II. DISCUSSION
A. Introduction.
This memo discusses whether the income from gift shop sales, food sales, facility rentals, and the sale of membership lists by a tax-exempt aquarium would be considered "Unrelated Business Income" (UBI) and thus subject to taxation. Any UBI of a tax exempt organization will be subjected to the Unrelated Business Income Tax (UBIT); three elements must be met for income to be considered UBI. UBI is income from (1) a trade or business that is (2) regularly carried on and that is (3) not "substantially related" to the organization.s exempt purpose. 26 U.S.C. ' 512(a), ' 513(a); Treas. Reg. ' 1.513-1(a). If at least one of the three elements are not met, there will not be an UBIT imposed on the organization. In other words, all three elements must be met for UBIT to be imposed.
1. Trade or Business. Income is considered UBI only if its earned from the conduct of a trade or business. ' 513(a). To determine whether an activity constitute a trade or business, the most important factor to consider is whether a profit motive exists. See American Bar Endowment v. United States, 477 U.S. 105 (1986). Other factors include the conduct (i.e., manner and frequency) of the activities and the existence of competition with a commercial enterprise.
2. Regularly Carried On. The Regulations state that "specific business activities of an exempt organization will be deemed to be .regularly carried on. if they manifest a frequency and a continuity, and are pursued in a manner, generally similar to comparable commercial activities of nonexempt organizations." Treas. Reg ' 1.513-1(c)(1). The key for this determination is the time schedule at which analogous commercial businesses operate. For example, if an activity is a type that a nonexempt entity would conduct on a year-round basis, the same activity by an exempt organization will not be treated as regularly carried on if its conducted .over a period of only a few weeks.." Id.
3. Substantially-Related Test. Income from a trade or business activity that is regularly carried on will be subject to UBIT only if it is "not substantially related... to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis of its exemption." ' 513(a); Treas. Reg. 1.513-1(d)(1). The Regulations provide that the relationship must be a causal one, and that an activity is substantially related to the performance of its exempt purpose only when it contributes .importantly. to the achievement of such purpose." Both the causal relationship and its importance are to be determined on the basis and facts of each case. Treas. Reg. 1.513-1(d)(2). This test focuses on the relationship of the trade or business to the organization.s exempt purpose, not on the nature of the activity or the manner in which it is conducted. Presumably, the activity engaged in by the organization may be commercial and not be subject to the UBIT, as long as the activity is substantially related to the exempt purpose.
The substantially-related test is essentially a proxy for a direct examination of whether an income-producing activity of an exempt organization constitutes unfair competition with a commercial enterprise. The primary objective of the unrelated business income tax was to eliminate a source of unfair competition by placing the unrelated business activities of certain exempt organizations upon the same tax basis as the nonexempt business endeavors with which they compete. Treas. Reg. ' 1.513-1(b).
B. Gift Shops.
The IRS has ruled on the status of gift shops. As long as the gifts are substantially related to the aquarium.s exempt purpose, the income from gift shop sales not be subject to UBIT. There is no question that a gift shop is a trade or business that is regularly carried on. Whether it is substantially related depends on the type of items that are sold. The IRS will apply a primary purpose test to determine if the sale of an item is related to its exempt purpose. In applying the test, the IRS looks to the nature, scope, and motivation for the particular sales activities. The degree of connection between the item and the museum.s collection and the extent to which the item relates to the form and design of the original item are considered. Size, location, accuracy of the representation as well as the overall impression conveyed by the article are to be considered. One must consider whether the dominant impression one gains from viewing or using the article relates to the original article and determine whether the non-charitable use or function predominates. 1999 C.P.E. Guide Topic N-I-7 '513(a). For example, the IRS ruled that sale of greeting cards featuring reproduction of works of art in the museum.s collection and from other art collections was substantially related to the museum.s purpose. The IRS stated:
The sale of greeting cards displaying reproductions of art works contributes importantly to the achievement of the museum.s exempt purposes by stimulating and enhancing public awareness, interest, and appreciation of art. Moreover, a broader segment of the public may be encouraged to visit the museum itself and share in its educational functions and programs as a result of seeing the cards. The fact that the cards are promoted and sold in a clearly commercial manner at a profit and in competition with commercial greeting card publishers does not alter the fact of the activity.s relatedness to the museum.s exempt purpose.
