Submitted J . Morrison

JM P

Submitted J . Morrison

135 T .C . No . 1 3

UNITED STATES TAX COUR T

OCEAN PINES ASSOCIATION, INC ., Petitioner v .

COMMISSIONER OF INTERNAL REVENUE, Responden t

Docket No . 5127-08 .

Filed

August

30,

2010 .

P, a homeownersassociation exempt from tax under

sec . 501(c)(4), I .R .C ., operated two parking lots and a

beach club eight miles from the area in which it s

members lived . The parking lots and the primary beach

club facilities were accessible only to the

association's members and their guests . The

association did not report its net income from the

parking lot and beach club activities as unrelated

business taxable income on its tax returns for 2003 and

2004 . R issued a notice of'deficiency determining that

.the net income was subject to the unrelated business

income tax because the operation of the parking lots

and the beach club is not substantially related to the

promotion of community welfare (the purpose

constituting the basis of the Association's exemption

under sec . 501, I .R .C ., see secs . 1 .501(c)(4)-1(a)(2),

1 .513-1(a), (d)(1), Income Tax Regs .) and because the

revenue received from operating the parking lots is not,

rent from real property under sec . 512(b) ., I .R .C .

SERVED Aug 30 2010

Held : The operation of the parking lots and the

beach club is not substantially related to the

promotion of community welfare because the facilities

are not open to the general public .

Held , further , the revenue received from operating

the parking lots is not rent from real property .

Steven M . Gevarter , for petitioner .

Jared W . Murphy , for respondent .

OPINIO N

MORRISON,

Judge : On November 29, 2007, respondent

Commissioner of Internal Revenue mailed a notice of deficiency

for the taxable years 2003 and 2004 to petitioner Ocean Pines

Association, Inc . We refer to respondent as the IRS . We refer

to petitioner as the Association . In the notice, the IRS

determined the following deficiencies. in income tax and additions

to tax under section 6651(a)(1) :1

Year

Deficiency

2003

$65,929

2004

94,195,

Addition to Tax

Sec . 6651(a)(1)

$16,48 2

23,54 9

After concessions, the issues remaining for decision are : (1 )

'Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years at issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure .

whether the Association's operation of a beach club and two

nearby parking lots is substantially related to the promotion o f

community welfare (we holdtthat the operation is no t

substantially related, and'~that therefore the operation i s

subject to the tax on unrelated-business income), and (2) whether

the-revenue received by the Association from its members for

parking on its two parking"lots is exempt from the tax on

unrelated-business income as rent from real property within the

meaning of section 512(b) (3)

(we hold that the revenue is not,

rent from real property) .

Background

The parties agreed to.?submit this case to the Court withou t

trial under Rule 122 . We adopt as findings of fact all

statements contained in the stipulation of facts . The

stipulation of facts and the attached exhibits are incorporated

here by this reference . The Association is a homeowners

association and nonstock corporation organized and incorporated

under the laws of Maryland with its principal office in Maryland .

The IRS ruled that it was exempt . from federal income tax as an

organization described in section .501(c)(4) (civic league or

organizations not organized for profit but operated exclusivel y

for the promotion of social welfare) .

The Association's articles of incorporation state that one

of its purposes is "to further and promote the community welfare

4 of property owners in the residential community located in . .

Worcester County, Maryland known as `Ocean Pines'" . Its

membership consists of all of the owners of residential property

within the 3,500-acre area known as Ocean Pines . According to

the 2000 census, the population of Ocean Pines was 10,496 . The

Association collects property assessments and other fees from . its

members and enforces zoning restrictions against its members . It

maintains bulkheads, roadways, and parking lots within .Ocean

Pines . The Association also operates recreational facilities in

Ocean Pines that are open to both members and nonmembers,

including five swimming pools, a golf course, two marinas, a

yacht club, tennis complexes, a soccer field, 10 parks, and five

walking trails . The Association provides, through its Recreation

and Parks Department, various seminars, sports camps, a

children's softball league, swimming lessons, and adult aquatic

programs to both members and nonmembers . Some of the

recreational facilities and services described above are free .

