Exempt Organizations

Exempt Organizations

Technical Guide

TG 3-10: Disqualifying and Non-Exempt

Activities - Trade or Business Activities –

IRC Section 501(c)(3)

This document is not an official pronouncement of the law or the position of the IRS and cannot be used,

cited, or relied upon as such. This guide is current through the revision date. Changes after the revision

date may affect the contents of this document and users should consider any subsequent resources to

ensure technical accuracy. All references to “Section” in this document refer to the Internal Revenue

Code of 1986, as amended, unless specifically noted otherwise. The taxpayer names and addresses

shown in examples within this publication are fictitious.

Technical Guide Revision Date: 2/1/2024

Publication 5833 (2-2024) Catalog Number 94184R Department of the Treasury Internal Revenue Service www.irs.gov

Table of Contents

I. Overview .............................................................................................. 4

A. Background / History ..................................................................... 4

B. Relevant Terms .............................................................................. 5

C. Law / Authority ............................................................................... 5

II. Section 501(c)(3) Organizations ......................................................... 5

A. Organizational and Operational Tests .......................................... 6

B. Unrelated Trade or Business ........................................................ 6

B.1. Excluded Activities .............................................................. 7

B.2. Special Exceptions ............................................................. 10

B.3. Profit Motive ....................................................................... 11

B.4. Regularly Carried On.......................................................... 12

C. Exempt Purpose(s) ...................................................................... 16

C.1. Fragmentation Rule ............................................................ 18

C.2. Substantially Related ......................................................... 19

C.3. Commerciality Doctrine ..................................................... 22

D. Published Rulings and Court Opinions...................................... 24

D.1. Charitable Purposes .......................................................... 24

D.2. Unrelated Business Income .............................................. 25

D.3. Substantial Non-exempt Purpose ..................................... 25

III. Other Considerations ........................................................................ 26

A. Advertising ................................................................................... 26

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B. Partnership Activity ..................................................................... 27

C. Feeder Organizations .................................................................. 27

C.1. Primary Purpose Test ........................................................ 28

C.2. Trade or Business Defined ................................................ 29

C.3. Exceptions to Trade or Business ...................................... 29

C.4. Profit Motive Test ............................................................... 29

C.5. Subsidiary-Integral Part of Parent ..................................... 30

C.6. Subsidiary-Trade or Business ........................................... 30

C.7. Subsidiary-Relationship Test ............................................ 30

C.8. Services to Exempt Organizations .................................... 30

C.9. Other Resources ................................................................ 31

D. Unrelated Business Taxable Income (UBTI) and Unrelated

Business Income Tax (UBIT) ....................................................... 31

IV. Examination Techniques .................................................................. 33

A. Organizational Test...................................................................... 33

B. Operational Test........................................................................... 33

V. Additional Resources........................................................................ 36

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I. Overview

(1) 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.

A.

Background / History

(1) Prior to 1950, exempt organizations enjoyed total exemption from Federal

income tax. If a charitable organization met the organizational and operational

requirements of the statute, there was no limitation on the amount of business

activity an exempt organization could conduct if the earnings from the business

were used for exempt purposes. Concerns included:

a. The Courts extended the “destination of income test” to charitable

organizations whose primary purpose was to carry on a trade or business

for profit and turn over such profits to one or more exempt organizations.

b. Charitable organizations were acquiring real estate with borrowed funds. A

typical transaction involved a tax-exempt organization borrowing money to

acquire real estate, leasing the property back to the seller under a longterm lease, and servicing the loan with tax-free rental income from the

lease.

(2) 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.

(3) The Tax Reform Act of 1969 made significant changes to the unrelated

business income tax rules by:

a. Extending the tax to all exempt organizations described in Section 501(c)

and 401(a) (except United States instrumentalities)

b. Expanding the tax on debt-financed income to cover not only certain rents

from debt-financed acquisitions of real estate, but to tax other debtfinanced income

c. Subjecting some payments to a tax-exempt organization of interest,

annuities, royalties, and rent from a taxable or tax-exempt subsidiary of

such organization to tax.

(4) Since 1969, Congress has made a number of changes to the unrelated

business income tax rules, but the structure of the tax has remained largely

intact. Mostly, changes have been to provide additional income exclusions from

tax on certain activities, including:

a. Rules relating to payments from taxable and tax-exempt subsidiaries to an

exempt parent were tightened to prevent subsidiaries of tax-exempt

organizations from reducing their otherwise taxable income by borrowing

leasing, or licensing assets from a tax-exempt parent organization at

inflated levels (1997)

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b. Providing an exclusion from the definition of acquisition indebtedness

(certain indebtedness of a small business investment company licensed

under the Small Business Investment Act of 1958)

c. Providing an exclusion for the gain or loss from certain dispositions of

certain brownfield property (American Jobs Creation Act of 2004).

(5) The Tax Cuts and Jobs Act of 2017 specified tax-exempt organizations must

compute unrelated business taxable income, including any net operating loss

(NOL) deductions, separately for each trade or business (referred to as a "silo")

for tax years beginning after 12/31/2017.

B.

Relevant Terms

(1) Trade or Business: Any activity carried on for the production of income via the

sale of goods or performance of services.

(2) 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.

C.

Law / Authority

(1) Section 501(c)(3)

(2) Section 502

(3) Section 511

(4) Section 512

(5) Section 513

(6) Treasury Regulation (Treas. Reg.) 1.501(c)(3)-1

(7) Treas. Reg. 1.513

II. Section 501(c)(3) Organizations

(1) In general, the following requirements exist for an organization to receive

tax-exempt status under Section 501(c)(3):

a. Organized and operated exclusively for exempt purposes

b. No private inurement to organization insiders

c. No more than an incidental private benefit to private persons who aren’t

organization insiders

d. No substantial part of the organization’s activities may be lobbying

e. The organization may not participate or intervene in political activities.

(2) An exempt organization may have revenue from four sources:

a. Contributions, gifts, and grants

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b. Trade or business income that is related to exempt activities (program

service revenue)

c. Investment income

d. Trade or business income that isn’t related to exempt activities

(3) In general, the Federal income tax exemption extends to the first three

categories and doesn’t extend to an organization’s unrelated trade or business

income.

(4) Activities related to a Section 501(c)(3)’s exempt purpose won’t have an

adverse effect on receiving or maintaining its tax-exempt status. However,

activities 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.

A.

Organizational and Operational Tests

(1) Section 501(c)(3) requires an organization to be both “organized” and

“operated” exclusively for one or more Section 501(c)(3) purposes. If the

organization fails either the organizational test or the operational test, it isn’t

exempt. See Treas. Reg. 1.501(c)(3)-1(a)(1).

(2) The organizational test applies to the organization’s articles of organization

(also known as the “organizing document”).

(3) The term “exempt purpose” means any purpose or purposes specified in

section 501(c)(3) – charitable, religious, scientific, testing for public safety,

literary, educational, fostering national or international sports competitions, or

the prevention of cruelty to children or animals.

(4) In applying the operational test, the IRS focuses on the organization’s

operations through its activities and how those activities further exempt

purposes.

(5) See Exempt Organizations Technical Guide, TG 3-1: IRC 501(c)(3) Overview,

Application, Exemption Requirements for organizational and operational

requirements.

B.

Unrelated Trade or Business

(1) 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.

(2) Section 513(a) defines the term “unrelated trade or business” as any trade or

business, the conduct of which isn’t 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 (or, in the case of an organization described in Section

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511(a)(2)(B), to the exercise or performance of any purpose or function

described in Section 501(c)(3)).

(3) 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

(4) The following code sections apply to unrelated trade or business activity of

exempt organizations:

a. Section 511, Imposition of tax on unrelated business income of charitable,

etc., organizations

b. Section 512, Unrelated business taxable income

c. Section 513, Unrelated trade or business

d. Section 514, Unrelated debt-financed income

(5) Section 502, 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. See

Section III. C. Feeder Organizations, following.

B.1. Excluded Activities

(1) 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.

See Section 513(a) and Treas. Reg. 1.513-1(e).

