(a) Passive Income in General

The unrelated business rules were enacted to ameliorate the effects of competition between tax-exempt organizations and for-profit businesses by taxing the net income derived by exempt organizations from unrelated business activities.⁴ The principle underlying this statutory scheme is that the business endeavors of exempt entities must be active ones for competitive activity to result. Correspondingly, income obtained by an exempt organization in a passive manner generally is income that is not acquired as the result of competitive undertakings; consequently, most forms of passive income received by exempt organizations are not taxed as unrelated business income.⁵

The legislative history of these provisions indicates that Congress believed that passive income received by tax-exempt organizations should not be taxed as unrelated business income “where it is used for exempt purposes because investments producing incomes of these types have long been recognized as proper for educational and charitable organizations.”⁶ Forms of passive income incurred by exempt organizations that may not be strictly within the technical meaning of one of the specific terms referenced in the passive income rules may nonetheless be outside the framework of unrelated business income taxation.⁷

(b) Dividends

Dividends paid to tax-exempt organizations generally are not taxable as unrelated business income.⁸ Basically, a dividend is an amount of income allotted to each of one or more persons who are entitled (by reason of their capital contributions) to share in the net profits generated by a business undertaking, usually a corporation; it is a payment to shareholders (stockholders) out of the payor's net profits.⁹

It has been, for some time, conventional wisdom that income received by a tax-exempt organization from a controlled foreign corporation is not taxable as unrelated business income because the income is considered a nontaxable dividend. This is a fundamental concept underlying use of blocker corporations.¹⁰ The statutory law that is indirectly on point pertains to controlled foreign corporations;¹¹ the thought has been that this included income is to be treated as a dividend.¹²

When Congress enacted the rule that, where a controlled foreign corporation is insuring third-party risks, the income from that activity is subject to tax as unrelated business income, it inserted language in the legislative history to the effect that, generally, this type of included income is dividend income and not unrelated business income.¹³

(c) Interest

Interest paid to a tax-exempt organization generally is not taxable as unrelated business income.¹⁴ Basically, interest is an amount of income constituting compensation that one person pays to another for the use of money.¹⁵

(d) Securities Lending Income

Qualified payments with respect to loans of securities are generally excluded from unrelated business income taxation.¹⁶ This exclusion is available for the lending of securities to a broker and the return of identical securities.¹⁷ For this nontaxation treatment to apply, the security loans must be fully collateralized and be terminable on five business days' notice by the lending organization. Further, an agreement between the parties must provide for reasonable procedures to implement the obligation of the borrower to furnish collateral to the lender with a fair market value on each business day the loan is outstanding in an amount at least equal to the fair market value of the security at the close of business on the preceding day.¹⁸

(e) Certain Consideration

Amounts received or accrued by tax-exempt organizations as consideration for entering into agreements to make loans are excluded from unrelated business income taxation.¹⁹

(f) Annuities

Income received by a tax-exempt organization as an annuity generally is not taxable as unrelated business income.²⁰ Basically, an annuity is an amount of money, fixed by contract between the annuitor and the annuitant, that is paid annually in one sum, or otherwise during the course of a year in installments (such as semiannually or quarterly).²¹

(g) Royalties

Generally, a royalty paid to a tax-exempt organization is excludable from unrelated income taxation.²² Basically, a royalty is a payment for the use of a valuable intangible right, such as a trademark, trade name, service mark, logo, or copyright, regardless of whether the property represented by the right is used; royalties also include the right to a share of production reserved to the owner of the property for permitting another to work mines and quarries or to drill for oil or gas.²³ Royalties have also been characterized as payments that constitute passive income, such as the compensation paid by a licensee to the licensor for the use of the licensor's patented invention.²⁴

One of the issues in this area is the extent to which a tax-exempt organization can be involved in the enterprise that generates the revenue, such as through the provision of services. In the principal opinion on the point, a federal appellate court wrote that a payment cannot constitute a royalty for these purposes to the extent it represents “compensation for services [other than insubstantial ones] rendered by the owner of the property.”²⁵ If the exempt organization's services in this context are more than incidental, the IRS may view the relationship between the parties as that of partners or joint venturers, thus defeating the exception.²⁶

A court relied heavily on the foregoing definition of royalties in concluding that a tax-exempt organization is liable for the unrelated business income tax on payments it received from vendors for its services, rejecting the argument that the revenue constituted royalties.²⁷ The court noted that agreements with these vendors do not license them to use the exempt organization's intangible property or obligate it to make intangible property available to them. The payments were held to be for services rendered, with the exempt organization “exploit[ing] its own reputation with its members by endorsing [one of the vendors] and inducing its members to patronize that company.”²⁸

