7.27.6  Computation of Unrelated Business Tax Income

7.27.6.1  (02-23-1999)
Overview

  1. This section provides information on the computation of unrelated business taxable income under IRC 512.

  2. The income of an exempt organization is subject to the tax on unrelated business taxable income imposed by IRC 511, if such income is from a trade or business regularly carried on and that trade or business is not substantially related (aside from the need of the organization for funds or the use it makes of the profits) to the organization’s exercise or performance of the purposes of functions on which its exemption is based.

  3. Once it is determined that the above conditions exist, it is necessary to determine to what extent the income from such trade or business is subject to tax under IRC 511.

  4. IRC 512 defines the term "unrelated business taxable income" (except for special exceptions discussed later) as the gross income derived from unrelated trade or business regularly carried on, less the deductions directly connected with such trade or business, computed with the modifications provided in IRC 512(b).

  5. If an organization regularly carries on two or more unrelated business activities, its unrelated business taxable income is the aggregate of its gross income from such activities less the aggregate allowable deductions attributable thereto. See Reg. 1.512(a)–1(a).

7.27.6.2  (02-23-1999)
Deductions and Expenses

  1. In computing the unrelated business taxable income of an exempt organization, deductions are allowed for expenses, depreciation and similar items, which are deductible by a commercial enterprise in computing its taxable income, provided such items are directly connected with the carrying on of unrelated trade or business.

  2. Except as discussed in IRM 7.27.6.3, to be "directly connected with" the conduct of unrelated trade or business for purposes of IRC 512, an item of deduction must have a proximate and primary relationship to the carrying on of unrelated trade or business. See Reg. 1.512(a)–1(a).

7.27.6.2.1  (02-23-1999)
Expenses Attributable Solely to Unrelated Business Activities

  1. Expenses, depreciation and similar items attributable solely to the conduct of unrelated trade or business are clearly proximately and primarily related to that business activity. Therefore, such expenses are deductible in full in computing the unrelated business taxable income of the organization. See Reg. 1.512(a)–1(b).

7.27.6.2.2  (02-23-1999)
Expenses Attributable Solely to Organization’s Exempt Purpose

  1. Expenses attributable solely to accomplishing an organization’s exempt purpose may not be deducted from the organization’s unrelated business income. See, e.g., Iowa State University v. Commissioner, 500 F.2d 508 (Ct. Cl. 1974), where the court held that the expenses of an exempt radio station could not be deducted against the income from a nonexempt television station even though the stations shared facilities and staff.

7.27.6.2.3  (02-23-1999)
Dual Use of Facilities or Personnel

  1. Where facilities or personnel are used for both exempt functions and the conduct of unrelated trade or business, the expenses, depreciation and similar items attributable to such facilities or personnel must be allocated between the two uses on a reasonable basis. See Reg. 1.512(a)–1(c). The portion of such item allocated to the unrelated business activity is considered proximately and primarily related to that business activity and is allowable as a deduction in computing the unrelated business taxable income.

  2. The following examples discuss this principle:

    Example:

    X, an exempt organization subject to the provisions of IRC 511, pays its president a salary of $20,000 a year. X derives gross income from the conduct of unrelated trade or business activities. The president devotes approximately 10 percent of his/her time during the year to the unrelated business activity. For purposes of computing X’s unrelated business taxable income, a deduction of $2,000 (10 percent of $20,000) is allowed for the salary paid to its president. See Reg. 1.512(a)–1(c).

    Example:

    Amounts received by an exempt school that annually contracts with an individual who conducts a summer tennis camp with the school furnishing the tennis courts, housing and dining facilities are from dual use of facilities and personnel. An allocable portion of expenses attributable to the facilities and personnel may be deducted in computing unrelated business taxable income. Rev. Rul. 76–402, 1976–2 C.B. 177, amplified by Rev. Rul. 80–297, 1980–2 C.B. 196.

  3. In Rennselaer Polytechnic Institute v. Commissioner, 732 F.2d 1058 (2d Cir. 1984), an IRC 501(c) (3) educational organization operated a field house, which it devoted to two uses: student use, including physical education, college ice hockey and student ice skating, and commercial use, including commercial ice shows and public ice skating. Amounts derived from commercial use constitute unrelated business taxable income, and the issue presented concerned the allocation of indirect expenses. The organization contended that it is entitled to allocate fixed expenses on the basis of actual use, while the Service argued that such allocation should be based on the total time available for use. The court agreed with the organization and held that apportioning indirect expenses such as depreciation on the basis of actual hours used is a reasonable method of allocation under Reg. 1.512(a)–1(c). The Service has not acquiesced in this decision.

  4. In Disabled American Veterans v. United States, 704 F.2d 1570 (Fed. Cir. 1983), the court considered allocation issues with respect to the organization’s Special Solicitation program. The court held that the organization must allocate expenses of its direct mail solicitation program between the taxable and exempt portions of the program. The court also stated that the way to arrive at the correct figure is to compare the taxable receipts to the total receipts and then to apply that proportion to expenses.

  5. In CORE Special Purpose Fund v. Commissioner, T.C. Memo. 1985–48, the court denied business expense deductions in computing unrelated business taxable income attributable to the sale of advertising in an organization’s magazines. Although the organization received income from advertising, the advertising regulations under Reg. 1.512(a)–1(f) could not be used because of the organization’s failure to produce credible evidence of its advertising and publishing expenses. The general allocation requirements under Reg. 1.512(a)–1(c) were deemed applicable. The court held that deductions were not allowed because the organization did not adequately substantiate a claim that such expenses were incurred or were directly connected with the unrelated advertising activity. The court did allow the organization to deduct a portion of its claimed legal and accounting fees and telephone expenses.

7.27.6.3  (02-23-1999)
Exploitation of Exempt Functions

  1. In certain cases, gross income is derived from an unrelated trade or business activity which exploits an exempt activity. One example of such exploitation is the sale of advertising in a periodical of an exempt organization which contains editorial material related to the accomplishment of the organization’s exempt purpose. For a comprehensive discussion of the exploitation of exempt functions, see IRM 7.27.5 (concerning unrelated trade or business).

  2. In most cases of income from exploitation of exempt functions, expenses, depreciation and similar items attributable to the conduct of the exempt activities are not deductible in computing unrelated business taxable income. Such items are incident to an activity which is carried on to further the exempt purpose of the organization. They do not possess the necessary proximate and primary relationship to the unrelated trade or business activity and are, therefore, not directly connected with that business activity. See Reg. 1.512(a)–1(d). See also, IRM 7.27.6.2.

  3. In certain circumstances, however, expenses that are attributable to the exempt activity qualify as directly connected with carrying on the unrelated trade or business activity. To get any deduction for such expenses, the unrelated business must be of a kind carried on for profit by taxable organizations and the exploited activity must be of a type normally conducted by taxable organizations in pursuance of such business. Even then, these expenses are allocated first to the exempt function to the extent of income derived from or attributable to it and only the balance, if any, is deductible against unrelated income. Further, allocation of expenses attributable to the exempt function can be made to the unrelated business activity only to the extent that it does not result in a loss.

7.27.6.4  (02-23-1999)
Sale of Advertising in Exempt Organization Periodicals

  1. The sale of advertising in a periodical of an exempt organization that contains editorial material related to the accomplishment of its exempt purpose is exploitation of an exempt function of the kind discussed in IRM 7.27.6.3 above. See Reg. 1.512(a)–1(f), which provides rules for determining the amount of unrelated business taxable income attributable to the sale of such advertising.

7.27.6.4.1  (02-23-1999)
Advertising— Unrelated Business Taxable Income

  1. For the purpose of arriving at the amount of unrelated business taxable income attributable to the sale of advertising, it is necessary to determine the gross advertising income, direct advertising costs, circulation income and readership costs. If membership fees are to be allocated to the periodical, it may also be necessary to determine the total periodical costs.

  2. Gross advertising income is defined in Reg. 1.512(a)–1(f)(3) as all amounts derived from the unrelated advertising activities of the exempt organization.

  3. Circulation income is defined as the income attributable to the production, distribution or circulation of a periodical (other than the gross advertising income), including all amounts realized from or attributable to the sale or distribution of the readership content of the periodical. This includes amounts realized from charges made for reprinting or republishing articles and special items in the periodical, and amounts realized from the sale of back issues. See Reg. 1.512(a)–1(f)(3).

  4. Total periodical costs (the total deductions attributable to the periodical) are equal to the sum of the direct advertising costs of the periodical and the readership costs of the periodical. See Reg. 1.512(a)–1(f)(6)(i).

  5. Direct advertising costs include all expenses, depreciation and similar items of deduction which are directly connected with the sale, publication and distribution of advertising. See Reg. 1.512(a)–1(f)(6)(ii)(a).

