(a) General Principles

The statutory definition of the term trade or business, used for unrelated business law purposes, states that it includes “any activity which is carried on for the production of income from the sale of goods or the performance of services.”³⁵ This definition is sweeping and encompasses nearly every activity that a tax-exempt organization may undertake. Indeed, the federal tax law views an exempt organization as a cluster of businesses, with each discrete activity susceptible to evaluation independently from the others.³⁶

The definition of the term trade or business, however, also embraces an activity that otherwise possesses the characteristics of a business as that term is defined by the federal income tax law in the business expense deduction setting.³⁷ This definition, then, is even more expansive than the statutory one, being informed by the considerable body of law as to the meaning of the word business that has accreted in the federal tax law generally.

There is a third element to consider in this regard, stemming from the view that, to constitute a business, an income-producing activity of a tax-exempt organization must have the general characteristics of a trade or business. Some courts of appeals have recognized that an exempt organization must carry out extensive business activities over a substantial period of time to be considered engaged in a trade or business.³⁸ In one case, a court held that the proceeds derived by an exempt organization from gambling operations were not taxable as unrelated business income, inasmuch as the organization's functions in this regard were considered insufficiently “extensive” to warrant treatment as a business.³⁹ In another instance, the receipt of payments by an exempt association pursuant to involvement in insurance plans was ruled to not constitute a business because the association's role was not extensive and did not possess the general characteristics of a trade or business.⁴⁰ This aspect of the analysis, however, is close to a separate test altogether, which is whether the business activities are regularly carried on.⁴¹

Where an activity carried on for profit constitutes an unrelated business, no part of the business may be excluded from classification as a business merely because it does not result in profit.⁴²

(b) Requirement of Profit Motive

The most important element in the federal tax law as to whether an activity is a trade or business, for purposes of the business expense deduction (aside from the underlying statutory definition), is the presence of a profit motive. The courts have exported the profit objective standard into this aspect of the law of tax-exempt organizations.

The Supreme Court held that the principal test in this regard is that the “taxpayer's primary purpose for engaging in the activity must be for income or profit.”⁴³ In the tax-exempt organizations context, the Court said that the inquiry should be whether the activity “was entered into with the dominant hope and intent of realizing a profit.”⁴⁴ An appellate court stated that the “existence of a genuine profit motive is the most important criterion for…a trade or business.”⁴⁵

Various federal courts of appeal have applied the profit motive element to ascertain whether an activity of a tax-exempt organization is a business for purposes of the unrelated business rules. For example, an appellate court employed an objective profit motivation test to ascertain whether an exempt organization's activity is a business. This court wrote that “there is no better objective measure of an organization's motive for conducting an activity than the ends it achieves.”⁴⁶ Subsequently, this court held that an activity of an exempt organization was a business because it “received considerable financial benefits” from performance of the activity, which was found to be “persuasive evidence” of a business endeavor.⁴⁷ On this latter occasion, the court defined as a business the situation where a “nonprofit entity performs comprehensive and essential business services in return for a fixed fee.”⁴⁸ Thereafter, this appellate court wrote simply that for an activity of a tax-exempt organization to be a business, it must be conducted with a “profit objective.”⁴⁹ Another appellate court observed that an insurance company's payments to an exempt association were not taxable, in that “it does not matter whether the payments were brokerage fees, gratuities, to promote goodwill, or interest,” since the association was not engaging in business activity for a profit.⁵⁰ Other courts of appeals have adopted this profit motive test.⁵¹

A court concluded, in the case of a tax-exempt labor union⁵² that collected per capita taxes from unions affiliated with it, that, other than the services the union provided its members and affiliated unions in furtherance of its exempt purposes, the union “provide[d] no goods or services for a profit and therefore cannot be [engaged in] a trade or business.”⁵³

The IRS applies the profit motive test in this context. In one example, a tax-exempt health care provider sold a building to another provider organization; it was used to operate a skilled nursing and personal care home. The selling entity provided food service to the patients for about seven months, at a net loss; the IRS characterized the food service operation as merely an “accommodation” to the purchasing entity.⁵⁴

On another occasion, the IRS concluded that, although the development of a housing project and sales of parcels of land was an unrelated business of an exempt planned community, the provision of water, sewer, and garbage services in conjunction with the project lacked a profit motive, so that the income received for the services was not taxable as unrelated business income.⁵⁵ The IRS ruled that a tax-exempt college or university is not engaged in an unrelated business when it enables charitable remainder trusts,⁵⁶ as to which it is trustee and remainder interest beneficiary, to participate in the investment return generated by the institution's endowment fund, inasmuch as the institution is not receiving any economic return by reason of the arrangement.⁵⁷ Likewise, the IRS held that the sharing of money, assets, and personnel among supported organizations and the supporting organization⁵⁸ did not amount to a form of business regularly carried on for the production of income.⁵⁹

(c) Competition

The presence or absence of competition—fair or unfair—is not among the criteria applied in assessing whether an activity of a tax-exempt organization is an unrelated business. This is the case notwithstanding the fact that concern about competition between exempt and for-profit organizations is the principal reason for and underpinning of the unrelated business rules.⁶⁰

Thus, an activity of a tax-exempt organization may be wholly noncompetitive with an activity of a for-profit organization and nonetheless be an unrelated business. For example, in an opinion finding that the operation of a bingo game by an exempt organization was an unrelated business, a court wrote that the “tax on unrelated business income is not limited to income earned by a trade or business that operates in competition with taxpaying entities.”⁶¹ Yet, in a case concerning an exempt labor union that collected per capita taxes from unions affiliated with it, a court concluded that the imposition of these taxes, which enabled the union to perform its exempt functions, “simply is not conducting a trade or business,” in part because the union was not providing any services in competition with taxable entities.⁶²

(d) Commerciality

Where there is competition, a court may conclude that the activity of a tax-exempt organization is being conducted in a commercial manner⁶³ and thus is an unrelated business. For example, the operation of a television station by an exempt university was held to be an unrelated business because it was operated in a commercial manner; the station was an affiliate of a national television broadcasting company.⁶⁴

Historically, the IRS has used the commerciality doctrine in assessing an organization's qualification for tax-exempt status; the doctrine was not used to ascertain the presence of an unrelated business. This approach is changing, however, with the IRS employing the doctrine in rationalizing that a business is an unrelated one. For example, the operation of an eating facility that helped attract visitors to a tax-exempt museum was held by the IRS to contribute importantly to the accomplishment of the museum's exempt purposes and thus constitute a related business.⁶⁵ Yet, subsequently, the IRS ruled that a tearoom operated by an exempt organization in conjunction with a consignment shop and a gift shop was a nonexempt function because of competition with commercial restaurants and the use of profit-making pricing formulas and advertising.⁶⁶ Indeed, on one occasion, the IRS ruled that an exempt organization was engaged in an unrelated business, determining that the business was unrelated by solely applying the commerciality doctrine.⁶⁷

(e) Charging of Fees

Many tax-exempt organizations charge fees for the services they provide; where the business generating this revenue is a related one, the receipts are characterized as exempt function revenue.⁶⁸ Universities, colleges, hospitals, museums, planetariums, orchestras, and like institutions generate exempt function revenue without adverse impact as to their exempt status.⁶⁹ Organizations such as medical clinics, homes for the aged, and blood banks impose charges for their services and are not subject to unrelated income taxation (or deprived of exemption) as a result.⁷⁰ Indeed, the IRS, in a ruling discussing the tax status of homes for the aged as charitable organizations, observed that the “operating funds [of these homes] are derived principally from fees charged for residence in the home.”⁷¹ Similarly, the IRS ruled that a nonprofit theater may charge admission for its performances and nonetheless qualify as an exempt charitable organization.⁷² Other fee-based exempt charitable entities include hospices,⁷³ organizations providing specially designed housing for the elderly,⁷⁴ and organizations providing housing for the disabled.⁷⁵ Moreover, for some types of publicly supported charities, exempt function revenue is regarded as support enhancing public charity status.⁷⁶ Several categories of exempt organizations, such as business associations, unions, social clubs, fraternal groups, and veterans' organizations, are dues-based entities.

Yet the receipt of fee-for-service revenue is repeatedly regarded by the IRS as evidence of the conduct of an unrelated business. In one instance, the IRS opposed tax exemption for nonprofit consumer credit counseling agencies. The IRS sought to deny these agencies exempt status on the ground that they charged a fee for certain services, even though the fee was nominal and waived in instances of economic hardship. This effort was rebuffed in court.⁷⁷ Thereafter, the IRS's Office of Chief Counsel advised that if the “activity [of consumer credit counseling] may be deemed to benefit the community as a whole, the fact that fees are charged for the organization's services will not detract from the exempt nature of the activity” and that the “presence of a fee is relevant only if it inhibits accomplishment of the desired result.”⁷⁸ (Earlier, the Chief Counsel's office wrote that the fact that a charitable organization charges a fee for a good or service “will be relevant in very few cases,” that the “only inquiry” should be whether the charges “significantly detract from the organization's charitable purposes,” and that the cost issue is pertinent only where the activities involved are commercial in nature.⁷⁹) At about the same time, the IRS ruled that an organization that is operated to provide legal services to indigents may charge, for each hour of legal assistance provided, a “nominal hourly fee determined by reference to the client's own hourly income.”⁸⁰

In recent years, the IRS has become quite adamant, albeit inconsistent, on this point. Frequently, the agency will take the position that the charging of fees is evidence of substantial commercial activity or purpose,⁸¹ thus precluding exemption as a charitable entity.⁸² An organization was denied recognition of exemption as a charitable and educational entity because it charged “substantial fees,”⁸³ even though the federal tax law does not preclude exemption on that basis. A consumer care organization was denied recognition of exemption in part because of its “funding mechanism,” cast by the IRS as “essentially a fee-for-service structure similar to the manner in which for-profit businesses charge their clients in proportion to the services they receive.”⁸⁴ Yet the agency held that the sale of grantmaking services by a community foundation to charitable organizations in its community was a related business, notwithstanding the fact that the foundation charged a fee, based on staff hourly rates, for its services.⁸⁵

There have been instances where the IRS determined that an organization is charitable in nature, and thus tax-exempt, because it provides services that are free to the recipients. This is, however, an independent basis for finding a charitable activity, usually invoked where the services, assistance, or benefits provided are not inherently charitable in nature. In one instance, a computer services sharing organization was ruled to be an exempt charitable organization because the IRS concluded that the services provided to the participating institutions of higher education were charitable as advancing education; no requirement was imposed that the services be provided without charge.⁸⁶ In another instance, a similar organization was found to be charitable even though the services it rendered to the participating educational institutions were regarded as nonexempt functions (being “administrative”); the distinguishing feature was that the organization received less than 15 percent of its financial support from the colleges and universities that received the services.⁸⁷

(f) Fragmentation Rule

The IRS has the authority to tax net income from an activity as unrelated business taxable income where the activity is an integral part of a cluster of activities that is in furtherance of a tax-exempt purpose. To ferret out unrelated business, the IRS regards an exempt organization as a bundle of activities and evaluates each of the activities in isolation to determine if one or more of them constitute a trade or business. This assessment process is known as fragmentation.