Mineral royalties, whether measured by production or by gross or taxable income from the mineral property, are excludable in computing unrelated business taxable income. Where, however, a tax-exempt organization owns a working interest in a mineral property and is not relieved of its share of the development costs by the terms of any agreement with an operator, income received is not excludable from unrelated income taxation.²⁹ The holder of a mineral interest is not liable for the expenses of development (or operations) for these purposes where the holder's interest is a net profit interest not subject to expenses that exceed gross profits. Thus, a tax-exempt university was ruled to have excludable royalty interests, where the interests it held in various oil- and gas-producing properties were based on the gross profits from the properties reduced by all expenses of development and operations.³⁰

The IRS ruled that patent development and management service fees deducted from royalties collected from licensees by a tax-exempt charitable organization for distribution to the beneficial owners of the patents were not within this exception for royalties; the IRS said that “although the amounts paid to the [exempt] organization are derived from royalties, they do not retain the character of royalties in the organization's hands” for these purposes.³¹ However, the IRS decided that income derived by an exempt organization from the sale of advertising in publications produced by an independent firm was properly characterized as royalty income.³² Likewise, the IRS determined that amounts received from licensees by an exempt organization, which was the legal and beneficial owner of patents assigned to it by inventors for specified percentages of future royalties, constituted excludable royalty income.³³ A federal court of appeals held that income consisting of 100 percent of the net profits in certain oil properties, received by an exempt organization from two corporations controlled by it, constituted income from overriding royalties and thus was excluded from taxation.³⁴

(h) Rent

Another exclusion from unrelated business income taxation is available with respect to certain rents.³⁵ The principal exclusion is for rents from real property.³⁶ Rent is a form of income that is paid for the occupation or similar use of property.

(i) Other Investment Income

The IRS ruled that the interest earned by a tax-exempt organization pursuant to interest rate swap agreements is not taxable as unrelated business income.⁵⁶ The anticipated result of the interest rate swap is to provide the tax-exempt organization with interest payments that are preferable, from its investment standpoint, to those provided for in a floating rate note.

In addition to the foregoing forms of investment income, income from notional principal contracts,⁵⁷ and other substantially similar income from ordinary and routine investments to the extent determined by the IRS, is excluded in computing unrelated business taxable income.⁵⁸ This exclusion embraces interest rate and currency swaps, as well as equity and commodity swaps.⁵⁹

(j) Capital Gains

Excluded from unrelated business income taxation generally are gains from the sale, exchange, or other disposition of capital gain property.⁶⁰ This exclusion for capital gains does not extend to dispositions of inventory or property held primarily for sale to customers in the ordinary course of a business.⁶¹ The IRS applies eight factors in determining whether property is being sold in the ordinary course of business: (1) the purpose for which the property was acquired; (2) the cost of it; (3) the activities of the owner in the improvement and disposition of the property; (4) the extent of improvements made to the property; (5) the proximity of the sale to the purchase; (6) the purpose for which the property was held; (7) prevailing market conditions; and (8) the frequency, continuity, and size of the sales.⁶² For example, the IRS ruled that the gain from the sale by tax-exempt organizations of leased fee interests in condominium apartments to lessees was not taxable because of the exclusion for capital gain.⁶³ Likewise, the IRS ruled that the sale by a charitable organization of its entire interest in an apartment building would generate excludable capital gain, with the agency emphasizing that the organization did not play any role in the sale or marketing of individual condominium units.⁶⁴ Conversely, the improvement and frequent sale of land by an exempt organization was held to be an unrelated business.⁶⁵

Nonetheless, there is an exception from this second limitation⁶⁶ that excludes gains and losses from the sale, exchange, or other disposition of certain real property and mortgages acquired from financial institutions that are in conservatorship or receivership.⁶⁷ Only real property and mortgages owned by a financial institution (or held by the financial institution as security for a loan) at the time when the institution entered conservatorship or receivership are eligible for the exception.

