By Gorham S. (Rory) Clark, Esq.
If an organization engages primarily in activities that accomplish a stated exempt purpose, the fact that it engages in commercial activities will not jeopardize its §501(c) status, so long as such activity is purely incidental and its income is devoted to the exempt purpose. However, such commercial activity, unless subject to an exclusion, will not be exempt from taxation. Income produced from such commercial activity will be classified as Unrelated Business Taxable Income (UBTI) and taxed at corporate rates. Thus, if the activity is merely incidental to the operations of the tax-exempt organization and the activity satisfies the requirements of §§ 511-513, it will be categorized as UBTI that is taxable, but will not cause the organization to lose its exempt status.
As detailed below, if activities generate UBTI that is deemed excessive the organization will lose its tax-exempt status. Moreover, if the activity generating UBTI is excessive, the organization cannot avoid revocation of its tax-exempt status simply by paying unrelated business income tax.
Income from an activity is taxable UBTI if the activity is: (1) a trade or business; (2) regularly carried on by the exempt entity; and (3) not substantially related to the exempt purposes (without regard to the fact that the organization uses the profits for its exempt purpose).
1. Trade or Business Activity
An “unrelated trade or business” is defined in § 513 as “any trade or business the conduct of which is not substantially related (aside from the need of such organization for income, or the use it makes of the profits derived) to the exercise or performance” by the organization for its exempt purpose. “Trade or business” includes “any activity, which is carried on for the production of income from the sale of goods or the performance of services.” In determining whether an activity is a “trade or business” for purposes of § 513, the courts historically have used either the “profit motive test” or “the unfair competition test.” Congress defined a “trade or business “ as “any activity which is carried on for the production of income from the sale of goods or the performance of services.” This definition was further clarified in Treas. Reg. § 1.513-1(b)(1985) as “any activity of [an exempt] organization which is carried on for the production of income and which otherwise possesses the characteristics required to constitute a ‘trade or business’ within the meaning of section 162” for purposes of §§511-513.
In the profit motive test, the focus is on whether the activity is “carried on for the production of income from the sale of goods or the performance of services.” In the unfair competition test, the focus is on whether the tax exempt organization enjoyed an unfair competitive advantage over tax-paying entities engaged in similar activities or on whether the activity is conducted in a competitive, commercial manner. The caveat is that evidence of profits alone is not controlling on the issue as to whether or not a nonprofit organization is generating UBTI subject to taxation.
2. Regularly Carried On.
Once it has been determined that an activity is a “trade or business” for purposes of UBTI, the discussion turns to whether or not that activity is “regularly carried on” by the exempt organization. A trade or business is considered “regularly carried on” if they show a frequency and continuity, and are pursued in a manner similar to, comparable commercial activities of nonexempt organizations. In one case where the organization sold advertising in a yearbook for approximately 46 weeks per year, the court found this was sufficiently regular for its earnings to be subject to income tax as unrelated trade or business. The court held that even though the time frame for actual publication was shorter and the organization did not conduct advertising activity as rigorously as a commercial organization, such activities was persistent enough to constitute an activity that was “regularly carried on” by the organization.
Similarly, where an organization conducted research projects for various private sponsors the court held that such activities constituted “regularly carried on” activities by the organization, which should be taxed as unrelated business income. In this case, the projects were discrete, they took place over a discrete period of time, and they did not continue or repeat. The projects, alone, were deemed insufficient to possess the continuity necessary to be comparable to commercial venture conducted by a nonexempt organization. However, the court stated that the aggregate of the projects conducted for the private sponsors was itself a trade or business and together satisfied the “regularly carried on” requirement of § 512. Therefore, such activities were subject to the unrelated business income tax.
3. No Substantial Relation
If the activity is a “trade or business” and it is “regularly” carried on by the exempt organization, the courts turn to whether the activity is not “substantially” related to the exempt purposes. The Fourth Circuit (identified three factors relevant in determining whether a trade or business is “substantially” related to an organization’s exempt purpose:
1) whether fees charged are directly proportionate to benefits received;
2) whether participation is limited to members and thus is of no benefit to those in the industry who are non-members; and
3) whether the service provided is one commonly furnished by for-profit entities.
In this case, a tax-exempt business league appealed the Tax Court’s decision upholding a determination that the league was liable for taxes on unrelated business income. The league’s function was to act as a contract negotiator and arbitrator for its members, a function that benefited the industry as a whole rather than any individual. However, it also administered vacation pay and guaranteed annual income accounts for its members for a fee. In looking at the three factors mentioned above, the court held that the second activity was not substantially related to its negotiation and arbitration activities because (1) the fees charged were not proportionate to the benefits received as the only benefit received was possibly good feelings between labor and management; (2) participation in the activity was limited to members only so it did not benefit the industry as a whole; and (3) the administration of vacation pay and guaranteeing annual income accounts could be performed by a for-profit organization. Thus, the court held that the league’s second activity was not substantially related to its exempt purpose and was taxable as unrelated business income.
B. Exclusions from UBTI
The Code, provides for numerous (although often limited) exclusions or deductions from UBTI. The most important of which are as follows:
1. Exclusion of Passive Income (i.e., Dividends, Interest, Royalties, Rents, and Occasional Sale Proceeds;
2. Exclusion of Revenue from Qualified Trade Shows;
3. Exclusion of Qualified Sponsorship Payments;
4. Exclusion of Revenue from Volunteer Activities. (Any activity which would otherwise be a trade or business, but in which substantially all the work in carrying out the activity is performed by uncompensated volunteers, will not be considered an unrelated trade or business and will not be taxable.);
5. Exclusion of Proceeds of Donated Merchandise;
6. $1,000 Deduction; and
7. Deduction for Charitable Contributions. (A tax-exempt organization is allowed to deduct up to 10% of its taxable income for charitable contributions.).
Among the exceptions to the exclusion of income from UBTI are these that relate to Passive Income:
1. Income Received from Debt-Financed Property. (Income from property held to produce income to which there is acquisition indebtedness is not excluded from UBTI to the extent it is debt-financed); and
2. Income Received from Controlled Entities.