(2) Regarding volunteer labor:

a. Volunteers are defined as people who aren’t compensated for their work.

Mere reimbursement of expenses incurred by volunteers is not

compensation.

b. The term "substantially all" isn’t defined in Section 513 or the

regulations. When analyzing all the facts and circumstances, it’s helpful to

identify and compare the number of hours worked by those

uncompensated to the number of hours worked by those compensated to

determine if substantially all the work is carried on by unpaid volunteers.

The type of work performed by those who are compensated versus

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volunteer labor should also be considered. Existing court cases don’t

apply a set percentage test. The "substantially all" test is to be applied in a

general manner.

c. Work provided by third-party contractors isn’t volunteer labor. If the

organization conducting trade or business activities makes a payment to a

third party in return for supplying labor, the amount paid is considered

compensation in applying the volunteer labor exception. It’s irrelevant that

workers aren’t compensated directly by the organization. What is relevant

is that compensation is paid for the labor, not whether or not the labor is

paid as employees or independent contractors.

d. A significant factor is whether the services performed by volunteers is

material in the income-producing endeavor. In Rev. Rul. 78-144, the IRS

reasoned that although the work in carrying on the activity may be

volunteer labor, the performance of service was not a material incomeproducing factor in carrying on the business. Therefore, the volunteer

exception didn’t apply to the activity.

(3) Compensation is interpreted broadly and can take many forms.

a. Tips received by workers are compensation even though they are not paid

by the organization.

b. A worker who obtains goods or services at a reduced price in return for

his services may be considered compensated.

c. At the same time, there must be a "but-for" connection between the

payment and the services, such that the payment would not otherwise be

received but for the provision of services.

De minimis amounts received by workers aren’t compensation.

Reimbursement of incurred expenses is not compensation. Free food and

beverages may be considered payment of compensation. However, the

facts and circumstances of each case must be examined to determine if

the amounts in question are de minimis.

Workforce constitutes all workers involved in carrying out the activities in

question must be considered. This could include any workers involved in

the activity.

(4) Trade or business activity will meet the convenience exception if it is carried

on by the organization primarily for the convenience of its members, students,

patients, officers, or employees.

(5) The sale of donated merchandise substantially all of which has been received

as a gift or contribution is generally not an unrelated trade or business.

(6) The following court cases and rulings address exceptions to trade or business

activities:

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a. Waco Lodge No. 166, Benevolent and Protective Order of Elks v.

Commissioner, 696 F.2d. 372 (5th Cir. 1983). The organization, granted

exemption pursuant to Section 501(c)(3), conducted profit-making bingo

games with work performed for cash compensation, and the balance of

the work performed by volunteers. Four of the volunteers received free

drinks from the bar where the main part of the bar's business on those

nights came from the people playing bingo. The Tax Court “determined

that Section 513(f), the so-called ‘bingo exception,’ did not exempt the

Lodge from taxation, because the bingo games were illegal under Texas

law. The Lodge did not challenge that determination.” The court held that

the availability and value of the free drinks, averaging 63 cents per hour,

was not compensation because the court did “not believe that the Code's

definition of compensation was meant to include such a trifling

inducement.” Additionally, it determined a substantial percentage,

approximately 21 %, of the work performed was compensated and

prevented the bingo operation from meeting the exception for volunteer

labor under Section 513(a)(1).

b. St. Joseph Farms of Indiana Brothers of the Congregation of Holy Cross,

Southwest Province, Inc. v. Commissioner, 85 T.C. 9 (1985), non-acq.

1986-2 C.B. 1. A Section 501(c)(3) religious order, a subordinate of the

US Catholic Conference which was granted a group exemption, operated

a farm which produced livestock and crops that were marketed

commercially. The religious order participated in federal farm subsidy

programs and received subsidies over $10,000 in two of the years

examined. The religious order was comprised of Brothers who took a vow

of poverty and received no actual compensation in the form of salaries. All

Brothers residing on the farm received food, clothing, shelter, and medical

care, regardless of whether they were involved in farm operations. The

Tax Court held that although the organization's farming operations

constituted unrelated trade or business, the exception for volunteer labor

under Section 513(a)(1) was applicable. The court pointed to 94 percent of

the total hours worked in operating the farm and 91 percent of the labor is

supplied by the Brothers. The court reasoned that the support provided

the Brothers operating the farm wasn’t compensation for purposes of

Section 513(a)(1), since such support would be provided to each Brother

regardless of whether the Brother was assigned to operating the farm.

c. Shiloh Youth Revival Centers, Inc. v. Commissioner, 88 T.C. 565 (1987).

The members of a Section 501(c)(3) religious organization engaged in

forestry, cleaning and maintenance, painting, and other "donated labor"

activities. The organization claimed the conduct of its trades or business

was substantially related to its tax-exempt purpose, but the court

concluded that the exempt functions of its activities were incidental to

raising revenue. The members accepted virtually all types of unskilled jobs

with the organization’s primary concern being production of income and

maintaining full employment. Also, its formal work philosophy was

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developed to strengthen its defense against imposition of unrelated

business income tax and desire to reduce its tax burden. The court

concluded that the conduct of the organization’s business was not

substantially related to it purposes of religious training, worship, and

evangelism. However, unlike the ruling in St. Joseph Farms, the court

stated the activities were not peculiarly suited to the accomplishment of its

objectives and the volunteer labor exception under Section 513(a)(1)

didn’t apply because the organization's members didn’t receive benefits if

they didn’t display at least a willingness to work and the organization

would not have tolerated members who refused to work. Moreover, the

organization could provide for the needs of its members only if virtually all

the members work as compared with St. Joseph’s Farms where only 12 to

14 out of the 167 members worked in St. Joseph’s unrelated business. In

St. Joseph’s, if farm operations ceased the Brothers who operated the

farm would receive the same support whereas here if business operations

ceased it would cease to exist. The court concluded that the organization's

activities constituted unrelated trade or business.

d. Rev. Rul. 69-267, 1969-1 C.B. 160. A gift shop operated by a full-time,

salaried manager assisted by members of the hospital auxiliary of a

hospital exempt under Section 501(c)(3) that results in an annual net profit

which is made part of the hospital's general operating fund is for the

convenience of its patients, visitors and employees and isn’t an unrelated

trade or business activity.

e. Rev. Rul. 74-399, 1974-2 C.B. 172. The operation of a dining room,

cafeteria, and snack bar not contemplated or designed to serve as a

public restaurant but merely to serve the exempt purposes of the exempt

art museum for the convenience of its staff, employees and members of

the public visiting the museum is substantially related to the museum's

exempt purposes and consequently doesn’t constitute an unrelated trade

or business activity.

B.2. Special Exceptions

(1) Over the years, tax-exempt organizations have successfully lobbied Congress

for special exceptions to unrelated trade or business. The exceptions are limited

to specific types of exempt organizations for specific events or activities.

(2) Exceptions include:

a. Section 513(d) Qualified convention and trade show activities carried on

by qualifying organizations described in Sections 501(c)(3), (4), (5), and

(6). See Treas. Reg. 1.513-3.

Income from a qualified public entertainment activity engaged in by

qualified organizations described in Sections 501(c)(3), (4), (5). A qualified

public entertainment activity is one traditionally conducted at fairs or

expositions promoting agricultural and educational purposes, including,

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but not limited to, any activity one of the purposes of which is to attract the

public to fairs or expositions or to promote the breeding of animals or the

development of products or equipment See Section 513(d)(2)(B).

b. Section 513(e) Tax-exempt hospital or a cooperative organization created

by two or more tax-exempt hospitals providing specific services to other

hospitals that have facilities to serve not more than 100 inpatients. See

Treas. Reg. 1.513-6.

c. Section 513(f) Unrelated trade or business does not include any trade or

business which consists of conducting certain bingo games. See Section

513(f) and Treas. Reg. 1.513-5.

d. Section 513(h) Distribution of low-cost articles without obligation to

purchase and exchanges and rentals of member lists. Certain distributions

of “low-cost articles,” if the distribution is incidental to the solicitation of

charitable contribution, and a trade or businesses involved with exchanges

and rentals of member lists aren’t an unrelated trade or business. See

Section 513(h).

e. Section 513(i) Soliciting and receiving "qualified sponsorship payments” is

not an unrelated trade or business. There are several requirements and

limitations to be a “qualified sponsorship payment.” See Section 513(i) and

Treas. Reg. 1.513-4.