(k) Loan Commitment Fees

The law was unclear as to whether loan commitment fees constitute unrelated business taxable income. A loan commitment fee is a nonrefundable charge made by a lender to reserve a sum of money with fixed terms for a specified period of time. This type of charge compensates the lender for the risk inherent in committing to make the loan (such as for the lender's exposure to interest rate changes and for potential lost opportunities). Today, however, an exclusion from this type of tax treatment applies; the reference is to “amounts received or accrued as consideration for entering into agreements to make loans.”⁶⁸

(l) Research Income

Income derived from research⁶⁹ for government is excluded from unrelated business income taxation, as is income derived from research for anyone in the case of a tax-exempt college, university, or hospital, and of “fundamental research” units.⁷⁰ According to the legislative history, the term research includes “not only fundamental research but also applied research such as testing and experimental construction and production.”⁷¹ With respect to the separate exclusion for college, university, or hospital research, “funds received for research by other institutions [do not] necessarily represent unrelated business income,” such as a grant by a corporation to a foundation to finance scientific research if the results of the research are to be made freely available to the public.⁷² Without defining the term research, the IRS was content to find applicability of this rule because the studies were not “merely quality control programs or ordinary testing for certification purposes, as a final procedural step before marketing.”⁷³

In employing the term research in this context, the IRS generally looks to the body of law defining the term in relation to what is considered tax-exempt scientific research.⁷⁴ Thus, the issue is usually whether the activity is being carried on in connection with commercial or industrial operations; if it is, it will almost assuredly be regarded by the IRS as an unrelated trade or business.⁷⁵ In one instance, the IRS found applicability of the exclusion because the studies undertaken by an exempt medical college in the testing of pharmaceutical products under contracts with the manufacturers were held to be more than ordinary testing.⁷⁶ In another instance, the exclusion was held to be applicable to contract work done by an exempt educational institution for the federal government in the field of rocketry.⁷⁷

(m) Electric Companies' Member Income

In the case of a tax-exempt mutual or cooperative electric company,⁷⁸ there is an exclusion from unrelated business income taxation for income that is treated as member income.⁷⁹

(n) Foreign Source Income

A look-through rule characterizes certain foreign source income—namely, income from insurance activities conducted by offshore captives of tax-exempt organizations—as unrelated business income.⁸⁰ Generally, U.S. shareholders of controlled foreign corporations must include in income their shares of the foreign entities' income, including certain insurance income.⁸¹ The IRS, before creation of this statutory rule, treated these income inclusions as dividends, with the consequence that the income received by exempt organizations was excludable from tax.⁸² This look-through rule, however, overrides the former treatment of this type of income as dividends.

This rule does not apply to amounts that are attributable to insurance of risks of the tax-exempt organization itself, certain of its exempt affiliates, or an officer or director of, or an individual who (directly or indirectly) performs services for, the exempt organization (or certain exempt affiliates), provided that the insurance primarily covers risks associated with the individual's performance of services in connection with the exempt organization (or exempt affiliates).⁸³

The notion that income derived by tax-exempt organizations from controlled foreign corporations⁸⁴ is generally treated as dividend income has a curious provenance. That has been the ruling policy of the IRS since at least 1988.⁸⁵ In the context of enactment of the insurance rule in 1996, the House Committee on Ways and Means reviewed this ruling policy and pronounced it correct.⁸⁶ The Committee stated that “income exclusions under Subpart F have been characterized as dividends for unrelated business income tax purposes.”⁸⁷ The IRS ruling policy has continued to follow its general approach.⁸⁸

Recent litigation, however, is running contrary to the general position taken by the IRS in its private letter rulings and the assumption as to the state of the law found in the Ways and Means Committee report. Two courts have held that Subpart F inclusions do not constitute (1) actual dividends because such dividends require a distribution by the corporation and receipt by the shareholder, and a change of ownership of something of value, neither of which occurred in the facts of the case,⁸⁹ and (2) deemed dividends because, when Congress decides to deem a payment a dividend, it states as much in the Internal Revenue Code, which was not done in the law pertaining to this case.⁹⁰

It may be that Subpart F inclusions can be considered one or more forms of passive income that are excludible from unrelated business income taxation, without reliance on specific characterization as a dividend.⁹¹ Also, controlled foreign corporations can make payments that qualify as dividends under the explicit statutory rules.

(o) Brownfield Sites Gain

An exclusion from unrelated business taxable income is available for gain or loss from the sale or exchange of certain brownfield properties by a tax-exempt organization, whether the properties are held directly or indirectly through a partnership.⁹² For property to qualify for the exclusion, the property must be acquired during the period beginning January 1, 2005, and ending December 31, 2009, although the property may be disposed of after that date. Certain certification requirements must be met. Also, the exempt organization or the partnership of which it is a partner must expend a minimum amount on remediation expenses, which may be determined by averaging expenses across multiple qualifying brownfield properties for a period of as many as eight years.⁹³

(p) Religious Order Rule

The unrelated business income tax does not apply to a trade or business conducted by a tax-exempt or educational institution maintained by a religious order,⁹⁴ even if the business is an unrelated one, if (1) the business consists of the provision of services under a license issued by a federal regulatory agency; (2) less than 10 percent of its net income is used for unrelated activities; and (3) the business has been operated by the order or educational institution since before May 27, 1969.⁹⁵