Others are available only for a fee, which is typically higher

for nonmembers than members . The Association maintains two

volunteer fire stations and a police force . Parking within the

Ocean Pines . area is free . and open to both members and nonmembers .

The Association owns beachfront property, approximately eight

miles from the . Ocean Pines area in Ocean City, an area within

Worcester County, Maryland . The Ocean City property consists of

1

-

5

two parking lots, containing 300 parking spaces in total, and an

oceanfront beach club, known as the Ocean Pines Beach Club . The

Association's members who use the : parking lots and the beach club

commute approximately 15 minutes by car from Ocean Pines to Ocean

City . The beach club is open from the beginning of Memorial Day

weekend until Labor Day (w6 refer to this period as the summer

months) . The beach club is closed during the evenings unless

reserved for special events . The beach club allows both

Association members and nonmembers to purchase food and beverage

services and to use its restrooms'for free . However, the

swimming pool, gym lockers and shower facilities are accessibl e

only to Association members . The'record does not reveal whethe r

the Association charges a `separate fee to its members who us e

these facilities . In the summer months, the Association limits

use of the parking lots to : its members who have purchased parking

lot permits, and their guests .- They may use the parking lots

during the day until 4 p .m' . Only the Association's members are

eligible to purchase permits for the parking lots . The

Association's members must? pay a weekly or monthly fee depending

on the period for which the permit is issued . The Association's

employees in Ocean Pines issue the permits . The Association

leases the parking lots to third-party businesses during the

summer months from approximately 4 p .m . until approximately 3

a .m . The Association also leases the lots during all nonsummer

- 6 -

months . It provides no significant services to the third-party

businesses . The Association employs a guard daily during the

summer months from 8 a .m . until 4 p .m . The guard removes a chain

barring entrance to the parking lots at the beginning of each day

during the summer months (and replaces it at the end of each

summer day) and checks the parking permit decals on the vehicles

as they enter the parking lots . If the vehicles do not have

permit decals, they are turned away . If any vehicle remains on

the parking lot from the periods of use by the third-party

businesses, the parking guard places a note on the vehicle

demanding that the owner remove the vehicle from the parking lot

as soon as possible . The parking guard does not collect fees or

park vehicles ; the lots offer no valet services . Parking is

available upon a first-come, first served basis ; i .e ., there are

no assigned parking spaces . The Association does not maintain

common areas in Ocean City, such as beach or bike paths, nor does

it levy assessments on the residents or homeowners in Ocean City .

In 2003, the Association received $232,089 in revenue-from

the two parking lots, $61,024 of which was paid by the thirdparty businesses . It paid $39,092 in expenses attributable to

the operation of the parking lots by the Association (as opposed

to the leasing of the parking lots to third-party businesses) .

It incurred a $20,486 net loss for operation of the beach club in

2003 . In 2004, the Association received $266,487 in revenue from

7 -

the two parking lots, $64,692 of which was paid by third-party

businesses . It paid $21,939 in expenses attributable to the

operation of the parking lots by the Association . It incurred a

$1,741 net loss for operation of the beach club in 2004 . Th e

Association timely filed Form 990, Return of Organization Exempt

1

From Income Tax, but did not file the form on which the unrelate d

business income tax is reported, Form 990-T, Exempt Organizatio n

Business Income Tax Returns . The Form 990 is not in the record .

The IRS issued a notice of deficiency to the Association on

November 29, 2007 (discussed above), determining that the

Association owed unrelated' business income tax on the net income

attributable to the operation of its parking lots . The ne t

income figures used to calculate the'deficiency in unrelated

business income tax for each tax year at issue included the

income from the leasing of the parking lots to third parties an d

a deduction for the parking lot expenses, but excluded the losses

from the operation of the beach club .2 The IRS determined the,

late-filing addition to tax in the notice because the Association

failed to file a Form 990-,T . The Association filed a petition in

response to the notice of deficiency . When this case was called

from the calendar for the trial session of this Court at

Baltimore, Maryland, the parties filed a joint motion for leav e

2As explained below, the IRS now concedes that the losses

from the operation of the beach club are deductible against the

net income figures used to . calculate the deficiency .

