Greenberg Traurig Alert
IRS Rules on Operation of a Gift-Shop;
Services Provided to Hospital Affiliates
By Harry J. Friedman, Greenberg Traurig, Miami
View or download the PDF version of this Alert here.
Gift Shop Operations
A recent Technical Advice Memorandum ("TAM") addresses unrelated trade or
business income tax issues common to many organizations. (A TAM is a private letter ruling
issued by the IRS National Office in connection with an audit.) The TAM deals with tax
consequences of the operation of a gift shop and a tea room by a Section 501(c)(3)
organization. The same issues presented by the operation of a gift shop and a tea room may
be equally relevant to gift shops operated by exempt organizations on the internet.
Generally, tax exempt organizations are required to pay Federal income tax on income
arising from activities that (i) constitute a trade or business and (ii) are unrelated to
the organizations exempt purpose. (See, GT Alert, February 2000, for a
more detailed description of the unrelated trade or business income tax rules.) The fact
that the proceeds from the unrelated trade or business activity are used for exempt
purposes does not affect Federal income tax treatment of the income earned by the
organization. In addition to the imposition of income tax, substantial unrelated trade or
business activity may result in the organization losing its tax exempt status.
The TAM states that the exempt organization involved was organized to aid deserving
women to earn their own living by means of their own handiwork. The organization furthered
this exempt purpose by providing a place where its clients could sell articles and
food-stuffs prepared by them. The organization operates three contiguous shops: a
consignment shop, a gift shop and a tea room, all of approximately the same size. All
three shops were operated by both volunteers and paid employees of the organization. The
consignment shop displayed and sold goods made by the needy women. The gift shop purchased
decorative items from regular for-profit vendors for re-sale to the public. The tea room
was a luncheon facility providing meals to the general public.
The organization asserted that the operation of the gift shop was necessary to create a
reason for people to come to the premises, a showroom with ambience that repeatedly
attracts high-end clientele and a showcase of quality merchandise. The organization urged
that the items purchased from for-profit vendors in the gift shop were necessary in order
to bring in prospective customers for the consignment shop. Operation of the gift shop
thus enhanced the organizations ability to successfully operate the consignment
shop, a major exempt purpose of the organization.
The tea room was adjacent to the consignment shop and the gift shop. It operated as a
lunchroom, selling food to the general public. The organization asserted that the tea
rooms appeal attracted people by permitting them to socialize and shop
The organization urged that its only purpose in operating the gift shop and the tea
room was to further its primary exempt purpose of helping people who face adversity to
help themselves and to enhance the handicraft sales activity through attracting customers
and providing funds to subsidize the organizations exempt purposes. The tea room
provided 34% of the organizations revenues, the consignment shop 33% of the revenues
and the gift shop 28% of the revenues. The remainder of the revenues of the organization
came from donations and membership dues. The consignment shop utilized approximately 40%
of the organizations financial and physical resources; the tea room and the gift
shop each utilized approximately 30% of the financial and physical resources.
The TAM first addressed whether the operation of the gift shop and tea room affected
the exempt status of the organization. The Treasury Regulations provide that an
organization will not be regarded as operating "exclusively" for exempt purposes
if more than an insubstantial part of its activities is not in furtherance of an exempt
purpose. An organization may meet these requirements, although it operates a trade or
business as a substantial part of its business, if (i) the operation of the trade or
business is in furtherance of the organizations exempt purpose and (ii) the
organization is not organized or operated for the primary purpose of carrying on an
unrelated trade or business.
In Revenue Ruling 68-167, the IRS ruled that the operation of a market that sold
needlepoint and cooking of needy women was an exempt activity. Normally, the retail sale
of goods is business activity. However, the purpose of retail sales may have an exempt
purpose such as the facts presented in the Revenue Ruling and the circumstances presented
by the TAM.
The TAM observes that an organization can operate a trade or business that is unrelated
to its exempt purpose so long as the activity is in furtherance of the exempt purpose.
Raising money for exempt purposes may be in furtherance of the exempt purpose even if the
income arising from the activity is taxable. Thus, the TAM reasons, the focus must be on
the purpose of the activity, not the taxability.
