The unrelated business rules constitute one of the most important components of the law of tax-exempt organizations. These rules influence nearly every operational decision made on behalf of an exempt organization, including the nature and scope of activities, financing and investments, use of a subsidiary, and involvement in joint ventures. Though some exempt organizations have an innate aversion to unrelated business activities, others aggressively embrace them as a way to generate needed revenue. Whether avoided or accommodated, the unrelated business rules—approaching 60 years of existence—are among the continually expanding bodies of tax law affecting the activities of nearly all nonprofit organizations.
Nearly all tax-exempt organizations are subject to the unrelated business rules.1 Thus, before it need concern itself with those rules, an organization must first qualify for tax-exempt status.2 Once that is accomplished, the organization may 1 See § 1.7.
Hopkins, The Law of Tax-Exempt Organizations, Eighth Edition (John Wiley & Sons, 2003) (hereinafter Tax- Exempt Organizations), particularly chapter 23 (concerning the exemption recognition process). The basic tests for qualification for exemption are summarized in id. chapter 8, and the various categories of tax-exempt have to contemplate the extent to which it can engage in unrelated business and retain its exemption.
The term tax-exempt organization is an anomaly, inasmuch as few organizations are, as a matter of federal tax law, wholly exempt from tax. Aside from governmental entities, just about every nonprofit organization that enjoys general tax exemption is subject to one or more federal income or excise taxes (as well as state and/or local taxes). Levies that may be imposed on otherwise exempt organizations include taxes on charitable organizations that engage in excess expenditures to influence legislation or for political activities, a tax on the investment income of social clubs, taxes on private foundations, taxes on exempt organizations that are disqualified persons in excess benefit transactions, a tax on membership organizations that engage in forms of advocacy, and a tax on charitable organizations that pay premiums on personal benefit contracts. Nonetheless, the federal tax that tax-exempt organizations in general are most likely to pay (or engage in planning to avoid) is the tax on unrelated business income.
Section 61(a) of the Internal Revenue Code provides that “[e]xcept as otherwise provided in this subtitle [Subtitle A—income taxes], gross income means all income from whatever source derived,” including items such as interest, dividends, compensation for services, and receipts derived from the conduct of business. The Code provides for a variety of deductions, exclusions, and exemptions in computing taxable income. Many of these are contained in IRC. Subtitle A, Subchapter B, entitled “Computation of taxable income.” Pertinent in the taxexempt organizations context, however, is the body of exemption provisions contained in Subtitle A, Subchapter F, captioned “Exempt organizations.” Exemption from federal income taxation is derived from a specific provision to that end in the Internal Revenue Code. Derivation of exemption is here used in the sense of recognition of exemption by the appropriate administrative agency (the Internal Revenue Service (IRS)) or as a matter of law, as opposed to exemption that is a byproduct (albeit a resolutely sought one) of some other tax status (such as a cooperative or a state instrumentality). A federal tax exemption is a privilege (a matter of legislative grace), not an entitlement,11 and—being an exception to the norm of taxation—is often strictly 3 See § 1.10.
Internal Revenue Code of 1986, as amended (IRC) § 4911 or § 4912. See Tax-Exempt Organizations, §§ 20.3(b), 20.6. 5 IRC §§ 527(f) and/or 4955. See Tax-Exempt Organizations, §§ 21.2, 21.3. 6 IRC § 512(a)(3)(A). See Tax-Exempt Organizations, § 14.3. 7 IRC §§ 4941–4948. See Tax-Exempt Organizations, § 11.4; Hopkins & Blazek, Private Foundations: Tax Law and Compliance, Second Edition (John Wiley & Sons, 2003) (hereinafter Private Foundations), §§ 5.14(d), 6.6(c), 8.4, 9.9, 10.1. 8 IRC § 4958(a)(1), (b). See Tax-Exempt Organizations, § 19.11(f); Hopkins, The Law of Intermediate Sanctions: A Guide for Nonprofits (John Wiley & Sons, 2003) (hereinafter Intermediate Sanctions), § 3.1. 9 IRC § 6033(e)(2). See Tax-Exempt Organizations, § 20.8(b). 10 IRC § 170(f)(10)(F). See Hopkins, The Tax Law of Charitable Giving, Third Edition (John Wiley & Sons, 2005) (hereinafter Charitable Giving), § 17.6(b). 11 As discussed, however, the federal tax exemption for many nonprofit organizations (such as charitable ones) is a reflection of the heritage and societal structure of the United States (see Tax-Exempt Organizations, § 1.3). construed. (The same principle applies with respect to tax deductions13 and tax exclusions.14) This type of exemption must be enacted by Congress and will not be granted by implication. Two related tax precepts are (1) that a person requesting exemption must demonstrate compliance with the requirements set forth in the statute that grants the exemption, and (2) that the party claiming the exemption bears the burden of proof of eligibility for the exemption. Thus, a court wrote that the federal tax statutory law “generally consists of narrowly defined categories of exemption” and is “replete with rigid requirements which a putatively exempt organization must demonstrate it meets.” The IRS and the courts are alert for efforts to gain a tax exemption when the underlying motive is the purpose of “confounding tax collection.”
