FOSS Nonprofits: Judged on their Merits at the IRS?

This is the first post in a series by, Aaron Williamson, and sponsored by OSI Affiliate Mozilla Foundation in partnership with the Software Freedom Conservancy. Future posts will build on this background with information for projects considering their organizational and governance options, including whether to incorporate and to seek tax-exempt status.

The free and open source software community depends heavily upon the work of community-funded nonprofit organizations. These organizations develop software, organize community events, manage key infrastructure, and educate people about FOSS. They serve as key organizing points for the people and companies that develop and sustain FOSS.

Historically, some of the most important FOSS nonprofits have been U.S. tax-exempt organizations—entities recognized by the U.S. Internal Revenue Service as exempt from federal income tax according to IRS regulations. But over the last few years, the community has witnessed changes in the IRS’s handling of applications for tax-exempt status from FOSS organizations. Most troubling, the IRS has denied applications from organizations whose missions and activities differ very little from existing (and exempt) FOSS nonprofits.

The IRS’s actions raised concerns within the community about whether tax exempt status would be available to future FOSS organizations and what these changes might mean for the exempt organizations upon which the community already depends. The Open Source Initiative and the Software Freedom Conservancy formed a working group to explore these questions and gather more information about the issue.

This post will cover what the working group has learned about how this issue developed, where things stand now, and what recent developments at the IRS mean for the future. In future posts, we’ll provide additional guidance to FOSS projects about organizational options, including when U.S. tax-exempt status is a viable option.

About Nonprofit and Tax-Exempt Organizations

Some background on nonprofit and tax-exempt organizations is necessary to understand this issue. While “nonprofit” is often used synonymously with “tax-exempt organization,” the two are not interchangeable. A nonprofit organization is one that is not owned by—or organized for the profit of—shareholders or members. A tax-exempt organization is one that is eligible for special tax treatment from the government because its mission and operations meet certain criteria.

This post relates to U.S. nonprofit organizations that wish to be recognized by the IRS as exempt from federal income tax. The FOSS community is home to many different types of nonprofit organizations. Many are organized outside the U.S. Likewise, some U.S.-based organizations will never seek tax-exempt status. The issues discussed here do not apply to these organizations.

Types of Tax-Exempt Organization

U.S. tax law recognizes several different types of tax-exempt organization. Only a few are potentially available to FOSS organizations:

Public charities are the most well-known. They’re often called 501(c)(3) organizations because the laws applicable to them are found in Section 501(c)(3) of the U.S. Internal Revenue Code. Public charities are unique among tax-exempt entities—not only are they exempt from federal income tax, but the donations they receive are tax-deductible for donors.

To qualify for this benefit, public charities are also subject to strict regulations. For example, they must be operated exclusively for certain exempt purposes (e.g. charitable, scientific, or educational) specifically defined by law; they cannot be operated for the benefit any private individual or entity; and they are heavily restricted in their ability to lobby for political candidates and legislation.

There are many more FOSS public charities than any other type of exempt organization. They include the Apache Software Foundation, the Free Software Foundation, the Mozilla Foundation, Open Source Initiative, and the Software Freedom Conservancy.

Trade associations, exempt under Section 501(c)(6), are nonprofits organized to promote the “common business interest” of their members. A trade association must be member-supported and its activities must be dedicating to improving business conditions in one or more lines of business engaged in by its members. Trade associations cannot be organized for the purpose of doing something that is ordinarily done for profit. Like public charities, trade associations cannot be operated to benefit private interests. Unlike public charities, trade associations can engage in lobbying. Donations to trade associations are not tax-deductible for donors.

There are relatively few FOSS trade associations, but they include prominent organizations like the Eclipse Foundation, the Linux Foundation, and the OpenStack Foundation.

Social welfare organizations, exempt under Section 501(c)(4), are nonprofits organized to promote “social welfare.” This category encompasses a much broader range of activities than the two above. To qualify, an organization “must operate primarily to further the common good and general welfare of the people of the community” rather than a limited set of private groups or interests. Like other exempt organizations, social welfare organizations cannot be operated to benefit private interests. They can engage in lobbying. Donations to them are not tax-deductible.

There are very few FOSS social welfare organizations. The only one I’m aware of is the Open Source Geospatial Foundation.

The Tax-Exempt Application Process

Public charities are required to apply to the IRS for recognition of their tax-exempt status before they can solicit tax-exempt donations. (If the IRS grants an applicant tax-exempt status, that status usually applies retroactively to the date the organization was founded.) Trade associations and social welfare organizations may operate as exempt organizations without ever applying to the IRS for recognition of their tax exempt status. However, many organizations apply nonetheless, to be certain that the IRS agrees with their position. Social welfare organizations that do not apply for recognition must still notify the IRS that they are operating as a 501(c)(4).

Once an organization applies for recognition of its tax-exempt status, the application is first assigned to a lower-level examiner. If the application clearly fits within (or contradicts) IRS regulations, the examiner will approve (or deny) the application. Otherwise, the examiner will typically request further information or clarifications from the applicant. If the lower-level examiner is unable to determine whether the application should be granted, it will be flagged for review by a tax attorney in the IRS national office in Washington, D.C.

