SCOTUS Reports

Tag: Unrelated Business Taxable Income

  • Sherwin-Williams Co. Employee Health Plan Trust v. Commissioner, 115 T.C. 440 (2000): The Application of Set-Aside Limits for Voluntary Employees’ Beneficiary Associations

    Sherwin-Williams Co. Employee Health Plan Trust v. Commissioner, 115 T. C. 440 (2000)

    Investment income set aside by a VEBA for administrative costs connected with providing benefits is subject to set-aside limits under IRC Section 512(a)(3)(E)(i).

    Summary

    The Sherwin-Williams Company Employee Health Plan Trust (Trust), a tax-exempt voluntary employees’ beneficiary association (VEBA), challenged the IRS’s determination that its investment income set aside for administrative costs was subject to unrelated business income tax (UBTI). The Trust argued that these costs were exempt function income and not subject to the set-aside limits under IRC Section 512(a)(3)(E)(i). The Tax Court ruled against the Trust, holding that the set-aside limits do apply to such income, and the amounts set aside must not exceed the account limit determined under IRC Section 419A without regard to the post-retirement medical benefits reserve.

    Facts

    The Trust was established by Sherwin-Williams to fund health care benefits for its employees. It was recognized as a VEBA under IRC Section 501(c)(9). The Trust’s income came from member contributions and investments. For the tax years 1991 and 1992, the Trust set aside investment income to cover administrative costs related to health care benefits. The IRS determined that these amounts were subject to UBTI because they exceeded the set-aside limits prescribed by IRC Section 512(a)(3)(E)(i).

    Procedural History

    The IRS issued a notice of deficiency to the Trust for the tax years 1991 and 1992, asserting deficiencies due to the Trust’s failure to include the set-aside investment income in its UBTI calculations. The Trust filed a petition with the U. S. Tax Court challenging the IRS’s determinations. The Tax Court held in favor of the IRS, finding that the investment income at issue was subject to the set-aside limits under IRC Section 512(a)(3)(E)(i).

    Issue(s)

    1. Whether the amount of investment income set aside by the Trust to provide for the payment of reasonable costs of administration directly connected with providing for the payment of health care benefits is subject to the limitation prescribed by IRC Section 512(a)(3)(E)(i)?
    2. Whether, in calculating the limitation prescribed by IRC Section 512(a)(3)(E)(i), the amount of assets set aside by the Trust to provide for the payment of health care benefits, including reasonable costs of administration, must be reduced by the reserve for post-retirement medical benefits described in IRC Section 419A(c)(2)(A)?

    Holding

    1. Yes, because the plain language of IRC Section 512(a)(3)(B) treats income set aside for administrative costs as income set aside for the purpose described in that section, which is subject to the limitation prescribed by IRC Section 512(a)(3)(E)(i).
    2. No, because the limitation prescribed by IRC Section 512(a)(3)(E)(i) requires only the account limit determined under IRC Section 419A to be reduced by the reserve for post-retirement medical benefits, not the amount of assets set aside.

    Court’s Reasoning

    The Tax Court interpreted IRC Section 512(a)(3)(B) to mean that income set aside for administrative costs related to exempt purposes is still subject to the set-aside limits under IRC Section 512(a)(3)(E)(i). The court rejected the Trust’s argument that administrative costs constitute an independent source of exempt function income, stating that such costs are part of the set-aside for benefits under IRC Section 512(a)(3)(B)(ii). The court also clarified that the parenthetical phrase in IRC Section 512(a)(3)(E)(i) regarding the exclusion of the post-retirement medical benefits reserve applies only to the calculation of the account limit under IRC Section 419A, not to the calculation of the total assets set aside. This interpretation was supported by the legislative history and temporary regulations. The court noted that the Trust’s own agreement acknowledged the applicability of IRC Section 512(a)(3)(E)(i) to administrative costs.

    Practical Implications

    This decision clarifies that VEBAs must include investment income set aside for administrative costs in their UBTI calculations if such amounts exceed the limits set by IRC Section 512(a)(3)(E)(i). Practitioners should ensure that their clients’ VEBAs adhere to these set-aside limits, carefully calculating the account limit under IRC Section 419A without including the post-retirement medical benefits reserve. This ruling impacts how VEBAs structure their reserves and may influence their financial planning and tax strategies. Subsequent cases, such as those involving other types of exempt organizations, may reference this decision to interpret similar set-aside provisions.

  • Ohio Farm Bureau Fed’n v. Commissioner, 106 T.C. 222 (1996): When Tax-Exempt Organizations’ Service and Noncompete Payments Are Not Unrelated Business Income

    Ohio Farm Bureau Federation, Inc. v. Commissioner of Internal Revenue, 106 T. C. 222 (1996)

    Payments received by a tax-exempt organization for services related to its exempt purpose and for noncompetition are not unrelated business income if they do not arise from a regularly conducted trade or business.

