(i) Tax-Exempt Organizations Involved.   The sanctions apply with respect to tax-exempt public charities,¹⁷² tax-exempt social welfare organizations,¹⁷³ and tax-exempt health insurance issuers.¹⁷⁴ These organizations are termed applicable tax-exempt organizations.¹⁷⁵ Organizations of this nature include any organization described in one of these three categories of exempt organizations at any time during the five-year period ending on the date of the transaction.¹⁷⁶

There are no exemptions from these rules. That is, all tax-exempt public charities, social welfare organizations, and health insurance issuers are applicable tax-exempt organizations.

(ii) Excess Benefit Transactions.   This tax regime has as its heart the excess benefit transaction. Essentially, an excess benefit transaction is the same as a private inurement transaction. In an instance of one of these transactions, tax sanctions can be imposed on the disqualified person or persons who improperly benefited from the transaction and perhaps on any organization managers who participated in the transaction knowing that it was improper.

The term excess benefit transaction is based on the contract law concept of consideration, which means the approximately equal benefits that parties to a contract must receive from the arrangement; consideration is required for the agreement to be enforceable. An excess benefit transaction is any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person, if the value of the economic benefit provided by the exempt organization exceeds the value of the consideration (including the performance of services) received for providing the benefit.¹⁷⁷ This type of benefit is known as an excess benefit.¹⁷⁸

The principal focus is on compensation, which generally is all economic benefits provided by an applicable tax-exempt organization in exchange for performance of services. Compensation generally includes all forms of cash and noncash compensation (including salary, fees, bonuses, severance payments, and deferred compensation), payment of liability insurance premiums, payments to welfare benefit plans (such as medical, dental, life insurance, severance pay, and disability benefits plans), and fringe benefits.¹⁷⁹

An economic benefit may not be treated as consideration for performance of services unless the organization clearly intended and made the payments as compensation for services.¹⁸⁰ In determining whether payments or transactions of this nature are forms of compensation, the relevant factors include whether the appropriate decision-making body approved the transfer as compensation in accordance with established procedures and whether the organization and the recipient reported the transfer (other than in the case of nontaxable fringe benefits) as compensation on relevant returns or other forms.¹⁸¹

The phrasing directly or indirectly means the provision of an economic benefit directly by the organization or indirectly by means of a controlled entity. Thus, an applicable tax-exempt organization cannot avoid involvement in an excess benefit transaction by causing a controlled entity to engage in the transaction.¹⁸²

Existing law standards, including those established under the law concerning ordinary and necessary business expenses,¹⁸³ apply in determining reasonableness of compensation and fair market value.¹⁸⁴ In this regard, an individual need not necessarily accept reduced compensation merely because they render services to a tax-exempt, as opposed to a taxable, organization.¹⁸⁵ If there are comparable institutions in the for-profit sector (such as hospitals), compensation paid to their executives may be taken into account in determining reasonableness.

There is no requirement, generally, that a disqualified person know that a transaction is an excess benefit transaction. An individual can act in good faith and nonetheless be penalized for engaging in what turns out to be an excess benefit transaction.

The first of the intermediate sanctions cases involved the issue as to whether certain transactions—the sale of assets of applicable tax-exempt organizations to disqualified persons—constituted excess benefit transactions. The court held that they were, in that the value of the transferred assets “far exceeded” the consideration paid by the disqualified persons.¹⁸⁶

Automatic Excess Benefit Transactions. An economic benefit may not be treated as consideration for the performance of services unless the organization providing the benefit clearly indicates its intent to treat the benefit as compensation when paid (such as by issuance of an IRS Form W-2 or 1099).¹⁸⁷ These transactions are known as automatic excess benefit transactions. A transaction can be an automatic excess benefit transaction even though its terms and conditions show that it is, in fact, reasonable. Transactions of this nature include the provision by an applicable tax-exempt organization to a disqualified person, for personal purposes, of use of a vehicle, access to the organization's charge accounts, and payment for the expenses of spousal travel.

(iii) Revenue-Sharing Transactions.   To the extent provided in tax regulations, the term excess benefit transaction includes any transaction in which the amount of any economic benefit provided to or for the use of a disqualified person is determined in whole or in part by the revenues of one or more activities of the organization, but only if the transaction results in impermissible private inurement.¹⁸⁸ In this context, the excess benefit is the amount of impermissible private inurement.

This type of compensation structure is a revenue-sharing arrangement. These rules, technically, are not in force because accompanying tax regulations have not been promulgated.¹⁸⁹ Nonetheless, the IRS is applying the general rules to revenue-sharing arrangements.

A revenue-sharing arrangement may be an excess benefit transaction if it permits a disqualified person to receive additional compensation without providing proportional benefits that contribute to the charitable organization's accomplishment of its exempt purpose.¹⁹⁰

(iv) Rebuttable Presumption of Reasonableness.   There is a rebuttable presumption of reasonableness with respect to compensation and other arrangements with disqualified persons. Where the criteria of the presumption are satisfied, the burden of proving an excess benefit transaction shifts to the IRS. The presumption arises where the arrangement was approved by a board of directors or trustees (or committee of the board) that was composed entirely of individuals unrelated to and not subject to the control of the disqualified persons involved in the arrangement, obtained and relied upon appropriate data as to comparability, and adequately documented the basis for its determination.¹⁹¹

(v) Disqualified Persons.   In this context, the term disqualified person means any person who was, at any time during the five-year period ending on the date of the transaction involved, in a position to exercise substantial influence over the affairs of the organization.¹⁹² The term also means a member of the family of an individual who meets this definition and an entity in which persons described in either of these two categories own more than a 35 percent interest.¹⁹³

The following persons are deemed—automatically—to be disqualified persons (i.e., to have substantial influence): voting members of the governing body; presidents, chief executive officers, and chief operating officers; and treasurers and chief financial officers.¹⁹⁴ Persons deemed to not have substantial influence include other tax-exempt charitable organizations and employees who are not highly compensated employees for employee benefit purposes.¹⁹⁵

Certain facts and circumstances are considered in determining whether a person is a disqualified person. Facts and circumstances that tend to show substantial influence include the fact that the person founded the organization; the person is a substantial contributor to the organization; the person's compensation is primarily based on revenues derived from activities of the organization that the person controls; the person has or shares authority to control or determine a substantial portion of the organization's capital expenditures, operating budget, or compensation for employees; or the person manages a discrete segment or activity of the organization that represents a substantial portion of the activities, assets, income, or expenses of the organization, as compared with the organization as a whole.¹⁹⁶

Facts and circumstances that tend to show no substantial influence over the affairs of an organization include the fact that the person has taken a vow of poverty on behalf of a religious organization; the person functioned as a lawyer, accountant, or investment manager or advisor; or the person does not participate in any management decisions affecting the organization as a whole or a discrete segment or activity of the organization that represents a substantial portion of the organization's activities, assets, income, or expenses.¹⁹⁷

Disqualified persons include organization managers. These are individuals who are trustees, directors, or officers of an applicable tax-exempt organization, as well as those having powers or responsibilities similar to those of trustees, directors, or officers of the organization.¹⁹⁸ The term member of the family is defined as (1) spouses, ancestors, children, grandchildren, great-grandchildren, and the spouses of children, grandchildren, and great-grandchildren, and (2) the brothers and sisters (whether by the whole or half-blood) of the individual and their spouses.¹⁹⁹

(vi) Initial Contract Exception.   The intermediate sanctions rules do not apply to a fixed payment made to a person pursuant to an initial contract. A fixed payment is an amount of money or other property specified in the contract, or determined by a fixed formula specified in the contract, which is to be paid or transferred in exchange for the provision of specified services or property.²⁰⁰ A fixed formula may incorporate an amount that depends on future events (such as an increase in the Consumer Price Index) or contingencies, provided that no person exercises discretion when calculating the amount of a payment or deciding whether to make a payment (such as a bonus). A specified event or contingency may include the amount of revenues generated by (or other objective measure of) one or more activities of the charitable organization.

A fixed payment does not include any amount paid to a person under a reimbursement or similar arrangement where discretion is exercised by any person with respect to the amount of expenses incurred or reimbursed.

An initial contract is a binding written contract between an applicable tax-exempt organization and a person who was not a disqualified person immediately before entering into the contract. This exception, however, does not apply to any fixed payment made pursuant to an initial contract during any tax year of the person contracting with the organization, if the person fails to perform substantially the person's obligations under the contract during that year.

A written binding contract that provides that the contract is terminable or subject to cancellation by the applicable tax-exempt organization (other than as a result of a lack of substantial performance by the disqualified person) without the other party's consent and without substantial penalty to the organization is treated as a new contract as of the earliest date that any such termination or cancellation, if made, would be effective.

A compensation package can be partially sheltered by these rules. For example, a person can have a base salary that is a fixed payment pursuant to an initial contract and also have an annual performance-based bonus.

(vii) Tax Structure.   The intermediate sanctions penalties are structured as excise taxes. A disqualified person who benefited from an excess benefit transaction is subject to an initial excise tax equal to 25 percent of the amount of the excess benefit.²⁰¹ An additional tax, in an amount equal to 200 percent of the amount involved, may be imposed on a disqualified person where the initial tax was imposed and if there was no correction (defined below) of the excess benefit transaction within a specified period.²⁰²

An organization manager who participated in an excess benefit transaction, knowing that it was this type of a transaction, is subject to an initial excise tax of 10 percent of the excess benefit where an initial tax is imposed on a disqualified person.²⁰³

Taxes on excess benefit transactions that are corrected (see following discussion) within the correction period may be eligible for abatement.²⁰⁴

(viii) Correction.   In addition to payment of the tax penalties, the transaction must be corrected. The term correction means undoing the excess benefit to the extent possible and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.²⁰⁵

The correction amount with respect to an excess benefit transaction is the sum of the excess benefit and interest on the excess benefit.²⁰⁶ The amount of the interest charge is determined by multiplying the amount of the excess benefit by an interest rate, compounded annually, for the period from the date the excess benefit transaction occurred to the date of correction.

Caution should be exercised when correcting an excess benefit transaction. If not undertaken properly, the attempted undoing of the arrangement can cause another excess benefit transaction.

(ix) Reporting of Excess Benefit Transactions.   Disqualified persons and organization managers liable for payment of excise taxes as the result of excess benefit transactions are required to file Form 4720 as the return by which these taxes are paid. An excess benefit transaction must also be reported on the annual information return of the applicable tax-exempt organization.²⁰⁷

(x) Scope of Sanctions.   These intermediate sanctions may be imposed by the IRS in lieu of or in addition to revocation of an organization's tax-exempt status.²⁰⁸ The sanctions are, in general, to be the sole sanction imposed in those cases in which the excess benefit does not rise to such a level as to call into question whether, on the whole, the organization functions as a charitable or social welfare organization.

In practice, the revocation of tax-exempt status, with or without the imposition of these excise taxes, is to occur only when the organization no longer operates as a charitable or social welfare organization.²⁰⁹ Preexisting law principles apply in determining whether an organization no longer operates as a tax-exempt organization. The loss of tax-exempt status could occur in a year, or as of a year, the organization was involved in a transaction constituting a substantial amount of private inurement.²¹⁰

(xi) Additional Penalties.   A person may be assessed penalties for acting willfully and flagrantly in the intermediate sanctions setting.²¹¹ In one instance, a tax advisor explained the private inurement rules to a disqualified person, who nonetheless continued a pattern of engaging in excess benefit transactions, thereby incurring this penalty.²¹²

(xii) Interrelationship with Private Inurement Doctrine.   The intermediate sanctions penalties may be imposed by the IRS in lieu of or in addition to revocation of the tax-exempt status of an applicable tax-exempt organization.²¹³ In general, these sanctions are the sole penalty imposed in cases in which the excess benefit does not rise to such a level as to call into question whether, on the whole, the organization functions as an applicable tax-exempt organization.²¹⁴

Revocation of tax-exempt status, with or without imposition of intermediate sanctions taxes, is to occur only when the applicable tax-exempt organization no longer operates as an applicable tax-exempt organization.²¹⁵ Existing law principles apply in determining whether an applicable tax-exempt organization no longer operates as an exempt organization. For example, the loss of exempt status would occur in a year, or as of a year, the entity was involved in a transaction constituting a substantial amount of private inurement.