The fragmentation rule states that an “activity does not lose identity as trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purpose of the organization.”⁸⁸ Thus, as noted, the IRS is empowered to fragment the operations of a tax-exempt organization, operated as an integrated whole, into its component parts in search of one or more unrelated businesses.

The fragmentation rule was fashioned to tax the net income derived by a tax-exempt organization from the soliciting, selling, and publishing of commercial advertising, even where the advertising is published in a publication of an exempt organization that contains editorial matter related to the exempt purposes of the organization.⁸⁹ That is, the advertising functions constitute an unrelated business even though the overall set of publishing activities amounts to one or more related businesses; the advertising is an integral part of the larger publication activity.⁹⁰

Applications of the fragmentation rule abound. A tax-exempt blood bank, which sold blood plasma to commercial laboratories, was found by the IRS to not be engaging in unrelated business when it sold by-product plasma and salvage plasma, because these plasmas were produced in the conduct of related businesses, but was ruled to be engaged in unrelated business when it sold plasmapheresed plasma and plasma it purchased from other blood banks.⁹¹ An exempt organization, whose primary purpose was to retain and stimulate commerce in the downtown area of a city where parking facilities were inadequate, was ruled to be engaged in related businesses when it operated a fringe parking lot and shuttle service to the downtown shops, and an unrelated business by conducting a park-and-shop plan.⁹²

Likewise, the use of a tax-exempt university's golf course by its students and employees was ruled to not be unrelated businesses, while use of the course by alumni of the university and major donors to it was found to be unrelated businesses.⁹³ The fragmentation rule was applied to differentiate between related and unrelated travel tours conducted by an educational and religious organization.⁹⁴ An exempt charitable organization was held to be a dealer in certain parcels of real property and thus engaged in unrelated business with respect to those properties, even though the principal impetus for the acquisition and sale of real property by the organization was achievement of exempt purposes.⁹⁵ An exempt monastery whose members made and sold caskets was ruled to be engaged in a related business as long as the caskets were used in funeral services conducted by churches that were part of the religious denomination supporting the monastery, but was held to be conducting an unrelated business where the caskets were used in services conducted by other types of churches.⁹⁶ An exempt organization established to benefit deserving women, in part by enabling them to sell foodstuffs and handicrafts, was held to operate a consignment shop as a related business, but a retail gift shop and a small restaurant were found to be unrelated businesses.⁹⁷ The IRS ruled that the sale of grantmaking services by a community foundation⁹⁸ to charitable organizations, principally small private foundations in its community, was a related business, although sales of administrative and clerical services to them were held to be unrelated businesses.⁹⁹

(g) Nonbusiness Activities

Not every activity of a tax-exempt organization that generates a financial return is a trade or business for purposes of the unrelated business rules. As the Supreme Court observed, the “narrow category of trade or business” is a “concept which falls far short of reaching every income or profit making activity.”¹⁰⁰ Specifically in the exempt organizations context, an appellate court wrote that “there are instances where some activities by some exempt organizations to earn income in a noncommercial manner will not amount to the conduct of a trade or business.”¹⁰¹

The most obvious of the types of nonbusiness activities is the management by a tax-exempt organization of its own investment properties. Under the general rules concerning the business expense deduction defining business activity, the management of an investment portfolio composed wholly of the manager's own securities and other assets does not constitute the carrying on of a trade or business. The Supreme Court held that the mere derivation of income from securities and other assets and keeping of related records is not the operation of a business.¹⁰² On that occasion, the Court sustained the government's position that “mere personal investment activities never constitute carrying on a trade or business.”¹⁰³ Subsequently, the Court stated that “investing is not a trade or business.”¹⁰⁴ Likewise, a court of appeals observed that the “mere management of investments…is insufficient to constitute the carrying on of a trade or business.”¹⁰⁵

This principle of law is applicable in the tax-exempt organizations context. For example, the IRS ruled that the receipt of income by an exempt employees' trust from installment notes purchased from the employer-settlor was not income from the operation of a business, noting that the trust “merely keeps the records and receives the periodic payments of principal and interest collected for it by the employer.”¹⁰⁶ Likewise, the agency held that a reversion of funds from a qualified plan to a charitable organization did not “possess the characteristics” required for an activity to qualify as a business.¹⁰⁷ For a time, there was controversy over whether the practice, engaged in by some tax-exempt organizations, of lending securities to brokerage houses for compensation was an unrelated business; the IRS ultimately arrived at the view that securities lending is a form of “ordinary or routine investment activities” and thus is not a business.¹⁰⁸ A court held that certain investment activities conducted by a charitable organization were not businesses.¹⁰⁹

Other similar activities do not rise to the level of a business. In one instance, a tax-exempt association of physicians was held to not be taxable on certain payments it annually received by reason of its sponsorship of group insurance plans that were available to its members and their employees, with the court writing that the payments “were neither brokerage fees nor other compensation for commercial services, but were the way the parties decided to acknowledge the…[association's] eventual claim to the excess reserves while…[the insurance company involved] was still holding and using the reserves.”¹¹⁰ In another case, an exempt dental society that sponsored a payment plan to finance dental care was held to not be taxable on refunds for income taxes and interest on amounts paid as excess reserve funds from a bank and as collections on defaulted notes.¹¹¹ A comparable position was taken by a court in concluding that an exempt organization did not engage in an unrelated business by making health insurance available to its members, in that the organization did not control the financial result of the insurance activities.¹¹²

In still another case, a court held that the proceeds derived by a tax-exempt organization from gambling operations were not taxable as unrelated business income, in that the economic activity did not constitute a business.¹¹³ The operations involved the use of “tip jars,” with the exempt organization's role confined to applying for gambling permits and purchasing the tip-jar tickets; the significant and substantial portion of the gambling activities was the sale of the tickets at participating taverns. The exempt organization's functions in this regard were considered insufficiently “extensive” to warrant treatment as a business.¹¹⁴

(h) Real Estate Development Activities

Tax-exempt organizations acquire real property, by purchase or contribution, for a variety of reasons, usually to advance exempt purposes or for investment. There may come a time when an exempt organization decides to maximize its value of the property by selling or developing it. A federal tax issue in this context is whether the organization is liquidating the investment, resulting in capital gain,¹¹⁵ or selling property in the ordinary course of business, as a dealer, resulting in ordinary income that is often regarded as unrelated business income.¹¹⁶

The elements to take into account in this evaluation are many. One is the purpose for which the property was acquired. Others are the purpose for which it was held; the length of time it was held; the proximity of the sale to the purchase of the property; the activities of the exempt organization in improving and disposing of the property; and the frequency, continuity, and size of the sales of the property.¹¹⁷

In the absence of use of the property for exempt functions, the factor of frequency of sales tends to be the most important of the criteria.¹¹⁸ Even in this context, the activity may not be characterized as a business if the sales activity results from unanticipated, externally introduced factors that make impossible the continued preexisting use of the property. The IRS places emphasis on the presence of and the reasons for improvements on the land.

The standard followed in making these determinations, as to whether property is held primarily for sale in the ordinary course of business or is held for investment, is a primary purpose test. In this setting, the word primary has been interpreted to mean “of first importance” or “principally.”¹¹⁹ By this standard, the IRS ruled, ordinary income would not result unless a “sales purpose” is “dominant.”¹²⁰

In a typical instance, the IRS accorded capital gain treatment to the sale of real estate by a public charity, where the property had been acquired by bequest and held for a significant period, and where there was no advertising of the transaction.¹²¹ Likewise, a public charity sold a parcel of unimproved real estate, preceded by improvements mandated by a city; the IRS ruled that the organization made a “passive and gradual” disposition of the property, with the sales proceeds not taxable as unrelated business income.¹²² The IRS reached the same conclusion in connection with a “liquidity challenged” charitable trust that wanted to sell leased fee interests in three condominium properties; the underlying land had been acquired by gift nearly 100 years beforehand, and most of it had been maintained to produce rental income in support of the trust's exempt activities.¹²³ Thus, the ideal circumstances—for preservation of the capital gains exclusion—are acquisition of the real estate by gift or devise, a long holding period, little or no development of the property, little or no marketing of the availability of the property, and a valid reason for its sale.¹²⁴ Occasionally, land development and sales are activities in furtherance of an exempt purpose.¹²⁵

Even if the primary purpose underlying the acquisition and holding of real property is advancement of exempt purposes, the IRS may apply the fragmentation rule¹²⁶ in search of unrelated business. As the IRS stated the matter in one instance, a charitable organization “engaged in substantial regularly carried on unrelated trade [or] business as a component of its substantially related land purchase activity.”¹²⁷

(i) Occasional Sales

Another illustration of a transaction involving a tax-exempt organization that is not a business undertaking is the occasional sale of an item of property. For example, the IRS held that a sale of property by an exempt entity was not under circumstances where the property was held primarily for sale to customers in the ordinary course of business.¹²⁸ Similarly, a one-time transfer of assets by a group insurance trust affiliated with an exempt association to its supporting organization, triggered by the unexpected demutualization of an insurance company, was ruled by the IRS to not cause unrelated business income taxation.¹²⁹ By contrast, as noted, the subdivision, development, and sale of real estate parcels by an exempt organization was held by the IRS to be a business carried on in a manner similar to the activities of for-profit residential land development companies.¹³⁰ This aspect of the law, however, is closely analogous to the regularly carried on test.¹³¹

(j) Concept of Investment Plus

Activities that solely (or perhaps substantially) give rise to passive income, usually investment income, are generally not considered active businesses and thus not unrelated businesses.¹³² A set of activities may, of course, entail more than passive investing and thus are considered one or more businesses. This concept has been dubbed by a court investment plus.

A federal court of appeals held that a private equity fund was engaged in a trade or business as that phrase is applied in the context of the multiemployer pension termination liability law.¹³³ This definition of the term trade or business may be applicable in the unrelated business setting, serving as a reminder that activities that go beyond conventional investing can be considered, for federal tax purposes, a business.

