(a) Profit Motive Test

Under the profit motive test, an activity conducted simply to produce some revenue without an expectation of producing a profit (similar to the hobby loss rules) is not a business.²⁵ An insurance program entered into with “dominant hope and intent of realizing a profit and otherwise possessing the character of a trade or business” is unrelated.²⁶ This test is applied in situations when a nonprofit has more than one unrelated business. Losses from the unprofitable activity or hobby cannot necessarily be offset against profits from other businesses. Likewise, the excess expenses (losses) generated in fundamentally exempt activity, such as an educational publication undertaken without the intention of making a profit, cannot be deducted against the profits from a profit-motivated project.²⁷ Social clubs have continually battled with the IRS about this issue.²⁸

(b) Commerciality Test

The commerciality test looks to the type of operation: If the activity is carried on in a manner similar to a commercial business, it constitutes a trade or business. This test poses serious problems for the unsuspecting because there are no statutory or regulatory parameters to follow. A broad range of UBI cases where the scope of sales or service activity was beyond that normally found in the exempt setting have been decided by examining the commercial taint of the activity.²⁹ The primary purpose for the activity is determined by reference to the “manner in which the activities are conducted, the commercial hue of those activities, and the existence of and amount of annual or accumulated profits.”³⁰ An organization regularly operating an investment service business, even though its customers were other tax-exempt organizations, was found not to qualify for tax exemption because providing investment services on a regular basis for a fee is a trade or business ordinarily carried on for profit.³¹

Similarly, because a conference center was operated in a commercial manner on a break-even basis, it too was denied exemption.³² It organized and sponsored more than 600 educational conferences a year in areas as diverse as civil and human rights, international relations, public policy, the environment, medical education, mental health, and disability. Twenty percent of the events were held for government clients, 50 percent for nonprofit and/or educational clients, and 30 to 40 percent for “other” users, including many weddings and other private events. Only a few of the events were financially subsidized with lower prices. The court said, “as it is clear from the facts that plaintiff engages in conduct of both a commercial and exempt nature, the question whether it is entitled to tax-exempt status turns largely on whether its activities are conducted primarily for a commercial or for an exempt purpose” and decided the former was true.³³ The fact that Airlie was seeking to recover tax-exempt status previously lost due to private inurement issues may have influenced the case. Exhibit 21.1 highlights characteristics which indicate that an organization is operating in a commercial fashion.

“YES” answers to questions are warnings that signal the EO's exposure to a challenge that the organization operates in a commercial manner and may not be exempt.
	Yes	No
COMPETITIVENESS: Does the exempt organization's activity compete with for-profit businesses conducting the same activity? Is there a counterpart for the activity in the business sector, particularly a small business?
PERSONNEL MOTIVATION: Do managers receive generous compensation? Is the activity run by well-paid staff members?
SELLING TECHNIQUES: Are advertising and promotional materials utilized? Are retailing methods, such as mail-order catalog or display systems, similar to those of for-profit enterprises?
PRICING: Is the highest price the market will bear charged for goods and services? There are no scaled or reduced rates available for members of a charitable class.
CUSTOMER PROFILE: Are the organization's services and goods for sale to anyone? Are they available to the general public on a regular basis, rather than only for persons participating in the organization's other exempt activities?
ORGANIZATION'S FOCUS/GOOD WORKS RATIO: Does the organization conduct significant other charitable program activity? Is the income-producing activity its primary focus rather than exempt ones?
CHARACTER OF ORGANIZATION'S SUPPORT: Is very little or none of the organization's support from voluntary contributions, grants, or other unearned sources?

Dedicating the profits to charity (sounding like Newman's Own) from selling flowers at market prices on a website failed the “commerciality test” factors listed in Exhibit 21.1. The activity competed on a regular and continuous basis with for-profit businesses, and the fact that the purchaser could designate the charitable recipient did not make the activity a qualifying exempt function.³⁴ Another question to consider is whether the business represents a “substantial nonexempt purpose.” A coffee shop started by members of a church for the express purpose of prayer and proselytization, and planning to give away all the profits, still failed the exempt purpose test.³⁵ Religious activities were not conducted. It was located in an area with no other shops, open for regular business hours, and was rented to others for private events.

Promotion of a professional sports rodeo and advancement of information and knowledge concerning rodeos was found not to serve an educational purpose qualified for tax-exempt status.³⁶ Similarly, an organization planning to “design and sell clothing online to consumers ‘while reaching out to the needy and to veterans'” did not have an acceptable exempt purpose. The fact that for every shirt sold a shirt was donated to someone in need did not remove the “commercial hue” of the selling activity.³⁷ Providing durable medical equipment to patients discharged from hospital but still needing rehabilitation at commercially competitive prices was deemed an unrelated business.³⁸

(c) Fragmentation Rule

Further evidence of the overreaching scope of the term trade or business is found in the fragmentation rule.³⁹ This rule carves out an activity carried on alongside an exempt one and proves that unrelated business does not lose its identity and taxability when it is earned in a related setting. Take, for example, a museum shop. The shop itself is clearly a trade or business, often established with a profit motive and operated in a commercial manner. Items sold in such shops, however, often include educational items, such as books and reproductions of artworks, that serve an exempt purpose. The fragmentation rule requires that all items sold be analyzed to identify the educational, or related, items the profit from which is not taxable, and the unrelated souvenir items that do produce taxable income. The standards applied to identify museum objects as related or unrelated are well documented in IRS rulings.⁴⁰

(a) Meaning of Irregular

Intermittent activities may be deemed regularly carried on or to have commercial characteristics unless they are discontinuous or periodic. For example, the revenue from a monthly (certainly weekly) dance is likely to be classified as UBI; an annual fund-raising event that features dancing would not. By the same token, ads sold for a monthly newsletter would be classed as regular commercial activity; program ads sold for an annual ball may not. Where the planning and sales effort of a special event or athletic tournament are conducted over a span of time throughout the year, the IRS deems the activity itself to be regularly carried on despite the fact that the event occurs infrequently, on an annual or biannual basis.⁴⁴

Congress specifically mentioned income derived from an annual athletic exhibition in stating that the UBI applies only to business regularly carried on.⁴⁵ When the IRS proposed taxing broadcast rights, it argued that preparatory time, not the actual playing time, determines regularity. If an event or program takes the entire year to produce, the span of time spent negotiating contracts and otherwise working on the event is considered. Examples of the arguments follow:

• Time spent by volunteers in soliciting advertisements or sponsorships were to be considered in evaluating the time span of the activity.⁴⁶
• An eight-month concert season program was ruled to be comparable to commercial entertainment operations and thereby regularly carried on.⁴⁷
• The National College Athletic Association (NCAA) convinced the court that an independent company's year-round effort to sell ads for the Final Four championship basketball tournament program was not attributable to the NCAA. The three-week duration of the tournament made it irregular and the program income excludable from UBIT even though the activity was an unrelated business.⁴⁸
• Year-round sales effort for ads in a labor organization's yearbook, in the IRS's eyes, meant the activity is regularly carried on. The facts indicated that the yearbook had relevance to the members throughout the year and the vast majority of advertisements carried a definitely commercial message.⁴⁹
• One private ruling, however, said it would be difficult to conclude that an annual ball, which occurs only once each year, is regularly carried on.⁵⁰
• Biannual publication of a business league's directory was also ruled to be a regular activity; the every-other-year publication cycle was regular or normal in commercial settings. The IRS opined that continuity did not necessarily mean “continuously,” but rather having a connection with similar activities in the past that will be carried forward into the future.⁵¹

Payment made to a statewide farm federation under a nonsponsorship and noncompetition agreement was made in a nonrecurring transaction.⁵² Although there was profit motive in making the agreement, no regular trade or business activity occurred when the federation agreed not to compete with the successor to its regional cooperative organization.

When the Museum of Flight Foundation rented the first Boeing 747 back to the company to use for testing purposes, the IRS contended that the personal property rent paid by Boeing to borrow the plane back for testing purposes was taxable unrelated business income. A court overturned the decision and found that the lease was not a business regularly carried on and agreed with the museum that the transaction was a “one-time, completely fortuitous lease of unique equipment.”⁵³

(b) Seasonal Activity

Activities conducted during a period traditionally identified as seasonal, such as Christmas or Thanksgiving, if conducted during the season, will be considered regular and the income will not qualify to be excluded from UBIT. Greeting cards sold during October or November or Independence Day balloons sold in June/July would be regular sales activity.

(a) Examples of Related Activity

Related income-producing activities include the following:

• Admission tickets for performances or lectures.
• Student or member tuition or class fees.
• Symphony society sale of symphonic musical recordings.
• Products made by handicapped workers or vocational trainees.⁵⁸
• Hospital room, drug, and other patient charges.
• Commercial stores employing developmentally or emotionally disturbed persons.⁵⁹
• Agriculture college sale of produce or student work.
• Sale of educational materials (see §21.13 for museum issues).
• College golf course usage by students and faculty.⁶⁰
• Secretarial and telephone answering service training program for indigent and homeless persons.⁶¹
• Sale of online bibliographic data from EO's central databases.⁶²
• “Public entertainment activities,” or agricultural and educational fair or exposition (§21.9(d)).
• “Qualified conventions and trade shows” (§21.9(e)).
• Producing tapes of endangered ethnic music.⁶³
• Birthing center operated as a part of a church in respect of its religious tenets and belief that birth is a sacred and spiritual event.⁶⁴
• Coffee shop designed as a convenient eating place for cultural center; visitors and employees accessed from inside the building.⁶⁵

An “interactive virtual library” selling access to both its collections and staff over the Internet, just as if one were visiting the library in person, as well as providing advice based on its expertise in library science to other libraries and businesses, was considered a related activity for a library.⁶⁶ Sales of caskets for use in connection with religious burial ceremonies or services of the church of which the monastery is a part furthers its exempt religious purposes, but sales of caskets to members of the general public would be unrelated business activity for the religious group.⁶⁷

(b) Sales of Goods or Merchandise

Many tax-exempt organizations sell physical items that are used in connection with conducting programs. In deciding why and when the sale of such goods is treated as an activity that has a causal relationship to an organization's mission, several factors must be considered. Items reflecting the organization's mission, such as a T-shirt displaying the universal symbol of breast cancer in pink⁶⁸ or a reproduction of a work of art on playing cards sold in a museum gift shop,⁶⁹ are treated as advancing the mission.

A private ruling that is worth study involved an EO dedicated to educating the public that early detection of breast cancer saves lives. The organization advanced this mission through various means, including a website, help line, community-based breast education, screening and treatment programs, and a variety of educational materials designed to meet the breast health and breast cancer information needs of the population.

The educational materials cover the topics of general breast health, risk factors and prevention, early detection, diagnosis, treatment, after treatment, support issues, specific populations, and resources. Merchandise displaying the pink universal symbol of breast cancer awareness is sold on the EO's website, including shirts and other apparel, jewelry, pins, and other items. Each item offered for sale is evaluated for its relevance and appropriateness to the mission. A bookmark providing a recommended three-step approach to positive breast health is included with each purchased item. E-mail confirmation statements confirming a purchase recommend regular screening for breast cancer as well as the toll-free number and website. The IRS found that the sale of the items was related to the organization's exempt purposes and does not constitute an unrelated trade or business.⁷⁰

Operation of a weekly flea market by the alumni association of a community college was deemed unrelated to its exempt purpose of providing financial and civic support to the college. Additionally, the fees received from market vendors were not rent excludable from the unrelated business income as a modification.⁷¹ Other alumni associations have received rulings on revenue-raising activity that one should study in this context.⁷²

In what one might think is an alarming private ruling, the IRS, with no description of the “products” sold through an online catalog and a print catalog at various retail outlets, deemed the sales activity to be an unrelated business. Because the ruling lacks sufficient details to understand the negative conclusion, it is important to reread 1973 revenue rulings that have formed the standards for evaluating relatedness of such sales.⁷³

Exhibit 21.4 presents a checklist of issues to consider when the tax-exempt organization sells merchandise.

(c) School Athletic and Entertainment Events

College-sponsored events have traditionally been thought to foster school spirit and advance the educational purposes of the schools. Revenues produced through sales of admission tickets, event programs, refreshments, and similar items have not normally been treated as UBI. Legislative history underlying the UBI provisions states that “athletic activities of schools are substantially related to their educational functions. For example, a university would not be taxable on income derived from a basketball tournament sponsored by it, even where the teams were composed of students from other schools.”⁷⁴

Payments for radio and television broadcast rights, however, have been controversial. In 1977, the IRS advised Texas Christian University, Southern Methodist University, the University of Southern California, and the Cotton Bowl Athletic Association that revenue derived by the universities from the telecasting and radio broadcasting of athletic events constituted unrelated trade or business income. In 1978, the IRS reversed its position after a challenge by the Cotton Bowl and National College Athletic Association.⁷⁵ In 1979, the IRS further expanded its position regarding such events and provided a good outline to determine if the income is UBI:⁷⁶

• Sales of broadcast rights were regularly carried on and the activity was looked at as a profit-motivated trade or business activity, with extensive time expended in training the teams and preparing for the game.
• The events were regularly carried on (systematic and consistent, not discontinuous or periodic).
• Games, however, were related to the Cotton Bowl's exempt purpose. Income from sale of the game broadcast was a byproduct because it was presented in its original state and provided a simultaneous extension of the exempt-function game to the general public.