- 8 -

to submit the case under Rule 122, which the Court granted, and a

stipulation of settled issues . In the stipulation of settled

issues, the IRS'conceded tha t

the revenue received by the Association from the

leasing of its Ocean City parking lots to third parties

in the evening hours and during the off-season(" is

excepted from § 511 unrelated business taxable income

because it satisfies the § 512(b) exception to

unrelated business income for the rent from real

property .

The IRS also conceded that the Association was not liable for the

late-filing addition to tax under section~6651(a)(1) because it

relied on the advice of its accountants in determining that

filing a Form 990-T for the years at issue was not necessary .

The parties stipulated that the amount of net income from the

Association's operation of the parking lots and the beach club

potentially subject to the unrelated business income tax is

$111,487 in 2003 and $178,115 in 2004 . . These net income amounts

were calculated by excluding the revenue received from the thirdparty businesses for rental of the parking lots, by including the

parking lot fees received from members of the Association, by

deducting the losses from the operation of the beach club, and by

deducting all of the expenses from the operation of the parking .

lots .

'The revenue referred to in the stipulation of settled

issues is the $61,024 paid in 2003 and the $64,692 paid in 2004

by the third-party businesses, unreduced by any expenses

allocable to the Association's operation of the parking lots .

Discussion

The Association has the burden of proving that th e

determinations of the deficiencies in the notice are wrong . See

Rule 142(a) ;

Welch v . Helverina , 290 U .S . 111, 115 (1933) . For

reasons explained below, we hold that the operation of the

parking lots and the beach club is not substantially related to

the promotion of community, welfare and that the income from

operation of the parking lbts is not rent from real property

within the meaning of section 512`(b)(3) . Therefore ., the income

{

from operation of the parking lots and the beach club is subject

to the unrelated business income tax .

I .

Whether the Operation-'of the Parking Lots and the Beach Club

Is Substantially Related to the Promotion of community

Welfar e

Section 501(c)(4) exempts from Federal tax "Civic leagues or

organizations not organized for profit but operated exclusively

for the promotion of social welfare" . Regulations clarify that

"An organization is operated exclusively for the promotion of

social welfare if it is primarily engaged in promoting in some

way the common good and general welfare of the people of th e

i

community ." Sec . 1 .501(c),(4)-l(a)(2), Income Tax Regs . B y

implication, the regulation defines "exclusively" to mean

"primarily" . Thus, "an or'ganizat ;ion will not be denied exemptio n

if it partakes in activities not in furtherance of an exempt

purpose so long as such nonconforming activities are

- 10 insubstantial in comparison to activities which further exempt

purpose(s) ."

Ky . Bar Found ., Inc . v . Commissioner , 78 T .C . 921,

923 (1982) . Section .501(c)(4) organizations, like some other

types of tax-exempt organizations, must pay income tax on their

"unrelated business taxable income" . See sec . 511(a)(1) .

Section 512(a)(1) defines "unrelated business taxable income" .

It provides :

Except as otherwise provided in this subsection, the

term "unrelated business taxable income" means the

gross income derived by any organization from any

unrelated trade or business * * * regularly carried on

by it, less the deductions allowed by this chapter

which are directly connected with the carrying on of

such trade or business, both computed with the

modifications provided in subsection (b) .

Section 513(a) provides that the term "unrelated trade or

business" means 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" .

Accordingly, income is unrelated business taxable income if it is

derived from a regularly carried-on trade or business that is not

substantially related to the purpose constituting the basis of

the organization's exemption under section 501 . See sec . 1 .5131(a), (d)(1), Income Tax Regs . For the conduct of a trade or

business to be substantially related to the purpose or purposes

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for which the organizationiwas granted a tax exemption ,

"performance of the services from'which the gross income is

derived must contribute importantly to the accomplishment of

these purposes ." Sec . 1 .513-1(d) ;(2), Income Tax Regs . The

parties agree that the parking lot'and beach club activity

constitute a regularly carried-on trade or'business, but disagre e

as to whether the activity is substantially related to the

purpose of promoting community welfare, the purpose constituting

the basis of the Association's exemption under section 501(c)(4) .