At the same time, provisions granting exemptions for charitable organizations are usually liberally construed. Thus, a court wrote that the “judiciary will liberally construe, and rightfully so, provisions giving exemptions for charitable, religious, and educational purposes.” Another court said that “in view of the fact that bequests for public purposes operate in aid of good government and perform by private means what ultimately would fall upon the public, exemption from taxation is not so much a matter of grace or favor as rather an act of justice.” Similarly, it has been held that the exemption of income devoted to charity, by means of the charitable contribution deductions, should not be narrowly construed. These provisions respecting income destined for charity are accorded favorable construction, as they are “begotten E.g., Knights of Columbus Bldg. Ass’n v. United States, 88-1 U.S.T.C. ¶ 9336 (D. Conn. 1988) (“A tax exemption is a benefit conferred by the legislature in its discretion. Because there is no entitlement to an exemption absent allowance by the legislature, the exemption provisions are strictly construed”); Mercantile Bank & Trust Co. v. United States, 441 F.2d 364, 366 (8th Cir. 1971) (“Special benefits to taxpayers, such as tax exemption status, do not turn upon general equitable considerations but are matters of legislative grace”). See also Conference of Major Religious Superiors of Women, Inc. v. Dist. of Columbia, 348 F.2d 783 (D.C. Cir. 1965); Am. Auto. Ass’n v. Comm’r, 19 T.C. 1146 (1953); Associated Indus. of Cleveland v. Comm’r, 7 T.C. 1449 (1946); Bingler v. Johnson, 394 U.S. 741 (1969) and authorities cited therein. In general, Murtagh, The Role of the Courts in the Interpretation of the Internal Revenue Code, 24 Tax Law. 523 (1971). Deputy v. DuPont, 308 U.S. 488 (1940); White v. United States, 305 U.S. 281 (1938). In Alfred I. duPont Testamentary Trust v. Comm’r, 514 F.2d 917, 922 (5th Cir. 1975), a case involving tax deductions claimed by a trust, the court wrote that the deductions “must fit into a statutory category of deductibility, else the trustees must carry out their fiduciary duty at the expense of the trust, rather than the public fisc.” E.g., Estate of Levine v. Comm’r, 526 F.2d 717, 717 (2d Cir. 1975), in which the court was prompted to observe that “[o]ne suspects that because the Internal Revenue Code . . . piles exceptions upon exclusions, it invites efforts to outwit the tax collector.”
Harrison v. Barker Annuity Fund, 90 F.2d 286, 288 (7th Cir. 1937). The court also said that “courts quite generally have extended liberal construction to statutes furthering the encouragement of bequests for purposes which tend toward the public good, without reference to personal or selfish motives” (id.). SICO Found. v. United States, 295 F.2d 924, 930, n.19 (Ct. Cl. 1962), and cases cited therein. from motives of public policy,” and any ambiguity therein has traditionally been resolved against taxation.
The provision in the Internal Revenue Code that is the general source of the federal income tax exemption is IRC. § 501(a),25 which states that an “organization described in subsection (c) or (d) or section 401(a) [the latter relating to employee benefit funds] shall be exempt from taxation under this subtitle [Subtitle A—income taxes] unless such exemption is denied under section 501 or 503.” The U.S. Supreme Court characterized IRC. § 501(a) as the “linchpin of the statutory benefit [exemption] system.” The Court summarized the exemption provided by IRC. § 501(a) as according “advantageous treatment to several types of nonprofit corporations [and trusts, unincorporated associations, and certain limited liability companies], including exemption of their income from taxation and [for those that are also eligible charitable donees] deductibility by benefactors of the amounts of their donations.”
Thus, to be recognized as tax-exempt under IRC. § 501(a), an organization must conform to the appropriate descriptive provisions of IRC. §§ 501(c), 501(d), or 401(a). This exemption, however, does not extend to an organization’s unrelated business taxable income.28 An organization that seeks to obtain tax-exempt status, therefore, bears the burden of proving that it satisfies all the requirements of the exemption statute involved.
In this book, the term tax-exempt organization refers to a nonprofit organization that is generally exempt from (excused from paying) the federal income tax. There are, of course, other federal taxes (such as excise and employment taxes), and there are categories of exemptions from them as well. At the state level, there are exemptions associated with income, sales, use, excise, and property taxes.
