficially gone even further by incorporating the complete qualification worksheet in the form.  If excluding the qualification checklist from the body of the form was intended to make it easier to complete – a mere 2-page document compared to the intimidating stack of pages in the full Form 1023 – in essence the qualification restrictions appear meaningless.  Potentially (and what has been happening) as a result of the appearance of simplicity, unrepresented fledgling nonprofits will be lured into filing the form themselves without so much as a glance at the instructions or qualification worksheets.  This has resulted in some undesirable consequences for entities that were not formed properly, or were not qualified to use the EZ form in the first place.  Since the IRS does not require provision of the founding documents, these are sometimes improperly prepared.  At least some of the common mistakes could be prevented if the yes/no checklist for EZ qualification was in the body of the Form.

Group Exemption.  The Group Exemption application fee dropped from $3,000 to $2,000 in the latest revision of the 1023 family.  In years past there was the expectation among nonprofit professionals that the Group Exemption might be phased out eventually; this lowering of the fee would seem to indicate that such elimination is not on the IRS’ near-term agenda.

This reduction of the fee is reasonable in light of the fact that the application itself is one of the simplest in the 1023 family to complete.  In fact, there is not an official form for this process; a mere letter is required.  The requisite information to be enclosed in such letter is clearly prescribed in IRS materials.  Most entities seeking a Group Ruling have been in existence for some period, have already obtained an individual exemption, and are now seeking to restructure as a central organization in the hub of other mini-versions of itself.  In this scenario, there is less cause for concern on the part of the IRS since it has had a full opportunity to scrutinize the entity previously.  In consequence a lower price tag on the application is thought appropriate.

In fact, the IRS achieves its own purposes by granting Group Exemption rulings.  The central organization takes on the role of the IRS in that it evaluates its subordinates in the Group for proper tax exempt formation and operation on an annual basis.  Each year the central organization requires financials and updates from its subordinates and merely reports to the IRS as to which organizations should still be included.  Because most entities holding Group Exemption ruling are/have been advised by counsel, there will usually be a higher understanding of the exemption requirements with these central organizations; this will often, in turn, help the subordinates gain an understanding of exemption rules.  Because the subordinates are often smaller associations, this level of scrutiny achieves a greater compliance with requirements than if each filed the Form 1023-EZ on their own.

In the last five years there has been an ebb and flow in the IRS’ efficiency, which has resulted in widely varying wait times for exemption determinations.  Anecdotally, it was observed that in the heyday of recent IRS efficiency, around 2010 or 2011, some full applications flew through the examination process in as little as 5 weeks.  On the other hand, 2013 was observed to be the worst year – with wait times up to a year and a half for simple applications needing no interaction with the IRS; the applications were simply stuck in the ostensibly unmovable backlog and remained unassigned for months on end.  Due to this backlog the IRS created the Form 1023-EZ option for smaller organizations to get through the mire more quickly, allowing exemption specialists to focus on more complicated applications.

It remains to be seen, but I suspect that the IRS desires to encourage the pursuit of Group Exemption Rulings through this more accessible fee structure, thereby, as discussed, lessening its overall workload.

Overdue Updating.  In addition to removing the obsolete option for small organizations under $10,000 in annual revenue (mentioned above), the new Form 1023 also finally removed the messy red add-on guidance that graced the form for the last five years, directing applicants to override portions of the existing instructions.  Examples included the outdated mailing address instructions, as well as the nearly 2/3 page of confusing language that referred to the “advanced ruling” protocol, which has been obsolete since 2008.  The Form 1023 now appears much cleaner with the 2018 upgrade.

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New IRS Procedure Grants Charities Greater Mobility Thursday, Mar 1 2018 

The IRS has recently released a revised Revenue Procedure giving tax exempt entities greater flexibility.  Previously an organization needed to decide at the onset where they wanted to be incorporated for the long haul, knowing that any future adjustment to the organization’s home state would require that organization to file the IRS Form 1023 “Application for Exemption” all over again.  These restrictions were unambiguous in the 40 and 50 year-old Revenue Rulings 67-390 and 77-469 which spelled out the requirements and provided clear examples.  As a result, it was unusual to see a charity switch locations due to the associated paperwork and hassles involved.

But now the IRS has expressly abandoned the restrictions of those Revenue Rulings and opened the door to new strategic possibilities for charities to consider.

With the same stroke the named regulations also stated that entities moving from one qualifying exempt structure to another would be excused from the need to reapply.  For example, an unincorporated association that has been approved for exemption and later becomes incorporated would – under the old rules – be required to apply all over again because a new legal entity had been created.  The rules now do not require reapplication in that scenario.

Rationale.  The rationale given for these changes is one of consistency.  The previous rules governing when an organization must re-apply for a FEIN, and when it must re-apply for exemption were not in line with one another, leading to somewhat irrational results.

Presumably this change will simplify matters for the IRS by creating a reduction in its workload once the redundant examination of “old-but-newly-headquartered” charities is eliminated.  The old law requiring a thorough examination of a charity which had changed nothing in terms of its exempt purposes, but merely its address may not have been the best allocation of scarce IRS resources – especially since the exempt organization would have already been scrutinized by the Service in determining qualification for exemption.

State Law.  This change in the rules will highlight the different corporate codes of the various states.  It will now be state rules that govern whether a charity can successfully transfer operations in one fluid motion, as opposed to the herky-jerky dissolution and reincorporation process.  The state tools to be used to make changes to an entity’s jurisdiction are the articles of domestication and articles of conversion, options currently available on a state-by-state basis.  It remains to be seen whether any changes to state codes or attempts at uniform protocol will follow this change in an effort to make the new IRS’s Procedure more seamless.

Potential Pitfall?  A conceivable area where the gate-keeping function might fall through the cracks, however, is in the case of a true “reincorporation” into another state, rather than just the filing of articles of conversion which could move the corporation to its new home under the same charter.  When unsupervised charities are writing their own articles of incorporation, things tend to go amiss.  One of the most-cited reasons for the rejection of a Form 1023 application is that the founding document either didn’t have a proper purpose clause or the required dissolution clause.