The Association contends that the parking lot and beach clu b

activity "[promote] the community welfare of the property owners"

t

of Ocean Pines, which is one of the purposes of the Association

that was set forth in its articles of incorporation . It argue s

that "the ability to walk on the beach or swim either in, the

ocean or in the pool at the * * * [beach club] * * * directly

promotes the health and wellness (i .e ., `community welfare') o f

the * * * [Association's] members" . The -IRS argues, first, that

the facilities at the beach club are solely recreational and thus

would be nontaxable if operated by a section 501(c)(7 )

organization (a "club" that is "organized for pleasure,

recreation, and other nonprofitable purposes") but are taxable

because they are operated by a section 501(c)(4) organization .

It argues, second, that the beach club and the parking lots do

not promote community welfare because they are not open to the

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general public . We need not determine whether the IRS's first

argument is correct . We agree with the IRS's second argument .

We conclude that the operation of the beach club and the parking

lots does not promote community welfare because they are not

accessible to nonmembers ; that is, the general public .

In

Flat Top Lake Association, Inc . . v . United States , 868

F .2d 108, 111-113 (4th Cir . 1989), the Court of Appeals for the .

Fourth Circuit held that a homeowners association that restricts

the use of its facilities to its members does not promote the

welfare of the community . Although Flat Top

concerned the

question of eligibility for section 501(c)(4) status, as opposed

to the question of whether a particular activity of a section

501(c)(4) organization is substantially related to the promotion

of community welfare and is therefore exempt from the unrelated

business income tax, the two questions are related . As the Tax

Court held in Profl . Ins . Agents of Mich . v . Commissioner , 78

T .C . 246, 267 (1982), affd . 726 F .2d 1097 (6th Cir . 1984) :

Logically, if * * * activities do not contribute to

* * * [an organization's tax-exempt purpose] in the

context of determining whether an organizatio n

qualifies for exemption, then surely these same

activities cannot be said to be related to the

organization's exempt purpose in the context of th e

UBTI provisions .

Applying these principles, a homeowners association generally

does not promote community welfare if all of the association's

facilities are closed to the general public (i .e ., closed to

13 nonmembers of the association) . See Flat Top Lake Association,

Inc . v . United States ,

supra

at 111-113 . It follows that if

a

homeowners association has one facility that is closed to the

general public, then that facility is not substantially related

to the promotion of community welfare . The income from that

facility is subject to the unrelated business income tax unless

an exception applies .

The IRS does not contend that the Association's tax-exempt

status should be revoked . JIt concedes that most of the

.Association's facilities and services are open to the general

public . Its contention is, that income from the portion of its

facilities not open to the general public (i .e ., the beach club

and the parking lots) is subject to the unrelated business incom e

tax because the operation of these facilities is not

substantially related to the promotion of community welfare . W e

agree . The parking lots and the beach club are not accessible to

the general public .' Only' Association members and their guests

may park in the parking lots . Although the beach club allow s

'The Association argues for these purposes that its

membership is so broad that its membership should be considered

the general public and therefore Its parking lots and beach club

(which are open only to its members and their guests) should be

considered open,to the general .public . But the court in Flat Top

held that a homeowners association that operates for the

exclusive benefit of its members "does not serve a `community' as

that term relates to the broader concept of social welfare . "

Flat Top Lake Association, Inc . . v . . United States , 868 F .2d 108,

ill (4th Cir . 1989) .

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both Association members and nonmembers to access its food and

beverage services and its restrooms, its primary facilities (the

swimming pool, gym lockers, and showers) are accessible only to

the Association's members . Thus, the operation of the parking

lots and the beach club .is not substantially related to the

purpose of "[promoting]_social welfare" within the meaning of

section 501(c)(4) because they are not open to the general

public . Thus, unless an exception applies, the income

attributable to the operation of the parking lots and the beach

club is subject to the unrelated business income tax .

