When you think of unrelated business taxable income, thoughts of pasta may not come to mind. But back in 1950, during the debate over whether to revise the internal revenue code to prevent an erosion of the tax base caused by nonprofits running commercial businesses, at least one congressional representative was thinking of pasta. Specifically, he was thinking of the C.F. Mueller Company, a leading pasta manufacturer, which was then owned by New York University (a nonprofit), and is still in existence today as part of TreeHouse Foods, Inc.
Prior to the congressional debates, the tax court had decided (14 T.C. 922, Mueller) that transferring a commercial business to a nonprofit organization did not mean the income from the commercial business was no longer taxable. The tax court decision was overturned in 1951 by the US Court of Appeals for the Third Circuit because tax law at the time did not differentiate between the types of income a nonprofit could earn. In effect, the law was based on where the income went, not where it came from.
However, in September 1950, the Revenue Act of 1950 became law, and took effect in tax years beginning after 1950. That law established the concept of unrelated business income as income earned by business activities of a nonprofit that are unrelated to the tax-exempt purpose of the nonprofit. The law made such income generally taxable.
Is the modern equivalent of selling pasta – charging for technical assistance in the use of a searchable database – unrelated business taxable income? The IRS recently issued a letter ruling (PLR 201701002, Number 109422-16) in response to that question from a private foundation.
The foundation was formed for the charitable purpose of improving the lives of low income children and their families in a particular area. Among other exempt activities, the foundation collects, analyzes, interprets, and shares data to improve community decision making.
The foundation maintains a repository containing both publicly available data, and non-public information. A free searchable database tool is available on the foundation’s website. The foundation also offers technical assistance to other nonprofits, foundations, government agencies, and community organizations. An organization seeking the technical services initiates a project request, and the data and information provided in the requesting organization’s project is added to the foundation’s repository for use in other projects.
The foundation previously absorbed all costs of providing technical assistance, but was unable to continue doing so, and wanted to charge a reasonable fee for projects taking more than four hours of staff time. The fee would be based on ability to pay, and in some cases, would be less than cost.
The foundation would continue to make data publicly available through its web-based searchable database tool, and the organizations seeking the service would not resell the resulting information.
Here’s the current relevant tax law.
From internal revenue code section 511. Imposes a tax on a section 501(c)(3) organization’s unrelated business taxable income (as defined in section 512 of the code).
From internal revenue code section 512. Defines the term “unrelated business taxable income” as the gross income derived by an organization from any unrelated trade or business (as defined in section 513) regularly carried on by it, less allowable deductions, both computed with the modifications provided in section 512(b). Generally, income will be treated as derived from the conduct of an “unrelated trade or business” if: (1) it is income from trade or business; (2) such trade or business is regularly carried on by the organization; and (3) the conduct of such trade or business is not substantially related (other than through the production of funds) to the organization’s performance of its exempt functions.
From federal tax regulation 1.513-1(d)(2). A substantial causal relationship must exist between the conduct of the organization’s trade or business activities that generated the income and the achievement of the organization’s exempt purpose. A substantial causal relationship exists where the production or distribution of the goods or the performance of the services (from which the income is derived) contributes importantly to the accomplishment of the organization’s exempt purpose. Therefore, where the goods or services do not contribute importantly to the accomplishment of the organization’s exempt purposes, the income earned is not derived from the conduct of related trade or business.
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Based solely on the facts and representations submitted, we rule that the foundation’s technical assistance services are substantially related to the foundation’s exempt purpose and will not be subject to unrelated business income tax under section 511 of the code or excess business holdings tax under section 4943(a).
In this case, the foundation’s technical assistance services are substantially related to the performance of its exempt functions. The services are part of the organization’s exempt data activities.
The foundation’s screening process ensures that it only undertakes projects that will provide valuable research and data to serve its charitable mission of improving the lives of low income children and their families. Performing the data analysis and interpretation services related to each project gives the foundation access to new data and identifies new research questions related to its charitable mission.
The foundation makes the results of each project publicly available on its website. It also requires that its clients never sell the results of any project or use the results for any purpose other than the exempt purpose for which the foundation agreed to provide its products or services; namely, to improve the lives of low income children and their families.
The foundation’s technical assistance services have a primarily charitable purpose and differ from those available through commercial ventures. Further, providing the technical assistance furthers the foundation’s own charitable purposes because the foundation uses resulting data and analysis for its own research and grantmaking purposes, in addition to assisting client social sector organizations to perform their own charitable activities.
In addition, the foundation’s services differ from those commercially available because the foundation has access to raw data that is not available to commercial ventures and its activities are performed by employees of the foundation who have developed particular knowledge and extensive understanding of issues facing low income children and their families in the region and perform such functions as part of other activities that further the foundation’s exempt purposes.
Finally, the foundation will determine on a case-by-case basis whether to charge a fee below cost to complete the project.
Therefore, the foundation’s technical assistance services will not constitute an unrelated trade or business under section 513 of the code. Furthermore, the income derived from those activities will not be subject to the unrelated business income tax imposed by section 511.