This Insights blog is Part 3 of a 3-Part series focused
on 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”).
Part 1—Tax Exemption and the Framework for the Unrelated
Business Income Rules—provided an overview of
the organizational and operational tests of section 501(c)(3) of
the Code and alluded to the trigger for unrelated business income
rules. Part 2–Unrelated Business Income Tax Rules,
Modifications, and Exceptions—dived deeper into,
well, the specific rules, modifications, and exceptions.
This Part 3 will dive deeper into the meaning of a trade or
business that is “substantially related” to an exempt
purpose of the tax-exempt organization.
“Substantially Related.”
An 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) (emphasis
added).
A trade or business is “substantially
related” (and therefore not an
“unrelated” trade or business for unrelated business
income tax rules) only if the production or distribution of the
goods or the performance of the services from which the gross
income is derived contributes importantly to the accomplishment of
the purposes for which exemption was granted. “A
‘substantially related’ trade or business ‘has causal
relationship to the achievement of exempt purposes’ and
‘must contribute importantly to the accomplishment of those
purposes.'” Ocean Pines Ass’n v. Comm’r,
672 F.3d 284, 287-289 (4th Cir. 2012) (quoting 26 C.F.R. §
1.513-1(d)(2)). Section 1.513-1(d)(2) of the Treasury Regulations
provides as follows:
Type of relationship required. Trade or
business is related to exempt purposes, in the relevant
sense, only where the conduct of the business activities has causal
relationship to the achievement of exempt purposes (other than
through the production of income); and it is substantially
related, for purposes of section 513, only if the causal
relationship is a substantial one. Thus, for the conduct
of trade or business from which a particular amount of gross income
is derived to be substantially related to purposes for which
exemption is granted, the production or distribution of the goods
or the performance of the services from which the gross income is
derived must contribute importantly to the accomplishment
of those purposes. Where the production or distribution of
the goods or the performance of the services does not
contribute importantly to the accomplishment of the exempt
purposes of an organization, the income from the sale of the goods
or the performance of the services does not derive from the conduct
of related trade or business. Whether activities productive of
gross income contribute importantly to the accomplishment of any
purpose for which an organization is granted exemption depends in
each case upon the facts and circumstances involved.
26 C.F.R. § 1.513-1(d)(2)(emphasis in bold added).
In determining whether an activity is “substantially
related” to an exempt purpose, the courts look to the
operation of the activity, and not to the benefit of the
organization’s members. See Veterans of Foreign
Wars, Dep’t of Michigan v. Comm’r of Internal Revenue,
89 T.C. 7, 38 (1987) (finding that income received from a certain
Christmas card fundraising activity of the VFW was not
substantially related to its exempt purpose).
For example, the IRS has ruled that sales of pharmaceutical
supplies by a tax-exempt hospital to members of the general public,
or to private patients of physicians practicing in a building owned
by the hospital, do not qualify for the “convenience”
exception. Rev. Rul. 68–375, 1968–2 C.B. 245;
Rev. Rul. 68–374, 1968–2 C.B. 242.
The IRS determined that “(t)he buyer-seller relationship
between these off-street patrons and the pharmacy” was
insufficient to classify them as “patients” of the
hospital. The IRS concluded that these revenues were subject to
unrelated business income taxation because there was “no
substantial causal relationship between the achievement of the
hospital’s exempt purposes and the sale of pharmaceutical
supplies” to such individuals. See Rev. Rul.
68–374; see also New Jersey Council of Teaching
Hosps. v. Comm’r of Internal Revenue, 149 T.C. 466, 480-81
(2017) (providing detailed analysis on “substantially
related” and the “convenience of members”
exception).
Examples of “Substantially Related.”
In Revenue Ruling 74-399, 1974-2 C.B. 172, the IRS
found that a tax-exempt museum’s operation of
an eating facility that helped to attract visitors to a museum and
enhanced the efficient operation of the entire museum by enabling
the staff and employees to remain on its premises throughout the
workday may contribute importantly to the accomplishment of the
museum’s exempt purposes and would not constitute unrelated
trade or business. The Revenue Ruling states, in relevant part, as
follows:
Because there are places of refreshment in the museum visitors
are able to devote a greater portion of their time and attention to
the museum’s collection, exhibits and other educational
facilities than would be the case if they had to interrupt or
terminate their tours of the museum to seek outside eating
facilities at mealtime. The eating facilities also enhance the
efficient operation of the entire museum by enabling the museum
staff and employees to remain on its premises throughout the
workday. Thus, the museum’s operation of the
eating facilities is a service that contributes importantly to the
accomplishment of its exempt purposes.