II .

Whether Parking Lot Income Is Rent From Real Property Within

the Meaning of Section 512(b)(3 )

Section 512(a) provides that unrelated business taxable

income is income earned by a tax-exempt organization . from an

unrelated trade or business it regularly carries on, subject to

the modifications in section 512(b) . One of these modifications,

in section 512(b)(3)(A)(i), is that "rents from real property"

are excluded from unrelated business taxable income . The IRS

claims that the income from operating the two parking lots is not

rent from real property because of statements in legislative

reports and because, it says, a regulation explicitly bars income

from operation of a parking lot from qualification for th e

exception . The Association contends that under the regulation ,

the income from operating the two parking lots is rent from rea l

property . We agree with the IRS :

- 15 When Congress enacted the unrelated business income tax

provisions as part of the'Revenue Act of 1950, ch . 994, 64 Stat .

906, the House Ways and Means Committee report stated that the

provision of the law excluding rents from real property fro m

i

unrelated business taxable income was intended to exclude incom e

from passive ownership of assets :The tax applied to unrelated business taxable

income does not apply, to dividends, interest, royalties

(including of course, overriding royalties), rents

(other than certain rents on . property acquired with

borrowed funds), and gains from sales of leased

property . Your committee believes that such "passive"

income should not be taxed where it is used for exempt

purposes because investments producing incomes of these

types have long been recognized as proper for

educational and charitable organizations .

H . Rept . 2319, 81st'Cong ., ; 2d Sess . 38 (1950), 1950-2 C .B . 380 ,

409 . It later stated :

The term "rents from real property" does not include

income from the operation ofa hotel but does include

rents derived from a lease of the hotel itself .

Similarly, income derived from the operation of a

parking lot is not considered "rents from real

property ." [Emphasis added . ]

Id .

at 110, 1950-2 C .B . at 459 . The Senate Finance Committee

report also included the language above regarding operation of a

hotel and a parking .lot . S . ReptF . 2375, 81st Cong ., 2d Sess . 108

(1950), 1950-2 C .B . 483, 560 .

The tax on unrelated business income, as enacted in 1950,

did not apply to churches and some other tax-exempt

organizations . Revenue Act of 1950, sec . 421(b)(1), 64 Stat .

- 16 948 . In 1969, the Treasury Department recommended extending the

unrelated business income tax to all tax-exempt organizations .

U .S . Treasury Dept . Tax Reform Studies and Proposals (Part 1) 2627 (1969) . The Joint Committee staff supported the Treasury

Department's recommendation, citing its own research on the scope

of churches' unrelated business activities . One of the examples

of an unrelated business given by the staff was a church's

operation of a parking lot . Staff of Joint Comm . on Taxation,

Tax-Exempt Organizations 20-21 (J . Comm . Print 1969) . The House

Ways and Means Committee report on the Tax Reform Act of 1969,

Pub . L . 91-172, 83 Stat . 487, incorporated the Joint Committee's

examples of proliferating church-operated businesses in

describing why it was recommending an expansion of the unrelated

business income tax :

There is inequity in taxing certain exempt

organizations on their "unrelated business income" and

not taxing others . It has become apparent that

organizations now subject to the provision and those

not subject to it are equally apt to engage in

unrelated business . For example, numerous business

activities of churches have come to the attention of

the committee . Some churches are involved in operating

chains of religious bookstores, hotels, factories,

companies leasing business property, radio and TV

stations, newspapers, parking lots , record companies,

groceries, bakeries, cleaners, candy sale businesses,

restaurants, etc . * * * [Emphasis added . ]

The bill in extending the unrelated business

income tax to churches provides a period of time

for churches to dispose of unrelated business or to

spin them off in separate taxable corporations .