On the other hand, to the average visionary the idea of moving state locations might appear to be just the sort of legal matter that might warrant hiring an attorney for the process, which would (generally) lower the incidence of improperly scribed articles of incorporation.  Additionally, it might be assumed that an organization that was originally required to get it right in the first state would have a higher likelihood of getting it right in the second state, but time will tell.

It will be interesting to watch whether the added privileges of movement will lead to increased productivity in the exempt world, or if the released grip of IRS oversight will simply allow early-stage carelessness to sneak into the process.  Mistakes made in founding documents can lead to undesirable results.  If an entity builds on an improper foundation, the tax consequences can be bleak when the error is finally discovered.  Of course, the new IRS guidelines make clear that the organizational and operational tests are still required for any relocated entity, but how will this compliance be verified?  A relocated entity will, of course, be required to report the change on the following annual report to the IRS (Form 990), but the level of scrutiny given to the new incorporation documents remains to be seen.

Anecdotally, when the IRS made the Form 1023-EZ available, the rules regarding proper formation were still in place, but many start-up founders breezed right over these requirements.  This resulted in many improperly formed “charities” that had false assurances of status because they had forked over the $275 and gotten an official notice from the IRS.  The appeal of the “EZ” form has made it altogether too easy for well-intended charities to develop on improper foundations.

It will be interesting to watch guidance emerge to accompany this new latitude in the nonprofit world.

California Charity to Pay for Self-Dealing & Other Offenses Thursday, Dec 10 2009 

California’s Attorney General filed suit against the L.B. Research Foundation (“L.B.”) and its board members this past September, disclosing alleged areas of “gross mismanagement” and requesting involuntary dissolution of the organization.

The apparent deficiencies noted, as described below, could easily occur in charities that are not aware of pertinent legal requirements.

Failure to Maintain Adequate Books & Records

L.B. was unable to produce many of the many of the documents requested by the Attorney General, including adopted bylaws, grant applications, grant agreements, final grant reports, or meeting minutes for the first 7 years – all things required of private foundations under various US and California code sections.[1] Board members have a fiduciary duty of care to keep proper books.

Violation of Board Officer Rules

In California, a nonprofit public benefit corporation must have a chairman, a secretary, and a chief financial officer.  The chairman cannot concurrently serve in either of the other two offices.  In this case, Mr. Buckberg (the founder) was single-handedly selecting the officers – who purportedly did not even know of their appointments until the annual meeting.  Board members were sometimes uninformed of the names of fellow board members. Grants were being fully distributed before the “officers” were aware of them.

The board was not operating as a board as it did not have control; all decision making was in the hands of Mr. Buckberg.  This scenario may have an all too common resemblance to many nonprofit boards.

Self-Dealing

The prohibition of private inurement and self-dealing, though central to the definition of a nonprofit organization, are too often glossed over by nonprofit leadership.  This apparently was true of the board of L.B. – which to all appearances was unaware that the charity could not award grants for the private benefit of board members.

Substantial contributors to a private foundation or those in management over it are considered “disqualified persons,” meaning that they are prohibited from using, receiving, or benefiting from the organization’s assets or income.[2]

Yet according to the Attorney General, L.B. reportedly made the following grants:

  • Over $60,000 to UCLA Foundation to support Mr. Buckberg’s research and laboratory
  • Over $120,000 to produce an educational DVD, all rights being owned by Mr. Buckberg and his cousin, and which also supported a patent owned by Mr. Buckberg and another board member
  • Over $15,000 to a for-profit company owned by Mr. Buckberg and his cousin for the production of the Helical Heart Model, which was also patented by these individuals
  • Over $140,000 for research which would be overseen by Mr. Buckberg
  • Over  $50,000 for expenses related to conferences to promote a medical device patented by Mr. Buckberg and another board member
  • Over $40,000 for statistical analysis related to the same medical device
  • Over $8,000 to a board member for research and a conference
  • Funneling $25,000 to a board member’s friend as quid pro quo for the member’s donation
  • Over $1,000,000 to UCLA to create an endowed faculty chair that Mr. Buckberg applied for, which he did not get, and then spent over $400,000 in legal fees suing UCLA for the position

Members of a nonprofit board have a fiduciary duty of loyalty, which prohibits the kind of self-dealing that was seemingly pervasive among this board, and primarily by its founder.

Expenditure Responsibility

When a private foundation makes a grant to a non-tax-exempt entity, it is required to exercise expenditure responsibility, whereby it must 1) make pre-grant inquiries, 2) enter into grant agreements, 3) obtain full and complete reports and final reports from the grantees, 4) base grants to individuals on procedures preapproved by the IRS, 5) award grants on an objective, nondiscriminatory basis from a pool large enough to constitute a charitable class, and 6) keep all records related to grants made to individuals.

L.B. adhered to virtually none of these requirements when doling out grants, which consequently should have been considered taxable expenditures.

Settlement

A settlement agreement was reached by all on December 4, requiring the organization and several of its officers to pay hefty sums, including all the Attorney General’s legal fees.  The organization is required to undergo board member training and hire consultants to rework its policies and develop proper granting procedures.  The board must also increase the number of independent members.  Mr. Buckberg was stripped of financial control, including the checkbook.  He even has to turn over his keys to L.B.’s post office box.

Although L.B. was not forced to dissolve as the Attorney General originally sought, this resolution has left the organization unrecognizable in terms of its management, and probably its reputation.

Organizations should not be lulled into apathy because past corner-cutting has yet to be exposed.  L.B. Research Foundation “got away with it” for ten years before paying a big price.

Lastly, the ignorance of L.B.’s board not only didn’t serve as a defense – it was in fact counted against them.

This case and settlement can be located at the following links, respectively:

http://ag.ca.gov/cms_attachments/press/pdfs/n1799_lbresearch.pdf

http://ag.ca.gov/cms_attachments/press/pdfs/n1840_document.pdf


[1] 26 U.S.C. § 4945; California Corporations Code §§ 6620, 6321, and 6322.

[2] 26 U.S.C. § 4946(a) and (b).