Tax regulations provide that, in determining whether to continue to recognize the tax exemption of a charitable entity that engages in an excess benefit transaction that violates the private inurement doctrine, the IRS will consider all relevant facts and circumstances, including (1) the size and scope of the organization's regular and ongoing activities that further exempt purposes before and after one or more excess benefit transactions occurred, (2) the size and scope of one or more excess benefit transactions in relation to the size and scope of the organization's regular and ongoing exempt functions, (3) whether the organization has been involved in multiple excess benefit transactions, (4) whether the organization has implemented safeguards that are reasonably calculated to prevent future violations, and (5) whether the excess benefit transaction has been corrected or the organization has made good-faith efforts to seek correction from the disqualified person or persons who benefited from the excess benefit transaction.²¹⁶

The fourth and fifth of these factors “weigh more heavily” in favor of continuing tax exemption where the organization has discovered the excess benefit transaction and takes corrective action before the IRS learns of the matter. Correction of an excess benefit transaction after the IRS discovers it, by itself, is never a sufficient basis for continuing recognition of exemption.²¹⁷

(i) Tax-Exempt Organizations Involved.   These intermediate sanctions apply with respect to all charitable organizations, other than private foundations. That is, the sanctions apply with respect to all public charities. Therefore, from the standpoint of charitable fundraising, the charity involved is almost certain to be an applicable tax-exempt organization.

(ii) Disqualified Persons in Fundraising Context.   Generally, a fundraising executive is not a disqualified person with respect to the charitable organization being served. He or she is not normally in a position to exercise substantial influence over the affairs of the organization. This is usually the case when the fundraiser is an employee (such as a director of development) or a consultant (independent contractor).

There are, nonetheless, situations where the fundraising professional is a disqualified person. The fundraiser may be an organization manager. If the fundraising function is in a related entity, such as a foundation²¹⁸ directly affiliated with a university or hospital, and the fundraiser is the chief executive officer of that foundation, he or she would be a disqualified person with respect to the foundation under the general rule. Occasionally, a fundraiser will be a disqualified person by virtue of being a member of a family that includes a disqualified person.

An independent fundraising person may be considered a disqualified person. This is particularly the case where the person has control over a fundraising program of a charitable organization that is a meaningful source of the organization's revenue. It is noted that the fact that a person manages a discrete segment or activity of an organization, that represents a substantial portion of the activities, assets, income, or expenses of the organization, tends to lead to the conclusion that the person is a disqualified person.

This is an area where charities and their fundraising professionals need to proceed with caution. The IRS is of the view that a person who manages a discrete, meaningful segment or activity of a charitable organization is a disqualified person. The IRS tried, by means of proposed regulations, to make that the absolute rule.²¹⁹ Because that would be overreaching in relation to the statutory definition, however, the IRS was relegated to placement of this factor as an element in a facts-and-circumstances test.

As an example, a charitable organization decided to use bingo games as a method of generating revenue. The charity entered into a contract with a company that operates these games. This company managed the promotion and operation of the bingo activity; provided all necessary staff, equipment, and services; and paid the charity a percentage of the revenue from the bingo activity. The company retained the balance of the proceeds. The charity provided no goods or services in connection with the bingo operation other than the use of its hall for the bingo games. The annual gross revenue earned from the games represented more than one-half of the charity's total annual revenue. The company's compensation is primarily based on revenues from an activity that it controls. Because the company managed a discrete activity of the charitable organization that represented a substantial portion of the charity's income, the IRS is of the view that the company is a disqualified person with respect to the charitable organization.²²⁰

(iii) Excess Benefit Transactions in Fundraising Context.   The most obvious instance of the existence of an excess benefit transaction in the fundraising context is the payment of excessive compensation to the fundraising executive, as employee or consultant, assuming the fundraiser is a disqualified person.

Some fundraisers are compensated, in whole or in part, on the basis of the revenue flow of the charitable organization involved. This arrangement may be structured as a commission or some other form of percentage-based compensation. In any event, it is likely to be a revenue-sharing arrangement.

At the present, as noted, the specific provision concerning revenue-sharing arrangements is not in force. Nonetheless, the IRS is reviewing these compensation structures, using the general definition of the term excess benefit transaction. It may be advisable to limit the amount of this type of compensation, irrespective of how it is ascertained. The fact that a revenue-sharing arrangement is subject to a cap is a relevant factor in determining the reasonableness of the compensation.²²¹

As noted, the fact that a person's compensation is primarily based on revenues derived from activities of the organization that the person controls is a factor leading toward a decision that the person is a disqualified person.

One of the greatest concerns in this setting pertains to arrangements involving special events, where the events are coordinated, if not entirely conducted, by for-profit companies. As discussed, a company of this nature can be regarded as a disqualified person. In that event, the fees paid to the company would be tested against a standard of reasonableness.

Indeed, the first technical advice memorandum issued by the IRS applying the intermediate sanctions rules involved fundraising. The case concerned a charitable organization that was established by a used car salesman; the organization solicited contributions of used vehicles. The IRS concluded that excess benefit transactions occurred in connection with the payment of his salary, repayment to him of undocumented loans, payments to a towing company (owned by his son), lease payments paid by the charity to his company for the leasing of an automobile, and the furnishing of automobiles to members of his family.²²²

Fundraising professionals may act as a team. Nonetheless, if they are disqualified persons, in determining whether these persons received any excess benefits in a particular year, the total value of each disqualified person's services provided to the applicable tax-exempt organization in that year must be compared with the value of the benefits received by that particular disqualified person for that year. That is, each person's compensation must be tested for reasonableness, rather than the team as a unit.²²³ Presumably, this outcome is different where there is a partnership or other formal joint venture.

(iv) Automatic Excess Benefit Transactions.   A tax-exempt charitable organization was formed to provide housing, employment, and other services to veterans. It hired veterans to solicit cash contributions for it, allowing them to retain a percentage of the funds as payment for their services. There was no evidence of this organization's intent to treat these payments as compensation. The IRS classified these payment arrangements as automatic excess benefit transactions (without discussion as to whether any of the payees were disqualified persons).²²⁴

(v) Initial Contract Exception.   The initial contract exception can be of considerable utility in the fundraising setting. It is available when a charitable organization hires a fundraising professional, whether as an employee or independent contractor, where the person was not a disqualified person immediately before entering into the contract.²²⁵ When the parameters of the exception are satisfied, the compensation arrangement is totally exempted from the intermediate sanctions law penalties.

It is clear, then, that the charitable organization and/or fundraising professional who believes there may be liability associated with a transaction with a charitable organization should endeavor to satisfy the criteria of the initial contract exception.

(vi) Rebuttable Presumption of Reasonableness.   The rebuttable presumption of reasonableness can also be useful for the fundraising professional, particularly in circumstances where the initial contract exception cannot apply. The fundraiser should endeavor to be certain that the various elements of the presumption are satisfied, to shift the burden of proof to the IRS in the event of a challenge to the reasonableness of compensation.

(vii) Reporting of Excess Benefit Transactions.   It is sometimes said that the intermediate sanctions rules are a concern only to disqualified persons and not to the charitable organization involved or other persons who are not disqualified persons; however, this often is not the case. From a fundraising perspective, a charitable organization embroiled in an excess benefit transaction is expected to report that transaction on its annual information return, which is a public document.²²⁶ The result, at a minimum, can be adverse publicity, which can harm the programs of the charitable organization involved and perhaps fundraisers who are not disqualified persons.

(viii) Tax Penalties.   If a fundraising professional, who is a disqualified person and hired by a charitable organization, is paid excessive compensation, the arrangement would be a taxable excess benefit transaction, assuming inapplicability of the initial contract exception.

Assume, as an illustration, that this fundraising professional was paid a compensation package of $200,000 for a three-year period. Following audit, the IRS concluded that this individual's services were worth only $100,000. This fundraising executive would then owe initial excise taxes totaling $75,000 (a $25,000 tax per year on the excess benefit of $100,000). Also, this compensation arrangement would have to be corrected by the fundraiser, by means of payment of $300,000 to the charity, plus suitable interest. If these steps were not timely taken, the fundraiser may have additional excise taxes imposed, totaling $600,000. The total obligation of the fundraiser would be $975,000, not including penalties, interest, and legal fees. A board member of this charity who approved this compensation package, knowing it to be excessive, would be liable for $10,000 in taxes and perhaps the taxes of one or more other board members.

(ix) Third-Party Summons: Statute of Limitations.   In general, the statute of limitations for assessing an intermediate sanctions excise tax is three years.²²⁷ The statute of limitations begins to run on the later of the date the tax-exempt organization files the annual information return involved or the due date for the return.²²⁸

If a fundraising professional is a disqualified person and the IRS is investigating the possibility of that person's participation in an excess benefit transaction, the IRS may issue a third-party summons to the charitable organization involved in pursuit of facts. The disqualified person may object to the summons if it is issued after the three-year statute of limitations has run. According to a court, that is not a basis for quashing the summons. All that is required to sustain the validity of the summons is that the IRS must show that the “investigation will be conducted pursuant to a legitimate purpose, that the inquiry may be relevant to the purpose, that the information sought is not already within the [IRS's] possession, and that the administrative steps required by the [Internal Revenue] Code have been followed.”²²⁹ Thus, the court declined to quash a summons issued, after the three-year statute of limitations with respect to a charitable organization had run, seeking information from the organization as to whether a disqualified person participated in an excess benefit transaction.²³⁰

(i) Introduction.   The taxation of unrelated income, a feature of the federal tax laws since 1950, is based on the concept that tax-exempt organizations should not compete with for-profit organizations. Also, the unrelated income rules are believed to be a more effective and workable sanction for authentic enforcement of the law of tax-exempt organizations than denial or revocation of tax-exempt status.

The unrelated income rules are based on a simple concept: the unrelated business income tax applies only to active business income that arises from activities that are unrelated to the organization's exempt purposes. Yet, despite the simplicity of the tax structure, it is not always easy to determine which activities of a tax-exempt organization are related to exempt purposes and which are unrelated businesses.

If a substantial portion of an organization's income is from unrelated sources, the organization will not qualify for tax exemption. That is, to be tax-exempt, a nonprofit organization must be organized and operated primarily for exempt purposes. An organization may satisfy the requirements for tax exemption as a charitable organization, however, even though it operates a business as a substantial part of its activities, where the operation of the business is in furtherance of the organization's exempt purposes and where the organization is not organized and operated for the primary purpose of carrying on an unrelated business (technically termed a trade or business). In determining the existence or nonexistence of this primary purpose, all of the circumstances must be considered, including the size and extent of the business and of the activities that are in furtherance of one or more exempt purposes.²³⁷

At the other end of the spectrum, incidental business activity will not alone cause a charitable or other type of tax-exempt organization to lose or be denied tax exemption, although the income derived from the activity may be taxable.²³⁸ That is, the federal tax law allows a tax-exempt organization to engage in a certain amount of income-producing activity that is unrelated to exempt purposes.

Business activities may preclude initial qualification of an otherwise tax-exempt organization as a charitable or other entity. This can occur through failure to satisfy the operational test that determines whether the organization is being operated principally for exempt purposes.²³⁹ Likewise, an organization will not meet the organizational test if its articles of organization (the document by which it was established) empower it, as more than an insubstantial part of its functions, to carry on activities that do not further its exempt purpose.²⁴⁰

The unrelated business income tax applies with respect to all charitable and nearly all other types of tax-exempt organizations.²⁴¹ They include religious organizations (including churches), educational organizations (including universities, colleges, and schools), health care organizations (including hospitals), and scientific organizations (including research entities).²⁴² This tax also applies with respect to any college or university that is an agency or instrumentality of any government or political subdivision of a government, or that is owned or operated by a government or political subdivision, or by any agency or instrumentality of one or more governments or political subdivisions, and further applies to any corporation wholly owned by one or more of these colleges or universities.²⁴³

Beyond the realm of charitable entities, the rules are applicable with respect to social welfare organizations (including advocacy groups),²⁴⁴ labor organizations (including unions),²⁴⁵ trade and professional associations,²⁴⁶ fraternal organizations,²⁴⁷ and veterans' organizations.²⁴⁸ Special rules²⁴⁹ tax all income not related to exempt functions (including investment income) of social clubs,²⁵⁰ homeowners' associations,²⁵¹ and political organizations.²⁵²

The few tax-exempt organizations that are excepted from the tax are instrumentalities of the federal government,²⁵³ certain religious and apostolic organizations,²⁵⁴ farmers' cooperatives,²⁵⁵ and shipowners' protection and indemnity associations.²⁵⁶

Certain organizations are not generally subject to the unrelated business rules simply because they are not allowed to engage in any active business endeavors. This is the case, for example, with respect to private foundations (within limitations) and title-holding organizations.²⁵⁷ As to the former, the operation of an active business (externally or internally) by a private foundation would likely trigger application of the excess business holdings restrictions.²⁵⁸ As to the latter, tax-exempt title-holding corporations are allowed to engage in unrelated business activities to the extent the income derived is from the holding of real property and generally as long as the unrelated income is not in excess of 10 percent of annual gross income.²⁵⁹

The original concept underlying these rules was that of the outside business owned and perhaps operated by a tax-exempt organization. In 1969, however, Congress significantly expanded the reach of these rules by authorizing the IRS to evaluate activities conducted by exempt organizations internally—so-called inside activities.