Rev. Rul. 74-399 (emphasis added).
In Rev. Rul. 69-268, 1969-1 C.B. 160, a
tax-exempt hospital operated a cafeteria and
coffee shop open to hospital staff and persons visiting hospital
patients. The general public was not encouraged to use the food
facilities. One of the exempt purposes of the hospital is to
provide health care for members of the community. The IRS found
that the operation of the hospital’s eating facilities was held
not unrelated trade or business within the meaning
of section 513 of the Code. The IRS found that visits by outsiders
are regarded as a form of therapy that assisted in patient
recovery. The IRS noted that the hospital’s permitting outside
visitors to use its eating facilities enabled the visitors to spend
more time with the patients and thus contributed significantly to
the hospital’s exempt purpose.
In Rev. Rul. 81-138, 1981-1 C.B. 358, the IRS
evaluated a commercial lease arrangement involving a chamber of
commerce, being an exempt organization under section 501(c)(6) of
the Code. The chamber’s exempt purposes included encouraging
business development in a community. The chamber obtained a
mortgage to help finance a shell building’s construction leased
to an industrial tenant at less than full rental value. The IRS
found that the leasing of the property was not an unrelated
trade or business as defined in section 513 of the Code
because the lease was substantially related to the chamber
organization’s exempt purpose. The Revenue Ruling concluded as
follows:
The building that the organization owns may constitute
“debt-financed property” within the meaning of section
514(b)(1) of the Code since such property is held to produce income
and is subject to acquisition indebtedness. Thus, it is necessary
to determine whether substantially all of the use of the building
is substantially related to the exercise or performance by the
organization of the purpose or function constituting the basis for
its exemption, and therefore excluded from the definition of debt-
financed property under the provisions of section 514(b)(1)(A)(i).
. . .
(T)he leasing of the building by the organization, under the
circumstances described, when the project is initially financed by
contributions from the business community and is leased at less
than fair market value for similar facilities, is an activity
designed to attract industry to the community and is not an
activity of a kind ordinarily carried on for profit. The activity
therefore contributes importantly to the purposes constituting the
basis for the organization’s exempt status under section
501(c)(6) of the Code, and thus is substantially related to those
purposes within the meaning of section 514(b)(1)(A)(i).
In Rev. Rul. 77-47, 1977-1 C.B. 157, the IRS
evaluated a historical preservation association that was exempt
under section 501(c)(3) of the Code. The association acquired,
restored, and preserved historical significant buildings and opened
the restored buildings to the public for a nominal admission fee.
The association acquired other historically significant buildings
by the assumption of outstanding mortgages. It leased them at fair
rental value for uses that bore no relationship to the
building’s historical significance and did not allow for
viewing by the general public. The IRS concluded that,
because the leasing did not contribute significantly to the
association’s exempt purpose and had no causal relationship to
the achievement of that purpose, the exception under section
514(b)(1)(A) did not apply, and the leased
buildings were held to constitute debt-financed
property.
In Living Faith, Inc. v. Commissioner, 950
F.2d 365 (7th Cir. 1991), the issue was whether Living Faith
was operated exclusively for exempt purposes under section
501(c)(3) of the Code when Living Faith’s sole activities
involved the operation of two religious-based food stores and
restaurants called Country Life.
Living Faith was a Seventh-Day Adventist Church organized in
part to perform “outpost evangelism programs.” Living
Faith operated Country Life based on the Seventh-Day Adventist
religious dietary standards. Id. at 367. The Country Life
facilities were required to employ Seventh-Day Adventist management
and maintain a working relationship with the local Seventh-Day
Adventist Church. Living Faith’s food prices were competitive
with other vegetarian restaurants and health food stores.
Id. at 368.
Living Faith asserted that it operated its health food stores
with the exclusive, tax-exempt purpose of furthering the
Seventh-Day Adventist Church’s religious work as a health
ministry. Id. at 370. Living Faith used Country Store as a
means to evangelize the Seventh-Day Adventist faith. Each day,
Living Faith conducted a devotional and religious ceremony at the
facility. Living Faith provided the public with an opportunity to
sample vegetarian cooking by offering free meals. Living Faith
offered to the public a fee-based cooking school that promoted
vegetarian cooking. Living Faith also offered weekly Bible study
classes, free of charge, and occasionally provided meals to the
needy in exchange for chores. Id. at 368.