    Summary

    The Ohio Farm Bureau Federation, a tax-exempt agricultural organization, received payments from Landmark, Inc. , under a service contract to promote agricultural cooperatives and from a noncompetition clause upon the termination of their relationship. The Tax Court held that the service contract payments were substantially related to the Federation’s exempt purpose and thus not unrelated business taxable income (UBTI). Additionally, the noncompetition payment was not UBTI because it did not stem from a trade or business regularly carried on by the Federation. The court’s decision hinged on the activities’ alignment with the organization’s exempt purposes and the non-regular nature of the noncompetition agreement.

    Facts

    The Ohio Farm Bureau Federation, a tax-exempt organization under section 501(c)(5), formed Landmark, Inc. , in 1934 to promote agricultural cooperatives. In 1949, they entered a service contract where the Federation agreed to perform promotional and educational services for Landmark in exchange for fees. This relationship continued until 1985 when Landmark merged with another cooperative, leading to the termination of their contract. The termination agreement included a noncompetition clause, for which the Federation received $2,064,500. The Commissioner of Internal Revenue challenged the tax-exempt status of these payments as UBTI.

    Procedural History

    The Commissioner determined deficiencies in the Federation’s federal income tax for the taxable periods ending August 31, 1985, and August 31, 1986. The Federation petitioned the U. S. Tax Court to challenge these deficiencies, specifically contesting whether the payments under the service contract and the noncompetition clause constituted UBTI.

    Issue(s)

    1. Whether the $292,617 received by the Federation under the service contract with Landmark during the taxable year ending August 31, 1985, constituted unrelated business taxable income.
    2. Whether the lump-sum payment of $2,064,500 made by Landmark to the Federation pursuant to a noncompetition clause constituted unrelated business taxable income.

    Holding

    1. No, because the services provided by the Federation were substantially related to its tax-exempt purpose of promoting agricultural cooperatives.
    2. No, because the noncompetition payment did not arise from a trade or business regularly carried on by the Federation.

    Court’s Reasoning

    The court found that the Federation’s activities under the service contract were unique to its exempt purpose and benefited its members as a group, not individually, thus not constituting UBTI. The court applied the three elements for UBTI: the activity must be a trade or business, regularly carried on, and not substantially related to the organization’s exempt purpose. For the noncompetition payment, the court ruled it was not derived from a trade or business since it was a one-time event, lacking the continuity and regularity required for UBTI. The court cited Commissioner v. Groetzinger and other cases to distinguish sporadic activities from those regularly conducted as a business. The decision was influenced by the policy against taxing income that does not compete with taxable businesses.

    Practical Implications

    This ruling clarifies that payments for services aligned with an exempt organization’s purpose are not taxable as UBTI, provided they are not conducted as a regular business activity. It also establishes that noncompetition payments, if not part of regular business activity, are similarly exempt. Legal practitioners advising tax-exempt organizations should ensure that service contracts and termination agreements are structured to support the organization’s exempt purpose and avoid activities that could be construed as regularly conducted business. This case has been influential in subsequent cases involving similar tax issues for exempt organizations and has implications for how these organizations structure their relationships with for-profit entities to maintain their tax-exempt status.

  • Chicago Metro. Ski Council v. Commissioner, 104 T.C. 341 (1995): Deductibility of Editorial Expenses from Advertising Income for Social Clubs

    Chicago Metro. Ski Council v. Commissioner, 104 T. C. 341 (1995)

    Social clubs may deduct editorial expenses from advertising income in computing unrelated business taxable income under section 1. 512(a)-1(f) of the Income Tax Regulations.

    Summary

    The Chicago Metropolitan Ski Council, a social club under section 501(c)(7), published a magazine with both editorial content and paid advertisements. The issue was whether the club could deduct editorial expenses from the advertising income for tax purposes. The Tax Court held that section 1. 512(a)-1(f) of the Income Tax Regulations, which allows such deductions, applies to social clubs. This decision affirmed the deductibility of all publication expenses against advertising income, resulting in smaller tax deficiencies than initially determined by the Commissioner.

    Facts

    Chicago Metropolitan Ski Council, a nonprofit corporation organized under Illinois law, was recognized as a social club exempt from federal income tax under section 501(c)(7). It published the Midwest Skier magazine, distributing it free to members and nonmembers. The magazine included both editorial content and paid advertisements from ski industry businesses. For the tax years ending June 30, 1987, and June 30, 1988, the club earned advertising revenue of $40,296 and $39,383, respectively, and incurred publication expenses totaling $36,311 and $40,185. The Commissioner initially allowed all these expenses to be deducted from the advertising income but later reconsidered, allowing only 39. 823% of expenses based on the proportion of advertising space.

