Greenberg Traurig Alert

Update: Unrelated Trade or Business Income Taxation

September 1999
By Harry J. Friedman, Greenberg Traurig, Miami Office

  View or download the PDF version of this Alert here.

Over the last several years, the Internal Revenue Service (the "Service") has taken a great deal of interest in the commercial activities of tax-exempt organizations. Tax-exempt organizations are frequently seeking new sources of revenues to use to further their exempt purposes. A number of cases have addressed the consequences of an exempt organization receiving income from the marketing of mailing lists and deals between credit card issuers and tax-exempt organizations to market affinity credit cards. The growth of the Internet has generated numerous questions about the treatment of revenues earned by tax-exempt organizations from their websites. (See, GT Alert, August, 1999)

The unrelated business income tax ("UBIT") is an area often ignored by exempt organizations. Recently, an IRS representative indicated that of the 1.3 million exempt organizations filing tax returns, only 36,000 - 37,000 filed Form 990-T, the form for reporting unrelated trade or business income. This small portion of the universe of exempt organizations reporting unrelated trade or business income has drawn the interest of the Service, armed with the assumption that many more organizations are engaging in activities that should be subject to UBIT. This GT Alert reviews the rules addressing UBIT.

General Rules

An organization otherwise exempt from Federal income tax is subject to tax on its "unrelated business taxable income". Unrelated business taxable income is income "derived by any organization from any unrelated trade or business... regularly carried on by it." The definition contains the three basic requirements that if found result in the income of an exempt organization being subject to UBIT:

1.) The income must be derived from an activity that constitutes a trade or business. In one case, a court concluded that a covenant not to compete was not a trade or business.

2.) The activity that constitutes the trade or business must be unrelated to the exempt purpose of the organization. The activity of an exempt organization is related to an exempt purpose if the conduct of the business activity has "causal relationship to the achievement of exempt purposes" and the relationship is a "substantial relationship." The intent is to exclude from taxation only income from those activities that further the exempt purposes of the organization. The need to obtain funds for other activities is not sufficient to make the income earning activity related to exempt purposes. For example, an organization engaged in the training of children in dance is not required to treat income from recitals as subject to UBIT. A union that provides course materials to improve the skills of its members does not have UBIT from fees paid by the members. The activity, improving skills of its members, is within the exempt purposes of a union.

3.) The activity constituting the unrelated trade or business must be regularly carried on. Generally, regularly carried on means conducting the activity in a manner comparable to commercial activities. In one case, a court concluded that the publication of the program for the NCAA Basketball Championship was not a business regularly carried on. However, other cases suggest that an event that occurs annually may constitute a trade or business regularly carried on.

The definition of UBIT should be considered in terms of its purpose. Commercial businesses are concerned that exempt organizations can conduct  competitive business with the advantage of not being required to pay Federal income taxes. The intent of taxation of unrelated business taxable income is to put for-profit businesses and exempt organizations on equal footing to the extent that the activity is unrelated to a charitable or other exempt purpose. The concept, in part, dates from a Supreme Court case involving New York University, which at the time, was operating a well-known macaroni manufacturer. The income from the sales of pasta was not subject to tax. The Supreme Court’s decision led Congress to enact laws to tax this income. Complaints by commercial providers of similar services continue to this day. The recently Proposed Treasury Regulations involving travel and tours sponsored by tax-exempt organizations were in response to complaints by commercial travel and tour operators that exempt organizations were unfairly competing with their businesses.

Exemptions

The Internal Revenue Code contains a list of certain types of incomes that are not subject to UBIT. Included are dividends and interest payments, royalties, rental income from real property, capital gain and certain income received by a college, university or hospital from research activities.

The exceptions to UBIT themselves have exceptions. Income from rent, interest or dividends derived from property subject to acquisition indebtedness are not excluded. For example, rental income derived from a mortgaged building would be subject to UBIT unless the activity from which the rental income is derived is related to the entity’s exempt purposes.

Another special rule taxes interest, royalties and rents received from for-profit organizations of which the recipient exempt organization owns more than 50% of the voting control. This provision is intended to prevent an exempt organization from engaging in an unrelated trade or business through a taxable subsidiary that, in turn, pays all of its income in the form of rent, interest or royalty payments to the exempt organization, effectively eliminating taxation of the activity. Legislation has been proposed to eliminate UBIT treatment if the payments between the taxable subsidiary and the exempt organization are fair market value. This would treat the receipt of payments from a subsidiary in the same manner as similar payments received from an unrelated entity.