The IRS Commissioner and the Tax Court found that Living Faith
was not qualified as exempt under section 501(c)(3) of the Code due
to the substantial nonexempt activity of operating commercial food
stores.
The Court of Appeals for the Seventh Circuit affirmed. The court
noted:
(W)e focus on “the purposes toward which an
organization’s activities are directed, and not the nature of
the activities.” The purposes need not be solely religious;
courts recognize that a nonexempt purpose, even “somewhat
beyond a de minimis level,” may be permitted without loss of
exception. The nonexempt purpose, however, cannot be substantial.
“The presence of a single nonexempt purpose, if substantial in
nature, will destroy the exemption regardless of the number or
importance of truly (exempt) purposes.”
A single activity may be carried on for more than one purpose.
The fact that an organization’s primary activity may constitute
a trade or business does not, of itself, disqualify it from
classification under § 501(c)(3), provided the trade or
business furthers or accomplishes an exempt purpose. If one of the
activity’s purposes, however, is substantial and nonexempt
(e.g., commercial), the organization will be denied exempt
status under § 501(c)(3), even if its activity also furthers
an exempt (e.g., religious) purpose.
Living Faith, 950 F.2d at 370 (internal citations
omitted).
The Court of Appeals found that Living Faith’s activities
were limited to the operation of the two food stores. The operation
of the eating facilities was presumptively commercial. The facility
was open to the public. It competed directly with other
restaurants. It used profit-making pricing formulas and engaged in
advertising. The facility had hours of operation competitive with
commercial enterprises. The underlying organization had no plans to
solicit donations. In sum, the food store operations were
substantial commercial operations and thus, the denial of exemption
under section 501(c)(3) was affirmed. See id. at 371,
373-377.
Indeed, “‘the 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)).
The Commerciality Doctrine.
One final legal concept for this three-part UBIT series and that
the IRS and the courts consider in the UBIT context is called the
“commerciality doctrine.”
This doctrine was created by the courts and, generally,
specifies that an organization will not qualify for tax exemption
under section 501(c)(3) of the Code if the organization is operated
in a manner that competes with for-profit enterprises. A focus of
this doctrine is whether the activities of the purported tax-exempt
organization allow it to gain an unfair market advantage over
for-profit enterprises by virtue of an exemption from income from
such activities.
Some types of tax-exempt organizations get a “pass”
from the commerciality doctrine. For example, exempt research
organizations, exempt educational institutions, and hospitals
generally are not subject to the commerciality doctrine with
respect to their foundational and traditional exempt activities,
even though those entities compete with for-profit enterprises that
provide similar goods or services.
The nebulous areas for the application of the doctrine usually
arise when trying to determine at what point the operation of a
particular activity should transform that organization into a
commercial enterprise and thereby to have forfeited its tax-exempt
status. If an organization is deemed to have violated the
commerciality doctrine by the operation of a non-exempt purpose or
activity, the organization’s tax exemption may be revoked and
the income from that non-exempt activity (as well as other income)
may be subject to federal income taxation.
Neither the Tax Courts nor Congress have established a
bright-line test for deciding when a tax-exempt organization’s
“commercial activity” meets the threshold for a violation
of the commerciality doctrine. Factors that the courts consider
include whether the organization is competing with for-profit
commercial enterprises, pricing policies of the organization such
as market-comparable or at-cost provision of goods or services,
whether the organization markets its goods or services like a
for-profit enterprise.
As one of my wise mentor’s once described the application of
the commerciality doctrine: If it looks like a duck, waddles
like a duck, and quacks like a duck, it probably is a duck. I
suppose the “duck test” is one way to make a
semi-informed decision on whether or not an activity of a
tax-exempt organization violates the commerciality doctrine.
Closing.
Well, tax-exemption friends, Romans, etc., that is a wrap for
this Three Part Series on Tax Exemption and Unrelated
Business Income Tax (UBIT). To close, and as I closed
Parts 1 and 2, I quote U.S. Tax Court Senior Judge Mark V. Holmes:
“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.” See Continuing Life Communities Thousand Oaks
LLC v. Comm’r, T.C. Memo. 2022-31 |April 6,
2022?|Holmes, J. | Dkt. No.
4806-15
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