Changes in Campaign Finance Regulations for §527 Nonprofits Monday, Sep 21 2009 

The US Court of Appeals, D.C. Circuit, recently made a significant ruling regarding § 527 organizations – those nonprofits existing primarily to influence the election or defeat of candidates for federal public office.  In the case of Emily’s List v. Federal Election Commission (FEC), decided September 18, 2009, the court majority wrote a 44 page opinion striking down recent (2004) FEC campaign spending limitations applied to these groups.

After the 2004 elections there was significant pressure on the FEC to reform the campaign spending of certain nonprofit groups who had reportedly spent several hundred million dollars in election-related advertising and programming.  There was a push to place restrictions on these groups similar to those on political parties.

This case dealt largely with the difference between hard and soft money.  A § 527 organization must keep two separate accounts.  Contributions in direct support of candidates and political parties is termed “hard money”, and such contributions may consist of no more than $5,000 from any one donor in any given year.  “Soft money” may not be contributed directly but may go towards political expenditures the form of cause or candidate supporting efforts such as advertising, get-out-the-vote campaigns, etc.; a donor may give as much as desired for such support.  Until this past Friday, FEC regulations restricted nonprofits in their activities by requiring that 50% (sometimes more) of certain expenditures come from the hard money account, rather than from the soft money account.  Since hard money is more difficult to accumulate than soft, the activities of these organizations were being inhibited.

The court in Emily’s List traced a history lesson, examining the evolving campaign finance laws as apposed to the freedoms provided under the First Amendment.  The Circuit court noted that the Supreme Court has generally approved statutory limitations on contributions to candidates and political parties – including contributions made by for-profit corporations.  On the other hand it has rejected expenditure limits on individuals, groups, candidates, and parties.

The Emily’s List court, while affirming that an organization’s direct contributions to candidates and parties may be limited, further ruled that such contributions should not prevent the organization from also engaging in supporting expenditures.  The court said, “A non-profit that makes expenditures to support federal candidates does not suddenly forfeit its First Amendment rights when it decides also to make direct contributions to parties or candidates.”  The organization in question – Emily’s List – is a pro-choice organization that makes supporting expenditures as well as direct contributions in furtherance of its causes and endorsed candidates.

The court ultimately boiled the issue down to whether these independent nonprofit organizations should be treated like individual citizens (which are entitled to expend unlimited amounts to express their views through supporting expenditures), or like political parties (which may be restricted).

Through lengthy discourse the court explained that § 527 organizations like Emily’s List, being neither for-profit nor closely connected with a particular candidate or political party, do not represent a situation ripe for corruption, which was the situation of concern behind campaign finance restrictions in the first place.  The court said, “Donations to and spending by a non-profit cannot corrupt a candidate or officeholder, at least in the absence of some [evidence] establishing such corruption or the appearance thereof.”  The court concluded that these organizations should be treated as individuals for political expenditures purposes, and therefore are entitled to have 100% of such expenditures come from their soft money accounts – the accounts that do not limit donations by individuals.

While § 527 organizations should be aware of the new rules, it remains to be seen whether this ruling will hold fast.

The full text of this case can be found at http://pacer.cadc.uscourts.gov/common/opinions/200909/08-5422-1206889.pdf.

Adopting Robert’s Rules of Order Thursday, Sep 10 2009 

In a recent article by nonprofit attorney Jack Siegel of Charity Governance Consulting entitled “Disorder From Robert’s Rules of Order” (http://www.charitygovernance.com/charity_governance/2009/08/disorder-from-roberts-rules-of-order.html), he reiterated his position that nonprofit boards should never assign blanket allegiance to the Robert’s Rules of Order in their bylaws.  In an effort to adopt all the policies considered proper for governance, new boards may be tempted to throw in a line encapsulating the whole of Robert’s Rules – without realizing the full extent of the 600+ page document to which they are committing themselves.

Although many people are familiar with the Robert’s Rules of Order by name, the vast majority of board members are not familiar with the complete compilation.  A board’s willingness to commit to an unknown document is often a hasty action to embrace standard practices for meetings that may not have been originally listed in the governing documents.  Most organizations, however, will never adhere to the level of detail and formality spelled out in the Rules.  Despite general impressions to the contrary, an adoption of these provisions can, if fully implemented, affect more than the efficiency of a meeting.  The last provisions of the Rules, for example, address the punishment of members – giving instructions for trying members, right down to the details for ejecting members from a meeting place.

The article cited above reviews the case of an organization that, having adopted Robert’s Rules, regretfully learned in more detail of its requirements when one of the board members engaged in improper behavior, meriting his removal.  The article explains:

What the organization apparently failed to recognize when they adopted Robert’s Rules of Rule is that Chapter XX (starting on page 624) outlines disciplinary proceedings.  The rules are themselves ambiguous as to whether they need only be adhered to if specifically adopted by the organization, or whether a blanket adoption of Robert’s Rules of Order requires these rules to be followed.  Whatever the intention, the rules provide the offender with the opportunity to argue that the specific disciplinary procedures must be followed if the organization adopted Robert’s Rules of Order.  The outlined disciplinary procedures contemplate a confidential investigation, notice to the offender, a trial with specific procedures, the group’s review of the trial, a report, and the implementation of remedies.

The board in this case did not follow the procedure of the Rules, rather threatening a lawsuit instead.  The offending member in turn was able to use the forgotten Robert’s Rules to gain an advantage in the situation.

The article concedes that most organizations adopting Robert’s Rules will usually manage to function without a mishap.  But when circumstances arise, as in the example above, Robert’s Rules can work to the detriment of the organization.  Unless board members have read, fully understand, and mean to practice the Rules, it is best not to adopt them in their entirety.   One feasible approach may be to adopt only those sections of the Rules that are thought appropriate.  Alternately, an organization’s own bylaws may be sufficient for the purposes at hand.

IRS Denies Tax Exemption to Non-Traditional Church Friday, Aug 21 2009 

The term “church” is not actually defined in the Internal Revenue Code but when the IRS determines what a church is for tax exemption purposes, in more recent rulings it has exhibited a disturbing lack of predictability.

The ECFA recently reported on a non-traditional church that was denied church status by the IRS earlier this year.  The organization applied for exemption as a church and religious organization (accounting for 60% of its activities) and as an educational organization by way of its seminary (40%).  Every service, from sermons to seminary classes was offered online.  There was no established physical meeting or teaching space.

