Our ongoing series on 501(c)(3) denials continues with not one but two rulings addressing a frequent topic of discussion: open source software development as a tax-exempt activity.

(A denial letter also came out for a rodeo that wants to be a 501(c)(3), but as a San Francisco-based attorney, I talk to a lot more open-source applicants than I do rodeos.)

There is a lot to learn here, but let’s start with a recap of what open source software is, when it is charitable, and when it is not. (For a much better and more thorough version of this recap, check out this Open Source Initiative article by Aaron Williamson from five years back, which is pretty consistent with how I’d describe the state of affairs today).

To vastly oversimplify:

• Open-source software is software whose underlying code is available for free and can be freely adapted by anyone else to build their own software or improve the existing software. Developers have lots of different reasons for making their software available on a free and open-source basis, some practical (e.g., making it available will allow us to crowdsource improvements to our commercially distributed software) and some ideological (e.g., software with the potential to solve important problems should not be proprietary, and the world will be a better place if we let everyone iterate and try to make it better).

• Many people, particularly among open-source software advocates, who want to form a non-profit and obtain 501(c)(3) status assume their project will qualify. After all, if I’m doing something for free and make it available to everyone and it makes the world a better place, why would it not be charitable?

• The answer is that not everything that is free or makes the world a better place is a 501(c)(3) activity. To establish 501(c)(3) status, your organization needs to be charitable (providing relief to the needy or distressed), educational (improving skills of individuals or providing useful information to the general public), scientific (research in a manner sufficiently in the public interest and not commercial), or in a few other categories (religious, youth amateur sports, etc.). So an open-source project needs to prove a significant impact on one of those categories. (And while the IRS might have bought it once upon a time, making better technology better is not inherently educational or scientific enough to pass the bar).

• On top of that, a 501(c)(3) cannot have a substantial non-exempt purpose or provide “excessive” private benefit (i.e., benefit to private parties that is more than incidental in comparison with the amount of charitable impact of the activity). Making open-source software available for free may be useful to many non-profits, but it is also useful to lots of for-profits. And if the primary impact of the activity is the better commercial performance of for-profit companies, that means the organization should not be exempt as a 501(c)(3) (and if a commercial for-profit is affiliated with the non-profit, you can assume the IRS will be skeptical). Of course, a lot turns on vague terms like ‘excessive,’ ‘incidental,’ and ‘primary’ here, but that is the way of things.

• After being initially too permissive, the IRS swung too far in the opposite direction and became too restrictive to open-source applicants. The IRS seemed to consider “open source” non-profits as automatically non-charitable (or at least at a very high risk of having excessive private benefit). While some open source software developers are more about the industry and should be 501(c)(6) trade associations, there are many open-source software developers in non-profit form that can and should qualify for 501(c)(3) status. For a while, it was more difficult than it should have been for those organizations.

• Thankfully, either as a result of a correction or a lack of resources to send all the denial letters they might want to send, the IRS has settled into something closer to the “right” approach: open-source software non-profits with a strong connection to charitable, educational, and scientific purposes should qualify; open-source software non-profits with minimal connection to one of those purposes or that appear to have significant motivation or impact to benefit commercial actors should not qualify.

Given all that history, the fact that we have a couple of new denial rulings on open-source 501(c)(3) applicants is worth a quick look. As previously disclaimed in the inaugural post in this series, we are trying to decipher unreadable private letter rulings that are non-binding on the IRS with respect to any other taxpayer, so take it all with a grain of salt.

PLR 202129016: Cryptocurrency Software Development and Distribution Not Charitable Enough According to IRS. This ruling is worth a read for anyone considering a non-profit with a cryptocurrency or blockchain focus.

The organization had a purpose “to develop and distribute open-source software, organize conferences on open source software, and participate in government and industry-funded R&D programs that aim to develop and promote the use of open-source libraries and repository for the advancement of digital currency technology.” The organization made some arguments that this activity was sufficiently charitable and educational because it (1) gave more people access to becoming a cryptocurrency development, (2) would provide education and career development to cryptocurrency developers, and (3) the software library would be freely available, and (4) there would be partnerships with educational institutions and conferences to increase worldwide knowledge regarding cryptocurrency software.