    Procedural History

    The Commissioner issued a notice of deficiency, disallowing a portion of the publication expenses as deductions. The Ski Council petitioned the Tax Court, contesting the Commissioner’s revised position. The case was assigned to a Special Trial Judge, whose opinion was adopted by the Tax Court.

    Issue(s)

    1. Whether section 1. 512(a)-1(f) of the Income Tax Regulations, which allows the deduction of editorial expenses from advertising income, applies to social clubs under section 501(c)(7).

    Holding

    1. Yes, because section 1. 512(a)-1(f) applies to social clubs, allowing the deduction of all editorial expenses from advertising income in computing unrelated business taxable income.

    Court’s Reasoning

    The Tax Court analyzed the legislative history and the language of the relevant sections of the Internal Revenue Code and regulations. It noted that while section 512(a)(3)(A) defines unrelated business taxable income for social clubs differently from section 512(a)(1), both sections use the phrase “directly connected with” when referring to allowable deductions. The court rejected the Commissioner’s argument that section 1. 512(a)-1(f) was inapplicable to social clubs, as the regulation did not explicitly limit its application. The court also cited Ye Mystic Krewe of Gasparilla v. Commissioner, which applied a similar test for deductions under section 512(a)(3)(A). The court concluded that applying section 1. 512(a)-1(f) to social clubs was consistent with the regulation’s intent to allow deductions for expenses directly connected with advertising income. The court emphasized that other regulatory provisions provide safeguards against the subsidization of exempt functions through taxable income.

    Practical Implications

    This decision clarifies that social clubs can deduct all expenses related to the publication of periodicals, including editorial expenses, from advertising income. This ruling impacts how social clubs calculate their unrelated business taxable income, potentially reducing their tax liabilities. Legal practitioners advising social clubs should ensure that clients are aware of this deduction when preparing tax returns. The decision may also influence how the IRS audits social clubs and how they structure their publications to maximize deductions. Subsequent cases have followed this precedent, reinforcing the applicability of section 1. 512(a)-1(f) to various types of exempt organizations.

  • Leila G. Newhall Unitrust v. Commissioner, 105 T.C. 406 (1995): Taxation of Charitable Remainder Unitrusts Receiving Unrelated Business Taxable Income

    Leila G. Newhall Unitrust v. Commissioner, 105 T. C. 406 (1995)

    A charitable remainder unitrust loses its tax-exempt status and is taxable on all its income if it receives any unrelated business taxable income (UBTI).

    Summary

    In Leila G. Newhall Unitrust v. Commissioner, the Tax Court ruled that the petitioner, a charitable remainder unitrust, was taxable on all its income for the years 1988 and 1989 because it received unrelated business taxable income (UBTI) from its interests in limited partnerships. The court determined that the trust’s passive ownership of partnership interests constituted being a “member” of the partnerships, and thus, the income was subject to UBTI rules. Furthermore, the court upheld the regulation that a charitable remainder unitrust loses its tax-exempt status for any year in which it has UBTI, necessitating taxation on its entire income. The decision also confirmed an addition to tax for substantial understatement of income for 1988.

    Facts

    The Leila G. Newhall Unitrust, a charitable remainder unitrust, received interests in Newhall Land & Farming Co. , Newhall Investment Properties, and Newhall Resources through a corporate liquidation in 1983 and 1985. These interests were publicly traded limited partnerships. For the tax years 1988 and 1989, the trust reported income from these partnerships and claimed it was not subject to unrelated business taxable income (UBTI). The Commissioner disagreed, asserting that the trust was liable for UBTI and, consequently, should be taxed on all its income as a result of losing its tax-exempt status under section 664(c).

    Procedural History

    The Commissioner determined deficiencies and additions to tax for the trust’s 1988 and 1989 tax returns. The trust challenged these determinations and also sought refunds for those years. The Tax Court reviewed the case, focusing on whether the trust received UBTI, the extent of its tax liability, and the applicability of an addition to tax under section 6661 for substantial understatement of income for 1988.

    Issue(s)

    1. Whether the trust received unrelated business taxable income (UBTI) under section 512(c) from its interests in limited partnerships.
    2. If the trust did receive UBTI, whether it is taxable under section 664(c) only to the extent of its UBTI or on its entire net income.
    3. Whether the trust is liable for the addition to tax under section 6661 for the taxable year 1988.

    Holding

    1. Yes, because the trust was a member of the partnerships and the partnerships’ income was considered UBTI under section 512(c).
    2. No, because the trust, having received UBTI, lost its tax-exempt status under section 664(c) and is taxable on its entire income.
    3. Yes, because the trust’s understatement of income tax for 1988 exceeded the threshold for a substantial underpayment under section 6661.