The primary objective of the unrelated business income tax is to eliminate a source of unfair competition for for-profit businesses by placing the unrelated business activities of tax-exempt organizations on the same tax basis as the nonexempt business endeavors with which they compete.²⁶⁰ Thus, the report of the House of Representatives Committee on Ways and Means that accompanied the 1950 legislation states that the “problem at which the tax on unrelated business income is directed here is primarily that of unfair competition” and the “tax-free status of … [nonprofit] organizations enables them to use their profits tax-free to expand operations, while their competitors can expand only with the profits remaining after taxes.”²⁶¹ The Senate Finance Committee reaffirmed this position in 1976 when it noted that one “major purpose” of the unrelated income tax “is to make certain that an exempt organization does not commercially exploit its exempt status for the purpose of unfairly competing with taxpaying organizations.”²⁶²

The absence or presence of unfair competition, however, is not among the criteria generally used to assess whether the revenue from a particular activity is subject to the unrelated income tax. Thus, it is possible for an exempt organization's activity to be wholly noncompetitive with an activity of a for-profit organization and nonetheless be treated as an unrelated business. For example, in a case finding that the operation of a bingo game by an exempt organization creates unrelated business income, a court observed that the “tax on unrelated business income is not limited to income earned by a trade or business that operates in competition with taxpaying entities.”²⁶³ Yet, the IRS and courts increasingly take the concept of unfair competition into account in application of the unrelated income rules.

The term unrelated trade or business is defined to mean any trade or business that is regularly carried on, the conduct of which is not substantially related to the exercise or performance by the exempt organization of its exempt purpose or function.²⁶⁴ The conduct of a business is not substantially related to an organization's exempt purpose solely because the organization may need the income or because of the use the organization makes of the profits derived from the business.

Therefore, absent an exception, gross income of a charitable or other tax-exempt organization is subject to the tax on unrelated business income where three factors are present: it is income from a trade or business, the business is regularly carried on by the organization, and the conduct of the trade or business is not substantially related to the organization's performance of its exempt functions.²⁶⁵

Thus, in adopting these rules in 1950 and in amplifying them in 1969, Congress has not prohibited commercial ventures by nonprofit organizations nor has it levied taxes only on the receipts of businesses that bear no relation at all to the tax-exempt purposes of nonprofit organizations. Instead, it struck a balance between, as the U.S. Supreme Court phrased it, “its two objectives of encouraging benevolent enterprise and restraining unfair competition.”²⁶⁶

The unrelated business rules are in a peculiar state of affairs these days. Despite the statutory scheme, the courts are simultaneously developing additional and sometimes different criteria for assessing the presence of unrelated business. It is out of this context that the doctrine of commerciality is emerging.²⁶⁷ The result is considerable confusion about the law in this area and the extensive judgmental leeway on the part of the courts and the IRS in applying it.

A large part of the impetus for revision of the law of unrelated income taxation was the charge by the small business community of unfair competition. The difference between the circumstances in the 1950s and 50 years later is that the competing activities of nonprofit organizations in the 1950s were of the unrelated variety, while as of the turn of the twenty-first century many of the competing activities are, under existing law, related to exempt functions. Moreover, increasingly, activities that were once thought to be fundraising (nontaxable) functions are being considered unrelated businesses, with the net income subject to taxation.

(ii) Deduction Law.   Generally, the term unrelated business taxable income means the gross income derived by an organization from an unrelated trade or business, regularly carried on by the organization, less business deductions that are directly connected with the carrying on of the trade or business.²⁶⁸ For purposes of computing unrelated business taxable income, both such gross income and business deductions are computed with certain modifications, as discussed as follows.

To be directly connected with the conduct of unrelated business, an item of deduction generally must have a proximate and primary relationship to the carrying on of that business. In the case of an organization that derives gross income from the regular conduct of two or more unrelated business activities, unrelated business taxable income is the aggregate of gross income from all such unrelated business activities less the aggregate of the deductions allowed with respect to all these unrelated business activities.²⁶⁹ Expenses, depreciation, and similar items attributable solely to the conduct of unrelated business are proximately and primarily related to that business and therefore qualify for deduction to the extent that they meet the requirements of relevant provisions of the federal tax law.²⁷⁰

Where facilities or personnel are used both to carry on exempt functions and to conduct unrelated trade or business, the expenses, depreciation, and similar items attributable to the facilities or personnel (as, for example, items of overhead) must be allocated between the two uses on a reasonable basis. The portion of any such item so allocated to the unrelated trade or business must be proximately and primarily related to that business and is allowable as a deduction in computing unrelated business income in the manner and to the extent permitted by the federal tax law.²⁷¹ In certain cases, gross income is derived from unrelated trade or business that exploits an exempt function. Generally, in these cases, expenses, depreciation, and similar items attributable to the conduct of the exempt function are not deductible in computing unrelated business taxable income. Because these items are incident to a function of the type, which is the chief purpose of the organization to conduct, they do not possess proximate and primary relationship to the unrelated trade or business. Therefore, they do not qualify as being directly connected with that business.²⁷²

Tax-exempt organizations are allowed, in computing their unrelated business taxable income (if any), a federal income tax charitable contribution deduction.²⁷³ This deduction is allowable irrespective of whether the contribution is directly connected with the carrying on of the business. The deduction may not exceed 10 percent of the organization's unrelated business taxable income computed without regard to the deduction.

The net operating loss deduction²⁷⁴ is allowed in computing unrelated business taxable income.²⁷⁵ The net operating loss carryback or carryover (from a tax year for which the exempt organization is subject to the unrelated business income tax) is determined under the net operating loss deduction rules without taking into account any amount of income or deduction that is not included under the unrelated business income tax rules in computing unrelated business taxable income.

(iii) Trade or Business.   The term trade or business includes any activity that is carried on for the production of income from the sale of goods or the performance of services.²⁷⁶ Moreover, an “activity does not lose identity as trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of the organization.”²⁷⁷ Additionally, “[w]here an activity carried on for profit constitutes an unrelated trade or business, no part of such trade or business shall be excluded from such classification merely because it does not result in profit.”²⁷⁸

By enactment of these rules in 1969, Congress confirmed the government's contention that income for a particular activity can be taxed as unrelated business income even where the activity is an integral part of a larger activity that is in furtherance of an exempt purpose. This provision is directed at, but is not confined to, activities of soliciting, selling, and publishing commercial advertising, even where the advertising is published in an exempt organization publication that contains editorial matter related to the exempt purposes of the organization. With this authority, the IRS is empowered to fragment an exempt organization's operation, run as an integrated whole, into its component parts in search of an unrelated trade or business.

This expansive definition of the term trade or business embraces nearly every activity of a tax-exempt organization. In this sense, every tax-exempt organization is viewed as a bundle of activities, each of which is a trade or business. (This definition has nothing to do with whether a particular activity is related or unrelated; there are related businesses and unrelated businesses.) Thus, the IRS is authorized to examine each of the activities in the bundle of activities constituting an exempt organization, in search of unrelated business. Each activity in the bundle can be examined as though it existed wholly independently of the others; an unrelated activity cannot, as a matter of law, be hidden from scrutiny by tucking it in among a host of related activities. This rule is known as the fragmentation rule.

Nothing in the statutory definition of the term trade or business requires the tax-exempt organization to engage in the activity with a profit motive. The courts, however, are grafting the profit motive requirement onto the definition, as the result of a 1987 Supreme Court decision.²⁷⁹ Thus, for example, the U.S. Tax Court held, in a case involving an activity of a trade association that consistently produced losses, that the ongoing losses are evidence that the activity was not engaged in with the requisite profit motive and therefore is not a business.²⁸⁰

Not every activity of an exempt organization that generates a financial return is a trade or business for purposes of the unrelated income tax rules. As the U.S. Supreme Court observed: the “narrow category of trade or business” is a “concept which falls far short of reaching every income or profit-making activity.”²⁸¹

Likewise, it is clear that the management of an investment portfolio composed wholly of the manager's own securities does not constitute the carrying on of a trade or business. For example, the Supreme Court held that the mere keeping of records and collection of interest and dividends from securities through managerial attention to the investments is not the operation of a business.²⁸² On that occasion, the Court sustained the government's position that “mere personal investment activities never constitute carrying on a trade or business.”²⁸³ Subsequently, the Supreme Court stated that “investing is not a trade or business.”²⁸⁴ Likewise, the Ninth Circuit Court of Appeals observed that “the mere management of investments … is insufficient to constitute the carrying on of a trade or business.”²⁸⁵

It is also clear that investment activities do not constitute the carrying on of a trade or business in this context. Thus, the IRS ruled that the receipt of income by an exempt employee's trust from installment notes purchased from the employer-settlor is not income derived from the operation of an unrelated trade or business.²⁸⁶ The IRS noted that the trust “merely keeps the records and receives the periodic payments of principal and interest collected for it by the employer.” Consequently, it is clear that mere record-keeping and income collection for a person's own investments do not constitute the carrying on of a trade or business.

Therefore, income that is passive income is generally not taxed, on the ground that it is not income derived from the active conduct of a trade or business. This exception, contained in the modifications discussed below, generally extends to forms of income such as dividends, interest, annuities, royalties, rents, and capital gain. Also, as discussed as follows, certain other items of income and activities are specifically exempted from the unrelated income tax.

(iv) Regularly Carried On Law.   In determining whether a trade or business from which a particular amount of gross income is derived is regularly carried on, within the meaning of the unrelated trade or business rules, regard must be given to the frequency and continuity with which the activities productive of the income are conducted and the manner in which they are pursued. (It is in this context that the statutory law comes the closest to using a general doctrine of commerciality.) This requirement must be applied in light of the purpose of the unrelated business income tax, which is to place exempt organization business activities on the same tax basis as the nonexempt business endeavors with which they compete. Hence, for example, specific business activities of an exempt organization will ordinarily be deemed to be regularly carried on if they manifest a frequency and continuity, and are pursued in a manner generally similar to comparable commercial activities of nonexempt organizations.²⁸⁷

Where income-producing activities are of a kind normally conducted by nonexempt commercial organizations on a year-round basis, the conduct of the activities by an exempt organization over a period of only a few weeks does not constitute the regular carrying on of a trade or business. For example, the operation of a sandwich stand by a hospital auxiliary for only two weeks at a state fair would not be the regular conduct of a trade or business. Similarly, if a charitable organization holds an occasional dance to which the public is admitted for a charge, hiring an orchestra and entertainers for the purpose, such an activity would not be a trade or business regularly carried on.²⁸⁸ The conduct of year-round business activities for one day each week, however, would constitute the regular carrying on of a trade or business. Thus, the operation of a commercial parking lot on one day of each week would be the regular conduct of a trade or business. Where income-producing activities are of a kind normally undertaken by nonexempt commercial organizations only on a seasonal basis, the conduct of such activities by an exempt organization during a significant portion of the season ordinarily constitutes the regular conduct of a trade or business. For example, the operation of a track for horse racing for several weeks of a year would be considered the regular conduct of a trade or business because it is usual to carry on this type of trade or business only during a particular season.²⁸⁹

In determining whether intermittently conducted activities are regularly carried on, the manner of conduct of the activities must be compared with the manner in which commercial activities are normally pursued by nonexempt organizations. In general, exempt organization business activities that are engaged in only discontinuously or periodically will not be considered regularly carried on if they are conducted without the competitive and promotional efforts typical of commercial endeavors. For example, the publication of advertising in programs for sports events or music or drama performances will not ordinarily be deemed to be the regular carrying on of business; however, where the nonqualifying sales are not merely casual but are systematically and consistently promoted and carried on by the organization, they meet the requirement of regularity.²⁹⁰

Certain intermittent income-producing activities occur so infrequently that neither their recurrence nor the manner of their conduct will cause them to be regarded as trade or business regularly carried on. For example, income-producing or fundraising activities lasting only a short period will not ordinarily be treated as regularly carried on if they recur only occasionally or sporadically. Furthermore, these activities will not be regarded as regularly carried on merely because they are conducted on an annually recurrent basis. Accordingly, income derived from the conduct of an annual dance or similar fundraising event for charity would not be income from a trade or business regularly carried on.²⁹¹

(v) Substantially Related.   Gross income derives from unrelated trade or business within the meaning of these rules if the conduct of the trade or business that produces the income is not substantially related (other than through the production of funds) to the purposes for which exemption is granted. The presence of this requirement necessitates an examination of the relationship between the business activities that generate the particular income in question—the activities, that is, of producing or distributing the goods or performing the services involved—and the accomplishment of the organization's exempt purposes.²⁹²

Trade or business is related to exempt purposes in the relevant sense only where the conduct of the business activity has a causal relationship to the achievement of an exempt purpose (other than through the production of income) and it is substantially related only if the causal relationship is a substantial one. Thus, for the conduct of trade or business from which a particular amount of gross income is derived to be substantially related to the purposes for which exemption is granted, the production or distribution of the goods or the performance of the services from which the gross income is derived must contribute importantly to the accomplishment of those purposes.²⁹³ Where the production or distribution of the goods or the performance of the services does not contribute importantly to the accomplishment of the exempt purposes of an organization, the income from the sale of the goods or the performance of the service does not derive from the conduct of related trade or business. Whether activities productive of gross income contribute importantly to the accomplishment of any purpose for which an organization is granted exemption depends in each case on the facts and circumstances involved.²⁹⁴