  6. Readership costs are expenses, depreciation, or similar items which are directly connected with the production and distribution of the readership content of the periodical. Thus, all the deductions that are attributable to an exempt organization’s periodical that are not allocated to direct advertising costs are included under readership costs. See Reg. 1.512(a)–1(f)(6)(iii).

  7. The mechanical and distribution costs must be allocated between the direct advertising costs and the readership costs. Unless a more accurate method is available, these costs should be allocated on the basis of lineage. Thus, mechanical and distribution costs are allocated to advertising costs on the basis that the ratio of advertising lineage bears to total lineage. See Reg. 1.512(a)–1(f)(6)(ii)(c).

  8. In American Medical Association v. United States, 887 F.2d 760 (7th Cir. 1989) aff’g and rev’g, 668 F. Supp. 1085 (N.D. Ill. 1987), 668 F. Supp. 1101 (N.D. Ill. 1987), 688 F. Supp. 358 (N.D. Ill. 1988) and 691 F. Supp. 1170 (N.D. Ill. 1988)) the Seventh Circuit Court of Appeals followed a "dominant motive" test in determining whether a cost was "directly connected with" an unrelated business. The AMA distributed a substantial number of copies of its periodicals free of charge. This "controlled circulation" was specifically directed at physicians who constitute an especially attractive audience for persons likely to advertise in the journals. The parties stipulated that the sole purpose behind the AMA’s controlled circulation was to appeal to advertisers. The IRS argued that the regulations adopt a purely objective standard for determining the nature of an expense — if the expense is related to the production or distribution of the journal’s articles, it is a "readership cost" deductible from advertising income only if circulation income is negative; if the expense is proximately related to production or distribution of advertising, it is a "direct advertising cost" and fully deductible from advertising revenue. The appeals court found this reading to be an overly restrictive construction of the regulations. In finding that the costs of producing articles in copies of the AMA’s journals distributed free of charge as part of the AMA’s controlled circulation were fully deductible "direct advertising costs," the court concluded that where the clearly dominant motivation of a given expenditure is to contribute to the taxable, unrelated enterprise, that cost is "directly connected with" the taxable enterprise and, therefore, deductible in its entirety from the income of the unrelated trade or business.

7.27.6.4.2  (02-23-1999)
Income and Deductions Attributable to Exempt Organization Periodicals

  1. If the direct advertising costs exceed the gross advertising income, the excess is allowable as a deduction in determining the unrelated business taxable income from any other unrelated trade or business activity carried on by the organization. See Reg. 1.512(a)–1(f)(2)(i).

  2. If, however, the gross advertising income of the periodical exceeds the direct advertising costs, Reg. 1.512(a)–1(d) provides that items of deduction attributable to the production and distribution of the readership content of the periodical (its exempt function) may be deducted from the "excess advertising income" in computing unrelated business taxable income, to the extent such deductions exceed "circulation income" (income from the exempt function) but may not result in a loss from the advertising activity. Such deductions may be taken into account in computing the unrelated business taxable income from this activity only. See Reg. 1.512(a)–1(f)(2)(ii).

  3. Thus, if the circulation income of the periodical equals or exceeds the readership costs of such periodical, the unrelated business taxable income attributable to the periodical is the excess of the gross advertising income of the periodical over direct advertising costs; but if the readership costs of an exempt organization periodical exceed the circulation income of the periodical, the unrelated business taxable income is the excess, if any, of the total income attributable to the periodical over the total periodical costs. This results in advertising income of an exempt organization periodical being taxed only if the periodical produces an overall profit for the year. See Reg. 1.512(a)–1(f)(2)(ii).

7.27.6.4.3  (02-23-1999)
Allocation of Membership Fees to Exempt Organization Periodicals

  1. Where the right to receive an exempt organization periodical is associated with membership for which fees are received, subscription income includes the portion of membership fees allocable to the periodical. Reg. 1.512(a)–1(f)(4) sets out three methods for allocating membership receipts to a periodical:

    1. If 20 percent or more of the total circulation of a periodical consists of sales to nonmembers, the price of the periodical for purposes of allocating membership receipts is the subscription price charged to nonmembers.

    2. If paragraph (a) does not apply and 20 percent or more of the organization’s members pay lower dues than other members because the former do not receive the periodical, allocation is based on the difference in membership fees paid. The price of the periodical is the amount of the reduction in membership dues for a member not receiving the periodical.

    3. Where neither paragraph (a) nor (b) applies, Reg. 1.512(a)–1(f)(4)(iii) provides a formula for the pro rata allocation of membership receipts based on the assumption that membership receipts and gross advertising income are equally available for all an organization’s exempt activities including the periodical.

    4. The share of membership receipts allocated to the periodical under this method is an amount equal to the organization’s membership receipts multiplied by a fraction the numerator of which is the total periodical costs and the denominator of which is such costs plus the cost of other exempt activities of the organization.

  2. The regulations were challenged in American Medical Association v. United States, supra, on procedural and substantive grounds. On appeal, the regulations were upheld by the Seventh Circuit. In the various opinions on American Medical Association, the courts set forth the following regarding membership dues allocations:

    1. Dues placed in an association equity fund must be included in membership receipts for purposes of the pro rata allocation formula under Reg. 1.512(a)–1(f)(4)(iii);

    2. Dues collected from members who would have received periodicals free of charge even if they had not been dues-paying members should be included in calculating membership receipts allocable to circulation income under Reg. 1.512(a)–1(f)(4)(iii);

    3. The cost of other exempt activities under Reg. 1.512(a)–1(f)(4)(iii) includes all costs of other periodicals, not just readership costs;

    4. The one year subscription rate (rather than one-half the two year subscription rate) should be used in calculating membership receipts allocable to circulation income under Reg. 1.512(a)–1(f)(4)(iii); and,

    5. A portion of reduced dues paid by medical students, interns and residents may be used in calculating membership receipts under Reg. 1.512(a)–1(f)(4)(i).

  3. In American Hospital Association v. United States, 654 F. Supp. 1152 (N.D. Ill. 1987) the court held that free distribution of an IRC 501(c)(6) organization’s periodicals to nonmembers should not be included in total circulation for purposes of Reg. 1.512(a)–1(f)(4)(i).

  4. In American Bar Association v. United States, 53 AFTR 2d 84–850 (N.D. Ill. 1984), the court permitted an IRC 501(c)(6) organization to take into account the costs of a separate fund described in IRC 501(c)(3) for purposes of calculating the pro rata allocation of membership receipts formula under Reg. 1.512(a)–1(f)(4)(iii).

  5. A detailed example of the allocation of membership receipts to advertising income under the formula given in Reg. 1.512(a)–1(f) (4) (iii) is contained in Rev. Rul. 81–101, 1981–1 C.B. 352. This ruling illustrates that in applying such formula the phrase "cost of other activities" means the total costs or expenses incurred by an organization in connection with its other exempt activities, and such costs are not offset by any income earned by the organization from such activities. See examples in Reg. 1.512(a)–1(f)(2)(iii).

7.27.6.4.4  (02-23-1999)
Consolidation of Periodicals’ Income and Deductions

  1. Where an exempt organization publishes two or more periodicals for the production of income, it may consolidate the gross income for all periodicals and the items of deduction directly connected with the periodicals (including the readership costs) for purposes of computing the unrelated business taxable income derived from the sale of advertising in the periodicals. Consolidation may not be applied to less than all periodicals of the organization and, once adopted, this treatment is binding unless consent is obtained as provided in IRC 446(e). See Reg. 1.512(a)–1(f)(7).

  2. A periodical is considered "published for the production of income" if:

    1. the gross advertising income received from the periodical generally is equal to at least 25 percent of the readership costs, and

    2. the publication of the periodical is an activity engaged in for profit.

  3. Reg. 1.512(a)–1(f)(7) provides, in pertinent part, that the determination whether the publication of a periodical is an activity engaged in for profit is to be made by reference to objective standards taking into account all the facts and circumstances involved in each case. The facts and circumstances must indicate that the organization carries on the activity with the objective that the publication of the periodical will result in economic profit (without regard to tax consequences), although not necessarily in a particular year. Thus, an exempt organization periodical may be treated as having been published with such an objective even though in a particular year its total periodical costs exceed its total income. Similarly, if an exempt organization begins publishing a new periodical, the fact that the total periodical costs exceed the total income for the start-up years because of a lack of advertising sales does not mean that the periodical was published without an objective of economic profit. The organization may establish that the activity was carried on with such an objective. This might be established by showing, for example, that there is a reasonable expectation that the total income, by reason of an increase in advertising sales, will exceed costs within a reasonable time. See §1.183–2 for additional factors bearing on this determination.

