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A. Background and Statutory History

Revenue Act of 1950

In the Revenue Act of 1950, the Congress enacted a tax on the unrelated trade or business income of certain otherwise tax-exempt organizations. Under the 1950 statute, the tax applied to charitable organizations (other than churches), trade associations, labor unions, and certain other categories of tax-exempt organizations.

Prior to enactment of the unrelated business income tax (the UBIT), an organization otherwise qualifying for exempt statuse.g., an organization that was organized and operated exclusively for charitable purposes-could receive tax-free earnings from operating a business so long as the business earnings were used to carry out the organization's exempt purposes.2 Under this "destination of income" test, large businesses owned by tax-exempt organizations could operate on a tax-free basis; thus, for example, the business was able to use all its earnings for expansion, not just after-tax earnings.

The legislative history of the 1950 Act states that "the problem at which the tax on unrelated business income is directed here is primarily that of unfair competition." 3 The legislation did not deny tax-exempt status (if otherwise available) solely because the organization carried on unrelated active business enterprises, but "merely imposes the same tax on income derived therefrom as is borne by their competitors." 4 Court decisions have cited the legislative history of the 1950 Act as reflecting that "the undisputed purpose of the unrelated business income tax was to prevent taxexempt organizations from competing unfairly with businesses whose earnings were taxed." 5

The 1950 Act also explicitly provided that no organization that is operated primarily for the purpose of carrying on a trade or business (subject to certain exceptions) for profit shall be tax-exempt merely because all its profits are payable to tax-exempt organizations. This rule overturned the "destination of income" test and makes a "feeder" organization, "which obviously is in direct competition with other taxable businesses," 6 fully taxable. Thus, the

2 See, e.g., Trinidad v. Sagrada Orden de Predicadores, 263 U.S. 578 (1924); C.F. Mueller Co. v. Comm'r, 190 F.2d 120 (3d Cir. 1951); Roche's Beach, Inc. v. Comm'r, 96 F.2d 776 (2d Cir. 1938). 3 H. Rpt. No. 2319, 81st Cong., 2d Sess. 36 (1950); Sen. Rpt. No. 2375, 81st Cong., 2d Sess. 28 (1950).

4 H. Rpt. No. 2319, supra n. 3, at 37; Sen. Rpt. No. 2375, supra n. 3, at 29.

5 See, e.g., U.S. v. American Bar Endowment, 106 S.Ct. 2426 (1986); U.S. v. American College of Physicians, 106 S.Ct. 1591 (1986) ("Congress perceived a need to restrain the unfair competition fostered by the tax laws").

6 H. Rpt. No. 2319, supra n. 3, at 41; Sen. Rpt. No. 2375, supra n. 3, at 35.


tax treatment of unrelated trade or business income is basically the same whether the trade or business activity is conducted directly by the organization or through a "feeder" subsidiary.

In interpreting the UBIT provisions, some court decisions have focused on the presence or absence of competition between a taxexempt organization and taxable entities engaged in similar activities, or have inquired whether the exempt organization carried on the activity in a commercial manner. Other court decisions have taken the view that the UBIT is not limited to situations where some specific aspect of unfair competition can be shown to have occurred; these decisions note that the statute is not formulated in terms of unfair competition, but in terms of "extracting the same revenue from businesses operated by exempt organizations as that levied upon similar businesses operated by nonexempt entities."8 In this view, the UBIT has both revenue and equitable objectives. Tax Reform Act of 1969

In the Tax Reform Act of 1969, the Congress extended the UBIT to all organizations that are exempt from Federal income tax under section 501(a), except certain U.S. instrumentalities created and made tax-exempt by a specific Act of Congress. As originally enacted, the UBIT had applied only to charitable, educational, religious, and other organizations tax-exempt under Code section 501(c)(3), other than churches; labor and agricultural organizations (sec. 501(c)(5)); trade associations (sec. 501(c)(6); qualified pension and profit-sharing trusts (sec. 401); and certain other types of taxexempt entities. However, by 1969 the Congress found that many other categories of exempt organizations-including churches, social clubs, and fraternal beneficiary societies-had begun "to engage in substantial commercial activity."10 The Congress concluded that there was no justification to tax (for example) a university or hospital on income from an unrelated trade or business, but not to tax a church or social club on income from the same types of activities.

