Spring 2006 issue of Horizons

UNRELATED BUSINESS INCOME

Another potential obstacle to a tax-exempt entity carrying on an activity, either through a partnership or on its own, is the propensity of the IRS to take the position that an activity is subject to income tax because it is an unrelated trade or busi- ness. The latter part of this phrase, “trade or business,” is used throughout the tax law but not fully defined. To be a trade or business, it might be sufficient that the activity gen- erates a stream of payments, and there is not a donative intent on the part of the payor. Thus, the key test is whether the activity is related to the purpose of the tax-exempt entity. Under the tax regulations, the activity must be “substantially related” to the purpose of the tax-exempt entity. There is sometimes a tendency of taxpayers to overstate the signifi- cance of an activity to the exempt activities of the organiza- tion.

The standard letter of tax-exempt status issued by the IRS does not rule on an activity-by-activity basis and leaves open the possibility that activities disclosed in the application may become unrelated trades or businesses.

CONCLUSION

To varying degrees, tax-exempt organizations may engage in activities that are in direct or indirect competition with the pri- vate sector. In certain cases, these activities may even be related to the exempt purposes of the organization. However, if the activity is larger in scope than necessary to carry out the exempt purposes of the organization or if the activity is not substantially related, issues will arise. Such issues include whether there is an unrelated business, which will be segregated from the other activities of the organization and taxed essentially on the same basis as a for-profit tax- payer. Furthermore, if an unrelated activity becomes exces- sive in relation to the organization's activities that are related to the exempt purpose, there is the potential for the loss of tax exempt status. While there may be room for creativity and new sources of revenue for tax-exempt organizations, safe harbors and bright-line tests to guide organizations away from traps for the unwary are often elusive. Careful planning with the recognition that the law may be unclear is in order. Questions? Contact either Judy Murphy, Partner-in-Charge, Not-for-Profit Services Group 314-290-3496 judy.murphy@rubinbrown.com or Jeff Person, Manager, Tax Consulting Services Group 314-290-3467 jeff.person@rubinbrown.com

Clearly, the fact that the net income is used for good and noble causes is important, or even critical, to the organiza- tion. However, this has no bearing on whether the activity itself satisfies the test of being substantially related under the regulations. The degree of relatedness is determined by the benefits of the activity without regard to the use of the income compared to the mission of the exempt organization. While there are a few public rulings on various activities, the creativity of not-for-profit organizations has far outpaced the government's capacity to provide guidance on a widespread basis. If a new organization is being formed, there will be a requirement to inform the IRS of the intended activities of the new organization. And on the current version of the applica- tion for exemption, there is a two-part question concerning whether the organization will engage in economic develop- ment activities. The revised application also has questions dealing with partnerships, LLCs and other development activ- ities. The fact that the IRS issues a favorable determination of tax-exempt status does not automatically mean that all of the activities of the organization are considered to be related.

38 • spring 2006 issue