B.3. Profit Motive

(1) Taxable corporate entities are organized to conduct activities for a profit. Absent

specific compelling evidence to the contrary, taxable corporate activities, even if

they suffer several years of net losses, are presumed to be conducted for a

profit motive.

(2) An activity must be profit-motivated in order to be considered a “trade or

business” for purposes of Section 513.

(3) In United States v. American Bar Endowment, 477 U.S. 105,106 S. Ct. 2426

(1986), the court held that a Section 501(c)(3) organization's insurance program

operated like a commercial entity and was a trade or business for purposes of

tax on unrelated business income. American Bar Endowment (ABE) engaged in

the following activity:

a. Served as group policyholder and administrator of insurance policies

offering life, accident, disability, and medical coverage.

b. Negotiated premium rates with insurers and selected which insurer would

provide coverage.

c. Compiled a list of its members, solicited their insurance business,

collected premiums, transmitted premiums to the insurer, maintained files

on each policyholder, answered member's questions concerning

insurance policies, and screened claims for benefits.

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d. Received all dividends (as required by member agreement) to further its

charitable and educational activities.

The Court stated that assembling a group of better than average insurance

risks, negotiating on their behalf with insurance companies, and administering a

group policy are activities engaged in by private commercial entities to make a

profit. The Court rejected ABE's arguments that its insurance activities weren’t

a trade or business, citing the crucial fact that members were required to assign

to ABE all dividends as a condition of participating in the insurance program.

The Court stated it’s simply incorrect to characterize the assignment of

dividends by each member as voluntary.

The Court held that the “standard test for the existence of a trade or business

for purposes of [Section] 162 is whether the activity ‘was entered into with the

dominant hope and intent of realizing a profit.’ Thus, several Courts of Appeals

have adopted the ‘profit motive’ test to determine whether an activity constitutes

a trade or business for purposes of the unrelated business income tax.”

(citations omitted).

(4) Cases involving the issue of whether an activity is a trade or business are "fact

specific". A decision is reached based on the facts in the case rather than a

point of law. In ABE, the Court determined that ABE conducted the activity like

a for-profit insurance broker. More so, ABE was as a standard example of

monopoly pricing, provided group insurance coverage with the characteristics of

a natural monopoly, and chose to appropriate for itself all of the profit possible

from that asset. Also, ABE received dividends normally accruing to its members

as compensation for performing the insurance activity.

(5) The Court stated that pre-existing groups like the ABA or a trade association

obviously have a considerable advantage over new entrants. The Court

concluded ABE's insurance program presented the potential for unfair

competition, there was no danger of unfair competition, and was an example of

precisely the sort of unfair competition Congress intended to prevent with UBIT.

The facts of the case supported the conclusion that ABE was conducting a

trade or business with a profit motive.

B.4. Regularly Carried On

(1) Trade or business activities must be “regularly carried on.” 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. See Treas. Reg. 1.513-1(c)(1).

(2) Treas. Reg. 1.513-1(c)(2) provides the application of the rules:

Subsection (i) states:

a. Where income producing activities are of a kind normally conducted by

nonexempt commercial organizations on a year-round basis, the conduct

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of such activities by an exempt organization over a period of only a few

weeks does not constitute the regular carrying on of trade or business.

For example, the operation of a sandwich stand, by a hospital auxiliary for

only two weeks at a state fair would not be the regular conduct of trade or

business. But the conduct of year-round business activities for one day

each week would constitute the regular carrying on of trade or business.

b. Where 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 trade

or business.

Subsection (ii) states:

a. In determining whether or not intermittently conducted activities are

regularly carried on, how the activities are conducted must be compared

with the manner in which commercial activities are normally pursued

by nonexempt organizations.

b. In general, activities which are engaged in only discontinuously or

periodically won’t be considered regularly carried on if they’re conducted

without the competitive and promotional efforts typical of commercial

endeavors. For example, the publication of advertising in programs for

sports events or music or drama performances won’t ordinarily be deemed

to be the regular carrying on of business.

Subsection (iii) states:

a. Certain intermittent income producing activities occur so infrequently that

neither their recurrence nor how they may be otherwise conducted will

cause them to be regarded as regularly carried on.

b. Activities lasting only a short period of time won’t ordinarily be treated as

regularly carried on if they recur only occasionally or sporadically.

c. Such activities won’t be regarded as regularly carried on merely because

they are conducted on an annually recurrent basis. For example,

income from the conduct of an annual dance or similar fundraising event

for charity wouldn’t be income from trade or business regularly carried on.

(3) The following revenue rulings and court cases address the “regularly carried on”

requirement:

a. Rev. Rul. 68-505, 1968-2 C.B. 248, holds that a two-week horse racing

meet featuring pari-mutuel betting conducted by a Section 501(c)(3)

county fair association is regularly carried on because it is usual to carry

on such trade or business only during a particular season.

b. Rev. Rul. 73-424, 1973-2 C.B. 190, holds that the sale of advertising by a

Section 501(c)(5) organization in its annual yearbook was a "regularly

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carried on" activity. Although the publication was distributed only on an

annual basis, the advertising solicitation required that a significant span of

time be devoted to the activity. The ruling states the organization was

engaged in activity typical of commercial endeavors and the activity

occurred with a frequency and continuity similar to commercial activities.

c. Rev. Rul. 75-200, 1975-1 C.B. 163, holds that the sale of advertising for a

concert program, by employees of a Section 501(c)(3) organization, which

it publishes weekly to distribute free over an eight-month period is a

business "regularly carried on." The majority of the advertisements are

sold in a general solicitation campaign extending over a four-month

period, where the rates charged for the advertising are generally

competitive with commercial publications. The ruling states the advertising

activity didn’t differ substantially from comparable commercial activities of

nonexempt organizations.

d. Rev. Rul. 75-201, 1975-1 C.B. 164, holds that the sale by a Section

501(c)(3) organization of commercial advertisements for concert books

that it publishes and distributes at its annual charity ball to raise funds for

a Section 501(c)(3) symphony orchestra is not "regularly carried on." A

major purpose of the organization was to raise funds for the symphony

orchestra. The revenue ruling states that the advertising income is not

"regularly carried on" within the meaning of Treas. Reg. 1.513-1(c)(2)(iii)

because the distribution of the concert books is part of an annual charity

ball, advertising solicitation is largely carried on by the volunteer

committee and is an intermittent activity that does not continue for an

extended period.

e. In Suffolk County Patrolmen's Benevolent Association, Inc. v.

Commissioner, 77 T.C. 1314 (1981), acq. 1984-2 C.B. 2, the court

determined that a fundraising activity conducted, based on the facts and

circumstances in the case, one weekend per year over a six-year period

was an intermittent activity. Also, preparation for the shows, including the

solicitation of advertisers, lasted no longer than 8 to 16 weeks per year.

The court stated that activities engaged in only discontinuously or

periodically generally won’t be considered regularly carried on if

conducted without the competitive and promotional efforts typical of

commercial endeavors. The conclusions that can be drawn from this case

are:

1) The time span for measuring the conduct of a fundraising activity is

the preparation and conduct of the event itself. If it’s infrequent (812 weeks prep and the event only one weekend per year), it’s

intermittent.

2) If the activity is an intermittent fundraising activity, the manner in

which it’s conducted isn’t determinative in whether it’s regularly

carried on.