7.27.6.5  (02-23-1999)
Special Rules for Foreign Organizations

  1. A foreign organization which is described in IRC 511 will be taxed on:

    1. Unrelated business taxable income which is derived from sources within the United States but which is not effectively connected with the conduct of a trade or business within the United States; plus

    2. Unrelated business taxable income effectively connected with the conduct of a trade or business within the United States whether or not such income is derived from sources within the United States.

  2. For guidance on how to determine whether income realized by a foreign organization is derived from sources within the United States or is effectively connected with the conduct of a trade or business within the United States, see part I, subchapter N, chapter 1 of the Code (IRC 861 and following) and the regulations thereunder.

7.27.6.6  (02-23-1999)
Special Rules for Veterans’ Organizations

  1. IRC 512(a)(4) excludes from unrelated business taxable income amounts attributable to payments for life, sick, accident or health insurance with respect to the members of veterans’ organizations, provided such amounts are set aside for the payments of insurance benefits, the administrative costs of administering the insurance program or for purposes described in IRC 170(c)(4).

  2. If the income from such an insurance set-aside is used for any other purpose, such amount is included in unrelated business taxable income without regard to any modifications provided in IRC 512(b), in the taxable year in which it is withdrawn from the set-aside. See Reg. 1.512(a)–4.

  3. To properly set aside the income from the insurance fund, an organization must keep adequate records describing the amount set aside and indicating the purpose for which it is to be used. The funds may not be commingled with other funds not to be set aside. Income which has been set aside may be invested, pending the action contemplated by the set-aside, without being regarded as having been used for other purposes.

7.27.6.7  (02-23-1999)
Modifications for Computing Unrelated Business Taxable Income

  1. IRC 512(b) excludes certain items, and any deductions directly connected with them, from unrelated business taxable income. Whether a particular item of income falls within any of these modifications depends on the substantive nature of the item rather than its form so that all the facts and circumstances in each case must be fully considered. The following sections discuss such modifications.

7.27.6.7.1  (02-23-1999)
Dividends, Interest, and Annuities

  1. Under IRC 512(b)(1), dividends, interest, and annuities, as well as the deductions directly connected with these types of income, are excluded in computing unrelated business taxable income. However, if such income is derived from debt-financed property (IRC 514) or, in the case of interest and annuities derived from a controlled organization (IRC 512(b)(13)), it is included in computing unrelated business taxable income to the extent provided in those sections.

  2. Reg. 1.512(b)–1(a)(1) expands the modification contained in IRC 512(b)(1) by stating that dividends, interest, payments with respect to securities loans, annuities, income from notional principal contracts, and directly connected deductions are excluded in computing unrelated business taxable income. The regulation also excludes other substantially similar income from ordinary and routine investments to the extent determined by the Service.

  3. Rev. Rul. 79–349, 1979–2 C.B. 233, describes an exempt employees’ trust engaged in the unrelated trade or business of making mortgage loans in a commercial manner. The ruling holds that the interest earned on the loans is excluded from the computation of the organization’s unrelated business taxable income under IRC 512(b)(1). The service fees charged on the loans are, however, included.

7.27.6.7.2  (02-23-1999)
Income From Lending Securities

  1. Payments received by an exempt organization on securities in its investment portfolio which are loaned to brokers are not treated as unrelated business income. In order for the payments to qualify under IRC 512(b)(1), however, the securities must be loaned pursuant to an agreement which:

    1. provides for the return to the organization of identical securities loaned;

    2. requires that payments be made to the exempt organization in amounts equivalent to the interest, dividends and other distributions that the owner of the securities is entitled to receive because of its ownership during the period of the loan;

    3. does not reduce the organization’s risk of loss or opportunity for gain as to the transferred securities;

    4. contains reasonable procedures to implement the obligation of the borrower to furnish collateral to the organization with a fair market value on each business day the loan is outstanding in an amount at least equal to the fair market value of the securities at the close of business on the preceding day; and

    5. permits the organization to terminate the loan at any time upon notice of no more than five business days.

  2. This treatment is not available if the securities which are loaned constitute inventory or are being held for sale to customers in the ordinary course of the organization’s trade or business.

7.27.6.7.3  (02-23-1999)
Royalties

  1. Royalties, including overriding royalties, are excluded under IRC 512(b)(2), whether measured by production or by gross or taxable income from the property. All deductions directly connected with excludable royalties must also be eliminated. However, if royalty income is derived from debt-financed property (IRC 514) or controlled organizations (IRC 512(b)(13)), it is included in computing unrelated business income to the extent provided in those sections.

  2. To be a royalty, a payment must relate to the use of a valuable right. Payments for the use of trademarks, trade names, service marks, or copyrights, whether or not payment is based on the use of such property, are ordinarily classified as royalties for federal tax purposes.

    1. See Commissioner v. Affiliated Enterprises. Inc., 123 F.2d 665 (10th Cir. 1941), cert. denied 315 U.S. 812 (1942).

  3. Similarly, payments for the use of a professional athlete’s name, photograph, likeness, or facsimile signature are ordinarily characterized as royalties. See generally, Cepeda v. Swift & Co., 415 F.2d 1205 (8th Cir. 1969) and Rev. Rul. 81–178, 1981–2 C.B. 135. Situation 1 of Rev. Rul. 81–178 relies on the rationale of the cases cited therein in reaching the conclusion that income from licensing agreements involving the use of certain athletes’ names, photographs, etc. is royalty income and thus excludable under IRC 512(b)(2).

  4. Royalties do not include payments for personal services.

    1. Situation 2 of Rev. Rul. 81–178 presents an example of such a case. There, an exempt organization entered into a licensing agreement for the endorsement of certain products and services that require personal appearances by, and interviews with, members of the organization. Income from such agreements is gross income from unrelated trade or business and, because the payments received by the organization are compensation for personal services, they are not excluded as royalties under IRC 512(b)(2).

    2. In Sierra Club, Inc. v. Commissioner, 86 F.3d 1526 (9th Cir. 1996), aff’g T.C. Memo. 1993–199, aff’g in part and rev’g in part and remanding 103 T.C. 307, the court confirmed that there is a distinction between payments for services and payments for the right to receive an intangible property right. The court held that royalties under IRC 512(b)(2) are defined as payments received for the right to use intangible property rights, and that royalties do not include payments for services.

    3. Mailing Lists — Based on the above definition, the Court of Appeals affirmed the decision of the Tax Court in Sierra Club, Inc. v. Commissioner, T.C. Memo. 1993–199, and found that income from mailing list rentals constituted royalty income. The Court of Appeals concluded that Sierra Club ( "SC" ) received royalty income. In so concluding, the court noted that SC neither performed services relating to the mailing list rental nor marketed the mailing lists. SC merely collected a fee for the mailing list rental. The court, rejecting the argument that any active marketing activity would convert a royalty into a non-royalty, specifically noted that SC’s activity in connection with the rental of its mailing list was substantially less than the amount of activity which other courts had found to preclude a finding of royalty income. The Ninth Circuit’s decision leaves unanswered the question of what services an exempt organization can perform in connection with mailing list rentals and still treat the income from them as royalty income. Although the court rejected the Tax Court’s all inclusive definition of royalties as including "active" and "passive" income, it did not state what activities will cause an organization to have unrelated business taxable income. Cf. Disabled American Veterans v. United States, 227 Ct. Cl. 474, 650 F.2d 1178 (Ct. Cl. 1981), where the Court of Claims found that because the organization performed substantial business activity in preparing and mailing the lists, royalty treatment was precluded. The Ninth Circuit’s decision in Sierra Club, Inc. is inconsistent with the Service’s administrative position that income from the regular sale of membership mailing lists by an exempt organization is subject to the unrelated business income tax and is not a royalty under IRC 512(b)(2).

    4. Affinity Credit Cards — In Sierra Club, Inc. v. Commissioner, 103 T.C. 307 (1994), the Tax Court held that the revenue from an affinity credit card program did not constitute unrelated business income. See also, Oregon State University Alumni Association, Inc. v. Commissioner, T.C. Memo. 1996–34, Alumni Association of the University of Oregon. Inc. v. Commissioner, T.C. Memo. 1996–63, and Mississippi State University Alumni, Inc. v. Commissioner, T.C. Memo. 1997–397. The Tax Court concluded that revenues received as part of the affinity card program were not received as compensation for services, but as payment for an intangible property right. Such compensation therefore constituted royalty income under IRC 512(b)(2).

