This Insights blog is Part 1 of a 3-Part series that
provides a focused overview of the unrelated business income tax
rules for the nonprofit organization that is tax-exempt pursuant to
section 501(c)(3) of the Internal Revenue Code (the
“Code”).
This Part 1 sets the framework and provides an overview for the
organizational and operational tests applicable to tax-exempt
organizations and, without getting into too much detail (yet), the
why or when the unrelated business income tax rules come into play
for the organization.
General Rule for Tax Exemption Under Section 501(c)(3) of the
Code.
To be exempt as an organization described in section 501(c)(3),
an organization must be both organized and operated exclusively for
one or more of the purposes specified in section 501(c)(3) of the
Code. See 26 U.S.C. § 501(c)(3); 26 C.F.R. § 1.501(c)(3)-1(a)(1). If an
organization fails to meet either the organizational test or the
operational test, the organization is not qualified for tax
exemption under section 501(c)(3) of the Code.
The Organizational Test.
Section 1.501(c)(3)-(1) of the Treasury Regulations contains the
organizational test:
Organizational test-(1)
In general. (i) An organization is organized exclusively
for one or more exempt purposes only if its articles of
organization (referred to in this section as its
articles) as defined in subparagraph (2) of this
paragraph: (A) Limit the purposes of such organization to one or
more exempt purposes; and (B) Do not expressly empower the
organization to engage, otherwise than as an insubstantial part of
its activities, in activities which in themselves are not in
furtherance of one or more exempt purposes.
26 C.F.R. § 1.501(c)(3)-1(b)(1) (emphasis added).
An organization is
organized exclusively for one or more exempt
purposes only if its articles of
organization: (A) Limit the purposes of such organization
to one or more exempt purposes; and (B) Do not expressly empower
the organization to engage, otherwise than as an insubstantial part
of its activities, in activities which in themselves are not in
furtherance of one or more exempt purposes.
Id. at § 1.501(c)(3)-1(b)(1)-(b)(1)(i)(B)
(emphasis added).
In no case shall an
organization be considered to be organized exclusively for one or
more exempt purposes, if, by the terms of its
articles, the purposes for which such organization is
created are broader than the purposes specified in
section 501(c)(3).
Id. at § 1.501(c)(3)-1(b)(1)(iv) (emphasis
added).
The term “articles of organization” or
“articles” includes the corporate charter or any other
written instrument “by which an organization is created.”
See id. at § 1.501(c)(3)-1(b)(2). The articles of
organization do not include, for example, an organization’s
bylaws.
The Operations Test.
An organization will be regarded as operated exclusively for one
or more exempt purposes only if the organization engages
primarily in activities that accomplish one or more of the
exempt purposes specified in section 501(c)(3). See 26 C.F.R. § 1.501(c)(3)-1(c). Under the
Treasury Regulations:
(a)n organization may meet the
requirements of section 501(c)(3) although it operates a trade or
business as a substantial part of its activities, if the operation
of such trade or business is in furtherance of the
organization’s exempt purpose or purposes and if the
organization is not organized or operated for the primary purpose
of carrying on an unrelated trade or business, as defined in
section 513. In determining the existence or nonexistence of such
primary purpose, all the circumstances must be considered,
including the size and extent of the trade or business and the size
and extent of the activities which are in furtherance of one or
more exempt purposes.
See 26 C.F.R. § 1.501(c)(3)-1(e).
“‘(T)he presence of a single nonexempt purpose, if
substantial in nature, will destroy the exemption regardless of the
number or importance of truly (exempt) purposes.'”
American Ass’n of Christian Schools Voluntary Employees
Beneficiary Ass’n Welfare Plan Trust v. United States, 850
F.2d 1510, 1513 (11th Cir.1988) (quoting Better Business Bureau
v. United States, 326 U.S. 279, 283, 66 S.Ct. 112, 114, 90
L.Ed. 67 (1945)).
General Rules for Unrelated Business
Income.
Pursuant to the authorities cited above, if a tax-exempt
organization engages in a nonexempt activity that is not
substantial in nature, the organization’s tax-exempt status may
not be defeated. However, the income derived from that trade or
business-even if the activity is not substantial in nature-may be
subject to taxation.
Under section 511 of the Code, a tax-exempt organization must
pay income tax on income classified as unrelated business income.
Generally, gross income from an unrelated trade or business, and
the applicable deductions relating to that income, are computed the
same way in which corporate income taxes are calculated.
See 26 U.S.C. §§ 511(a) (corporate rates
applicable to unrelated business income), 162 (trade or business
expenses), 167 (depreciation). Under section 513, an unrelated
trade or business is any trade or business the conduct of which is
not substantially related to the organization’s exempt
purpose.
Section 512 of the Code contains several exceptions and about 20
modifications to the unrelated business income tax rules. For
example, section 512 excludes from the definition of unrelated
business income from passive investments, royalties, and rent from
real property and personal property rented with real property,
provided no more than an incidental amount of the rent payment is
allocated to the rental of the personal property. Special rules
also apply to income received from real property that is
debt-financed and for income derived from qualified research
activities.
The unrelated business income tax rules are complex, and the
applicability of a particular exception or modification will depend
on the numerous facts and circumstances of the income-driving trade
or business of the organization.
Stay tuned for Part 2 of this 3-Part series where we will dive
deeper into the specific unrelated business income tax rules, the
exceptions and modifications to those rules, and some of the
exceptions to the exceptions. See Continuing Life Communities Thousand Oaks
LLC v. Comm’r, T.C. Memo. 2022-31 |April 6,
2022?|Holmes, J. | Dkt. No. 4806-15
(“One way to think about tax law is to view it as a series of
general rules qualified by exceptions, and exceptions to those
exceptions, and exceptions to those exceptions to those
exceptions.”).
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.