Tax Exemption and Unrelated Business Income Tax (UBIT): The Framework (Part 1 of 3)

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Tax Exemption and Unrelated Business Income Tax (UBIT): The Framework (Part 1 of 3)

This Insights blog is Part 1 of a 3-Part series that provides a focused overview of 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”).

This Part 1 sets the framework and provides an overview for the organizational and operational tests applicable to tax-exempt organizations and, without getting into too much detail (yet), the why or when the unrelated business income tax rules come into play for the organization.

General Rule for Tax Exemption Under Section 501(c)(3) of the Code.

To be exempt as an organization described in section 501(c)(3), an organization must be both organized and operated exclusively for one or more of the purposes specified in section 501(c)(3) of the Code. See 26 U.S.C. § 501(c)(3); 26 C.F.R. § 1.501(c)(3)-1(a)(1). If an organization fails to meet either the organizational test or the operational test, the organization is not qualified for tax exemption under section 501(c)(3) of the Code.

The Organizational Test.

Section 1.501(c)(3)-(1) of the Treasury Regulations contains the organizational test:

Organizational test—(1) In general. (i) An organization is organized exclusively for one or more exempt purposes only if its articles of organization (referred to in this section as its articles) as defined in subparagraph (2) of this paragraph: (A) Limit the purposes of such organization to one or more exempt purposes; and (B) Do not expressly empower the organization to engage, otherwise than as an insubstantial part of its activities, in activities which in themselves are not in furtherance of one or more exempt purposes.

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

An organization is organized exclusively for one or more exempt purposes only if its articles of organization: (A) Limit the purposes of such organization to one or more exempt purposes; and (B) Do not expressly empower the organization to engage, otherwise than as an insubstantial part of its activities, in activities which in themselves are not in furtherance of one or more exempt purposes.

Id. at § 1.501(c)(3)-1(b)(1)-(b)(1)(i)(B) (emphasis added).

In no case shall an organization be considered to be organized exclusively for one or more exempt purposes, if, by the terms of its articles, the purposes for which such organization is created are broader than the purposes specified in section 501(c)(3).

Id. at § 1.501(c)(3)-1(b)(1)(iv) (emphasis added).

The term “articles of organization” or “articles” includes the corporate charter or any other written instrument “by which an organization is created.” See id. at § 1.501(c)(3)-1(b)(2). The articles of organization do not include, for example, an organization’s bylaws.

The Operations Test.

An organization will be regarded as operated exclusively for one or more exempt purposes only if the organization engages primarily in activities that accomplish one or more of the exempt purposes specified in section 501(c)(3). See 26 C.F.R. § 1.501(c)(3)-1(c). Under the Treasury Regulations:

[a]n 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).

“‘[T]he 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)).

General Rules for Unrelated Business Income.

Pursuant to the authorities cited above, if a tax-exempt organization engages in a nonexempt activity that is not substantial in nature, the organization’s tax-exempt status may not be defeated. However, the income derived from that trade or business—even if the activity is not substantial in nature—may be subject to taxation.

Under section 511 of the Code, a tax-exempt organization must pay income tax on income classified as unrelated business income. Generally, gross income from an unrelated trade or business, and the applicable deductions relating to that income, are computed the same way in which corporate income taxes are calculated. See 26 U.S.C. §§ 511(a) (corporate rates applicable to unrelated business income), 162 (trade or business expenses), 167 (depreciation). Under section 513, an unrelated trade or business is any trade or business the conduct of which is not substantially related to the organization’s exempt purpose.

Section 512 of the Code contains several exceptions and about 20 modifications to the unrelated business income tax rules. For example, section 512 excludes from the definition of unrelated business income from passive investments, royalties, and rent from real property and personal property rented with real property, provided no more than an incidental amount of the rent payment is allocated to the rental of the personal property. Special rules also apply to income received from real property that is debt-financed and for income derived from qualified research activities.

The unrelated business income tax rules are complex, and the applicability of a particular exception or modification will depend on the numerous facts and circumstances of the income-driving trade or business of the organization.

Stay tuned for Part 2 of this 3-Part series where we will dive deeper into the specific unrelated business income tax rules, the exceptions and modifications to those rules, and some of the exceptions to the 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 (“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.”).