      Note:

      The Service’s administrative approach in the area of affinity credit cards is that affinity card cases should be resolved in a manner consistent with existing court cases. In the cases decided in favor of the taxpayer, the facts showed that the involvement of the exempt organization was relatively minimal, and the organizations generally hired outside contractors to perform most services associated with exploitation of the use of intangible property. Thus, courts concluded that the payment was for the intangible property rather than for services of the organization's members or employees. In the one case decided in favor of the government — Disabled American Veterans v. United States, 650 F.2d 1178 (Ct. Cl. 1981) — the organization's employees provided extensive services in connection with the list rental.

  5. The royalty exclusion does not apply to royalties which stem from an arrangement whereby the organization owns a working interest in a mineral property and is liable for its share of the development costs under the terms of its agreement with the operator of the property. See Reg. 1.512(b)–1(b). An exempt organization’s income from a mineral interest is not a royalty excluded from the computation of unrelated business taxable income by IRC 512(b)(2), where the organization is liable for the operating expenses associated with its interest. Rev. Rul. 69–179, 1969–1 C.B. 158.

  6. Patent development and management service fees deducted from royalties collected from licensees by an exempt charitable organization for distribution to the beneficial owners of the patents are not within the exception for royalties provided by IRC 512(b)(2). Rev. Rul. 73–193, 1973–1 C.B. 262. However, Rev. Rul. 76–297, 1976–2 C.B. 1978, provides that amounts received from licensees by an exempt organization, the legal and beneficial owner of patents assigned to it by inventors for specified percentages of future royalties, is royalty income that is excludable in computing unrelated business taxable income.

  7. In Fraternal Order of Police, Illinois State Troopers, Lodge No. 41 v. Commissioner, 87 T.C. 747, aff’d, 833 F.2d 717 (7th Cir. 1987), the court held, in part, that income from advertising appearing in an organization’s magazine, The Trooper, was subject to tax on unrelated business income, and that the royalty modification under IRC 512(b)(2) was not applicable. See IRM 7.27.5.

7.27.6.7.4  (02-23-1999)
Rents

  1. Under law in effect prior to the Tax Reform Act of 1969, IRC 512(b)(3) excluded all rents from real property (including personal property leased with the real property) and all deductions directly connected therewith in computing unrelated business taxable income. The intention was to exclude passive income from tax and not exclude an active business. However, exempt organizations began leasing business assets of an operating business to an independent management company and claiming the rent exclusion. The exempt organizations received most of the profits from the business in the form of "passive" rents and in one case the Tax Court held that such rental activity came under the rental exclusion for real property and personal property leased with real property. University Hill Foundation v. Commissioner, 51 T.C. 548 (1969), rev’d, 446 F.2d 701 (9th Cir. 1971), cert. denied, 405 U.S. 965 (1972). If the exempt organization had conducted the business itself, the profits from the business would be unrelated business taxable income. Although University Hill Foundation was reversed on appeal, IRC 512(b)(3) was amended to correct this abuse.

  2. Consistent with the passive income concept, the Tax Reform Act of 1969 provided for the taxation of rent derived from the leasing of either real or personal property where the determination of the amount of such rent depends on the net income from the property. S. Rep. No. 91–552, 91st Cong., 1st Sess. 69 (1969), 1969–3 C.B. 468; See Reg. 1.512(b)–1(c)(2)(iii)(b).

7.27.6.7.4.1  (02-23-1999)
Exclusion of Rents From Unrelated Business Taxable Income

  1. Rents from real property are excluded in computing unrelated business taxable income. Rents from personal property are not so excluded. Special rules apply when rents are received from personal property leased with real property (mixed lease). See IRM 7.27.7.4.3, infra.

  2. If rents are derived from debt-financed property (IRC 514) or controlled organizations (IRC 512(b)(13)), they are included in computing unrelated business income to the extent provided in those sections.

7.27.6.7.4.2  (02-23-1999)
Real Property, Personal Property, and Property Placed in Service

  1. Real property is all real property including any property described in IRC 1245(a)(3)(C). Also, income derived from a lease of a pipeline system, consisting of right-of-way interest in land, pipelines buried in the ground, pumping stations, plants, equipment, and other appurtenant property, constitutes rent from real property. Rev. Rul. 67–218, 1967–2 C.B. 213.

  2. Personal property is all personal property including any property described in IRC 1245(a)(3)(B). Also, income derived from railroad cars leased to an industrial company that had the responsibility for operation and maintenance of the cars constitutes rent from personal property. Rev. Rul. 60–206, 1960–1 C.B. 201. Also, see Cooper Tire & Rubber Company Employees’ Retirement Fund v. Commissioner, 36 T.C. 96 (1961), aff’d 306 F.2d 20 (6th Cir. 1962).

  3. Property is placed in service when it is first subject to use by the lessee under the terms of the lease. For example, property subject to a lease entered into on November 1, 1971, for a term commencing on January 1, 1972, shall be considered as placed in service on January 1, 1972, regardless of when the property is first actually used by the lessee. See Reg. 1.512(b)–1(c)(3)(iv).

7.27.6.7.4.3  (02-23-1999)
Exception for Mixed Leases

  1. Rents from personal property leased with real property (mixed lease) are excluded where the rent from the personal property is an incidental amount of the total rent as determined at the time the personal property is first placed in service.

  2. Rent from personal property will generally be considered incidental if the rent attributable to it does not exceed 10 percent of the total rents from all the leased property.

    Example:

    If the rents attributable to the personal property leased are determined to be $3,000 per year, and the total rents from all property leased are $10,000 per year, then the $3,000 is not to be excluded from the computation of unrelated business taxable income, since such amount is not an incidental portion of the total rents. Deductions directly connected with excluded rents are not allowable.

  3. Where the rent attributable to the personal property is more than 10 percent but does not exceed 50 percent of the total rent, determined at the time the personal property is first placed in service by the lessee, the rental income attributable to the real property is excluded from the computation of unrelated business taxable income.

  4. Where the rent attributable to the personal property is more than 50 percent of the total rent, determined at the time the personal property is first placed in service by the lessee, none of the rent (including the rent from real property) is excluded.

  5. Separate leases for real and personal property which have an integrated use (one or more leases for real property and another lease or leases for personal property to be used upon such real property) will be considered as one lease. See Reg. 1.512(b)–1(c)(2)(iii) and (3)(iii).

    Example:

    On January 1, 1971, A, an exempt organization, executes two leases with B. One is for the rental of a computer, with a stated annual rental of $750. The other is for the rental of office space in which to use the computer, at a stated annual rental of $7,250. The total annual rent under both leases for 1971 is $8,000. At the time the computer is first placed in service, however, taking both leases into consideration, it is determined that notwithstanding the terms of the leases, $3,000, or 37.5 percent ($3,000/$8,000), of the rent is actually attributable to the computer. Therefore, for 1971, only the $5,000 ($8,000 less $3,000) attributable to the rental of the office space is excluded from the computation of A’s unrelated business taxable income. See Reg. 1.512(b)–1(c)(4) Example (1).

  6. If a change in the amount of personal property in service results in an increase of 100 percent or more in the rent attributable to all the personal property leased, or there is a modification of the lease by which there is a change in the rent charged (whether or not there is a change in the amount of personal property rented), the rent attributable to personal property will be recomputed to determine whether the above mentioned 10 percent exclusion or 50 percent exception applies. Any change in the treatment of rents resulting from such recomputation is effective only for the period beginning with the event which occasioned the recomputation. See Reg. 1.512(b)–1(c)(3)(v). The following examples illustrate this principle.

    Example:

    Assume the facts as stated in the example set forth in IRM 7.27.7.4.3(2) above, except that on January 1, 1973, B rents a second computer from A, which is placed in service on that date. The total rent is increased to $2,000 for the computer lease and to $10,000 for the office space lease. It is determined at the time the second computer is first placed in service that notwithstanding the terms of the leases $7,000 of the rent is actually attributable to the computers. Since the rent attributable to personal property has increased by more than 100 percent ($4,000/$3,000 equals 133 percent), a redetermination must be made. As a result, 58.3 percent ($7,000/$12,000) of the total rent is determined to be attributable to personal property. Accordingly, since more than 50 percent of the total rent A receives is attributable to the personal property leased, none of the rents are excluded from the computation of A’s unrelated business taxable income by operation of IRC 512(b)(3).

    Example:

    Assume the facts as stated in the example above, except that on June 30, 1975, the lease between B and A is modified. The total rent for the computer lease is reduced to $1,500 and the total rent for the office space lease is reduced to $7,500. Pursuant to this lease modification by which there is a change in the rent charged, a redetermination is made as of June 30, 1975. As of the modification date, it is determined that notwithstanding the terms of the leases, the rent actually attributable to the computers is $4,000 or 44.4 percent ($4,000/$9,000), of the total rent. Since less than 50 percent of the total rent is now attributable to personal property, the rent attributable to real property ($5,000), for periods after June 30, 1975, is excluded from the computation of A’s unrelated business taxable income by operation of section 512(b)(3). However, the rent attributable to personal property, ($4,000), is not excluded from unrelated business taxable income for such periods by operation of section 512(b)(3) since it represents more than an incidental portion of the total rents.

