Nonprofit organizations are often seeking better, cost-effective ways to handle administrative services, for example, by using a management service organization (MSO). An MSO can be generally defined as an organization that primarily exists to provide administrative services to multiple organizations. An MSO will generally charge fees for providing such services and this raises the issue whether the income received from the fees for such services is subject to the unrelated business income tax (UBIT) and if so, to what extent. UBIT applies if the income derived by the organization is: (1) from a trade or business, (2) that is regularly carried on, and (3) that is unrelated to the organization’s exempt purpose. See I.R.C. §§ 511, 512.
Unfortunately, there is no per se rule on UBIT for an MSO in either the Internal Revenue Code or Treasury Regulations. However, a private letter ruling (PLR) issued in 2008, PLR 200832027, involving a community foundation may shed some light on the IRS’s perspective on this issue. PLR 200832027 addressed whether income received by a community foundation from providing various services to grant-making organizations constituted unrelated business taxable income; the IRS ultimately concluded that the grant-making services were not subject to UBIT, while the administrative and clerical were subject to UBIT.
PLR 200832027 involved a 501(c)(3) tax-exempt, 509(a)(1) publicly supported community foundation with the primary purpose of supporting charitable activities that benefited citizens in the community through grant-making activities within that community. The organization proposed to carry out its purpose by selling its internal grant management and administrative services to other grant-making charities. The grant-making charities receiving these services were primarily private foundations that operated independently in the community and that “lack the staff, expertise or resources to conduct their own internal grant-making functions.” The organization offered nine different services—from assisting with the establishment of a grant-making program to handling day-to-day inquires from potential grant applicants—which were sold for a reasonable fee based on the hourly rate of the organization’s staff.
Given that these services were provided for a fee and on a daily basis, it was clear that these activities met the first two conditions—of being a trade or business and being regularly carried on—for UBIT to apply. Thus, the IRS ruling was based primarily on an analysis of the third element: whether the trade or business is related to the organization’s exempt purpose or function. The IRS considers many factors to determine whether trade or business is substantially related to the purpose for which the organization’s exempt status was granted. See Treas. Reg. 1-513-1.
Purpose of UBIT. The IRS’s analysis was unquestionably guided by the primary objective of UBIT: “to eliminate a source of unfair competition by placing the unrelated trade or business activities of certain exempt organizations upon the same tax basis as the nonexempt business endeavors with which they compete.” See Treas. Reg. 1-513-1(b). However, the reality of the foundation management industry is that a nonprofit service provider is almost always in direct competition with a for-profit. As the IRS stated, “. . . the for-profit foundation management industry as a whole, provide[s] a diverse array of services” including grant-making, foundation accounting, asset management, regulatory matters, and other services that were “nearly identical” to those proposed by the nonprofit organization in PLR 200832027. However, the IRS also recognized that this fact alone, while relevant, is never determinative.
Substantially Causal Relationship. The IRS then looked to the relationship between the income-generating trade or business activity and the achievement of the organization’s exempt purpose. The two must have a substantial causal relationship (i.e., contribute importantly to the accomplishment of the exempt purpose) to be considered “substantially related.” In determining what services contributed importantly to accomplishing the organization’s exempt purpose, the IRS placed a heavy emphasis between those services that are unique to the charitable sector or organization providing those services, and those that are generic to general business administration. Additionally, although the organization in PLR 200832027 considered all services under the same umbrella for purposes of the ruling, the IRS instead found it more appropriate to separate the organization’s nine services into three main groups: grant-making (e.g., identifying opportunities for collaborating with other funders); administrative (e.g., maintaining a system of monitoring funded programs); and clerical (e.g., tracking grant applications).