In the case of social clubs (sec. 501(c)(7)) and voluntary employee beneficiary associations (sec. 501(c)(9)), the 1969 Act provided that the UBIT applies to all income of the organization other than exempt function income, such as membership dues. A principal effect of this rule is to subject the investment income of the club or VEBA to the UBIT. The legislative history reflects that since such entities are granted exempt status so that their members may join together to provide social facilities or other personal benefits with

1 See, e.g., Hope School v. U.S., 612 F.2d 298 (7th Cir. 1980); Hill Family Foundation v. U.S., 347 F.Supp. 1225 (D. Minn. 1972); Greene County Medical Society Foundation v. U.S., 345 F.Supp. 900 (W.D. Mo. 1972); Disabled American Veterans v. U.S., 650 F.2d 1178 (Ct. Cl. 1981).

See, e.g., Louisiana Credit Union League, v. U.S., 693 F.2d. 525 (5th Cir. 1982); Clarence LaBelle Post No. 217 v. U.S., 580 F.2d 270 (8th Cir. 1978); Disabled American Veterans v. U.S., supra n. 7, at 1187; Carolinas Farm & Power Equipment Dealers Assoc. v. U.S., 699 F.2d 167 (41a Cir. 1983); Smith-Dodd Businessman's Assoc. v. Comm'r, 65 T.C. 620 (1975). See also U.S. v. American Bar Endowment, supra, n. 5, referring to "potential for unfair competition" resulting from an insurance program of a tax-exempt organization even though the trial court had failed to identify any taxable entities actually competing with the exempt organization.

The UBIT also applies to certain State colleges and universities and their wholly owned subsidiaries (sec. 511(a)(2)).

10 H. Rpt. 91-413 (Pt. 1), 91st Cong., 1st Sess. 47 (1969); Sen. Rpt. 91-522, 91st Cong., 1st Sess. 67 (1969).

out tax consequences, the Congress concluded that the tax exemption should be limited to membership receipts. If investment income could be earned tax-free, the members of such entities would receive personal benefits out of tax-free funds.11

In addition to making other modifications to the UBIT (including enacting rules relating to the treatment of advertising income), the 1969 Act also broadened the prior-law rules relating to income earned by an otherwise exempt organization from debt-financed property. Under the prior rules, tax-exempt organizations had been able to utilize their exempt status to buy businesses and investments on credit, frequently at what was more than the market price, while contributing little or nothing to the transaction other than their tax exemption.12 The 1969 Act provided generally that any income of an exempt organization derived from debt-financed property, if unrelated to exempt functions, is subject to the tax in the proportion in which the property is financed by the debt (see F, below).

Subsequent legislation

While the Congress has not engaged in an overall reexamination of the principal provisions of the UBIT since 1969, subsequent legislation has modified the UBIT in various respects. These modifications have included providing exclusions from the UBIT (in the case of specified categories of exempt organizations) for income from (i) qualified trade show, convention, or State fair activities; (ii) providing certain hospital services; (iii) conducting bingo games; (iv) engaging in telephone pole rentals; (v) distribution of low-cost articles in soliciting charitable contributions; and (vi) certain exchanges or rentals of member or donor mailing lists. Other modifications have related to the debt-financed property rules, insurance activities of exempt organizations, and nonexempt function income of qualified trusts that are part of plans for payment of supplemental unemployment compensation benefits or for group legal services.

Effect of unrelated activities on exempt status

As noted above, in enacting the unrelated business income tax, the Congress did not preclude an organization from qualifying for tax-exempt status merely because it carries on a trade or business that is considered unrelated to its exempt purpose, provided the organization meets the requirements for exemption under the Code. For example, a charitable, educational, or religious organization may qualify for tax-exempt status under Code section 501(c)(3) if it is organized and operated exclusively for charitable, etc. purposesi.e., only if the organization "engages primarily in activities which accomplish one or more" such purposes, and only if not "more than an insubstantial part of its activities is not in furtherance of an exempt purpose." 13 Even though the organization operates a trade or business as a substantial part of its activities, the organization may qualify for section 501(c)(3) status "if the operation of such

11 H. Rpt. 91-413 (Pt. 1), supra n. 10, at 48; Sen. Rpt. 91-552, supra n. 10, at 71.
12 H. Rpt. 91-413 (Pt. 1), supra n. 10, at 44-45; Sen. Rpt. 91-552, supra n. 10, at 62-63.
13 Treas. Reg. sec. 1.501(c)3)-1(c).

trade or business is in furtherance of" its exempt purposes and "if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business...

