The new 501(c)(3) and the future of free software in the US
I'm the ED of a 501(c)3 non-profit (http://localwiki.org), and when we applied for our (c)3 status we got some flack along these lines, as well.  Here's my advice to the Yorba Foundation folks:If you haven't received your final rejection, you can appeal.Don't try and do this yourself.  The post says they spoke with folks at the Software Freedom Center, which is great, but I highly recommend finding a specialized attorney who's seen lots of applications and knows the right angle.  Hire an attorney who specializes in obtaining 501(c)3 status.  We made this mistake early on, thinking we could work through the NOLO book and apply ourselves.  It cost us.  For around $1k you can find a good non-profit attorney to help.We got flack for the open-source thing, too.  Our original exemption application was basically "Hey, we're a charity!  We give things away for free and release open source code, which can be used by everyone!"  Depending on the IRS agent assigned to you, you might get flack for this as well.  Generally speaking, they may not like that a for-profit business can use your organization's by-product to make lots of money for themselves.  We spent some time explaining how OSS worked to the agent, and was able to convince him that because (most) of our OSS is copyleft, that it would be a continually-free-and-open good, not a private benefit.Nevertheless, just releasing OSS is NOT an exempt purpose.  If you read the IRS regulations, they are very specific as to what a core exempt purpose is.  You'll need to pick one that fits best.  Generally speaking, it's 1) Church stuff 2) Scientific advancement and research 3) Furthering of the arts 4) Education 5) "Charity," meaning helping people who are disadvantaged in some way 6) Some others that I'm not remembering.Most OSS 501(c)3 don't get exemption by just releasing open source software-- they get exemption by being an educational institution.  So you may want to go that route -- the organization's core exemption is the creation of educational materials that help education members of a particular community in XYZ ways.  This is what we ended up doing -- we're classified as an educationally-exempt organization.  If you look up the 501(c)3 apps of some other OSS non-profits you'll see similarly -- e.g. Plone Foundation is set up as an educational organization.Edit: If you'd like to take a look at some of our back-and-forth with the IRS agent at the time, check out the page here: http://localwiki.net/org/Historic_501%28c%293_application_pr...  You'll see his response was similar to yours, but we decided to pursue educational exemption and were granted on that basis in the end.  
Also, you can call up the IRS Agent assigned to you and talk to them about the application, which can be extremely helpful.