In determining whether activities contribute importantly to the accomplishment of an exempt purpose, the size and extent of the activities involved must be considered in relation to the nature and extent of the exempt function that they purport to serve. Thus, where income is realized by an exempt organization from activities that are in part related to the performance of its exempt functions, but which are conducted on a larger scale than is reasonably necessary for performance of these functions, the gross income attributable to that portion of the activities in excess of the needs of exempt functions constitutes gross income from the conduct of unrelated trade or business.²⁹⁵

Gross income derived from charges for the performance of exempt functions does not constitute gross income from the conduct of unrelated trade or business. This principle encompasses income generated by functions such as performances by students enrolled in a school for training children in the performing arts, the conduct of refresher courses to improve the trade skills of members of a trade union, and the presentation of a trade show (at which sales do not occur) for exhibiting industry products by a trade association to stimulate demand for the products.²⁹⁶

Ordinarily, gross income from the sale of products that result from the performance of exempt functions does not constitute gross income from the conduct of unrelated trade or business if the products are sold in substantially the same state they are in upon completion of the exempt functions. Thus, in the case of a tax-exempt organization engaged in a program of rehabilitation of handicapped persons, income from sales of articles made by these persons as a part of their rehabilitation training would not be gross income from conduct of unrelated trade or business. The income in this case would be from the sale of products whose production contributed importantly to the accomplishment of purposes for which exemption is granted the organization—namely, rehabilitation of the handicapped. Conversely, if a product resulting from an exempt function is utilized or exploited in further business endeavors beyond those reasonably appropriate or necessary for disposition in the state it is in upon completion of exempt functions, the gross income derived therefrom would be from the conduct of unrelated trade or business. Thus, in the case of an experimental dairy herd maintained for scientific purposes by a tax-exempt organization, income from the sale of milk and cream produced in the ordinary course of operation of the project would not be gross income from conduct of unrelated trade or business. If the organization were to utilize the milk and cream in the further manufacture of food items such as ice cream and pastries, however, the gross income from the sale of the products would be from the conduct of unrelated trade or business unless the manufacturing activities themselves contribute importantly to the accomplishment of an exempt purpose of the organization.²⁹⁷

An asset or facility necessary to the conduct of exempt functions may also be employed in a commercial endeavor. In these cases, the mere fact of the use of the asset or facility in exempt functions does not, by itself, make the income from the commercial endeavor gross income from related trade or business. The test, instead, is whether the activities productive of the income in question contribute importantly to the accomplishment of exempt purposes. Assume, for example, that a tax-exempt museum has a theater auditorium that is specially designed and equipped for showing educational films in connection with its program of public education in the arts and sciences. The theater is a principal feature of the museum and is in continuous operation during the hours the museum is open to the public. If the organization were to operate the theater as an ordinary motion picture theater for public entertainment during the evening hours when the museum was closed, gross income from the operation would be gross income from conduct of unrelated trade or business.²⁹⁸

Activities carried on by an organization in the performance of exempt functions may generate goodwill or other intangibles that are capable of being exploited in commercial endeavors. Where an organization exploits such an intangible in commercial activities, the mere fact that the resultant income depends in part on an exempt function of the organization does not make it gross income from related trade or business. In these cases, unless the commercial activities themselves contribute importantly to accomplishing an exempt purpose, the income they produce is gross income from the conduct of unrelated trade or business.²⁹⁹

The law is replete with court cases and IRS rulings providing illustrations of related and unrelated activities. Colleges and universities can operate dormitories, cafeterias, and bookstores as related activities but can be taxable on travel tours and sports camps. Hospitals may operate gift shops, snack bars, and parking lots as related activities but may be taxable on sales of pharmaceuticals to the general public and on the sale of laboratory testing services to physicians. Museums may, without taxation, sell items reflective of their collections but be taxable on the sale of souvenirs. Trade associations may find themselves taxable on sales of items and particular services to members, while dues and subscription revenue are nontaxable. Fundraising events may be characterized as unrelated activities, particularly when compensation is paid or when the activity is regularly carried on.

(vi) Exceptions.   Exempt from the scope of unrelated trade or business is a business in which substantially all of the work in carrying on the business is performed for the organization without compensation.³⁰⁰ An example involving this exception is an exempt orphanage operating a secondhand clothing store and selling to the general public, where substantially all of the work in running the store is performed by volunteers.³⁰¹ As to the scope of this exception, Congress intended to provide an exclusion from the definition of unrelated trade or business only for those unrelated business activities in which the performance of services is a material income-producing factor in carrying on the business, and substantially all such services are performed without compensation.³⁰² Likewise, workers who conducted activities in a building rented by an exempt organization were held to be compensated by the organization where the rental payments included payments for “all labor for the supervision and handling of [each activity] upon the premises.”³⁰³

Payments by third parties can constitute the requisite compensation, where the tax-exempt organization involved transferred funds to the third party. For example, where security guards were present at and integral to gaming operations conducted by an exempt organization,³⁰⁴ the compensation of the guards by a company through a contract with the organization was held to be the type of compensation that defeated the exception for volunteer-conducted businesses.³⁰⁵

Also excluded is a business, in the case of a charitable organization or a state college or university, which is carried on by the organization primarily for the convenience of its members, students, patients, officers, or employees.³⁰⁶ An example involving this exception is a laundry operated by a college for the purpose of laundering dormitory linens and the clothing of students.³⁰⁷ Further, unrelated trade or business does not include a business that is the selling of merchandise, substantially all of which has been received by the organization as gifts or contributions.³⁰⁸ This last exception is available for thrift shops that sell donated clothes and books to the general public.³⁰⁹

Payments to a tax-exempt organization for lending securities to a broker and the return of identical securities are not items of unrelated business taxable income.³¹⁰ For this nontaxation treatment to apply, the security loans must be fully collateralized and must be terminable on five business days' notice by the lending organization. Further, an agreement between the parties must provide for reasonable procedures to implement the obligation of the borrower to furnish collateral to the lender 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 security at the close of business on the preceding day.

There are additional exceptions, including the conduct of entertainment at fairs and expositions and of trade shows by exempt organizations, the performance of certain services by hospitals for small hospitals, the conduct of certain bingo games, the sale of low-cost articles, and the rental of mailing lists under certain circumstances. Each of these exceptions is discussed next.

The rule with respect to entertainment at fairs and expositions³¹¹ applies to charitable, social welfare, labor, agricultural, and horticultural organizations that regularly conduct, as a substantial exempt purpose, an agricultural and educational fair or exposition.³¹²

The term unrelated trade or business does not include qualified public entertainment activities of an eligible organization.³¹³ This term is defined to mean “any entertainment or recreational activity of a kind traditionally conducted at fairs or expositions promoting agricultural and educational purposes, including but not limited to, an activity one of the purposes of which is to attract the public to fairs or expositions or to promote the breeding of animals or the development of products or equipment.”³¹⁴

No unrelated income taxation is to occur with respect to the operation of a qualified public entertainment activity that meets one of the following conditions: the public entertainment activity is conducted (1) in conjunction with an international, national, state, regional, or local fair or exposition, (2) in accordance with state law, which permits that activity to be conducted solely by an eligible type of exempt organization or by a governmental entity, or (3) in accordance with state law, which permits that activity to be conducted under license for not more than 20 days in any year and which permits the organization to pay a lower percentage of the revenue from this activity than the state requires from other organizations.³¹⁵

The rule with respect to trade show activities³¹⁶ applies to labor, agricultural, and horticultural organizations, and business leagues, which regularly conduct, as a substantial exempt purpose, shows that stimulate interest in and demand for the products of a particular industry or segment of it.

As respects the third of these items, the IRS maintains that income derived by a tax-exempt hospital from providing services to other exempt hospitals constitutes unrelated business income to the hospital providing the services, on the theory that the providing of services to other hospitals is not an activity that is substantially related to the tax-exempt purpose of the hospital providing the services.³¹⁷ Congress acted to reverse this position in the case of small hospitals.

Where a tax-exempt hospital provides certain services³¹⁸ only to other tax-exempt hospitals, there will not be an unrelated business as long as each of the recipient hospitals has facilities to serve not more than 100 inpatients and the services would be consistent with the recipient hospitals' exempt purposes if performed by them on their own behalf.³¹⁹

Bingo game income realized by most tax-exempt organizations is not subject to the unrelated business income tax.³²⁰ This exclusion applies where the bingo game is not conducted on a commercial basis and where the games do not violate state or local laws.

For a charitable, veterans', or other organization, to which contributions are deductible, the term unrelated business does not include activities relating to the distribution of low-cost articles if the distribution of the articles is incidental to the solicitation of charitable contributions.³²¹ A low-cost article is one that has a cost, not in excess of $5 (indexed for inflation),³²² to the organization that distributes the item or has the item distributed for it.³²³ A distribution qualifies under this rule if it is not made at the request of the distributee, it is made without the express consent of the distributee, and the articles that are distributed are accompanied by a request for a charitable contribution from the distributee to the organization and a statement that the distributee may retain the article whether or not a contribution is made.³²⁴

Also, for a charitable, veterans', or other, organization, to which contributions are deductible, the concept of a business does not include exchanging with another similar organization the names and addresses of donors to or members of the organization, or the renting of these lists to another similar organization.³²⁵

(vii) Modifications.   In determining unrelated business taxable income, both gross income derived from an unrelated trade or business and business deductions are computed by taking into account certain modifications.³²⁶

Passive income—namely dividends, interest, payments with respect to securities loans, annuities, royalties, certain rents (generally of real estate), and gain from the disposition of property—is generally excluded from unrelated business taxable income, along with directly connected deductions.³²⁷

The legislative history of these provisions indicates that Congress believed that passive income should not be taxed under these rules “where it is used for exempt purposes because investments producing incomes of these types have long been recognized as proper for educational and charitable organizations.”³²⁸ The strict definitional classifications of the types of passive income are not dispositive of the question as to their treatment in relation to the modification rules. Rather, “[w]hether a particular item of income falls within any of the modifications … shall be determined by all of the facts and circumstances of each case.”³²⁹

The legislative history of the unrelated business income tax provisions is amply clear on the point that Congress, in enacting these modifications, did not intend and has not authorized taxation of the passive receipt of income by exempt organizations, and that a technical satisfaction of the definitional requirements of the terms used in the statute is not required. Thus, the Senate Finance Committee observed in 1950 that the unrelated income tax was to apply to “so much of … [organizations'] income as rises from active business enterprises which are unrelated to the exempt purposes of the organizations.”³³⁰ The Committee added: “The problem at which the tax on unrelated business income is directed is primarily that of unfair competition.”³³¹ Speaking of the exclusion for passive sources of income, the Committee stated:

Dividends, interest, royalties, most rents, capital gains and losses and similar items are excluded from the base of the tax on unrelated income because your committee believes that they are “passive” in character and are not likely to result in serious competition for taxable business having similar income. Moreover, investment-producing incomes of these types have long been recognized as a proper source of revenue for educational and charitable organizations and trusts.³³²

It seems unmistakable that passive income, regardless of type, is properly includable within the exclusions provided by the modifications.³³³ (As discussed below, however, there is a recent line of thinking that asserts, at least as to the exclusion for royalties, that the exclusion may be available irrespective of whether the income is passive in nature.)³³⁴

The exclusion relating to gains and losses from the disposition of property does not extend to dispositions of inventory or property held primarily for sale to customers in the ordinary course of business.³³⁵

There are, however, important exceptions to this general exemption for passive income: (1) income in the form of rent, royalties, and the like from an active business is taxable; that is, merely labeling an item of income as rent, royalty, or the like does not make it tax-free;³³⁶ (2) the unrelated debt-financed income rules³³⁷ override the general exemption for passive income; and (3) interest, annuities, rents, and royalties (but not dividends) from a controlled corporation may be taxable.³³⁸

Income derived from research for government is excluded, as is income derived from research for anyone in the case of a college, university, or hospital and of fundamental research units.³³⁹ According to the legislative history, research includes “not only fundamental research but also applied research such as testing and experimental construction and production.”³⁴⁰ As respects the separate exemption for college, university, or hospital research, it is clear that “funds received for research by other institutions [do not] necessarily represent unrelated business income,” such as a grant by a corporation to a foundation to finance scientific research if the results of the research were to be made freely available to the public.³⁴¹

A specific deduction of $1,000 makes the first $1,000 of unrelated business income automatically nontaxable.³⁴² The purpose of this deduction is to eliminate the need for payments of small amounts of tax.