In this case the IRS based its finding on several grounds in denying the organization tax exemption status; the primary basis in its adverse determination letter (found at http://www.irs.gov/pub/irs-wd/0912039.pdf) related to the characteristics needed to meet the definition of a church.

Since 1978, the IRS has typically relied upon its own fourteen-point criteria to define a church:

  1. Distinct legal existence
  2. Recognized creed and form of worship
  3. Definite and distinct ecclesiastical government
  4. Formal code of doctrine and discipline
  5. Distinct religious history
  6. Membership not associated with any other church or denomination
  7. Organization of ordained ministers
  8. Ordained ministers selected after completing prescribed courses of study
  9. Literature of its own
  10. Established places of worship
  11. Regular congregations
  12. Regular religious services
  13. Sunday schools for the religious instruction of the young
  14. Schools for the preparation of its members

This list was recognized in American Guidance Foundation v. U.S., 490 F. Supp. 304 (D.D.C. 1980).  The court however chose to emphasize certain aspects from the list above, namely factors No.6 (Membership not associated with any other church or denomination), No.10 (Established places of worship), and No.12 (Regular religious services).  Additionally, the court declared to be of central importance “the existence of an established congregation served by an ordained ministry, the provision of regular religious services and religious education of the young, and the dissemination of a doctrinal code.”

The 14 factors stated above were not accepted as a definitive test in Foundation for Human Understanding v. Commissioner, 88 T.C. 1341 (1987).  Rather the court said that the IRS must consider all facts and circumstances.

But in analyzing the facts and circumstances of this case, the IRS appears to have actually narrowed the definition of a church.  Some of its reasoning on what is considered the most important criteria is as follows:

  • Sunday School.  “Your Sunday school classes exist entirely on the Internet . . . Because there are no tests or final examinations required of these students, there is no way to establish that the students are learning their religious lessons.  Thus, as a practical matter, you have no Sunday schools for the religious instruction of the young.”

The IRS appears to expect characteristics that are present in only some American churches.  Catholic churches, for example may have “tests and final examinations” for the children to assure that they have learned their “religious lessons,” but that is not typical of most Protestant churches – traditional or otherwise.  Furthermore, not every gathering of believers has the necessary resources or teachers available to conduct Sunday school.

  • Exclusive Membership.  “You state that you do not require prospective members to renounce other religious beliefs or their membership in other churches or religious orders to become members of your church. . . .This membership is insufficient to be treated as a regular congregation.”

Certainly many churches today do not inquire into all memberships of past churches and require renunciation when the congregant is willing to accept the creed of the present church.  This again may mark a line between highly organized Catholic churches and more informal Protestant ones.

  • Size of Pastorate & Congregation.  “You have one minister, [name], ministering to your ‘congregation,’ which is composed of only [number] people.  Thus you do not have a complete organization of ordained ministers ministering to their congregations.”

Size is not listed as a factor on the 14-point list; however, this factor seems to play an important role in the IRS’s consideration.  Many churches in our country have only one pastor.  We are not privy to the size of the congregation rejected here, but in our country small churches, including spin-offs, startups, and rural churches are perhaps more the rule than the exception.

  • Internet.  “Your services are held only on the Internet.  This is not a building or a physical place.  Thus you have no established places of worship.”

The internet has generated a plethora of never anticipated legal questions.  Some examples include acceptable methods to serve process, unauthorized practice of law across state lines, and intellectual property issues.  Simply because location is difficult to pin down does not mean it does not exist, as argued here.  As the world becomes smaller through tools such as video conferencing, this issue will increase in relevance.

Regardless of whether the organization considered should have received church status recognition, if this is the analysis to be used in making future determinations, how many of our existing churches would survive this test?

Minimum Wage Requirements as they Apply to Churches Saturday, Aug 1 2009 

On July 24, 2009, the federal minimum wage increased from $6.55 to $7.25 for those covered by the Fair Labor Standards Act (FLSA).  Where the state and federal minimum wage both apply but differ, the federal rate will apply when higher.  Some states have a higher minimum wage, some lower, and some mirror the federal rate.  Another major provision for employees under the FLSA is time and a half pay for work done in excess of 40 hours a week.

When does the FLSA apply?

Application of the Fair Labor Standards Act

There are two general cases under which an employee is covered by the FLSA rules:

  • Enterprise Basis – All employees working for organizations that engage in interstate commerce and that do at least $500,000 of business each year are covered.  Also included are all employees of hospitals, businesses providing medical or nursing care for residents, schools and preschools, and government agencies.
  • Individual Basis – All employees whose work regularly involves them in “interstate commerce” are covered.  This includes employees that regularly phone, mail, or travel out of state.  Also most “domestic service workers,” such as day workers, housekeepers, chauffeurs, cooks, or full‑time babysitters are included.

It has not always been clear to what extent the FLSA affects churches and other nonprofits.  The “Enterprise Basis” can apply to a church that brings in over $500,000 a year in activities that compete with for-profit business, such as the rental income provided from leasing their facilities to others.  Many churches run schools, which also puts them under the “Enterprise Basis.”[i] Under the “Individual Basis” church employees are regularly doing activities that can be construed as interstate commerce, such as telephoning, mailing, or traveling out of state.  In addition, most churches have domestic service workers that would be covered by the Act.

If these organizations are involved in interstate commerce, they are not exempt from the FLSA rules on the basis of their tax-free status.  The Supreme Court in Alamo Foundation v. Secretary of Labor[ii] was referring to the FLSA when it stated, “[T]he statute contains no express or implied exception for commercial activities conducted by religious or other nonprofit organizations, and the agency charged with its enforcement has consistently interpreted the statute to reach such businesses.”[iii]

But how do churches know whether they are engaging in “interstate commerce?”

One view comes from Kathleen Turpin, an expert in employment law and author of Working Together, A Guide to Employment Practices for Ministries.  She recommends asking the following questions to help churches determine if the FLSA applies to them:

  • Do we order teaching materials or other supplies from out of state?
  • Do we send newsletters or other information to people out of state?
  • Does anyone on staff travel out of state as part of their job?
  • Does our ministry have a Website where people out of state order items?

