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is not treated as subject to the tax. However, if income-producing activities are of a kind normally undertaken by nonexempt commercial organizations only on a seasonal basis, the conduct of such activities by an exempt organization during a significant portion of the season ordinarily constitutes the regular conduct of a trade or business. 21

Substantially related test

In general

Even if a tax-exempt organization regularly carries on a trade or business, the income from that activity is subject to the UBIT only if the activity is unrelated to the basis for the organization's taxexempt status-i.e., only if the activity is not substantially related (other than through the production of funds) to the purposes for which the organization's exemption is granted.22 Thus, this requirement necessitates examining whether there is a causal relationship between the production or distribution of the goods, the performance of the services, or other trade or business activity, and the accomplishment of the organization's exempt purposes.

The regulations provide that to meet the "substantially related" test, the business activity must "contribute importantly" to the accomplishment of the organization's exempt purposes. Whether this test is met depends in each case on the facts and circumstances involved.23 Accordingly, numerous cases, published revenue rulings, and private letter ruling have addressed a host of differing fact situations in applying this test.

In determining whether business activities contribute importantly to accomplishing exempt purposes, the regulations weigh the size and extent of the activities against the nature and extent of the exempt function which they are said to serve. Thus, if an organization derives income from activities that are in part related to the performance of its exempt functions, but that are conducted on a larger scale than reasonably necessary to perform such functions, the income attributable to that portion of the activities exceeding the exempt function needs constitutes unrelated business income.24

Certain applications of test

The regulations provide that gross income derived from charges for the performance of exempt functions is not subject to the UBIT. For example, the regulations state that the UBIT does not apply to admission charges for performances by students of a tax-exempt performing arts school, or to fees charged by a labor union to members for refresher training courses and related materials. Similarly, gross income derived from the sale of products resulting from the performance of exempt functions is not subject to UBIT, such as income from sale of articles made by handicapped individuals as part of the activities of a tax-exempt rehabilitation organization.25

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However, the UBIT may apply to income generated by the exploitation in commercial endeavors of good will or other intangibles arising out of exempt-function activities. For example, the regulations state that payments by an advertising agency to a taxexempt trade association for the mailing of commercial advertising materials to the association's members constitutes income from an unrelated trade or business. Similarly, the UBIT applies with the respect to income generated by a tax-exempt scientific organization in exploiting its research reputation by selling endorsements of commercial laboratory equipment.26

C. Excluded Activities

The Code provides that unrelated trade or business activities subject to the UBIT do not include the following.

Volunteer work. -The tax does not apply to income from an activity in which substantially all the work is performed without compensation (sec. 513(a)(1)). For example, the regulations provide that this exception would apply to income earned by a tax-exempt orphanage from operating a retail store open to the general public if substantially all the work in operating the store is done by unpaid volunteers.

Thrift shops.-The tax does not apply to income from the sale of merchandise substantially all of which has been received by the organization as gifts or contributions (sec. 513(a)(3)). For example, this exception applies to income earned by a thrift shop operated by a tax-exempt organization to which individuals desiring to benefit the organization contribute old clothes or other items to be sold to the general public, with the proceeds going to the exempt organization.

Member convenience.-The tax does not apply to income earned by a tax-exempt charity or by a State college or university from a trade or business carried on by the organization primarily for the convenience of its members, students, patients, officers, or employees (sec. 513(a)(2)). The regulations provide that this exception applies, for example, to revenues earned by a college from operating a laundry for cleaning students' clothing or dormitory linens.

Qualified trade show, State fair, etc. activities.-The tax does not apply to income derived from certain convention or trade show activities at which members of the sponsoring orginization sell products or services, or at which suppliers to the sponsoring organization's members sell products or services related to the organization's exempt activities (sec. 513(d)). This exception applies in the case of qualified convention and trade show activities of charitable organizations, social welfare organizations, labor or agricultural organizations, and trade associations. In addition, the UBIT does not apply to income derived from qualified public entertainment activities conducted at an agricultural and educational fair or exposition in the case of charitable organizations, social welfare organizations, and labor or agricultural organizations.

Low-cost articles.-In the case of a tax-exempt organization that is eligible to receive tax-deductible charitable contributions, the tax

26 Treas. Reg. sec. 1.513-1(dX4Xiv).

does not apply to income generated from the distribution of lowcost articles incidental to the solicitation of charitable contributions (sec. 513(h)).

Mailing lists.-The UBIT does not apply to income derived from exchanges or rental of donor or member lists among tax-exempt organizations that are eligible to receive tax-deductible charitable contributions (sec. 513(h)(1)).

Other items.-The statute also provides exceptions from the UBIT for income derived from the furnishing by a hospital of certain administrative and support services, at cost, to small hospitals (sec. 513(e)); certain bingo games not ordinarily carried on by forprofit organizations (sec. 513(f)); and certain rentals by mutual or cooperative telephone and electric companies of poles that carry electrical or telephone wires (sec. 513(g)).

D. Excluded Income

The statute excludes the following types of income from the definition of unrelated business taxable income (sec. 512(b)). Deductions that are directly connected with excludable income also do not enter into computation of the UBIT.

General rule.-The UBIT generally does not apply to dividends, interest, royalties (including overriding royalties), annuities, certain rents, gains on the disposition of property (other than inventory property), gains on the lapse or termination of securities options written by the organization in connection with its investment activities, and amounts received in connection with certain securities loans. (As described below, special computational rules apply in the case of investment income and other nonexempt function income of social clubs and certain other exempt organizations.)

The exclusions listed above for investment income and certain other income do not apply to the extent the income is derived from debt-financed property (as described below). In addition, interest, annuities, royalties, and rents derived from 80-percent subsidiaries, or certain other controlled organizations, are treated as unrelated business income generally in proportion to the income of such controlled organization that would be subject to the UBIT if derived directly by the tax-exempt organization (sec. 512(b)(13)).

