Tax Exemption and Unrelated Business Income Rules (UBIT): “Substantially Related” (Part 3 of 3)

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Cory D. Halliburton

Cory D. Halliburton



Cory Halliburton serves as general counsel and business adviser to a nationwide nonprofit / tax-exempt client base, as well as for multi-state professional service companies. He is a results-oriented attorney, with executive-level strategy and an understanding of the intersection of law and business judgment. With a practical upbringing, he pushes for process-driven results in internal governance, strategy and compliance with employment law, and complex or unique contracts and business relationships.

He dedicated the first ten years of his practice to mainly commercial litigation matters in West Texas and the Dallas-Fort Worth Metroplex. During that experience, Mr. Halliburton transitioned his practice to a more general counsel role, with an emphasis on nonprofit and tax-exempt organizations, advising those organizations through formation, dissolution, litigation, governance, leadership succession, employment law, contracts, intellectual property, tax exemption issues, policy creation, mergers and other. He has served as borrower’s counsel for tax-exempt bond and loan transactions near $100 million aggregate; some with complex pre-issue construction, debt payoff and other debt financing challenges.

Mr. Halliburton also serves as outside legal and business advisor for executive professionals in multi-state engineering firms, with a focus on drafting and counsel on significant service agreements, employment law matters, and protection of trade secrets.

This Insights blog is Part 3 of a 3-Part series focused on the unrelated business income tax rules for the nonprofit organization that is tax-exempt pursuant to section 501(c)(3) of the Internal Revenue Code (the “Code”).

Part 1—Tax Exemption and the Framework for the Unrelated Business Income Rules—provided an overview of the organizational and operational tests of section 501(c)(3) of the Code and alluded to the trigger for unrelated business income rules. Part 2–Unrelated Business Income Tax Rules, Modifications, and Exceptions—dived deeper into, well, the specific rules, modifications, and exceptions.

This Part 3 will dive deeper into the meaning of a trade or business that is “substantially related” to an exempt purpose of the tax-exempt organization.

“Substantially Related”

An organization may meet the requirements of section 501(c)(3) 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 or purposes and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business, as defined in section 513. In determining the existence or nonexistence of such primary purpose, all the circumstances must be considered, including the size and extent of the trade or business and the size and extent of the activities which are in furtherance of one or more exempt purposes.

See 26 C.F.R. § 1.501(c)(3)-1(e) (emphasis added).

A trade or business is “substantially related” (and therefore not an “unrelated” trade or business for unrelated business income tax rules) only if the production or distribution of the goods or the performance of the services from which the gross income is derived contributes importantly to the accomplishment of the purposes for which exemption was granted. “A ‘substantially related’ trade or business ‘has causal relationship to the achievement of exempt purposes’ and ‘must contribute importantly to the accomplishment of those purposes.’” Ocean Pines Ass’n v. Comm’r, 672 F.3d 284, 287-289 (4th Cir. 2012) (quoting 26 C.F.R. § 1.513-1(d)(2)). Section 1.513-1(d)(2) of the Treasury Regulations provides as follows:

Type of relationship required. Trade or business is related to exempt purposes, in the relevant sense, only where the conduct of the business activities has causal relationship to the achievement of exempt purposes (other than through the production of income); and it is substantially related, for purposes of section 513, only if the causal relationship is a substantial one. Thus, for the conduct of trade or business from which a particular amount of gross income is derived to be substantially related to purposes for which exemption is granted, the production or distribution of the goods or the performance of the services from which the gross income is derived must contribute importantly to the accomplishment of those purposes. Where the production or distribution of the goods or the performance of the services does not contribute importantly to the accomplishment of the exempt purposes of an organization, the income from the sale of the goods or the performance of the services does not derive from the conduct of related trade or business. Whether activities productive of gross income contribute importantly to the accomplishment of any purpose for which an organization is granted exemption depends in each case upon the facts and circumstances involved.

26 C.F.R. § 1.513-1(d)(2)(emphasis in bold added).

In determining whether an activity is “substantially related” to an exempt purpose, the courts look to the operation of the activity, and not to the benefit of the organization’s members. See Veterans of Foreign Wars, Dep’t of Michigan v. Comm’r of Internal Revenue, 89 T.C. 7, 38 (1987) (finding that income received from a certain Christmas card fundraising activity of the VFW was not substantially related to its exempt purpose).

For example, the IRS has ruled that sales of pharmaceutical supplies by a tax-exempt hospital to members of the general public, or to private patients of physicians practicing in a building owned by the hospital, do not qualify for the “convenience” exception. Rev. Rul. 68–375, 1968–2 C.B. 245; Rev. Rul. 68–374, 1968–2 C.B. 242. The IRS determined that “[t]he buyer-seller relationship between these off-street patrons and the pharmacy” was insufficient to classify them as “patients” of the hospital. The IRS concluded that these revenues were subject to unrelated business income taxation because there was “no substantial causal relationship between the achievement of the hospital’s exempt purposes and the sale of pharmaceutical supplies” to such individuals. See Rev. Rul. 68–374; see also New Jersey Council of Teaching Hosps. v. Comm’r of Internal Revenue, 149 T.C. 466, 480-81 (2017) (providing detailed analysis on “substantially related” and the “convenience of members” exception).