A long series of IRS proclamations on the subject were issued in following years concerning the sale of broadcast rights by colleges, all of which ruled that such sales produced related income.⁷⁷ These arguments eventually led to a Tax Code revision that permits payments in the form of a sponsorship, acknowledged with noncommercial language, to be treated as a contribution.⁷⁸

In 1981, the IRS applied the commerciality test⁷⁹ to find the promotion of rock concerts in a “multipurpose college auditorium” a taxable unrelated activity. The college's goal to maximize revenue to the exclusion of other considerations indicated that the facility was not operated as an educational program. The nature of the entertainment and the audience were not the criteria used to judge the activity's relatedness; instead, the detrimental fact was the college's selection of events based on their profitability. The facts outlined in the ruling evidencing the businesslike manner of conduct were as follows:⁸⁰

• During the school year, 45 ticket events were held, 44 percent of which were rock concerts.
• Contemporary professional entertainers comprised 40 percent of the concert season.
• The facility was managed by a director with more than 30 years' experience in promoting commercial events.
• The school's fine arts department had no involvement in the selection of events to be held at the center and normally did not participate.
• Twenty-six percent of the tickets were sold to nonstudents.
• Tickets were sold through a commercial ticket service.
• Ticket prices for students were not discounted.
• Concerts were generally indistinguishable by price or type of performance from similar events provided by commercial impresarios.
• Compensation to the performers was negotiated and generally the same as compensation paid by for-profit centers.

In another ruling, spouses and children of students, spouses and dependents of a university's employees, university alumni, and members of a President's Club (big donors and guests) were deemed to be unrelated users of a university's golf course. The IRS ruled that only use by full- and part-time students and employees was substantially related and that there was no causal relationship between the university's educational purposes and use of its golf course by any other persons.⁸¹

An alumni association was found to be on the wrong side of the fine line between fund-raising and performing exempt functions. The association claimed to be attracting new students and donors for a low-income community college. The association aided the college with scholarships, facility and library improvements, and traditional alumni events for students, faculty, alums, and community leaders.

The IRS found that the website only promoted the events and did not feature recruitment information for students and alums in classifying the events, thus producing unrelated business income. Weekly parties were held in the college parking areas featuring arts and craft vendors, entertainment, a farmers' market, and refreshment booths. The events were not staffed by volunteers. In sum, the IRS found that the events did not advance the association's mission and did not qualify for excusal from the unrelated business income tax classification. Nonetheless, the IRS has for many years held that fund-raising and grant making can be charitable activities if the commensurate test is met.⁸² In this instance the lack of information about their mission and accomplishments, both at the events and on the alumni website, inspired the IRS decision, which perhaps was in error.⁸³

(a) Rentals

Rentals of equipment and other personal property (such as computers or telephone systems) to others are specifically listed in IRC §512(b)(3) as a type of unrelated business income. Such a rental is presumed to be undertaken only to collect revenue to cover costs, with no direct connection to the organization's own exempt purposes. Whether rental charges are at, below, or above cost can be determinative in evaluating relatedness. A full fair market value rental arrangement might be considered evidence of lack of exempt purposes, although the taint can be overcome by other reasons for the rental, such as dissemination of specialized educational information. Such rental is said to exploit the exempt holding of the property. However, this general rule is not applicable in situations where the rental serves an exempt purpose, such as the following:

• Renting to, or sharing with, another nonprofit or, conceivably, an individual or a for-profit business is related if the rental expressly serves the landlord's exempt purposes. A museum's rental of artworks—which would otherwise be kept in its storage—to other institutions to ensure maximum public viewing of the works serves an exempt, and thereby a related, purpose.
• Rental of computers to its students, to facilitate their learning experience, would be a related activity for a school.

When the practice first became prevalent, the IRS took the position and fought hard to treat the fees for use of an organization's mailing list as unrelated rental income. After several unsuccessful court battles, they conceded that the income was excludable under the passive exception for royalties.⁸⁴ Real estate rentals are also excluded from UBI under the passive exceptions, but only if the property is unencumbered and not debt-financed property.⁸⁵

(b) Services

Rendering services by a charitable organization for its exempt constituents—students, patients, the underprivileged, or the parishioners—that accomplish an organization's mission is unquestionably a related activity. Certain types of services are inherently treated as related exempt activities: teaching, healing the sick, feeding the poor, or performing religious rites, for example. Organizations exempt under IRC §501(c)(3) perform services in pursuit of eight specific, but fairly broad, exempt purposes.⁸⁶ Services that other types of exempt organizations may provide are actually narrower. A business league, labor union, social clubs, and others must perform only services that accomplish the mission and benefit the industry, the union, or the club, not the EO's members as individuals. Services normally provided by commercial companies, such as job placement or employment counseling, do not serve a charitable purpose.⁸⁷

Services Provided to an Unrelated Nonprofit. Rendering services, such as billing, technical assistance, or administrative support, to other nonprofits does not serve the exempt purposes of the service provider, and is considered unrelated.⁸⁸ The fact that sharing creates efficiencies that allow all the nonprofits involved to save money, or improves program administration of the other nonprofits, does not necessarily cause the activity to be related. Providing services for a fee below, at, or for cost plus a modest profit may also not serve an exempt purpose and “is not charitable because of the absence of a donative intention.”⁸⁹ Only where the services themselves represent substantive programs better accomplished by selling the services to other organizations is the revenue considered related.

• The Tax Court sanctioned the sharing of computer database technology for a group of libraries based on the concept that if an activity was a necessary component part of the operation of one library, it served an exempt purpose to provide the service to other exempt organizations.⁹⁰ A regional computer network to collect and disseminate scientific and educational information for member educational organizations posed a similar case.⁹¹
• Assistance in management of endowment funds by participating colleges and universities for a charge substantially below cost was an exempt purpose.⁹²
• Training courses furnished by a university to a business were sanctioned.⁹³
• An HMO service provider created to provide management consulting to other exempt HMOs was not itself exempt.⁹⁴ Similarly, the exempt status of an organization providing management and administrative services to rural hospitals was revoked despite the fact that it had been a tax-exempt organization since 1956.⁹⁵
• Internet service providers are considered to sell business services and have mostly been found not qualified for tax exemption.⁹⁶
• A entity formed by unrelated exempt organizations (two (c)(3) and two (c)(6)) was not granted (c)(3) recognition of exemption for a new entity formed to provide centralized administrative functions of payroll, personnel, accounting, and fund-raising. The IRS said the activity was no different than an ordinary commercial business.⁹⁷
• Drug testing for a commercial company is not an exempt activity.⁹⁸

A nonprofit formed to create an 800-mile high-speed fiber-optic broadband telecommunications network to provide a backbone to support the proposed expansion of various high-speed telecommunications services in a rural area was found to serve a substantial nonexempt commercial purpose and therefore not be qualified for charitable exemption. The rural area in which the network would be established was serviced by standard telephone, cellular, and Internet technologies. The new entity sought to be the “carrier's carrier” by providing wholesale high-speed broadband connection paths to commercial telecommunication companies, who would then provide retail high-speed broadband communication services to individual subscribers. In other words, the IRS found it would provide the “backbone” through which commercial providers would offer their services to the public. The network would be open to all commercial providers or others requiring high-speed broadband.⁹⁹ Taking a contrasting position, a subsidiary of the business league was found to realize related, rather than unrelated, income. It performed lab testing for manufacturers seeking to gain certification with proof that their products meet the standards. Testing was essentially done on behalf of its parent organization, which creates and maintains the industry standards. The IRS ruled that the testing service benefited the industry as a whole by ensuring public health and safety.¹⁰⁰

The fact-driven issue of whether rendering services serves an exempt purpose brings many private ruling requests. Services offered to the general public continue to be treated as serving the purpose of the purchaser of the services rather than the mission. The first fact on which the rulings rest is whether the purchasers are members of a charitable class, such as the sick, poor, or uneducated. Examples of services offered for the purposes embodied in the charitable genre include:

• Providing hospital lab testing services to nonhospital patients was found to promote health and to serve an exempt purpose when there was no other hospital laboratory within a reasonable distance for those living in the area in which the hospital was located. Therefore, the services were related to the hospital's charitable mission.¹⁰¹
• A's performance of laboratory testing for the patients of private physicians located in B and the surrounding communities served by A is a related business. The provision of laboratory services for those doctors was deemed to be substantially related to A's tax-exempt purpose of improving the health of B and its surrounding communities.¹⁰²
• A website established to provide an “automated fundraising online marketplace” for manufacturers, distributors, and other corporations to donate net profits from sales to charities was deemed to be a commercial business conducting an unrelated activity. The applicant undoubtedly thought the activity was exempt because all of the profits went to charity, but the IRS opined that it failed the operational test.¹⁰³
• The IRS continues to distinguish between services that are charitable because they accomplish a charitable purpose and those they deem to be administrative and clerical commonly conducted by the business community and not unique to the charitable sector, particularly when it involves electronic media.¹⁰⁴ During 2014, they applied this opinion to refuse to grant exemption to an organization formed to provide information access to unserved and underserved business communities and to prevent business deterioration in minority communities through technology.¹⁰⁵
• Collecting donations earmarked by donors to specific “partners” with a “secure mass donation process” is not an activity qualifying for exemption under §501(c)(3). As a coordinator of software that allows donations from mobile devices, the entity would provide marketing, donation processing and collection, and distribution and reporting of results for fees including a monthly fee for use of a keyword and transaction fees based on the amount of credit card processing fees. As discussed earlier in this section and later for community foundation services, such services include those that are administrative and clerical and are not unique to the charitable sector, and instead are readily available throughout the business community.¹⁰⁶ Similarly, a scholarship program created by a §501(c)(4) organization that conducts a beauty pageant could not qualify for exemption under §501(c)(3) because it “provided private inurement to the benefit of a private shareholder or individual.”¹⁰⁷

Grant management services provided by a community foundation to private foundations in its community were fragmented into those services that accomplished an exempt purpose and those that did not. The expressed goal in providing the service was to educate and assist funders to provide more efficient support to the “citizens of X and ultimately for them to establish cooperative relationships with you that will maximize the pool of charitable resources available for the strategic funding of X-based programs.”¹⁰⁸ The services “sold at a reasonable fee” were as follows:

1. Assist to establish a grant-making program—guidelines and processes and procedures for reviewing requests, and so forth.
2. Review/evaluate grant requests, prepare reports on findings, conduct site visits and interviews or other pre-grant inquiries.
3. Prepare research in specific grant-making areas of interest and/or those entities conducting programs in specific areas of interest.
4. Design and/or maintain a system of monitoring funded programs.
5. Identify opportunities for collaborating with other funders.
6. Handle day-to-day inquiries (via mail or telephone) from potential grant applicants.
7. Print checks (for review/signature by authorized representative of the enrollee) for approved grants/expenses and balance the checking account.
8. Organize/staff board and grant committee meetings.
9. Track all grant applications and grants awarded and generate related reports.

The IRS found that items 1, 2, 3, and 5 rely on the particular knowledge and skills the foundation had developed through years of awarding grants and coordinating grant-making for the benefit of the entire community. The foundation's work helps to direct charitable giving in the local community more efficiently and increases the foundation's knowledge regarding charitable causes and programs in the community to enhance coordination of its own grant-making program with the grant-making of others.

Conversely, items 4, 6, 7, 8, and 9 were deemed to be administrative and clerical, with the IRS stating,

Your administrative group of services consists of activities requiring the expertise of office staff skilled and educated in general business administration and business management, personnel management and office procedures. The skill set required to conduct these activities is not unique to the charitable sector or to you. Rather, these activities are conducted throughout the business community on a daily basis by individuals such as office administrators, personnel managers, and executive assistants.¹⁰⁹

Therefore, those services were unrelated to the mission and would be treated as unrelated business income.¹¹⁰

A nonprofit formed to facilitate fund-raising by individuals and reduce the cost of soliciting such funds to registered organizations was deemed to be conducting a commercial business, not a charitable activity. The nonprofit creates and manages a website for registered charities to accept, process, and forward donations. The nonprofit engaged a related for-profit to manage an “e-commerce” element for the buying and selling of products. Purchasers and sellers can designate a portion of the sales transaction fee to a selected charity registered with the company. Two of the nonprofit directors were co-owners and founders of the for-profit entity. The IRS declared that impermissible private benefit (would better have been described as inurement) resulted from the arrangement so that the nonprofit did not qualify for tax exemption.¹¹¹

A's performance of laboratory testing for the patients of private physicians located in B and the surrounding communities served by A was found not to be an unrelated trade or business. The provision of laboratory services for those patients was deemed substantially related to, and contributing importantly to, A's tax-exempt purpose of improving the health of B and its surrounding communities, following the unique circumstances test of Rev. Rul. 85-110. Accordingly, A's revenue from such activity is not taxable as UBI.¹¹²

Alumni associations have received a wide range of rulings on revenue-raising activity that one should study in this context.¹¹³

Services Provided to an Affiliated Organization. Although providing business services to an unaffiliated organization is usually treated as an unrelated activity, such services provided to an affiliated exempt entity may be related.¹¹⁴ When services rendered by one member of a related group of organizations to others in the group are essential to the exempt functioning of the group, the services are considered to accomplish an exempt purpose. A wide range of services, including campus security, telephone and mail service, a central steam plant, financial services, an auditorium, a faculty house used for meals and meetings, a medical center, a library, and an interfaith fellowship center, provided by a graduate school to its related “small colleges arranged around a library,” were related to accomplishment of the school's exempt purposes.¹¹⁵ Similarly, cash management and investment services for school districts were an acceptable mission for an educational organization.¹¹⁶ Though each entity was legally separate, the graduate school's board of fellows included the presidents and board chairs of each member of the group; matters concerning central programs and service were subject to a two-thirds vote. The constitution and the college's bylaws provided for a council made up of the presidents of each college in the group to provide policy guidelines on the administration and development of common programs and facilities.

One ruling considered a hospital support organization created to purchase and operate a computer system for the medical faculty group practice¹¹⁷ and a motel located a short distance from the medical center.¹¹⁸ The doctors using the computers taught medical students, supervised interns and residents, and served private patients. The motel operation was operated as a convenience¹¹⁹ to the patients of the related hospital.

A supporting organization functioning as the parent of its affiliates was found to have related revenue from providing oversight, supervision, management, and strategic planning services to its closely related exempt organizations. The stated IRS rationale was that the sharing of resources “permit[ted] all of the entities to more efficiently carry out their respective tax-exempt operations” and that “transfers were a matter of accounting” and not generally considered a business activity.¹²⁰

Affiliate organizations for this purpose are usually referred to as being an integral part¹²¹ of a group or system. Integrated health-care delivery systems have led the way in clarifying this issue.¹²² Services rendered to the for-profit organizations in such a group may, however, be treated as unrelated activity.