According to Turpin if the answer to any one of these questions is in the affirmative, the organization is probably engaging in interstate commerce and needs to comply with the FLSA.

Possible Exemptions for Clergy & Other Religious Workers

Even if an organization’s employees are determined to be engaging in interstate commerce, some of its employees may yet be exempt from FLSA coverage.  One exception is found in the language of the FLSA which excludes “administrative, executive, and professional employees.”  The Dept. of Labor explains that this generally includes those that would otherwise be covered by the FLSA but earn at least $455 a week on a salaried basis.  Because this category is already above the minimum wage, the only noticeable difference from being covered under the Act is the lack of required overtime pay.

The 4th Circuit Court has also recognized a “ministerial exemption” to the FLSA, first argued in Shenandoah Baptist Church[iv] and discussed more fully in the 2004 case of Shaliehsabou v. Hebrew Home of Greater Wash., Inc.[v] The exemption can exclude a member of the clergy from being an “employee” within the FLSA meaning.  The notion of this exemption derived from a debate on the floor of Congress that was later delineated in some guidelines issued by the Dept. of Labor’s Wage and House Administrator.[vi] The relevant portion of those guidelines provides:

“Persons such as nuns, monks, priests, lay brothers, ministers, deacons, and other members of religious orders who serve pursuant to their religious obligations in schools, hospitals, and other institutions operated by their church or religious order shall not be considered to be ‘employees.’”[vii]

The 4th Circuit went on to use Title VII descriptions of “ministerial duties” to come up with the “primary duties” test to determine whether the exception applies.  They focused on “the function of the position,” rather than whether the person was formally ordained.  “[A]s a general rule, if the employee’s primary duties consist of teaching, spreading the faith, church governance, supervision of a religious order, or supervision or participation in religious ritual and worship, he or she should be considered ‘clergy.’”[viii]

Therefore, even though the clergy of a church are not covered by the FLSA due to the “ministerial exemption,” exemptions to the general rule are construed narrowly, and other employees may be covered by the FLSA.  Thus regarding these employees, the church is obliged to comply with minimum wage and overtime regulations.

Volunteers Not Covered by FLSA

Although the definition of “employee” under FLSA (found in Title 29 § 203 of the U.S. Code[ix]) is more sweeping than its use in other government regulations (such as ERISA), it does not include those who volunteer their time to a charitable organization.

There is not a specific exemption mentioned in the FLSA for church or charity volunteers in the private sector but the enforcers of the FLSA have interpreted it as if there was such an exemption.[x] But it is important to note that even if workers consider themselves “volunteers,” their intent alone will not exclude them from FLSA rules if they are accepting some other form of compensation.  In the Alamo case, former drug addicts who were working for free for the organization, considered themselves volunteers, but they were also residing there for free.[xi] This benefit transformed the workers from the “volunteer” category to “employee status.”[xii]

Churches thus need to be aware of the ramifications associated with rewarding volunteers for their labors.  Volunteers may be compensated for reasonable expenses directly associated with their work (gas money, etc) and accept small conveniences on the job (such as meals) as long as benefits in lieu of compensation do not exceed $500 a year.   If an organization is overly compensating its volunteers, it becomes seen as an employer in the eyes of the government, and the organization could face actions by the worker or the Dept. of Labor for not complying with FLSA wage laws.



[i] Dole v. Shenandoah Baptist Church, 899 F.2d 1389 (4th Cir. 1990).

[ii] Alamo Foundation v. Secretary of Labor, 471 U.S. 290.

[iii] Id. at 296-7.

[iv] Shenandoah Baptist Church, 899 F.2d 1389 (4th Cir. 1990)

[v] Shaliehsabou v. Hebrew Home of Greater Wash., Inc., 363 F.3d 299

[vi] Shaliehsabou, at 305.

[vii] Id.

[viii] Id., quoting Bruce N. Bagni, Discrimination in the Name of the Lord: A Critical Evaluation of Discrimination by Religious Organizations, 79 Colum. L. Rev. 1514, 1545 (1979).

[ix] Fair Labor Standards Act – Title 29 § 203(e)(1) Except as provided in paragraphs (2), (3), and (4), the term “employee” means any individual employed by an employer;  (g) “Employ” includes to suffer or permit to work.

[x] Walling v. Portland Terminal Co., 330 U.S. 148 at 152, stating “Section 3(g) of the Act defines ’employ’ as including ‘to suffer or permit to work’ and § 3(e) defines ’employee’ as ‘any individual employed by an employer.’ The definition ‘suffer or permit to work’ was obviously not intended to stamp all persons as employees who, without any express or implied compensation agreement, might work for their own advantage on the premises of another. Otherwise, all students would be employees of the school or college they attended, and as such entitled to receive minimum wages. So also, such a construction would sweep under the Act each person who, without promise or expectation of compensation, but solely for his personal purpose or pleasure, worked in activities carried on by other persons either for their pleasure or profit. But there is no indication from the legislation now before us that Congress intended to outlaw such relationships as these. The Act’s purpose as to wages was to insure that every person whose employment contemplated compensation should not be compelled to sell his services for less than the prescribed minimum wage. The definitions of ’employ’ and ’employee’ are broad enough to accomplish this. But, broad as they are, they cannot be interpreted so as to make a person whose work serves only his own interest an employee of another person who gives him aid and instruction.”

See also Alamo, at 295 stating, “An individual who, without promise or expectation of compensation, but solely for his personal purpose or pleasure, works in activities carried on by other persons either for their pleasure or profit, is outside the sweep of the Fair Labor Standards Act.”

[xi] Alamo, at 293, stating “[T]he associates who worked in these businesses were ‘employees’ of the Alamos and of the Foundation within the meaning of the Act. The associates who had testified at trial had vigorously protested the payment of wages, asserting that they considered themselves volunteers who were working only for religious and evangelical reasons. Nevertheless, the District Court found that the associates were ‘entirely dependent upon the Foundation for long periods.’  Although they did not expect compensation in the form of ordinary wages, the District Court found, they did expect the Foundation to provide them ‘food, shelter, clothing, transportation and medical benefits.’”