7.27.6.7.4.4  (02-23-1999)
Exception for Income Based on Net Profits

  1. Where the real or personal property rentals are measured by reference to the net income or profits from the property, the total rent from real and personal property is taxed. However, a lease based on a fixed percentage of the gross receipts or sales will not be taxed solely by reason of such lease. IRC 512(b)(3)(B)(ii) and Reg. 1.512(b)–1(c)(2)(iii)(b).

  2. In Ohio County & Independent Agriculture Societies, Delaware County Fair v. Commissioner, T.C. Memo. 1982–866, an agricultural society exempt under IRC 501(a) as an organization described in IRC 501(c)(5) conducted an annual fair and also rented its fair grounds to a horse sales company. Under a lease agreement, the exempt organization was paid 10 percent of the first $10,000 of the lessee organization’s yearly net profits from sales conducted on the premises, 20 percent of the next $10,000, and 25 percent of all net profits in excess of $20,000. The court held that the rents are based on a percentage of the lessee’s net profits and, therefore, in accordance with IRC 512(b)(3)(B)(ii), are not excluded in computing the tax on unrelated business income.

7.27.6.7.4.5  (02-23-1999)
Rendering of Personal Services

  1. Payment for the use or occupancy of rooms or other space where services are also rendered to the occupant does not constitute rent from real property. Therefore, the exclusion does not include transactions such as the use of hotel rooms, boarding house rooms or apartments furnishing hotel services. Other examples of uses involving services include tourist camps or homes, motels, use of space in parking lots, warehouses or storage garages. See Reg. 1.512(b)–1(c)(5).

  2. Generally, services are considered rendered to the occupant if they are primarily for his/her convenience and are different from those usually or customarily rendered in connection with the rental of rooms or space for occupancy only.

    1. The supplying of maid service constitutes one example of a service rendered to the occupant primarily for his/her convenience and not usually or customarily rendered in connection with the rental of rooms or space for occupancy only. See Reg. 1.512(b)–1(c)(5).

    2. The furnishing of heat and light, the cleaning of public entrances, exits, stairways and lobbies, and the collection of trash are not considered as services rendered to the occupant. See Reg. 1.512(b)–1(c)(5). Also, security services, parking, an unstaffed exercise room, swimming pools, tennis courts and other recreational facilities are services customarily rendered in connection with the rental of rooms or space for occupancy only.

  3. Examples of the effect of IRC 512(b)(3) include:

    1. Because of the services provided, the leasing of studio apartments with dining and other personal services is not excluded from unrelated trade or business income under IRC 512(b)(3). Rev. Rul. 69–69, 1969–1 C.B. 159.

    2. On the other hand, income derived by an exempt organization from the rental of its meeting hall, where only utilities and janitorial services are provided, does constitute rent from real property within the meaning of IRC 512(b)(3). Rev. Rul. 69–178, 1969–1 C.B. 158.

    3. Rev. Rul. 80–297, 1980–2 C.B. 196, considers two situations, both of which describe an exempt school that furnished the use of its tennis facilities for ten weeks during the summer. In the first situation, the school ran a tennis camp through two employees of its athletic department. The employees collected fees, scheduled courts and administered club affairs. The revenue ruling holds that the school’s income, under these circumstances, is not excludable real property rental income under IRC 512(b)(3) due to the personal services the school provides along with the facilities. In the second situation, the school rented its tennis courts to an individual who ran a tennis club through his/her employees. Since the school provided only the facilities, the revenue ruling holds that the school’s income under these circumstances is excludable rental income under IRC 512(b)(3).

    4. Rev. Rul. 80–298, 1980–2 C.B. 197, holds that a university’s leasing of its stadium to a professional football team is an unrelated trade or business under IRC 513, and that income from this activity is not excludable as rent from real property under IRC 512(b)(3). Linen services, ground maintenance, and stadium security provided by the university pursuant to a lease preclude the income from being classified as rent under IRC 512(b)(3).

7.27.6.7.5  (02-23-1999)
Gains and Losses From the Sale, Etc., of Property

  1. IRC 512(b)(5) provides an exclusion from the computation of unrelated business taxable income for gains and losses from the sale, exchange, or other disposition of property which is not:

    1. Stock in trade or other property of a kind which would properly be includable in inventory if on hand at the close of the taxable year; or

    2. Property held primarily for sale to customers in the ordinary course of the trade or business.

  2. In addition, if an organization has made an election under IRC 631 to treat the cutting of timber as a sale or exchange, any gains or losses resulting from such treatment shall not be excluded by reason of IRC 512(b)(5).

  3. If a gain is derived from the sale or other disposition of debt-financed property (IRC 514), it is included in computing unrelated business income to the extent provided in that section.

7.27.6.7.5.1  (02-23-1999)
Option Lapse Income

  1. The term "unrelated business taxable income" does not include gains realized on the lapse or termination of options to buy or sell securities when the options have been written in connection with the exempt organization’s investment activities. This applies whether or not the option is covered. Thus, all premiums received by an exempt organization on an option which it writes under these circumstances, regardless of whether the option lapses or is terminated, are not unrelated business taxable income. See Reg. 1.512(b)–1(d)(2).

  2. This treatment does not apply if an exempt organization writing the options takes such an active role in such activity that its options can be regarded an inventory or as being held for sale to customers in the ordinary course of its trade or business, or if the underlying securities on which the options are written constitute inventory or are being held for sale.

  3. Similarly, if an organization is engaged in the trade or business of writing options, the exclusion will not be available.

  4. IRC 512(b)(5) negates the contrary holding of Rev. Rul. 66–47, 1966–1 C.B. 149, and is effective for options which lapse or are terminated after January 1, 1976.

7.27.6.7.6  (02-23-1999)
Net Operating Loss

  1. Since the tax imposed by IRC 511 applies only to unrelated business taxable income, it is logical that the net operating loss for any taxable year, the carrybacks and carryovers of such losses, and the net operating loss deduction be computed without taking into account any of the income or deduction items which are specifically excluded in computing unrelated business taxable income. If this were not done, organizations would, in effect, be taxed on their exempt income, since unrelated business losses would then be offset by income from dividends, interest, etc. This would reduce the amount of loss which could be applied against unrelated business profits of preceding or succeeding taxable years. Therefore, to preserve the immunity of exempt income, all computations under IRC 172 are restricted to those items of income and deductions which enter into the calculation of unrelated business taxable income.

  2. In line with this concept, any prior taxable year for which the organization was not subject to the tax on unrelated business income is disregarded in computing the net operating loss deduction.

    Example:

    If an organization first became subject to the tax under IRC 511 in 1998, its net operating loss for that year is not a carryback to 1996 or 1997 when it had no unrelated business taxable income, nor is its net operating loss a carryover to succeeding years reduced by the related income of those prior years.

  3. However, Reg. 1.512(b)–1(e)(4) provides that in determining the span of years for which a net operating loss may be carried back or forward, for the purposes of IRC 172, the intervening taxable years for which the organization is not subject to the tax on unrelated business income must be taken into account.

    Example:

    If an organization subject to IRC 511 in 1998 has a net operating loss in that year, the last taxable year to which any part of that loss may be carried over is 2018, regardless of whether or not the organization was subject to the unrelated business income tax in any of the years 1999–2017.

7.27.6.7.7  (02-23-1999)
Income From Research

  1. One of the purposes listed in IRC 501(c)(3) is scientific. Income from research that is substantially related to an organization’s exempt scientific purposes does not constitute unrelated business taxable income.

    1. The term "scientific" includes the carrying on of scientific research in the public interest.

    2. The term "research" has a variety of meanings and is not synonymous with "scientific." The nature of particular research depends upon the purpose which it serves. For research to be scientific within the meaning of IRC 501(c)(3), it must be carried on in furtherance of a scientific purpose. The determination of whether research is scientific does not depend on whether such is classified as "fundamental" or "basic," in contrast to "applied" or "practical." See Reg. 1.501(c)(3)–1(d)(5). See also, IRM 7.27.4, which discusses scientific organizations.

  2. If an organization’s research activities do not meet the requirements for scientific research under Reg. 1.501(c)(3)–1(d)(5), amounts derived from such research might still be excluded from unrelated business taxable income, if the provisions of IRC 512(b)(7), (8), or (9) are applicable.

  3. IRC 512(b)(7) excludes from unrelated business taxable income all income derived from research performed for the United States, or any of its agencies or instrumentalities, or any State or political subdivision thereof. All deductions directly connected with such research are also excluded. Under this provision, an exempt organization that conducts research for the government will not be subject to the tax on unrelated business income regardless of whether the research activities further an exempt purpose. The key consideration with respect to this modification is that the research is being performed for a government entity.

