A charitable organization can lose its tax-exempt status even if its original mission sounds fully charitable. Under IRC Section 501(c)(3), an organization must be both organized and operated exclusively for exempt purposes. That means unrelated activities must remain insubstantial, and any private benefit must be incidental rather than central to what the organization does.
A recent U.S. Tax Court decision involving the Milk Saving Starving Children Foundation shows how serious the operational test can be. In that case, the court found the organization no longer operated primarily for its exempt purpose, making a full trial unnecessary. The ruling is a reminder that mission drift, commercial activity, and private benefit can put exemption at risk.
What the Organizational and Operational Tests Require
For an organization to remain exempt under Section 501(c)(3), it must do more than state a charitable purpose in its governing documents. It must also actually carry out activities that further that purpose in practice.
The organizational test looks at what the organization was created to do. The operational test looks at what it is really doing. If the organization’s activities become substantially commercial, or if private benefit becomes more than incidental, the IRS may determine that the exemption no longer applies.
The Milk Saving Starving Children Foundation Case
The Milk Saving Starving Children Foundation originally received recognition as a public charity based on a charitable plan to obtain rice, soy, and powdered milk for starving children around the world. But during an IRS examination of the organization’s 2018 year, the administrative record showed that those charitable distributions had stopped years earlier.
Instead, its revenue came from rental real estate, fundraising events, and a coffee shop. Its expenses included salaries, coffee shop supplies, insurance, and mortgage payments. The organization reported no meaningful charitable distribution activity tied to its original mission.
The Tax Court agreed with the IRS that the organization was no longer operated primarily in furtherance of exempt purposes. The court granted summary judgment, showing how decisive an operational failure can be.
Why Commercial Activity Creates Risk
Nonprofits are allowed to generate revenue. Cafés, thrift stores, rentals, fundraising activities, and similar operations are not automatically prohibited. But the legal issue is whether those activities are substantially related to the organization’s exempt purpose and whether they primarily serve a public rather than private interest.
The IRS may question exemption when:
- the commercial activity becomes a primary feature of the organization
- the link between revenue generation and the charitable mission is weak
- the organization competes with for-profit businesses in ways unrelated to mission
- charitable activity becomes minor, sporadic, or inactive
Using business income for charitable purposes does not automatically solve the problem. The IRS looks at both the source of the income and the way the organization operates.
How Private Benefit Can Undermine Exemption
Private benefit is another major concern when nonprofits engage in business-like activity. A private benefit may exist when insiders, board members, employees, related businesses, or preferred vendors receive more than incidental benefit from the organization’s operations.
The source material gives a strong example: a commercial company forms a nonprofit, the nonprofit solicits charitable donations, and then hires that same company to provide the services funded by those donations. When governance overlaps and independence is missing, the nonprofit may fail the operational test and potentially trigger excess benefit concerns.
This kind of arrangement becomes even riskier when the nonprofit’s board is not willing to seek competing vendors or follow conflict-of-interest procedures.
Warning Signs Nonprofits Should Watch For
A nonprofit may face heightened scrutiny when:
- its primary activities look commercial in nature
- charitable program expenditures are minimal
- related-party business arrangements are common
- the organization resumes charitable activity only when under examination
- board or employee relationships create lack of independence
The IRS will closely examine whether the real activity of the organization still matches the stated mission.
Practical Compliance Steps for Nonprofits
Organizations with revenue-producing activities should make sure their records and governance practices clearly support their exempt purpose.
Important steps include:
- showing in the financial records how both revenue and expenditures connect to mission
- reporting regularly carried on unrelated business activity as unrelated business income when required
- enforcing conflict-of-interest policies consistently
- reviewing vendor, compensation, and related-party relationships annually
- ensuring charitable programs remain active, measurable, and central to operations
These steps do not guarantee exemption, but they significantly strengthen the organization’s position if questioned by the IRS.
The organizational test asks what a nonprofit is designed to do. The operational test asks what it actually does. When charitable purpose becomes secondary to commercial activity, tax-exempt status can be lost, even if the organization still describes itself as charitable.
The Milk Saving Starving Children Foundation case is a strong reminder that nonprofits need more than a good mission statement. They need consistent operations, clear documentation, independent governance, and meaningful program activity that actually serves the public.
For organizations exploring creative revenue models, the key question is not simply whether income is being raised. It is whether the activity genuinely advances the exempt mission, or whether the mission is starting to function as a marketing tool for business.