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3) The fact that the organization hired professionals to conduct the

event and do most of the preparatory work didn’t change the

activity from intermittent to regularly carried on.

f. In National Collegiate Athletic Association v. Commissioner, 914 F.2d

1417 (10th Cir. 1990), which reversed National Collegiate Athletic

Association v. Commissioner, 92 T.C. 456 (1989), the NCAA conceded

that its program advertising was a “trade or business” not “substantially

related” to its exempt purpose. However, the Appellate Court determined

that the sale of advertising space in programs sold at "The Final Four"

Basketball Tournament wasn’t “regularly carried on.” The court stated that

to determine the normal time span of the activity it considered the

business of selling advertising space as that’s the business that’d be

generating unrelated business taxable income because the tournament

itself is substantially related to the NCAA's exempt purpose and isn’t the

business activity in question. Even though the preparation and solicitation

of the advertising by a third-party publisher took place over a period of

several months, the court determined that the time span to be used was

that of the event that earned the advertising income. Therefore, in this

case, the time span to be used in measuring the conduct of the activity

was the actual length of the tournament which was less than 3 weeks. The

Court stated that the publication of advertising is generally conducted on a

year-round basis. However, the NCAA's sale of program advertising was

conducted for only a few weeks and that time-period standing alone

couldn’t convert the NCAA's business into one regularly carried on. The

court considered the 3-week event "infrequent" and therefore intermittent.

The court stated it is not necessary to prove or disprove the existence of

actual competition but determined that the NCAA's once-a-year program

shouldn’t be considered an unfair competitor for the publishers of

advertising.

IRS Action on Decision - The IRS disagreed with the factual

characterizations and legal conclusions of the court in A.O.D. 1991-15,

1990 WL 692279. The IRS maintained the tournament was seasonal, like

other sports tournaments, not intermittent. Additionally, the NCAA's

advertising activity is indistinguishable from that of many commercial

businesses. While the court, ignoring Treas. Reg. 1.513-1(b), concluded

that the time span of the activity should be limited to the duration of the

actual event, the IRS position is that it should include the several months

of planning and preparation for the event.

The conclusions that can be drawn from this case are as follows:

1) Attributing the actions of a hired professional to the exempt

organization in order to determine the time span of an activity was

not accepted by the court.

15

2) The court concluded the actual time span or length of an event or

activity is used in measuring the conduct of the activity.

3) Comparison of the conduct of the organization’s activity to a similar

activity of a nonexempt entity did not support the concept that the

activity was an intermittent activity or was regularly carried on.

C.

Exempt Purpose(s)

(1) An organization will be regarded as "operated exclusively" for one or more

exempt purposes only if it:

a. Engages primarily in activities which accomplish one or more of the

exempt purposes specified in Section 501(c)(3).

b. No more than an insubstantial part of its activities don’t further exempt

purposes. See Treas. Reg. 1.501(c)(3)-1(c)(1).

(2) The purposes specified in Section 501(c)(3) are:

a. Religious

b. Charitable

c. Scientific

d. Testing for public safety

e. Literary

f. Educational

g. Fostering national or international sports competition

h. Prevention of cruelty to children or animals.

(3) The terms “exclusively,” “primarily,” “substantial” and “insubstantial” for

purposes of the operational test, apply to the review of the purposes, activities,

time, and resources of exempt organizations to determine if they are operating

for Section 501(c)(3) purposes. There is no express formula or measurement in

the Internal Revenue Code for the operational test. Rather, all facts and

circumstances pertaining to the operational test should be considered when

making these determinations. Often, exemption is determined on the basis of

stated purposes and proposed activities.

(4) 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.

(5) 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. See

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

16

(6) Whether an organization meets the requirements of Section 501(c)(3) even

though it operates a trade or business depends on "the purposes toward which

an organization’s activities are directed, and not the nature of the activities."

(7) 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.

(8) An organization which is organized and operated for the primary purpose of

carrying on an unrelated trade or business isn’t exempt under Section 501(c)(3)

even though it has certain religious purposes, its property is held in common,

and its profits don’t inure to the benefit of individual members of the

organization. See Section 501(d) and Treas. Reg. 1.501(d)–1 relating to

religious and apostolic organizations.

(9) The following court cases address the primary purpose issue:

a. B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352 (1978). The court ruled

the organization, organized to provide consulting services for a fee to taxexempt and non-profit clients, didn’t qualify for exemption under Section

501(c)(3) because it didn’t operate for exempt purposes but had a primary

purpose that was commercial. Its activity constituted the conduct of a

consulting business of the sort which is ordinarily carried on by

commercial ventures organized for profit.

b. Dumaine Farms v. Commissioner, 73 T.C. 650 (1980). A trust operating a

model farm as a demonstration conservation project applied for exempt

status under Section 501(c)(3) as a scientific and educational

organization. When it first applied it had engaged in no operations and it

was not fully operational by its final submission to the administrative

record. The IRS denied the application. The court stated the issue was a

standard question of whether this was a commercial enterprise or whether

it meets the organizational and operational tests and is exempt under

Section 501(c)(3). The court noted that the organization’s operation of a

conservation project, experimental projects and demonstration function

furthered its purpose of conserving the ecology. The articles appropriately

limited its purposes including that it shall not be the purpose of the trust to

make money except incidentally to its exempt purpose. Additionally, the

court stated the organization's goal was ‘to test and demonstrate the

restoration of overcultivated, exhausted land to a working ecological

balance” and that for ‘this reason it [was] essential to the [organization's]

purpose that the land be generally representative of the surrounding

farmland.” The fact the land didn’t have any significant environmental

attributes or part of an ecologically significant undeveloped area wasn’t a

bar to exemption.

Although the organization would not plant cash crops, it will plant and

harvest on a commercial scale. Additionally, the farm was not open

17

continuously to the public like a museum or nature trails, but the

organization worked closely with public agencies and academic

institutions to develop additional research. The Department of Agriculture

previously and currently worked to help conserve the land and the State

wanted to engage in conservation on the organization’s land. The

organization intended to participate in a State conservation program.

Research and results would be shared with county farmers and the public.

Note: See A.O.D. 1980-45 and subsequent IRS Announcement relating

to: Dumaine Farms, 1980-2 C.B. 1(1980) indicating IRS acquiescence on

the issues relating to (1) whether petitioner was operated exclusively in

furtherance of exempt purposes, and (2) whether petitioner served private

rather than public interests. The IRS non-acquiescence on the issue

relating to whether petitioner was organized exclusively for exempt

purposes and that if an organization’s purposes are more specific than

those listed in Section 501(c)(3) then, pursuant to Treas. Reg. 1.501(c)(3)(b)(1)(ii), it must describe the manner of its operations in detail.

C.1. Fragmentation Rule

(1) While tax-exempt organizations are organized for exempt purposes, they may

conduct both exempt activities and activities that are considered a trade or

business.

(2) 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.

(3) The fragmentation rule allows each trade or business activity to be analyzed

separately even though the conduct of the activity may be entwined with the

conduct of exempt activities or other trade or business activities.

(4) To illustrate the fragmentation rule, the following example is provided:

Facts - A rural hospital described in Section 501(c)(3) operates a kitchen facility

to provide meals to its inpatients at below cost. In addition, the hospital also

delivered meals to elderly shut-ins and to a social club on a fee basis. The

meals provided to the elderly are provided at slightly more than the hospital's

cost but substantially less than what the same meal would cost the elderly from

a for-profit caterer. The meals delivered to the social club result in a significant

net profit.

Analysis - The hospital is conducting the following three activities:

a. Sale of meals to inpatients at less than cost

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b. Sale of meals to elderly shut-ins at more than cost but less than fair

market value (the amount a taxable entity would charge)

c. Sale of meals to a social club at a net profit

All three activities are conducted within the framework of one hospital activity

and the one kitchen facility with, primarily, the same personnel.

Conclusion - The activities are conducted for different economic purposes as

follows:

a. The first activity isn’t profit-motivated, so it’s not a trade or business. The

activity serves the exempt charitable purpose of the hospital.

b. The second activity is a trade or business because it’s profit motivated.

This activity provides food to elderly shut-ins at a profit.

c. The third activity is a trade or business because it’s profit motivated. The

activity provides food to the social club at a profit.

By using the provisions of Section 513(c) to fragment the kitchen activity, the

organization ends up with three activities, two of which are trade or business

activities.