  4. IRC 512(b)(8) excludes from unrelated business taxable income all income derived from research performed "for any person" by a college, university, or hospital. All deductions directly connected with such research are also excluded. Under this provision, income from research conducted by a college, university, or hospital will not be subject to tax on unrelated business income, regardless of whether the research activities further an exempt purpose of such organization. The key consideration with respect to this modification is that the research is being performed by a college, university, or hospital.

  5. IRC 512(b)(9) excludes from unrelated business taxable income all income derived from research performed "for any person" by an organization operated primarily for the purpose of carrying on fundamental research. Such research may be performed "for any person," but the results of such research must be freely available to the general public. The key consideration with respect to this modification is that the nature of the research is "fundamental" rather than "applied."

    1. Whether an organization is operated primarily for the purpose of carrying on fundamental, as opposed to applied, research is a question of fact to be determined based on all the facts and circumstances.

  6. The term "research" does not include activities of a type ordinarily carried on as an incident to commercial or industrial operations, for example, the ordinary testing or inspection of materials or products or the designing or construction of equipment or buildings. Therefore, any income from such sources would constitute unrelated business income to an organization subject to tax under IRC 511, if regularly carried on and not related to its exempt purposes. See Reg. 1.512(b)–1(f)(4).

  7. In Midwest Research Institute v. United States, 554 F. Supp. 1379 (W.D. Mo. 1983) aff’d, 744 F.2d 635 (8th Cir. 1984), an IRC 501(c)(3) scientific organization conducted research projects for independent sponsors on a contract basis. The lower court held that income from such research was not subject to tax on unrelated business income. The court stated that the application of scientific research results through private intermediaries produced public benefit which outweighed private benefit, that most of the income received was from scientific research, and that the research encouraged the development of industry within a particular area. Income received from marketing results of research and rental of computer time was unrelated business taxable income. On appeal, the lower court decision was affirmed by the Eighth Circuit.

  8. In IIT Research Institute v. United States, 9 Ct. Cl. 13 (1985), an IRC 501(c)(3) scientific organization carried on numerous research assignments of various types pursuant to contracts. The organization generally priced its research services to cover its direct costs, overhead costs and a profit of six percent. Of 650 contracts, 58 were selected as being representative of the organization’s research endeavors. Of the 58 representative contracts, 34 were conceded to be substantially related. The remaining 24 were the subject of the court opinion. The Claims Court found that the research contracts were substantially related to scientific purposes because they either:

    1. involved the use of observation or experimentation to formulate or verify facts or natural laws;

    2. could only have been performed by an individual possessing scientific or technical expertise;

    3. added to knowledge within a particular scientific field;

    4. involved the application of scientific or mathematical reasoning; and/or

    5. were attempts to systematize or classify a body of scientific knowledge by collecting information and presenting it in a useful form. The court held that the research activities were not commercial in nature, and that research results need not be published in every instance in order to serve a public purpose. The court concluded by noting that in any event, income from nine of the 24 challenged contracts was excluded from unrelated business taxable income by IRC 512(b)(7). The organization performed research for the United States or a political subdivision of a state in these nine contracts.

7.27.6.7.8  (02-23-1999)
Charitable Contributions Deductions

  1. Under IRC 512(b)(10), an organization described in IRC 511(a) is allowed a deduction for charitable contributions up to 10 percent of its unrelated business taxable income computed without regard to the deduction for contributions. The provisions of IRC 170(b)(2) are not applicable to contributions by organizations described in IRC 511(a)(2). See Reg. 1.512(b)–1(g)(1).

  2. Under IRC 512(b)(11), a trust described in IRC 511(b) (2) is allowed a deduction for charitable contributions within the limitations prescribed by IRC 170(b)(1)(A) and (B). However, the limitation on the deduction is determined by reference to unrelated business taxable income computed without regard to the deduction, rather than by reference to adjusted gross income. The deduction is allowed whether or not the contributions are directly connected with the unrelated business. For the purposes of this deduction, a distribution by the trust made pursuant to the trust instrument to a beneficiary described in IRC 170 is treated in the same manner as a contribution. See Reg. 1.512(b)–1(g)(2).

  3. Contributions, in order to be deductible, must be paid to another organization which qualifies under IRC 170(c). For example, an exempt university which operates an unrelated business may deduct a contribution made to another university, but may not claim a deduction for contributions with respect to amounts spent for administering its own educational program. See Reg. 1.512(b)–1(g)(3).

  4. In Crosby Valve & Gage Company v. Commissioner, 380 F.2d 146 (1st Cir. 1967), cert. denied, 389 U.S. 976 (1967), the court considered whether a business corporation, wholly-owned by a charitable foundation, was entitled to claim a deduction for property transferred to its parent without consideration. The court concluded that the transfer of property from subsidiary to parent was not a gift that was deductible under IRC 170. Citing IRC 512(b)(10), the court stated that a charitable organization is barred from making contributions to itself, and there is no reason for a difference in tax treatment merely because the income was earned by a wholly-owned subsidiary, rather than directly by the tax-exempt organization.

  5. In South End Italian Independent Club, Inc. v. Commissioner, 87 T.C. 168 (1986), acq. in result, 1987–2 C.B. 1, the court held that an IRC 501(c)(7) social club that distributed its net proceeds from the operation of beano games in accordance with state law was not subject to the limitations imposed by IRC 512(b)(10), since the proceeds were deductible as ordinary and necessary business expenses under IRC 162, rather than as charitable contributions under IRC 170. See also, Women of the Motion Picture Industry, et al. v. Commissioner, T.C. Memo. 1997–518, where the Tax Court stated that "...the transfer of ‘instant Bingo’ proceeds to an organization’s general fund is no more deductible than would be a contribution to a reserve for future liabilities."

7.27.6.7.9  (02-23-1999)
Specific Deduction

  1. IRC 512(b)(12) provides for a $1,000 deduction from gross income in computing unrelated business taxable income, except that no deduction is allowed in computing the net operating loss under IRC 172. The deduction is limited to $1,000 regardless of the number of unrelated businesses in which the organization is engaged. Rev. Rul. 68–536, 1968–2 C.B. 244.

  2. An exception is provided in the case of a diocese, province of a religious order, or a convention or association of churches which may claim for each parish, individual church, district, or other local unit, a specific deduction limited to the lower of $1,000 or the gross income derived from an unrelated trade or business regularly carried on by such local unit. If a local unit is a legal entity, it must file a separate return and claim its own specific deduction not to exceed $1,000. In such case the diocese, province of a religious order, or convention or association of churches may not also claim that deduction. See Reg. 1.512(b)–1(h)(2).

7.27.6.7.10  (02-23-1999)
Income From Controlled Organizations

  1. In general, rent, interest, royalty and annuity expenses are deductible in computing the income of a business, and receipt of such income by tax-exempt organizations, before the Tax Reform Act of 1969, was not subject to tax. Some exempt organizations would, therefore, "rent" their physical plant to a wholly-owned taxable corporation for 80 percent or 90 percent of all the net profits (before taxes and before the rent deduction). This arrangement enabled the taxable corporation to escape nearly all of its income taxes because of the large "rent" deduction. S. Rep. No. 91–552, 91st Cong., 1st Sess. 73 (1969), 1969–3 C.B. 471.

  2. The Internal Revenue Service had not always been successful in its attempt to treat such rents as unrelated business taxable income and to characterize the payments according to the substance of the transaction regardless of its form.

    1. In one case, an exempt foundation transferred its working interests in oil and gas properties to two corporations of which it was the controlling shareholder under agreements giving it "net profits overriding royalties" and requiring the company to look only to the income from production for reimbursement of expenses. The District Court held that the foundation was not engaged in a trade or business and that the contracts under which the foundation received income in the form of overriding royalties "...did in truth and in fact create income from overriding royalties and not income from working interests." The Court of Appeals rejected the Government’s argument that the contracts, though framed as to create an appearance of overriding royalties, were in substance working interests. The court concluded that the amounts involved were royalties. United States v. Robert A. Welch Foundation, 288 F. Supp. 881 (D.C. Tex. 1963), aff’d 334 F.2d 774 (5th Cir. 1964).

    2. In Rev. Rul. 69–162, 1969–1 C.B. 158, the Service announced that it would not follow the decision in Welch, but would continue to review exempt organizations’ transfers of mineral properties to controlled corporations.

  3. IRC 512(b)(13) was added by the Tax Reform Act of 1969. This addition was part of an ongoing attempt to deal with the recharacterization issue.