    Court’s Reasoning

    The court applied section 512(c) to determine that the trust’s passive ownership of limited partnership interests constituted being a “member” of the partnerships, making the income subject to UBTI rules. The court rejected the trust’s argument that it was not a member because it did not actively participate in the partnerships, citing Service Bolt & Nut Co. Profit-Sharing Trust v. Commissioner for the broad definition of “member. ” The court also upheld the regulation under section 664(c), which states that a charitable remainder unitrust is taxable on all its income if it has any UBTI in a given year. The court found this regulation to be a reasonable interpretation of the statute, supported by legislative history, and consistent with the principle that exemptions are matters of legislative grace. The court also found that the trust’s understatement of income for 1988 was substantial under section 6661, leading to an addition to tax.

    Practical Implications

    This decision underscores the importance for charitable remainder unitrusts to carefully consider the tax implications of investments that may generate unrelated business taxable income. Trusts must be aware that even passive investments in partnerships can lead to the loss of their tax-exempt status, subjecting them to taxation on all their income for the affected years. Legal practitioners advising such trusts should recommend thorough due diligence on potential investments to avoid UBTI and the consequent full taxation. This ruling may also influence future cases involving the tax treatment of charitable trusts and their investments, emphasizing the strict interpretation of the UBTI rules and the conditions for maintaining tax-exempt status.

  • Oblinger Charitable Trust v. Commissioner, T.C. Memo. 1994-527: Exclusion of Sharecrop Lease Rents from Unrelated Business Taxable Income

    Oblinger Charitable Trust v. Commissioner, T. C. Memo. 1994-527

    Rents from sharecrop leases based on a fixed percentage of crop production are excluded from unrelated business taxable income under section 512(b)(3).

    Summary

    The Oblinger Charitable Trust, a nonexempt private foundation, leased farmland in Illinois under sharecrop agreements, receiving 50% of the crops as rent. The issue was whether these rents were excludable from unrelated business taxable income (UBIT). The court held that the rents did not violate the passive rent test of section 512(b)(3)(B)(ii), as they were based on a fixed percentage of crop receipts, not profits, and the arrangements constituted true landlord-tenant relationships rather than partnerships or joint ventures. This decision clarifies that sharecrop lease rents based on crop shares are not subject to UBIT, impacting how similar arrangements should be structured and reported by charitable entities.

    Facts

    The Oblinger Charitable Trust was created under the will of Emily D. Oblinger to support students at the University of Illinois. The trust owned farmland in Illinois and entered into sharecrop leases with Edwin and Leroy Wetzel. Under these leases, the tenants were responsible for all farming operations, machinery, and labor, while the trust provided the land, buildings, and shared certain costs like seed and fertilizer. The rent was fixed at 50% of the harvested crops. The trust received $34,331 and $55,105 from crop sales in 1985 and 1986, respectively. The Commissioner determined deficiencies in the trust’s excise and unrelated business income taxes, arguing the rents should be included in UBIT.

    Procedural History

    The case began with the Commissioner determining deficiencies in the trust’s Federal tax. The trust filed a petition with the U. S. Tax Court to contest these deficiencies, specifically challenging the inclusion of rents from sharecrop leases in its unrelated business taxable income.

    Issue(s)

    1. Whether rents received under sharecrop leases are excluded from unrelated business taxable income pursuant to section 512(b)(3)(B)(ii)?

    Holding

    1. Yes, because the rents were based on a fixed percentage of the harvested crops, not on income or profits, and the arrangements constituted true landlord-tenant relationships rather than partnerships or joint ventures.

    Court’s Reasoning

    The court applied section 512(b)(3), which excludes rents from real property from UBIT, subject to the passive rent test in section 512(b)(3)(B)(ii). The court found that the trust’s involvement did not rise to the level of a partnership or joint venture, as evidenced by the terms of the lease, the trust’s limited liability, and the absence of profit-sharing or loss carryover provisions. The court emphasized that the rent was a fixed percentage of the crops, akin to a percentage of receipts, not profits. The decision was supported by precedents like United States v. Myra Foundation and Moore Charitable Trust v. United States, which also upheld the exclusion of similar rents from UBIT. The court noted that the legislative history of section 512(b)(3) and related regulations aimed to prevent the inclusion of active business income as rent, but the fixed percentage of crop shares in this case did not violate this principle.

    Practical Implications

    This decision provides clear guidance for charitable entities and their tax advisors on structuring sharecrop leases to avoid UBIT. Charitable trusts and foundations can continue to use sharecrop leases to generate income without fear of UBIT, as long as the rent is based on a fixed percentage of crop production and the arrangement is a genuine landlord-tenant relationship. This ruling may encourage more charitable entities to invest in agricultural land and use sharecrop arrangements. It also reaffirms the importance of carefully drafting lease agreements to ensure they meet the statutory requirements for rent exclusion. Subsequent cases like Moore Charitable Trust v. United States have followed this precedent, solidifying the exclusion of such rents from UBIT.