The appellate court concluded that at least one private equity fund, which operated a business (through layers of fund-related activities), was not merely a passive investor but was “sufficiently operated, managed, and was advantaged by its relationship with its portfolio company,”¹³⁴ a business that became bankrupt. The court characterized the funds' activities, engaged in once they acquired controlling interests in struggling companies (called “portfolio companies”), as “implement[ing] restructuring and operational plans, build[ing] management teams, becom[ing] intimately involved in company operations, and otherwise caus[ing] growth in the portfolio companies in which the [funds] invest.”¹³⁵

As the court observed, these funds “engaged in a particular type of investment approach, to be distinguished from mere stock holding or mutual fund investments.”¹³⁶ The court found that “[n]umerous individuals with affiliations to various [funds'] entities…exerted substantial operational and managerial control over [the company], which at the time of the acquisition had 208 employees and continued as a [manufacturing] trade or business.”¹³⁷

In the unrelated business area, two Supreme Court opinions stand for the proposition that mere investing is not a trade or business.¹³⁸ The funds relied on these opinions in asserting that they were only investing, not engaging in business activities. But the court invoked an investment plus test. Under this test, more than investing with the objective of making a profit is needed to cause a set of activities to be a business. In this case, the appellate court held, the funds are “actively involved in the management and operation of the companies in which they invest.”¹³⁹

Thus, as noted, this opinion should be instructive to tax-exempt organizations with large endowment funds, private foundations, and the like, in that what may appear to be mere investing (a passive undertaking) can be more than that. Where there is a form of investment plus, the bundle of activities may, for tax law purposes, be considered an active business, which is to say an unrelated business.

(a) General Principles

In determining whether a trade or business from which a particular amount of gross income is derived by a tax-exempt organization is regularly carried on,¹⁴⁰ regard must be had to the frequency and continuity with which the activities productive of the income are conducted and the manner in which they are pursued. This requirement is applied in light of the purpose of the unrelated business income rules, which is to place tax-exempt organization business activities on the same tax basis as the nonexempt business endeavors with which they compete.¹⁴¹ Thus, for example, specific business activities of a tax-exempt organization will ordinarily be deemed to be regularly carried on if they manifest a frequency and continuity and are pursued in a manner generally similar to comparable commercial activities of nonexempt organizations.¹⁴²

For example, the IRS ruled that a tax-exempt organization that published a yearbook for its membership was regularly engaging in unrelated business because, by means of a contract with a commercial firm, it was “engaging in an extensive campaign of advertising solicitation” and thus to be conducting “competitive and promotional efforts typical of commercial endeavors.”¹⁴³ By contrast, an exempt health care organization that developed a series of computer programs concerning management and administration, and sold some of the programs to another health care entity, was ruled to have engaged in a “one-time only operation,” so that the sales proceeds were not taxable as unrelated business income.¹⁴⁴ Similarly, a commission received by a public charity's chief executive, functioning as its agent, was held to be a “one-time, unique event,” so that the brokerage activity that generated the income was not regularly carried on and the commission thus was not taxable as unrelated business income.¹⁴⁵ Also, the sale of software by an exempt church did not give rise to unrelated income because it was not a “continuous and consistent income-producing activity” inasmuch as the church “performed or carried on this activity once.”¹⁴⁶ Likewise, the transfer of investment assets from an exempt organization to its supporting organization¹⁴⁷ is exempt from unrelated business taxation under this rule,¹⁴⁸ as is the infrequent sale of parcels of real estate.¹⁴⁹

(b) Determining Regularity

Where income-producing activities are of a kind normally conducted by nonexempt organizations on a year-round basis, the conduct of the activities by a tax-exempt organization over a period of only a few weeks does not constitute the regular carrying on of a business.¹⁵⁰ For example, the operation of a sandwich stand by a hospital auxiliary organization for two weeks at a state fair is not the regular conduct of a business.¹⁵¹ The conduct of year-round business activities for one day each week, such as the operation of a commercial parking lot once a week, however, constitutes the regular carrying on of a business.¹⁵²

If income-producing activities are of a kind normally undertaken by nonexempt commercial organizations only on a seasonal basis, the conduct of the activities by a tax-exempt organization during a significant portion of the season ordinarily constitutes the regular conduct of a business.¹⁵³ For example, the operation of a track for horse racing for several weeks in a year is the regular conduct of a business where it is usual to carry on the business only during a particular season.¹⁵⁴ Likewise, where a distribution of greeting cards celebrating a holiday was deemed to be an unrelated business, the IRS measured regularity in terms of that holiday's season.¹⁵⁵

In determining whether intermittently conducted activities are regularly carried on, the manner of conduct of the activities must, as noted, be compared with the manner in which commercial activities are normally pursued by nonexempt organizations.¹⁵⁶ In general, tax-exempt organization business activities that are engaged in only discontinuously or periodically will not be considered regularly carried on if they are conducted without the competitive and promotional efforts typical of commercial endeavors.¹⁵⁷ As an illustration, the publication of advertising in programs for sports events or music or drama performances will not ordinarily be deemed to be the regular carrying on of a business.¹⁵⁸ Conversely,¹⁵⁹ where the nonqualifying sales are not merely casual but are systematically and consistently promoted and carried on by the organization, they meet the requirement of regularity.

The functions of a service provider with which a tax-exempt organization has contracted may be attributed to the exempt organization for these purposes. This is likely to be the case where the contract denominates the service provider as an agent of the exempt organization, in that the activities of an agent are attributed to the principal for law analysis purposes. In such a circumstance, the time expended by the service provider is attributed to the exempt organization for purposes of determining regularity.¹⁶⁰

Noncompetition under a covenant not to compete, characterized as a “onetime agreement not to engage in certain activities,” is not a taxable business inasmuch as the “activity” is not “continuous and regular.”¹⁶¹

(c) Preparatory Time

The IRS occasionally asserts that the time expended by a tax-exempt organization in preparing for the conduct of an unrelated business must be taken into account in assessing whether the activity is regularly carried on, even if the event itself occurs only one or two days a year.¹⁶² In one instance, an exempt organization sponsored a concert series occupying two weekends each year; the preparatory time (including ticket sales) per concert, which usually occupied up to six months, was held by the IRS to be the basis for holding that the concerts were unrelated businesses that were regularly carried on.¹⁶³

This preparatory time argument, however, has been rejected in court.¹⁶⁴ In the principal case, a federal court of appeals held that the argument is inconsistent with the tax regulations, which do not mention the concept. This court referenced the example concerning operation of a sandwich stand at a state fair,¹⁶⁵ denigrating the thought that preparatory time should be taken into consideration, observing that the regulations “do not mention time spent in planning the activity, building the stand, or purchasing the alfalfa sprouts for the sandwiches.”¹⁶⁶

Application of the preparatory time rule does not, however, always lead to the conclusion by the IRS that the activity is an unrelated business. For example, an exempt organization engaged in substantial year-round promotional activities for an annual literacy event held during the weekends of two months; the IRS ruled that, inasmuch as the event was substantially related to the organization's exempt purpose, the revenue involved was not subject to the unrelated business income tax.¹⁶⁷

(a) General Principles

A trade or business is related to tax-exempt purposes of a tax-exempt organization only where the conduct of the business activity has a causal relationship to the achievement of an exempt purpose (again, other than through the production of income); it is substantially related only if the causal relationship is a substantial one.¹⁷² Thus, for the conduct of a business from which a particular amount of gross income is derived to be substantially related to exempt purposes, the production or distribution of the goods or the performance of the services from which the gross income is derived must contribute importantly to the accomplishment of these purposes.¹⁷³ A court wrote that resolution of the substantial relationship test requires an examination of the “relationship between the business activities which generate the particular income in question…and the accomplishment of the organization's exempt purposes.”¹⁷⁴

Certainly, gross income derived from charges for the performance of a tax-exempt function does not constitute gross income from the conduct of an unrelated business.¹⁷⁵ Thus, income is not taxed when it is generated by functions such as performances by students enrolled in an exempt school for training children in the performing arts, the conduct of refresher courses to improve the trade skills of members of a union, and the presentation of a trade show for exhibiting industry products by a trade association to stimulate demand for the products.¹⁷⁶ Also, dues paid by bona fide members of an exempt organization are forms of related income.¹⁷⁷

Whether activities productive of gross income contribute importantly to the accomplishment of an organization's exempt purpose depends in each case on the facts and circumstances involved.¹⁷⁸ A court observed that each of these instances requires a case-by-case identification of the exempt purpose involved and an analysis of how the activity contributed to the advancement of that purpose.¹⁷⁹ By reason of court opinions and IRS rulings, there have been many determinations over the years as to whether particular activities are related businesses¹⁸⁰ or unrelated businesses.¹⁸¹

In one instance, a tax-exempt charitable organization whose purpose was enabling needy women to support themselves operated three businesses. The IRS concluded that a consignment shop was a business that was substantially related to the achievement of this exempt purpose. The agency determined that there was a causal relationship between the operation of a gift shop and the exempt purpose but that the relationship was not substantial. A tearoom was classified as an unrelated business.¹⁸²

In a series of technical advice memoranda, the IRS entered the ongoing fray over whether tax-exempt credit unions should retain their exempt status or lose it because of competition with commercial banks,¹⁸³ by holding that various insurance products and financial services provided by exempt credit unions to their members constituted unrelated businesses (and thus are not exempt functions but rather are businesses directly competing with for-profit banks). These unrelated products and services included the sale of accidental death and dismemberment, dental, cancer, guaranteed automobile protection, and credit disability insurance.¹⁸⁴ Thereafter, the agency's lawyers concluded that funds in the form of nonmember automated teller machine fees also are unrelated business income.¹⁸⁵ Nonetheless, thereafter, in a jury trial, a court concluded that an exempt credit union's sales of credit life and credit disability insurance, and guaranteed automobile protection insurance, were related businesses, in that they improved the social and economic life of the credit union's members.¹⁸⁶ Thereafter, a court held that revenue derived by an exempt credit union from the provision of credit life and credit disability insurance, and accidental death and dismemberment insurance, was not unrelated business income.¹⁸⁷ The IRS's ruling policy continued for a period, as illustrated by a determination that the sales of financial management services and of credit life and credit disability insurance were unrelated businesses; then the government's policy shifted.¹⁸⁸

(b) Size and Extent Test

In determining whether an activity contributes importantly to the accomplishment of a tax-exempt purpose, the size and extent of the activity must be considered in relation to the nature and extent of the exempt function that it purportedly serves.¹⁸⁹ Thus, where income is realized by an exempt organization from an activity that is generally related to the performance of its exempt functions, but the activity is conducted on a scale that is larger than reasonably necessary for performance of the functions, the gross income attributable to the portion of the activity that is in excess of the needs associated with exempt functions constitutes gross income from the conduct of an unrelated business.¹⁹⁰ This type of income is not derived from the production or distribution of goods or the performance of services that contribute importantly to the accomplishment of any exempt purpose of the organization.¹⁹¹