  4. In J. E. and L. E. Mabee Foundation v. United States, 533 F.2d 521 (10th Cir. 1976), a taxable corporation engaged in the production and sale of oil and gas through ownership of oil and gas leases. The corporation was a wholly-owned subsidiary of a tax-exempt foundation, which received payments directly from oil purchasers rather than indirectly through its subsidiary. The foundation argued that the provisions of IRC 512(b)(13) should not be applicable because the income was not "derived from" the subsidiary. The court rejected this argument and held that Congress intended to tax a charitable organization’s receipt of "royalties" from a controlled organization. In the court’s view, taxation does not depend upon the mechanical formality of whether the overriding royalty income was paid through the controlled organization generating the income, or directly to the charitable recipient.

7.27.6.7.10.1  (02-23-1999)
Computation of Unrelated Business Taxable Income From Controlled Organizations

  1. Under IRC 512(b)(13) the exclusions of interest, annuities, royalties and rents provided by IRC 512(b)(1), (2), and (3) do not apply where those amounts are derived from controlled organizations.

  2. Section 1041(a) of The Taxpayer Relief Act of 1997 revised IRC 512(b)(13) effective for tax years beginning after August 5, 1997, except for any payment made during the first two taxable years beginning on or after August 5, 1997, if the payment is made pursuant to a written binding contract in effect on June 8, 1997, and at all times thereafter before the payment.

  3. IRC 512(b)(13) now provides that, if an organization (referred to as the "controlling organization" ) receives or accrues (directly or indirectly) a "specified payment" from another entity which it controls (referred to as the "controlled entity" ), the controlling organization must include the payment as an item of gross income derived from an unrelated trade or business to the extent the payment reduces the net unrelated income of the controlled entity (or increases any net unrelated loss of the controlled entity),

    1. All deductions of the controlling organization directly connected with amounts treated as derived from an unrelated trade or business under the preceding sentence are allowed.

    2. For purposes of IRC 512(b)(13) the term "net unrelated income" means in the case of a controlled entity which is not exempt from tax under IRC 501(a), the portion of the entity’s taxable income which would be unrelated business taxable income if the entity were exempt from tax under IRC 501(a) and had the same exempt purposes as the controlling organization, or in the case of a controlled entity which is exempt from tax under IRC 501(a), the amount of the unrelated business taxable income of the controlled entity.

    3. For purposes of IRC 512(b) (13) the term "specified payment" means any interest, annuity, royalty, or rent.

    4. For purposes of IRC 512(b)(13) the term "control" means in the case of a corporation, ownership (by vote or value) of more than 50 percent of the stock in such corporation; in the case of a partnership, ownership of more than 50 percent of the profits interests or capital interests in such partnership, or in any other case, ownership of more than 50 percent of the beneficial interests in the entity.

    5. Under IRC 512(b)(13)(D)(ii), the constructive ownership rules of IRC 318 (relating to constructive ownership of stock) apply for purposes of determining ownership of stock in a corporation. Similar principles shall apply for purposes of determining ownership of interests in any other entity.

7.27.6.7.11  (02-23-1999)
Special Exclusion for a Religious Order

  1. IRC 512(b)(15) provides an exclusion from unrelated business taxable income carried on by a religious order or by an educational institution maintained by such order. This special exception is intended to cover a trade or business which has been operated since before May 27, 1959, and which consists of providing services under a license issued by a federal regulatory agency. More than 90 percent of the net income from the business must be devoted to religious, charitable or educational purposes. The organization must also establish that the rates or other charges for such services are competitive with the rates or other charges of similar taxable businesses. See Reg. 1.512(b)–1(j) and S. Rep. No. 91–552, 91st Cong., 1st Sess. 70 (1969), 1969–3 C.B. 469.

7.27.6.8  (02-23-1999)
Special Rules for Partnerships

  1. Generally, the unrelated business taxable income provisions cover situations where an exempt organization itself pursued the unrelated trade or business as a part of its overall activities. It is possible, however, that the organization is deriving unrelated business income not through direct dealings with the public but as a member of a partnership. If so, it must treat its share of the partnership income in the same fashion as if it had conducted the business activity in its own capacity as a corporation or trust.

  2. IRC 512(c) provides that if an organization to which IRC 511 applies is a member of a partnership regularly engaged in a trade or business which is an unrelated trade or business with respect to such organization, the exempt entity must include in its unrelated business taxable income that portion of its share of the partnership gross income (whether or not distributed), and the deductions attributable thereto, which is derived from the unrelated trade or business.

  3. The exceptions, additions and limitations contained in IRC 512(b) and discussed earlier in this Section also apply to partnership income and will, therefore, be taken into account for purposes of this computation. For instance, if an exempt educational institution is a partner in a partnership which operates a factory, and if such partnership also holds stock in a corporation, the exempt organization must include its share of the gross income from the operation of the factory in its unrelated business taxable income, but may exclude its share of any dividends received by the partnership from the corporation. See Reg. 1.512(c)–1.

  4. If the exempt organization and the partnership of which it is a member have different taxable years, the partnership items which enter into the computation of the organization’s unrelated business taxable income must be based on the income and deductions of the partnership for the taxable year of the partnership which ends within the organization’s taxable year.

  5. The term "unrelated business taxable income" does not include income from a limited partnership interest derived by certain testamentary trusts, if a number of highly restrictive conditions are met. For further details, see sections 1951(b)(8) and 1951(d) of the Tax Reform Act of 1976, Pub. L. No. 94–455.

  6. In Service Bolt and Nut Co. v. Commissioner, 724 F.2d 519 (6th Cir. 1983), the court considered whether amounts received from limited partnership interests constitute unrelated business taxable income. Qualified profit sharing trusts exempt under IRC 501(a) as organizations described in IRC 401(a) received income from limited partnerships. The court cited IRC 512(c), which provides that an exempt organization can be taxed on its share of the income received from a partnership of which it is a member, even though the partnership and not the exempt organization is the entity actively engaged in carrying on a trade or business. Refusing to distinguish between general partners and limited partners, the court concluded that income derived from limited partnership interests constitutes unrelated business taxable income.

7.27.6.8.1  (02-23-1999)
Publicly Traded Partnerships

  1. Section 13145(a)(1) of the Omnibus Budget Reconciliation Act of 1993, Pub. L. No. 103–66 (OBRA ‘93) repealed IRC 512(c)(2) to make it easier for exempt organizations to invest in publicly traded partnerships.

  2. The term "publicly traded partnership" is defined in IRC 7704 as a partnership whose interests are either traded on an established securities market, or are readily tradable on a secondary market (or the substantial equivalent thereof).

  3. To prevent passive income generated from a publicly traded partnership from escaping taxation, Congress enacted IRC 512(c)(2) as part of the Omnibus Budget Reconciliation Act of 1987. Before its repeal, IRC 512(c)(2) taxed all income from a publicly traded partnership as unrelated business income. IRC 512(c)(2) did not take into account whether the underlying character of the income was related or unrelated.

  4. IRC 512(c)(2) deterred exempt organizations from investing in publicly traded partnerships. Passive income that was not subject to unrelated business income tax when received from a non-publicly traded partnership was unrelated business income when received from a publicly traded partnership. IRC 512(c)(2) was repealed by OBRA ‘93, because Congress believed exempt organizations could provide a valuable source of capital that should be available to publicly traded partnerships. H.R. Rep. No. 103–111, 103rd Cong., 1st Sess. 617 (1993).

  5. With the repeal of IRC 512(c)(2) by OBRA ‘93, exempt organizations’ investments in publicly traded partnerships will be treated the same as income from other partnerships for purposes of determining unrelated business taxable income.

7.27.6.9  (02-23-1999)
Associate Member Dues

  1. Associate member dues are amounts paid to membership organizations by persons who may or may not receive all the rights and privileges afforded full members. Many organizations have long had various classes of members, however, associate membership became a significant issue in certain instances where exempt organizations created an associate (or limited benefit) member class in order for such individuals to qualify for insurance coverage, and their dues payments were merely payments for such insurance.

  2. Rev. Proc. 95–21, 1995–1 C.B. 686, provides that dues payments from associate members will not be treated as gross income from the conduct of an unrelated trade or business unless the associate member category was formed or availed or for the principal purpose of producing unrelated business income. Rev. Proc. 97–12, 1997–1 C.B. 631, is substantially similar to its predecessor with two significant clarifying provisions. First, the newer revenue procedure discusses IRC 512(d), which applies to the treatment of dues paid to IRC 501(c)(5) agricultural or horticultural organizations, and secondly, it extends the application of Rev. Proc. 95–21 to organizations described in IRC 501(c)(6), such as business leagues, chambers of commerce, real estate boards and boards of trade.