  • Disabled American Veterans v. Commissioner, 94 T.C. 60 (1990): Payments for Use of Intangible Assets as Royalties Under Tax-Exempt Organization Rules

    Disabled American Veterans v. Commissioner, 94 T. C. 60 (1990)

    Payments for the use of intangible assets by tax-exempt organizations can be classified as royalties and excluded from unrelated business taxable income (UBTI).

    Summary

    The Disabled American Veterans (DAV) rented portions of its donor list to other organizations, receiving payments in return. The issue was whether these payments were ‘royalties’ exempt from UBTI or ‘rents’ subject to tax. The court held that the payments were royalties, as they were for the one-time use of the intangible asset (the donor list). The decision clarified that royalties do not need to be passive income to be excluded from UBTI, impacting how tax-exempt organizations classify income from licensing intangible assets.

    Facts

    The Disabled American Veterans (DAV), a tax-exempt organization under section 501(c)(4), maintained a donor list to solicit contributions. From 1974 to 1985, DAV permitted other organizations to use names from this list for their mailings in exchange for payment. These payments were treated as income from an unrelated trade or business. DAV argued these were royalties, excluded from UBTI under section 512(b)(2), while the Commissioner argued they were rents, subject to UBTI.

    Procedural History

    The Commissioner determined deficiencies in DAV’s federal income tax for the years 1974-1985. After concessions, the issue of whether payments from DAV’s list rental activities were royalties or rents was tried. The court denied the Commissioner’s motion for partial summary judgment based on collateral estoppel, citing a change in legal climate due to Rev. Rul. 81-178, which affected the interpretation of royalties under section 512(b)(2).

    Issue(s)

    1. Whether payments received by DAV for the use of names from its donor list are royalties, excluded from UBTI under section 512(b)(2), or rents, subject to UBTI?

    Holding

    1. Yes, because the payments were for the one-time use of an intangible asset (the donor list), and royalties do not need to be derived from passive sources to be excluded from UBTI.

    Court’s Reasoning

    The court interpreted section 512(b)(2) broadly, aligning with Rev. Rul. 81-178, which defined royalties as payments for the use of intangible assets. The court rejected the argument that royalties must be passive income to be excluded from UBTI, noting that Congress did not include such a requirement in the statute. DAV’s activities to maintain and improve its donor list were seen as enhancing the value of the intangible asset, not changing the nature of the payments from royalties to rents. The court emphasized that the payments were solely for the licensing of the donor list, not for services, and thus were royalties under the law. The decision also considered precedent and the statutory structure, concluding that section 512(b)(2) excluded all royalties connected to an unrelated trade or business, regardless of the level of activity involved in generating them.

    Practical Implications

    This decision allows tax-exempt organizations to classify payments received for the use of their intangible assets as royalties, potentially reducing their tax liabilities by excluding such income from UBTI. Legal practitioners should note that active management or enhancement of an intangible asset does not preclude the classification of payments as royalties. This ruling may influence how organizations structure their licensing agreements and report income, potentially affecting fundraising and business strategies. Subsequent cases like National Collegiate Athletic Assn. v. Commissioner have distinguished this ruling by focusing on whether payments are truly for the use of an intangible or for services rendered.

  • National Collegiate Athletic Association v. Commissioner, T.C. Memo. 1990-37 (1990): Advertising Income as Unrelated Business Taxable Income

    National Collegiate Athletic Association v. Commissioner, T.C. Memo. 1990-37 (1990)

    Income derived by a tax-exempt organization from advertising in game programs for its major events constitutes unrelated business taxable income (UBTI) when the advertising activity is regularly carried on through an agent, and such income does not qualify for the royalty exception to UBTI.

    Summary

    The National Collegiate Athletic Association (NCAA), a tax-exempt organization, contracted with Lexington Productions (Host) to publish and sell advertising in programs for the 1982 Men’s Division 1 Basketball Championship Tournament. The Tax Court determined that the income NCAA received from program advertising was unrelated business taxable income (UBTI) because the advertising activity was regularly carried on through its agent, Host, and the income did not qualify as royalties. The court emphasized that the sale of advertising space is a distinct trade or business and that using an agent does not automatically make the activity intermittent. Furthermore, the income was not a royalty because NCAA’s involvement was not passive, and Host provided services beyond merely using NCAA’s rights.

    Facts

    The NCAA, a tax-exempt organization, sponsors numerous college athletic championships, including the Men’s Division 1 Basketball Championship Tournament. To generate revenue for the tournament, the NCAA contracted with Host to publish game programs and sell advertising space within them for the 1982 Final Four games and regional rounds. Under the contract, Host was designated as the NCAA’s “exclusive agent” for advertising sales and was responsible for all aspects of advertising solicitation, creation, billing, and collection. The NCAA’s involvement was minimal, primarily limited to recommending story ideas and reviewing a few proposed advertisements for compliance with contractual restrictions. The NCAA received a percentage of the net revenues from advertising sales.