[xii] Alamo, at 290, stating “The Foundation’s associates are ‘employees’ within the meaning of the Act, because they work in contemplation of compensation. Walling v. Portland Terminal Co., 330 U.S. 148, distinguished.  The fact that the associates themselves protest coverage under the Act is not dispositive, since the test of employment under the Act is one of ‘economic reality.’  And the fact that the compensation is primarily in the form of benefits rather than cash is immaterial in this context, such benefits simply being wages in another form.”

Pulpit Freedom: Right or Privilege? Saturday, Jul 25 2009 

Last week Tax Analysts reported that Alliance Defense Fund (ADF) intends to continue pushing “Pulpit Freedom Sunday” each year until the IRS is provoked to action.  Its debut last September involved 32 pastors speaking out boldly expressing their views on candidates and issues related to the election the following November.

Since the Johnson Amendment of 1954 (brought by Senator Lyndon B. Johnson), tax exempt organizations, including churches, have been prohibited from endorsing or opposing political candidates for public office.  Although this prohibition includes sermons, since its implementation, ADF reports that no pastors have been punished for violating it, nor have any churches lost tax exemption.

But the ADF maintains that the law encroaches upon the 1st Amendment right to freedom of speech, and even though no action has been taken under the restriction, it has silenced many churches that would otherwise be vocal.  Furthermore, ADF attorney Erik Stanley says that the current law is unclear, making it difficult for pastors – even lawyers – to know how to interpret its restrictions.  The “Pulpit Initiative” is intended to push the constitutional issue and bring clarity.  This year the ADF is calling for two courses of action.  To challenge the constitutionality of the Johnson Amendment, pastors are challenged to speak for and against candidates running for public office.  But to also educate more pastors of their rights, ADF is encouraging them to boldly speak their views of incumbent politicians, something permitted under current law.

A foundational question at issue is whether a church’s tax exemption is a privilege or a right.

Most people consider a “right” to be something inherent – and consequently very difficult to take away.  But what aspect of a church would make its right to tax exemption inherent?  Some point to the long history of such exemptions, but others would attribute the right to the role that churches fulfill.  Historically, much of the work done by churches has been viewed as the kind that which would naturally fall upon the government in the absense of the churches, such as performing acts of benevolence for the needy or attending to the “mental health” of their congregations.  Consequently, under this theory, the government exempts churches from taxes to encourage this necessary work.  In that sense the churches might loosely be considered to be distant arms of the government, using government funds to accomplish government work.  If the church becomes involved in partisan activities – work that is not nor should be performed by the government, those activities would not be exempted from taxation because they do not fulfill any charitable role of the government.

In any case, the Supreme Court has declared that tax exemption is not an inherent right.  In the 1970 case of Walz v. Tax Commission of the City of New York, the Court in a 5-4 decision preserving property tax exemption for a church said that the exemption was “permissible, but not constitutionally required.”  Going a step further in 1972, the Court of Christian Echoes National Ministry, Inc. v. U.S. said, “tax exemption is a privilege, a matter of grace rather than a right.”  But a bigger shift came in the 1983 case of Regan v. Taxation with Representation when the Court compared the exemption to a “tax subsidy.”

If exemption is indeed seen as a privilege or a subsidy, the church is getting some benefit beyond what is due them inherently and should not be surprised to see guidelines prescribing behavior.  Already existing examples include the prohibition against private inurement and unreasonable compensation, as well as the administrative burdens of tracking unrelated business income or monitoring international grants closely.  For various rationales, all these conditions come along as a result of the tax benefit provided.

But in a public debate on the Johnson Amendment this past May, Professor Douglas Laycock from the University of Michigan Law School argued the existence of “unconstitutional conditions” – that there are certain rights that cannot be withheld in exchange for government benefits.  Without this protection great abuse would result.  As an example that this doctrine is weakening, ADF’s chief counsel Ben Bull pointed out that ADF is currently defending a church that refused to perform a civil union for a lesbian couple, and its exemption is now threatened because the IRS claims they are no longer operating in the “public interest.”

So perhaps the greater fear is not the loss of the right to endorse a candidate, but that the pendulum is not done swinging and the conditions for tax exemption grow more invasive.  ADF is currently defending in several cases where, in their own words, “publicly preaching words straight from the Gospel has led to censorship…and even jail.”  Regardless of the uncertain outcome of those cases, the enacted Johnson Amendment already bans pastors around election times from speaking on moral issues that are fair game during non-election season – even though they mention no candidates by name.  If a pastor’s sermon could be construed as an endorsement, it’s off limits. The vagueness of the standard alone leaves a lot of room for the pendulum to continue swinging.

Pulpit Freedom: Right or Privilege? Saturday, Jul 25 2009 

Last week Tax Analysts reported that Alliance Defense Fund (ADF) intends to continue pushing “Pulpit Freedom Sunday” each year until the IRS is provoked to action.  Its debut last September involved 32 pastors speaking out boldly expressing their views on candidates and issues related to the election the following November.

Since the Johnson Amendment of 1954 (brought by Senator Lyndon B. Johnson), tax exempt organizations, including churches, have been prohibited from endorsing or opposing political candidates for public office.  Although this prohibition includes sermons, since its implementation, ADF reports that no pastors have been punished for violating it, nor have any churches lost tax exemption.

But the ADF maintains that the law encroaches upon the 1st Amendment right to freedom of speech, and even though no action has been taken under the restriction, it has silenced many churches that would otherwise be vocal.  Furthermore, ADF attorney Erik Stanley says that the current law is unclear, making it difficult for pastors – even lawyers – to know how to interpret its restrictions.  The “Pulpit Initiative” is intended to push the constitutional issue and bring clarity. This year the ADF is calling for two courses of action.  To challenge the constitutionality of the Johnson Amendment, pastors are challenged to speak for and against candidates running for public office.  But to also educate more pastors of their rights, ADF is encouraging them to boldly speak their views of incumbent politicians, something permitted under current law.

A foundational question at issue is whether a church’s tax exemption is a privilege or a right.