C.2. Substantially Related

(1) Even though an activity qualifies as a trade or business, it still may not be an

“unrelated trade or business” activity. Trade or business activity is unrelated if it

isn’t substantially related to the achievement of the organization’s exempt

purpose.

(2) 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).

(3) 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.

(4) 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.

(5) In United States v. American College of Physicians, 475 U.S. 834 (1986), the

U.S. Supreme Court provided guidelines for determining when an activity was

substantially related to an organization's exempt purpose activities.

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Facts:

a. The American College of Physicians (ACP) is an organization recognized

as exempt under Section 501(c)(3).

b. ACP’s purposes included upholding and maintaining high standards in

medical education and medical practice encouraging medical research

(especially in clinical medicine); and fostering measures for the prevention

of disease and for the improvement of public health.

c. In furtherance of its exempt purpose, ACP published a journal which

contained scholarly articles relevant to the practice of internal medicine. It

also contained advertisements for pharmaceuticals, of medical products,

supplies, and equipment useful in the practice of internal medicine, and

notices of positions desired or available in connection with the practice of

internal medicine.

d. Advertisements in the journal were "clustered" in two sections – “one at

the front and one at the back of each issue.”

e. Some advertising was for established drugs or devices and was repeated

monthly.

f. The organization's longstanding policy was to accept only advertisements

“containing information about the use of medical products. Advertisements

were screened for accuracy and relevance to internal medicine.

Court's Analysis:

a. Scrutiny should be placed on the conduct of the organization rather than

the educational quality of the advertisements.

b. All advertisements contain some information, and if a small amount of

informative content were enough to supply the important contribution

necessary to achieve tax-exemption for commercial advertising, it would

be rare that an advertisement would fail to meet the test. (Even if not

creating a per se rule against tax-exemption, is clearly antagonistic to the

concept of a per se rule for exemption for advertising revenue.)

c. The statute directs the focus to the “manner” in which the tax-exempt

organization operates its business.

Court's Conclusion:

a. The Court concluded that the type and subject nature of the ads did not

contribute importantly to the organization's educational exempt purpose.

(6) If an activity serves a substantial nonexempt purpose, however, the

organization doesn’t qualify for exemption even if the activity also furthers an

exempt purpose.

(7) In Schoger Foundation v. Commissioner, 76 T.C. 380 (1981), a not-for-profit

corporation was organized to own and operate a mountain lodge as a religious

retreat facility. Only the operational test was at issue. The lodge made available

20

to its guests numerous activities (religious, recreational, and social) none of

which were regularly scheduled or required. The religious activities revolved

around individual prayer and contemplation, with optional daily devotions and

occasional Sunday services. The recreational and social activities were of the

type usually offered at vacation resorts. No records were kept showing the

extent of participation by guests in any of the activities. The lodge’s brochure

references religion but stresses the accommodations and recreational activities.

Donations are solicited by cards left in the accommodations listing the expense

of lodging and food per day The court stated the cards are geared towards the

organization receiving enough to cover its expenses. The court found the record

did not establish that the majority of guest’s time was not engaged in recreation,

relaxation, and socializing. The court found nowhere in the record was it shown

that the recreational facilities were not used in more than in insubstantial

manner. The court held that on the facts of the case the organization failed to

establish that it was operated primarily for an exempt purpose within the

meaning of Section 501(c)(3) and that the recreational and social activities were

only incidental and less than substantial.

(8) The following contrasting revenue rulings illustrate the issue of furthering

exempt purposes:

a. In Rev. Rul. 73-128, 1973-1 C.B. 222, an organization that otherwise

qualifies for exemption under Section 501(c)(3) formed to operate a

vocational job training program for nonskilled persons unable to find

employment or cannot advance from poorly paid employment because of

inadequate education was found to further exempt purposes.

i.

The program involved the manufacture and sale of a line of toy

products.

ii.

Most of the merchandise produced is sold through regular

commercial channels.

iii.

Income from manufacturing finances the organization’s other

community service activities and deficits are met by public

contributions.

iv.

The organization recruits residents of a particular economically

depressed community.

v.

The program provided the unskilled persons with new skills

through on-the-job training while they were earning a living.

vi.

Trainees hired by the organization weren’t hired as permanent

employees and the organization tried to place them in permanent

positions in the community as soon as they were trained and then

recruited new trainees to continue the training process.

The IRS stated manufacture and sale of commercial items as an end itself

is not a charitable purpose. However, providing vocational training and

guidance to the unskilled and under-employed may qualify as a charitable

purpose if the manner of its achievement is otherwise charitable. The

question was whether the manufacturing of merchandise was the end or

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the means to accomplish a charitable purpose. The IRS concluded it was

the means and that there was a clear and distinct causal relationship

between the manufacturing and training to improve individuals’ abilities.

The IRS noted that there was no evidence that the scale of the operation

was conducted on a larger scale than was reasonably necessary to

accomplish the organization’s charitable purpose. The IRS stated the

manufacturing activities were an integral part of the training process and

an integral part of the organization’s charitable program which carried on a

business in furtherance of its exempt purposes.

b. In Rev. Rul. 73-127, 1973-1 C.B. 221, an organization formed to operate a

retail grocery store to provide free grocery delivery service to residents

who need it, to participate in the Federal food stamp program, and provide

job training for unemployed residents was denied exemption. The grocery

store planned to sell food to residents of a poverty area at prices

substantially lower than those charged by competing grocery stores.

i.

ii.

iii.

The store’s gross earnings were used principally to pay salaries

and to expand the operations of the store.

Only about four percent of the store’s earnings were allocated for

use in a continuous training program for the hard-core unemployed.

Some of the trainees became permanent employees at the grocery

store.

The IRS denied exemption under Section 501(c)(3) since the operation of

the grocery store is in itself an independent objective of the organization

and it didn’t serve solely as a vehicle for carrying out the training program

and was conducted on a scale larger than was reasonably necessary for

the performance of the training program.

C.3. Commerciality Doctrine

(1) 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. See Treas. Reg. Section 1.501(c)(3)–1(e)(1).

(2) Over the years, courts have decided what defines “commercial activity that isn’t

in furtherance of exempt purposes.”

a. In Better Business Bureau of Washington, D.C., Inc. v. United States, 326

U.S. 279 (1945), the court ruled the organization failed to operate for

educational purposes because it had a substantial commercial purpose.

The organization engaged in activities promoting and protecting the

welfare and business methods of merchants to profitably conduct their

businesses. The Court noted the commercial nature of the organization’s

operations as the basis for its conclusion.

(3) 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

22

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.”

(4) The courts have also developed factors to consider in analyzing the trade or

business activities of tax-exempt organizations.

a. In Living Faith, Inc. v. Commissioner, 950 F.2d 365 (7th Cir. 1991), the

organization was established for the purpose of keeping with the doctrines

of the Seventh-day Adventist Church. The court determined the

organization didn’t qualify for exemption under Section 501(c)(3) by

operating as a business in direct competition with restaurants and stores.

The court considered the following factors in determining commerciality:

i. The organization sold goods and services to the public

ii. The organization was in direct competition with for profit businesses

iii. The organization operated its businesses under the name of a

worldwide chain of restaurants and food stores

iv. The prices set by the organization were based on pricing formulas

common in retail food businesses and were at or higher than

market rates (e.g., buffet prices were three times wholesale cost of

food)

v. The organization advertised its services and food

b. In Airlie Foundation v. Commissioner, 283 F. Supp. 2d 58 (D.D.C. 2003),

the organization’s primary activity was operating a conference center. It

organized, hosted, conducted, and sponsored educational conferences in

its facilities. It hosts about 600 groups per year and derives 85% of its

operating revenue from fees paid by these clients. The IRS revoked its

recognition of the organizations tax-exempt status under Section 501(c).

The court upheld the IRS denial of the organization’s new application for

exemption although it carried out a number of charitable and educational

activities (the IRS did not argue that the organizational test was not

satisfied), because those activities were incidental to its primary activity of

operating a conference center in a commercial manner. The court stated

the foundation carried out its business with a “distinctive ‘commercial

hue.’” Among the factors the court considered in assessing 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.