IRS Scrutiny of FOSS Organizations

Beginning in 2010, a large proportion of the FOSS organizations that applied for tax-exempt status met resistance from the IRS. Many organizations received multiple rounds of questions probing the commercial uses of their software and asking whether they would be willing to modify their licenses to prohibit for-profit use. A high proportion of applications were flagged for review by the national office. Every application faced considerable delays—the average time between application and determination went from around 9 months to perhaps 2 or 3 years. Some organizations waited longer.

The delays were not unique to FOSS organizations—wait times for applicants increased across the board during this period. But FOSS organizations were singled out for heightened scrutiny, along with several other categories of applicants.

The BOLO List

In early 2010, the IRS began circulating a spreadsheet called the “be on the lookout” (BOLO) list to examiners in the exempt organizations division. The list highlighted categories of organizations—and specific phrases associated with them—that exempt organizations higher-ups wanted flagged for further review. The BOLO list later became the subject of intense controversy when the public learned that conservative and “tea party” lobbying groups were among the list’s suspect categories. (More on this below.) Nonprofit investigative journalism groups were also targeted.

In addition to these groups, the BOLO list instructed IRS examiners to “elevate to [their] manager[s]” any applications related to “open source software,” saying that “[t]he members of these organizations are usually the for-profit business or for-profit technicians of the software.”

Anyone familiar with the full breadth of FOSS nonprofits will recognize this description as a gross caricature. But for several years, it was the starting point for IRS review of applications from new FOSS nonprofits.

The IRS established an informal oversight committee within the “technical unit” of its exempt organizations division. The three or four agents in this group were tasked with reviewing every FOSS-related application that came through the agency and determining what guidance to provide to lower-level examiners regarding FOSS organizations.

Why Was FOSS Targeted?

It never became clear why FOSS organizations were singled out for scrutiny by the IRS. I once asked an agent on the oversight committee described above. He claimed not to know, but speculated that an audit of an existing organization may have raised concerns that FOSS organizations generally did not comport with IRS regulations of exempt organizations.

The agent also suggested that the scrutiny may have resulted from an increase in the number of applications from FOSS organizations. When called upon to explain its targeting of conservative organizations, the IRS likewise cited an “uptick” in applications from such groups. In that case, at least, this justification proved false: the scrutiny began before the uptick.

Whatever the reason for the IRS’s change in policy toward FOSS organizations during this time, it’s clear that it was based partly on misconceptions. While some FOSS organizations have been founded or managed in part by people with a commercial interest in the software they produce, this is far from the “usual” case. And in the case of 501(c)(6) organizations like the OpenStack Foundation (which was founded by Rackspace), it may be entirely consistent with IRS regulations.

That isn’t to say that the scrutiny was wholly inappropriate. The FOSS community too was sometimes given to misconceptions about the nature and purpose of tax-exempt status. Some commercial software companies attempted to operate their software development efforts as public charities, while selling commercial services through a related for-profit company. Others attempted to convert their commercial offering entirely to a nonprofit model by setting up a trade association, but in doing so clearly violated IRS regulations against engaging in activities ordinarily carried on for profit. And many organizations, while less clearly crossing traditional regulatory boundaries, pushed against the IRS’s traditional definitions of “charitable” and “educational” organizations.

FOSS organizations also routinely took it for granted that their applications would be approved, so long as they were giving software away freely and not profiting from the practice. To some degree, these organizations were relying justifiably on the IRS’s long history of approving applications from FOSS groups. In any case, a number of organizations drafted their own applications, without the advice of an attorney who might have caught red flags to be resolved before the applications were submitted. (This was far from the only issue, however—as an attorney at the Software Freedom Law Center, I personally advised organizations on applications that were denied during this time.)

Victims of Targeting

Dozens of FOSS organizations were affected in one way or another by the IRS’s targeting. Some, such as the Yorba Foundation (which applied as a public charity), had their applications denied. Yorba’s Jim Nelson wrote publicly about the denial, saying that the IRS’s questions to Yorba signaled a troubling hostility toward the FOSS philosophy. The IRS also denied applications from CASH Music, the OpenID Foundation, the OpenSocial Foundation, and the Foundation for Free Multimedia Technology, among others.

The OpenStack Foundation (a trade association) was also initially told its application would be denied, but after the foundation protested the denial, the IRS relented. Brave New Software, a public charity developing censorship-circumvention software, was also approved after an initial denial (and subsequent protest). The OSET Institute (then the Open Source Digital Voting Foundation) also experienced a similar reversal, but ultimately waited seven years and spent over $100,000 in legal fees for the privilege, and in the meantime its founders were forced to dip into their retirement accounts to keep the organization going.

Patterns in Approvals and Denials

While the IRS’s initial targeting of FOSS applications was indiscriminate, the outcomes were less so. From the applications approved and denied between 2010 and 2014, it’s possible to discern patterns in the IRS’s treatment of FOSS organizations.

