Last month, we published a post on the recently revised IRS EO Technical Guide: Disqualifying and Non-Exempt Activities, Inurement and Private Benefit. This month, we share some excerpts from the Exempt Organizations Technical Guide: Disqualifying and Non-Exempt Activities – Trade or Business Activities – IRC Section 501(c)(3).

This Technical Guide (TG) addresses the issue of Section 501(c)(3) organizations engaging in trade or business activities and how this affects an organization’s tax-exempt status.

Highlights from the Technical Guide include the following excerpts:

Unrelated Trade or Business

The Revenue Act of 1950 imposed a tax on the unrelated business income of charitable organizations (not including churches) and certain other exempt organizations. The primary purpose was to prevent unfair competition.

Unrelated Trade or Business: Any trade or business, the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under Section 501.

[A]ctivities not substantially related to an exempt purpose of the organization could have an adverse tax effect and possibly bar an organization from receiving exemption or jeopardize its continued exempt status.

The organization’s use of the profits from an activity doesn’t make the activity substantially related to an organization’s exempt purpose or function. Rather, this determination is activity based.

A Section 501(c)(3) organization is engaged in unrelated trade or business if the activity is:

a. A trade or business
b. Regularly carried on
c. Not substantially related to the organization’s exempt purpose

Feeder organizations, provides that an organization operated for the primary purpose of carrying on a trade or business for profit shall not be exempt because all of its profits are payable to an exempt organization.

Exceptions from unrelated trade or business activity include the following situations:

a. Substantially all the work is performed by volunteers.
b. Activity is carried on for an organization described in Section 501(c)(3) or a college or university primarily for the convenience of its members, students, patients, officers, or employees.
c. Substantially all of the merchandise sold was donated.

An activity must be profit-motivated in order to be considered a “trade or business” for purposes of Section 513.

Business activities of an exempt organization will ordinarily be considered “regularly carried on” if they’re conducted with a frequency and continuity, and are pursued in a manner, similar to comparable commercial activities of nonexempt organizations.

An organization isn’t operated exclusively for exempt purposes under Section 501(c)(3) if it has a single non-exempt purpose that is substantial in nature, regardless of the number or importance of the organization’s exempt purposes.

However, an organization may still meet the requirements although it operates a trade or business as a substantial part of its activities if the operation of such trade or business is in furtherance of the organization’s exempt purpose(s) and if the organization isn’t organized or operated for the primary purpose of carrying on an unrelated trade or business, as defined in Section 513.

In determining the existence or nonexistence of such primary purpose, all the circumstances must be considered. Factors to be considered include the size and extent of the trade or business and the size and extent of the activities which further the exempt purposes.

Exempt Purposes

Fragmentation Rule

The fragmentation rule found in Section 513(c) states in part: For purposes of this section, the term “trade or business” includes any activity which is carried on for the production of income from the sale of goods or the performance of services. For purposes of the preceding sentence, an activity doesn’t lose identity as a trade or business merely because it’s carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purpose of the organization.

Substantially Related

A business activity isn’t substantially related to an organization’s exempt purpose if it doesn’t contribute importantly to accomplishing that purpose (other than through the production of income).

The term “substantially related” requires an examination of how a business activity that generates the income helps an organization accomplish its exempt purpose. Treas. Reg. 1.513-1(d) states that to be substantially related:

a. The conduct of the business activity must have a “causal relationship” to the achievement of exempt purposes. And the “causal relationship” must be substantial.
b. The conduct of the business activity must “contribute importantly” to the accomplishment of the organization’s exempt purposes to be substantially related.

To “contribute importantly” depends on the facts and circumstances of each case. You’ll need to consider how the size and the extent of the activities relate to the nature and extent of the exempt function they intend to serve.

Other Considerations

Commerciality Doctrine

While operating a commercial business doesn’t automatically cause an organization to fail the operational test, any exempt organization that carries on substantial commercial activities, unrelated to its exempt purposes, will fail the operational test.

The IRS and the courts have applied the operational test to an organization’s activities by comparing the exempt organization’s activities to similar activities carried out by for-profit entities. It is reasoned that an organization operating in a commercial manner has commercial activity as its primary purpose. As the primary purpose, the commercial activities are substantial and unrelated to an organization’s exempt purposes, thereby excluding the organization from exemption. This is often referred to as the “commerciality doctrine.”

In  Airlie Foundation v. Commissioner, … [a]mong the factors the court considered in assessing commerciality:commerciality:

i. Competition with for-profit commercial entities
ii. Extent and degree of below cost services provided
iii. Pricing policies
iv. Reasonableness of financial reserves.
v. Use of commercial promotional methods (advertising)
vi. Extent to which the organization receives charitable donations.
vii. Nature of its clients.

Advertising

A common issue in trade or business activities is the sale of advertising in publications of newsletters, journals or periodicals that contain editorial content distributed to members and the general public.

The publication and dissemination of the editorial content contributes importantly to the organization’s exempt purpose. However, the sale of advertising in the publications is a trade or business activity that isn’t related to their exempt purpose.

Feeder Organizations

A feeder organization operates for the primary purpose of carrying on a trade or business for profit, the income from which is turned over or fed to a Section 501(c)(3) organization.

If an organization’s principal income-producing activity is the conduct of a trade or business, and it has no significant charitable activity other than the payment of its profits over to one or more exempt organizations, it’s operated for the primary purpose of carrying on a trade or business for profit within the meaning of Section 502 and won’t qualify for exemption under Section 501(c)(3).

This primary purpose test is concerned with how much business activity constitutes primarily engaged in a trade or business. 

Unrelated Business Taxable Income (UBTI) and Unrelated Business Income Tax (UBIT)

The Tax Cuts and Jobs Act of 2017 … changed the corporate tax rate range from 15 to 35 percent to one flat rate of 21 percent. This rate will be effective permanently for corporations (including exempt corporate organizations) whose tax year begins after January 1, 2018.

Exempt organizations that have $1,000 or more in gross receipts from an unrelated business activity must file Form 990-T, Exempt Organization Business Income Tax Return, on or before the 15th day of the 5th month of their taxable year. Treas. Reg. 1.6012-2(e). Even if an organization is specifically excluded from filing a Form 990 or 990 EZ, they must file Form 990-T if they have gross receipts of $1,000 or more from an unrelated business activity (for example, churches or organizations that file the 990-N Electronic Postcard). 

Examination Techniques

Organizational Test

In order to determine the exempt purposes of the organization, you must first go to the organizing document to see what purposes/activities the organization was formed for. … Form 1023 … information should be closely reviewed …. Review the organization bylaws, as they often contain purposes and goals of the organization. If a non-exempt purpose exists, the specialist must determine if the non-exempt purpose is substantial.

Operational Test

Review the Form 990 series return and take note of such items like the organization’s mission and activities, employees, volunteers, change in programs, and any unrelated business income.

Review the financial information and determine if the income, expenses, and assets are appropriate for the organization’s exempt functions, or is a trade or business indicated.

Review organization’s website for other indications of unrelated trade or business (including advertising).

Interview the CEO and other personnel responsible for conducting the activity on why and how the activity is conducted. 

Compare the way the activity is conducted by the tax-exempt organization to the way the same type of activity is conducted by a for-profit entity. The comparison should be both financial and operational.