(a) Volunteer-Conducted Businesses

Exempt from the scope of taxable unrelated trade or business is a business in which substantially all of the work in carrying on the business is performed for the tax-exempt organization without compensation.⁹⁷ An example of applicability of this exception is an exempt orphanage operating a secondhand clothing store and selling to the public, where substantially all of the work in operating the store is performed by volunteers.⁹⁸ Another illustration of this rule is the production and sale of phonograph records by a medical society, where the services of the performers were provided without compensation.⁹⁹ Still another illustration of this exception concerned a trade association that sold advertising in a commercial, unrelated manner, but avoided unrelated income taxation of the activity because the work involved was provided solely by volunteers.¹⁰⁰

A court ruled that this exemption was defeated in part because free drinks provided to the collectors and cashiers in connection with the conduct of a bingo game by a tax-exempt organization were considered “liquid compensation.”¹⁰¹ This position was, however, rejected on appeal.¹⁰² This court subsequently held that this exception was not available, in the case of an exempt organization that regularly carried on gambling activities, because the dealers and other individuals received tips from patrons of the games.¹⁰³ In another case, this court found that an exempt religious order that operated a farm was not taxable on the income derived from the farming operations because the farm was maintained by the uncompensated labor of the members of the order.¹⁰⁴

The matter of substantiality does not arise, of course, where all of the work in conducting the business is performed without compensation.¹⁰⁵ Where there are one or more compensated persons (whether as employees or independent contractors), substantiality is generally assessed in terms of hours expended. Although the term substantially all is not defined in this setting, it is defined in other contexts to mean at least 85 percent; the IRS follows that rule when applying the volunteer exception.¹⁰⁶

The volunteer exception was held by a court to be unavailable where 77 percent of the services were provided to an exempt organization without compensation.¹⁰⁷ By contrast, another court ruled that the exception was available where the volunteer services amounted to 94 percent of total hours worked.¹⁰⁸ The IRS has ruled that the exception is available where the percentage of volunteer labor was 87 percent,¹⁰⁹ 91 percent,¹¹⁰ and 97 percent.¹¹¹

This exception references receipt of compensation. Thus, individuals who do not receive any economic benefits in exchange for their services to an exempt organization are uncompensated workers (volunteers).¹¹² Mere reimbursement of expenses incurred by volunteers is not compensation.¹¹³ Economic benefits, however, can be considered compensation, even if not formally cast as a salary or fee for service,¹¹⁴ unless they are incidental.¹¹⁵ In some circumstances, nonmonetary benefits can amount to compensation.¹¹⁶

(b) Convenience Businesses

Excluded from unrelated income taxation, in the case of a tax-exempt charitable organization or a state college or university, is a business that is carried on by the organization primarily for the convenience of its members, students, patients, officers, or employees.¹¹⁷ An example of this exception is a laundry operated by an exempt college for the purpose of laundering dormitory linens and the clothing of students.¹¹⁸ As another illustration, the provision by an exempt hospital of mobile services to its patients by means of specially designed vans was ruled to be a convenience business.¹¹⁹

A court expanded this concept by holding that physicians on the staff of a teaching hospital were “members” of the hospital, in that the term “refers to any group of persons who are closely associated with the entity involved and who are necessary to the achievement of the organization's purposes.”¹²⁰ The IRS disagrees with this opinion, however, taking the position that the “hospital's staff physicians are neither ‘members' nor ‘employees' of the hospital in their capacities as private practitioners of medicine.”¹²¹

A court rejected the contention that fees for promotional services received by a tax-exempt organization from vendors were exempt from unrelated business income taxation on the basis of the convenience exception involving the organization's members.¹²² The court concluded that (1) by helping its members save time or money by directing them to low-cost or high-quality vendors, the organization was not serving the convenience of its members in their capacity as members; (2) the organization did not establish that its activity “benefitted its members in any meaningful way”; (3) even if the organization's business activity saved its members money, “there is no legal support for the notion that saving money, without more, is enough to qualify for” the convenience exception; and (4) even if the organization's business activity “were thought to provide a convenience to its members by saving them time or money,” the organization “has not shown that it conducted this activity primarily for the convenience of its members.”¹²³ “[I]t seems clear,” the court stated, that the organization's “primary purpose for engaging in these activities was to raise revenue for itself.”¹²⁴

Read literally, this exception pertains only to the classes of individuals who have the requisite relationship directly with the exempt organization; for example, it applies with respect to services carried on by an exempt hospital for the convenience of its patients. The IRS ruled, however, that the doctrine was available when an exempt organization's activities were for the convenience of patients of another, albeit related, exempt entity.¹²⁵ At the same time, the IRS refused to extend the doctrine to embrace spouses and children of a university's students.¹²⁶