Examples of “Substantially Related”

In Revenue Ruling 74-399, 1974-2 C.B. 172, the IRS found that a tax-exempt museum’s operation of an eating facility that helped to attract visitors to a museum and enhanced the efficient operation of the entire museum by enabling the staff and employees to remain on its premises throughout the workday may contribute importantly to the accomplishment of the museum’s exempt purposes and would not constitute unrelated trade or business. The Revenue Ruling states, in relevant part, as follows:

Because there are places of refreshment in the museum visitors are able to devote a greater portion of their time and attention to the museum’s collection, exhibits and other educational facilities than would be the case if they had to interrupt or terminate their tours of the museum to seek outside eating facilities at mealtime. The eating facilities also enhance the efficient operation of the entire museum by enabling the museum staff and employees to remain on its premises throughout the workday. Thus, the museum’s operation of the eating facilities is a service that contributes importantly to the accomplishment of its exempt purposes.

Rev. Rul. 74-399 (emphasis added).

In Rev. Rul. 69-268, 1969-1 C.B. 160, a  tax-exempt hospital operated a cafeteria and coffee shop open to hospital staff and persons visiting hospital patients. The general public was not encouraged to use the food facilities. One of the exempt purposes of the hospital is to provide health care for members of the community. The IRS found that the operation of the hospital’s eating facilities was held not unrelated trade or business within the meaning of section 513 of the Code. The IRS found that visits by outsiders are regarded as a form of therapy that assisted in patient recovery. The IRS noted that the hospital’s permitting outside visitors to use its eating facilities enabled the visitors to spend more time with the patients and thus contributed significantly to the hospital’s exempt purpose.

In Rev. Rul. 81-138, 1981-1 C.B. 358, the IRS evaluated a commercial lease arrangement involving a chamber of commerce, being an exempt organization under section 501(c)(6) of the Code. The chamber’s exempt purposes included encouraging business development in a community. The chamber obtained a mortgage to help finance a shell building’s construction leased to an industrial tenant at less than full rental value. The IRS found that the leasing of the property was not an unrelated trade or business as defined in section 513 of the Code because the lease was substantially related to the chamber organization’s exempt purpose. The Revenue Ruling concluded as follows:

The building that the organization owns may constitute “debt-financed property” within the meaning of section 514(b)(1) of the Code since such property is held to produce income and is subject to acquisition indebtedness. Thus, it is necessary to determine whether substantially all of the use of the building is substantially related to the exercise or performance by the organization of the purpose or function constituting the basis for its exemption, and therefore excluded from the definition of debt- financed property under the provisions of section 514(b)(1)(A)(i). . . .

[T]he leasing of the building by the organization, under the circumstances described, when the project is initially financed by contributions from the business community and is leased at less than fair market value for similar facilities, is an activity designed to attract industry to the community and is not an activity of a kind ordinarily carried on for profit. The activity therefore contributes importantly to the purposes constituting the basis for the organization’s exempt status under section 501(c)(6) of the Code, and thus is substantially related to those purposes within the meaning of section 514(b)(1)(A)(i).

In Rev. Rul. 77-47, 1977-1 C.B. 157, the IRS evaluated a historical preservation association that was exempt under section 501(c)(3) of the Code. The association acquired, restored, and preserved historical significant buildings and opened the restored buildings to the public for a nominal admission fee. The association acquired other historically significant buildings by the assumption of outstanding mortgages. It leased them at fair rental value for uses that bore no relationship to the building’s historical significance and did not allow for viewing by the general public. The IRS concluded that, because the leasing did not contribute significantly to the association’s exempt purpose and had no causal relationship to the achievement of that purpose, the exception under section 514(b)(1)(A) did not apply, and the leased buildings were held to constitute debt-financed property.

In Living Faith, Inc. v. Commissioner, 950 F.2d 365 (7th Cir. 1991), the issue was whether Living Faith was operated exclusively for exempt purposes under section 501(c)(3) of the Code when Living Faith’s sole activities involved the operation of two religious-based food stores and restaurants called Country Life.

Living Faith was a Seventh-Day Adventist Church organized in part to perform “outpost evangelism programs.” Living Faith operated Country Life based on the Seventh-Day Adventist religious dietary standards. Id. at 367. The Country Life facilities were required to employ Seventh-Day Adventist management and maintain a working relationship with the local Seventh-Day Adventist Church. Living Faith’s food prices were competitive with other vegetarian restaurants and health food stores. Id. at 368.