For example, the IRS ruled that an activity of a tax-exempt association, which was the supplying of companies (members and nonmembers) with employment injury histories on prospective employees, was an unrelated business, in that the activity went “well beyond” any promotion of efficient business practices.¹⁹² Likewise, a retail grocery store operation, established to sell food in a poverty area at below-market prices and to provide job training for unemployed individuals, failed to qualify for exemption because the activity was conducted on a “much larger scale than reasonably necessary” for the training program.¹⁹³ Similarly, the provision of private-duty nurses to unrelated exempt organizations by an exempt health care entity, which provided nurses to patients of related organizations as a related business, was ruled to be an activity performed on a scale much larger than necessary for the achievement of exempt purposes.¹⁹⁴

By contrast, a tax-exempt organization formed to provide a therapeutic program for emotionally disturbed adolescents was the subject of a ruling from the IRS that a retail grocery store operation, almost fully staffed by adolescents to secure their emotional rehabilitation, was not an unrelated business because it was operated on a scale no larger than reasonably necessary for its training and rehabilitation program.¹⁹⁵ A like finding was made in relation to the manufacture and marketing of toys, which was the means by which an exempt organization accomplished its charitable purpose of training unemployed and underemployed individuals.¹⁹⁶

(c) Same State Rule

Ordinarily, gross income from the sale of items that result from the performance of tax-exempt functions does not constitute gross income from the conduct of an unrelated business if the item is sold in substantially the same state it is in on completion of the exempt functions.¹⁹⁷ Thus, in the case of a charitable organization engaged in a program of rehabilitation of disabled individuals, income from the sale of items made by them as part of their rehabilitation training was not gross income from the conduct of an unrelated business. The income in this instance was from the sale of products, the production of which contributed importantly to the accomplishment of the organization's exempt purposes, namely, rehabilitation of the disabled.¹⁹⁸ Conversely, if an item resulting from an exempt function is utilized or exploited in further business endeavors beyond that reasonably appropriate or necessary for disposition in the state it is in on completion of exempt functions, the gross income derived from these endeavors is from the conduct of unrelated business.¹⁹⁹

As an illustration, a tax-exempt scientific organization maintained an experimental dairy herd; the sale of milk and cream produced in the ordinary course of the program is a related business, while the sale of food items made from the milk and cream, such as ice cream and pastries, generally is an unrelated business.²⁰⁰ Similarly, an exempt organization that operated a salmon hatchery as an exempt function sold some of its harvested and unprocessed salmon stock to fish processors as a related business; however, sale by this organization of salmon nuggets (fish that was seasoned and breaded, formed into nugget shape, and deep-fried) was ruled by the IRS to be an unrelated business.²⁰¹

(d) Dual Use Rule

An asset or facility of a tax-exempt organization that is necessary for the conduct of exempt functions may also be utilized for nonexempt purposes. In these dual use instances, the mere fact of the use of the asset or facility in an exempt function does not, by itself, make the income from the nonexempt endeavor gross income from a related business. The test is whether the activities producing the income in question contribute importantly to the accomplishment of exempt purposes.²⁰² For example, an exempt museum shows educational films in its theater during its normal hours of operation in furtherance of its public education program; use of the theater for public entertainment in the evening hours when the museum is otherwise closed is an unrelated business.²⁰³ Similarly, a mailing service operated by an exempt organization was ruled to be an unrelated trade or business even though the mailing equipment was also used for exempt purposes.²⁰⁴

Another illustration is the athletic facilities of a college or university, which, while used primarily for educational purposes, may also be made available for members of the faculty, other employees of the institution, and members of the public. Income derived from the use of the facilities by those who are not students or employees of the institution is likely to be unrelated business income.²⁰⁵ For example, the IRS ruled that the operation by a tax-exempt school of a ski facility for the public was the conduct of an unrelated business, while use of the facility by the students of the school for recreational purposes and in its physical education program was a related activity.²⁰⁶ Likewise, a college that made available its facilities and personnel to an individual not associated with the institution for the conduct of a summer tennis camp was ruled to be engaged in the conduct of an unrelated business.²⁰⁷

The provision of athletic or other activities by an educational institution to outsiders may be a tax-exempt function, inasmuch as the instruction of individuals on the subject of a sport can be an educational activity.²⁰⁸ As illustrations, the IRS held that the following were exempt educational activities: the conduct of a summer hockey camp for youths by a college,²⁰⁹ the conduct of four summer sports camps by a university,²¹⁰ and the operation of a summer sports camp by a university-affiliated athletic association.²¹¹ Similarly, the IRS determined that a college may operate a professional repertory theater on its campus that is open to the public²¹² and that a college may make its facilities available to outside organizations for the conduct of conferences²¹³—both activities being in furtherance of exempt purposes.

This area of the law intertwines with the exclusion from unrelated income taxation for rent received by tax-exempt organizations.²¹⁴ For example, a college may lease its facilities to a professional sports team for the conduct of a summer camp and receive nontaxable lease income, as long as the college does not provide food or cleaning services to the team.²¹⁵ By contrast, where the institution provides services, such as cleaning, food, laundry, security, and grounds maintenance, the exclusion for rent is defeated.²¹⁶

This dichotomy is reflected in an IRS analysis of a tax-exempt school that used its tennis facilities, operated during the academic year as a related activity, in the summer as a public tennis club operated by employees of the school. The IRS, in ruling that the operation of this club was an unrelated business not sheltered by the exclusion for rental income, observed that if the school had leased the facilities to an unrelated party without the provision of services for a fixed fee, the exclusion would have been available.²¹⁷ In a comparable ruling, the IRS determined that, when a university that leased its stadium to a professional sports team for several months of the year and provided the utilities, grounds maintenance, and dressing room, linen, and stadium security services, it was engaged in an unrelated business and was not entitled to the rental income exclusion.²¹⁸

(e) Exploitation Rule

Activities carried on by a tax-exempt organization in the performance of exempt functions may generate goodwill or other intangibles that are capable of being exploited in commercial endeavors. Where an exempt organization exploits this type of intangible in commercial activities, the fact that the resultant income depended in part on the conduct of an exempt function of the organization does not make it gross income from a related business. In these cases, unless the activities contribute importantly to the accomplishment of an exempt purpose, the income that they produce is gross income from the conduct of an unrelated business.²¹⁹

Thus, the rules with respect to taxation of advertising revenue received by tax-exempt organizations treat advertising as an exploitation of exempt publication activity.²²⁰ As another illustration of this exploitation rule, where access to athletic facilities of an educational institution by students is covered by a general student fee, outside use may trigger the exploitation rule; if separate charges for use of the facilities are imposed on students, faculty, and outsiders, any unrelated income is a product of the dual use rule.²²¹

(f) Related Business Activities

A myriad of determinations by the courts and the IRS conclude that activities conducted by tax-exempt organizations are related businesses, including these: operation of a furniture shop by an exempt halfway house;²²² sale of computer-based cataloging services to libraries maintained by for-profit organizations;²²³ conduct of a product certification program as part of an effort to prevent trade abuses in the automobile racing business;²²⁴ sale of products to encourage wildlife preservation;²²⁵ operation of restaurants and cocktail lounges by social clubs and veterans' organizations for their members;²²⁶ operation of a beauty shop and barber shop by a senior citizens' center;²²⁷ conduct of an employment program providing training and work experience for the disabled;²²⁸ loan organization and servicing activities;²²⁹ facilitation of court proceedings by telephone;²³⁰ provision of veterinary services by a tax-exempt humane society;²³¹ operation of a health club for individuals reflective of the community;²³² sale of computer software by an organization formed to make new scientific technology widely available for the benefit of the public;²³³ sale of life memberships in a rural lodge used only for religious and educational purposes;²³⁴ management of a project to restore historic property;²³⁵ operation of golf courses to promote rehabilitation of disadvantaged youths;²³⁶ performance of art conservation services for private collectors;²³⁷ sale of posters and other promotional items carrying the organization's program message;²³⁸ publication and sale by a shipowners' and ship operators' organization of common tariffs;²³⁹ operation of a mobile cancer screening program;²⁴⁰ licensing of an educational institution's curriculum to other colleges and universities;²⁴¹ cleaning up of spills of oil and oil products;²⁴² operation of a birthing center by a church;²⁴³ sponsorship of gospel concerts by a broadcast ministry;²⁴⁴ and operation by a charitable organization of a parking garage for the benefit of its member charities.²⁴⁵

Also: provision of services by a community development organization to a community development bank;²⁴⁶ conduct by a public charity of market development and investment programs intended to promote investment in foreign countries;²⁴⁷ operation of a center for regional economic development, and for educational and cultural activities;²⁴⁸ sale of caskets by an exempt cemetery company;²⁴⁹ conduct of national amateur athletic contests;²⁵⁰ lease of the assets of a hospital district to a charitable organization that was to operate the hospital;²⁵¹ operation by a charitable organization of a mushroom growing and processing facility predominantly to employ poor and drug-addicted individuals;²⁵² provision of credit enhancement services to developers of, and predevelopment and construction lending to projects that result in, affordable housing;²⁵³ conduct by a library of a remote access project, fee-based services, research assistance for library users, business information collection, and library management training;²⁵⁴ operation by a public charity of noncommercial television and radio stations;²⁵⁵ sale of cat-related merchandise by an organization that educates the public about the ownership of cats;²⁵⁶ use by a charitable organization of a vessel to provide ferry service for a limited time in the context of an emergency;²⁵⁷ leasing of industrial buildings by a charitable organization to promote development of an economically distressed county;²⁵⁸ renovation of a conference center and redevelopment of commercial rental property;²⁵⁹ carrying out of student loan securitization transactions by a supporting organization for the benefit of the supported organization that undertakes a variety of exempt student loan programs;²⁶⁰ delivery by an exempt business league of an online legal information service to its members;²⁶¹ the conduct of public outreach events by a charitable organization in cooperation with exempt and nonexempt sponsoring organizations;²⁶² the operation by a union of a pharmacy program for the benefit of its members;²⁶³ the promotion of the enjoyment of and involvement in a sports game;²⁶⁴ and the undertaking of stream mitigation activities by charity managing a nature preserve.²⁶⁵

Private letter rulings from the IRS provide additional illustrations of related business activity.²⁶⁶