Nonetheless, the term tax-exempt organization is not literally accurate; there is no category of nonprofit organization (other than certain governmental entities) that is not subject to some form of federal tax. The income tax that is potentially applicable to nearly all tax-exempt organizations is the tax on unrelated business income. Exempt entities can be taxed for engaging in political activities;30 public charities are subject to tax in the case of substantial efforts to influence legislation31 or participation in political campaign activities;32 and some exempt organizations, such as social clubs and political organizations, are taxable on their investment income.33 Associations and like organizations can be subject to a proxy tax when they engage in attempts to influence legislation or engage in political activities.34 Private foundations can be caught up in a variety of excise taxes.35 No nonprofit organization has an entitlement to tax exemption; that is, there is no entity that has some inherent right to exempt status (other than certain governmental entities). From a pure-law standpoint, tax exemptions and the kinds of entities that may claim them exist essentially as whims of the legislature involved. No constitutional law principle mandates tax exemption.
An illustration of this point is the grant by Congress of tax-exempt status to certain mutual organizations—albeit with the stricture that, to qualify for the exemption, an organization must have been organized before September 1, 1957.36 Before that date, exemption was available for all savings and loan associations. The purpose of the exemption was to afford savings institutions that did not have capital stock an opportunity to accumulate a surplus, so as to provide their depositors with greater security. This exemption was repealed because Congress determined that its purpose was no longer appropriate, because the savings and loan industry had developed to the point where the ratio of capital account to total deposits was comparable to that of nonexempt commercial banks. A challenge to this law by an otherwise qualified organization formed in 1962 failed, with the U.S. Supreme Court holding that Congress did not act in an arbitrary and unconstitutional manner in declining to extend the exemption beyond the particular year. There are other illustrations of this point. For years, organizations such as Blue Cross and Blue Shield entities were tax-exempt;38 Congress, however, determined that these organizations had evolved into entities that were essentially no different from commercial health insurance providers, and thus generally legislated this exemption out of existence.39 (Later, Congress realized that it had gone too far in this regard and restored exemption for some providers of insurance that function as charitable risk pools.40) Congress allowed the exempt status for group legal services organizations41 to expire without ceremony in 1992; it also created a category of exemption for state-sponsored workers’ compensation reinsurance organizations, with the stipulation that they must have been established before June 1, 1996.42 Indeed, in 1982, Congress established exemption for a certain type of veterans’ organization, with one of the criteria being that the entity be established before 1880.
There is a main list of tax-exempt organizations,44 to or from which Congress periodically adds or deletes categories of organizations. Occasionally, Congress extends the list of organizations that are exempt as charitable entities.45 Otherwise, it may create a new provision describing the particular exemption criteria.46
The definition in the law of the term nonprofit organization, and the concept of the nonprofit sector as critical to the creation and functioning of a civil society, do not distinguish nonprofit organizations that are tax-exempt from those that are not. This is because the tax aspect of nonprofit organizations is not relevant to either subject. Indeed, rather than defining either the term nonprofit organization or such an organization’s societal role, the federal tax law principles respecting tax exemption of these entities reflect and flow out of the essence of these subjects. This is somewhat unusual, as nearly all of the provisions of the federal tax laws are based on some form of rationale inherent in tax policy. The fundamental reason for the law of tax-exempt organizations, however, has little to do with any underlying tax policy. Rather, this aspect of the tax law is grounded in a body of thought far distant from tax policy: political philosophy as to the proper construction of a democratic society.
This raises, then, the matter of the rationale for the eligibility of nonprofit organizations for tax-exempt status: the fundamental characteristic that enables a nonprofit organization to qualify as an exempt organization. In fact, there is no single qualifying feature; however, the most common one is the doctrine of private inurement.47 This circumstance mirrors the fact that the present-day statutory exemption rules are not the product of a carefully formulated plan. Rather, they are a hodgepodge of statutory law that has evolved over more than 90 years, as various Congresses have deleted from (infrequently) and added to (frequently) the roster of exempt entities, causing it to grow substantially over the decades. One observer noted that the various categories of exempt organizations “are not the result of any planned legislative scheme,” but were enacted over the decades “by a variety of legislators for a variety of reasons.”48 Six basic rationales underlie qualification for tax-exempt status for nonprofit organizations. On a simplistic plane, a nonprofit entity is exempt because Congress wrote a provision in the Internal Revenue Code according exemption for it. IRC §§ 501(e), 501(f), 501(k), 501(m), 501(n).
IRC §§ 521, 526–529. The staff of the Joint Committee on Taxation and the Department of the Treasury measure the economic value (ostensible revenue losses) of various tax preferences, such as tax deductions, credits, and exclusions (termed tax expenditures). Although the income tax charitable contribution deduction tends to be the fifth or sixth largest tax expenditure, the ones that are larger include the exclusions for pension plan contributions and earnings, the exclusion from gross income of employer contributions for health insurance premiums and health care, the deductibility of mortgage interest on personal residences, the reduced rates of tax on long-term capital gains, and the deduction for state and local governments’ income and personal property taxes. The Joint Committee on Taxation staff estimated that, for the federal government’s fiscal years 2005– 2009, the tax expenditure for the income tax charitable deduction will be $228.5 billion. Estimates of Federal Tax Expenditures for Fiscal Years 2005-2009 (JCS-1-05). See § 1.9; Tax-Exempt Organizations, ch. 19.