Rev. Rul 73-104, 1973-1 CB 264. The ruling is especially interesting because the cards were sold through a catalog as well as a gift shop at the museum. Moreover, the museum sold the cards to ordinary retail stores at a volume discount. The museum also personalized the cards upon request. Together, these factors make the sale of cards indistinguishable from card sales by commercial card companies. The IRS in fact stated, "[a]lthough we were not entirely comfortable with the frankly commercial scope of the methods of distribution in Rev. Rul 73-104, we were unable to develop a satisfactory legal rationale for a more restrictive rule". Gen. Couns. Mem. 37902 (Mar. 28, 1979); Gen. Couns. Mem. 39346 (Mar. 15, 1985).
In Revenue Ruling 73-105, the IRS ruled that income from the sale of art books and reproductions of items not included in the museum.s own collection was not UBI, because it enhanced the appreciation of art generally. The sale of scientific books and of souvenirs from the city in which the museum was located was not substantially related to the museum.s exempt purpose. This ruling applies the fragmentation rule and considers the sale of each specific item, or, at the very least, categories of items, in determining whether they have a substantial, causal relationship to the achievement of the organization.s exempt purpose. Rev. Rul. 73-105, 1973-1 CB 264.
Therefore, applied to an aquarium.s situation, an item-by-item determination will need to be made of each good that is sold in the gift shop to determine if the good is substantially related to the organization.s exempt purpose.
C. Food/Restaurant Sales.
The IRS has also ruled on the status of food./restaurant sales. As long as the restaurant.s size and scope are commensurate with needs of the exempt organization.s staff and visitors, and not the general public, the sales derived from such activities are not considered UBIT. 1999 C.P.E. Guide Topic N-I-7. Section 513(a)(2) states, in part, that any trade or business carried on by a 501(c)(3) organization primarily for the convenience of its members, students, patients, officers, or employees does not constitute "unrelated trade or business." In Revenue Ruling 74-399, the IRS held that the operation of a dining room, cafeteria, and snack bar by an exempt art museum for use by the museum staff, employees, and members of the visiting public did not constitute an unrelated trade or business. The Revenue Ruling gave three reasons for this holding: (1) the facilities attract visitors by providing in-house dining; (2) the operation of these facilities allows visitors to devote more time to the museum.s educational exhibits than if they had to seek outside eating facilities; and (3) these facilities enhance the efficient operation of the museum by enabling staff and employees to remain on the premises throughout the workday. Rev. Rul. 74-399, (97-4-2C.B.172)
In a Private Ruling, however, the IRS held that the operation of a restaurant constituted a trade or business that was regularly carried on that was unrelated to museum.s exempt purposes. Unlike the previous situation, the restaurant: (1) solicited patrons through an advertising program; (2) treated restaurant patrons differently than visitors to the art museum by waiving fees; (3) the restaurant was of a size commensurate with accommodation of the museum staff, employees, members, and patrons visiting the museum; and (4) the restaurant was designed in part to serve as a public restaurant The IRS held that the operation of a restaurant is beyond what is necessary to serve the organization.s exempt purpose. Prv. Ltr. Rul. 97-200002.
Therefore, under the "fragmentation rule" of Section 513(c), the unrelated segments of a trade or business must be separated from the related aspects and, therefore, restaurant sales to museum visitors and employees would not constitute UBIT, while sales to those who do not pay admission to the museum would constitute UBIT. Id. 1999 C.P.E. Guide Topic N-1-3.
D. Sale of Membership Lists/Affinity Income.
In regards to the tax implications of the sale of membership lists and other sorts of affinity income, the IRS and the courts are at odds. The IRS continues to view the renting of a mailing list and the marketing of a credit card by an exempt organization as involving services typically provided by a commercial company, while the Tax Court has held that amounts derived from such undertakings constitute royalty income that is excluded from the computation of Unrelated Business Taxable Income (UBTI) under IRC ' 512(b)(2). 1999 C.P.E. Guide Topic N-I-3. Specifically, the IRS relies on ' 513(h)(1)(B) which states that "unrelated trade or business" does not include "(i) exchanging with another such organization names and addresses of donors to (or members of) such organization, or (ii) renting such names and addresses to another such organization" [emphasis added]. ' 513(h)(1)(B). Therefore, the IRS holds that the exchanging or renting of mailing lists to nonexempt entities constitutes UBTI; the transactions must only occur with "like" organizations. In a Private Letter Ruling, the IRS held that the exception "ONLY applies where BOTH organizations involved are tax exempt under Section 501, and contributions to which are deductible under section 170(c)(2) or (3)." Prv. Ltr. Rul. 9724006. Thus, by the IRS.s view, an aquarium must not exchange or rent its membership lists to non-501 entities to whom contributions are not deductible under
' 170(c)(2) or (3) (e.g., for-profit entities). See also Prv. Ltr. Rul. 9247001.