Living Faith asserted that it operated its health food stores with the exclusive, tax-exempt purpose of furthering the Seventh-Day Adventist Church’s religious work as a health ministry. Id. at 370. Living Faith used Country Store as a means to evangelize the Seventh-Day Adventist faith. Each day, Living Faith conducted a devotional and religious ceremony at the facility. Living Faith provided the public with an opportunity to sample vegetarian cooking by offering free meals. Living Faith offered to the public a fee-based cooking school that promoted vegetarian cooking. Living Faith also offered weekly Bible study classes, free of charge, and occasionally provided meals to the needy in exchange for chores. Id. at 368.

The IRS Commissioner and the Tax Court found that Living Faith was not qualified as exempt under section 501(c)(3) of the Code due to the substantial nonexempt activity of operating commercial food stores.

The Court of Appeals for the Seventh Circuit affirmed. The court noted:

[W]e focus on “the purposes toward which an organization’s activities are directed, and not the nature of the activities.” The purposes need not be solely religious; courts recognize that a nonexempt purpose, even “somewhat beyond a de minimis level,” may be permitted without loss of exception. The nonexempt purpose, however, cannot be substantial. “The presence of a single nonexempt purpose, if substantial in nature, will destroy the exemption regardless of the number or importance of truly [exempt] purposes.”

A single activity may be carried on for more than one purpose. The fact that an organization’s primary activity may constitute a trade or business does not, of itself, disqualify it from classification under § 501(c)(3), provided the trade or business furthers or accomplishes an exempt purpose. If one of the activity’s purposes, however, is substantial and nonexempt (e.g., commercial), the organization will be denied exempt status under § 501(c)(3), even if its activity also furthers an exempt (e.g., religious) purpose.

Living Faith, 950 F.2d at 370 (internal citations omitted).

The Court of Appeals found that Living Faith’s activities were limited to the operation of the two food stores. The operation of the eating facilities was presumptively commercial. The facility was open to the public. It competed directly with other restaurants. It used profit-making pricing formulas and engaged in advertising. The facility had hours of operation competitive with commercial enterprises. The underlying organization had no plans to solicit donations. In sum, the food store operations were substantial commercial operations and thus, the denial of exemption under section 501(c)(3) was affirmed. See id. at 371, 373-377.

Indeed, “‘the presence of a single nonexempt purpose, if substantial in nature, will destroy the exemption regardless of the number or importance of truly [exempt] purposes.’” American Ass’n of Christian Schools Voluntary Employees Beneficiary Ass’n Welfare Plan Trust v. United States, 850 F.2d 1510, 1513 (11th Cir.1988) (quoting Better Business Bureau v. United States, 326 U.S. 279, 283, 66 S.Ct. 112, 114, 90 L.Ed. 67 (1945)).

The Commerciality Doctrine

One final legal concept for this three-part UBIT series and that the IRS and the courts consider in the UBIT context is called the “commerciality doctrine.”

This doctrine was created by the courts and, generally, specifies that an organization will not qualify for tax exemption under section 501(c)(3) of the Code if the organization is operated in a manner that competes with for-profit enterprises. A focus of this doctrine is whether the activities of the purported tax-exempt organization allow it to gain an unfair market advantage over for-profit enterprises by virtue of an exemption from income from such activities.

Some types of tax-exempt organizations get a “pass” from the commerciality doctrine. For example, exempt research organizations, exempt educational institutions, and hospitals generally are not subject to the commerciality doctrine with respect to their foundational and traditional exempt activities, even though those entities compete with for-profit enterprises that provide similar goods or services.

The nebulous areas for the application of the doctrine usually arise when trying to determine at what point the operation of a particular activity should transform that organization into a commercial enterprise and thereby to have forfeited its tax-exempt status. If an organization is deemed to have violated the commerciality doctrine by the operation of a non-exempt purpose or activity, the organization’s tax exemption may be revoked and the income from that non-exempt activity (as well as other income) may be subject to federal income taxation.

Neither the Tax Courts nor Congress have established a bright-line test for deciding when a tax-exempt organization’s “commercial activity” meets the threshold for a violation of the commerciality doctrine. Factors that the courts consider include whether the organization is competing with for-profit commercial enterprises, pricing policies of the organization such as market-comparable or at-cost provision of goods or services, whether the organization markets its goods or services like a for-profit enterprise.

As one of my wise mentor’s once described the application of the commerciality doctrine: If it looks like a duck, waddles like a duck, and quacks like a duck, it probably is a duck. I suppose the “duck test” is one way to make a semi-informed decision on whether or not an activity of a tax-exempt organization violates the commerciality doctrine.


Well, tax-exemption friends, Romans, etc., that is a wrap for this Three Part Series on Tax Exemption and Unrelated Business Income Tax (UBIT). To close, and as I closed Parts 1 and 2, I quote U.S. Tax Court Senior Judge Mark V. Holmes: “One way to think about tax law is to view it as a series of general rules qualified by exceptions, and exceptions to those exceptions, and exceptions to those exceptions to those exceptions.” See Continuing Life Communities Thousand Oaks LLC v. Comm’r, T.C. Memo. 2022-31 |April 6, 2022|Holmes, J. | Dkt. No. 4806-15.


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