(viii) Partnership Law.   Generally, a trade or business regularly carried on by a partnership of which an exempt organization is a member is an unrelated trade or business with respect to the organization. In computing its unrelated business taxable income, the organization must (subject to the modifications rules) include its share (whether or not distributed) of the gross income of the partnership from the unrelated trade or business and its share of the partnership deductions directly connected with this gross income.³⁴³

(ix) Bucketing Law.   In an instance of a tax-exempt organization with two or more unrelated businesses, unrelated business taxable income must first be computed separately with respect to each business.³⁴⁴ The organization's unrelated business taxable income for a year is the sum of the amounts (not less than zero) computed for each separate unrelated business, less the specific deduction.³⁴⁵ A net operating loss deduction is allowed only with respect to a business from which the loss arose.³⁴⁶

The result of this body of law is that a deduction from one unrelated business for a tax year may not be used by a tax-exempt organization to offset income from another unrelated business for the same tax year. This law generally does not, however, prevent an exempt organization from using a deduction from one tax year to offset income from the same unrelated business in another tax year, where appropriate.

Statutory law does not provide criteria for determining whether a tax-exempt organization has more than one unrelated business or how to identify separate unrelated businesses for purposes of calculating unrelated business taxable income. Generally, an exempt organization identifies each of its separate unrelated businesses using the first two digits of the North American Industry Classification System code that most accurately describes the unrelated business.³⁴⁷ (The NAICS is an industry classification system utilized to collect, analyze, and publish statistical data related to the U.S. business economy.) The NAICS two-digit code must identify the unrelated business in which the exempt organization engages directly or indirectly, and not activities the conduct of which are substantially related to the exercise or performance by the organization of its exempt purpose or function.³⁴⁸

An organization's activities in the nature of investments that give rise to unrelated business income may be treated collectively as a separate unrelated business for bucketing rule purposes.³⁴⁹ Generally, an organization's investment activities are limited to its qualifying partnership interests, qualifying S corporation interests, and debt-financed property or properties.³⁵⁰ Qualifying partnership interests do not include interests in a general partnership but may include interests in limited partnerships.

(x) Tax Structure.   The federal tax law imposes a tax on unrelated business taxable income.³⁵¹ The unrelated business income tax rate payable by most tax-exempt organizations is the flat 21 percent corporate rate.³⁵² Some organizations, such as trusts, are subject to the individual income tax rates.³⁵³

Tax-exempt organizations must make quarterly estimated payments of the tax on unrelated business taxable income, under the same rules that require quarterly estimated payments of corporate income taxes.³⁵⁴ Revenue and expenses associated with unrelated business activity are reported to the IRS on a tax return (Form 990-T).³⁵⁵

(i) Fundraising as Business.   Many fundraising practices possess the technical characteristics of an unrelated trade or business. Reviewing the criteria for unrelated income taxation summarized earlier, some fundraising activities are trades or businesses, regularly carried on, and not efforts that are substantially related to the performance of tax-exempt functions. Further, applying the tests often used by the IRS and the courts, some fundraising endeavors have a commercial counterpart and are being conducted in competition with that counterpart, and are being undertaken with the objective of realizing a profit.³⁵⁶ Treatment of a fundraising effort as an unrelated business may appear to be a rather strained result, and certainly is not consistent with the intent of Congress when it enacted the unrelated income rules in 1950, but nonetheless can be a logical and technically accurate application of the rules.

Until recently, the IRS avoided application of the unrelated income rules to charitable organizations' fundraising endeavors. Even if the matter was given much thought, the rationale seems to have been that either the fundraising activity was not a trade or business or was not regularly carried on.

The rationale that fundraising activities are not businesses was expressed by the Senate Committee on Finance in 1969, when it stated that “where an activity does not possess the characteristics of a trade or business within the meaning of IRC [§] 162, such as when an organization sends out low-cost articles incidental to the solicitation of charitable contributions, the unrelated business income tax does not apply since the organization is not in competition with taxable organizations.”³⁵⁷ An examination of this rationale, however, reveals two elements that substantially undermine its widespread application: the funds received by the organization were in the form of gifts, not payments for the articles or services provided, and the activity was not in competition with commercial endeavors. Either or both of these two elements may be absent in a charitable fundraising endeavor.

Thus, a tax-exempt organization may engage in fundraising efforts that have their commercial counterparts. Some of these activities are sheltered by law from consideration as businesses, such as a business (1) in which substantially all of the work is performed for the organization by volunteers,³⁵⁸ (2) that is carried on primarily for the convenience of the organization's members, students, patients, officers, or employees,³⁵⁹ or (3) which consists of the sale of merchandise, substantially all of which has been received by the organization as gifts.³⁶⁰ Also, a statute exempts from unrelated business income taxation the receipts from certain types of bingo games.³⁶¹

Perhaps the beginning of serious regard of fundraising activities as businesses can be traced to the enactment of the Tax Reform Act of 1969, where Congress authorized the taxation of revenue from the acquisition and publication of advertising in the magazines of tax-exempt organizations. To accomplish this result, Congress codified two rules previously contained in the income tax regulations: it enacted laws that state: (1) the term trade or business includes any activity carried on for the production of income from the sale of goods or the performance of services, and (2) an activity of producing or distributing goods or performing services from which gross income is derived does not lose identity as a trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors that may or may not be related to the exempt purposes of the organization.³⁶²

Needless to say, this definition of the term trade or business is encompassing. In addition to the breadth of this definition, the IRS is, as noted, authorized by statute to examine an exempt organization's activities one by one (rather than as a single bundle of activities) and fragment its operations in search of unrelated business endeavors.³⁶³ As a result of both of these rules, the fundraising practices of charitable organizations are now, more than ever, exposed and thus more vulnerable to the charge that they are unrelated businesses.³⁶⁴

The IRS has not been reticent, in recent years, to apply these rules in an expansionist manner. For example, the IRS sought (unsuccessfully) to characterize as an unrelated business the selling by universities of the televising and broadcasting rights in connection with the institutions' athletic events.³⁶⁵ Also, the IRS attempted (again unsuccessfully, because of overriding action by Congress) to narrowly interpret the rules (discussed previously) portraying certain forms of income as passive income to contend that income from the writing of options³⁶⁶ and from the lending of securities³⁶⁷ by exempt organizations is taxable as unrelated business income.

More directly, the IRS held that the regular sales of membership mailing lists by an exempt educational organization to colleges and business firms for the production of income is an unrelated trade or business.³⁶⁸ Furthermore, the IRS³⁶⁹ and the courts³⁷⁰ have regarded the regular conduct of bingo games by exempt organizations to be unrelated activities. As noted, Congress subsequently developed partial exemptions for these types of activities,³⁷¹ but the point is that the IRS advanced the positions. Other illustrations of fundraising that have been considered by the IRS to be unrelated business are special events such as concerts³⁷² and golf tournaments and charity balls.³⁷³

A federal court of appeals held that a solicitation of charitable contributions by means of the mailing of greeting cards to potential contributors did not constitute the conduct of an unrelated trade or business.³⁷⁴ The case concerned a school that unsuccessfully attempted to raise funds from private foundations and other organizations, so it turned to a program of mailing packages of greeting cards to prospective donors, with information about the school and a request for contributions. An outside firm printed, packaged, and mailed the greeting cards and the accompanying solicitation letter. The court rejected the government's contention that the solicitation was a trade or business, finding that the greeting cards were not being sold but were distributed incidentally to the solicitation of charitable contributions. As noted, the income tax regulations provide that an “activity does not possess the characteristics of a trade or business … when an organization sends out low-cost articles incidental to the solicitation of charitable contributions.”³⁷⁵ The government argued that this rule was inapplicable in this case because the funds involved were not gifts, but the court said that to read the law in that narrow manner would “completely emasculate” the exception.³⁷⁶ The court held that the case turned on the fact that the unrelated income rules were designed to prevent nonprofit organizations from unfairly competing with for-profit companies, and that the school's fundraising program did not give it an “unfair competitive advantage over taxpaying greeting card businesses.”³⁷⁷

While the decision is undoubtedly a correct one, three troublesome facts should be considered: the IRS pursued the issue in the first instance, even into litigation; the trial court agreed with the IRS position; and the IRS at trial secured a verdict by jury.

The U.S. Court of Claims (now the U.S. Court of Federal Claims) subsequently examined application of the unrelated business rules as they relate to certain fundraising efforts of a national veterans' organization.³⁷⁸ The case focused on two fundraising practices of the organization. The first was its practice of offering items (premiums) to potential donors as part of its semiannual direct mail solicitation. The premiums, offered in exchange for contributions of $2.00, $3.00, or $5.00, were maps, charts, calendars, and books. The rationale for this use of premiums was that it gained the attention of the recipients so that more initial responses were obtained or, in instances involving prior donors, the level of contributions was upgraded. The second practice was the rental of names on the organization's mailing list to both tax-exempt and commercial organizations. The court found that certain of the organization's solicitation activities using premiums constituted a trade or business because they were conducted in a competitive and commercial manner. In making the differentiation, the court ruled that “if the contribution required for any one premium was set at an amount greatly in excess of the retail value of the premiums concerned, a competitive situation would not be present.”³⁷⁹ Because the $2.00 premium items were valued at $0.85 to $1.00 and the $3.00 items were valued at $1.50, the court concluded that there was not any unrelated business activity. But, because the $5.00 premium items were valued at $2.95 to $5.45, the court found the requisite trade or business, noting that the sending of a $5.00 contribution “may well have formed a contract binding … [the organization] to furnish the premium item.”³⁸⁰ Also finding that the solicitation was regularly carried on, because of “sufficient similarity to a commercial endeavor,”³⁸¹ and was not an activity related to the organization's tax-exempt purposes (notwithstanding the utility of the premiums as attention-getting devices), the court declared the presence of an unrelated business. The court also determined that the rental of the organization's donor list is a trade or business that is regularly carried on and that is not substantially related to the accomplishment of its tax-exempt purposes.³⁸²

It is clear from these two court cases that the use of premiums as part of a fundraising activity is much less likely to be considered an unrelated trade or business if the items are mailed with the solicitation. That is, where the recipients are informed that the premiums can be retained without any obligation to make a contribution, the activity is not conducted in a competitive manner and hence presumably is not a trade or business. But, as the Court of Claims observed, “[w]hen premiums are advertised and offered only in exchange for prior contributions in stated amounts, the activity takes on much more of a commercial nature.”³⁸³

Subsequently, the full Court of Claims adopted the trial judge's report, with some modifications but none concerning the substantive unrelated business issues. Thus, the position of the entire court in the case was that the amounts received by the veterans' organization from a semiannual solicitations program utilizing premium items constituted unrelated business income and that the amounts received by the organization from the rental of its mailing list also constituted unrelated business income. Consequently, the emerging law appears to be that “when premiums are advertised and offered only in exchange for prior contributions in stated amounts,”³⁸⁴ the activity becomes a commercial one. If the organization, however, “had mailed the premiums with its solicitations and had informed the recipients that the premiums could be retained without any obligation arising to make a contribution,”³⁸⁵ the activity would not be a business because it is not a competitive practice.³⁸⁶

Armed with this victory out of the Court of Claims, the IRS is applying the rule concerning premium items to situations where organizations distribute greeting cards for the purpose of raising funds. Some charitable groups have engrafted onto their greeting card distribution program some elements that go beyond the mere sending of cards in the hope that a contribution will result. Some of these factors include “suggesting” a minimum contribution, which is equivalent to the retail value of the cards, and invoicing the recipient of the cards for the amount requested. In one instance, an organization entered into a contract with an independent card distributor, which distributed cards to the organization's members. A minimum contribution was requested per box of cards, and follow-up notices were sent to nonresponsive recipients requesting either payment for the cards or their return. The distributor was paid a fixed amount for each box of cards mailed. In another instance, an organization solicited orders for cards at the time it mailed its newsletter. In some years, a commercial supplier processed the orders; in other years, the organization fulfilled the requests. In all instances, a “minimum price” was suggested. Individuals who returned money that was less than the suggested price were invoiced for the difference.