The organizations whose 501(c)(3) applications were approved during this period, generally speaking, worked on software that served traditionally “charitable” or “educational” purposes (as the IRS has interpreted those concepts). The Apereo Foundation supports the development of software for use by educational institutions. The OpenMRS Foundation produces a medical records platform for healthcare providers, particularly in developing countries. The OSET Foundation produces software for secure, auditable digital voting. The Sahana Software Foundation produces a software platform to support disaster relief.

By contrast, most of the organizations whose 501(c)(3) applications were denied produced more general-purpose software. BigBlueButton builds web conferencing software. OpenFOAM develops tools to enable engineers to model fluid dynamics. The OpenID and OpenSocial Foundations produced web standards and accompanying software to ease federation between websites. The Yorba Foundation made desktop software for GNOME.

While it may sound unsurprising that the IRS approved applications for public charity status from organizations that produced software for “charitable” purposes and denied applications from organizations that did not, this is true only with the benefit of hindsight. Prior to 2010, the IRS had approved many applications from FOSS organizations producing general-purpose software (the Free Software Foundation and Apache Software Foundation are prime examples) and had expressed no change in policy.

Moreover, there was little else to distinguish the organizations that were denied from those that were approved. Each group produced software that competed in one way or another with commercially available software. And compare BigBlueButton’s web conferencing software with the “enterprise calendar system” (Bedework) supported by the Apereo Foundation: both are equally useful to commercial and charitable enterprises; the primary difference is Apereo’s targeting.

And while the IRS seemed to generally divide applicants as described above, this distinction did not always hold—there was a fair amount of overlap between approved and denied organizations. The LEAP Encryption Access Project—which develops tools to improve access to secure, private communication—was denied exempt status as a 501(c)(4) social welfare organization. Meanwhile, the IRS approved 501(c)(3) applications from the Calyx Institute, Brave New Software, and the Internet Security Research Group, all of which are—in one way or another—devoted to the same purpose. Similarly, the IRS denied the OpenFOAM Foundation’s application for public charity status but approved the Open Source Geospatial Foundation’s application as a social welfare organization, despite the fact that both produced software with primarily engineering and educational applications.

It is impossible to know what ultimately made the difference for the “close-call” applications that were approved. In all likelihood, it was a mix of factors, including the quality of the application and the receptiveness of the individual examiner.

A Shakeup at the IRS

Just as the IRS’s targeting of FOSS organizations became a subject of widespread concern in the community, the nature of the problem changed dramatically—and it may have been largely (but silently) resolved.

In 2013, the controversy over the IRS’s targeting of conservative political organizations—via the same BOLO list hounding FOSS organizations—erupted into a national scandal. An investigation by the Treasury Department (which oversees the IRS) concluded that “inappropriate criteria” were used to target applications for scrutiny. Later, the director of the exempt organizations division was forced to resign.

By this point it did not matter, as later reporting suggested, that the BOLO list was probably not the sinister political hit list that the IRS’s critics imagined. That instead, it was likely developed as an expedient to aid lower-level examiners after a series of restructurings and policy changes left the IRS’s exempt organizations division understaffed and mismanaged.

The damage was done. The IRS not only abolished the BOLO list, it completely overhauled its handling of applications for tax-exempt status. The IRS Office of Chief Counsel took over second-order review of applications from the exempt organizations division’s technical unit—the one that had housed the ad hoc committee responsible for reviewing the FOSS applications flagged by virtue of the BOLO list.

The IRS also shifted its compliance focus, applying less scrutiny to organizations’ initial tax-exempt applications, and more scrutiny to their annual tax returns. As a part of this shift, the IRS introduced a new “EZ” tax-exempt application, allowing smaller organizations to obtain status without providing most of the kinds of information that previously triggered heightened review.

The End of the Trouble?

Taken together, these events suggest that the heightened scrutiny of open source organization’s applications was part of a larger problem at the IRS that has been partly resolved (or has at least taken on a different form). And anecdotally, the IRS appears to be denying fewer FOSS-related applications (although it is likely that fewer organizations are applying due to the difficulties encountered over the last several years).

This is not to say that it’s safe to once again assume that every application from a FOSS nonprofit will—or should—be approved. It remains unlikely that the IRS will view an organization as charitable merely because it produces FOSS and does not profit from it. Rather, the gross distinction discussed above likely still holds—an organization will only be granted exemption as a public charity if the software it produces, or the organization’s work as a whole, serves some “charitable” purpose as the IRS understands it. (The less common cases of trade associations and social welfare organizations will be discussed in a later post.)

Any FOSS project considering whether to incorporate or to apply for tax-exempt status should seek the advice of an attorney experienced with the laws and regulations applicable to exempt organizations. And generally speaking, FOSS organizations should probably avoid the new “EZ” application process, to avoid nasty surprises at tax time. But there is reason to believe that the worst is over—that FOSS organizations will be judged on their merits, and not unfairly singled out based on a false stereotype embedded in a spreadsheet.