(g) Unrelated Business Activities

Many determinations by the courts and the IRS conclude that activities conducted by tax-exempt organizations are unrelated businesses, including these: operation of dining facilities for the public by exempt social clubs and veterans' organizations;²⁶⁷ sale of membership lists to commercial companies by educational organizations;²⁶⁸ provision of pet boarding and grooming services to the public by an animal cruelty prevention organization;²⁶⁹ carrying on of commercially sponsored research, where publication of the research is withheld or delayed significantly beyond the time reasonably necessary to establish ownership rights;²⁷⁰ presentation of commercial programs by an exempt broadcasting station;²⁷¹ operation of a miniature golf course in a commercial manner, by an organization working to provide for the welfare of youths;²⁷² management of health and welfare plans by a business league for a fee;²⁷³ sale of heavy-duty appliances to senior citizens by a senior citizens' center;²⁷⁴ and provision of veterinary services for a fee by an animal cruelty prevention society.²⁷⁵

Also: operation of a commuting program by a labor union for its members;²⁷⁶ sale of work uniforms by a union;²⁷⁷ sale of a computer-based information retrieval and message service provided by a for-profit business;²⁷⁸ sale of information about real estate used to prepare market evaluations and house appraisals;²⁷⁹ provision of arbitration, mediation, and other alternative dispute resolution services for the benefit of consumers;²⁸⁰ sale of herbs and herb products by an exempt scientific research organization to private practitioners and the public;²⁸¹ operation by a low-income housing corporation of a temporary storage business open to the public;²⁸² storage by an agricultural organization of trailers, campers, motor homes, boats, and automobiles;²⁸³ use by the public of a golf course maintained by an exempt planned community;²⁸⁴ and sale of life insurance policies by an exempt fraternal beneficiary society to the nonmember widows of deceased insured members within one year following the member's death where the widows can name as a beneficiary someone other than a dependent of a member.²⁸⁵

Private letter rulings from the IRS provide additional illustrations of unrelated business activity.²⁸⁶

Occasionally, a situation will arise where monies are paid to an agent of a tax-exempt organization, who in turn pays the monies over to the organization, with the monies taxable as unrelated business income. This situation occurs, for example, in connection with an exempt religious order, which requires its members to provide services for a component of the supervising church and to turn over their remuneration to the order under a vow of poverty. Under these circumstances, the payments for services are income to the order and not to the member.²⁸⁷ Where the individual is not acting as agent for the order and is performing services (as an employee) of the type ordinarily required by members of the religious order, however, the income is to the individual, and the unrelated income tax is avoided, because the monies are received by the order as charitable contributions.

(a) Educational Institutions

Tax-exempt colleges, universities, and schools²⁸⁸ have as their principal function the education of their students; consequently, income generated by the conduct of this related activity in the form of tuition, fees, assessments, and food service revenue is not taxable.²⁸⁹ Another major exempt function conducted by these institutions is research; this type of activity is not normally taxed, either because it is inherently an exempt function or because it is sheltered from tax by statute.²⁹⁰ Other exempt functions of these institutions are sports programs,²⁹¹ operation of bookstores,²⁹² operation of a university press,²⁹³ publication of scholarly works by their faculty and students,²⁹⁴ sale of handicraft articles (in the case of an exempt vocational school),²⁹⁵ operation of a health and physical fitness center,²⁹⁶ and operation of a farm (in the case of an exempt agricultural college).²⁹⁷ By contrast, an activity such as the manufacture and sale of automobile tires by an exempt college is almost certain to be an unrelated business, even if students performed minor clerical or bookkeeping functions as part of their educational program.²⁹⁸

Provision by a tax-exempt educational institution of campus housing and related services to its students, such as in dormitories, is a substantially related business.²⁹⁹ It is not clear whether the provision of housing by an exempt educational institution to its faculty members is a related or an unrelated business.³⁰⁰ Otherwise, revenue generated from the renting of rooms by an educational institution to individuals other than its students is unrelated business income; this includes rentals to potential students, family members of potential students, guest speakers, performers, and guests of nonaffiliated nonprofit organizations in the institution's immediate geographic area who are speakers or performers at the institution.³⁰¹

Educational organizations can engage in activities that are exempt functions in that they facilitate or otherwise support the accomplishment of the institutions' educational purposes and major functions, such as student housing. Thus, a public charity that constructed, owned, and leased a college's student housing project was ruled to be engaged in related business activities (that is, operated to advance education³⁰²).³⁰³ Likewise, a public charity was held to be engaging in related business activities when it commenced establishment of student housing facilities in college communities, with emphasis on housing for low-income students.³⁰⁴

As to the sports programs of tax-exempt educational institutions, the IRS ruled that an exempt organization that sponsored a postseason all-star college football game for the benefit of a state university did not jeopardize its exempt status because of, nor realize unrelated income from the sale of, television broadcast rights of the games since broadcasting of the games “contributes importantly” to the accomplishment of its exempt purposes;³⁰⁵ that payments received by a state university for the sale of radio and television broadcasting rights to its basketball and football games were not unrelated business income because carrying on the sporting events was substantially related to the university's exempt purposes;³⁰⁶ that income received by an exempt organization that promoted professional automobile racing from the sale of television broadcast rights to the races it sanctioned did not constitute unrelated income because the television coverage effectively popularized automobile racing;³⁰⁷ that income derived from the sale by an exempt organization that sponsored and sanctioned amateur athletics of television rights to broadcast its athletic events was not unrelated income because the television medium was used to disseminate its goals and purposes to the public;³⁰⁸ that an exempt organization promoting interest in a particular sport that sold television rights to championship golf tournaments that it sponsored did not incur unrelated income because the grant of the rights was directly related to its exempt purposes;³⁰⁹ that the income received by an exempt amateur sports organization for the licensing of television broadcasting rights was not unrelated income because the broadcasting of the sports events was substantially related to the organization's exempt purpose of promoting international goodwill;³¹⁰ and that payments to be received from the sale of radio and television broadcasting rights to an athletic event were not items of unrelated income because the promotion of the event (the organization's exempt purpose) was furthered by the broadcasting of it.³¹¹

The IRS issued a ruling holding that the sale of exclusive television and radio broadcasting rights to athletic events to an independent producer by a tax-exempt national governing body for amateur athletics was not unrelated business because the “broadcasting of the organization's sponsored, supervised, and regulated athletic events promotes the various amateur sports, fosters widespread public interest in the benefits of its nationwide amateur athletic program, and encourages public participation,” and, therefore, the sale of the broadcasting rights and the broadcasting of the events was an exempt function.³¹² The IRS issued a similar ruling with respect to the sale of broadcasting rights to a national radio and television network by an organization created by a regional collegiate athletic conference composed of exempt universities to hold an annual athletic event.³¹³

The IRS asserted that the payment by a business of a sponsorship fee to a college, university, or bowl association in connection with the telecasting or radio broadcasting of an athletic event was unrelated business income because the package of “valuable services” received by the business was not substantially related to exempt purposes and amounted to advertising services.³¹⁴ This matter was generally resolved by the enactment of legislation concerning the qualified sponsorship payment.³¹⁵

A tax-exempt educational institution may provide athletic facilities, dormitories, and other components of the campus to persons other than its students, such as for seminars or the training of professional athletes. The income derived from the provision of the facilities in these circumstances is likely to be regarded by the IRS as unrelated business income where the institution is providing collateral services such as meals or maintenance; a mere leasing of facilities would likely generate passive rental income excluded from taxation.³¹⁶ The provision of dormitory space may be an activity that is substantially related to an exempt purpose, however, as the IRS ruled in an instance of rental of dormitory rooms primarily to individuals under age 25 by an exempt organization whose purpose was to provide for the welfare of young people.³¹⁷

(b) Health Care Organizations

Hospitals and other health care providers³¹⁸ have as their principal business the promotion of health; income generated by this related activity in the form of revenue from patients (whether by means of Medicare, Medicaid, insurance, or private pay) is not taxable.³¹⁹ Other organizations operating in the health care context have varieties of related businesses.

(c) Museums

Tax-exempt museums operate related businesses when they maintain collections and make them accessible to the general public; admissions fees and the like are income from related business. Some museum business operations are nontaxable by reason of the lines of law referenced previously, pertaining to parking lots, snack bars, and the like. The operation of a dining room, cafeteria, and/or snack bar by an exempt museum for use by its staff, employees, and members of the public usually is a related activity.³⁷⁹ Food service operations of this nature are considered related businesses when they are merely “convenient eating places” for visitors and employees, as opposed to endeavors “designed to serve as a public restaurant.”³⁸⁰

The most difficult issues in the unrelated trade or business context presented by museum operations relate to sales to the public. Where, for example, a tax-exempt museum sells to the public greeting cards that display printed reproductions of selected works from the museum's collection and from other art collections, the sales activity is substantially related to the museum's exempt purpose.³⁸¹ The rationale for this conclusion is that (1) the sale of the cards “contributes importantly to the achievement of the museum's exempt educational purposes by stimulating and enhancing public awareness, interest, and appreciation of art,” and (2) a “broader segment of the public may be encouraged to visit the museum itself to share in its educational functions and programs as a result of seeing the cards.”³⁸²

The fragmentation rule³⁸³ is applied to segment the retailing activities of tax-exempt museums.³⁸⁴ Where an item sold by an exempt museum is “low-cost”³⁸⁵ and bears the museum's logo, the sales activity is likely to be considered a related business. As the prices of items increase, so too does the likelihood that the IRS will find the sales activity to be substantially unrelated to the museum's exempt purposes (with the possible exception of clothing bearing reference to the museum).

A difficult issue in this context is the distinction drawn by the IRS between museum reproductions and adaptations. Generally, the sales of reproductions of items in the museum's collection will be considered related activity. The relatedness of sales of adaptations, which are items that incorporate or reflect original art but differ significantly from the original work, may be more difficult to ascertain (unless the item encourages the public to visit the museum).