McGovern, The Exemption Provisions of Subchapter F, 29 Tax Law. 523 (1976). Other overviews of the various tax exemption provisions are in Hansmann, The Rationale for Exempting Nonprofit Organizations from Corporate Income Taxation, 91 Yale L.J. 69 (1981); Bittker & Rahdert, The Exemption of Nonprofit Organizations from Federal Income Taxation, 85 Yale L.J. 299 (1976).
Thus, some organizations are exempt for no more engaging reason than that Congress said so. Certainly, there is no grand philosophical construct buttressing this type of exemption.
Some of the federal income tax exemptions were enacted in the spirit of being merely declaratory of, or furthering, then-existing laws. The House Committee on Ways and Means, in legislating a forerunner to the provision that exempts from federal income taxation certain voluntary employees’ beneficiary associations, commented that “these associations are common today [1928] and it appears desirable to provide specifically for their exemption from ordinary corporation tax.” The exemption for nonprofit cemetery companies was enacted to parallel then-existing state and local property tax exemptions. The exemption for farmers’ cooperatives has been characterized as an element of the federal government’s policy of supporting agriculture. The provision exempting certain U.S. corporate instrumentalities from tax was deemed declaratory of the exemption simultaneously provided by the particular enabling statute. The provision according exemption to multiparent title-holding corporations was derived from the IRS’s refusal to recognize exempt status for title-holding corporations serving more than one unrelated parent entity.57 Tax exemption for categories of nonprofit organizations can arise as a byproduct of enactment of legislation. In these instances, exemption is granted to facilitate accomplishment of the purpose of another legislative end. Thus, exempt status was approved for funds underlying employee benefit programs. Other examples include exemption for professional football leagues, which emanated from the merger of the National Football League and the American Football League; and for state-sponsored providers of health care to the needy, which was required to accommodate the goals of Congress in creating health care delivery legislation.
There is a pure tax rationale for the existence of a few tax-exempt organizations. The exemption for social clubs, homeowners’ associations, and political organizations is reflective of this category. Under general tax principles, an organization of this nature may not be considered as having any income, inasmuch as there has been no shift of benefit from the member to the organization; the organization merely facilitates a joint activity of its members. Under these circumstances, the individual is in substantially the same position as if he or she had spent his or her income for purposes of pleasure, recreation, or similar benefits without the intervention of the separate organization.
The fourth rationale for tax-exempt status is a policy one—not tax policy, but policy with regard to less essential elements of the structure of a civil society. This is why, for example, exempt status has been granted to fraternal organizations, title-holding companies, and qualified tuition programs. The fifth rationale for tax-exempt status rests solidly on a philosophical principle. Nevertheless, there are degrees of scale here; some principles are less grandiose than others. Thus, there are nonprofit organizations that are exempt because their objectives are of direct importance to a significant segment of society and indirectly of consequence to all society. Within this frame lies the rationale for exemption of entities such as labor organizations, trade and business associations, and veterans’ organizations.
The sixth rationale for tax-exempt status for nonprofit organizations is predicated on the view that exemption is required to facilitate achievement of an end of significance to the entirety of society. Most organizations that are generally thought of as charitable in nature are entities that are meaningful to the structure and functioning of society in the United States. At least to some degree, this rationale embraces social welfare organizations. This rationale may be termed the political philosophy rationale.
Related to this rationale is the concept that promotion of certain activities may be viewed as desirable policy; tax exemption is accorded to encourage the activity. This may explain tax exemption for arrangements to provide employee benefits; arrangements for individuals to save for health, retirement, and education; and the exemption for small or rural commercial organizations that engage in activities such as farming, provision of financial services, insurance, electricity, or other public good.
The categories of tax-exempt organizations are as follows:
Instrumentalities of the United States Single-parent title-holding companies Charitable organizations Social welfare organizations Labor and agricultural organizations Business leagues Social and recreational clubs Fraternal beneficiary societies Voluntary employees’ beneficiary societies Domestic fraternal beneficiary societies Teachers’ retirement funds Benevolent life insurance associations Cemetery companies Credit unions Mutual insurance companies Crop operations finance corporations Supplemental unemployment benefit trusts Employee-funded pension trusts War veterans’ organizations Black lung benefit trusts A veterans’ organization founded prior to 188092 Trusts described in section 4049 of the Employee Retirement Income Security Act Title-holding companies for multiple beneficiaries Organizations providing medical insurance for those difficult to insure State-formed workers’ compensation organizations The National Railroad Retirement Investment Trust Religious and apostolic organizations Cooperative hospital service organizations Cooperative service organizations of educational institutions100 Farmers’ cooperatives Political organizations Homeowners’ associations
This enumeration of tax-exempt organizations does not include references to multiemployer pension trusts, day care centers, or shipowners’ and indemnity organizations.106 Because no data have yet been compiled as to them, there is no listing of charitable risk pools or prepaid tuition plan trusts. The federal tax law recognizes 68 categories of tax-exempt organizations.