(c) Sales of Gift Items

Unrelated trade or business does not include a business, conducted by a tax-exempt organization, that constitutes the selling of merchandise, substantially all of which has been received by the organization by means of contributions.¹²⁷ This exception is available for thrift shops that sell donated clothes, books, furniture, and similar items (merchandise) to the general public.¹²⁸

Despite its origin, however, this exception is not confined to businesses that are thrift shops, either independent stores or thrift shops operated by tax-exempt organizations such as schools. For example, the IRS ruled that an exempt organization could solicit contributions of home heating oil from individuals who had converted to gas heat, extract the oil from fuel tanks, and sell it to the public, and not be involved in an unrelated business by reason of this exception.¹²⁹ Likewise, the IRS held that a charitable organization may maintain a property donation program, where contributed vehicles and other properties are sold to generate funds, with the program not considered an unrelated business by virtue of this exception.¹³⁰

On one occasion, an IRS agent failed to apply this rule, instead turning the sales-of-gift-items rule inside out. A charitable organization had a fundraising program by which it solicited gifts of and sold real estate time-shares. The IRS inexplicably ruled that the primary purpose of the organization was “attracting customers who would otherwise have gone elsewhere to sell their timeshares.”¹³¹ (This approach would cast a car donation program as one attracting “customers” who otherwise would have sold their automobiles.) The IRS then found that the organization was “principally operating to serve the business needs” of companies the charity hired to conduct real estate closings, deed transfers, and appraisals, concluding that the organization was “conducting itself as a commercial, profit-making enterprise.”

As noted, substantially all of the merchandise involved must have been contributed. In one instance, the IRS held that the exception was available where less than 5 percent of total sales was of purchased items.¹³² Generally, however, the IRS defines substantially all to require that at least 85 percent of the items sold are donated items. For this exception to be utilized, however, the tax-exempt organization itself must be in the requisite business; it is not enough to have the business owned and operated by an independent contractor who merely uses an exempt organization's name and pays over certain receipts to the exempt organization.¹³³

(d) Businesses of Employees' Associations

Excluded from unrelated business income taxation is a business, in the case of a tax-exempt local association of employees¹³⁴ organized before May 27, 1969, that is the selling by the organization of items of work-related clothing and equipment and items normally sold through vending machines, through food-dispensing facilities, or by snack bars, for the convenience of its members at their usual places of employment.¹³⁵ The IRS ruled that this type of association may change its form from unincorporated entity to a corporation without losing its grandfathered status.¹³⁶

(e) Entertainment Activities

Another exception from unrelated business income taxation is applicable with respect to the conduct of entertainment at fairs and expositions.¹³⁷ This rule applies to charitable, social welfare, labor, agricultural, and horticultural organizations¹³⁸ that regularly conduct, as a substantial tax-exempt purpose, an agricultural and/or educational fair or exposition.¹³⁹ This exemption from the unrelated income tax overrides an IRS pronouncement.¹⁴⁰

The term unrelated trade or business does not include qualified public entertainment activities of an eligible organization.¹⁴¹ This term is defined to mean any “entertainment or recreational activity of a kind traditionally conducted at fairs or expositions promoting agricultural and educational purposes, including, but not limited to, any activity one of the purposes of which is to attract the public to fairs or expositions or to promote the breeding of animals or the development of products or equipment.”¹⁴²

Unrelated income taxation is not to occur with respect to the operation of a qualified public entertainment activity that meets one of the following conditions: The public entertainment activity is conducted (1) in conjunction with an international, national, state, regional, or local fair or exposition; (2) in accordance with state law that permits that activity to be conducted solely by an eligible type of tax-exempt organization or by a governmental entity; or (3) in accordance with state law that permits that activity to be conducted under license for not more than 20 days in any year and that permits the organization to pay a lower percentage of the revenue from this activity than the state requires from other organizations.¹⁴³

(f) Trade Shows

Activities that promote demand for industry products and services, like advertising and other promotional activities, generally constitute businesses if carried on for the production of income. The federal tax law provides what the IRS termed a “narrow exception” in this context¹⁴⁴ for certain tax-exempt organizations that conduct industry-promotion activities in connection with a convention, annual meeting, or trade show.