The IRS was pretty brief in its response, apparently unconvinced that maintaining this software was a charitable purpose (which sounds right — while one could imagine arguments for certain blockchain technologies focused on making a particular impact on a particular problem, the ruling did not include any facts that specified what that impact would be and why it was charitable). Once your primary purpose is not considered charitable, the fact that the organization also did educational activities (which are inherently charitable) is not enough to save the organization. The primary purpose was to develop and distribute the software.

The IRS also made the (overbroad) statement that “Your software applications can be used by anyone with interest in (the cryptocurrency), which establishes that your purpose is not exclusively charitable.” Taken literally, that would suggest any software open to everyone cannot be charitable — but that can’t be right or every 501(c)(3) that produces open-source software would be out of compliance. Instead, I think it is best to recharacterize that statement as “If your open source software is open to everyone, you need to be able to explain what is inherently charitable about that software. And just supporting cryptocurrency development is not a charitable activity. So, if this is your activity, you need to show limits that impact a charitable class. You did not do that, so no 501(c)(3) letter for you.” (Of course, this is just me trying to put words in the IRS’s mouth.)

PLR 202129017: Research Management Software Development and Distribution Not Charitable Enough Either. This ruling is also worth a read because it is the kind of application that I absolutely could have seen going through, even though I certainly see the basis for denial.

The organization had a primary activity of “the design, development, and distribution of generally free web-based research management software” that it makes available to all researchers. The organization also had a secondary (probably indisputably educational activity) of “providing worksheets, lesson plans, and occasional training or workshops; the teachers at participating schools conduct the activities with the students as part of the school's curriculum” (a good reminder that having a secondary exempt activity is not enough if the IRS is not convinced that your primary activity is charitable).

At a glance, the organization had some facts in its favor: (1) its open-source software was focused on something that can be a 501(c)(3) activity: promoting scientific research and discovery; and (2) the expected users presumably included many non-profits and government organizations (e.g., research universities) or students. While not enough on their own, these facts compare favorably to the organization in the first ruling because scientific research is much more associated with 501(c)(3) activity than cryptocurrency. Under the right circumstances, I could see arguing that these facts make the promulgation of open source software ‘charitable enough’ to overcome some of the ‘downsides’ of open source software as an activity.

Here, the IRS did not buy that argument, of course. Instead, the IRS focused on a few key points in denying the application:

• Research alone is not a 501(c)(3) activity. It needs to be scientific research conducted in the public interest and must not include activities that are incidental to commercial or industrial operations. The IRS found that the organizations’ own activities benefited a class of researchers (including recreational or commercial researchers) beyond research in the public interest. Even though the organization said it was not specifically geared to commercial product testing or pharmaceutical lab testing, the IRS cited the potential use of the software by those users as evidence of a substantial non-exempt purpose.

• The IRS viewed the organization’s development and distribution of its software as having a commercial aspect. For example, while the software is available for free, paying customers (e.g., professional research labs and pharmaceutical labs) paying for additional services. And the IRS generally found the development of software to be indistinguishable from what a commercial research management software would develop.

• The software ensured that all researchers kept their own data, and the company had no access to it. This might seem positive as a data policy, but the IRS may see this as a lost opportunity. Part of what can make research charitable is the requirement that it be distributed to the public. If users of the software are not committed to distributing it to the public, and the organization itself cannot distribute the data to the public, then the IRS is not likely to view the activity as 501(c)(3)-worthy.

Takeaway: Does this represent a sea change in the IRS approach to open-source software? Probably not — these rulings are not too far off the balanced approach the IRS has been taking in recent years. Applications involving nonprofits that make their software available for free are approved with some regularity. Most of those organizations probably have additional screens or more concentrated focuses that helped them make a case for charitability. And some of those organizations probably just got lucky even though they had all of the same issues the two organizations in these rulings did.

However, it is worth monitoring to see if the IRS is resuming its skepticism of open source organizations. At least one of these rulings could plausibly have gone the other way in my view. And some of the statements in the rulings seem overly broad, as noted above. We still do not have a clear, workable test for open-source non-profits to follow when structuring their activities. In the meantime, the best approach for these applicants remains (1) focus on defining what is inherently charitable about the software being created and distributed, (2) consider how you can provide limits that offset concerns about a private benefit or that would make the software less useful in commercial contexts (e.g., a commitment that users must make available any research data developed using the software), and (3) hope for the best.