In the first instance, the IRS held that the program involved sale of the cards.³⁸⁷ The IRS noted that commercial practices were being employed, namely, payment for or return of the cards, and the sending of follow-up notices. Because of these practices, the IRS concluded that the payments were not gifts because they were not “voluntary” and because the amount paid exceeded the fair market value of the cards. The receipts were thus characterized as a sale of the cards at their fair market value in a competitive manner. In the second instance, the IRS stressed the same factors. Again, the program was said to be “indistinguishable from normal commercial operations.”³⁸⁸ Therefore, it is clear that the IRS will treat a greeting card distribution program as an unrelated business where there is a “suggested” price equivalent to the retail value of the cards and where the recipients are invoiced for the payment. Where the cards are distributed without any obligation to the recipient and where there is no subsequent invoicing, however, the better view is that the activity is not an unrelated business and any support provided in response to the appeal is a deductible charitable contribution.³⁸⁹

This matter developed further when the IRS embarked on litigation characterizing card distribution programs of tax-exempt veterans' organizations as unrelated businesses, in the face of the contention that the programs constitute forms of fundraising. Although the government lost the first case in this series,³⁹⁰ the U.S. Tax Court subsequently ruled that the revenue derived by a veterans' organization from the distribution of Christmas cards to its members constitutes unrelated business income.³⁹¹ While recipients of the boxes of cards were not under any legal obligation to pay for them, the literature was written to convey the impression that the cards cannot be considered unsolicited. This card program involved the organization for about one week of time per month from September through February of each year. The program produced substantial profits, being the second-largest revenue source for the organization (behind dues). The veterans' organization contended that the boxes of cards were gifts to its members (in the nature of premiums) and that the monies sent to it from the members also were gifts. It rejected the thought that it was selling the cards and thus that a business was involved. The organization also contended that the activity was not regularly carried on (and therefore not taxable) and that the card dissemination was a related activity in that it promoted comradeship among its members. In finding the activity to be a business, the court concluded that the organization had a profit motive and that the card program constituted the “sale of goods,” noting that 85 to 90 percent of those who paid for the cards paid precisely the amount requested ($2.00 or $3.00, depending on the year involved). It further found that the exception in the tax regulations for low-cost articles³⁹² was inapplicable, in part because of its rejection of the thought that there was any solicitation of contributions. The card program was held to be regularly carried on because of its extent on a seasonal basis and taxable because it was not related to the advancement of the organization's purposes.

Thus, since the raising of funds by a charitable organization is not in itself an exempt function, many types of fundraising activities are vulnerable to the claim that they are unrelated trades or businesses.

(ii) Regularly Carried On Law.   In many instances, the only rationale that precludes taxation of the net income derived from a fundraising effort is the fact that the fundraising is not regularly carried on.

The rationale that fundraising activities are not taxable businesses because they are not regularly carried on finds support in the early IRS literature. The basic position of the IRS is that exempt organization business activities which are engaged in only discontinuously or periodically will not be considered regularly carried on if they are conducted without the competitive and promotional efforts typical of commercial endeavors. As noted, the operation of a sandwich stand by a hospital auxiliary for two weeks at a state fair is not the regular conduct of a trade or business,³⁹³ while the operation of a parking lot for commercial purposes one day each week on a year-round basis is the regular conduct of a trade or business.³⁹⁴ Thus, an annually recurrent dance or similar fundraising event for charity would not be regular since it occurs so infrequently.³⁹⁵

In one case, the U.S. Tax Court concluded that the annual fundraising activity of a charitable organization, consisting of the presentation and sponsoring of a professional vaudeville show one weekend per year, was not regularly carried on.³⁹⁶ The court observed: “The fact that an organization seeks to insure the success of its fundraising venture by beginning to plan and prepare for it earlier should not adversely affect the tax treatment of the income derived from the venture.”³⁹⁷ Indeed, the court went on to note that the IRS “apparently believes that all fundraisers of exempt organizations are conducted by amateurs in an amateurish manner. We do not believe that this is, nor should be, the case. It is entirely reasonable for an exempt organization to hire professionals in an effort to insure the success of a fundraiser.…”³⁹⁸

Just as many fundraising practices are technically trades or businesses, however, so are many regularly carried on. Inasmuch as other rationales for avoiding unrelated income taxation (principally, the contention that the activity is substantially related or that the income is passive) are unlikely to apply in the fundraising context, it is today quite possible for a fundraising activity to be deemed a trade or business that is regularly carried on and an undertaking that is not substantially related to the exercise of a charitable organization's exempt purposes.

There are several instances of the assumption by the IRS of this position, and they are multiplying. One is a 1979 private letter ruling, concerning a case involving a religious organization that conducted, as its principal fundraising activity, bingo games and related concessions.³⁹⁹ Players were charged a fixed amount for the use of bingo cards, the games were held on three nights each week, and the receipts from and expenses of the games were substantial. The IRS concluded that the “bingo games constitute a trade or business with the general public, the conduct of which is not substantially related to the exercise or the performance by the organization of the purpose for which it was organized other than the use it makes of the profits derived from the games.”⁴⁰⁰

The IRS is giving an expansive reading to the rules concerning activities that are regularly carried on, no longer confining the analysis to the period of time the event actually took place. The IRS also takes into account the amount of time the organization prepared for the activity (preparatory time) and the time following the activity and still associated with it (winding-down time). An activity may be found to be regularly carried on when preparatory time and winding-down time are considered, but not when only the time of the event is evaluated. One court has rejected the view that preparatory time is to be regarded for this purpose.⁴⁰¹ The IRS remains in disagreement with these holdings and is continuing to litigate the issue.⁴⁰²

IRS ruled, without discussion of the matter of preparatory time, that an annual golf tournament and annual charity ball were not taxable as unrelated businesses because they were not regularly carried on.⁴⁰³ The preparatory time rule only goes to whether an activity is regularly carried on; it does not always mean that the activity is unrelated. Thus, the IRS held that a literacy event, held eight weekends annually but also entailing “extensive planning,” was regularly carried on and was a related activity.⁴⁰⁴

(iii) Private Benefit.   It is common for a charitable organization to provide information to prospective donors about the tax and other financial implications of a contribution. This is particularly the case in the context of planned giving.⁴⁰⁵ Yet, case law suggests that the provision of services of this nature rises to the level of impermissible private benefit, which would endanger the tax-exempt status of the organization.

A fundamental precept of the federal tax law concerning charitable organizations is that they may not, without imperiling their tax-exempt status, be operated in a manner that causes persons to derive a private benefit from their operations.⁴⁰⁶ Yet the offering of services that amount to personal financial and tax planning—an essential element of the appreciated property and planned gift techniques—may not be considered exempt activities but rather the provision of private benefit. While it would seem nearly inconceivable to contend that, when a charitable organization works with a donor to effect a major gift that will generate significant tax savings for the donor by reason of a charitable contribution deduction, the organization is jeopardizing its tax-exempt status because it is providing a private benefit, this conclusion was the import of the following court decision.

The case concerned the tax status of an organization that engaged in financial counseling by providing tax planning services (including charitable giving considerations) to wealthy individuals referred to it by subscribing religious organizations. The counseling given by the organization consisted of advice on how a contributor might increase current or planned gifts to religious organizations, including the development of a financial plan that, among other objectives, resulted in a reduction of federal income and estate taxes.

The position of the IRS was that this organization could not qualify for federal income tax exemption because it served the private interests of individuals by enabling them to reduce their tax burden. The organization's position was that it was merely engaging in activities that tax-exempt organizations may themselves undertake without loss of their tax exemption. The court agreed with the government, finding that the organization's “sole financial planning activity, albeit an exempt purpose furthering … [exempt] fundraising efforts, has a nonexempt purpose of offering advice to individuals on tax matters that reduces an individual's personal and estate tax liabilities.”⁴⁰⁷ As the court dryly stated, “We do not find within the scope of the word charity that the financial planning for wealthy individuals described in this case is a charitable purpose.”⁴⁰⁸

In this opinion, the court singled out the planned giving techniques for portrayal as methods that give rise to unwarranted private benefit. Thus, the court observed:

For example, when petitioner advises a contributor to establish a charitable unitrust gift, the contributor ultimately forfeits the remainder. Nevertheless, this loss is voluntarily exchanged for considerable lifetime advantages. Unitrusts generate substantial income and estate and gift tax benefits, such as retained income for life, reduced capital gains tax, if any, on the exchange of appreciated investments, favorable tax rates for part or all of the income payments on certain investments, and lower probate costs. Consequently, there are real and substantial benefits inuring to the contributors by the petitioner's activities.⁴⁰⁹

Concluded the court: “We think the tax benefits inuring to the contributors are … substantial enough to deny exemption.”⁴¹⁰

Subsequently, the Tax Court issued an opinion that raised anew questions about the imposition of the unrelated income tax in the fundraising context.⁴¹¹ At issue was the tax status of a membership organization for citizens' band radio operators that used insurance, travel, and discount plans to attract new members. The organization contended that it was only doing what many tax-exempt organizations do to raise contributions, analogizing these activities to fundraising events such as rallies and dinners. The court rejected this argument, defining a “fundraising event” as a “single occurrence that may occur on limited occasions during a given year and its purpose is to further the exempt activities of the organization,” contrasting these events with endeavors that “are continuous or continual activities which are certainly more pervasive a part of the organization than a sporadic event and [that are] … an end in themselves.”⁴¹² A wide variety of fundraising methods other than special events are “continuous” and “pervasive,” and are intended “to further the exempt activities of the organization.” Also, no legitimate fundraising activity is an end in itself, yet many tax-exempt organizations and institutions have major, ongoing fundraising and development programs that are permanent fixtures among the totality of the entities' activities. This decision, then, is another in a series of cases that is forming the foundation for the contention that certain types of fundraising endeavors are unrelated businesses.

In a 1983 case, the Tax Court concluded that a novel “fundraising” scheme was an unrelated trade or business. A nonprofit school consulted with a tax-shelter investments firm in search of fundraising methods, with the result being a program in which individuals purchased various real properties from the school, which the school simultaneously purchased from third parties; both the sellers and the buyers were clients of the investments firm. There were about 22 of these transactions during the years at issue, from which the school received income reflecting the difference between the sales prices and the purchase prices. Finding the “simultaneous purchase and sale of real estate … not substantially related to the exercise or performance of [the school's] … exempt function,” the court held that the net income from the transactions was unrelated business taxable income.⁴¹³

In another case that same year, the Tax Court held that an admittedly religious organization was not tax-exempt because it engaged in a substantial nonexempt purpose, which was the counseling of individuals on the purported tax benefits accruing to those who become ministers of the organization.⁴¹⁴ The court found the organization, which went by the name of The Ecclesiastical Order of the Ism of Am, akin to a “commercial tax service, albeit within a narrower field (i.e., tax benefits to ministers and churches) and a narrower class of customers (i.e., petitioner's ministers),” and thus said that it served private purposes.⁴¹⁵ The many detailed discussions in the organization's literature of ways to maximize tax benefits led the court to observe that “although petitioner may well advocate belief in the God of Am, it also advocates belief in the God of Tax Avoidance.”⁴¹⁶ In words that have considerable implications for fundraising for charitable purposes generally, the court wrote that a “substantial nonexempt purpose does not become an exempt purpose simply because it promotes the organization in some way.”⁴¹⁷ The court somewhat recognized the larger meaning of its opinion and attempted to narrow its scope by noting that “[w]e are not holding today that any group which discusses the tax consequences of donations to and/or expenditures of its organization is in danger of losing or not acquiring tax-exempt status.”⁴¹⁸

The Tax Court revisited this topic early in 1984, holding that an organization, the membership of which is religious missions, was not entitled to tax-exempt status as a religious organization because it engaged in the substantial nonexempt purpose of providing financial and tax advice.⁴¹⁹ Once again, the court was heavily influenced by the recent rush of cases before it, concerning, in the words of the court, “efforts of taxpayers to hide behind the cover of purported tax-exempt religious organizations for significant tax avoidance purposes.”⁴²⁰ As the court saw the facts of the case, each member “mission” was the result of individuals attempting to create churches involving only their families to “convert after-tax personal and family expenses into tax deductible charitable contributions”;⁴²¹ the central organization provided sample incorporation papers, tax seminars, and other forms of tax advice and assistance to those creating the missions. Consequently, the court was persuaded that the “pattern of tax avoidance activities which appears to be present at the membership level, combined with … [the organization's] admitted role as a tax advisor to its members,” justified the conclusion that the organization was ineligible for tax exemption.⁴²²

(iv) Fundraising and Program Activities.   Part of the dilemma in this area stems from functional accounting, a process adopted by the IRS several years ago and imposed on charitable organizations as part of the annual information return preparation and filing process. This method of accounting separates a charitable organization's functions into three categories: program, administration, and fundraising.⁴²³ The dilemma exists because many individuals—including some in law and fundraising—continue to regard fundraising as part of program because its purpose is to promote the organization's activities in some fashion. This misunderstanding is in part fueled by the distinctions in law—accounting notwithstanding—simply between exempt functions and nonexempt functions. Because it is inconceivable that fundraising is a nonexempt function, it must be an exempt function—so the reasoning goes. From that position, it is an easy jump in logic to the conclusion that fundraising is the same as program (as neither is a nonexempt function), but such a conclusion is erroneous.