    Procedural History

    The Internal Revenue Service (IRS) determined that the income the NCAA received from program advertising was unrelated business taxable income and issued a notice of deficiency. The NCAA challenged this determination in the Tax Court.

    Issue(s)

    1. Whether the income received by the NCAA from the sale of advertising in game programs for the 1982 Men’s Division 1 Basketball Championship Tournament constituted unrelated business taxable income under Section 512 of the Internal Revenue Code.
    2. If the income is considered unrelated business taxable income, whether it is excludable from taxation as a royalty under Section 512(b)(2).

    Holding

    1. Yes, the income from program advertising is unrelated business taxable income because the advertising activity was “regularly carried on” by the NCAA through its agent, Host.
    2. No, the income is not excludable as a royalty because the NCAA’s role was not passive, and the income was not solely for the use of intangible rights.

    Court’s Reasoning

    The court applied a three-pronged test to determine if income is UBTI: (1) Is it income from a trade or business? (2) Is the trade or business regularly carried on? (3) Is the conduct of the business substantially related to the organization’s exempt purpose? The court found that selling advertising space is a “trade or business” distinct from the exempt function of the NCAA. While the NCAA argued its role was passive and the activity was intermittent, the court emphasized the agency relationship with Host. The contract explicitly designated Host as the NCAA’s “exclusive agent” and granted NCAA control over advertising content. The court stated, “In sum, the contract manifested an intent (1) that Host would act on petitioner’s behalf in conducting the sale of advertising and (2) that petitioner could control Host’s activities, elements of an agency relationship.” Because Host acted as the NCAA’s agent, Host’s regular advertising activities were attributed to the NCAA. The court distinguished this case from situations involving truly intermittent activities. Regarding the royalty exclusion, the court determined that the income was not a royalty because it was not solely for the passive use of NCAA’s intangible rights. Host provided active services in soliciting, creating, and selling advertising. The court noted, “By contrast, the agreement in this case imposed a duty upon Host to perform certain services on petitioner’s behalf and under petitioner’s control.”

    Practical Implications

    This case clarifies that tax-exempt organizations cannot easily avoid UBTI on advertising revenue by contracting out the sales activities to an agent. The “regularly carried on” element of UBTI can be met even if the exempt organization itself is not directly involved in the day-to-day operations if it exercises control through an agency relationship. Organizations must carefully structure their agreements to ensure that income from advertising is either substantially related to their exempt purpose or truly qualifies as passive royalty income. The case highlights that the royalty exception is narrowly construed and generally does not apply when the organization or its agent actively engages in the business activity generating the income, even if it involves the use of the organization’s name or logo. Later cases have cited NCAA v. Commissioner to reinforce the principle that advertising revenue is generally UBTI unless a specific exception applies and to emphasize the importance of analyzing the nature of the relationship between the exempt organization and any third parties involved in income-generating activities.

  • National Water Well Association, Inc. v. Commissioner, 92 T.C. 75 (1989): When Insurance Dividends Constitute Unrelated Business Taxable Income for Exempt Organizations

    National Water Well Association, Inc. v. Commissioner, 92 T. C. 75 (1989)

    Dividends received by a tax-exempt business league from an insurance program it endorsed and actively managed are taxable as unrelated business income when the activity constitutes a trade or business not substantially related to the organization’s exempt purpose.

    Summary

    In National Water Well Association, Inc. v. Commissioner, the Tax Court ruled that dividends received by a business league from an insurance program it endorsed were taxable as unrelated business income. The Association, exempt under section 501(c)(6), received a significant dividend from an industry casualty insurance program it actively promoted and administered. The court determined that the Association’s activities constituted a trade or business due to its profit motive and extensive involvement, and the income was unrelated to its exempt purpose because it did not benefit the industry as a whole but rather individual members. The decision underscores the importance of ensuring that income-generating activities of exempt organizations are closely aligned with their tax-exempt purposes to avoid taxation.

    Facts

    The National Water Well Association, Inc. , a business league exempt from taxation under section 501(c)(6), endorsed and sponsored an industry casualty insurance program developed by Maryland Casualty Insurance Co. The Association agreed to provide marketing and administrative services, including providing membership lists, writing safety articles, offering exhibit space at conventions, and distributing information about the insurance. In 1980, the Association received a dividend of $271,293 from Maryland Casualty, retaining $117,188 after distributing the remainder to insured members. The Association used a portion of the retained dividend to promote safety in the industry.

    Procedural History

    The Commissioner of Internal Revenue determined a deficiency in the Association’s Federal income tax, asserting that the retained dividend was unrelated business taxable income (UBTI). The Association contested this determination, arguing that the dividend was either not derived from a trade or business or was substantially related to its exempt purpose. The case was submitted fully stipulated to the United States Tax Court, which issued its opinion in 1989.