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vii.

Nature of its clients.

(5) In American Institute for Economic Research v. United States, 302 F.2d 934

(Ct. CL 1962), the Court considered the status of an organization that provided

analysis of securities and industries and of the economic climate in general. It

published two periodicals, sold subscriptions to various periodicals, and

provided fee-based investment advice services for purchases of individual

securities. The Court held that the service offered by the organization is one

commonly associated with a commercial enterprise, was in competition with

other commercial organizations providing similar services and its activities have

a commercial hue. It also held the organization had primarily a non-exempt

commercial purpose not incidental to its educational purpose and wasn’t

entitled to exemption under Section 501(c)(3).

D.

Published Rulings and Court Opinions

(1) Additional rulings and court cases are listed in the following subsections by

category.

D.1. Charitable Purposes

(1) Rev. Rul. 71-529, 1971-2 C.B. 234, states an organization providing assistance

in the management of participating colleges’ and universities’ endowment or

investment funds for a charge substantially below cost qualified for exemption

under Section 501(c)(3). It obtained contributions to cover all or part of the costs

of the management of such funds or to provide supplemental income or capital

to be used exclusively for the charitable, educational, or scientific purposes of

such organizations. Most of the operating expenses of the organization,

including the costs of the services of the investment counselors and the

custodian banks, are paid for by grants from independent charitable

organizations. The member organizations pay only a nominal fee for the

services performed. Membership in the organization was restricted to colleges

and universities exempt under Section 501(c)(3) and the organization made its

services available only to the exempt organizations (participating colleges and

universities) controlling it.

(2) In Rev. Rul. 72-369, 1972-2 C.B. 245, an organization was formed to provide

managerial and consulting services to Section 501(c)(3) organizations. The

organization entered into agreements with unrelated Section 501(c)(3)

organizations to furnish managerial and consulting services on a cost basis.

Providing managerial and consulting services on a regular basis for a fee is a

trade or business ordinarily carried on for profit. Providing services at cost and

solely to exempt organizations is not sufficient to characterize this activity as

charitable within the meaning of Section 501(c)(3). Furnishing the services at

cost lacks the donative element necessary to establish this activity as

charitable.

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D.2. Unrelated Business Income

(1) Rev. Rul. 73-587, 1973-2 C.B. 192 describes an exempt organization operating

for the prevention of cruelty to animals. In furtherance of such purpose, it

maintains and operates an animal shelter for the care, protection, placement,

and, if necessary, humane disposal of stray or unwanted animals. The ruling

provides the organization’s provision of pet boarding and grooming services to

the general public, for a fee, are ordinary commercial services, has no causal

relationship to the prevention of cruelty to animals, and don’t contribute

importantly to the organization’s exempt purpose. The operation of pet boarding

and grooming services is regularly carried on. It constitutes the conduct of a

trade or business. Therefore, the income earned from those services is from an

unrelated trade of business.

(2) In Rev. Rul. 69-430, 1969-2 C.B. 129, the organization engages primarily in

activities in furtherance of its exempt purposes, but publication and distribution

of a book will not contribute in any manner to the accomplishment of the exempt

purposes. The organization has undertaken to exploit the book in a commercial

manner. It has arranged for the printing, distribution, and retail sale of the book.

The organization has also arranged for appropriate publicity and advertising in

connection with the distribution and sale of the book. The income from the

publication and sale of a book in the manner described, on a topic unrelated to

the organization’s exempt purpose, is unrelated business income.

(3) Rev. Rul. 69-528, 1969-2 C.B. 127 concerns an organization formed to provide

investment services for a fee exclusively to organizations exempt under Section

501(c)(3). The ruling stated the organization providing investment services for a

fee on a regular basis is a trade or business ordinarily carried on for profit. The

organization isn’t described in Section 501(c)(3) since it’s regularly carrying on

the business of providing investment services that would be unrelated trade or

business if carried on by any of the tax-exempt organizations on whose behalf it

operates.

D.3. Substantial Non-exempt Purpose

(1) In Zagfly, Inc. v. Commissioner, 603 F. Appx. 638 (9th Cir. 2015), the court of

appeals found that the organization's primary activity of operating a web-based

broker that sold flowers at market rates didn’t accomplish one or more of the

exempt purposes specified in Section 501(c)(3), but rather a commercial activity

that amounted to an unrelated trade or business. When customers purchased

flowers, they were able to designate a charitable organization from a list of

approved organizations. The organization planned to donate the business profit

arising from the transaction to charitable organizations. Organizations received

a share of its profits only if the recipient was exempt under Section 501(c)(3).

The organization hoped to expand web site offerings to include other goods and

services. The court upheld the Tax Court’s conclusion that the operational test

wasn’t met. Based on this, the court declined to address the unrelated trade or

business analysis under Treas. Reg. 1.501(c)(3)-1(e).

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(2) In Easter House, 12 Cl. Ct. 476, 60 AFTR2d 87-5119 (Cl. Ct., 1987), the

organization provides services for unwed mothers and children incident to its

operation of an adoption service. The adoption agency's application for taxexempt status under Section 501(c)(3) was denied on the basis that the agency

operated as a trade or business competing with and in a manner not

“distinguishable from commercial adoption agency,” and this was its primary

purpose. The court indicated the following items in the record supported the

ruling:

a. The agency made substantial profits by charging substantial fees, which

was its only source of income.

b. There was substantial accumulation of capital surplus in comparison to

direct expenditures by the agency for charitable and educational

purposes.

c. The operation was funded completely by substantial fixed fees charged

adoptive parents and it never solicited or planned to solicit charitable

contributions.

d. Fixed fees charged adoptive parents were not subject to downward

adjustment to meet potential adoptive parents' income or ability to pay.

e. The organization was structured and operated like a commercial

organization.

Note: The court also held there was inurement (pp. 488-89) in this case.

Therefore, the organization couldn’t qualify under Section 501(c)(3).

III. Other Considerations

(1) There are some common trade or business activities that tax-exempt

organizations engage in which are considered unrelated trade or business and

subject to tax. This section addresses advertising, partnership activity, and

feeder organizations.

A.

Advertising

(1) 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.

(2) 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.

(3) See Sections II.B.4, Regularly Carried On, and II.C.2, Substantially Related, of

this TG for revenue rulings and court cases that address advertising issues.

(4) Additionally, for a detailed discussion, see TG 48: Unrelated Business Income

Tax.

26

B.

Partnership Activity

(1) Exempt organizations have used partnerships, both as an investment vehicle

and to accomplish exempt purposes. While most exempt organizations carry on

all their activities directly within their organizational structure, many exempt

organizations choose to carry on some of their activities in other indirect ways.

Some organizations decide to create wholly owned taxable subsidiaries for both

tax and non-tax reasons. Such a taxable entity often serves as a repository for

what would otherwise constitute an unrelated trade or business under Section

513(a) if it were conducted directly by the exempt organization. Other exempt

organizations may choose to participate in a partnership, again for both tax and

non-tax reasons. An exempt organization's participation in a partnership may

take the form of either a general or a limited partner.

(2) An exempt organization’s receipts from partnership activity results in unrelated

business taxable income (UBTI) under Section 512(c)(1):

“In general, if a trade or business regularly carried on by a partnership of

which an organization is a member is an unrelated trade or business with

respect to such organization, such organization in computing its unrelated

business taxable income shall, subject to the exceptions, additions, and

limitations contained in subsection (b), include its share (whether or not

distributed) of the gross income of the partnership from such unrelated

trade or business and its share of the partnership deductions directly

connected with such gross income.”

(3) A partnership may generate two basic categories of potentially taxable income

for an organization:

a. Fees for services provided to the partnership, and

b. Allocations of partnership income.

(4) Rulings related to partnership interests and treatment of income include:

a. Rev. Rul. 79-222, 1979-2 C.B. 236 provides that the "look through" rule of

Section 512(c) for determining the taxation of partnership distributions

applies regardless of whether the interest held by the exempt organization

is that of a limited or general partner.

b. In Service Bolt and Nut Co. Profit Sharing Trust v. Commissioner, 78 T.C.