Cooperative Efforts. When an organization is created to serve a consortium of organizations with a common building or pooled investment funds, the IRS has generally allowed its exemption when the new organization itself is partly supported by independent donations. When services are program related, the cooperative performance of charitable or educational functions has generally been acceptable to the IRS.¹²³

• Certain cooperative service organizations are specifically exempt. IRC §501(e) grants exempt status to cooperative hospital organizations formed to provide, on a group basis, specified services including data processing, purchasing, warehousing, billing and collection, food, clinical, industrial engineering, laboratory, printing, communications, record center, and personnel services. Note that laundry is not on the list.
• Cooperative service organizations established to “hold, commingle, and collectively invest” stocks and securities of educational institutions are also provided a special exempt category under IRC §501(f).
• IRC §513(e) allows a special exclusion from UBI for the income earned by a hospital providing the types of services listed in IRC §501(e) to another hospital that has facilities to serve fewer than 100 patients, provided the price for such services is rendered at cost plus a “reasonable amount of return on the capital goods used” in providing the service.

Member Services. Services furnished to members must also accomplish an exempt purpose to be treated as related. Services provided by churches, schools, hospitals, and most other charitable organizations are ordinarily treated as related. Classification of member services by business leagues, labor unions, and other non-(c)(3) organizations is not always clear. The question is whether the service yields private inurement to the individual member or to the profession as a whole and therefore to the general public. Excessive unrelated member services can imperil an association's exempt status. Chapters 7 and 8 present extensive consideration of this issue.

The fact that services provided to member cooperatives are not directly proportional to the amount of the fees paid indicates that individual economic benefits are not directly tied to the payments. Educational programs to promote farm cooperatives, information regarding economic and social conditions for farmers and farm products, and other services were found by the Tax Court to be conducted by a statewide federation of local county farm bureaus for exempt purposes.¹²⁴ Regarding a payment under a noncompete agreement, the revenue was found not to stem from the performance of services or the sale of goods so as to produce unrelated business income.¹²⁵

(c) Licensing Use of the Organization's Name

Licensing the use of an organization's name normally is accomplished by a contract permitting use of the organization's intangible property—its name—with the compensation constituting royalty income that is excluded from UBI.¹²⁶ Such arrangements can constitute commercial exploitation of an exempt asset if the nonprofit agrees to endorse products, distribute materials on behalf of the list renter, and perform other services associated with use of its intangible property.¹²⁷ In 1981, the IRS began to propose that the sale of names and mailing lists in connection with insurance programs and other commercial marketing plans resulted in unrelated business income.¹²⁸ The IRS argued that the extensive involvement of the exempt organization in servicing the membership lists alone made such activity an active business. Later the Tax Court forced them to admit that the licensing of the organization's name and logo alone produces passive royalty income. Endorsements and promotion by the organization in its publications and member/donor correspondence, however, constituted the performance of valuable services that produced unrelated income.¹²⁹ An agreement containing a requirement that promotional or other services be performed by the organization should be bifurcated to separate the consideration for the royalty and mailing list aspects of the contract.

(d) Advertising

Sale of advertising in an otherwise exempt publication is considered unrelated business income unless an exception applies.¹³⁰ Advertisements are said to promote the interests of the individual advertiser or company and cannot therefore be related to the charitable purposes of the organization. The corporate sponsorship rules adopted in 1997 bifurcated the rules for advertising. The language and business logo displays permitted for ads placed in a special-event catalog, in a bowl game program, or on a nonprofit television or radio station program are much more favorable than the information that can be displayed in periodicals.¹³¹ When the sponsorship standards for quantitative and qualitative data do not apply, what constitutes an advertisement will be a display similar to those found in newspapers and magazines and on radio and television. Except for addressing the question of expense allocations, the regulations contain no mention of periodical advertisements. Most of the guidance available on this subject predates the sponsorship bifurcation. The definitions for advertisement and periodical found in the sponsorship regulations quoted in the next section are said to apply only for that purpose. Readers will, however, find those definitions useful in identifying the character of ads contained in periodicals and should be alert for new developments.

An advertisement contains quantitative and qualitative information that promotes the sale of the sponsor's product or engagement of its services. The following examples are indicative of IRS thinking:

• The American College of Physicians was unsuccessful in arguing that the drug company ads in its health journal published for physicians educated the doctors. The college said the ads provided the reader with a comprehensive and systematic presentation of goods and services needed in the profession and informed physicians about new drug discoveries, but the court disagreed.¹³²
• A college newspaper training program for journalism students enrolled in an advertising course produced related income.¹³³
• Sponsors listed without typical advertising copy may be considered contributors, not advertisers. Different sizes of acknowledgments indicating different amounts of money donated do not cause the ad to be classified as commercial.¹³⁴
• Advertising revenues received by a police troopers' labor union from sale of business listings and ads in its annual publication were found to be unrelated business income.¹³⁵ The firm hired to sell the ads and produce the Constabulary was acting on the union's behalf and under its control in an agency relationship¹³⁶ similar to that found in the NCAA case.
• A professional 501(c)(6) society did not receive taxable UBI in its scholarly journal from advertising under the terms of an agreement with the publisher, because commercial advertising wasn't regularly carried on. The publishing agreement provided that the publisher publishes, produces, sells, distributes, and internationally promotes the journal at its own expense.¹³⁷

Despite classification of ad revenues as UBI, the formula for calculating the taxable UBI often results in little, if any, taxable income. Using the exploitation method,¹³⁸ the cost of the publication in which the ads appear, net of any revenue associated with its distribution, are deductible against the net advertising revenue. This formula sometimes yields surprising results that permit ad sale programs to escape tax. See Exhibit 21.5 for the calculation worksheet.

(e) Sponsorships

Sponsorships of a wide variety of events—golf tournaments, fun runs, football bowl games, public television, art exhibitions, and so on—are a favorite form of business support for exempt organizations. The appeal of wide public exposure for sponsoring worthy causes and cultural programs has gained extensive popularity and is thought to make good business sense. The Cotton Bowl Association's payments from Mobil Oil Company were, in 1991, after a lengthy controversy, treated as UBI.¹³⁹ The IRS found that substantial benefit in the form of advertising was given to Mobil. After an outcry from the exempt community, and in the face of proposed legislation to exempt such payment, the IRS issued proposed regulations concerning the character of sponsorship payments in 1993. The proposals were said to reflect an IRS policy decision not to be responsible for hampering an exempt organization's need to raise private support. The regulation intended to distinguish between commercial advertising and benevolent payments.

In 1997, Congress codified the proposed regulations to delineate those sponsorship payments that constitute a donation from those that represent payment for an advertisement taxable as UBI.¹⁴⁰ The provision reduced the uncertainty of reliance on a proposed regulation, but significantly narrowed the definition of an acceptable acknowledgment. The code says the term unrelated trade or business does not include the activity of soliciting and receiving qualified sponsorship payments.¹⁴¹

Qualified Sponsorship Payment. The term qualified sponsorship payment means any payment of money, transfer of property, or performance of services by any person engaged in a trade or business with respect to which there is no arrangement or expectation that the person will receive any substantial return benefit. In determining whether a payment is a qualified sponsorship payment, it is irrelevant whether the sponsored activity is related or unrelated to the recipient organization's exempt purpose.

It is also irrelevant whether the sponsored activity is temporary or permanent. The sponsored activity can be either related or unrelated to the organization's exempt purpose. Qualifying sponsorships can be received in connection with ongoing activities of an extended or indefinite duration and in support of an exempt organization's operations, not just a single event or special series.

When a sponsorship payment is considered unrelated income because return benefits are provided, the payment may still be modified or excluded from tax under another of the many exceptions applicable to unrelated business income, including a once-a-year event or one run by volunteers.¹⁴² Importantly, the entire amount of a qualified scholarship payment is treated as a contribution in calculating the public support test.¹⁴³ The following types of sponsorship payments are not qualified and are subject to the unrelated business income tax rules:

• Any payment that is contingent upon the level of attendance at one or more events, broadcast ratings, or other factors indicating the degree of public exposure to one or more events. The possibility that the event may not occur is not a contingency for this purpose.¹⁴⁴
• Periodical and trade show payments that entitle the payor to the use or acknowledgment of the name or logo (or product line) of the payor's trade or business in regularly scheduled and printed materials published by or on behalf of the payee organization that is not related to and primarily distributed in connection with a specific event conducted by the payee organization.¹⁴⁵
• Any payment made in connection with qualified convention or trade show activity.¹⁴⁶

Substantial Return Benefit. A substantial return benefit does not include (1) goods, services, or other benefit of insubstantial value that are disregarded or (2) the use or acknowledgment of the name or logo of the sponsor's trade or business in connection with the activities of the exempt organization. A benefit provided to the payor may include (1) advertising; (2) certain exclusive provider arrangements;¹⁴⁷ (3) providing facilities, services, or other privileges to the sponsor or persons designated by the sponsor; and (4) granting the sponsor an exclusive or nonexclusive right to use an intangible asset, such as a trademark, patent, logo, or designation of the exempt organization.¹⁴⁸

Use or Acknowledgment. The code only specifically mentions the use or acknowledgment of the sponsor's name and logo. Anyone watching public TV or radio sees and hears not only the sponsor's name and logo, but also its address, phone number, and often extensive “value-neutral descriptions” of its business. A typical sponsor announcement says, “Black, Brown & White is a 90-year-old plaintiff's law firm with offices around the world serving a broad base of international business clients.” The regulations broaden the code definition by saying:¹⁴⁹

Use or acknowledgment may include exclusive sponsorship arrangements; logos and slogans that do not contain qualitative or comparative descriptions of the payor's product-line or services; a list of the payor's locations, telephone numbers or Internet address; value-neutral descriptions, including displays or visual depictions, of the payor's product-lines or services; and the payor's brand or trade names and product or service listings. Logos or slogans that are an established part of a payor's identity are not considered to contain qualitative or comparative descriptions. Mere display or distribution, whether for free or remuneration, of a payor's product by the payor or the exempt organization to the general public at a sponsored activity is not considered an inducement to purchase, sell, or use the payor's product for purposes of the section.

The use of the name or logo (or product lines) of the sponsor in connection with the activities of the exempt organization is not treated as providing a substantial return benefit. The regulations include 12 examples to clarify the rules. Permitted acknowledgments include display of the auto manufacturer's latest-model cars; the sponsor's name in promotions and advertisements of an event; naming the event after the sponsor; the sponsor's name and logo on uniforms, goalposts, and drink cups; and display of the sponsor's logo that sounds like an ad (“Better Research, Better Health”). Items constituting a return benefit include dinners, event tickets, pro-am playing spots, a program advertisement, souvenir flags bearing the team name, a licensing organization's logo, and product endorsements.

Advertising. An advertisement is any message or other programming material that is broadcast or otherwise transmitted, published, displayed, or distributed and that promotes or markets any trade or business or any service, facility, or product. Advertising includes messages containing qualitative or comparative language; price information or other indication of savings or value; or an endorsement or an inducement to purchase, sell, or use any company, service, facility, or product. A single message that contains both advertising and an acknowledgment is advertising. Purchase of broadcast time by the sponsor to be aired during a sponsored event is not treated as an advertisement placed by the organization.

Certain Goods or Services Disregarded. Substantial return benefit does not include goods, services, or other benefits provided to the sponsor or designates that have an aggregate fair market value of no more than 2 percent of the amount of the payment.¹⁵⁰ Token items—bookmarks, calendars, key chains, mugs, posters, or T-shirts—bearing the organization's name or logo that have an aggregate cost within the limit established for low-cost articles can be provided to sponsors. The values of all return benefits are combined to determine whether excess benefits are provided. When the 2 percent limit is exceeded in total, the value of all benefits is unrelated income. Say, for example, a $100,000-a-year sponsor requires the exempt organization to place an advertisement in its program that has a value of $2,000. The ad alone does not exceed the 2 percent limit. If tickets for employees worth $1,000 are also provided, the total of $3,000 would be treated as unrelated income. If a $4,000 dinner is instead provided for the sponsor's executives, $4,000 would represent a substantial return benefit, and only $96,000 of the payment is a qualifying sponsorship.

The quid pro quo disclosure rules require that benefits in excess of $75 be valued and reported to corporate sponsors so that even though the benefits are disregarded for sponsorship classification purposes, the donor acknowledgments should report the value of benefits. The fair market value is determined by the willing buyer–willing seller rules.¹⁵¹

Hyperlinks. Happily, a hyperlink to a sponsor's website address is deemed an acknowledgment that does not constitute advertising on behalf of the sponsor. A permissible acknowledgment occurs when a symphony orchestra lists its sponsors on its website and includes a hyperlink to each sponsor's site. If the link is to a page on which the sponsor displays the organization's endorsement of its products, a valuable benefit is provided to the sponsor, and an advertisement has occurred.¹⁵²

Exclusivity Arrangements. An arrangement for exclusive sponsorship of an exempt organization's activities or representation of a particular trade or business in connection with programs generally does not result in substantial return benefit. However, a sponsorship arrangement that limits the sale, distribution, availability, or use of competing products, services, or facilities in connection with an organization's activity is deemed to be a substantial benefit.¹⁵³

Periodicals. The acknowledgment/advertisement distinction does not apply if the sponsor's thank-you is published in the organization's periodical, either printed or electronic. The term periodical means regularly scheduled materials published by or on behalf of the exempt organization that are not related to and primarily distributed in connection with a specific event. Even if the language is limited to the permissible language previously described for a sponsorship, an acknowledgment printed in the monthly newsletter is treated as producing unrelated income. Favorable cost allocation rules allow deduction of a portion of the overall cost of a publication against the revenue received from advertisers.¹⁵⁴ An organization is not allowed to take advantage of these rules unless the exempt organization can clearly establish that the online materials are prepared and distributed in substantially the same manner as traditional periodicals.¹⁵⁵ The definition of periodical is “regularly scheduled and printed material published by or on behalf of the payee organization that is not related to and primarily distributed in connection with a specific event conducted by the payee organization.”¹⁵⁶ The IRS said that “most of the materials made available on exempt organization Web sites are clearly prepared in a manner that is distinguishable from the methodology used in the preparation of periodicals.”¹⁵⁷ If the content is regularly updated each Monday with articles and features that look like a print magazine, it will appear that the intention is to provide a periodical. Certainly, if the site information replaces an existing magazine and is available only to subscribers or members, it would be difficult to argue that the site is not a periodical. The IRS affirmed its position that content regularly updated and presented in a manner indistinguishable from print publications (articles and event schedules) makes an Internet site subject to the cost allocation rules.¹⁵⁸ Favorable rules allow deduction of a portion of the overall cost of the “publication” or website.