Most people consider a “right” to be something inherent – and consequently very difficult to take away.  But what aspect of a church would make its right to tax exemption inherent?  Some point to the long history of such exemptions, but others would attribute the right to the role that churches fulfill.  Historically, much of the work done by churches has been viewed as the kind that which would naturally fall upon the government in the absense of the churches, such as performing acts of benevolence for the needy or attending to the “mental health” of their congregations. Consequently, under this theory, the government exempts churches from taxes to encourage this necessary work.  In that sense the churches might loosely be considered to be distant arms of the government, using government funds to accomplish government work. If the church becomes involved in partisan activities – work that is not nor should be performed by the government, those activities would not be exempted from taxation because they do not fulfill any charitable role of the government.

In any case, the Supreme Court has declared that tax exemption is not an inherent right.  In the 1970 case of Walz v. Tax Commission of the City of New York, the Court in a 5-4 decision preserving property tax exemption for a church said that the exemption was “permissible, but not constitutionally required.”  Going a step further in 1972, the Court of Christian Echoes National Ministry, Inc. v. U.S. said, “tax exemption is a privilege, a matter of grace rather than a right.”  But a bigger shift came in the 1983 case of Regan v. Taxation with Representation when the Court compared the exemption to a “tax subsidy.”

If exemption is indeed seen as a privilege or a subsidy, the church is getting some benefit beyond what is due them inherently and should not be surprised to see guidelines prescribing behavior.  Already existing examples include the prohibition against private inurement and unreasonable compensation, as well as the administrative burdens of tracking unrelated business income or monitoring international grants closely. For various rationales, all these conditions come along as a result of the tax benefit provided.

But in a public debate on the Johnson Amendment this past May, Professor Douglas Laycock from the University of Michigan Law School argued the existence of “unconstitutional conditions” – that there are certain rights that cannot be withheld in exchange for government benefits. Without this protection great abuse would result. As an example that this doctrine is weakening, ADF’s chief counsel Ben Bull pointed out that ADF is currently defending a church that refused to perform a civil union for a lesbian couple, and its exemption is now threatened because the IRS claims they are no longer operating in the “public interest.”

So perhaps the greater fear is not the loss of the right to endorse a candidate, but that the pendulum is not done swinging and the conditions for tax exemption grow more invasive.  ADF is currently defending in several cases where, in their own words, “publicly preaching words straight from the Gospel has led to censorship…and even jail.” Regardless of the uncertain outcome of those cases, the enacted Johnson Amendment already bans pastors around election times from speaking on moral issues that are fair game during non-election season – even though they mention no candidates by name.  If a pastor’s sermon could be construed as an endorsement, it’s off limits. The vagueness of the standard alone leaves a lot of room for the pendulum to continue swinging.

Defining “Excessive UBI” Monday, Jul 20 2009 

Unrelated business income (UBI) occurs when a nonprofit organization engages in a trade or business that is regularly carried out that is not substantially related to that organization’s exempt purposes.  Charities must pay taxes on this UBI in a manner similar to their for-profit counterparts.  In addition to taxes, however, the charities are not permitted to carry on too much unrelated business without endangering their tax-exemption.  The rules for determining firstly what constitutes unrelated business and secondly whether there is excessive UBI are generally acknowledged to be murky areas of the law.

Issue 1:  What is Unrelated Business?

Commerciality doctrine.  The first issue of determining whether the activity of a tax-exempt organization is considered unrelated business is controlled by what has come to be known as the “commerciality doctrine.”  Because this judge-made doctrine has taken on varying definitions and interpretations, it currently lacks uniform application and consequently requires a separate article from this one to depict its evolution in the courts.  But in short, it is described by nonprofit expert Bruce R. Hopkins this way:  “A tax-exempt organization is considered to be engaged in a nonexempt activity when that activity is engaged in a manner that is classified as commercial in nature.  An activity is a commercial one if it has a direct counterpart in, or is conducted in the same manner as is the case in, the realm of for-profit organizations.”  Once the charity’s activity is determined to be unrelated business, the second issue must be considered.

Issue 2:  How much UBI will be considered “excessive UBI” and consequently jeopardize the charity’s tax exempt status?

As mentioned above, the unrelated business income tax (UBIT) on a charity’s UBI might not be the only consequence.  Too much unrelated business can jeopardize the tax exempt status of a charity.

Case Law.  Public charities establish and keep their tax exempt status by being organized and operated exclusively for exempt purposes as specified in IRC § 501(c)(3).  Although courts sometimes substitute the word “primarily” in place of “exclusively” the latter is still the correct term of art.  According to Stevens Bros. Foundation, Inc. v. Commissioner, 324 F.2d 633, its definition is no longer open for debate. The Court of Manning Association v. Commissioner, 93 T.C. 596 explains:

“The word ‘exclusively’ has not been literally construed to mean ‘solely’ or ‘absolutely without exception,’ Church in Boston v. Commissioner, 71 T.C. 102, 107 (1978), and we have recognized that ‘a nonexempt purpose even perhaps somewhat beyond a de minimis level has been permitted without loss of exemption,’ Copyright Clearance Center v. Commissioner, 79 T.C. 793, 805 (1982).  Nevertheless, there is a limit beyond which the statute may not be stretched. That limit was set forth by the Supreme Court in Better Business Bureau v. United States, 326 U.S. 279, 283 (1945), as follows:

‘[T]he presence of a single [nonexempt] * * * purpose, if substantial in nature, will destroy the exemption regardless of the number or importance of truly [exempt] * * * purposes.’”

The case of Goldsboro Art League v. Commissioner 75 T.C. 337 puts it like this:

“A substantial nonexempt purpose will disqualify an organization from tax exemption despite the number or the importance of its exempt purposes. * * * Whether an organization satisfies the operational test is a question of fact.”

Therefore, a nonexempt purpose cannot be “substantial” or it will jeopardize the tax exempt status.  This determination is based on the specific facts of each situation.

In reality, neither case law nor the IRS has given any kind of formula for determining the parameters of “insubstantial” UBI.  Rarely are the actual numbers in these cases recorded for our analysis.  In the case of New Faith, Inc. v. Commissioner, T.C. Memo 1992-601, the charity’s commercial activity accounted for approximately 80% of its gross expenditures and nearly 100% of its gross revenues; the charity’s tax exemption was lost in this case.   The case of Church in Boston v. Commissioner, 71 T.C. 102, involved a situation where 20% UBI was found to be too substantial, also resulting in the lost of tax exemption.  That Court stated:

“These facts demonstrate that petitioner’s * * * nonexempt activities * * * are more than incidental or a ‘slight and comparatively unimportant deviation from the narrow furrow of tax approved activity.’ St. Louis Union Trust Co., 374 F.2d 427 at 432-433.”