This exception with respect to trade show activities¹⁴⁵ is available for qualifying organizations, namely, tax-exempt labor, agricultural, and horticultural organizations, business leagues,¹⁴⁶ and charitable and social welfare organizations¹⁴⁷ that regularly conduct, as a substantial exempt purpose, shows that stimulate interest in and demand for the products of a particular industry or segment of industry or that educate persons in attendance regarding new developments or products or services related to the exempt activities of the organization.¹⁴⁸

Under these rules, the term unrelated trade or business does not include qualified convention and trade show activities of an eligible organization.¹⁴⁹ The term qualified convention and trade show activities is defined to mean any “activity of a kind traditionally conducted at conventions, annual meetings, or trade shows, including but not limited to, any activity one of the purposes of which is to attract persons in an industry generally (without regard to membership in the sponsoring organization) as well as members of the public to the show for the purpose of displaying industry products or services, or to educate persons engaged in the industry in the development of new products and services or new rules and regulations affecting the industry.”¹⁵⁰ This term thus refers to a “specific event at which individuals representing a particular industry and members of the general public gather in person at one location during a certain period of time.”¹⁵¹

A qualified convention and trade show activity is a convention and trade show activity that is (1) carried on by a qualifying organization; (2) conducted in conjunction with an international, national, state, regional, or local convention, annual meeting, or show; (3) sponsored by a qualifying organization that has as one of its purposes in sponsoring the activity the promotion and stimulation of interest in and demand for the products and services of the industry involved in general or the education of persons in attendance regarding new developments or products and services related to the exempt activities of the organization; and (4) designed to achieve this purpose through the character of the exhibits and the extent of the industry products displayed.¹⁵²

The income that is excluded from taxation by these rules is derived from the rental of display space to exhibitors. This is the case even though the exhibitors who rent the space are permitted to sell or solicit orders, as long as the show is a qualified trade show or a qualified convention and trade show.¹⁵³ This exclusion is also available with respect to a “supplier's exhibit” that is conducted by a qualifying organization in conjunction with a qualified convention or trade show.¹⁵⁴ This exclusion is not available, however, to a stand-alone suppliers' exhibit that is not a qualified convention or trade show.¹⁵⁵ Nonetheless, income from a suppliers' exhibit is not taxable where the displays are educational in nature and are displays at which soliciting and selling are prohibited.¹⁵⁶

There is, moreover, an aspect of this issue that may resolve the tax issue for many tax-exempt organizations not expressly covered by these rules. This relates to the fact that an unrelated business must be regularly carried on before the revenue from the business can be taxed as unrelated income.¹⁵⁷ Thus, the net income derived by an exempt organization (irrespective of the statutory basis for its tax exemption) from the conduct of a trade show would not be taxable as unrelated income if the trade show is not regularly carried on. A court case gives support to the premise that the conduct of a typical trade show is not an activity that is regularly carried on.¹⁵⁸

A tax-exempt organization may sponsor and perform educational and supporting services for a trade show (such as use of its name, promotion of attendance, planning of exhibits and demonstrations, and provision of lectures for the exhibits and demonstrations) without having the compensation for its efforts taxed as unrelated income, as long as the trade show is not a sales facility.¹⁵⁹ The IRS ruled that the convention and trade show activities qualified for this exception, and that the fact that this sponsorship of and participation in “commercial trade shows” with a for-profit entity did not change their nature as qualified activities.¹⁶⁰

The IRS issued guidance as to when Internet activities conducted by qualifying organizations (or at least exempt business leagues) fall within this exception for qualified convention and trade show activity.¹⁶¹

(g) Hospital Services

An exception from unrelated business income taxation is applicable with respect to the performance of certain services for small hospitals. It generally is the position of the IRS that income that a tax-exempt hospital derives from provision of services to other exempt hospitals constitutes unrelated business income to the hospital that is the provider of the services, on the theory that the providing of services to other hospitals is not an activity that is substantially related to the exempt purpose of the provider hospital.¹⁶² Congress acted to reverse this rule in the case of small hospitals.

This special rule¹⁶³ applies where a tax-exempt hospital¹⁶⁴ provides services only to other exempt hospitals, as long as each of the recipient hospitals has facilities to serve no more than 100 inpatients and the services would be consistent with the recipient hospitals' exempt purposes if performed by them on their own behalf. The services provided must be confined to certain ones.¹⁶⁵

(h) Gambling

Bingo game income realized by most tax-exempt organizations is not subject to unrelated business income taxation.¹⁶⁶ This exclusion applies where the bingo game¹⁶⁷ is not conducted on a commercial basis and where the games do not violate state or local laws.¹⁶⁸ It is the view of the IRS that this exception applies only to gambling activities in which all wagers are placed, all winners are determined, and all prizes are distributed in the presence of the players of the game, so that the conduct of a “pull-tab operation” is not embraced by the exception.¹⁶⁹ This view was reflected in a court opinion holding that proceeds attributable to an organization's “instant bingo” activities were not protected by the exception because individuals could play and win in isolation.¹⁷⁰ By virtue of the way the organizations are taxed, the bingo game exception is not applicable to social clubs, voluntary employees' beneficiary associations, political organizations, and homeowners' associations.¹⁷¹