(f) Insurance

Group insurance programs have been a subject of active litigation between trade unions, business leagues, and the IRS. The IRS has prevailed in classifying revenues produced in an internally managed insurance program for members as UBI.¹⁵⁹ Instead of conducting the insurance program directly, a nonprofit can license its membership lists to insurance providers in return for royalty income that is modified, or excluded, from taxation.¹⁶⁰ Similar to the factors considered in affinity card rulings and other mailing list licensing cases, the issue is to what extent the organization renders personal services in connection with the arrangement. It is also important to note in this context that organizations that provide commercial-type insurance cannot qualify for tax-exempt status under §501(m).

The criteria used to evaluate group insurance programs were outlined in a private ruling requested by a business league serving the public health community.¹⁶¹ The facts leading the IRS to conclude that valuable services were provided, causing the payments to be classified as taxable UBI rather than royalties excluded by §512(b)(2), were as follows:

• The insurance company acted as the league's agent in choosing suitable policies for its members, marketing the program to members, and performing administrative services such as creation of presentation brochures, seeking enrollments, and handling the premium collections.
• The league agreed to endorse the program and allow the insurance agent to use its logo, name, and membership list to promote the program to its members.
• The league retained the right to approve the form and content of mailings to its members, endorse the plan, and advise its members of its availability, and include plan information in new-member packets.
• The league's involvement was direct and extensive and represented the rendering of valuable personal services, so that the so-called licensing payments did not qualify as royalty income.

Careful structuring of the contractual arrangements for such plans should bifurcate the revenues, resulting in some unrelated taxable income and some nontaxable royalty. The agreement should identify the specific services to be rendered and the compensation for the services. Terms of payments due for use of the organization's name should be identified as royalty payments for use of intangible property. At best, two separate agreements could be executed.

(g) Real Estate

The tax character of real estate acquired and held primarily for investment purposes may be changed by the manner in which the exempt organization disposes of the property. The question is whether the organization becomes a developer selling land to customers in a business activity. Development projects can be characterized as related (low-income or elderly housing, for example), as a trade or business (subdivision, debt-financed rental, hotel), as an investment (unindebted rental), or sometimes as a combination of all three. The criteria for determining that sales by an exempt organization are business activity are as follows:¹⁶²

• Purpose for which the property was acquired and also purpose for which it was held.
• Proximity of sale to purchase of the property.
• Substantiality, frequency, and size of land sales.
• Improvements (roads, utilities, sidewalks, and the like) made to enhance attractiveness of the property.
• Activities of owner in improving and selling property.
• Nature of sales solicitations and advertisements.
• Use of sales brokers.

The income tax standards for determining when a sale of property results in a capital gain or loss (taxed if property is indebted) are instructive in evaluating the character of the land.¹⁶³ Essentially, the standard distinguishes between a property held in the ordinary course of business and one that is an investment asset. Ordinary (unrelated) income results when the intention to sell is dominant.¹⁶⁴ Thus, the different methods of selling real estate by an exempt organization will have the following results:

• Leasing or selling raw land is a passive investment activity not resulting in unrelated business income.
• Limited preliminary development work, such as obtaining permits and approval prior to sale of the property, may not convert the sale(s) into a business transaction.
• Development of the property, such as installing streets and utilities, prior to the sale converts the property into a business asset and produces UBI.
• Sale of land in many parcels over a period of time indicates a business activity.

Development of an apartment building and parking garage as a part of an urban renewal effort is a related business for an organization whose purpose is to combat community deterioration. The organization operated to assist the city by encouraging revitalization of its downtown area. Although the activity would result in UBI if conducted for investment, in this case the activity served the organization's exempt purposes.¹⁶⁵ A Catholic religious order received IRS sanction for a UBI exclusion of gain earned in a one-time liquidation of vacant land that had been used as part of its exempt facility. The order proposed to convert the land into 751 residential lots. The order obtained the permits, subdivided the land, and made the minimum physical improvements necessary to sell the lots, but an independent broker was to market and sell the lots. The issue was whether the order was selling property “held for sale to customers in the ordinary course of a trade or business.” The fact that the order took the steps necessary to prepare the land for sale and maintained control over the development process did not constitute active business activity.¹⁶⁶

Similarly, the subdivision and other activities necessary to make a 20-acre tract “saleable” did not cause the sales transactions to be unrelated business activity. The school had purchased a 135-acre tract, of which it needed only 80 acres. The important factor was the original intention in acquiring the land and actual use was not to hold it in inventory for sale to customers.¹⁶⁷

(h) Agency Theory

An agency theory may be applied to “look through” certain arrangements. To avoid UBI classification for a potentially unrelated activity, an organization might engage an independent party to conduct the activity in return for a royalty or a rental payment. Inherently passive activities for which compensation is paid in the form of rent or royalty are excluded from UBIT, even if the activity is deemed unrelated. The question is, however, whether one must look through the transactions and attribute the activity of the independent party back to the organization, as the National Collegiate Athletic Association (NCAA) case illustrates. In finding that the for-profit acts as agent, myriad factors, including control over the manner and means of performing the work, the skill required, method of payment, duration of relationship, and so forth, must be considered. An operating paradigm that permits the tax-exempt organization to exercise significant control over the sales effort, editorial content, or handling of funds indicates that the exempt is conducting the activity.¹⁶⁸ The fiscal-year 2002 IRS EO CPE Text says the “question of whether an entity or individual is deemed to be an agent of another for tax purposes is at the heart of many controversies.”¹⁶⁹ Readers trying to decide whose income is whose to identify either unrelated income or deductible contributions will want to study this text. The article contains an overview of relevant common-law and IRS rulings on the issue and a checklist of factors that indicate an agency relationship. The accounting standards to identify an agency's transactions are outlined in §11.5(d).

The NCAA hired an unrelated commercial publishing company to produce its tournament programs. The NCAA gave the publisher a free hand in soliciting the advertisements, designing the copy, and distributing the programs, in return for a percentage of the advertising and direct sales revenues. Because it had little or no involvement in the activity, the NCAA treated the income as a passive and irregularly carried-on activity not subject to the unrelated business income tax. There was no argument that selling the program for the event itself produced related income; nor was there any question that the advertising income was unrelated. The tournament lasts only three weeks.

The issue considered by the Tax Court was whether the NCAA had sufficiently disengaged itself under the contract.¹⁷⁰ Did it sell the right to use its name, or did it engage in the ad activity itself? Because the publisher acted as the NCAA's agent, the activity was totally attributable to the NCAA. The Tenth Circuit Court agreed with the Tax Court, but reversed the decision because the activity was irregularly carried on and not in competition with business. The existence of an agency relationship was not disputed. The IRS disagrees with the appellate decision regarding irregularity.¹⁷¹

The Arkansas State Police Association (ASPA) lost its battle to classify revenues from its publication as unrelated business income.¹⁷² The ASPA engaged an independent company to publish its magazine, The Arkansas Trooper. The ASPA participated in, and maintained control over, the content and other aspects of the publication. Neither the Tax Court nor the Eighth Circuit agreed with the ASPA's argument that its role was passive, de minimis, and related only to the protection of its name and thereby produced nontaxable royalty income. The court distinguished the affinity card cases¹⁷³ by looking at whose business was being promoted by use of the name. The magazine advanced the interests of the ASPA, not the publisher—unlike the affinity card programs, which promote the interests of the banks issuing the cards. The court said, “A royalty exists when A uses the name of B to promote A's products.”¹⁷⁴ The fact that the agreement was labeled as a royalty and licensing agreement did not make it so. Following the reasoning of the NCAA case, the court decided that the agreement imposed a duty on the publisher to perform services on behalf of the ASPA and did not produce payments to the ASPA for the use of its name.

The agency theory was escaped, however, by an organization that turned over the publication of its monthly journal to a commercial company, retaining one-third of the revenues from subscriptions and reprints. All advertising income, two-thirds of the circulation revenues, and all the risk of publication expenses were borne by the company. Under the circumstances, the company was acting on its own behalf, not as agent for the charity. No advertising revenue was allocated to the charity.¹⁷⁵

Earnings of an ostensibly independent for-profit subsidiary may also be allocated back to the nonprofit parent under the agency theory. The subsidiary's business is treated as separate only if it is managed at arm's length without the parent taking part in daily operations.¹⁷⁶

(i) Exclusive Marketing Agreements/Covenants Not to Compete

The Georgia Institute of Technology renamed its sports arena McDonald's Center. The basketball court floor prominently displays a golden arch, and you can guess what kind of food and drink is exclusively served in the facility. The school received $5.5 million in return for agreeing to such actions. How this revenue is classified for federal tax purposes depends on the following medley of unrelated business income concepts and tax rules applied to the proverbial facts and circumstances:

• Is the activity a regularly-carried-on trade or business? (Does this answer depend on whether annual renewals occur rather than a one-time payment for a longer period of time?) (§21.6)
• Has the school licensed its intangible property right (its goodwill§ and student body) in return for an excludable royalty? (§21.10(d))
• Does the method of acknowledgment constitute a sponsorship payment treated as a contribution? (§21.8(e))
• Has the school rented space for food service? (§21.10(c))
• Is the school required to perform any services in connection with the agreement? (§21.10(d))
• Is the sports arena a student convenience facility provided as part of the academic mission and the school's responsibility to feed the students? (§21.9(c))
• Should the payment be fragmented into different parts? (§21.4(c))
• Does the outcome depend on the number of nonstudents who patronize the facility? (§21.8(e))
• Are rebates or discounts negotiated with vendors as part of the competitive bidding process (say, for example, hotel rooms for attendees at a conference) unrelated income? Generally, discounts (and rebates) are considered an adjustment to the purchase price and do not constitute gross income to the purchaser, so logically the answer would be no.

The answer for each institution considering an exclusive-use agreement will depend on its particular set of facts and circumstances; such income is not automatically subject to tax. ¹⁷⁷The Supplementary Information to the sponsorship regulations says that an “Exclusive Provider Agreement occurs when the exempt organization agrees to limit distribution of competing products in connection with the payment.”¹⁷⁸ The sponsorship regulations deem exclusivity agreements to result in a substantial return benefit.¹⁷⁹ When the exclusivity is necessary for reasons of limited vending space and/or as a result of a competitive bidding process in acquiring the goods, no benefit occurs. Purchase discounts and rebates negotiated with vendors are considered an adjustment to the purchase price and do not constitute gross income to the purchaser.¹⁸⁰ The provision of substantial services in connection with a vendor contract, however, can cause an otherwise nontaxable agreement to result in unrelated income. If Georgia Institute of Technology, in the preceding example, agrees that coaches will make promotional appearances on behalf of McDonald's, the value of those services becomes UBI.

(j) Revenue Produced on the Internet

The character of revenues paid to an exempt organization from activities it conducts on the Internet, including sales of goods and services, is an evolving issue. There is no question that the law, regulations, court decisions, and rulings that apply to identify and tax unrelated business off the Web can be applied to online activities, but certain unique aspects of the Internet raise unique and unanswered questions.¹⁸¹ Some use a one-click rule, to suggest that the first click to a linked site may not produce unrelated income, but two clicks might. The following is the author's list of questions that an organization producing revenue from its site should ask; each question is keyed to the portions of this chapter that further discuss the issue. The last question was posed in the new revenue ruling, possibly signaling that promised guidance is at last forthcoming.