Royalties

Many of the recent cases have revolved around the definition of the term "royalties." The courts have indicated that a royalty must be derived from a source for which the exempt organization does not provide any substantial services. Cases dealing with affinity credit cards and the rental of mailing lists have frequently turned on whether or not the activities of the exempt organization constituted services provided to the paying organization or, instead, merely the delivery of intangible personal property, payments for which constitute "royalties." The frequency of this issue, being litigated by the Service, mandates that organizations examine contracts for the use of intangible property to ensure that they present the issues in the most favorable light. For example, the contract for the rental of a mailing list should not provide that the payment from the user of the mailing list constitutes a commission for referrals. The agreement should not state that the exempt organization is involved in the commercial organization’s marketing activities. Often, the contracts for these arrangements are drafted by counsel for the for-profit organization, who may not be as sensitive to the UBIT issue as are representatives of the exempt organization. Poorly drafted agreements may be a crucial factor in an adverse tax decision by the Service.

Advertising income is another source of UBIT. It is clear that income of an exempt organization from advertising in periodicals that it publishes is subject to tax. Often the issue is whether or not simply references to a commercial organization made in exchange for compensation constitutes advertising. The issue was recently highlighted by payments received by football bowl games from sponsors. The Service initially took the position that such payments constituted advertising income to exempt organizations that operated football games. The uproar eventually led to the enactment of legislation that specifically defines the "acknowledgement" of sponsors, and provides that acknowledgements do not constitute advertising services. While the legislation provides a roadmap of how to avoid advertising treatment, exempt organizations must match the agreements they have entered into with the standards contained in the statute.

Internet related problems have arisen from several different types of activities in which exempt organizations have used their websites. Links to for-profit sponsors may constitute advertising income to the exempt organization. The Service has indicated that while it is looking closely at the issue, it believes such links constitute advertising. Other organizations have entered into deals with organizations with links from the exempt organizations’ websites. Each customer of the for-profit organization that uses the exempt organization’s website to link to the commercial website and purchases a product or a service results in a payment to the exempt organization. While this arguably should be no different than selling a mailing list, the tax treatment of this is unclear. Contractual language may be important here as well in defining the nature of the payment.

Partnerships

An exempt organization can not escape UBIT treatment simply by organizing the activity as a partnership or S corporation. (Certain types of exempt organizations can be shareholders of an S corporation.) In the case of an S corporation, income allocated to the exempt organization is treated as subject to UBIT, regardless of the source of the income. For example, interest earned by an S corporation is subject to UBIT when allocated to an exempt organization.

If an exempt organization is a partner in a partnership, the treatment of income allocated to the exempt organization depends on the nature of the activity of the partnership from which the income is derived. If the income allocated to the exempt organization is derived from interest or dividends, the income will not be subject to UBIT. If the income allocated to the exempt organization is derived from an activity that would constitute an  unrelated trade or business if conducted by the exempt organization directly, the income would be subject to UBIT. The rule does not differentiate between limited partners and general partners. Further, the same rule would apply to members of a limited liability company.

The recent case involving Redlands Surgical Services leads to what many commentators believe is a UBIT problem. In the Redlands Surgical Services case a single purpose entity was refused exempt status. Its sole activity was being a general partner in a partnership with for-profit entities that operated an ambulatory surgical center. The fact that the organization did not control the activity supported rejection of exempt status. Many have suggested that in the case where the organization had other exempt activities, the failure to control the joint venture may result in UBIT treatment for the income allocated from the partnership or limited liability company to the exempt organization. Control of the activity, in order to ensure that it is conducted for exempt purposes, was important in Redlands. The same may be true to avoid UBIT classification when the activity may be generally related to the organization’s exempt purposes, for example, providing healthcare or education. Representatives of the Service have indicated they are looking closely at this issue.

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The definition of UBIT should be considered in terms of its purpose. Commercial businesses are concerned that exempt organizations can conduct competitive business with the advantage of not being required to pay Federal income taxes. The intent of taxation of unrelated business taxable income is to put for-profit businesses and exempt organizations on equal footing to the extent that the activity is unrelated to a charitable or other exempt purpose. The concept, in part, dates from a well publicized case involving an organization supporting New York University, which was operating a well-known macaroni manufacturer. The fact that the revenues from the sale of pasta were not subject to tax led Congress to enact laws to tax the income from activities competing with commercial businesses. Complaints by commercial providers of goods and services similar to those provided by exempt organizations continue to this day. The recently Proposed Treasury Regulations involving travel and tours sponsored by tax exempt organizations were in response to complaints by commercial travel and tour operators that exempt organizations were unfairly competing with their businesses.

© 1999 Greenberg Traurig