Rents. The exclusion from the UBIT of rental income applies to rents from real property, or from a lease of real and personal property if the rent attributable to the personal property constitutes an incidental amount of the total rent (sec. 512(b)(3)). Rents attributable to personal property that amount to more than 10 percent of the total rents due under the lease do not qualify as incidental. Also, neither rents attributable to real property nor rents attributable to personal property are excluded from the UBIT if more than half of the total rent under the lease is attributable to personal property, or if the amount of rent depends on the income or profits derived from the leased property (other than a fixed percentage of receipts or sales).

Research.-The statute also excludes certain income from research from the UBIT; for this purpose, research does not include activities of a type ordinarily carried on in commerce or industry,

such as ordinary product testing or design.27 In the case of a college, university, or hospital, or an organization operated primarily to carry on fundamental research the results of which are freely available to the general public, income from research performed for any person is not subject to the UBIT (secs. 512(b)(8), (b)(9)). Other exempt organizations may exclude from the UBIT income from research performed for the United States, its agencies and instrumentalities, or for any State or political subdivision thereof (sec. 512(b)(7)).

In a 1976 ruling, 28 the IRS set forth factors to be considered in determining whether income from commercially sponsored research conducted by a scientific research organization is subject to the UBIT. A scientific organization may qualify for tax-exempt status under section 501(c)(3) if it conducts scientific research in the public interest (e.g., if the research results are made available to the public on a nondiscriminatory basis). Under the ruling, if the results of commercially sponsored projects generally are published in such form as to be available to the interested public within a reasonably short time after completion, the organization is treated as engaging in scientific research in the public interest, even though the sponsor retains ownership rights in the research results. By contrast, if the organization agrees to withhold publication beyond the time reasonably necessary to obtain patents, or agrees to forego publication completely, the ruling holds that income from conducting the commercially sponsored research is subject to the UBIT.

E. Special Rules; Computation of UBIT Liability Special rules for social clubs, VEBAs, etc.

The statute provides special rules for computing the unrelated business taxable income of social clubs (sec. 501(c)(7)), voluntary employee beneficiary associations (sec. 501(c)(9)), supplemental unemployment compensation benefit trusts (sec. 501(c)(17)), and group legal service organizations (sec. 501(c)(20)). Under these rules, the UBIT applies to all gross income other than exempt function income, reduced by directly related deductions (sec. 512(a)(3)).

The term exempt function income includes dues, fees, charges or similar amounts paid by the organization's members for goods, facilities, and services that form the basis of the organization's taxexempt status. In addition, exempt function income includes amounts set aside (1) for charitable purposes (as where a national organization of college fraternities or sororities sets aside amounts for scholarships) or (2), except in the case of social clubs, to provide for the payment of life, sick, accident, or other benefits. (However, amounts set aside for such exempt purposes become subject to the UBIT to the extent actually used for other purposes.) Finally, the UBIT is not imposed on gain from sales of assets used in the performance of the organization's exempt functions (as where a social club sells its clubhouse) to the extent the proceeds are reinvested in assets used for those functions (as where the proceeds of a sale fit

27 Treas. Reg. Sec. 1.512(b)-1(f)(4).
28 Rev. Rul. 76-296, 1976-2 C.B. 141.

ting the above description are used to build a larger clubhouse) within a specified period.

Veterans organizations

In the case of a veterans organization (sec. 501(c)(19)), the UBIT does not apply to amounts paid for life, sick, accident, or health insurance for members and dependents that are set aside to pay for insurance benefits or for charitable purposes (sec. 512(c)(4)). However, amounts set aside for such purposes but actually used for other purposes are subject to the UBIT.

Certain insurance activities

The Tax Reform Act of 1986 enacted rules relating to certain insurance activities of tax-exempt organizations. Under these rules, a charitable or social welfare organization is tax-exempt only if no substantial part of its activities consists of providing commercialtype insurance. If the organization does provide such insurance without violating this prohibition, its insurance activity is treated as an unrelated trade or business; however, the income is taxed under the rules relating to insurance companies rather than the general UBIT rules (sec. 501(m)).

The Congress also directed the Treasury to study and report on the appropriate tax treatment of fraternal beneficiary organizations (sec. 501(c)(8)) that engage in certain insurance activities. 29

Deductions

The Code provides the following deduction rules for computing the UBIT.

Specific deduction.-Each tax-exempt organization is allowed a specific deduction of $1000 (sec. 512(b)(12)). Local units of churches, associations of churches, and religious orders each are entitled to a specific deduction equal to the lesser of $1000 or the gross income derived from any unrelated trade or business regularly carried on by the local unit.

Net operating losses.-The net operating loss (NOL) deduction applies to the computation of the UBIT (sec. 512(b)(6)). Only income and deduction items not excluded from the UBIT are taken into account for these purposes, and preceding years in which the organization was not subject to the exempt organization rules are ignored in computing NOLS, NOL carrybacks, and NOL carryforwards.

Charitable contributions.-Tax-exempt organizations and State colleges and universities generally are entitled to deductions of up to 10 percent of unrelated business taxable income for charitable contributions, whether or not the contributions are related to carrying on of the trade or business (sec. 512(b) (10), (11)).

Computation of tax liability

Exempt organizations other than trusts are taxed on their unrelated business taxable income at the corporate tax rates (sec. 511(a)). Thus, in taxable years beginning on or after July 1, 1987, the UBIT rates are graduated with a maximum rate of 34 percent;

29 H. Rpt. 99-426, 99th Cong., 1st Sess. 666 (1985); H. Rpt. 99-841 (Vol. II), 99th Cong., 2d Sess. 345-46 (1986).

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