From this perspective, the tax consequences where a small charity holds an annual car wash, a symphony hosts an annual theater party, a hospital sponsors an annual ball, or a university maintains a planned-giving program are unclear. In each of these cases, functional accounting dictates that the expenses associated with those activities be allocated to fundraising. But do these activities constitute program or are they nonexempt functions? In the four illustrations, the activities are not programs. They are nonexempt functions, and as to the latter they are insubstantial activities. In many cases, then, the tax aspects of fundraising come down to this: Is the fundraising activity substantial (in relation to the organization's other and overall activities) or is it a business? Special-event fundraising is likely to be the prime candidate for classification as a business, particularly where the event has a commercial counterpart. Some examples of this include car washes, bake sales, games, theater parties, dinner parties, and dances. As noted, it is the fact that these events are not regularly carried on that usually spares them taxation.⁴²⁴

Consequently, most fundraising efforts by charitable organizations will escape unrelated income taxation. Those that are taxed are held frequently, are operated in a commercial manner, and utilize paid assistance. Nonetheless, this still leaves the fact that fundraising is not program and is a nonexempt function. Two other principles of tax law apply in this setting. One is that the existence of a single nonexempt purpose, if substantial in nature, will destroy a tax exemption regardless of the number or importance of truly exempt purposes.⁴²⁵ The other is that a tax-exempt organization must serve public purposes and will lose its exemption if it serves private purposes.⁴²⁶ An illustration of the latter principle in the fundraising context is discussed above.⁴²⁷

Thus, the IRS may regulate charitable fundraising by characterizing it as unrelated business and the courts are trending toward a line of thinking that equates charitable giving and associated tax planning with private benefit, thereby causing denial or loss of tax exemption. Either way, the basic rules governing federal income tax exemption and unrelated business activity are being applied in relation to fundraising endeavors, so that fundraising charitable groups are facing a new wave of regulation, with their exempt status or unrelated income taxation as the government's leverage.

The foregoing analysis notwithstanding, the U.S. Claims Court became the first court to squarely face and analyze the difference, for tax purposes, between a fundraising activity and a business activity. The specific issue before this court was whether income, received by a charitable organization as the result of assignments to it of dividends paid in connection with insurance policies purchased by members of a related professional association at group rates, was to be taxed as unrelated income. The court ruled that the program constituted fundraising, not a commercial venture.⁴²⁸ While, as discussed,⁴²⁹ this holding was subsequently overturned, the opportunity was presented to develop a contrast between fundraising efforts and business undertakings.

At the outset, the court wrote that where the tax-exempt organization involved in an unrelated income tax case is a charitable one, the “court must distinguish between those activities that constitute a trade or business and those that are merely fundraising.”⁴³⁰ Admittedly, said the court, this distinction is not always readily apparent, as “[c]haritable activities are sometimes so similar to commercial transactions that it becomes very difficult to determine whether the organization is raising money ‘from the sale of goods or the performance of services’ [the statutory definition of a business activity]⁴³¹ or whether the goods or services are provided merely as an incident to a fundraising activity.”⁴³² Nonetheless, the court held that the test is whether the activity in question is “operated in a competitive, commercial manner,” which is a “question of fact and turns upon the circumstances of each case.”⁴³³ “At bottom,” the court wrote, “the inquiry is whether the actions of the participants conform with normal assumptions about how people behave in a commercial context” and “[i]f they do not, it may be because the participants are engaged in a charitable fundraising activity.”⁴³⁴

In the specific case and in application of these rules, the court stressed five elements: (1) the activity under examination was a pioneering idea at its inception, (2) the activity was originally devised as a fundraising effort and has been so presented since then, (3) the “staggering amount of money” and “astounding profitability” that are generated by the activity,⁴³⁵ (4) the degree of the organization's candor toward its members and the public concerning the operation and revenue of the program, and (5) the fact that the activity is operated with the consent and approval of the association's membership. Concerning the third element, substantial profits and consistently high profit margins are usually cited as reasons for determining that the activity involved is a business. In this case, however, the amounts of money involved were so great that they could not be rationalized in conventional business analysis terms; the only explanation that was suitable to the court was that the funds were the result of successful charitable fundraising.

Despite the findings of the lower courts, the U.S. Supreme Court held that the provision of group insurance policies, underwritten by major insurance companies, by the American Bar Endowment (ABE), a charitable organization, to its members constituted the carrying on of an unrelated trade or business.⁴³⁶ The Court noted that the organization negotiated premium rates with insurers, selected the insurers that provided the coverage, solicited its membership, collected the premiums, transmitted the premiums to the insurer, maintained files on each policyholder, answered members' questions concerning insurance policies, and screened claims for benefits. In finding the activity to be a business, the Court observed that the ABE “prices its insurance to remain competitive with the rest of the market,” the Court “can easily view this case as a standard example of monopoly pricing,” and the case “presents an example of precisely the sort of unfair competition that Congress intended to prevent.”⁴³⁷ The Court concluded that the “only valid argument in ABE's favor, therefore, is that the insurance program is billed as a fundraising effort.”⁴³⁸ But the Court summarily rejected this contention with a rather peculiar observation: “That fact, standing alone, cannot be determinative, or any exempt organization could engage in a tax-free business by ‘giving away’ its product in return for a ‘contribution’ equal to the market value of the product.”⁴³⁹ That, however, is not the state of the law.⁴⁴⁰ The dissent concluded that the provision of insurance to the ABE members was not competitive with commercial enterprises and that the program was “operated as a charitable fundraising endeavor.”⁴⁴¹

As contemporary fundraising techniques have become more intricate and creative, so too have applications of the unrelated business income rules in this setting. This has been in part due to the increasing activism of the IRS in the charitable fundraising context, as illustrated by the intense scrutiny now being accorded by the IRS to the field of special events and corporate sponsorships.⁴⁴² This field, however, is only one of many in the realm of charitable fundraising concerning the IRS and the courts.

The IRS held that an event, where vendors offer arts and crafts, a farmers' market, entertainment, and refreshment booths to the public, sponsored by a tax-exempt alumni association operating to provide financial and civic support to a public college, is an unrelated business.⁴⁴³ The association funds a scholarship program and provides financial support for maintenance of certain college facilities, including a computer room in the library and maintenance of the football field. It publishes an alumni newsletter and conducts annual ceremonies and social events involving graduates, faculty, and staff of the college, as well as community leaders. The IRS's lawyers rejected the alumni association's contentions that the event is a substantially related activity because it has the potential for student recruitment, generating donors, and endearing the college's alumni to that institution,⁴⁴⁴ and it lessens the burdens of government and relieves the distress of the elderly (the majority of the attendees of the event are over age 55).

(v) Principal–Agent Relationships.   Some charitable organizations, in an attempt to minimize their exposure to the unrelated business income tax, contract with independent companies for services pertaining to fundraising that might be considered unrelated activities if the organizations were to conduct the activities themselves. Often, this approach is successful, but it can backfire if the company is regarded as an agent of the charity. (The functions of an agent are regarded in the law as those of the principal.) In this instance, the activities of the agent are attributed to the charitable organization (the principal) for the purpose of calculating the extent of the total activities to, in turn, determine whether the bundle of activities constitutes a business that has been regularly carried on. One court adopted this position of the IRS, concluding that a publishing company operated as an agent of a charitable organization, so that the agent's advertising solicitation services were deemed to be activities of the charity.⁴⁴⁵

(vi) Royalty Exception.   Another current creative undertaking by fundraising charitable organizations is to attempt to structure an activity so that the income generated by the activity can be considered a tax-free royalty.⁴⁴⁶ Because the term royalty is not defined in the Internal Revenue Code or the tax regulations, the scope of the term has been the subject of considerable litigation. There are essentially three ways to define the boundaries of what is a royalty, which basically is a payment for the right to use an item of intangible property: (1) as only a payment that is a form of investment income, when no services may be provided by the royalty recipient; (2) as only a payment that is a form of passive income, when an insubstantial amount of services may be provided by the royalty recipient; or (3) as any payment that constitutes a royalty irrespective of the extent of services the recipient of the royalty may provide.

The position of the IRS was, for some time, that a royalty is excluded from unrelated business income taxation only when it satisfies the first of these definitions, that is, is investment income. Thus, the IRS asserted that if a charitable or other type of tax-exempt organization is actively participating in the undertaking that generates the income (such as promoting a product or service to its membership or making public endorsements), the organization is part of a joint venture and the exclusion for royalties is unavailable. This view has been dramatically rejected by the U.S. Tax Court, which has held that, to be excludable from taxation, the income need only be a payment for the use of one or more valuable intangible property rights.⁴⁴⁷ In one instance, that court held that revenue from the rental of mailing lists (where the statutory exception was unavailable)⁴⁴⁸ was properly treated as a royalty.⁴⁴⁹ In another, that court extended this analysis to income received from an affinity card program.⁴⁵⁰

The core of this interpretation of the royalty exception by the Tax Court is that, although Congress may have believed that royalties and similar types of excluded income are passive,⁴⁵¹ that does not necessarily mean that they must always, in fact, be passive.⁴⁵² Stated in the reverse, this view holds that a statutorily classified item of income excludable from tax remains excludable irrespective of whether the income is derived from an investment, is passive, or is generated from the active conduct of a trade or business.

As the consequence of an appeal of the Tax Court's findings, an opinion issued by the U.S. Court of Appeals for the Ninth Circuit in mid-1996 represents the most authoritative court analysis of this issue. Reviewing dictionary definitions of the term royalty, this appellate court concluded that a royalty is a payment for the right to use intangible property. In a sharp departure from the Tax Court approach, however, the court added that a royalty “cannot include compensation for services rendered by the owner of the property.”⁴⁵³ Thus, the Ninth Circuit adopted the second of the definitions as to the scope of the royalty exception.⁴⁵⁴

This definition is a compromise between the position taken by tax-exempt organizations and that of the IRS. The court of appeals wrote that, to the extent the Service “claims that a tax-exempt organization can do nothing to acquire such fees,” the agency is “incorrect.”⁴⁵⁵ Yet, “to the extent that … [an exempt organization] appears to argue that a ‘royalty’ is any payment for the use of a property right—such as a copyright—regardless of any additional services that are performed in addition to the owner simply permitting another to use the right at issue, we disagree.”⁴⁵⁶

The Ninth Circuit's reading of the facts concerning the mailing list rentals favored the exempt organization in the litigation, which had contracted out many of the services involved in marketing and renting its lists. The court found that the organization “did nothing more than collect a fee” for these rentals.⁴⁵⁷ The income received by the organization from the list rentals was held to be royalty income and not payment for services.⁴⁵⁸ The circumstances concerning the affinity card program were afforded far different treatment. The appellate court disapproved of the way in which the Tax Court had resolved certain factual issues, namely, in favor of the exempt organization involved. This court also strongly suggested that the affinity card program fees were not excludable royalties, because of the extent of services provided.⁴⁵⁹

The Tax Court decided the affinity card program case in mid-1999.⁴⁶⁰ This case, therefore, turned on whether the exempt organization involved was rendering services in connection with the program. The organization, of course, had argued that its name, logo, and mailing list are intangible assets, and that pursuant to the agreement with the card services company it had licensed those properties to the company in exchange for payments that constitute royalties. The IRS asserted that the organization, in this connection, was in a business involving “marketing,” “sponsoring,” “promoting,” and/or “endorsing” the credit card program. The government contended that the contracts entered into by the exempt organization were for services only and that the resulting income was not royalty income because the organization was being paid for these services.

The Tax Court focused on the agreement between the organization and the card company. The provisions regulating the company's use of the exempt organization's name and marks were seen as being in the contract to preserve the organization's property interests in those items. The right to advise and consent with regard to the marketing material prepared by the company was viewed as a right intended to safeguard the organization's name, marks, logo, and other intangibles used in the marketing. Thus, the financial consideration the organization received under this agreement was held to be, at least in part, consideration for the use of valuable intangible property, and as such constituted royalties.

The government asserted that the exempt organization provided seven types of services, all as part of the contention that it was in the business of marketing the credit card program to its members. None of these assertions was successful. One of these sets of asserted services was the organization's control over the marketing materials by way of its power to negate. Also, the organization was provided monthly accountings by the card company. Nonetheless, the court was moved by the fact that the organization did not receive a fee for any marketing activities and did not share in any economics realized by the company in its expenditures made in carrying out its marketing responsibilities.

The court expressly held that the exempt organization's rights in this regard were not inconsistent with a royalty arrangement. These rights were characterized as only evidencing the organization's concern with “protecting the worth of its property interest in its good name and marks.”⁴⁶¹ It was held not to be an indirect method of putting the organization in the business of marketing.

The court rejected the idea that the credit card was being offered by the organization as a member service. The bank involved was the financial institution that extended credit to the members, and it was the card company's marketing efforts that brought the possibility of the credit card and certain other services to the attention of the members. Mere endorsement of the program was held not to be a service provided by the organization.

Although the card company advertised in the exempt organization's publications, it was not given any financial preferences. The company used the organization's nonprofit mail permit on one occasion; the court was convinced that was a mistake. The license agreement, requiring the organization to “cooperate” with the company, was found by the court to “not [be] an agreement to endorse or promote the credit card program beyond the endorsement that necessarily results from [the organization's] license of its logo, name, and the other intangibles here in question.”⁴⁶²

In short, none of the receipts of this exempt organization were in consideration for services provided by the organization as part of the credit card program. All of the receipts were found to be in consideration for the use of the organization's valuable intangible property and, as such, constituted tax-excludable royalties.