(i) Pole Rentals

In the case of a mutual or cooperative telephone or electric company,¹⁷² the term unrelated trade or business does not include engaging in qualified utility pole rentals.¹⁷³

(j) Low-Cost Articles

Another exception from unrelated business income taxation is available only to tax-exempt organizations eligible to receive tax-deductible charitable contributions,¹⁷⁴ for activities relating to certain distributions of low-cost articles incidental to the solicitation of charitable contributions.¹⁷⁵ While this statutory provision is generally reflective of a similar rule stated in the income tax regulations,¹⁷⁶ there is one important refinement, which is that the term low-cost article is defined as any article (or aggregate of articles distributed to a single distributee in a year) that has a cost not in excess of $5 (adjusted for inflation¹⁷⁷) to the organization that distributes the item or on behalf of which the item is distributed.¹⁷⁸ These rules also require that the distribution of the items be unsolicited and be accompanied by a statement that the distributee may retain the low-cost article irrespective of whether a charitable contribution is made.¹⁷⁹

(k) Mailing Lists

Another exception from unrelated business income taxation available to the category of tax-exempt organizations eligible for the low-cost articles exception¹⁸⁰ is applicable to the exchanging or renting of membership or donor mailing lists with or to another of these exempt organizations.¹⁸¹

Absent this exception, however, the rental or exchange of a mailing list by a tax-exempt organization, when regularly carried on, is considered by the IRS to be an unrelated business. This is not a problem from an economic standpoint when the activity involves a list rental,¹⁸² in that taxes can be paid from the resulting net income. When the activity is a list exchange, however, there is no income from the transaction available to pay the tax; it is nonetheless the view of the IRS that these exchanges are unrelated businesses.¹⁸³ In calculating the amount of “income” of this nature, the IRS advised that the method to use should be in accordance with the rules concerning facilities used for related and unrelated purposes; thus, expenses and deductions are to be allocated between the two uses on a reasonable basis.¹⁸⁴

If properly structured, however, a mailing list rental or exchange program involving a noncharitable tax-exempt organization can avoid unrelated business income taxation by reason of treatment of the income as an excludable royalty.¹⁸⁵

(l) Associate Member Dues

If a tax-exempt agricultural or horticultural organization¹⁸⁶ requires annual dues not exceeding $100 (indexed for inflation¹⁸⁷) to be paid in order to be a member of the organization, no portion of the dues may be considered unrelated business income because of any benefits or privileges to which these members are entitled.¹⁸⁸

The term dues is defined as any “payment required to be made in order to be recognized by the organization as a member of the organization.”¹⁸⁹ If a person makes a single payment that entitles the person to be recognized as a member of the organization for more than 12 months, the payment can be prorated for purposes of applying the $100 cap.¹⁹⁰

(m) Small Business Corporations Rules

A charitable tax-exempt organization¹⁹¹ may be a shareholder in an S corporation, which is a corporation that is treated for federal income tax purposes as a partnership.¹⁹² The authorization to own this type of a security is a revision of prior law.¹⁹³

This type of interest is an interest in an unrelated business.¹⁹⁴ Items of income, loss, or deduction of an S corporation flow through to eligible tax-exempt organization shareholders as unrelated business income.¹⁹⁵ Gain or loss on the disposition of stock in an S corporation also results in unrelated business income.¹⁹⁶

(a) General Rules

Generally, to be directly connected with the conduct of an unrelated business, an item of deduction must have a proximate and primary relationship to the carrying on of that business. In the case of a tax-exempt organization that derives gross income from the regular conduct of two or more unrelated business activities, unrelated business taxable income is the aggregate of gross income from all unrelated business activities, less the aggregate of the deductions allowed with respect to all unrelated business activities.²⁴⁹ Expenses, depreciation, and similar items attributable solely to the conduct of unrelated business are proximately and primarily related to that business and therefore qualify for deduction to the extent that they meet the requirements of relevant provisions of the federal income tax law.²⁵⁰ A loss incurred in the conduct of an unrelated activity may be offset against the net gain occasioned by the conduct of another unrelated activity only where the loss activity is conducted with a profit objective.²⁵¹