Taxation of the unrelated business income of tax-exempt organizations—a feature of the federal tax law introduced in 1950—is predicated on the concept that this approach is a more effective and workable sanction for enforcement of this aspect of the law of exempt organizations than denial or revocation of exempt status because of unrelated business activity.110 This aspect of the law rests on two concepts: (1) activities that are unrelated to an exempt organization’s purposes are to be segregated from related business activities, and (2) the net income from unrelated business activities is taxed in essentially the same manner as net income earned by for-profit organizations. That is, the unrelated business income tax applies only to income generated by active business activities that are unrelated to an exempt organization’s tax-exempt purposes.
See Tax-Exempt Organizations, app. C. As the preceding footnotes indicate, the many categories of tax-exempt organizations are discussed in various chapters throughout Tax-Exempt Organizations. Nonetheless, as the following observation by the U.S. Tax Court affirms, “[t]rying to understand the various exempt organization provisions of the Internal Revenue Code is as difficult as capturing a drop of mercury under your thumb.” Weingarden v. Comm’r, 86 T.C. 669, 675 (1986), rev’d on other grounds, 825 F.2d 1027 (6th Cir. 1987). Analyses of developments leading to enactment of the unrelated business rules include Stone, Adhering to the Old Line: Uncovering the History and Political Function of the Unrelated Business Income Tax, a University of Iowa Legal Studies Research Paper (No. 04-06), available at http://ssrn.com/abstract=634264 (hereinafter Stone Research Paper); Brody, Of Sovereignty and Subsidy: Conceptualizing the Charity Tax Exemption, 23 J. Corp. L. 585 (1998); Hansmann, Unfair Competition and the Unrelated Business Income Tax, 75 Va. L. Rev. 605 (1989); Myers, Taxing the Colleges, 38 Cornell L.Q. 388 (1953). An analysis of the state of the law prior to enactment of these rules appears in Blodgett, Taxation of Businesses Conducted by Charitable Organizations, 4 N.Y.U. Fourth Ann. Inst. on Fed. Tax’n 418 (1946).
The primary objective of the unrelated business rules is to eliminate a source of unfair competition with for-profit businesses. This is achieved by placing the unrelated business activities of tax-exempt organizations on the same tax basis as the nonexempt business endeavors with which they compete. The House Ways and Means Committee report that accompanied the Revenue Act of 1950 contained the observation that the “problem at which the tax on unrelated business income is directed here is primarily that of unfair competition,” in that exempt organizations can “use their profits tax-free to expand operations, while their competitors can expand only with the profits remaining after taxes.” The Senate Committee on Finance reaffirmed this position nearly three decades later when it noted that one “major purpose” of the unrelated business rules “is to make certain that an exempt organization does not commercially exploit its exempt status for the purpose of unfairly competing with taxpaying organizations.”
This rationale for the unrelated business rules has begun to be subjected to revisionist theories, specifically the view that other objectives are equally important. A federal appellate court observed that, “although Congress enacted the [unrelated business income rules] to eliminate a perceived form of unfair competition, that aim existed as a corollary to the larger goals of producing revenue and achieving equity in the tax system.” Another appellate court, electing more reticence, stated that “while the equalization of competition between taxable and taxexempt entities was a major goal of the unrelated business income tax, it was by no means that statute’s sole objective.” At a minimum, however, elimination of this type of competition clearly was Congress’s principal aim; the tax regulations proclaim, as noted, that such was the federal legislature’s “primary objective.” Without doubt, the most interesting and innovative rationale for the unrelated business income rules is that their primary function is “political”; that is, that this body of law “deters charities from engaging in activities that do not comport with policymakers’ perceptions of the type of activity subsidized by the charitable exemption.” This view asserts that Congress really was not concerned about unfair competition or revenue loss, but used the unrelated business rules concept as a “political expedient” for avoiding an analysis of the policies underlying the tax exemption for charitable organizations. Proponents of this view argue that policymakers “simply acted to eliminate the cognitive dissonance” by giving charitable organizations a tax incentive to avoid active unrelated business and instead engage in passive investment (as well as related business activities). Pursuant to this view, Congress and others were concerned about a tax-exempt university’s acquisition of a spaghetti company, not unfair competition. This notion has it that the unrelated business income rules were “designed to channel charities away from problematic activities by setting up a tax gradient that favors income-generating activities compatible with perceptions of charitable activity” and to disfavor “highly visible activities that challenge perceptions of charitable activities—active business endeavors unrelated to any charitable purpose.” This approach sees the function of the unrelated business rules as forcing charities to stick with activities that are “more compatible with perceptions of charitable activity—traditional, passive investment and active business endeavors related to accomplishing a charitable objective”; hence, charitable organizations that were “willing to ‘adhere to the old line’ of good works and passive investment were rewarded.”