The court of Manning actually refutes the notion of any safe harbor and stresses again that each case is decided on its individual facts.  In Manning, the charitable organization was erroneously interpreting previous case law to mean that it could safely devote up to 10% of its activities to UBI:

“Petitioner calls attention to World Family Corp. v. Commissioner, 81 T.C. 958 (1983), as suggesting, in petitioner’s words, that ‘where a nonexempt function represents less than ten percent of total efforts, the doctrine of ‘exclusively’ will not be contravened.’ It then treats that suggestion as a ‘rule of law’ establishing a ‘10-percent safe harbor’ limitation, and undertakes to show that only about 10 percent of the time was expended by its officers and others on its behalf on matters relating to genealogy while some 90 percent of efforts were devoted to other matters such as negotiating the lease, etc.  * * * [C]ontrary to petitioner’s position, World Family Corp. v. Commissioner establishes no such 10-percent safe harbor rule.” [Emphasis added]

In fact, the Court in World Family Corp. v. Commissioner (81 T.C. at 967 n. 10) stated:

“We establish no general rule for future cases in finding 10 percent to be insubstantial. We noted a similar caveat in Church in Boston in which we found approximately 20 percent of expenditures to constitute more than an insubstantial activity: ‘We hasten to point out that while the facts in the instant case merit a denial of exempt status to petitioner, we do not set forth a percentage test which can be relied upon for future reference with respect to nonexempt activities of an organization. Each case must be decided upon its own unique facts and circumstances.’ Church in Boston v. Commissioner, 71 T.C. 102, 108 (1978). [Emphasis added]

Before harkening back to the test iterated in the Better Business Bureau case, supra, the Manning Court went on to say, simply:

“This case must also be decided upon its own unique facts and circumstances. It is unnecessary for us to ‘make a determination based upon some economical and moral calculus * * *. It is sufficient only to find, as we do, that ‘more than an insubstantial part of its activities is not in furtherance of an exempt purpose.’’  Christian Stewardship Assistance, Inc. v. Commissioner, 70 T.C. 1037, 1042 (1978).”

Therefore case law gives no clear guidelines and even explicitly rejects “safe harbors” for this area, though the cases show that at least 20% can be too much.  But the courts refuse to be pinned down on to a particular ratio and reserve the right to examine the facts and circumstances of each case before making a determination of excessive UBI.

Expert Opinion: 15% to 30% borders excessive UBI.  Below are the general impressions from different attorneys and nonprofit experts regarding what constitutes excessive UBI.  Most feel that 15% to 30% is as far as an exempt organization should push the limit.

Mosher & Associates is a firm out of Chicago that specializes in nonprofit legal issues.  In an article entitled “Learning to Recognize and Manage Unrelated Business Income Tax” found in their first quarterly report of their Nonprofit Update in 2007, they write:

“[T]oo much unrelated business activity can jeopardize an organization’s tax-exempt status. While no set limit exists, as a general rule, organizations generating more than 20% of their gross revenues should consider setting up a subsidiary to conduct such business activities.”

In an article on UBI from the Ann Arbor law firm Magill & Rumsey, P.C.,

“Organization leaders must also be attentive to excessive unrelated business income. A large proportion of unrelated business income could indicate that the organization is not organized and operated primarily for its tax-exempt purposes. While there appears to be no hard and fast rule, many authorities believe that a safe level of gross unrelated business income is 20 to 30% of the organization’s total income depending upon the specific organization and the nature of activities involved.”

On the other hand, Wendell Bird, a nonprofit expert out of Atlanta, wrote the following in his 1999 article “Publishing Activities of Exempt Organizations” appearing in Tax Exempt Organizations.  Although it is geared to address publishing activities, the case seems to suggest that there are circumstances where UBI that exceeds 50% is permissible.

“In more recent technical advice, the Service ruled that a religious college and school that operated a publishing division that ‘amounted to more than one-half of the organization’s total receipts,’ and was well beyond the textbook needs of the college and school, generated UBI but did not revoke the exemption.  This was so even though the pricing was ‘probably comparable to ordinary commercial prices,’ and the sales methods were ‘indistinguishable from ordinary commercial sales practices.’”

Commensurate-in-scope doctrine. Lastly this doctrine, built from a 1964 Revenue Ruling and a 1971 General Counsel Memorandum, seems to allow some organizations to maintain very high levels of UBI in relation to their total revenue if the UBI goes directly to further the charitable purposes.  This is sometimes called “destination of income” test.  This test looks to see if there is “real, bona fide, or genuine charitable purposes, as manifested by the charitable accomplishments of the organization, and not a mathematical measuring of business purpose as opposed to charitable purpose.”  Gen. Couns. Mem. 32869 (Oct. 9, 1963).   The case involved in the 1964 Rev. Rul. involved a charity that had was earning substantial amounts of rental income from its property and giving it to charitable purposes.

But this doctrine cannot be safely relied upon by charities as there are many cases that clearly state that just because an organization uses its profits for charitable purposes does not mean that the excessive UBI is excused.  According to Fishman & Schwarz’s Nonprofit Organizations, a distinction may be drawn between these seemingly contradictory cases.  The founding cases for the commensurate-in-scope doctrine all involved situations of passive income sources such as rental income.  Passive sources of income such as dividends, interest, and royalties often do not even qualify for UBIT, based upon the rational that they are not as disruptive to the for-profit market.  Ultimately, Fishman & Schwarz do not recommend placing heavy reliance upon this doctrine, as it is in great need of more clarification.

For Profit Entities to avoid Excessive UBI.  In light of the difficulty involved in drawing clear lines around excessive UBI, many charitable organizations choose to spin their commercial activities off into a for-profit organization.  Although it comes with downsides, this format can prevent the charity from jeopardizing its vital tax exempt status.

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