    Issue(s)

    1. Whether the dividends received by the Association from the industry casualty insurance program constitute unrelated business taxable income under section 512?
    2. If so, whether the income is excludable from the unrelated business tax as royalties under section 512(b)(2)?

    Holding

    1. Yes, because the Association’s activities in endorsing and managing the insurance program constituted a trade or business carried on with a profit motive, and the income was not substantially related to the Association’s exempt purpose.
    2. No, because the dividends were not passive income but compensation for the Association’s active involvement in the insurance program.

    Court’s Reasoning

    The court applied the profit motive test to determine that the Association’s activities constituted a trade or business. The Association’s extensive involvement in promoting and administering the insurance program, coupled with the significant dividends it received, indicated a profit motive. The court cited Professional Insurance Agents of Michigan v. Commissioner and other cases to support its conclusion that the activities were conducted in a competitive, commercial manner.

    The court also found that the income was not substantially related to the Association’s exempt purpose of promoting the water well industry. The benefits of the insurance program were limited to individual members who paid premiums, rather than benefiting the industry as a whole. The court emphasized that the Association’s conduct of the activity did not contribute importantly to its exempt purposes, as required by the regulations.

    The court rejected the Association’s argument that the dividends were royalties, noting that the income was not passive but compensation for the Association’s active role in the insurance program.

    Practical Implications

    This decision underscores the importance of ensuring that income-generating activities of tax-exempt organizations are closely aligned with their exempt purposes. Organizations endorsing or managing insurance programs should carefully consider whether their involvement constitutes a trade or business and whether the income benefits the industry as a whole or only individual members.

    Exempt organizations must be cautious in structuring their activities to avoid generating unrelated business income, which could subject them to taxation. The decision also highlights the need for organizations to maintain a clear separation between their exempt activities and any commercial endeavors.

    Later cases, such as Fraternal Order of Police Illinois State Troopers Lodge No. 41 v. Commissioner, have applied similar reasoning to determine whether an organization’s activities constitute a trade or business and whether the income is substantially related to its exempt purpose.

  • Country Club v. Commissioner, 92 T.C. 21 (1989): Offsetting Losses from Unrelated Business Taxable Income Activities

    Country Club v. Commissioner, 92 T. C. 21 (1989)

    A tax-exempt social club may offset losses from one unrelated business taxable income activity against gains from another such activity if both activities are profit-motivated.

    Summary

    In Country Club v. Commissioner, a tax-exempt social club sought to offset net losses from its nonmember food and beverage sales against the profits from its nonmember golf tournaments and interest income. The court ruled that the club could aggregate its unrelated business taxable income (UBTI) from multiple activities, allowing losses from one to offset gains from another, provided all activities were entered into with the objective of profit. This decision clarified the application of Section 512(a)(3) of the Internal Revenue Code, emphasizing that Congress intended to tax income not derived from member activities but did not preclude the offsetting of losses between profit-motivated activities.

    Facts

    The petitioner, a tax-exempt social club under Section 501(c)(7), operated facilities including a golf club, restaurant, bar, swimming pool, and tennis courts for its members and occasionally nonmembers. In 1979, the club derived revenue from nonmember golf tournaments, food and beverage sales to nonmembers, and interest income. The club reported a deficiency in its 1979 Federal income tax due to its attempt to offset net losses from nonmember food and beverage sales against other nonmember income sources.

    Procedural History

    The case was assigned to a Special Trial Judge, whose opinion was adopted by the Tax Court. The Commissioner of Internal Revenue determined a deficiency in the club’s 1979 tax return, leading the club to file a petition for redetermination. The Tax Court reviewed the case and ultimately decided in favor of the petitioner.

    Issue(s)

    1. Whether a tax-exempt social club may offset net losses from one unrelated business taxable income activity against net gains from another such activity under Section 512(a)(3) of the Internal Revenue Code?

    Holding

    1. Yes, because the statute and legislative history indicate that Congress intended to allow such offsets as long as all activities were entered into with a profit motive.

    Court’s Reasoning

    The court analyzed the language of Section 512(a)(3) and its legislative history, concluding that the purpose was to tax income from nonmember activities but not to disallow the offsetting of losses between profit-motivated activities. The court distinguished this case from others where losses from exempt activities were improperly used to offset unrelated business income. The club’s activities were classified into three profit-motivated sources: golf tournaments, nonmember banquets, and interest income. The court rejected the Commissioner’s argument that taxable profit was necessary to establish profit motivation, holding that any incremental increase in available funds to the club constituted profit motivation. The court’s decision was supported by a majority of judges and was consistent with the policy of not allowing nonmember income to subsidize member activities, yet allowing losses from one profit-seeking activity to offset gains from another.