Generally, unrelated business activities must be confined to something less than a substantial portion of a tax-exempt organization’s overall activities. This is a manifestation of the primary purpose test. According to traditional analysis, if a substantial portion of an exempt organization’s income is from unrelated sources, the organization cannot qualify for tax exemption. Thus, for example, an organization failed to qualify as a tax-exempt social welfare organization because its primary activity became the operation of a commercial resort. The IRS may deny or revoke the exempt status of an organization that regularly derives more than one-half of its annual revenue from unrelated activities. In one instance, the agency ruled that an organization could not qualify as a tax-exempt social club, in part because 75 percent of its gross income was derived from commercial rental activity that was held to be a business, regularly carried on, and conducted for profit.
Although there generally are no specific percentage limitations in this area, it is common to measure substantiality and insubstantiality in terms of percentages of expenditures or time. Thus, generally, if a substantial portion of a tax-exempt organization’s income is from unrelated sources, the organization cannot qualify for exemption. For example, a court barred an organization from achieving exempt status because the organization received about one-third of its revenue from an unrelated business. Another court held that an organization could not retain its exempt status because about 50 percent of the time of its employees and nearly 60 percent of its income over a two-year period were attributable to unrelated business activities.133 A 10-percent rule has been both relied on134 and rejected135—by the same court.
“The fact is that, in 1947 and 1950, the Treasury, Congress and the press alike were obsessed with Mueller [the company], not unfair competition.” Id. at 63. In general, Note, The Macaroni Monopoly: The Developing Concept of Unrelated Business Income of Exempt Organizations, 81 Harv. L. Rev. 1280 (1968). Stone Research Paper at 66.
Still, this approach is not always taken by either the IRS or the courts. As the IRS framed the matter, there is no “quantitative limitation” on the amount of unrelated business in which a tax-exempt organization may engage. Likewise, a court wrote that “[w]hether an activity [of an exempt organization] is substantial is a facts-and-circumstances inquiry not always dependent upon time or expenditure percentages.” This is not a type of determination that is “based upon some economical and moral calculus.” In this context, there is no “percentage test which can be relied upon for future reference with respect to nonexempt activities of an organization,” inasmuch as “[e]ach case must be decided upon its own unique facts and circumstances.”
Yet there are countervailing principles. The IRS, from time to time, applies the commensurate test, which compares the extent of a tax-exempt organization’s resources to its program efforts. Pursuant to this test, an organization may derive a substantial portion of its revenue in the form of unrelated business income, yet nonetheless be exempt because it also expends a significant amount of time on exempt functions. Thus, in one instance, although a charitable organization derived 98 percent of its income from an unrelated business, it remained exempt because 41 percent of the organization’s activities, as measured in terms of expenditure of time, constituted exempt programs. Using another approach, the IRS permitted an organization to remain exempt even though two-thirds of its operations were unrelated businesses, inasmuch as the reason for the conduct of these businesses was achievement of charitable purposes. On that occasion, the IRS said that one way in which a business may further exempt purposes “is to raise money for the exempt purpose of the organization, notwithstanding that the actual trade or business activity may be taxable.” The agency reiterated that the “proper focus is upon the purpose of [the organization’s] activities and not upon the taxability of its activities.”
An organization may qualify as a tax-exempt entity, even though it operates a trade or business as a substantial part of its activities, when the operation of the business is in furtherance of the organization’s exempt purposes. In determining the nature of a primary purpose, all the circumstances must be considered, including the size and extent of the trade or business and of the activities that further one or more exempt purposes.144 For example, an organization that purchased and sold at retail products manufactured by blind individuals was held by a court to qualify as an exempt charitable organization, because its activities resulted in employment for the blind, notwithstanding its receipt of net profits and its distribution of some of these profits to qualified workers.
Funds received by a tax-exempt organization that is acting as an agent for another organization are not taxable income to the exempt organization, and thus are not unrelated business income.
The unrelated business rules apply to nearly all categories of tax-exempt organizations. These entities include religious organizations (including churches), educational organizations (including universities, colleges, and schools), health care organizations (including hospitals), scientific organizations (including research institutions), public charities of various types, and similar organizations. Beyond the realm of charitable organizations, the rules apply to social welfare organizations (including advocacy groups), trade and professional associations, fraternal organizations, employee benefit funds, and veterans’ organizations. These rules also apply to charitable trusts.
Special rules tax all income not related to exempt functions (including investment income) of social clubs, homeowners’ associations, and political organizations.