Application of the fragmentation rule may depend on whether the primary purpose of an article sold is utilitarian. The position of the IRS's lawyers is that if the “primary purpose of the article is utilitarian and the utilitarian aspects are the predominant reasons for the production and sale of the article, it should not be considered related.” Conversely, if the “utilitarian or ornamental aspects are merely incidental to the article's relation to an exempt purpose, then the article should be considered related.” Under this standard, sales of “items of a souvenir, trivial, or convenience nature” are unrelated business.³⁸⁶ Museum sales of original art or craft may be unrelated business, in that the sales activity is inconsistent with the purpose of exhibiting art for the benefit of the public.³⁸⁷

In another of these instances, a tax-exempt museum, which sponsored programs for children, maintained a shop; the IRS found that the sale of certain tots' and children's items constituted an unrelated business. Nonetheless, items that were reproductions or adaptations of articles displayed in the collections and exhibits were held salable in related business. The IRS reiterated its general view that, where the primary purpose behind the production and sale of an item is utilitarian, ornamental, and/or souvenir in nature, or only generally educational, the matter entails unrelated business activity.³⁸⁸

The IRS ruled that a tax-exempt museum may operate an art conservation laboratory and perform conservation work for other institutions and collectors for a fee without incurring unrelated business income.³⁸⁹ Likewise, the agency ruled that a museum store may sell items in furtherance of the exempt museum's exempt purpose, other than those that have utilitarian purposes.³⁹⁰ The IRS ruled that the sale of merchandise by an exempt museum, in its gift shop, contributed importantly to its exempt purpose and thus that the resulting income was not unrelated business income; the items sold included books and documentary videos.³⁹¹

(d) Social Welfare Organizations

The few IRS public and private letter rulings and court opinions that apply the unrelated business rules to tax-exempt social welfare organizations conclude that related activities include the conduct of weekly dances by a volunteer fire company,³⁹² the tax collection activities by a social welfare organization on behalf of its member municipalities,³⁹³ the provision of group insurance and workers' compensation self-insurance for member counties by a social welfare entity,³⁹⁴ and the provision of workers' compensation insurance to county government employees by a social welfare organization.³⁹⁵

The weekly operation of a bingo game by an exempt social welfare organization was found to be an unrelated business.³⁹⁶

(e) Business Leagues

A tax-exempt association (or, technically, an exempt business league³⁹⁷) is subject to the unrelated income rules. The basic related business function of an exempt association is the provision of services to its members in exchange for dues; thus, this type of dues income is related revenue.

(f) Labor and Agricultural Organizations

One of the principal issues in the unrelated income context for tax-exempt labor unions⁴⁵⁶ is the taxation of revenue (dues) derived from associate members (sometimes termed limited benefit members) who joined the organization solely to be able to participate in the organization's health insurance plans. The evolving view is that this dues revenue is taxable.⁴⁵⁷ When this issue was initially litigated, the government lost, basically on the ground that the courts lacked the authority to define the bona fide membership of exempt labor unions.⁴⁵⁸ The prevailing view, however, is that the same rules that apply with respect to associations⁴⁵⁹ apply in the case of labor organizations.

In other applications of the unrelated income rules to tax-exempt labor organizations, the IRS found to be taxable the income derived by an exempt labor organization from the operation of semiweekly bingo games⁴⁶⁰ and from the performance of accounting and tax services for some of its members.⁴⁶¹

Tax-exempt agricultural organizations are likewise subject to the tax on unrelated business income. As an illustration, the IRS ruled that the following is taxable: income received by an exempt agricultural organization from the sale of supplies and equipment to members,⁴⁶² commissions from the sale of members' cattle,⁴⁶³ income from the sale of supplies to seedsmen,⁴⁶⁴ and income from the operation of club facilities for its members and their guests.⁴⁶⁵

(g) Credit Unions

In the context of the ongoing battle between commercial financial institutions and tax-exempt credit unions over the appropriate scope of services of the latter,⁴⁶⁶ the IRS ruled that various insurance products and other financial services provided by exempt credit unions to the public constitute unrelated businesses.⁴⁶⁷ Nonetheless, the government's position has been rejected by a court on two occasions.⁴⁶⁸ However, the IRS remained, for a while, wedded to its position in this regard.⁴⁶⁹

Subsequently, however, the IRS revised its position.⁴⁷⁰ Pursuant to the new policy, income from the following activities is being treated by the IRS as state credit unions' related business income: sale of checks, fees from check printing companies, debit and credit card programs' interchange fees, interest from credit card loans, and sale of collateral protection insurance. Nor will income from sales of the following products to members produce unrelated business income: credit life and credit disability insurance, and gap automobile insurance. Income from sales of these products to nonmembers, however, will be treated as unrelated income.

Income from the marketing of the following insurance products is considered by the IRS to be unrelated business income: automobile warranties, dental insurance, cancer insurance, accidental death and dismemberment insurance, life insurance, and health insurance. Also, ATM per-transaction fees from nonmembers are regarded as unrelated income. Royalty arrangements, however, may entail nontaxable income.

(h) Advertising

Generally, the net income derived by a tax-exempt organization from the sale of advertising is taxable as unrelated business income.⁴⁷¹

(i) Fundraising

Fundraising practices of charitable organizations and the unrelated business rules have long had a precarious relationship. For this purpose, the term fundraising means the solicitation of contributions, grants, and other forms of financial support, usually by charitable organizations.⁴⁹⁸ Fundraising activities are almost always distinct from program activities, and can be businesses.⁴⁹⁹

(j) Travel Tour Activities

Whether travel tour activities conducted by an exempt organization are substantially related to an exempt purpose is determined by an analysis of all of the relevant facts and circumstances, including how a travel tour is developed, promoted, and operated.⁵³²

This matter of travel opportunities as unrelated business started in the higher education context, in connection with tours offered by colleges, universities, and alumni and alumnae associations. In an unpublished technical advice memorandum issued in 1977, the IRS ruled that an international travel tour program conducted by an alumni association was an unrelated business; the agency cited the absence of any “formal educational program” and the lack of any plan for “contacting and meeting with alumni in the countries visited.”⁵³³ Tours that feature organized study, lectures, reports, library access, and reading lists may be considered educational in nature.⁵³⁴ Tours that are “not significantly different from commercially sponsored” tours are usually unrelated businesses, however, as are extension (or add-on) tours.⁵³⁵

The balance of the law, as stated in regulations, on this point must be extracted from examples. An absence of “scheduled instruction or curriculum related to the destination being visited”⁵³⁶ can lead to a finding of an unrelated business. Thus, for example, it is not a related business for a tax-exempt university alumni association to operate a tour program for its members and guests, where a faculty member is a guest on the tour and participants are encouraged to continue their “lifelong learning” by joining a tour.⁵³⁷ Conversely, a tour conducted by teachers and directed to students enrolled in degree programs at educational institutions can be a related business, particularly where five or six hours per day are devoted to organized study, preparation of reports, lectures, instruction, and recitation by the students, and where a library of material is available, examinations are given at the end of the tour, and academic credit is offered for participation in the tour.⁵³⁸

A tax-exempt membership organization can exist to foster cultural unity and educate Americans about their country of origin. Tours of this organization that are designed to “immerse participants in [the country's] history, culture and language” may be related businesses, particularly where “[s]ubstantially all of the daily itinerary” is devoted to instruction and visits to places of historical significance. If the trips, however, consist of optional tours and destinations of principally recreational interest and lack instruction or curriculum, they will likely be unrelated businesses.⁵³⁹

A tour where the participants assist in data collection to facilitate scientific research can qualify as a related business.⁵⁴⁰ An archaeological expedition with a significant educational component can constitute a related business.⁵⁴¹ A tour enabling participants to attend plays and concerts will be an unrelated business, where the emphasis is on social and recreational activities rather than a “coordinated educational program.”⁵⁴²

Advocacy travel can qualify as related business. For example, travel tours for a tax-exempt organization's members to Washington, D.C., where the participants spend substantially all of their time over several days attending meetings with legislators and government officials, and receiving briefings on policy developments related to the issue that is the organization's focus, are related businesses.⁵⁴³ This is the case even though the participants have some time in the evenings to engage in social and recreational activities.

(k) Provision of Services

In general, net income from the provision of services by a tax-exempt organization to another organization, including another exempt organization, is unrelated business income.⁵⁴⁴ This is because it is not automatically an exempt function for one exempt organization to provide services to another, even where both organizations have the same category of exempt status. For example, the IRS ruled that the provision of administrative services by an exempt association to an exempt voluntary employees' beneficiary association, where the latter entity provided a health and welfare benefit plan for the former entity's members' employees, was an unrelated business.⁵⁴⁵ Likewise, the provision of management services by an exempt association to a charitable organization it founded was ruled by the IRS to be an unrelated business.⁵⁴⁶ Indeed, the provision of management services by a nonprofit organization to unaffiliated charitable organizations led to the revocation of the organization's exemption as a charitable entity.⁵⁴⁷

There are two exceptions to this general rule. One is that, under certain circumstances, it can be a related business for a tax-exempt organization to provide services of this nature to another exempt entity. As an illustration, an exempt business association with an aggressive litigation strategy placed the litigation function in a separate exempt organization because of a substantial risk of counterclaims and other retaliatory actions against the association and its members; the IRS concluded that the provision by the association of management and administrative services to the other exempt organization was in furtherance of the association's exempt purposes.⁵⁴⁸ Likewise, the IRS ruled that a national charitable organization engaged in related business activities when it provided certain coordination services for its chapters in connection with a new program it was implementing.⁵⁴⁹ Additionally, an exempt organization that was an arm of an association of public school boards that administered the association's cash/risk management funds was found to be engaged in the charitable activity of lessening the burdens of government.⁵⁵⁰ Similarly, the IRS ruled that charitable purposes were being served when a community foundation⁵⁵¹ sold grantmaking services to charitable organizations in its community.⁵⁵² Likewise, the IRS approved an arrangement by which a private operating foundation sells “technical assistance services” to “social sector organizations.”⁵⁵³

Also, the provision of professional, managerial, and administrative services among a group of interrelated health care organizations, directly or by means of a partnership, was ruled to be a bundle of related businesses.⁵⁵⁴ Similarly, the lease and management of a computer system to a partnership by a supporting organization of a university's medical center, which system was used for billing, collection, and record keeping of the partners, was found to be a related business because the partners were physicians on the faculty of the university's medical school and teaching hospital.⁵⁵⁵ Further, the IRS ruled that a graduate educational institution was engaged in a related business when it provided “central services” to a group of affiliated colleges (such as campus security, a central steam plant, accounting services, and a risk and property insurance program).⁵⁵⁶ Other IRS rulings are issued from time to time on this point.⁵⁵⁷

The other exception is where the tax-exempt organizations are related entities, usually as parent and subsidiary. In the health care context, for example, the IRS has a ruling policy that the provision of services by and to related entities is not an unrelated business. This policy is articulated in rulings concerning the tax consequences of creation of a health care delivery system by means of a joint operating agreement. The arrangement entails what the IRS terms the provision of corporate services by and among exempt organizations (in the case of this type of system, several hospitals and a parent supporting organization). The IRS stated that, if the participating exempt organizations are in a parent-and-subsidiary relationship, corporate services provided between them that are necessary to the accomplishment of their exempt purposes are treated as other than an unrelated business, and the financial arrangements between them are viewed as merely a matter of accounting.⁵⁵⁸ Indeed, in these rulings, the IRS extended the matter-of-accounting rationale to relationships that are analogous to parent-subsidiary arrangements.