There is a vagary in the Ninth Circuit's opinion as to the range of the gap between merely collecting a fee (with no activities) and the amount of tolerable activity the court seemingly contemplates within the boundaries as to what constitutes an excludable royalty. In the context of mailing list rentals, two examples were offered: provision of a rate sheet listing the fee charged for use of each copyrighted design, and retention of the right to approve how the design is used and marketed. Activities that are problematic in this area in general are endorsements, use of the tax-exempt organization's postal permit to send solicitation materials, publishing of paid advertising, the right of the exempt organization to advise with respect to marketing materials, sorting mailing lists, provision of list information on magnetic tape or labels, and provision of other clerical, telephone, and administrative services.⁴⁶³

During the pendency of this litigation, the IRS held to its views in its rulings. For example, the IRS ruled that payments by a commercial enterprise for use of the name and logo of a charitable organization are taxable as unrelated business income (and are not excludable royalties) because the charity also provided endorsements of the business's services.⁴⁶⁴

The denouement of the government's stance came when two other appellate court cases on the subject of the exclusion for royalty income were decided in favor of the tax-exempt organizations.⁴⁶⁵ By this point, the IRS realized that this series of defeats was insurmountable—that the courts were not accepting its interpretation of the scope of the tax-excludable royalty. The IRS National Office, late in 1999, communicated with its exempt organizations specialists in the field, essentially capitulating on the point; a memorandum distributed to them stated bluntly that “[c]ases should be resolved in a manner consistent with the existing court cases.”⁴⁶⁶ This memorandum added that “it is now clear that courts will continue to find the income [generated by activities such as mailing list rentals and affinity card programs] to be excluded royalty income unless the factual record clearly reflects more than unsubstantial services being provided.” Two factors were highlighted by the IRS as establishing nontaxable royalty income: where the involvement of the exempt organization is “relatively minimal” and where the exempt organization “hired outside contractors to perform most services associated with the exploitation of the use of intangible property.”

The matter of income from the exchange of mailing lists continues to fester. The statutory exception for this type of exchange is only applicable when the parties to the exchange are charitable entities.⁴⁶⁷ The position of the IRS has consistently been that the exchange of mailing lists by a tax-exempt organization with similar exempt organizations does not create unrelated business income (namely, barter income of an amount equal to the value of the lists received).⁴⁶⁸ The rationale is that the activity is not a business because it is not carried on for profit but rather to obtain the names of potential donors. The IRS is also of the view that this type of exchange is a business that is substantially related to the organization's exempt function as being a “generally accepted method used by publicly supported organizations to assist them in maintaining and enhancing their active donor files.”⁴⁶⁹ Where a tax-exempt organization exchanges mailing lists to produce income, however, it is the view of the IRS that the transaction is economically the same as a rental and thus is an unrelated trade or business.⁴⁷⁰ The IRS rejects the argument that an exchange of mailing lists creates capital gain that is excluded from taxation.⁴⁷¹ It also does not accept the contention that the exchange is a tax-free like-kind exchange of property⁴⁷² because title to the property does not pass and the exchange is only a one-time (rather than permanent) transaction. The IRS, however, will not rule on how this form of income is to be calculated, including the deductions that may be available, stating that this is to be ascertained on a case-by-case basis.⁴⁷³

One of the arguments persistently advanced by the IRS is that the statutory exception protecting certain mailing list transactions from taxation is to be read as permitting (perhaps requiring) taxation of these transactions in situations where the exception is not available. This contention is equally persistently rejected in the courts.⁴⁷⁴ The legislative history of the provision is to the contrary of the IRS position. One element of this history states as follows: “No inference is intended as to whether or not revenues from mailing list activities other than those described in the provision, or from mailing list activities described in the provision, but occurring prior to the effective date, constitute unrelated business income.”⁴⁷⁵ This point was also reflected in the House debate on the legislation, in remarks offered by the then-Chairman of the House Committee on Ways and Means: this provision “carries no inference whatever that mailing list revenues beyond its scope or prior to its effective date should be considered taxable to an exempt organization.”⁴⁷⁶

(vii) Sale-of-Gift-Items Exception.   As noted, a business constituting the sale of merchandise, substantially all of which has been received by the organization as contributions, is not an unrelated business.⁴⁷⁷ Although this exception is principally utilized by thrift shops,⁴⁷⁸ it is available in other contexts, such as fundraising programs involving gifts of automobiles, boats, and airplanes.

The IRS, however, revoked the tax-exempt status of an organization claiming to be operating an automobile donation program to fund its charitable grantmaking.⁴⁷⁹ Apparently, this organization's operations were too closely related, from the IRS's perspective, to those of a used-car dealership. The formal reasons for the revocation appear to be the organization's lack of adequate records⁴⁸⁰ and violation of the doctrine of private benefit.⁴⁸¹

Another charitable organization had its exemption revoked, in part because of the nature of its fundraising program. This entity solicits contributions of real estate timeshares and sells them. The IRS, ignoring this exception to the unrelated business rules, wrote that the primary purpose of the organization is “attracting customers who would otherwise have gone elsewhere to sell their timeshares.”⁴⁸² That could be said of any charity soliciting noncash gifts, including real estate. The owners of property always have the option to sell it or contribute it to any charity. The IRS, for purpose of its faulty analysis, turned this type of transaction inside out.

(viii) Commercial Coventures.   The IRS has assumed a generous stance concerning charitable sales promotions or commercial coventures, where a charitable organization consents to be a donee under circumstances in which a commercial business agrees to make a gift to the charity, with that agreement advertised to the public, and where the amount of the gift is predicated on the extent of products sold or services provided by the business to the public during a particular time period.⁴⁸³ The IRS agrees with the charitable community that these payments are contributions, deductible as such; in practice, these payments are often deducted as business expenses.

(ix) Cause-Related Marketing.   The position of the IRS as to cause-related marketing is different. In these circumstances, the charitable organization is marketing a product or service to the public, or similarly using its resources. These efforts are analyzed by the IRS, applying traditional unrelated business income analysis. Often, the activity is considered a business that is regularly carried on, albeit a related (and thus nontaxable) one.⁴⁸⁴ The activity can also be regarded as an unrelated business, however, particularly where the marketing is considered to be commercial in nature.⁴⁸⁵

(x) Corporate Services.   It has become increasingly common for a charitable or other tax-exempt organization to provide services to another charitable or other tax-exempt organization, in circumstances where the services are not inherently exempt functions. These services are management, other administrative, or fundraising services; they have come to be known as corporate services.

Traditionally, the provision of corporate services was considered by the IRS to be the conduct of unrelated business. In recent years, however, the IRS reviewed the tax aspects of joint operating agreements, which are contracts by which a number of health care providers and associated entities function on an interrelated basis, resulting in health care provider networks.⁴⁸⁶ Within these networks is the provision of corporate services by some of these organizations, for compensation.

Were this compensation taxable as unrelated business income, these networks would not be workable. Resolving this issue, the IRS, on the basis of law developed in another context,⁴⁸⁷ concluded that the income flows arising from the provision of these corporate services should be regarded as a matter of accounting, which means that the income is disregarded for unrelated business income purposes. To have this result, however, the IRS ruled that the relationship between the organizations must either be that of parent and subsidiary or be analogous to that of parent and subsidiary.

This development was transformative for many other types of tax-exempt organizations because the tax law rationale underlying these agreements could not be confined to the context of joint operating agreements. It meant that any situation in which one tax-exempt organization has a parent–subsidiary relationship with another exempt organization (such as an exempt organization with a related fundraising foundation) could be protected by this rationale. It also meant that the matter-of-accounting rationale could be extended to any arrangement where the relationship between two tax-exempt organizations is analogous to that of parent and subsidiary.

Some time passed before this rationale was extended outside the realm of joint operating agreements. The first occasion where this happened involved a tax-exempt social welfare organization, which provided corporate services to its related foundation.⁴⁸⁸ There, a parent–subsidiary relationship was found. Thereafter, the IRS began issuing rulings on the matter of what it means to have a relationship that is analogous to that of parent and subsidiary.⁴⁸⁹

These developments make it clear that a tax-exempt organization can provide corporate services to another tax-exempt organization, without engaging in unrelated business activity, as long as the relationship is at least analogous to that of parent and subsidiary. These activities may include fundraising services.

(i) Allocations.   The TAM stated that the “Service recognizes that many educational and religious organizations … carry out their exempt functions through directly mailing educational or religious material that also contain elements of fundraising.” The IRS continued: “In fact fundraising letters are sometimes the principal means by which the general public is made aware of the exempt purposes and programs of an organization.” Consequently, the IRS, in this TAM, concluded that “reasonable allocations of mixed programs are allowed.”

But then the IRS's lawyers concluded that the “extent that an allocation may be taken between fundraising and program-related activities depends on the facts and circumstances of each particular case.” In this case, the IRS concluded that the “vast bulk of … [the charity's] fundraising mail-outs had very little content that could be described as having educational value ….” The IRS concluded that the educational content in the fundraising material was thus “insubstantial.”

The IRS found that the “thrust of … [the charity's] fundraising literature is the solicitation of readers to participate in a sweepstakes in an effort to raise funds rather than to educate the public.” The IRS added that the “appeal to fund research and find a cure for … [the disease involved] is secondary in the letters to an appeal to acquire wealth through gambling.”

Using both linear and square-inch methods, the IRS measured sample mailings and concluded that over 90 percent of the content of the mailings was not educational. In so doing, the IRS, as noted, included generic material.

(ii) Commensurate Test.   An important aspect of this TAM is its analysis of the commensurate test. This test, established by the IRS in 1964,⁴⁹² endeavors to determine whether a charitable organization is carrying on charitable works commensurate in scope with its financial resources. In the particular facts underlying the ruling, the charity derived most of its income from rents, yet preserved its tax exemption because it satisfied the commensurate test.

The test was applied in 1967,⁴⁹³ then went unused until 1990, when the IRS launched the second phase of its Special Emphasis Program concerning charitable solicitations. The commensurate test was resurrected and made a part of federal fundraising regulation by its inclusion in the 82-question “Exempt Organizations Charitable Solicitations Compliance Improvement Program Study Checksheet.”⁴⁹⁴

According to the TAM, the commensurate test, when applied in the fundraising context, means that an “organization whose principal activity consists of the raising of funds must carry on a charitable program commensurate in scope with its financial resources in order to qualify for section 501(c)(3) exemption.”

Wrote the IRS:

The “commensurate test” does not lend itself to a rigid numerical distribution formula—there is no fixed percentage of income that an organization must pay out for charitable purposes. The financial resources of any organization may be affected by such factors as start-up costs, overhead, scale of operations, whether labor is volunteer or salaried, phone or postal costs, etc. In each case, therefore, the particular facts and circumstances of the organization must be considered. Accordingly, a specific payout percentage does not automatically mandate the conclusion that the organization under consideration has a primary purpose that is not charitable. In each case, it should be ascertained whether the failure to make real and substantial contributions for charitable purposes is due to reasonable cause.…

While there is no specified payout percentage, and while special facts and circumstances may control the conclusion, distribution levels that are low invite close scrutiny. The “commensurate test” requires that organizations have a charitable program that is both real and, taking the organization's circumstances and financial resources into account, substantial. Therefore, an organization that raises funds for charitable purposes but consistently uses virtually all its income for administrative and promotional expenses with little or no direct charitable accomplishments cannot reasonably argue that its charitable program is commensurate with its financial resources and capabilities.

The IRS found that, during the two years under review, the organization expended 3.9 percent of its revenues for charitable programs. The IRS's lawyers characterized that as a “truly insignificant figure compared to all the time and treasure involved.” Under all of the facts and circumstances discovered, the IRS decided that the organization did not carry on a charitable program commensurate in scope with its financial resources. Consequently, it was recommended that the organization's exemption be revoked as of the date the organization entered into the contract with the fundraising firm.

(iii) Private Benefit Standard.   The IRS also proposed revocation of this exemption on the ground that the charity had been operated for the private interest of the fundraiser rather than the public interest.

This is an application of the private benefit doctrine so dramatically expanded by the Tax Court in 1989.⁴⁹⁵ The doctrine allows an exemption to be revoked where there is private benefit, even though there is no violation of the statutory prohibition on private inurement.

The private inurement doctrine requires an insider; the private benefit rule does not.⁴⁹⁶ The IRS conceded that the fundraiser did not control the charity in this case, but it found the relationship to be “symbiotic.”

(iv) Substantial Nonexempt Purpose Test.   Another basis for revocation of the exemption was application of the substantial nonexempt purpose test. The IRS held that “engaging in wide-scale sweepstakes activities with often misleading contest representations [was] neither necessary nor valuable in achieving … [the organization's] educational or health goals, except to obtain money.” The IRS found that the organization's “gambling devices” were essentially indistinguishable from devices used by commercial entities such as Reader's Digest and Publishers Clearinghouse. The organization's fundraising activities were characterized by the IRS as being “indistinguishable from ordinary commercial activities.”