• Do the goods and services sold through the site advance the organization's exempt purposes? They certainly can. This determination is made in reference to the mission and the purposes for which the organization was originally found to be exempt. Registration for a Latin class and purchase of study tapes on the Internet should be treated no differently than physical registration and purchases from the bookstore (§§21.7 and 21.8).
• Does the organization recognize its sponsors or contributors on its website? If so, do the IRC §513(i)(2)(A) rules delineating donor acknowledgments versus advertisements apply to links to business sponsors? Can the one-click rule apply? When does the link represent advertising for the sponsor? A simple banner placed on the organization's site, containing information allowed under the sponsorship regulations, constitutes a permitted acknowledgment that is not advertising. Advertising results when the organization's links to the sponsor's site that contains promotional material indicate that the EO endorses the sponsor's products (§21.8(j)). Simply linking to a sponsor's home (or other) page, on which promotional matter does not appear, does not create an advertisement.¹⁸² A link to another site that contains references to a political campaign can be troublesome.¹⁸³
• What is the character of income received as “referral fees” from online vendors, such as Amazon.com, to their nonprofit associates? Does it matter whether the payments are referred to as donations, commissions, revenue share, referral fees, or even advertising? Can such payments be characterized as royalties? Does the result change if the link is established to allow the site visitor to purchase books published by the organization itself? There should be little doubt, in view of the Sierra Club decision, that the payments received from licensing the use of an organization's mailing list and name and logo are royalties. Further, passive royalty income, received in an arrangement that does not require the organization to perform services, is not taxable (whether or not it is unrelated). Creative organizations will therefore compose agreements with commercial distributors that designate such transactions as licensing transactions under which the organization is not required to provide any services. Certainly, very little effort on the organization's part is involved, so arguably the passive royalty modification should apply (§21.10(d)).
• Is the hyperlink itself an intangible property the licensing of which produces passive royalty income? The same reasoning applied by the Tax Court in the Sierra Club and other affinity card decisions should apply to treat a hyperlink as an intangible property capable of being licensed in return for a royalty. If the exempt organization, in return for placing the link on the commercial company's site, agrees to provide referral services to the company's customers, for example, it could be treated as rendering business services, and a portion of the payment would have to be allocated or fragmented between the royalty and the service portion (§21.10(d)).
• Are payments from charity malls and electronic script programs pure donations to the exempt organization?¹⁸⁴ The primary question in classifying payments from such programs is whether the amount the organization receives represents a donation. A donation stems from disinterested and detached generosity in which the donor expects nothing in return for his or her payment.¹⁸⁵ When the purchaser pays more than the fair market value for an item and the payment to the organization represents that excess, a donation results. If the purchaser pays full fair market value and the Internet vendor voluntarily gives part of the sales proceeds to the organization, again a donation results. The mutually beneficial arrangement an exempt organization enters into with an Internet vendor should not necessarily be any different from the relationship between the exempt and its development director. Unrelated business income may arise, however, when the amount is instead tied to some action or some service to be rendered by the exempt organization. Because the connection to the mall vendor stems from that vendor's use of the organization's name and logos, the payment may be royalty excluded from tax, as described for the preceding question.
• Can revenues produced in connection with a trade show conducted entirely on the Internet—a so-called virtual show—qualify for UBI exclusion under §513(d)(2)? The IRS says no. See §21.9(e).
• Are there other examples of activities that may not be virtual? Yes: bingo games. The exception that excludes income from bingo games from UBI defines a qualifying bingo game as one in which (1) wagers are placed, (2) winners are determined, and (3) prizes are distributed, all in the presence of all persons placing wagers in such game.¹⁸⁶

(a) Volunteers

A business in which substantially all of the work is performed without compensation is excluded from UBI when the labor is an income-producing factor. If the business is capital intensive, so that the income is primarily attributable to the investment in property and equipment, such as rental real estate, the fact that accounting and other administrative services are provided by volunteers may not apply.¹⁸⁸ Substantially for this purpose means at least 80 to 85 percent of the total work performed, measured normally by the total hours worked. A paid manager or executive, administrative personnel, and other support staff can operate the business if most of the work is performed by volunteers. This rule is the reason the boxes of candy, coupon books, and other items sold by children to raise funds for parent–teacher organizations do not result in unrelated business income to the school or PTA.¹⁸⁹

In most cases the number of hours worked, rather than the relative value of the work, is used to measure the percent test. This means that the value of volunteer time need not necessarily be quantified for comparison to monetary compensation paid. In the case of a group of volunteer singing doctors, the value of the doctors' time was considered. Because the doctors were the stars of the records producing the income, their time was counted by the court at a premium, which offset administrative personnel whose time was compensated modestly.¹⁹⁰ Having 77 percent of its labor donated by volunteers, however, was not enough to allow a bingo operation to avail itself of this exception. The 23 percent compensated workforce ratio was substantial enough to cause an Elks Lodge to pay tax on its bingo profits.¹⁹¹

Expense reimbursements, in-kind benefits, and prizes are treated as compensation if they are compensatory in nature. Particularly when the expenses enable the volunteers to work longer hours and serve the convenience of the organization, the payments need not be counted in measuring this exception. However, solicitors for a religious organization that traveled in vans and lived a very Spartan life were not unpaid volunteers, as the organization had claimed, because their livelihood was provided by the organization.¹⁹² Similarly, when food, lodging, and other living expenses were furnished to sustain members of a religious group, the members working for the group's service-oriented business teams were not treated as volunteers.¹⁹³

The result for members of a religious order was different.¹⁹⁴ Under a but-for test, it was decided that food, shelter, clothing, and medical care received by brothers in a religious order were paid without regard to whether they worked. The members of the order were under a vow of poverty and were provided necessities by the order without regard to their particular assignment. The court deemed the benefits provided to not be compensatory. There was not a connection between the services and the benefits because it was not the case that “but for rendering of services, the payments would not have been made.”¹⁹⁵ It was also noted that only 14 out of St. Joseph's 167 members worked on the farm and that the court had no doubt that, if the farm ceased to operate, the farm-working brothers would continue to receive their livelihood. The farm revenue was therefore excluded from UBI.

(b) Donated Goods

The selling of merchandise, substantially all of which is received by the organization as gifts or contributions, is not treated as a taxable activity. Thrift and resale shops selling donated goods are afforded this exception from UBI for donated goods they sell. A shop selling goods on consignment as well as donated goods must distinguish between the two types of goods. Under the fragmentation rules,¹⁹⁶ the consigned goods sales would be separated, or fragmented, from the donated goods and any net profit from those sales included in UBI. Note that consignment sales by volunteer-run resale shops would be excluded under the volunteer exception.

(c) Convenience

For §501(c)(3) organizations only, a cafeteria, bookstore, residence, or similar facility used in the organization's programs and operated for the convenience of members, students, patients, officers, or employees is specifically excepted from UBI.¹⁹⁷ Visitors have been added to the list. This exception is based on the theory that conveniences allow persons to more fully participate in exempt activities. Patients recover faster when family and friends visit or stay with them in the hospital, and the cafeteria facilitates the visits.

When the café, shop, dorm, or parking lot is also open to the general public, the revenue produced by public use is unrelated income. Using the fragmentation rule, revenues attributable to qualified visitors must be distinguished from the unrelated revenue received from other customers.¹⁹⁸ For example, meals served to nonmuseum visitors responding to advertisements promoting a museum's restaurant produced unrelated income.¹⁹⁹ No exempt purpose was served by selling the meals, because the general public had access to the restaurant without having to pay for or visit the museum's art exhibits. If, instead, the promotion had emphasized the convenience of the restaurant, the result might have been different. A museum café is a related facility if it:²⁰⁰

• Attracts visitors to the museum by providing in-house dining.
• Allows visitors to devote more time to the museum's educational facilities than if they had to seek outside eating facilities.
• Enhances the efficient operation of the museum by enabling staff and employees to remain on the premises throughout the day.

Parking lot fees paid by participants in an exempt organization's activities are also excluded from UBI under the convenience exception. A lot open to both visitors and nonvisitors is fragmented into its visitor convenience and nonvisitor parts. If the lot is operated by an independent party under a lease arrangement in which the exempt organization performs no services, the nonvisitor revenue can be classified as rental income excludable from UBI by the passive income modifications. If the organization itself operates the lot, the revenue from general public usage is a trade or business.²⁰¹ A beach parking lot operated by a social welfare organization on behalf of a homeowners' association (located eight miles from the community) failed to qualify for the exception.²⁰²

The IRS Examination Guidelines for Colleges and Universities²⁰³ contains useful criteria for applying the convenience exception for UBI purposes. Most important, the facts and circumstances of each situation are determinative. The items sold to students, officers, and employees in the school bookstores are individually judged. First, the relatedness of an item is evaluated. Books and materials required and recommended for classes; supplies such as notebooks, pencils, and computers (one a year); and athletic gear necessary to participate in physical education programs are listed as items that advance the educational institution's exempt purposes. Materials that further the intellectual life of the campus community, such as books, tapes, records, and compact discs, are also deemed related. The unstated presumption is that students or staff can spend more time studying (they need not travel to the mall) if they have toiletries, novelty items bearing the institution's insignia, candy, cigarettes, magazines, greeting cards, film, cameras, and small appliances easily available to them. Sales to alumni, parents, and other outsiders are unrelated and not excludable under the convenience exception.

(d) Bingo Games

Bingo games not conducted in violation of any state or local law are excluded from UBI. IRC §513(f) defines bingo as any game of bingo of a type in which usually (1) wagers are placed, (2) winners are determined, and (3) distribution of prizes or other property is made, in the presence of all persons placing wagers in such game. The regulations expand the definition as follows:

A bingo game is a game of chance played with cards that are generally printed with five rows of five squares each. Participants place markers over randomly called numbers on the cards in an attempt to form a preselected pattern such as a horizontal, vertical, or diagonal line, or all four corners. The first participant to form the preselected pattern wins the game. Pull-tabs and other forms of instant bingo are not bingo in the IRS's opinion and produce UBI despite the fact that such variations of the bingo game are so classified by the state bingo authority. Any other game of chance including but not limited to, keno, dice, cards, and lotteries, is not bingo (and will create UBI).²⁰⁴

During 1990, the IRS aggressively examined nonprofits in the Southwest District and assessed tax on any bingo variations not strictly meeting the code and regulation definitions.²⁰⁵ In calculating the taxable income earned from a pull-tab operation, all of the “ordinary and necessary” business expenses are deductible.²⁰⁶ That portion of the profits from the pull-tabs that is required to be paid out for or dedicated only to charitable purposes under local law is treated as a business expense. Publication 3079, entitled Gaming Publication for Tax-Exempt Organizations, was issued in June 2010 to explain these rules comprehensively.

(e) Entertainment, Conventions, and Trade Shows

Public entertainment is defined as that traditionally conducted at fairs or expositions promoting agricultural and educational purposes (including but not limited to animals or products and equipment) and does not produce UBI for §501(c)(3), (4), or (5) organizations. To constitute a qualified show, the event must be held in conjunction with an international, national, state, regional, or local fair, or be in accordance with provisions of state law that permits such a fair.²⁰⁷

A convention or trade show is an event intended to attract persons in an industry (without regard to membership in the sponsoring organization), as well as members of the public, to the show for the purpose of displaying industry products, stimulating interest in and demand for industry products or services, or educating persons engaged in the industry in the development of new products and services or new rules and regulations affecting the industry. Exhibitors are permitted to sell products or services, and the organization can charge for the display space.

An agricultural exhibition group owning the exhibition facilities may generate both taxable and nontaxable income from programs conducted in the facility. The leasing of the facilities during its off-season (10½ months of the year) can produce passive income excluded from UBI. In a unique and interesting ruling, it was determined that free admission for its shareholders (essentially members) was found not to result in private inurement because such admissions constituted only 3 percent of the tickets given away.²⁰⁸ Commissions and rebates received from concessionaires granted the right to serve food and beverages in the facility did constitute unrelated business income.

The first of what one hoped at the time would be ongoing guidance on the tax consequences of activities conducted on the Internet was issued in late December 2004.²⁰⁹ With two contrasting examples, the IRS looked at the use of a website to disseminate information about a trade show. In one situation, the organization conducted qualifying trade shows in a physical fashion. The association augments and enhances each show by allowing members and the interested public to access the same information available at the show on the website. Information and visual displays, such as product directories and specific product listings, links to the websites of exhibitors represented at the show, and order forms to allow online purchases are shown. The information was displayed only three days before and three days after each show. The site was controlled by the association and the site display was found to be in conjunction with, ancillary to, and merely an extension of the show. The site was said to be an alternative medium that augments and enhances the actual show. Thus, the site in combination with the show qualified for what the IRS said was a narrow exception for UBI purposes.

In a second example, a virtual trade show, which was conducted only online and only for two weeks, was considered. The same type of information, links, and sales activity described in the preceding example were displayed on the site. The IRS found that the online trade show was not a qualifying show. It focused on the words “intended to attract persons … to the show,” which it interpreted as meaning physical presence. It found that the website itself is not a convention or trade show because it is not a special event where members, suppliers, and potential customers gather in person at one physical location during a certain period of time and interact face to face. The code itself says that an organization qualified to conduct a convention or trade show is a §501(c)(4), (5), or (6) organization that regularly conducts as one of its substantial exempt purposes a show that stimulates interest in, and demand for, the products of a particular industry or segment of such industry or that educates persons in attendance regarding new developments or products and services related to the exempt activities of the organization.²¹⁰

Note the words “persons in attendance,” which is an impossible condition for a virtual show.

(f) Indian Tribes

Income earned by a federally recognized Indian tribe from the conduct of an unincorporated business or a corporation incorporated under the Indian Reorganization Act of 1934 (IRA) is not subject to federal income tax.²¹¹ A corporation formed instead under the laws of the state in which the tribe is located, however, would be subject to tax even though it is owned and controlled by an Indian tribe or members of a tribe. The basis of this distinction lies in the definition of an Indian tribe. Section 1 of the Internal Revenue Code subjects individuals, trusts, and estates to tax; Section 11 taxes corporations. A tribe is not such a taxable entity; a separately incorporated business would be.²¹²

In 1981 the IRS ruled that a properly established Indian tribal corporation (under the IRA) had the same tax status as an Indian tribe with regard to activities carried on within the boundaries of the reservation.²¹³ This restriction to on-reservation activity was reconsidered and removed in the 1994 ruling. The ruling says that because an Indian tribe is not a taxable entity, any income earned by it—on or off the reservation—is not taxable. The ruling states that it applies only to federal income taxes. It does not affect the application of other federal taxes, such as employment and excise taxes (including excise taxes on wagering), to Indian tribes or tribal corporations. A draft of an IRS “Guide to Indian Taxation Issues” was reviewed with tribal representatives on March 3, 1994, but not formally issued. The IRS issued procedural and administrative tax regulations under the Indian Tribal Governmental Tax Status Act of 1982.²¹⁴

(g) Low-Cost Articles

For §501(c)(3) and veterans groups, gift premiums distributed with no obligation to purchase in connection with the solicitations of contributions are not treated as a sale of the gift premium. The gift must be part of a fund-raising campaign and must cost (not fair market value) the organization no more than $9.90 (during 2012; indexed annually for inflation).²¹⁵ Two important factors must be present:

1. The recipient of the premium must not request or consent to receive the premium.
2. Literature requesting a donation must accompany the premium along with a statement that the recipient may keep the low-cost article regardless of whether a charitable donation is made.

If the donation is less than the current low-cost amount, the fair market value of the premium cannot be disregarded and must reduce the deductible portion of the donor's gift.