Grant-making services. The IRS determined that the grant-making services were substantially related to the organization’s exempt purpose. A significant factor in the IRS’s determination was the unique knowledge and skill set required to provide the grant-making services. In PLR 200832027, the IRS described the specific grant-making services provided by the organization as “activities that rely upon the particular knowledge and skills [of the organization]” which were “developed by [the organization], honed through years of grant-making in [the community], and uniquely developed to benefit the charitable community [].” Additionally, even though similar services were available from the for-profit foundation management industry, the IRS noted “[the organization’s] specific grant-making services are uniquely tailored to allow [the organization] to achieve [its] exempt purpose in [the community] effectively and efficiently.” Therefore, these grant-making services contributed importantly to the organization’s exempt purpose in issuing grants that supported charitable activities that benefited citizens of that community.
Administrative and clerical services. On the other hand, the IRS determined that the administrative and clerical services were not substantially related to the organization’s exempt purpose. In PLR 200803027, the IRS described the administrative services as “activities requiring the expertise of office staff skilled and educated in general business administration and business management, personnel management and office procedures” which are normally carried out by office administrators, personnel managers, and executive assistants. The IRS further went on to describe the clerical services as “activities requiring office staff trained in general office procedures, including word processing, data entry, and booking entries” which are normally carried out by secretaries, receptionists, and bookkeepers. Importantly, it highlighted that these administrative and clerical activities are conducted every day in businesses (rather than being uniquely grant-making activities) and that the skill set for both “is not unique to the charitable sector or to [the organization].” Thus, although these services may incidentally serve the exempt purpose of assisting charities, the IRS stated, “they are generic and routine commercial services that do not contribute importantly to accomplishing your exempt purpose [].”
* PLR 200832028 also discusses computer and legal services. The IRS determined that neither the computer service (to “maintain and update Enrollee’s web pages”) or legal service (to “represent Enrollee before associations of charitable organizations or other bodies as directed”) were “unique to the charitable sector or to [the organization] and therefore did not contribute importantly to accomplishing the organization’s exempt purpose.
Scope of Activity. The IRS next turned to whether the activity was “conducted on a larger scale than is reasonably necessary” to achieve the tax-exempt purpose. See Treas. Reg. 1-513-1(d)(3). The IRS found that the grant making services were sufficiently narrowly tailored because they were developed to address the specific needs and concerns of that charitable community. The administrative and clerical services, on the other hand, were not narrowly tailored because they encompassed a wide range of services and were broadly conducted. Importantly, the IRS recognized some legitimacy in the argument “that [administrative and clerical] services assists charities conduct their charitable functions.” However, the IRS warned that the argument’s logical extreme is to “include any and all services that [the organization] could possibly provide to a charitable organization.”
Service Fees. Finally, the IRS looked at the fee charged for the services. Fees are a relevant consideration for whether an organization’s predominant purpose is to conduct business. See B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352 (1978). The IRS considers services provided by an organization for a fee substantially below cost as a charitable activity. See Rev. Rul. 71-529. Here, however, none of the services were considered “substantially related” to the exempt function according to this factor because the organization in PLR 200832027 was essentially providing services at cost (i.e., at the employee’s hourly rate).
While PLR 200832027 may provide some insight regarding an MSO and UBIT, it is important to remember a PLR is not binding on other parties and cannot be used as precedent. Thus, it still leaves many questions unanswered. Even within the circumstances of PLR 200832027, it is unclear whether the administrative and clerical services could have been properly tailored in scope in order to be considered substantially related. Additionally, it is unclear what services, if any, would be characterized as non-generic administrative and clerical services, unique to the charitable sector or organization, for purposes of avoiding UBIT. Finally, although the IRS mandated that the organization in PLR 200832027 make a reasonable allocation of the fees and expenses between the related and unrelated activities, the IRS did not express an opinion as to what a reasonable allocation would look like.
PLR200832027 is available here.
– Emily Chan
Post-publication Resources
IRS Confirms That a Charity May Provide Consulting Services for a Fee to Social Sector Organizations Without Incurring UBIT (Loeb & Loeb)