812 (1982), aff'd 724 F.2d 519 (6th Cir. 1983), the courts held the income

received from limited partnership interests constituted unrelated business

taxable income.

(5) For a detailed discussion, see TG 48: Unrelated Business Income Tax.

C.

Feeder Organizations

(1) Section 502, Feeder Organizations, was enacted to deny exemption to

organizations whose primary purpose is to carry on a trade or business for profit

27

and turn over such profits to one or more exempt organizations. Enactment

resulted from concern that:

a. Such organizations weren’t themselves carrying out an exempt purpose,

and

b. Trade or business activities were being conducted in direct competition

with other taxable businesses.

C.1. Primary Purpose Test

(1) 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.

(2) 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).

(3) This primary purpose test is concerned with how much business activity

constitutes primarily engaged in a trade or business. What constitutes a trade or

business for profit has not been strictly defined under Section 502, although it’s

clear that this test involves the evaluation of the facts and circumstances in

each case, including the size and extent of the trade or business and the size

and extent of the exempt activities. See Treas. Reg. 1.502-1(a).

(4) An example of the primary purpose issue is found in Rev. Rul. 73-164, 1973-1

C.B. 223:

A church formed a separate organization to promote and provide financial

support for its charitable programs. The organization accomplished its exempt

purpose by printing religious materials for the church at cost.

a. The publishing function for church materials accounted for approximately

10 percent of the organization’s overall publishing activities.

b. The remaining 90 percent was devoted to the operation of a commercial

printing business, from which all of the organization’s substantial profits

were derived.

c. The organization paid over all the net income to the church at the end of

each calendar quarter of operation.

Although the organization may be said to be organized and operated

exclusively for charitable purposes because the use of all of its assets is

effectively dedicated to exclusively charitable objects, its only basis for

qualifying, apart from the relatively insignificant amount of printing performed at

cost for the church, is that all of its profits are required to be paid to the church.

Since the organization has no other significant charitable activity and its

28

principal income-producing activity is the conduct of a trade or business, it’s

precluded from exemption under Section 501(c)(3) by reason of Section 502.

C.2. Trade or Business Defined

(1) Under Section 513, the term “trade or business” is defined as any activity which

is carried on for the production of income from the sale of goods or the

performance of services.

(2) This includes any activity carried on for the production of income and which

otherwise possess the characteristics required to constitute a trade or business

within the meaning of Section 162 and which, in addition, is not substantially

related to the performance of the exempt functions. Treas. Reg. 1.513-1(b).

(3) Thus, as a general rule, an activity that qualifies as a trade or business under

Section 162 also qualifies as a trade or business under Section 513. Treas.

Reg. 1.513-1(b).

C.3. Exceptions to Trade or Business

(1) For purposes of feeder organizations, the term trade or business (for taxable

years beginning after December 31, 1969) doesn’t include Treas. Reg. 1.5021(d)(2).

a. The deriving of rents described in Section 512(b)(3)(A) (unless the rents

derived by an organization wouldn’t be excluded from unrelated business

income under Section 512(b)(3) and regulations)

b. Any trade or business in which substantially all the work in carrying on

such trade or business is performed for the organization without

compensation

c. Any trade or business (such as a thrift shop) which consists of the selling

of merchandise, substantially all of which has been received by the

organization as gifts or contributions.

C.4. Profit Motive Test

(1) Section 162 permits a taxpayer to deduct all the ordinary and necessary

expenses paid or incurred during the taxable period in carrying on a trade or

business.

(2) Thus, if an organization’s motive or intent for engaging in an activity is the

production of income, then that activity constitutes a trade or business.

However, the absence of profit alone won’t prevent an enterprise from being

classified as a trade or business.

(3) For example, in United States v. American Bar Endowment, 477 U.S. 105

(1986), the court held that a Section 501(c)(3) organization’s insurance program

operated like a commercial entity and was a trade or business for purposes of

tax on unrelated business income. See prior Section II.B.3(3) – (5) for a detailed

discussion of the case.

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C.5. Subsidiary-Integral Part of Parent

(1) Treas. Reg. 1.502-1(b) provides that if an exempt organization’s subsidiary

organization would itself be exempt on the ground that its activities are an

integral part of the exempt activities of the parent organization, its exemption

won’t be lost because, as a matter of accounting between the two

organizations, the subsidiary makes a profit from its dealings with the parent.

C.6. Subsidiary-Trade or Business

(1) Treas. Reg. 1.502-1(b) further states that the subsidiary organization isn’t

exempt from tax if it’s operated primarily for the purpose of carrying on an

unrelated trade or business if regularly carried on by the parent organization.

C.7. Subsidiary-Relationship Test

(1) For purposes of Treas. Reg. 1.502-1(b), organizations are related only if they

consist of:

a. A parent organization and one or more of its subsidiary organizations, or

b. Subsidiary organizations having a common parent organization.

(2) The regulation provides that an exempt organization isn’t related to another

exempt organization merely because they both engage in the same type of

exempt activities.

(3) However, a strict parent-subsidiary relationship isn’t required for organizations

to be considered “related” within the meaning of Treas. Reg.1.502-1(b).

(4) For example, in Rev. Rul. 68-26, 1968-1 CB 272, a church-controlled subsidiary

(incorporated without stock by the church) that printed standardized educational

and religious material for the church’s parochial school system, prepared and

edited by the school system, and sold the materials only to that system isn’t a

feeder organization described in Section 502. The ruling states that although a

technical parent-subsidiary relationship is lacking due to the nonstock character

of the subsidiary, a substantially similar relationship exists through the control

and close supervision” of the subsidiary’s affairs by the church. The subsidiary

is carrying out an integral part of the activities of the church.

C.8. Services to Exempt Organizations

(1) Some organizations aren’t engaged in a business to make money for

designated charitable organizations but are organized and operated to provide

services for specific charitable organizations.

(2) Rev. Rul. 54-305, 1954-2 C.B. 127, describes a corporation organized and

operated for the primary purpose of operating and maintaining a supply

purchasing agency for the benefit of its otherwise unrelated members exempt

from Federal income tax as charitable organizations. The organization secured

for hospitals and other charitable institutions the advantages of cooperation in

establishing uniform standards as to quality and kind of supplies and promoted

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the economical and efficient administration of hospitals. Substantial profits are

realized by the organization from these services. Only a portion of such profits

are distributed by the organization to its members (charitable hospitals). The

organization was found to be engaged in business activities which would be

unrelated activities if carried on by any one of the tax-exempt organizations

served and thus not exempt from UBIT.

(3) Section 501(e) provides exemption for certain cooperative hospital service

organizations for taxable years ending after June 28, 1968. Organizations

outside the scope of Section 501(e), such as those hospital service

organizations providing laundry services, are still subject to Section 502.

(4) Section 501(f) provides exemption for certain cooperative investment service

organizations organized and controlled by organizations described in either

Section 170(b)(1)(A)(ii) (schools) or 170(b)(1)(A)(iv) (certain organizations that

support schools) for the collective investment of their funds in stocks and

securities. Section 501(f) applies only to taxable years ending after

December 31, 1973.

C.9. Other Resources

(1) Additional sources of information include:

a. CPE 1983-F, IRC 502 - Feeder Organizations

b. Exempt Organizations Determinations Training-Unit 2, Lesson 5,

Advanced Fundraising Issues

c. Training 11231-002 (Rev. 5-2006) TEGE EO Examinations

Advanced-Module B, Lesson 8, IRC Section 502 Feeder Organizations.

D.