    Practical Implications

    This decision impacts how tax-exempt social clubs and similar organizations handle their unrelated business income. It allows them to offset losses from one profit-motivated activity against gains from another, potentially reducing their tax liability. Practitioners should consider the profit motive of each activity when advising clients on tax planning. This ruling also affects how the IRS might audit such organizations, focusing on the profit motivation of their activities. Subsequent cases, such as Cleveland Athletic Club v. United States, have reinforced this principle, while The Brook, Inc. v. Commissioner has provided contrasting views based on different statutory interpretations.

  • Fraternal Order of Police v. Commissioner, 87 T.C. 747 (1986): Advertising Income of Exempt Organizations as Unrelated Business Taxable Income

    Fraternal Order of Police Illinois State Troopers Lodge No. 41 v. Commissioner of Internal Revenue, 87 T.C. 747 (1986)

    Advertising revenue generated by an exempt organization’s publication can constitute unrelated business taxable income if the advertising activity is considered a trade or business, regularly carried on, and not substantially related to the organization’s exempt purpose.

    Summary

    The Fraternal Order of Police (FOP), an exempt organization, published a magazine called “The Trooper” which contained articles relevant to police officers and business listings. The listings were of two types: a business directory and larger display ads. The IRS determined that income from these listings was unrelated business taxable income. The Tax Court held that the business listings constituted advertising, the publication of which is a trade or business. Because this business was regularly carried on and not substantially related to FOP’s exempt purpose, the income was taxable. The court also rejected FOP’s argument that the income was excludable as royalties.

    Facts

    The Fraternal Order of Police (FOP) Illinois State Troopers Lodge No. 41 was a tax-exempt organization under section 501(c)(8) of the Internal Revenue Code. FOP published “The Trooper” magazine, which included articles for police officers and two types of business listings: a classified business directory and larger display advertisements. Organization Services Corp. (OSC) solicited and managed the listings under agreements with FOP, and FOP received a percentage of the gross advertising revenue. The listings covered a wide range of goods and services and were marketed to businesses as a way to support FOP and its charitable activities. Acknowledgement forms and checks from businesses often referred to payments as “advertising.”.

    Procedural History

    The Commissioner of the Internal Revenue determined deficiencies in FOP’s income tax, asserting that receipts from the business listings in “The Trooper” constituted unrelated business taxable income. FOP challenged this determination in the United States Tax Court.

    Issue(s)

    1. Whether the publication of business listings in “The Trooper” magazine constitutes a “trade or business” within the meaning of section 513 of the Internal Revenue Code.
    2. If the publication of business listings is a trade or business, whether the income derived from these listings is excludable from unrelated business taxable income as royalties under section 512(b)(2) of the Internal Revenue Code.

    Holding

    1. Yes, the publication of business listings in “The Trooper” constitutes a “trade or business” because it is an activity carried on for the production of income from the sale of services (advertising), as unambiguously established by Congress in section 513(c).
    2. No, the income derived from the business listings is not excludable as royalties because FOP’s involvement in the publication was active, not passive, and the payments were for advertising services, not for the use of FOP’s name in a passive royalty arrangement.

    Court’s Reasoning

    The court reasoned that section 513(c) of the Internal Revenue Code explicitly defines “trade or business” to include “any activity which is carried on for the production of income from the sale of goods or the performance of services,” and further clarifies that “advertising income from publications…will constitute unrelated business income.” The court found that the listings in “The Trooper” were indeed advertising, resembling listings in commercial publications and telephone directories, and marketed as such. The court cited United States v. American College of Physicians, stating, “The statute clearly established advertising as a trade or business…because Congress has declared unambiguously that the publication of paid advertising is a trade or business activity distinct from the publication of accompanying educational articles and editorial content.” The court also noted FOP’s profit motive and active role in the publication through agreements with OSC, content control, and financial oversight. Regarding the royalty exclusion, the court determined that royalties are typically passive income for the use of rights like trademarks. However, FOP’s active involvement in the magazine’s publication, including content control and oversight of the advertising program, indicated that the income was not passive royalties but rather payment for services rendered in a trade or business.

    Practical Implications

    This case clarifies that income from advertising in publications of tax-exempt organizations is generally considered unrelated business taxable income (UBTI). It emphasizes that Congress has explicitly defined advertising as a trade or business for UBTI purposes. Exempt organizations must carefully evaluate revenue from advertising activities in their publications. The case highlights that even if a publication serves an exempt purpose through its editorial content, advertising revenue within it can still be taxable. Furthermore, the decision reinforces the distinction between active business income and passive royalty income, particularly in the context of exempt organizations. Organizations cannot easily recharacterize active income streams, like advertising sales where they retain control and involvement, as passive royalties to avoid UBTI. This case, along with American College of Physicians, serves as a key precedent in determining UBTI for exempt organizations engaged in publishing activities with advertising components.