Some tax-exempt organizations are not generally involved with the unrelated business rules, simply because they are not allowed to engage in any active unrelated business endeavors. The best example of this is private foundations, whose operation of an active unrelated business (internally or externally) would trigger application of the excess business holdings rules. These rules do not apply to governmental entities, however, other than colleges and universities that are agencies or instrumentalities of a governmental or political subdivision of a government, or that are owned or operated by a government or such political subdivision or by any agency or instrumentality of one or more governments or political subdivisions of them. The rules also apply to any corporation wholly owned by one or more of these colleges or universities. These rules also do not Oddly, the tax regulations, in the tax exemption context, expressly identify only some of the types of exempt organizations that are subject to the unrelated business rules: single-member title-holding companies apply to instrumentalities of the federal government, certain religious and apostolic organizations, farmers’ cooperatives, and shipowners’ protection and indemnity associations.
The presence or absence of competition—fair or unfair—is not among the criteria, in a statute or regulation, applied in assessing whether an activity of a taxexempt organization is an unrelated business. This is so 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. 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.” 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.
Until the introduction of the unrelated business income tax in 1950, tax-exempt organizations enjoyed full exemption from federal income tax. If a charitable or other exempt organization met the organizational and operational tests, there was no statutory limitation on the amount of business activity an exempt organization could conduct, as long as the earnings from the business were used for exempt purposes. Courts even extended this destination of income test to the exemption of charitable organizations that did not conduct any charitable programs, but rather operated commercial businesses for the benefit of a charitable organization, thus acting as feeder organizations.
In the years before 1950, charitable organizations also were acquiring real estate with borrowed funds. In a typical transaction, a tax-exempt organization would borrow money to acquire real property, lease the property to the seller under a long-term lease, and service the loan with tax-free rental income from the lease. Concern arose that exempt organizations were in effect leveraging their tax exemption through such transactions and thereby threatening the nation’s tax base by acquiring, by means of debt, income-producing assets that, following the acquisition, no longer generated revenue for the federal government. As a response to these practices, Congress in 1950 subjected charitable organizations (other than churches) and certain other exempt organizations to tax on their net unrelated business income. The tax was intended to prevent unfair competition. Excluded from this tax were passive investment income and certain gains and losses from the disposition of property. Excluded from the definition of an unrelated trade or business was a trade or business in which substantially all of the work in carrying on the business is performed without compensation; a trade or business carried on primarily for the convenience of the members and certain others; and a trade or business that sells merchandise, substantially all of which was received by the organization as contributions.
To address the matter of feeder organizations, the 1950 legislation provided that, in general, an organization that is operated primarily for the purpose of carrying on a trade or business for profit may not be recognized as tax-exempt merely because all of the organization’s profits are payable to exempt organizations. To cope with the leveraging of exemption, the 1950 enactment, by expanding the unrelated debt-financed income rules, taxed certain rents received in connection with the leveraged sale and leaseback of real estate. When writing the Tax Reform Act of 1969, Congress made significant changes to the unrelated business rules, including an extension of the unrelated business income tax to all tax-exempt organizations.158 In addition, the 1969 act expanded the tax on debt-financed income to cover not only certain rents from debt-financed acquisitions of real estate, but also other debt-financed income. To prevent evasion of the unrelated business income tax through the use of controlled subsidiaries, the 1969 act also generally provided that payments to a taxexempt organization of interest, annuities, royalties, or rent from a taxable or tax-exempt subsidiary of the organization may be subject to tax. These provisions were intended to prevent an exempt organization from “renting” assets to a subsidiary for use in an unrelated business, thereby permitting the subsidiary to escape income taxation by means of a large deduction for rent. Since 1969, although Congress has made a number of changes to the unrelated business rules, the structure of this aspect of the law of tax-exempt organizations has remained largely intact.
In general, tax-exempt organizations have greater discretion than taxable organizations in determining whether to report income as taxable, by asking whether income is from a regularly conducted trade or business, and whether the conduct of the trade or business is substantially related to exempt purposes. In addition, even if an exempt organization treats income as being unrelated and therefore subject to tax, an exempt organization might allocate expenses for an exempt activity to an unrelated activity, in order to minimize or eliminate the tax. Issues often arise as to whether certain types of receipts constitute royalties, which generally are excluded in determining an exempt organization’s 158 That is, to entities described in IRC §§ 401(a) and 501(c). unrelated business income. Two issues that have been the source of considerable debate in this area are (1) whether income from an affinity credit card program constitutes a royalty, and (2) whether income from a mailing list rental constitutes a royalty. Several court decisions have been issued on these points. Also, an exempt organization that provides more than a small amount of clerical services may risk having payments received in exchange for a license classified as payments for services rather than as excludable royalties.
To become, and to remain, tax-exempt, organizations are required to satisfy various tests. One set of these requirements is adherence to the doctrine concerning avoidance of private inurement, which doctrine applies to most categories of exempt organizations. Private inurement transactions are distinguishable from unrelated business, yet there can also be some overlap of these two areas of the law of tax-exempt organizations.