In general

B. Elements of an Unrelated Trade or Business


Subject to specified exceptions, modifications, and special computational rules, an activity of an otherwise tax-exempt organization generates gross income for purposes of the unrelated business income tax if (1) the income is derived from a trade or business, (2) the trade or business is regularly carried on by the organization, and (3) the conduct of the trade or business is not substantially related (aside from the organization's need for revenues or the use it makes of such revenues) to the organization's performance of its tax-exempt functions (secs. 512(a), 513(a); Treas. Reg. sec. 1.5131(a)).

Definition of trade or business

General rule

In general, any activity of an exempt organization that is carried on for the production of income from the sale of goods or the performance of services, or any other activity to produce income that constitutes a trade or business within the meaning of section 162, constitutes a trade or business for purposes of the UBIT.15 The Treasury regulations state that any such activity that is not substantially related to the performance of the organization's exempt functions "presents sufficient likelihood of unfair competition to be within the policy of the tax", inasmuch as "the primary objective of adoption of the unrelated business income tax was to eliminate a source of unfair competition by placing the unrelated business activities of certain exempt organizations on the same tax basis as the nonexempt business endeavors with which they compete."16

On the other hand, the tax does not apply to an activity "that does not possess the characteristics of a trade or business within the meaning of section 162" (allowing deductions to nonexempt taxpayers for trade or business expenses), "since the organization is not in competition with taxable organizations" with respect to that activity. For example, the regulations state that the tax does not apply with respect to the activity of sending out low-cost articles incidental to soliciting charitable contributions. The latter rule in the regulations has been supplanted by a more detailed statutory rule enacted in the Tax Reform Act of 1986 (Code sec. 513(h)).

Fragmentation rule

The statute and regulations provide that activities carried on for the production of income from the sale of goods or the performance of services from which a particular amount of gross income is derived constitute a trade or business even though carried on within a larger aggregate of similar activities or other endeavors that may

14 Treas. Reg. sec. 1.501(c)(3)-1(e)(1).

15 Sec. 513(c); Treas. Reg. sec. 1.513-1(b). See U.S. v. American Bar Endowment, supra, n. 5. 16 Treas. Reg. sec. 1.513-1(b).

be related to the organization's exempt purposes.17 If an activity carried on for profit constitutes an unrelated trade or business, no part of the activity is to be disregarded merely because it does not result in profit.18

Under this fragmentation rule, each component part of revenueproducing activities is to be examined separately to determine whether it gives rise to unrelated business income. For example, the regulations provide that advertising activities do not lose their identity as a trade or business even though published in educational materials; thus, income from advertising generally is treated as unrelated business income even if publication and sale of the magazine by the exempt organization may qualify as related educational activities. 19

The fragmentation rule also applies to the sale of merchandise by an exempt organization. Accordingly, if a museum operates a gift shop, each item sold will be tested separately against the definition of an unrelated trade or business, and gross income from those items that do not qualify as substantially related to the museum's educational purposes constitutes unrelated business income.


Regularly carried on test

Even if an exempt organization conducts an unrelated trade or business, the income therefrom is not subject to the UBIT unless the activity is "regularly carried on" by the organization (sec. 512(a)). This test looks to the frequency and continuity of the income-producing activities, and the manner in which the exempt organization conducts the activities as compared with the manner in which commercial activities are normally pursued by taxable businesses. In light of the purpose of the tax "to place exempt organization business actitivies upon the same tax basis as the nonexempt business endeavors with which they compete," specific business activities of an exempt organization ordinarily are deemed to be regularly carried on "if they manifest a frequency and continuity, and are pursued in a manner, generally similar to comparable commercial activities of nonexempt organizations." 20

Under these rules, an organization does not trigger the UBIT if it conducts for a brief period during the year an income-producing activity of a kind that taxable businesses normally conduct throughout the year. For example, a hospital auxiliary could operate a sandwich stand at a two-week State fair once a year without subjecting the income to the tax. Likewise, income derived from infrequent, intermittent income-producing activities, such as the conduct of an annual dance or similar fund-raising event for charity,

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19 See U.S. v. American College of Physicians, supra n. 5, in which the Supreme Court rejected an IRS argument that the Congress intended a blanket rule requiring the taxation of income from all commercial advertising in tax-exempt professional journals without specific analysis of the circumstances. In the particular case at issue, however, the Court concluded, based on the trial court's findings of fact, that the UBIT applied to income earned by the American College of Physicians from selling commercial advertising space in its professional journal, The Annals of Internal Medicine.

19 See, e.g., Rev. Rul. 73-105, 1973-1 C.B. 264.

20 Treas. Reg. sec. 1.513-1(c).

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