A program for distribution of low-cost articles cannot qualify for this exception if it presents unfair competition to nonexempt businesses and is conducted like a commercial enterprise.²¹⁶ A religious group's donation solicitations in return for caps, T-shirts, and similar items at public sporting and entertainment events was found to be conducted in a profit-seeking fashion in competition with for-profit vendors.²¹⁷ For this reason as well as its failure to prove that it distributed the items with no obligation to purchase, the revenues were treated as unrelated business income.

(h) Mailing Lists

Again, for the organizations eligible to receive charitable donations under §170—primarily §501(c)(3) and veterans organizations—a business involving the exchange or renting of mailing lists between such organizations is excluded from UBI classification. This special treatment was added by Congress in 1986 based on IRS recommendation.²¹⁸ Sale or exchange of mailing lists by such organizations to others and sales by all other types of §501(c) organizations, ostensibly by omission, create UBI. Courts have found, much to the consternation of the IRS, that §513(h) does not overrule the passive royalty income exception that modifies revenues from licensing of mailing lists for all types of tax-exempt organizations.²¹⁹

A program allowing credit card holders to direct the bank's affinity card program to pay rebates to named charities is a charitable giving program. When the cardholder voluntarily designated a specific charity, the bank was acting as an agent so that its transfer of the funds to the charity on behalf of the cardholder qualified as a charitable contribution.²²⁰ The furnishing of the charity's mailing list to the card company did not constitute rental of the list because the revenue stemmed from cardholders' voluntary action.

(a) Dividends and Interest

Dividends and interest paid on amounts invested in savings accounts, certificates of deposit, money market accounts, bonds, loans, preferred or common stocks, and payments in respect to security loans and annuities, net of any allocable deductions, are excluded from UBI.

In 1978, the general exclusion of interest and dividends was expanded to include the words “payments in respect of security loans.” Before that time, there was uncertainty regarding techniques such as strips, interest rate swaps, and currency hedges. It is now recognized that such investments are ordinary and routine and income earned from such transactions in security portfolios is considered as investment income for §512 purposes.²²¹

When securities producing dividends and interest are acquired with indebtedness, the income is swept back into UBI by IRC §514. An organization must be careful to use new money to acquire each element of investment in its portfolio. A pension fund owning five-year certificates of deposit (CDs) in 1979 (after interest rates had risen more than five points) received UBI when it purchased new CDs using its old CDs as collateral. Although the fund escaped an early withdrawal penalty and received a higher rate of interest, the new CD was a debt-financed asset purchase. Thus, the fund's original CD produced modified or nontaxable income, and the new higher-rate CD acquired with the loan proceeds was held to be taxable as unrelated debt-financed income.²²² The CD switch, incidentally, was not a permissible “payment in respect of a security loan.” Such a loan allows a broker to use an organization's securities in return for a fee, not as a loan against which the securities are used as collateral.

The Omnibus Budget Reduction Act of 1993 amended §512 to provide that gain and loss received from unexercised options on investment assets such as securities and real estate, as well as loan commitment fee forfeitures, are excluded from UBI. Subpart F income, consisting of at least 95 percent passive investment income distributed by a blocker corporation in a foreign country, was found not to be unrelated business income.²²³

(b) Capital Gains

Gains from the sale, exchange, or other disposition of property are classified as UBI depending on the character of the property sold. Generally, the normal income tax rules of IRC §§1221 and 1231 for identifying capital, versus ordinary-income, property apply to identify property covered by this exception. Sales of stock in trade or other inventory-type property, or of property held for sale to customers in the ordinary course of trade or business, produce UBI. The level of sales activity, character of the property, and other factors determine whether an asset is a capital asset.²²⁴

Options/Shorts. Gains on lapse or termination of covered and uncovered options, if written as a part of investment activity, are not taxable.²²⁵ Short-term capital gain from a short sale of publicly traded stock through a broker was ruled not to create UBI. Although a short sale technically creates an obligation for the purchaser to pay for any loss that may occur on covering the short position, this possible loss is not treated as acquisition indebtedness.²²⁶

Timber. Timber standing on real estate owned by the exempt organization can be treated as a capital asset if the organization retains an economic interest in the timber.²²⁷ The somewhat complicated rules must be studied for organizations owning such property to ensure proper tax treatment. Percentage depletion may apply, and specific rules for allocating the cost basis of the underlying property between the real estate and the timber are provided.²²⁸

Social Club Issues. A gain from the sale of real estate used by a social club in regular club activities (its exempt function) is not classed as UBI to the extent the proceeds are reinvested one year before or three years after the date of the sale.²²⁹ An intention to use the replacement land for club activities is insufficient. Because social clubs (particularly country clubs and old-line city clubs) often own valuable and desirable real estate, this exception can be valuable. When the property is considered as a nonexempt function, the club must treat the revenue as nonmember revenue and also face the possibility of failing the 35/15 test necessary to maintain ongoing exemption.

Harvesting pine trees to preserve the usefulness of a club's property as a wildlife habitat was found to advance the club's exempt purposes. The club, created in 1870, owned a five-square-mile fish and game preserve and historic clubhouse building adjacent to public land areas maintained in a natural state. The club engaged professional foresters to plan timber harvesting to improve the habitat for wild game and to control gypsy moths. Sale of the timber pursuant to the plans did not create unrelated business income.²³⁰

A Florida club sold a portion of its property to participate in a land price boom and distributed the proceeds to the members. The court said the sale was a violent departure from the club's normal behavior and not merely incidental to the regular functions of the club. Because financial gain was the aim, the court revoked the club's exemption.²³¹

Property contiguous to a club and held for possible future expansion, or simply protecting the club from the suburbs, is not exempt function property. Only property in actual, direct, continuous, and regular use for social and recreational purposes qualifies. Accordingly, a golf club was taxed on gain from selling off-road frontage. The land was originally acquired with the expectation that it would be used for club facilities, but in actuality was not.²³²

Use of vacant land containing no physical improvements but used for jogging, picnics, kite-flying contests, and other outdoor activities was found to constitute direct use by club members. The court said, “It is certainly conceivable that joggers derive as much pleasure and recreation from their pastime as golfers do from their rounds on the links.”²³³ A “buffer tract,” containing a steep incline and heavily wooded with thick undergrowth, however, was found not to be used directly in exempt functions. Even though it isolated the club from the surrounding developed area and roads, its physical condition indicated that it was not devoted to exempt activity. Proceeds from granting a permanent easement for passage and use produced UBI.²³⁴

(c) Rentals

Rental income is considered a passive type of investment income that is modified or excluded from UBI, except in the following cases:

• Personal property rentals are taxable unless they are rented incidentally (not more than 10 percent of rent) with real property.
• A fluctuating rental agreement that calculates the rent based on net profits from the property is unrelated income; rent based on gross revenue is not UBI.

The regulations say that

payments for the use or occupancy of rooms and other space where services are also rendered to the occupant, such as for the use or occupancy of rooms or other quarters in hotels, boarding houses, or apartment houses furnishing hotel services, or in tourist camps or tourist homes, motor courts, or motels, or for the use or occupancy of space in parking lots, warehouses, or storage garages, does not constitute rent from real property.²³⁵

When substantial services are rendered, such as the rental of a theater complete with staff or rental of a hotel room complete with room service, the rental is not considered passive.²³⁶

The “convenience”²³⁷ exception may, however, apply to hotel-type services provided with rooms rented to persons participating in the organization's activities. Revenue from the temporary rental of school facilities illustrated this concept.²³⁸ Tenants found to have an acceptable relationship to the school included family members of students and faculty, potential students and their families, guest speakers at the institution, and guests of other nonaffiliated nonprofit organizations in the immediate geographic area who are also speakers or musical performers at the institution.

Sharecrop arrangements for farmland owned by an organization may or may not be treated as excludable from UBI under the rent exception. The method for calculating the rent and risk borne by the organization is determinative. The issue is whether the exempt is a joint venturer participating in the farming operations. The following factors were considered in two court cases on the subject.²³⁹

• The organization is not involved in the day-to-day operation of the farm; it simply provides the land and buildings.
• The organization bears no risk of loss from accidents.
• The organization is not required to contribute to any losses from the operation, but pays only an agreed portion of the operating expenses (in one case, 50 percent).
• The rent is equal to a fixed percentage of the gross sale of the crop or a fixed amount, not a percentage of net profits.²⁴⁰

Leases of rural land to raise livestock and hunt deer in concert with wildlife conservation programs was viewed by the IRS as serving an exempt purpose.²⁴¹ An organization seeking to promote conservation of naturally occurring species of raptors and other wildlife, and apparently owning a large piece of rural land, sought approval for revenue-producing use of their property. Two factors allowed the IRS to rule that the leases were not taxable and exempt purposes were served: The organization expected that the annual expenses of conserving the wildlife would exceed the revenue and the character of the revenue was rental unrelated to revenue produced by the activity.

Parking lot rental presents a similar situation. Rental of the bare real estate to another party that operates the lot (where the organization has no relationship or responsibility whatsoever to the parkers) clearly produces passive rental income.²⁴² If the exempt provides some services to the operator, UBI taint may occur. A beach club operated by a homeowner's association was found not to promote community welfare because it was not accessible to nonmembers (the activity was unrelated). Additionally, the level of services provided was more than insubstantial.²⁴³

The regulations speak of “services rendered … primarily for the convenience and other than those usually or customarily rendered in connection with the rental of rooms or other space for occupancy only.” Providing maid service, but not trash hauling, in renting a room is the example given.²⁴⁴ Operation of a parking lot for the benefit of employees and persons participating in an exempt organization's functions, rather than disinterested persons, is a related activity.²⁴⁵ The IRS considered two issues regarding the owning and renting of an apartment complex. The less than 1 percent of the gross revenue derived from covered parking spaces and coin-operated laundry machines was considered to be unrelated business income. This ratio was at issue in deciding whether the private foundation owner possessed excess business holdings. Because the real property rental was more than 95 percent of the gross revenue, the complex was not treated as a business enterprise under IRC § 4943.²⁴⁶

Substantial services were provided to corporate and business patrons who rented an educational organization's facilities for receptions in the evenings. The services provided included maintenance, security personnel, and liquor service (because the organization held the license). The IRS was not convinced that the rentals served an exempt purpose in finding that the programs were primarily social- or business-oriented and included such items as cocktails, dinner-dances, awards presentations, and holiday celebrations. While there was some educational benefit to the attendees of viewing exhibits, they were ancillary to the events' principal purpose.²⁴⁷ The IRS noted that the holding would be different if the request was for the organization to create an educational event in its space, with the food and services provided only incidentally.

The character of rentals of airspace above and the roof of an organization's building for telecommunication towers presents an interesting question. The roof itself is real, not personal, property. The author welcomes opinions about the nature of the airspace, which she understands may depend on local law.

(d) Royalties

The fact that the term royalties is not defined by the code or regulations pertaining to unrelated income has caused significant controversy. The battle focused on licensing of mailing lists, EO logos, and associated issuance of affinity cards. The regulations provide that royalties, whether measured by production or by the gross or taxable income from the property, are modified, or excluded from UBI.²⁴⁸ In the cases described here, the courts said, and the IRS eventually conceded, that a royalty paid for the use of intangible property rights is excluded from UBI unless substantial services are performed in connection with the arrangement. Participation in an oil and gas working interest in which the organization is responsible for its share of development costs results in business income not modified, or excluded, from UBI.²⁴⁹

Initially, the IRS insisted that none of the revenue paid in return for licensing the use of an organization's mailing list was treated as a royalty payment.²⁵⁰ While agreeing that mailing lists are intangible property, the IRS argued that the activity exploiting the lists was conducted like an active business. The Tax Court in 1993 ruled,²⁵¹ and the 9th Circuit Court agreed,²⁵² that there was no evidence that Congress intended to limit the royalty exception to passively held investment properties. The Tax Court, on remand, decided that the Sierra Club did not render taxable services when it retained quality control rights over its logo used in a bank affinity card program. The payments received for use of its name, logo, and mailing lists constituted royalties from the licensing of its intangible property rights. Characterization of income as a royalty was not lost when the club scrutinized promotional materials to prevent abuse of its logo.²⁵³ The IRS announced in December 1999 that it had instructed its agents to cease attempts to tax revenues from affinity card and mailing list rental cases, as a result of its losses in the courts.

From the Sierra Club and other battles concerning the royalty exception, guidelines have emerged.²⁵⁴ Payments that can be treated as royalty income excluded from UBIT are distinguishable by the following criteria from those that will be taxable compensation for services rendered:

• Payments are made pursuant to written documents which stipulate that the organization is licensing its intangible property.
• The payments are specifically designated as royalties.
• The tax-exempt organization does not participate in marketing the affinity cards, insurance, or other products the commercial company is promoting to the organization's members and supporters.
• When the organization is to participate in the marketing effort, the services to be rendered are clearly defined and compensation for such services is set out in the agreement.
• When the organization promotes the program with advertisements in its newsletters or magazines, fees for the ads are separately paid for by the licensee. Net income allocable to the ad revenues is reported as UBI.
• Any retained rights to inspect or manipulate the marketing materials are permitted for reasons of protecting the organization's name and reputation, rather than being required of the organization. If production and design of brochures, letters, and other promotional materials are performed by the organization, compensation for the work should be stipulated.

This issue is of particular interest in the scientific and medical fields, where considerable sums are earned from royalties paid for the use of patented devices and methods. Perhaps because the licensing of intellectual property rights for patents involves complex legal issues and potential for liability, the agreements are very carefully structured. There is usually no question that the EO assigns all responsibility for services performed in developing the patent to the licensee. Thus, the revenue received by the EO is unquestionably passive and eligible to be modified or excluded from UBI.²⁵⁵ To confuse this issue, IRC §513(h)(1)(B) excludes revenues attributable to the exchange of lists between entities eligible to receive charitable contributions.²⁵⁶

(e) Subsidiary Payments

Payments of interest, rents, royalties, or annuities excluded under the general rules are includable in UBI if paid by either a controlled taxable subsidiary or a controlled tax-exempt subsidiary. On August 5, 1997, the percentage of ownership constituting control for this purpose was reduced from 80 percent to 50 percent. The code defines control as follows:

• In the case of a corporation, ownership (by vote or value) of more than 50 percent of the stock in such corporation.
• In the case of a partnership, ownership of more than 50 percent of the profits, interests, or capital interests of the partnership.
• In any other case, ownership of more than 50 percent of the beneficial interests in the entity.