The doctrine of private inurement is one of the most important sets of rules within the law of tax-exempt organizations—it is the fundamental defining principle distinguishing nonprofit organizations from for-profit organizations.160 The private inurement doctrine is a statutory criterion for federal income tax exemption for nine types of exempt organizations: 1. Charitable organizations 2. Social welfare organizations 3. Associations and other business leagues 4. Social clubs 5. Voluntary employees’ beneficiary associations 6. Teachers’ retirement fund associations 7. Cemetery companies 8. Veterans’ organizations 9. State-sponsored organizations providing health care to high-risk individuals
Thus, aside from being organized and operated primarily for a tax-exempt purpose and otherwise meeting the applicable statutory requirements for exemption, an organization subject to the doctrine must comport with the federal tax law prohibiting private inurement. Despite the fact that this law is applicable to several categories of tax-exempt organizations, nearly all of the law concerning private inurement has been developed involving transactions with charitable organizations.
The oddly phrased and utterly antiquated language of the private inurement doctrine requires that the tax-exempt organization be organized and operated so that “no part of . . . [its] net earnings . . . inures to the benefit of any private shareholder or individual.”161 This provision reads as though it were proscribing the payment of dividends. In fact, it is rare for a tax-exempt organization to have shareholders,162 let alone to make payments to them. Moreover, the private inurement doctrine can be triggered by the involvement of persons other than individuals, such as corporations, partnerships, limited liability companies, estates, and trusts. The meaning of the statutory language today is barely reflected in its literal form and transcends the nearly century-old formulation: None of the income or assets of a tax-exempt organization subject to the private inurement doctrine may be permitted, directly or indirectly, to unduly benefit an individual or other person who has a close relationship to the organization, particularly those who are in a position to exercise a significant degree of control over the organization.
The private benefit doctrine is considerably different from the private inurement doctrine, although it subsumes the latter doctrine. As an extrapolation of the operational test, the private benefit doctrine is applicable only to charitable organizations. The rules pertaining to excess benefit transactions are applicable to public charitable organizations and social welfare organizations. To be tax-exempt, a nonprofit organization must be organized and operated primarily for exempt purposes. The federal tax law thus allows an exempt organization to engage in a certain amount of income-producing activity that is unrelated to its exempt purposes. When the organization derives net income from one or more unrelated business activities, a tax is imposed on that income. An organization’s tax exemption will be denied or revoked if a certain portion of its activities is not promoting one or more of its exempt purposes.
A tax-exempt charitable organization may operate a trade or business as a substantial part of its activities, if the operation of the trade or business furthers the organization’s exempt purpose or purposes and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business. In determining the existence or nonexistence of this primary purpose, all of the circumstances must be considered, including the size and extent of the trade or business and the size and extent of the activities that are in furtherance of one or more exempt purposes. An organization that is organized and operated for the primary purpose of carrying on a trade or business cannot be exempt even though it has religious purposes, its property is held in common, and its profits do not inure to the benefit of individual members of the organization. An organization cannot be a tax-exempt social welfare organization if its primary activity is carrying on a business with the general public in a manner similar to organizations that are operated for profit. An exempt business league cannot have, as one of its purposes, engagement in a regular business of a kind that is ordinarily carried on for profit, if that engagement is more than insubstantial. A club cannot be exempt as a social club if it engages in business, such as making its social and recreational facilities available to the general public or by selling real estate, timber, or other products.
In a fine characterization, this phraseology was termed a “nondistribution constraint.” Hansmann, The Role of Nonprofit Enterprise, 89 Yale L.J. 835, 838 (1980).
Business activities may preclude the initial qualification of an otherwise taxexempt organization. If the organization is not being operated principally for exempt purposes, it will fail the operational test. If an organization’s articles of organization empower it to carry on substantial activities that are not in furtherance of its exempt purposes, it will not meet the organizational test. A nonprofit organization may still satisfy the operational test, even when it operates a business as a substantial part of its activities, as long as the business promotes the organization’s exempt purpose. If the organization’s primary purpose is carrying on a nonexempt business for profit, it is denied tax-exempt status, perhaps on the ground that it is a feeder organization. Generally, there are no formal percentage-based quantifications in this context. An exempt titleholding company usually cannot have income from an actively conducted unrelated trade or business; an exception permits such income in an amount up to 10 percent of the company’s gross income for the tax year, when the income is incidentally derived from the holding of real property.
Occasionally, the IRS will assume a different stance toward the tax consequences of one or more unrelated businesses when the question is qualification for tax exemption. That is, the IRS may conclude that a business is unrelated to an organization’s exempt purpose and thus is subject to the unrelated business income tax, but the IRS may also agree that the purpose of the unrelated business is such that the activity furthers the organization’s exempt functions (by generating funds for exempt programs), even if the unrelated business activity is more than one-half of total operations. In this circumstance, then, the exempt organization can be in the anomalous position of having a considerable amount of taxable business activity and still being tax-exempt.
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