Where facilities and/or personnel are used both to carry on tax-exempt activities and to conduct unrelated trade or business, the expenses, depreciation, and similar items attributable to the facilities and/or personnel, such as overhead or items of salary, must be allocated between the two uses on a reasonable basis.²⁵² Despite the statutory rule that an expense must be directly connected with an unrelated business, the regulations merely state that the portion of the expense allocated to the unrelated business activity is, where the allocation is on a reasonable basis, proximately and primarily related to the business activity.²⁵³ Once an item is proximately and primarily related to a business undertaking, it is allowable as a deduction in computing unrelated business income in the manner and to the extent permitted by federal income tax law generally.²⁵⁴

Gross income may be derived from an unrelated trade or business that exploits a tax-exempt function. Generally, in these situations, expenses, depreciation, and similar items attributable to the conduct of the tax-exempt function are not deductible in computing unrelated business taxable income. Since the items are incident to a function of the type that is the chief purpose of the organization to conduct, they do not possess a proximate and primary relationship to the unrelated trade or business. Therefore, they do not qualify as being directly connected with that business.²⁵⁵

A tax-exempt organization will be denied business expense deductions in computing its unrelated business taxable income if it cannot adequately substantiate that the expenses were incurred or that they were directly connected with the unrelated activity. In one instance, an organization derived unrelated business income from the sale of advertising space in two magazines and incurred expenses in connection with solicitation of the advertising and publication of the magazines. A court basically upheld the position of the IRS, which disallowed all of the claimed deductions (other than those for certain printing expenses) because the organization failed to establish the existence or relevance of the expenses.²⁵⁶

(b) Charitable Deduction

Tax-exempt organizations²⁵⁷ are allowed, in computing their unrelated business taxable income (if any), a federal income tax charitable contribution deduction.²⁵⁸ This deduction is allowable irrespective of whether the contribution is directly connected with the carrying on of the trade or business. This deduction may not exceed 10 percent of the organization's unrelated business taxable income computed without regard to the deduction.²⁵⁹

Trusts²⁶⁰ are allowed a charitable contribution deduction;²⁶¹ the amount that is deductible is basically the same as that allowable pursuant to the rules applicable to charitable gifts by individuals.²⁶² Again, a deductible charitable gift from a trust need not be directly connected to the conduct of an unrelated business.

Qualification for either of these charitable contribution deductions requires that the payments be made to another organization; that is, the funds may not be used by the organization in administration of its own charitable programs. For example, a tax-exempt university that operates an unrelated business is allowed this charitable deduction for contributions to another exempt university for educational purposes, but is not allowed the deduction for amounts expended in administering its own educational program.²⁶³

(c) Specific Deduction

In computing unrelated business taxable income, a specific deduction of $1,000 is available.²⁶⁴ This deduction, however, is not allowed in computing net operating losses.²⁶⁵ A diocese, province of a religious order, or convention or association of churches is allowed, with respect to each parish, individual church, district, or other local unit, a specific deduction equal to the lower of $1,000 or the gross income derived from an unrelated business regularly carried on by such an entity.²⁶⁶ This deduction is intended to eliminate imposition of the unrelated income tax in cases in which exaction of the tax would involve excessive costs of collection in relation to any payments received by the government.²⁶⁷

As to this local unit rule, however, a diocese, province of a religious order, or convention or association of churches is not entitled to a specific deduction for a local unit that, for a tax year, files a separate return. In that instance, the local unit may claim a specific deduction equal to the lower of $1,000 or the gross income derived from any unrelated trade or business that it regularly conducts.²⁶⁸

(d) Net Operating Losses

The net operating loss deduction²⁶⁹ is allowed in computing unrelated business taxable income.²⁷⁰ The net operating loss carryback or carryover (from a tax year for which the exempt organization is subject to the unrelated business income tax) is determined under the net operating loss deduction rules without taking into account any amount of income or deduction that is not included under the unrelated business income tax rules in computing unrelated business taxable income. For example, a loss attributable to an unrelated trade or business is not to be diminished by reason of the receipt of dividend income.²⁷¹

For the purpose of computing the net operating loss deduction, any prior tax year for which a tax-exempt organization was not subject to the unrelated business income tax may not be taken into account. Thus, if the organization was not subject to this tax for a preceding tax year, the net operating loss is not a carryback to such preceding tax year, and the net operating loss carryover to succeeding tax years is not reduced by the taxable income for such preceding tax year.²⁷²

A net operating loss carryback or carryover is allowed only from a tax year for which the exempt organization is subject to the unrelated business income tax rules.²⁷³ In determining the span of years for which a net operating loss may be carried for purposes of the net operating loss deduction rules, tax years in which an exempt organization was not subject to the unrelated business income tax regime may be taken into account.²⁷⁴