The inclusion portion of amounts received is essentially that amount of the payment that would have been taxable to the controlled organization as UBI had it not paid the interest, rent, or royalty that could be claimed as a deductible expense. For a nonexempt controlled entity, the taxable amount is equal to that portion of such entity's taxable income that would have been UBIT had it been a tax-exempt entity.

There is some uncertainty regarding the meaning of beneficial interests in a nonprofit entity. Under regulations issued before the 1997 amendment, control of a nonstock organization resulted from interlocking directors. If at least 80 percent (now read as 50) of the directors of one organization are representatives of the second organization or have the right to appoint or control the board of the second, control exists.

The attribution rules of IRC §318 apply for purposes of determining constructive ownership of stock in a corporation. Similar principles shall apply for purposes of determining ownership of interests in any other entity. Before mid-1997, amounts paid by a second-tier subsidiary were nontaxable and not subject to inclusion, because this section at that time contained no attribution or indirect ownership requirement that would treat the parent as controlling its subsidiary's subsidiary.²⁵⁷ Although not a tax issue for the tax-exempt organization itself, a financial issue that arises for an exempt organization owning a subsidiary is the so-called General Utilities doctrine. The transfer of substantially all of the assets of a taxable corporation to a tax-exempt organization (commonly, as its parent) is essentially treated as a taxable sale of the transferred assets at their fair market value.²⁵⁸ The conversion of a taxable entity to a tax-exempt one is similarly treated as a transaction in which gain must be recognized. Assets the exempt will use to conduct an unrelated business and that are transferred are not taxed at the time of transfer (because they will be taxed when eventually sold).

(f) Research

Research income is not taxable if the research is performed for the United States, its agencies, or a state or political subdivision thereof by any exempt organization.²⁵⁹ In addition:

• A college, university, or hospital can exclude all research income from private or governmental contractors.²⁶⁰
• An exempt organization performing fundamental research, the results of which are freely available to the general public, can also exclude all research income.²⁶¹

See §5.3 for discussion of the distinction between scientific research that is treated as related income and testing that is considered a commercial and unrelated enterprise.

(g) Partnerships and S Corporations

A tax-exempt organization's share of income from a partnership, regardless of whether distributed or paid to the organization, flows through to the nonprofit partner and retains its character as rent, interest, business, or other type of income.²⁶² If the partnership conducts a trade or business that is unrelated to the organization's exempt purpose, the organization's share of the business income, less associated deductions, must be reported as unrelated business taxable income. The exceptions and modifications²⁶³ pertaining to passive income apply to exclude the organization's share of interest or other passive income distributed by the partnership. This rule applies to organizations that are general and limited partners.²⁶⁴

Until January 1, 1994, distributions from publicly traded partnerships were fully taxable to the tax-exempt partner, including retirement plans. Since 1994, the partnership's income is fragmented to allow each type of income to flow through to the tax-exempt partner according to the general rule outlined previously. Thus, partnership income or loss retains its character as either taxable business income or passive investment income in the hands of the tax-exempt partner.²⁶⁵ A publicly traded partnership is one for which interests in it are traded on an established securities market or are readily tradable on a secondary market.²⁶⁶

Partnership return instructions to Form 1065 require that the entity provide sufficient information to tax-exempt partners to allow them to correctly report unrelated income items. In the authors' experience, such information sometimes is found lacking or is confusing. Financial advisors to institutional investors have created sophisticated forms of investment vehicles in recent years. Some trade securities, some buy rental buildings, some buy security hedges, and some invest venture capital. The income tax rules pertaining to the character of income earned are complex. Those that invest in real estate commonly distribute income attributable to indebted property that may be taxable.²⁶⁷

A partnership that elects to use the mark-to-market rules²⁶⁸ for securities trading reports the income on line 1 of Form K-1, “ordinary income from trade or business,” to its partners, although it actually has not realized short-term capital gain. Such income is not, therefore, treated as unrelated business income.²⁶⁹ Dividends, interest, payments with respect to securities loaned, annuities, income from a notional principal contract, or other substantially similar income from ordinary and routine investment²⁷⁰ is modified or excluded from unrelated business income. Income from the sale of property “other than stock in trade or other property of a kind which would properly be included in the inventory of the organization if on hand at the close of the tax year” is also excluded.²⁷¹ Thus, the gain or loss is specifically excluded from the computation of unrelated business income unless the partnership is a dealer in securities. Additionally, gain from the lapse or termination (sale) of options to buy or sell securities written in connection with the organization's investment activity is excluded from unrelated business income.²⁷²

Subchapter S Interests. Organizations exempt under §§501(c)(3) and 401(a) are eligible, effective for tax years beginning after December 31, 1997, to become shareholders of an S corporation.²⁷³ Stock in an S corporation, however, represents an interest in an unrelated trade or business. Unlike partnership distributions, all items of income, loss, or deduction taken into account under IRC §1366(a), and any gain or loss on disposition of the stock in the S corporation, shall be taken into account in computing the unrelated business taxable income of such organizations, including passive income otherwise modified from tax.²⁷⁴ Thus, where possible, an exempt organization's investment in an entity that will produce a significant amount of passive income should preferably be held in partnership form.

(a) Properties Not Subject to Debt-Financed Rules

The type of indebted property subject to the debt-financed rules is best defined by listing those that are not included in the term.

Exempt-Use Property. When substantially all of the actual use of real, tangible, or intangible property is substantially related to the performance of the organization's charitable, educational, or other exempt functions, the property is not subject to the debt-financed rules.²⁹⁷ The exempt purpose usage must occur at least 85 percent or more of the time. To be exempt, such use must be actually devoted to exempt activity purposes and used directly in the organization's exempt or related activities.²⁹⁸ Assume that a university borrows money and builds an office tower for its projected staff needs over a 20-year period. During the period its staff occupies less than 85 percent of the building, the non-university-use portion of the property will be treated as debt-financed and a portion of the income reportable as unrelated business income. A building rented by a foundation dedicated to medical training for a medical clinic with which it had a close relationship was found to be exempt-use property.²⁹⁹ Similarly, a building rented at below-market rates to encourage industry to enter a business development area was an exempt-use building.³⁰⁰ In what arguably was an incorrect ruling, the historic properties acquired by an educational organization promoting an appreciation of history and architecture were treated as unrelated properties for this purpose. The market rentals were found not to bear a relationship to the buildings' historical or architectural significance, nor did they accommodate viewing by the public.³⁰¹ The fact that the income from the property is needed and/or used in conducting exempt programs does not qualify the property as exempt-use property.

Property used by one or more related tax-exempt organizations is considered to be exempt usage by the related property owner. For this purpose, organizations are related if more than 50 percent of the members of one are members of the other.³⁰²

Income Otherwise Excluded. When the income from property is treated as unrelated business income for some other reason, such as hotel room rentals or royalties paid by a 50-percent-plus-owned subsidiary, the income is not treated as unrelated for this purpose. The code specifically excludes debt-financed property taxable for another reason so as to not count the income twice.³⁰³ Similarly, an indebted property used in an unrelated activity that is excluded from UBI because it is managed by volunteers; is operated for the convenience of members, students, or visitors; or is a facility for sale of donated goods, is not treated as unrelated debt-financed property.³⁰⁴ Research property producing income otherwise excluded from the UBIT is also not subject to the acquisition indebtedness taint.³⁰⁵ The following qualified organizations generally do not incur acquisition indebtedness in connection with the purchase or improvement of exempt-function property:³⁰⁶

• An educational organization that normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on, or a school as defined in §170(b)(1)(A)(ii).³⁰⁷
• A multiparent title-holding company defined in §501(c)(25).
• A pension trust described in §401.

Property financed with federal funding provided or insured by the Federal Housing Administration, if used to finance purchase, construction, or rehabilitation of residential property for low-income persons, is excluded.

A charitable gift annuity issued as the sole consideration in exchange for property worth more than 90 percent of the value of the annuity is not considered acquisition indebtedness. The annuity must be payable over the life (not for a minimum or maximum number of payments) of one or two persons alive at the time. The annuity must not be measured by the property's (or any other property's) income.

Neighborhood Land. Real property acquired for the principal purpose of, and intention for use in, conducting the organization's exempt activities within 10 years commencing from the time of acquisition is not necessarily treated as debt-financed property. This exclusion ceases to apply if the intention to devote the property to exempt purposes is abandoned before the expiration of the 10-year period. Except in the case of a church, the future exempt-use classification ceases to apply after the end of the 10-year period. The future-use time period for a church or convention or association of churches is 15 years and applies whether or not the acquired land meets the neighborhood test.³⁰⁸ At least 90 days before the end of the fifth year, a ruling request must be submitted with information to satisfy the IRS that it is reasonably certain that the land will be used for exempt purposes before the expiration of the 10-year period. Binding contracts do not necessarily have to be in place to get approval. The organization must, however, at least have definite plans with completion dates and have taken affirmative action (funding campaign, for example) toward fulfillment of the plans.³⁰⁹

Property is in the neighborhood of other property owned and used by the organization in the performance of its exempt purposes if the acquired property is contiguous with the exempt-purpose property or would be contiguous with such property except for the interposition of a road, street, railroad, stream, or similar obstruction. When the facts and circumstances make it unreasonable to acquire contiguous property, property located within one mile of existing exempt property(ies) may be treated as neighborhood land. In one situation, contiguous land was substantially developed and thereby unavailable. Three parcels one city block away were considered qualified neighborhood land because the organization planned to demolish existing structures to make way for a new building site.³¹⁰

A structure on the future-use land is excluded if the plans for the land require that the structure be demolished or removed in order to use the land for exempt purposes. This exception does not apply to structures erected on the land after the acquisition of the land, nor to property subject to a business lease.

The future-use land, not including buildings, acquired and held for use by an exempt organization within 10 years (for churches, 15 years) from the date it is acquired, and located in the neighborhood in which the organization carries out a project, is exempt from this provision. This exception applies until the plans are abandoned. After five years, the organization's plans for use must be “reasonably certain.”³¹¹

Tax status of the tenant or user is not necessarily determinative. Rental of an indebted medical office building used by staff physicians was found to be related to a hospital's purposes.³¹² Although their restoration served a charitable purpose, the rental of restored historic properties to private tenants was deemed not to serve an exempt purpose where the properties were not open to the public.³¹³ Regulations suggest that all facts and circumstances of property usage will be considered.

Property Acquired Subject to Debt. When property is acquired subject to a mortgage or similar lien at the time of acquisition, the amount of the indebtedness secured by such mortgage or lien shall be considered acquisition indebtedness. This rule applies even though the organization does not assume or agree to pay such indebtedness. Debt placed on property by a donor will be attributed to the organization when the organization agrees to pay all or part of the debt or makes any payments on the equity.³¹⁴ Liens similar to mortgages, such as a security interest under the Uniform Commercial Code, pledges, an agreement to hold title in escrow, and certain tax obligations, are also treated as acquisition indebtedness.

Bequeathed or donated property that is encumbered and subject to existing debt at the time it is given to the exempt organization is not treated as acquisition indebted property for 10 years following the date of its acquisition. Encumbered property that is donated to the organization as a gift is subject to a similar 10-year exclusion if the donor placed the mortgage on the property more than five years prior to the gift and had owned the property more than five years before the gift. In the case of both bequeathed and gifted property, there must be no assumption or agreement to pay the indebtedness secured by the mortgage. Nor can the organization make any payment for the equity in the property owned by the decedent or donor.

Transitory Debt. What the IRS calls “transitory debt” does not give rise to taxable income. Acquisition indebtedness occurs “with respect to” debt-financed property. A connection is required between the incurrence of debt and the acquisition or improvement of property. When an organization incurs indebtedness in the same transaction in which debt-financed property is acquired, the nexus between the debt and the property is apparent. However, if debt is incurred before or after the acquisition or improvement of property, then the debt is treated as acquisition indebtedness only if it would not have been incurred but for the acquisition or improvement.