17 H . Rept . 91-413 (Part 1), at 47-48 (1969), 1969-3 C .B . 200, 230231 . Similarly, the report of the Senate Finance Committee

stated :

I

-

In recent years, many, of the exempt organizations not

now subject to the unrelated : business income tax--such

as churches, social clubs, fraternal beneficiar y

societies, etc .--have 'begun to engage in substantial

commercial activity . I For example, numerous business

activities of churches have come to the attention of

the committee . Some 'churches are engaged in operating

publishing houses, hotels, factories, radio and TV

stations, parking lots , newspapers, bakeries,

restaurants, etc . Furthermore, it is difficult to

justify taxing a university or hospital which runs a

public restaurant or hotel or other business and not

tax a country club or, lodge engaged in similar

activity . [Emphasis added . ]

S . Rept . 91-552, at 67 (1969), 1969-3 C .B . 423, 467 . The reports

suggest that income from dperating .a parking lot was not exemp t

from the unrelated business income tax under any provision . The

f

legislative history stated or implied four times that the

operation of'parking lotstlyields unrelated business taxable

income and not rent from real property .

-

Section 1 .512(b)-1(c)r(5), Income Tax Regs ., provides tha t

income from the operationlof a parking lot is not rent from real

property ., The regulation ; provides :

Rendering of services . For .purposes of this paragraph,

payments for the use or occupancy of rooms and other

space where services are also rendered to the occupant,

such as for the use or occupancy of rooms or other

quarters in hotels, boarding houses, or apartment

houses furnishing hotel services, or in tourist camps

or tourist homes, motor courts, or motels, or for the

use or occupancy of space in parking lots , warehouses,

or storage garages, does not constitute rent from real

- 18 -

property . Generally, services are considered rendered

to the occupant if they are primarily for his

convenience and are other than those usually or

customarily rendered in connection with the rental of

rooms or other space for occupancy only . The supplying

of maid service, for example, constitutes such service ;

whereas the furnishing of heat and light, the cleaning

of public entrances, exits, stairways, and lobbies, the

collection of trash, etc ., are not considered as

services rendered to the occupant . Payments for the

use or occupancy of entire private residences or living

quarters in duplex or multiple housing units, of

offices in any office building, etc ., are generally

treated as rent from real property . [Emphasis added . ]

The Association, in interpreting the above regulation, argues

that income from operating a parking lot is rent from real

property unless the services provided by the tax-exempt

organization in operating it are "substantial ." It states that

the services it provides at the lots, i .e . the provision of

parking guards to open the . lots and to check parking decals, are

insubstantial . It compares its level of service to its parking

lot customers to the level of service involved in the trash

collection mentioned in the regulation . But the test in the

regulation for determining whether the services are rendered to

the occupant (and therefore disqualify the organization from

using the rental exception) is not whether the services provided

are substantial, but whether the services are

(1)

"primarily" for

the "convenience" of the occupant and (2) are "other than those

usually or customarily rendered in connection with the rental of

rooms or other space for occupancy only ." And as to the question

of whether the services provided by an operator of a parking lot

g

19 -

satisfy this test, the regulation also provides guidance . The

first sentence of the regtlation lists "the use or occupancy of

space in parking lots" as"an example of "use or'occupancy of

rooms and other space where services are also rendered to th e

occupant" . The regulation, as we interpret it, determines that

the services provided by an operator of a parking lot (at least a

typical parking lot) are primarily for the convenience of the

customer and are other than those usually or customarily . rendered

in connection with the rental of,rooms or space for occupancy

only .' Although this conclusion might not apply to a parking lot

that is so unusual that it would not be considered a "parking

lot" within the ordinary meaning of the term, there is nothing to

suggest that the services the Association provides to its parking

lot customers are unusual ;in this context . Thus, the net income

the Association earned from operating the parking lots during th e

summer months does,not constitute rent from real property a s

defined in section 512(b)(3) . The net income is subject to th e

unrelated business income tax .

'The lease payments from third-party businesses are rent

from real property under the regulation, and thus were properly

conceded by the .IRS as excludable from unrelated business taxable

income, because Ocean Pines did not directly operate the parking

lot on the behalf of the third-party businesses .

20 -

In reaching our holdings here, we have considered .all

arguments made, and, to the extent not mentioned above, we

conclude they are moot, irrelevant, or without merit .

To reflect the foregoing,

Decision will be entere d

under Rule 155 .