Greenberg Traurig Alert

IRS Rules on Operation of a Gift-Shop;
Services Provided to Hospital Affiliates

June 2000
By Harry J. Friedman, Greenberg Traurig, Miami Office

  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 organization’s 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 organization’s 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 room’s appeal attracted people by permitting them to socialize and shop simultaneously.

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 organization’s exempt purposes. The tea room provided 34% of the organization’s 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 organization’s 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 organization’s 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 organization’s 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 organization’s 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 museum’s 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 hospital’s 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 organizations.

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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