For example, E, an exempt organization, pledged securities as security for a loan from a bank. The loan proceeds are used by E to purchase an office building. The building is leased to a law firm. The indebtedness was incurred before the acquisition of the office building and would not have been incurred but for the acquisition. The outstanding principal indebtedness is acquisition indebtedness, and the office building is debt-financed property.³¹⁵ Income from a short sale of publicly traded stock through a broker is not considered unrelated debt-financed income for an EO.³¹⁶ Essentially, the transaction does not involve borrowing to acquire an asset, but instead to sell. The code applies to indebtedness incurred to acquire or improve property. Though it does not seem entirely logical, the ruling describes an exempt organization that “borrows 100 shares of A stock and sells the shares.” The broker retains the sales proceeds, plus $250 cash and any income earned on the proceeds, as collateral for the organization's obligation to return the borrowed shares. Although the short sale creates an obligation, it does not create §514 acquisition indebtedness.³¹⁷

The IRS privately ruled that a partnership holding short sale positions to protect its long positions in publicly traded corporations also did not hold indebted property. Thus, the donation of a partnership interest to a private foundation was not an asset subject to indebtedness and did not result in a “bargain sale” for self-dealing purposes.³¹⁸ Because the short positions do not constitute mortgages or liens, the transfer of the limited partnership interests that are subject to short positions does not constitute an act of self-dealing.³¹⁹

The same type of reasoning may be applied to a line of credit secured by the organization's investment portfolio. For example, in the case where expected funding is delayed and the organization prefers not to sell its securities to meet its payroll or pledged grants, a line of credit may be necessary. The proceeds of a margin loan are not used to acquire an income-producing asset, but rather to provide working capital to pay for operating expenses. It could be argued that the loan is equivalent to an acquisition because it allows the organization not to sell its investments temporarily. Technically, however, no purchase occurs. The IRS labels such indebtedness “transitory” and considers it part of a “routine investment program” falling short of acquisition indebtedness.³²⁰

The IRS privately ruled that an exempt trust's short-term borrowing from a bank to cover distributions to its participants did not trigger unrelated debt-financed income, because the indebtedness was incurred not for the purpose of making investments but rather “solely for convenience in administering the Fund C's exempt function, and to minimize adverse effects [of] settlement delays.”³²¹ Similarly, an exempt organization that invested in a fund which engaged in short-term borrowing to cover distributions to its investors was not treated as receiving income from the fund subject to the acquisition indebtedness rules.³²²

(b) Other Types of Debts

The obligation to make payments to the donor in connection with a charitable remainder trust gift does not constitute a debt. When some other individual or organization is entitled to income from the property for life or another time period, a remainder interest in the property is not considered to be subject to acquisition indebtedness.³²³

Both the indebtedness incurred by a partnership and any indebtedness incurred by the organization to acquire its interest in the partnership are treated as acquisition indebtedness.³²⁴ The fact that the organization's undivided interest is legally subject to debt on the entire property was considered in one situation. Because the charity paid off its share of the mortgage and received releases of liability from the mortgages and co-owners, the remaining lien was not treated as acquisition indebtedness to the organization.³²⁵ Conversely, the borrowed funds used to purchase a mineral production payment to provide program-operating funds was acquisition indebtedness. The fact that the indebtedness was only payable out of the production with borrowed funds and the use of the net proceeds for exempt purposes did not allow exclusion of the indebtedness.³²⁶

Although investment of pension fund assets is admittedly inherent in its exempt purposes, debt-financed investments made by such a fund (or most other exempt organizations) are not inherent in a fund's purposes.³²⁷ The Southwest Texas Electric Cooperative's purchase of Treasury notes with Rural Electrification Administration (REA) loan proceeds represented a debt-financed investment. The loan proceeds were required to be used to pay construction costs. The cooperative's cash flow, however, allowed it to pay part of the construction costs with operating funds. To take advantage of a more than 4 percent spread in the REA loan and prevailing Treasury note rates, the cooperative deliberately “drew down” on the REA loan. The Tax Court agreed with the IRS that the interest income was taxable debt-financed income.³²⁸

Schools and their supporting organizations, certain pension trusts, and §501(c)(25) title-holding companies may have a special exception for indebted real property. These rules are referred to as the tax-exempt entity leasing rules. If the property is purchased in a partnership with for-profit investors, profit- and loss-sharing ratios must have substantial economic effect and not violate the disproportionate allocation rules.³²⁹ These so-called leasing rules are fully discussed in The Law of Tax-Exempt Organizations, 10th Edition.³³⁰

(c) Acquisition Indebtedness

Acquisition indebtedness is the unpaid amount of any debt incurred to acquire or improve property or any debt “reasonably foreseen” at the time of acquisition that would not have been incurred otherwise.³³¹ The test is whether the debt would have been incurred but for such acquisition or improvement.³³² An extension, renewal, or refinancing of an obligation evidencing a preexisting indebtedness is not treated as the creation of new indebtedness. Securities purchased on margin are debt financed; payments for loan of securities already owned are not. Indebtedness the incurrence of which is inherent in the performance or exercise of the organization's exempt functions is excluded. For example, the indebtedness incurred by a credit union in accepting deposits from its members is not acquisition indebtedness. Although the author finds no citation, it seems reasonable to say that margin debt borrowed against the organization's securities to pay its operating expenses is not acquisition indebtedness in relation to the securities. One could argue, however, that the margin allows the organization not to sell the securities and essentially constitutes their acquisition.

(d) Calculation of Taxable Portion

A portion of the income from property subject to acquisition indebtedness, not excludable for one of the reasons previously discussed, is taxable as unrelated business income.³³³ The taxable portion is calculated by comparing the average amount of the acquisition indebtedness for the year in relation to the average tax basis of the property. The formula for calculation of income subject to tax is as follows:

Each property subject to debt is calculated separately, with the resulting income or loss netted to arrive at the portion includable in UBI. Expenses directly connected with the property are deducted from gross revenues in the same proportion. The normal income tax rules apply to determine includable income and qualifying deductions.³³⁴

The average acquisition indebtedness equals the arithmetic average of the principal balance due on the debt at the end of each month or partial month of the tax year. The average adjusted basis is similarly calculated, adding up the net of the property cost less allowable depreciation, using the straight-line method of depreciation, on a monthly basis. The proportion-of-use test is applied to identify property used for exempt and nonexempt purposes and can be based on a comparison of the number of days used for exempt purposes with the total time the property is used, or on the basis of square footage used for each, or on relative costs.³³⁵

The formula for calculating the portion of taxable capital gain or loss on the sale of the property is different in one respect. The average value of indebtedness (the numerator) is equal to the highest amount of indebtedness during the full year preceding sales, rather than the number of months the property was held during the tax year being used as the numerator.

(a) Identifying Related and Unrelated Objects

After the IRS and museums argued for 10 years about the relatedness of a wide variety of objects sold, four exhaustive private rulings were issued in 1983 and are still followed.³⁴⁰ The primary concern for a museum is to identify the relatedness of each object sold in its shops and to segregate any unrelated sales. The connection between the item sold and achievement of the museum's exempt purpose is evidenced by the facts and circumstances of each object and the policy of the curatorial department in identifying, labeling, and categorizing objects on public view, reproductions of which are made and sold. The rulings direct that each object be examined to prove that the items being sold have educational value. The following factors are to be considered in designating an item as related or unrelated:

• Interpretive material describing an artistic, cultural, or historical relationship to the museum's collection or exhibits provided to buyer.
• Nature, scope, and motivation for the sales activity.
• Whether sales are solely for production of income, or are an activity to enhance visitor awareness of art.
• Curatorial supervision in choosing related items.
• Reproductions of objects in the particular museum or in other collections, including prints, slides, posters, postcards, and greeting cards, are generally exempt.
• Adaptations, including imprinted utilitarian objects such as dishes, ashtrays, and clothing, must be accompanied by interpretive materials and must depict objects or identify an exhibition. Objects printed with logos were deemed unrelated, although in practice, the IRS has been lenient.
• Souvenirs and convenience items are generally unrelated unless imprinted with reproductions or promoting a particular event or exhibition. Souvenirs promoting the town in which the museum is located are not considered related to the museum's purposes.
• Toys and other teaching items for children are deemed inherently educational and therefore related.³⁴¹

(b) Original Works of Art

Original works of art created by living (or deceased) artists and sold by museums are considered unrelated by the IRS. They think it is inconsistent with the purpose of exhibiting art for public benefit to deprive the public of the opportunity of viewing the art by selling it. This opinion is questioned by some, and readers may observe that original works are routinely sold by museums and art centers. In one instance the authors are aware of, the IRS approved the sale of craft items by a craft museum as an educational activity. Thus, a museum that sells, or is considering the sale of, original works of art in its gift shop or bookstore has no absolute clear guidance in deciding whether such sales are related or unrelated to its exempt purposes. Unquestionably, when the sales activity is undertaken simply to raise funds, the sales are unrelated. Whether the items sold promote an exempt purpose may be difficult to determine, as the first two of the following citations indicate.

• A cooperative art gallery established to encourage individual emerging artists was not allowed to qualify as an exempt organization because, in the IRS's opinion, the interests of the general public were not served by promoting the careers of individual artists. The art sales were deemed to serve no exempt purpose and constituted UBI. Because the organization was supported entirely by UBI from the sales of art of the artists, it was not exempt.³⁴²
• A community art center located in an isolated area with no commercial galleries conducted classes and a complex of educational activities. The Tax Court decided that its sales of original art exhibited in the center were related to exempt purposes based on the fact that no other cultural center existed in the county, the art sales were not the center's sole source of support, and public art education was facilitated by using juries to ensure artistic quality and integrity of items for sale.³⁴³
• An unrelated gallery managed by volunteers and/or selling donated works of art produces unrelated income, but the income is not taxable because of exceptions. Exempt status can depend on whether the gallery is a substantial part of the organization's activities. A gallery exclusively selling works of its members is denied exemption because it solely benefits its members.³⁴⁴ See §21.3 for consequences of receiving such income.

(a) Advertising

Revenue received from the sale of advertising in an otherwise exempt publication is considered business income under the tax code and is taxed unless:³⁵¹

• The publication schedule or ad sale activity is irregularly carried on.
• The advertising is sold by volunteers.
• The advertising activity is related to one of the organization's underlying exempt purposes, such as ads sold by college journalism students or trainees.
• The ads do not contain commercial material, appear essentially as a listing without significant distinction among those listed, and represent acknowledgment of contributors or sponsors.
• The content of the advertisement is not quantitative or qualitative and thereby qualifies as a permissible acknowledgment of a sponsor.³⁵²

The IRS has continually taken the position that advertising sold using the exempt organization's name is unrelated activity, despite creative contracts attributing the activity to an independent commercial firm.³⁵³

(b) Readership versus Ad Lineage Costs

Even if ad revenue is classified as unrelated business income, the tax consequence is limited by the portion of the readership and editorial costs allowed as deductions against the ad revenue. The important question is what portion of the expense of producing and distributing the publication can be allocated against the revenue.³⁵⁴ It is helpful first to study Exhibit 21.5, Calculating the Taxable Portion of Advertising Revenue, a worksheet reflecting the order in which readership and editorial costs versus advertising costs are allocated.³⁵⁵

The formula prorates deductions in arriving at taxable advertising income. Publication costs are first divided into two categories: direct advertising and readership. Because readership costs are exempt-function costs, under the exploitation rule they theoretically should not be deductible at all against the UBI income. In a limited exception, the regulations allow readership costs in excess of readership income to be deducted against advertising income. In other words, advertising revenues can be offset with a readership loss. Arriving at a readership loss, however, means the publication's underlying production costs must be more than its revenues.

(c) Circulation Income

Circulation income is income attributable to the production, distribution, or circulation of a periodical (other than advertising revenue), including sale of reprints and back issues.³⁵⁶ When members receive an organization's publication as a part of their basic membership fee, a portion of the member dues is allocated to circulation income. Other types of member income, such as educational program fees or convention registration, are not allocated.³⁵⁷ When the publication is given free to members but is sold to nonmembers, a portion of the members' dues is allocated to readership revenue. The formula requires allocation of a hypothetical portion of the dues, as illustrated in the calculation. Free copies given to nonmembers have been subject to controversy with the IRS. If the organization has more than one publication, the IRS and the courts disagree on the denominator of the fraction for calculation of allocable exempt function costs.³⁵⁸ In a 2011 case involving the National Education Association (NEA), the Tax Court agreed with the IRS that a portion of member dues was allocable to its publication for purposes of calculating the tax on unrelated advertising revenues. Dues notices disclosed the amount of the dues separately attributable to the magazine and said that receipt of the magazine was a benefit of membership and, according to the court, a legal right. The fact that the publication was available to the public on the NEA Internet site for free did not negate attribution of dues to the publication.³⁵⁹

(d) Commercial Publication Programs

A publication program can be considered a commercial venture, despite its educational content. Distinguishing characteristics are found by examining the organization's motivation and management decisions. Characteristics found to evidence a commercial nature include:

• Presence of substantial profits. Accumulation of profits over a number of years evidences a commercial purpose. The mere presence of profits, by itself, does not bar exemption,³⁶⁰ but other factors will be considered. For what purpose are profits being accumulated? Do the reserves represent a reasonable amount of working capital or a savings account for future expansion plans?
• Pricing methods. The method of pricing books or magazines sold yields significant evidence of commercial taint. Pricing at or below an amount calculated to cover costs shows nonprofit motive. Pricing below comparable commercial publications is not required, but certainly can evidence an intention to encourage readership and to educate, rather than to produce a profit.
• Other factors. Other factors can show commerciality:
  • Aggressive commercial practices resembling those undertaken by commercial publishers³⁶¹
  • Substantial salaries or royalties paid to individuals
  • Distribution by commercial licensers
• Nonprofit publications. By contrast, nonprofit and noncommercial publications³⁶²
  • Rely on volunteers and/or pay modest wages.
  • Sell some unprofitable books and magazines.
  • Prepare and choose materials according to educational methods, not commercial appeal.
  • Donate parts of press runs to other exempt organizations or members.
  • Balance deficit budgets with contributions.

A Christian school publishing program, for example, was treated as an unrelated activity despite the educational nature of the books it sold.³⁶³ Although the program had significant commercial attributes—more than 1,200 titles produced on presses that ran 16 hours a day and sold throughout the world—the IRS said that two particular characteristics caused it to consider the activity as unrelated:

1. The methods used in selling the textbooks are indistinguishable from ordinary commercial sales practices.
2. Fifty percent of the school's highly compensated employees were sales representatives.

The IRS provided some useful criteria for deciding what constitutes a periodical in a 1994 private ruling.³⁶⁴ The definition is important because that portion of membership dues allocated to published periodicals is treated as taxable unrelated income. An educational organization devoted to the study of reproduction distributed a variety of publications, some of which were deemed periodicals and others of which were not. A quarterly newsletter and annual meeting programs distributed to members were periodicals for the following reasons:

• Each was published at regular recurring intervals.
• The right to receive the publication was associated with membership or similar status in the organization for which dues, fees, or other charges were received (even though nonmembers may also receive the publication).
• Each contained editorial materials related to the accomplishment of the organization's exempt purposes, in this case, publicizing scientific developments in the field, technical articles, and reports of annual meetings.
• The newsletter was part of an ongoing series, with each issue indicating its relation to prior or future issues; it contained a regular feature column, president's message, and reports of organizational meetings and activities.
• With respect to the advertising portion of the publications, the purpose was the production of income.