The first time this parent-subsidiary rationale was used outside the health care setting was in connection with a typical situation where a tax-exempt social welfare organization provided corporate services to its related foundation.⁵⁵⁹ This arrangement was held not to generate unrelated business income, because of the “close structural relationship” between the two organizations. The IRS subsequently ruled on this point.⁵⁶⁰

As to arrangements where the relationship is analogous to that of parent and subsidiary, the first illustration was provided in the case of vertically, horizontally, and geographically integrated charitable health care systems, utilizing two supporting organizations, where the IRS ruled that the affiliation agreements involved relationships analogous to that of parent and subsidiary.⁵⁶¹ A subsequent case concerned two charitable organizations that managed health care facilities; they entered into a management agreement with a third such organization.⁵⁶²

Another instance, involving the leasing of facilities by a tax-exempt hospital to another exempt hospital, illustrated this approach. The IRS ruled that the leasing activity was an exempt function because of the direct physical connection and close professional affiliation of the institutions.⁵⁶³ As to the latter factor, however, the lessor and lessee hospitals were closely associated with an exempt medical school; thus the IRS could have ruled that the two hospitals were in a relationship analogous to that of parent and subsidiary.

(l) Sales of Merchandise

Generally, the sale of merchandise to the public is a commercial enterprise and thus, from the standpoint of the law of tax-exempt organizations, usually is an unrelated business.⁵⁶⁴ On occasion, nonetheless, sales of merchandise can be related activities, such as in the museum and fundraising contexts.⁵⁶⁵ The facts and circumstances of each case will determine whether merchandise sales are a related or unrelated business.

In one instance, a public charity had as its tax-exempt purpose the eradication of breast cancer by funding research, educating the public, and sponsoring screening and treatment programs. The IRS ruled that the sale of merchandise, bearing a breast cancer awareness symbol, by the organization and its affiliates is a related activity because it encourages early detection of the disease and thus the saving of lives.⁵⁶⁶

By contrast, in connection with a tax-exempt organization operating several community centers in furtherance of religious, charitable, and educational purposes, the IRS ruled (without analysis) that the sale of T-shirts, baseball caps, bottled water, and towels to the patrons of the centers is unrelated business income.⁵⁶⁷ Similarly, the IRS determined that an exempt conservation and preservation organization, selling a product by means of its online store, by print catalog, and at various retail outlets, with almost no provision of educational information, was engaging in an unrelated business.⁵⁶⁸

(m) Share-Crop Leasing

The subject of the tax treatment accorded share-crop revenue received by tax-exempt organizations is informed by two bodies of law: the existence or nonexistence of a general partnership or joint venture for tax purposes⁵⁶⁹ and interpretation of the passive rent rules.⁵⁷⁰

A share-crop lease arrangement may involve land that is owned by a tax-exempt organization and leased by the organization to a farmer. Under the terms of the lease, the tenant is exclusively responsible for managing and operating the farm property. The tenant is also required to prepare a farm operating plan, including a schedule of crops to be grown on the land, seeding or planting rates, chemicals and fertilizers to be used, conservation practices and tillage plans, livestock breeding and market schedules, nutrition and feeding schedules, and harvesting and storage plans. After the operating plan is complete, the tenant is usually required to submit the plan to the exempt organization for review.

The tax-exempt organization is generally responsible for all of the costs associated with the land and fixed improvements, including the costs of wells and pumps, irrigation equipment, and initially required limestone and rock phosphates. In ascertaining whether amounts received by a tax-exempt organization pursuant to a share-crop lease constitute excludable rent, the first determination is whether the arrangement is a true lease or amounts to a joint venture. Secondly, there must be a decision as to whether the exclusion for rental income applies.

In the first court case on this point, it was concluded that the tax-exempt organization's income was “true rent” within the scope of the rental exclusion⁵⁷¹ and that the relationship between the parties was not a joint venture or partnership; thus the income was not taxable as unrelated business income.⁵⁷² Other courts reached the same conclusion.⁵⁷³

(n) Retirement Plan Reversions

A tax-exempt organization may maintain a qualified pension or other retirement plan to provide retirement benefits to its employees. Generally, the assets of the plan must be used exclusively for the employees and their beneficiaries,⁵⁷⁴ and the contributions of an employer to a qualified plan are deductible in the year in which the contributions are paid.⁵⁷⁵ This type of plan may be terminated; in that instance, all benefits accrued to the date of termination must become completely vested and nonforfeitable, and plan benefits must be distributed to the participants in the plan, or annuities providing for the payment of comparable benefits must be purchased and distributed to the participants. Where the plan is terminated and assets remain after the satisfaction of all liabilities to plan participants and other beneficiaries, and if the excess of assets is attributable to actuarial error, the employer is permitted to recover the excess assets.⁵⁷⁶ Generally, this excess must be included in the gross income of the employer.

Where the employer organization is a tax-exempt organization that is subject to the rule that all income other than exempt function income is taxable as unrelated business income,⁵⁷⁷ such as a social club,⁵⁷⁸ generally the amount of the reversion is includable in the organization's unrelated business income because it is not exempt function income.⁵⁷⁹

In other instances, however, this type of income may be excluded from taxation by reason of the tax benefit rule. Under the exclusionary portion of this rule, gross income does not include income attributable to the recovery during a tax year of any amount deducted in any prior tax year to the extent that amount did not reduce the amount of income tax involved.⁵⁸⁰ By contrast, under the inclusionary aspect of this rule, where the amount previously deducted from gross income generates a tax benefit and is then recaptured in a subsequent year, the recaptured amount is includable in gross income in the year of the recapture.⁵⁸¹ Consequently, to the extent that this type of tax-exempt organization deducted contributions to a defined benefit plan in determining its taxable nonexempt function income, the inclusionary aspect of the tax benefit rule is applicable.⁵⁸²

Where the employer organization is a tax-exempt organization that is not subject to this rule concerning taxation of nonexempt function income, the tax consequences of a reversion of plan assets are different. Because (1) the operation of the plan is not a business but rather an administrative function that is part of the overall operations of the exempt organization and (2) the funds that revert on termination of the plan are a one-time source of income rather than income from an activity that is regularly carried on,⁵⁸³ the reverted funds are generally not taxable as unrelated business income.⁵⁸⁴ Thus, for example, the IRS ruled that the reversion of assets from a defined benefit pension plan to a tax-exempt charitable organization employer, as part of termination of the plan, would not give rise to unrelated business income.⁵⁸⁵

(o) Internet Communications

Although tax-exempt organizations obviously use the Internet to conduct related and unrelated business, little law specific to the subject has developed. It is clear, however, that the federal tax law does not provide unique treatment to transactions or activities of exempt organizations merely because the Internet is the medium. The IRS saliently observed that utilization of the Internet to “accomplish a particular task does not change the way the tax laws apply to that task.”⁵⁸⁶ The IRS added that “[a]dvertising is still advertising and fundraising is still fundraising.”⁵⁸⁷ Overall, unrelated business conducted by means of the Internet is still unrelated business.

The IRS has issued a few pronouncements in this field, such as a ruling that creation by a for-profit corporation of a website on which to conduct business is an expansion of the corporation's business rather than an acquisition of a new or different business.⁵⁸⁸ The agency held that a public charity may conduct a portion of its health care provider services on a website.⁵⁸⁹ The IRS ruled that certain website listings and links by a tax-exempt organization are not businesses, that they do not cause licensing royalties to be taxable, and that a website link to a corporate sponsor is not advertising.⁵⁹⁰ The IRS held that activities conducted on the premises of an exempt business league's trade shows and on a special section of the organization's website that allows its members and the public to access the same information that is available at the physical shows constituted qualified convention and trade show activity.⁵⁹¹ This type of Internet activity, however, if it does not coincide with or otherwise augment or enhance an exempt organization's convention or trade show, is ineligible for the trade show exception.⁵⁹²

A significant issue in this context is the matter of tax-exempt organizations' website hypertext links to related or recommended sites. These exchanges may be treated by the IRS the same way as mailing list exchanges.⁵⁹³ Compensation for a linkage may be unrelated business income. (An absence of compensation may entail private benefit or the like.⁵⁹⁴)

Also involved are corporate sponsorships, inasmuch as some tax-exempt organizations seek corporate support to underwrite the production of all or a portion of the organization's website. These relationships may be short-term or continue on a long-term basis. The financial support may be acknowledged by means of display of a corporate logo, notation of the sponsor's Web address and/or 800 number, a “moving banner” (a graphic advertisement, usually a moving image, measured in pixels), or a link. The issue is whether the support is a qualified sponsorship payment (in which case the revenue is not taxable⁵⁹⁵) or is advertising income (which generally is taxable as unrelated business income⁵⁹⁶). Use of a link in an acknowledgment may change the character of a corporation's payment, converting it from nontaxable sponsorship to taxable advertising income.⁵⁹⁷

Another problem relates to the rule that qualified sponsorship payments do not include payments that entitle the sponsors to acknowledgments in regularly scheduled printed material published by or on behalf of the tax-exempt organization.⁵⁹⁸ Here the issue is the characterization of website materials. Most of the material made available on exempt organizations' websites is prepared in a manner that is distinguishable from the methodology used in the preparation of periodicals.