7.27.6.9.1  (02-23-1999)
Safe Harbor for Agricultural and Horticultural Organizations

  1. IRC 512(d), which applies to years beginning after December 31, 1986, provides a "safe harbor" from unrelated business taxable income for dues of $100 or less, indexed for inflation, paid to IRC 501(c)(5) agricultural or horticultural organizations. See section 1115(a) of the Small Business Job Protection Act of 1996 (Pub. L. No. 104–188). Under IRC 512(d), if an organization requires the payment of annual dues and the amount of the dues does not exceed $100, the dues will not be treated as derived from an unrelated trade or business. The statute provides that the $100 dues ceiling will be indexed according to a cost of living adjustment for tax years beginning in a calendar year after 1995. It also defines "dues" as any payment, whether or not specifically designated as dues, that is required to be made in order to be recognized as a member of the organization.

7.27.6.10  (02-23-1999)
Special Rules for S Corporations

  1. Section 1316(a)(2) of the Small Business Job Protection Act, Pub. L. No. 104–188 110 Stat. 1755 (1996), added IRC 1361(c)(7) (redesignated as IRC 1361(c)(6) by the Taxpayer Relief Act of 1997, Pub. L. No. 105–34, 111 Stat. 788 (1997) (TRA ‘97)) to allow organizations described in IRC 501(c)(3) and 401(a) and exempt from tax under IRC 501(a) to own stock in an S Corporation without causing the corporation to lose its S Corporation status.

  2. However, under IRC 512(e), the items of income, deduction or loss that are considered to be distributed by the S Corporation to a shareholder that is a tax-exempt organization will in all cases be treated as unrelated business taxable income by the exempt organization, regardless of the source or nature of the income, deduction or loss. In addition, any gain or loss on the disposition of the S Corporation stock by the exempt organization will be treated as unrelated business taxable income.

7.27.6.11  (02-23-1999)
Digests of Published Rulings and Procedures for Computation of Unrelated Business Taxable Income

  1. Fundamental research.— Income derived from research by a tax-exempt college, university, or hospital, or by a tax-exempt organization and operated primarily for the purpose of carrying on fundamental research, does not constitute income from an unrelated trade or business. Income derived by any organization to which Supplement U (predecessor to the tax on unrelated business income) is applicable from research for the United States or any of its agencies or for a State or political subdivision thereof is not income from an unrelated trade or business. Rev. Rul. 54–73, 1954–1 C.B. 160.

  2. Leased equipment.— The trustee of an employees’ trust described in IRC 401(a) and exempt under IRC 501(a) purchased railroad tank cars in the name of the trust. These cars were leased to an industrial company for a period of years with options for renewals. The sole activity with respect to this venture of the trustee is to receive the periodic rental income, the lessee having the responsibility for operation and maintenance of the cars. Under these circumstances the trust is subject to tax on the rental income from the personal property as unrelated business taxable income. Rev. Rul. 60–206, 1960–1 C.B. 201.

  3. Leased pipeline.— Income derived by an exempt organization from the lease of a pipeline system, consisting of right-of-way interests in land, pipelines buried in the ground, pumping stations, plants, equipment, and other appurtenant properties, constitutes rent from real property (including personal property leased with the real property) within the meaning of IRC 512(b) (3). Rev. Rul. 67–218, 1967–2 C.B. 213.

  4. Leasing studio apartments; services rendered; not considered rental.— The leasing of studio apartments and the operation of a dining hall is unrelated trade or business where occupancy in the apartments is neither primarily for the convenience of members nor based on criteria which further the exempt purposes of the organization. Because substantial services are rendered, payments by tenants are not considered rent under the IRC 512(b)(3) exclusion. Rev. Rul. 69–69, 1969–1 C.B. 159.

  5. Meeting hall; occasional rental.— Income derived by an exempt organization from the occasional use of its meeting hall constitutes rents from real property within the meaning of IRC 512(b)(3) and is excluded in determining unrelated business taxable income. Rev. Rul. 69–178, 1969–1 C.B. 158.

  6. Mineral interest income.— An exempt organization’s income from a mineral interest is not a royalty excluded from the computation of unrelated business taxable income by IRC 512(b)(2) where the organization is liable for the operating expenses associated with its interest. Rev. Rul. 69–179, 1969–1 C.B. 158.

  7. Patent development fees.— Patent development and management service fees deducted from royalties collected from licensees by an exempt charitable organization for distribution to the beneficial owners of the patents is not within the exception for royalties provided by IRC 512(b)(2) in determining unrelated business taxable income. Rev. Rul. 73–193, 1973–1 C.B. 262.

  8. Royalties received as patent owner.— Amounts received from licensees by an exempt organization, the legal and beneficial owner of patents assigned to it by inventors for specified percentages of future royalties, constitute royalty income that is excludable in computing unrelated business taxable income; Rev. Rul. 73–193 distinguished. Rev. Rul. 76–297, 1976–2 C.B. 178.

  9. Summer tennis camp conducted on school campus.— Amounts received by an exempt school that annually contracts with an individual who conducts a summer tennis camp with the school furnishing the tennis courts, housing and dining facilities are from dual use of facilities and personnel rather than exploitation of exempt functions. An allocable portion of expenses attributable to the facilities and personnel may be deducted in computing unrelated business taxable income. Rev. Rul. 76–402, 1976–2 C.B. 177.

  10. Income from lending securities.— Income derived by an exempt organization from the temporary transfer of securities to a brokerage house to cover short sales of the brokerage house in exchange for collateral of equal value, which is held by the organization pursuant to a contract requiring the brokerage house to pay the organization an amount equivalent to the dividend or interest income that would have been earned by the securities plus either a premium based on a percentage of the value of the securities or income earned from investing the collateral is not subject to tax as unrelated business taxable income. Rev. Rul. 78–88, 1978–1 C.B. 163.

  11. Income from limited partnership.— The investment of an exempt employees’ trust as a limited partner in a partnership carrying on an unrelated trade or business may result in unrelated business taxable income within IRC 512. In setting forth specific rules applicable to members of partnerships in computing their unrelated business taxable income, IRC 512(c) makes no distinction between general and limited partners. Rev. Rul. 79–222, 1979–2 C.B. 236.

  12. Interest and service fees on mortgage loans.— Interest income earned by an exempt employees’ trust from mortgage loans, which form a significant portion of the trust’s assets, does not enter into the computation of unrelated business taxable income under IRC 512. Service fee receipts earned by the trust in connection with such loans, however, do enter into the computation. Rev. Rul. 79–349, 1979–2 C.B. 233.

  13. School leasing tennis facilities.—- An exempt school that uses its tennis facilities for ten weeks in the summer as a public tennis club operated by employees of the school’s athletic department is engaged in unrelated trade or business, and the income earned is not excludable from unrelated business taxable income as rent from real property. If the school leases the tennis facilities for a fixed fee to an unrelated individual who operates a tennis club for the public, the school is still engaged in unrelated trade or business, but the lease income is excluded from unrelated business taxable income as rent from real property. Rev. Rul. 76–402 amplified. Rev. Rul. 80–297, 1980–2 C.B. 196.

  14. University leasing stadium.— An exempt university that leases its stadium to a professional football team for several months of the year and provides the utilities, grounds maintenance, and dressing room, linen, and stadium security services is engaged in unrelated trade or business. Further, the university’s income from the lease is not excluded from unrelated business taxable income as rent from real property. Rev. Rul . 80–298, 1980–2, C.B. 197.

  15. Allocation of membership receipts.— In computing the amount of unrelated business taxable income from advertising in an exempt organization’s periodical, the proper method of allocating membership receipts to circulation income under the formula in Reg. 1.512(a)–1(f)(4)(iii) is illustrated. Rev. Rul. 81–101, 1981–1 C.B. 352.

  16. Payments for personal appearances.— Payments an exempt labor organization receives from various business enterprises for the use of the organization’s trademark and similar properties are royalties within IRC 512(b)(2) and are not taken into account in determining unrelated business taxable income. However, payments the organization receives for personal appearances and interviews by its members are not royalties, but are compensation for personal services and must be taken into account in computing the organization’s unrelated business taxable income. Rev. Rul. 81–178, 1981–2 C.B. 135.

  17. Associate member dues.— Dues payments from associate members of organizations described in IRC 501(c)(5) will not be treated as gross income from the conduct of an unrelated trade or business unless the associate member category was formed or availed of for the principal purpose of producing unrelated business income. Rev. Proc. 95–21, 1995–1 C.B. 686.

  18. Associate member dues.— Rev. Proc. 95–21 is amplified, in part, and modified, in part, by referring to IRC 512(d), and by extending the principles contained in Rev. Proc. 95–21 to organizations described in IRC 501(c)(6). Rev. Proc. 97–12, 1997–1 C.B. 631.


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