Unrelated Business Taxable Income (UBTI) and Unrelated

Business Income Tax (UBIT)

(1) Section 511(a)(1) imposes a tax, computed as provided in Section 11, on the

unrelated business taxable income of every organization described in Section

511(a)(2).

a. The tax applies to all organizations exempt under Sections 501(a), other

than organizations described in Section 501(c)(1) or trusts described in

511(b), except as provided in this part (Part III, Subchapter F) or part II

(relating to private foundations).

b. Section 501(c)(1) organizations are any corporations organized under an

Act of Congress which are instrumentalities of the United States subject to

specific requirements in Section 501(c)(1)(A) and (B).

c. The tax is also imposed upon the UBTI of state colleges and universities

which is an agency or instrumentality of any government or any political

subdivision thereof, which is owned or operated by a government or any

political subdivision thereof, or by any agency or instrumentality of one or

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more governments or political subdivisions, or any corporations wholly

owned by one or more state college or university.

(2) Exempt organizations subject to the unrelated business income tax imposed by

Section 511(a) are organized either as a corporation or a trust.

(3) In the case of corporations:

a. Through December 2017, the Section 11 rates on UBTI ranged from 15

percent to 35 percent. See Section 11 effective to December 21, 2017.

b. The Tax Cuts and Jobs Act of 2017 (Pub. L. 115-97, Section 13001)

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.

(4) In the case of trusts:

a. Through December 2017, exempt organizations that are trusts were taxed

on their unrelated business taxable income at the trust rates provided in

Section 1(e). These rates ranged from 15% to 39.6%, depending on

amount of taxable income. See Section 511(b).

b. The Tax Cuts and Jobs Act of 2017 (Pub. L. 115-97, Section 11001)

changed the rates. Effective January 1, 2018, through December 31,

2025, trusts will be taxed on their unrelated business taxable income at

the trust rates provided in Section 1(j)(2)(E). The rates range from 10% to

37% .

(5) 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 990T 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). See Section 511(a)(2)(A) and Treas. Reg. 1.6012-2(e).

(6) Under Section 6104(d), a Section 501(c)(3) organization is required to disclose

any return which is filed under Section 6011 by an organization described in

Section 501(c)(3) and which relates to any tax imposed by Section 511 (relating

to imposition of tax on UBI of charitable organizations).

(7) See TG 48: Unrelated Business Income Tax.

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IV. Examination Techniques

(1) This section provides examination techniques to identify non-exempt trade or

business activities and to determine if such activities jeopardize the

organizations exempt status.

A.

Organizational Test

(1) 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.

(2) Form 1023, Application for Recognition of Exemption Under Section 501(c)(3)

of the Internal Revenue Code, Part IV, Your Activities, asks applicants to

describe their past, present, and planned activities in a narrative and asks

applicants to complete a series of "Yes" or "No" questions regarding their

specific activities. This information should be closely reviewed in order to

determine:

a. Whether the activities are conducted to further one or more exempt

purposes, and

b. Whether the activities further a non-exempt purpose.

(3) Review the organization bylaws, as they often contain purposes and goals of

the organization.

(4) If a non-exempt purpose exists, the specialist must determine if the non-exempt

purpose is substantial.

a. If the non-exempt purpose is substantial, the organization won’t meet the

operational test for exemption under Section 501(c)(3).

b. If the non-exempt activity is incidental, it won’t result in denial of

exemption.

(5) If the non-exempt activity is substantial and constitutes a necessary part of its

activities in order to achieve its purpose, consideration might be given to

exemption under another subsection.

(6) See IRM 7.20 Exempt Organizations Determinations Letter Program.

B.

Operational Test

(1) The following examination techniques can be used in identifying trade or

business activities conducted by an exempt organization:

a. 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.

b. 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.

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c. Tour facilities to identify possible trade or business activities.

d. Review newsletters and other publications for indications of unrelated

trade or business (including advertising).

e. Review organization’s website for other indications of unrelated trade or

business (including advertising).

f. Review the books and records for revenues and expenses indicating the

organization is conducting a business operation.

g. Review minutes from board meetings.

(2) The following examination techniques can be used in determining whether an

activity is conducted by an exempt organization as a trade or business with

intent to make a profit:

a. Interview the CEO and other personnel responsible for conducting the

activity on why and how the activity is conducted. This will help to consider

all facts and circumstances when determining whether there is a profit

motive for conducting the activity.

b. Tour the facilities to actually observe the activity.

c. Isolate the financial transactions of the activity to determine whether the

activity resulted in a profit or loss. A good starting point is to analyze the

activity budget or departmental schedules of the financial statements.

d. Review the minutes of the organization to establish the intent of the

activity and for progress reports on the activity.

e. Chart the profit and loss of the activity over several years to determine

how financially successful the activity has been.

(3) The following examination techniques can be used to determine whether an

activity is “regularly carried on”:

a. Ask questions regarding how the activity is conducted.

b. Review the minutes of the organization for information describing the

expectations and timetable for the activity.

c. Request all pertinent documentation concerning the conduct of the activity

such as procedures, publications, and contracts.

d. 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.

(4) Use these examination techniques to determine whether an activity is

substantially related to the organization's exempt purpose:

a. Review the board minutes for information relating to activities.

b. Request all pertinent documentation concerning the conduct of the activity

(e.g., procedures, publications, contracts).

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c. 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.

(5) To determine whether an unrelated trade or business qualifies for the general

exceptions of Section 513(a), use the following examination techniques:

a. Interview organization officers about how the activity is conducted. to

determine the motive for conducting the activity.

b. Interview employees who conduct the activity to find out where and how

the activity is conducted.

c. Tour the facilities to observe the conduct of the activity and the amount of

general public patronage.

d. Review the minutes of the organization for information describing the

expectations and results of the activity.

e. Request all documentation concerning the conduct of the activity such as

procedures, publications, contracts, volunteer time records,

acknowledgments, and values of contributed merchandise.

f. In order to determine the scope of the activity, 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.

(6) To determine whether an unrelated trade or business qualifies for the special

exceptions of Section 513(d)-(i), use the following examination techniques:

a. Check for any recent change in legislation or interpretation.

b. Interview relevant officers and employees early and often during the

examination to understand exactly how the activity is being conducted.

c. Review the minutes of the organization for information describing the

expectations and results of the activity.

d. Secure copies of all documentation concerning the procedures and

operation of the activity including, but not limited to, periodicals,

advertisements, acknowledgments, video tapes, audio tapes, brochures,

programs, contracts, lease agreements, and any other materials that will

describe the activity or event.

e. If applicable, tour the facilities to observe the conduct of the activity to

ensure that the organizations are qualified organizations, and that the

activity is being conducted in a manner consistent with the special

exceptions under Section 513 paragraphs (d)-(i).

f. Isolate the financial transactions of the exempt activity and the unrelated

business activity starting with the financial statements. Often this

information will be in schedules to the financial statements. If the activity is

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reported as UBI, the accountant will have tax workpapers that have

isolated the activity’s financial transactions.

g. If the activity hasn’t been reported as UBI, and the activities aren’t

scheduled in the financial statements or any other reliable documents,

analyze the books and records to identify the sources of income for the

exempt activity and the unrelated business activity. The expenses should

be analyzed to match the expenses with the appropriate sources of

income.

h. Even though the organization may have the financial transactions of the

activities isolated, you still need to apply the first six audit steps listed here

to ensure the information is accurate and complete.

(7) See IRM 4.70 TE/GE Examinations

V. Additional Resources

(1) Publication 557, Tax-Exempt Status For Your Organization

(2) Publication 598, Tax on Unrelated Business Income of Exempt Organizations

(3) Publication 4221-PC, Compliance Guide for 501(c)(3) Public Charities

(4) Publication 4221-PF, Compliance Guide for 501(c)(3) Private Foundations

(5) EO Determinations Training, Unit 1A, Lesson 9-501(c)(3) Operational Test;

Lesson 16, Introduction to Unrelated Business Income (UBI)

(6) Exempt Organizations Examinations (Basic) Training – Part 1, Module A,

Unrelated Business Income (Training 70219-002) (4-2019)

(7) Exempt Organizations, Examinations-Advanced, Module C-Unrelated Trade or

Business, Sections 511 and 513 (Training 11231-004) (5-2006) (Catalog

Number 47887D)

(8) TG 3-1: Overview, Applications, Exemption Requirements Section 501(c)(3)

(9) TG 48: Unrelated Business Income Tax

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