The TAM concludes that the sole purpose of the gift shop and tea room were to raise
funds to support the organizations charitable program and to provide a means of
attracting clientele. As a result, the TAM concludes that the operations did not support a
finding that the organization has a substantial non-exempt purpose in undertaking the
activities. Accordingly, the TAM finds that the exempt status of the organization should
not be affected by the operation of the tea room and the gift shop.
The TAM should be compared to a number of judicial decisions that found that a primary
purpose of the operation of an organization was based solely on the magnitude of the
unrelated trade or business. In a number of judicial decisions the amount of income
derived from the activity compared to the total income of the organization, the amount of
expenditures for the activity compared with total expenditures of the organization, and
the amount of time devoted to the activity by employees compared to total hours worked
were measures of "substantiality." In contrast in the TAM, the percentage of
revenues and expenditures were not controlling in light of the size of the activity. The
TAM does not address the fact that a majority of the revenues and the expenditures of the
organization were in connection with an unrelated trade or business. Instead, the TAM
focuses on the relationship of the activities to the exempt purposes of the organization.
It is unclear to what extent the second purpose of operating the tea room and the gift
shop, improving the results of the consignment shop, affected the decision. Would simply
the use of the funds have been sufficient to avoid revocation of exempt status? A second
purpose may be important; simply using the funds derived from the activity for exempt
purposes may not be enough.
The TAM did conclude that the operation of the gift shop and the tea room were not
substantially related to the exempt purpose of aiding needy women and constituted an
unrelated trade or business. The sale of items which have no causal relationship to the
organizations exempt purpose do not contribute to the accomplishment of the exempt
purpose and, thus, constitute an unrelated trade or business. Merely the fact that the
gift shop created "an aura of sophistication and tastefulness" did not itself
create a causal relationship to the sale of the handicraft items. This ruling is
consistent with Revenue Ruling 73-105 which concluded that items sold in a museum gift
shop unrelated to the museum would generate taxable income.
In Revenue Ruling 74-399, the operation of an eating facility that helped attract
visitors to a museum and enhanced the efficient operation of the museum by enabling the
staff and employees to remain on its premises was found to have contributed importantly to
the museums exempt purposes. However the operation of the tea room by the
organization that was the subject of the TAM was distinguished because its operations were
commercial. The TAM notes that the tea room was competing with other restaurants, used
profit-making formulas, its hours of operation were competitive with other commercial
operations, and there was no plan to solicit funds from the public.
Providing Services to Taxable Members of Hospital Systems
At a recent conference on exempt organizations in Washington, D.C., a representative of
the IRS indicated that ancillary services, such as management services, computer services
and consulting services, provided by a tax-exempt hospital or other tax-exempt affiliates
to for-profit affiliates within the system, may result in unrelated trade or business
income tax ("UBIT"). The issues arose in the context of an example involving a
hospital system composed of an exempt parent, a hospital, a medical group practice, a
Section 501(c)(4) HMO and a for-profit management company. The hospital leases
debt-financed space to another hospital and participates in a partnership with another
hospital that involves operating a clinic.
The IRS representative indicated that the ancillary services provided by an exempt
organization to for-profit organization did not have a "substantial causal
relationship to the achievement" of the hospitals exempt purposes. Simply the
fact that the non-exempt organization and the for-profit business have the same parent
corporation, did not avoid characterization of revenues paid by the for-profit affiliate
to the exempt hospital as UBIT. Presumably, the failure of the for profit affiliate to pay
for the services would constitute prohibited private benefit.
Ancillary services provided to a partnership of which the exempt organization is a
partner may also give rise to UBIT. The IRS representative indicated that the fact that
the other partners in the partnership were Section 501(c)(3) organizations would not
affect this result. The services provided to the partnership are not within the exempt
purposes of the other partner.
This conclusion is consistent with the private letter rulings issued by the IRS in
connection with the formation of joint operating agreements. These rulings create a
requirement of affiliation in order for a sharing of non-exempt services to not constitute
an unrelated trade or business. In essence, management services provided to unrelated
parties are no different than those services provided by unrelated for-profit
Similarly, a leasing of space to an unrelated hospital or other health care provider
will result in UBIT if the facility leased was acquired or constructed with borrowed
funds. Providing space to an unrelated hospital will not be considered an exempt activity.
© 2000 Greenberg Traurig
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