Organizations that wish to qualify as a tax-exempt organization under IRC §501(c)(3) must serve a public rather than private interest pursuant to Reg. §1.501(c)(3)-1(d)(ii). That issue tripped the application of the organization that is the subject of PLR 201651016.

Reg. §1.501(c)(3)-1(d)(ii) specifically provides:

An organization is not organized or operated exclusively for one or more of the purposes specified in subdivision (i) of this subparagraph unless it serves a public rather than a private interest. Thus, to meet the requirement of this subdivision, it is necessary for an organization to establish that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests.

Note that the regulation doesn’t provide any exception that allows a targeted benefit organization is the individual in question is truly deserving—rather a designated individual organization simply cannot qualify for §501(c)(3) status.

In this case the organization looking to be granted §501(c)(3) status provided the following details on its purpose:

You were originally formed to provide financial assistance solely to the N family. Your activities consist of raising funds to assist the family of M, a child diagnosed with cancer, with medical expenses related to cancer preventive treatments that are not covered by the family's medical insurance. Your board reviews the medical expenses and distributes funds to the medical provider administering care. One of your board members shares the same last name as the recipient, M. Although you indicated on Form 1023 that your officers or directors are related through family or business relationships, you did not provide an explanation of the relationships.

Very likely the family in question is both in need and deserving, but the regulation doesn’t allow for such an organization to get §501(c)(3) status. The organization likely was made aware of that fact during its application process.

Therefore, it made a change to its purposes as follows:

You revised your activities during the processing of your application by stating you will provide financial assistance to other families in the P area with children that have been diagnosed with cancer or other life threatening illnesses. You will provide financial support to several families annually to help defer medical expenses including hospital visits/stays not covered by medical insurance. Families must submit a request for assistance in writing and include the name and age of the dependent child, the nature of the child's medical condition, the treatments the child is undergoing at the time of the request, and proof of residence in the P area. The families must also provide proof that all qualified insurance claims have been exhausted and/or denied for coverage of medical expenses, treatments, or stays incurred in the treatment of the child. All medical expenses will be reviewed by your board and funds will only be distributed in the name of the medical provider administering care. You will advertise the availability of these funds during all of your fundraising events and on social media.

…[Y]ou stated that up to 50% of your total funds raised will be made available to the N family for M and the other 50% will be available to other qualifying families who request assistance.

Unfortunately, reserving ½ of the funds for a specific beneficiary continued to provide the prohibited private benefit.

The IRS points out that in Rev. Rul. 67-367 the existence of preselected individuals to benefit from the organization barred exempt status:

Revenue Ruling 67-367, 1967-2 C.B. 188 describes a nonprofit organization whose sole activity was the operation of a 'scholarship' plan for making payments to pre-selected, specifically named individuals. The organization did not qualify for exemption from federal income tax under section 501(c)(3) of the Code because it was serving private rather than public or charitable interests.

The IRS found that this organization, even with the ½ reserved for other parties, was still an organization of the sort described in that ruling:

You are like the organization described in Revenue Ruling 67-367 because you were formed and are operated to benefit a preselected individual. You were formed to provide financial assistance to the N family for M's medical expenses. You expanded your activities to include providing assistance to other families whose children have been diagnosed with cancer or other life threatening illnesses. However, up to 50% of your funds raised will still be given to the N family for M, thereby resulting in substantial private benefit to the N family. Per Treas. Reg. Section 1.501(c)(3)-1(d)(1)(ii), you are not operated exclusively for an exempt purpose because you serve a private rather than a public interest.

The IRS also referred to a 1986 Tax Court decision denying exempt status for an organization where 30% of the benefits went to family members of the founder:

In Wendy L. Parker Rehabilitation Foundation, Inc. v. Commissioner, T.C. Memo. 1986-348, the tax court upheld the Service's position that a foundation formed to aid coma victims, including a family member of the founders, was not entitled to recognition of exemption. Approximately 30% of the organization's net income was expected to be distributed to aid the family member of the founders who was a coma victim with medical and rehabilitative. The court found that the family coma victim was a substantial beneficiary of the foundation's activities.

The IRS found that this case was much like that one, noting:

Similar to Wendy L. Parker Rehabilitation Foundation, Inc., Petitioner v. Commissioner of Internal Revenue, a substantial amount of your funds will be expended for the benefit of the N family for M. While the extent of your board's relationship to the N family and M is not clear, one of your board members does share the same last name as the N family and M and you clearly indicate that you were formed for the sole purpose of providing financial assistance to the N family for M.

For these reasons, the IRS denied the organization’s request to be granted §501(c)(3) status.