Online storefronts, replete with virtual shopping carts, on tax-exempt organizations' websites may be subject to the same analysis the IRS applies in the context of museum gift shop sales.⁵⁹⁹ Still other aspects of this subject include the tax treatment of online auctions, and affiliate and other co-venture programs with merchants (including booksellers). (A principal issue is whether any resulting income is a tax-excludable royalty.⁶⁰⁰)⁶⁰¹

(p) Debt Management Plan Services

Debt management plan services are regarded as unrelated trade or business when conducted by an organization that is not a credit counseling organization.⁶⁰² With respect to the provision of debt management plan services by a credit counseling organization, in order for the income from these services to not be unrelated business income, the debt management plan service with respect to such income must contribute importantly to the accomplishment of credit counseling services and must not be conducted on a larger scale than reasonably necessary for the accomplishment of the services.⁶⁰³

(q) Other Organizations' Exempt Functions

An activity that is a related business when conducted by one type of tax-exempt organization may be an unrelated business when conducted by another type of exempt organization. For example, the IRS ruled that a certification program conducted by an exempt educational and scientific organization was an unrelated business, because it primarily advanced the interests of individuals in a particular profession and only incidentally served the interests of the public.⁶⁰⁴ The activity was said to be appropriate when conducted by an exempt business league⁶⁰⁵ but an activity promoting nonexempt purposes when conducted by a charitable organization.⁶⁰⁶

(a) General Principles

In computing a tax-exempt organization's unrelated business taxable income, there must be included with respect to each debt-financed property that is unrelated to the organization's exempt function—as an item of gross income derived from an unrelated trade or business—an amount of income from the property, subject to tax in the proportion in which the property is financed by the debt.⁶⁵⁴ Basically, deductions are allowed with respect to each debt-financed property in the same proportion.⁶⁵⁵ The allowable deductions are those that are directly connected with the debt-financed property or its income, although any depreciation may only be computed on the straight-line method.⁶⁵⁶ As the mortgage is paid, the percentage taken into account usually diminishes. Capital gains on the sale of unrelated debt-financed property are also taxed in the same proportions.⁶⁵⁷

(b) Debt-Financed Property

The term debt-financed property means, with certain exceptions, all property (for example, rental real estate, tangible personalty, and corporate stock) that is held to produce income (for example, rents, royalties, interest, and dividends) and with respect to which there is an acquisition indebtedness⁶⁵⁸ at any time during the tax year (or during the preceding 12 months, if the property is disposed of during the year).⁶⁵⁹

Excepted from the term debt-financed property is (1) property where substantially all (at least 85 percent) of its use is substantially related (aside from the need of the tax-exempt organization for income or funds) to the exercise or performance by the organization of its exempt purpose or, if less than substantially all of its use is related, to the extent that its use is substantially related to the organization's exempt purpose;⁶⁶⁰ (2) property to the extent that its income is already subject to tax as income from the conduct of an unrelated trade or business;⁶⁶¹ (3) property to the extent that the income is derived from research activities and therefore excluded from unrelated business taxable income;⁶⁶² and (4) property to the extent that its use is in a trade or business exempted from tax because substantially all the work is performed without compensation, the business is carried on primarily for the convenience of members, students, patients, officers, or employees, or the business is the selling of merchandise, substantially all of which was received as gifts or contributions.⁶⁶³

Likewise, the IRS ruled that rental income derived by a public charity from debt-financed property was not unrelated debt-financed income because the property was an “innovation and incubator center,” designed to create employment opportunities and increase higher education in technology, that was operated in furtherance of charitable purposes.⁶⁶⁴ Similarly, the agency held that rental income derived by a public charity (which operated a continuing care retirement community) from debt-financed property leased (by means of a limited liability company that is a disregarded entity⁶⁶⁵) to a tax-exempt hospital, which will use it for an outpatient medical clinic to serve the residents of the community, was not unrelated debt-financed income because the leasing function was a charitable undertaking.⁶⁶⁶ Further, the IRS held that rental income to be derived by a public charity that assists individuals with disabilities from the leasing of a portion of a tax-exempt bond-financed building to another public charity with similar purposes was not unrelated debt-financed income because the rental activity was in furtherance of the lessor's charitable purposes.⁶⁶⁷

Property owned by a tax-exempt organization and used by a related exempt organization or by an exempt organization related to the related exempt organization is not treated as debt-financed property to the extent the property is used by either organization in furtherance of its tax-exempt purpose.⁶⁶⁸ In one instance, the IRS held that a charitable organization may acquire a building, use a portion of it, and lease the other portion to a related charitable organization and a related business league for their offices and activities, and that the building will not be treated as debt-financed property.⁶⁶⁹

The neighborhood land rule provides an exemption from the debt-financed property rules for interim income from neighborhood real property acquired for a tax-exempt purpose. The tax on unrelated debt-financed income does not apply to income from real property, located in the neighborhood of other property owned by the tax-exempt organization, which it plans to devote to exempt uses within 10 years of the time of acquisition.⁶⁷⁰ This rule applies after the first five years of the 10-year period only if the exempt organization satisfies the IRS that future use of the acquired land in furtherance of its exempt purposes before the expiration of the period is reasonably certain;⁶⁷¹ this process is to be initiated by filing a ruling request at least 90 days before the end of the fifth year.⁶⁷² A more generous 15-year rule is established for churches; also, it is not required that the property be in the neighborhood of the church.⁶⁷³

If debt-financed property is sold or otherwise disposed of, a percentage of the total gain or loss derived from the disposition is included in the computation of unrelated business taxable income.⁶⁷⁴ The IRS recognizes, however, that the unrelated debt-financed income rules do not render taxable a transaction that would not be taxable by virtue of a nonrecognition provision of the federal tax law if it were carried out by an entity that is not tax-exempt.⁶⁷⁵

(c) Acquisition Indebtedness

Income-producing property is considered to be unrelated debt-financed property (making income from it, less deductions, taxable) only where there is an acquisition indebtedness attributable to it. Acquisition indebtedness, with respect to debt-financed property, means the unpaid amount of the indebtedness incurred by the tax-exempt organization in acquiring or improving the property, the indebtedness incurred before any acquisition or improvement of the property if the indebtedness would not have been incurred but for the acquisition or improvement, and the indebtedness incurred after the acquisition or improvement of the property if the indebtedness would not have been incurred but for the acquisition or improvement and the incurring of the indebtedness was reasonably foreseeable at the time of the acquisition or improvement.⁶⁷⁶

If property is acquired by a tax-exempt organization subject to a mortgage or other similar lien, the indebtedness thereby secured is considered an acquisition indebtedness incurred by the organization when the property is acquired, even though the organization did not assume or agree to pay the indebtedness.⁶⁷⁷ Some relief is provided, however, with respect to mortgaged property acquired as a result of a bequest or devise. That is, the indebtedness secured by this type of mortgage is not treated as acquisition indebtedness during the 10-year period following the date of acquisition. A similar rule applies to mortgaged property received by gift, where the mortgage was placed on the property more than five years before the gift and the property was held by the donor more than five years before the gift.⁶⁷⁸

Other exceptions from the scope of acquisition indebtedness are the following:

• The term acquisition indebtedness does not include indebtedness that was incurred in circumstances where incurrence of the debt was inherent in the performance of a tax-exempt function of an organization or otherwise in advancement of the organization's exempt purpose, such as the indebtedness incurred by an exempt credit union⁶⁷⁹ in accepting deposits from its members.⁶⁸⁰ It has been held, however, that the purchase of securities on margin and with borrowed funds is not inherent in (meaning essential to) the performance or exercise of a credit union's exempt purposes or function, so that a portion of the resulting income is taxable as debt-financed income.⁶⁸¹
• The term does not include an obligation to pay an annuity that (1) is the sole consideration issued in exchange for property if, at the time of the exchange, the value of the annuity is less than 90 percent of the value of the property received in the exchange; (2) is payable over the life of one individual who is living at the time the annuity is issued, or over the lives of two individuals living at that time; and (3) is payable under a contract that does not guarantee a minimum amount of payments or specify a maximum amount of payments and does not provide for any adjustment of the amount of the annuity payments by reference to the income received from the transferred property or any other property.⁶⁸²
• The term does not include an obligation to finance the purchase, rehabilitation, or construction of housing for low- and moderate-income persons to the extent that it is insured by the Federal Housing Administration.⁶⁸³
• The term does not include indebtedness incurred by certain small business investment companies if the indebtedness is evidenced by a certain type of debenture.⁶⁸⁴
• The term does not include a tax-exempt organization's obligation to return collateral security pursuant to a securities lending arrangement, thereby making it clear that, in ordinary circumstances, payments on securities loans are not debt-financed income.⁶⁸⁵

For these purposes, the term acquisition indebtedness generally does not include indebtedness incurred by a qualified organization in acquiring or improving any real property.⁶⁸⁶ A qualified organization is an operating educational institution,⁶⁸⁷ any affiliated support organization,⁶⁸⁸ and a tax-exempt multiparent title-holding organization,⁶⁸⁹ as well as any trust that constitutes a pension trust.⁶⁹⁰ Nonetheless, in computing the unrelated income of a shareholder or beneficiary of a disqualified holder (namely, a multiparent title-holding organization⁶⁹¹) of an interest in a multiparent title-holding entity attributable to the interest, the holder's pro rata share of the items of income that are treated as gross income derived from an unrelated business (without regard to the exception for debt-financed property) is taken into account as gross income of the disqualified holder derived from an unrelated business; the holder's pro rata share of deductions is likewise taken into account.⁶⁹²

Thus, under this exception, income from investments in real property is not treated as income from debt-financed property and therefore as unrelated business income. Mortgages are not considered real property for purposes of this exception.⁶⁹³ Thus, a supporting organization with respect to an exempt university was able to acquire, in a partial debt financing and by means of a single-member limited liability company, a commercial retail center, without having the tenants' rents be taxable.⁶⁹⁴

The intent of these rules is to treat an otherwise tax-exempt organization in the same manner as an ordinary business enterprise to the extent that the exempt organization purchases property through the use of borrowed funds.⁶⁹⁵ The IRS recalled this intent in passing on the tax status of indebtedness owed to an exempt labor union by its wholly owned subsidiary title-holding company resulting from a loan to pay debts incurred to acquire two income-producing office buildings. The IRS ruled that this interorganizational indebtedness was not an acquisition indebtedness because the “very nature of the title-holding company as well as the parent-subsidiary relationship show this indebtedness to be merely a matter of accounting between the organizations rather than an indebtedness as contemplated by” these rules.⁶⁹⁶

The income of a tax-exempt organization that is attributable to a short sale of publicly traded stock through a broker is not unrelated debt-financed income and thus is not taxable as unrelated business income.⁶⁹⁷ This is because, although a short sale creates an obligation, it does not create an indebtedness for tax purposes⁶⁹⁸ and thus there is no acquisition indebtedness.⁶⁹⁹ This position of the IRS is not intended to cause any inference with respect to a borrowing of property other than publicly traded stock sold short through a broker. Securities purchased on margin by a tax-exempt organization constitute debt-financed property, which generates unrelated business income.⁷⁰⁰

(d) Exempt Function Borrowing

At issue is application of the acquisition indebtedness rules in circumstances where an exempt organization borrows funds to make charitable grants, support exempt-purpose programs, or pay administrative expenses. An argument may be made that, in determining whether a borrowing constitutes an acquisition indebtedness, an exempt organization should be allowed, as a general rule, to trace use of the proceeds of the debt to the asset acquired or expense paid with the proceeds; if the proceeds are used for an exempt purpose, the borrowing generally would not, pursuant to this argument, be treated as acquisition indebtedness with respect to any investment assets the organization may contemporaneously own or acquire. If an organization is attempting to circumvent the unrelated debt-financed property rules, the but for and reasonably foreseeable tests could be used to override the tracing approach. The IRS, however, has informally expressed concern that a borrowing to fund exempt activities is acquisition indebtedness attributable to investment assets when the debt, albeit motivated by the needs of the organization's exempt programs, is incurred contemporaneously with the purchase of investment assets.