On the other hand, the Tax Court regards affinity income as royalties, as long as tax-exempt entity does not render more than minimal services. A royalty is by definition passive . a payment for the use of an intangible property right; therefore royalties cannot include compensation for services rendered by the owner of the property. See Sierra Club, Inc. v. Commissioner, 86 F.2d 1526 (9th Cir. 1996). Specifically excluded from the ' 512 definition of UBTI are "all royalties (including overriding royalties) whether measured by gross or taxable income from the property, and all deductions directly connected with such income. ' 512(b)(2). See also Alumni Association of the University of Oregon, Inc. v. Commissioner, T.C. Memo. 1996-63; Oregon State University Alumni Association v. Commissioner, T.C. Memo. 1996-34; Mississippi State University Alumni, Inc. v. Commissioner, T.C. Memo. 1997-397. In the last case, as in the earlier cases, the Tax Court held that income received by an organization (here, the "MSU Alumni") from an affinity credit card program constituted a royalty under ' 512(b)(2). The court further concluded that payments with respect to the use of an organization.s mailing list in the program were royalties as well. MSU Alumni entered into a three-year agreement with People.s and Trust ("PB&T") in 1987 allowing the bank to administer an affinity card program directed at the organization.s members. The contract was renewed and amended in 1991, expressly noting that PB&T.s payments to MSU Alumni were royalties. Under the 1987 agreement, PB&T agreed to pay MSU Alumni based on the number of transactions, plus a supplement for each new cardholder or annual fee paid. MSU agreed to allow PB&T to write a letter over the signature of its (MSU Alumni.s) executive director explaining that PB&T was the exclusive provider of the credit cards. Additionally, PB&T was accorded the exclusive right to use MSU Alumni.s name and trademark on the affinity card and advertising materials. PB&T, which agreed to prepare and pay for all marketing materials, drafted the promotional literature and sent it to MSU Alumni.s members, parents and students, faculty and staff. MSU Alumni provided its member list twice a year with monthly updates.
Although MSU Alumni was not required to do so, it did make copies of credit card applications available in its offices where interested visitors could pick them up. MSU Alumni did not contact PB&T with respect to the status of any applications or requests for credit limit increases. It was represented that MSU.s Alumni.s executive director met with PB&T.s representatives about four times a year to discuss the contract, and MSU Alumni.s marketing coordinator spent a negligible amount of time on matters relating to the contract. While MSU Alumni generally did not rent its mailing list, it did contract with a company to sell items bearing the MSU seal. The bank paid for advertisements in the alumni association newsletter and various student publications, and hired students to give out publications. The court compared the facts of the MSU Alumni case with those described in Sierra Club, Inc. v. Commissioner, 86 F.3d 1526 (9th Cir. 1996), where the taxpayer was entitled to set rental rates, review requests to rent the lists, and approve and schedule mailing. In that case, the Ninth Circuit concluded that rental payments for the list were royalties, and the Sierra Club did not provide services with regard to the mailing lists. The court also noted that it was PB&T, not MSU Alumni, that was competing with other credit card issuers. Likewise, the court rejected the IRS.s argument that because the organization had reported memorabilia income as UBIT, it should report income from PB&T as UBIT, noting that such disparate treatment does not deprive the income from the bank of its status as a royalty. See 1999 C.P.E. Guide Topic N-I-3.
The key is that the royalty income exception to UBTI does not apply if the exempt organization performs more than minimal services in addition to granting the right to use its intangible property. In Disabled Veterans v. United States, 650 F.2d 1178 (Ct. Cl.), the Court of Claims affirmed the Tax Court.s holding that DAV.s income from the rental of its donor lists to other organizations was not royalty income under Code Section 512(b)(2), which excludes from taxation the conventional type of passive investment income traditionally earned by exempt organizations such as dividends, interests, annuities, real property rents. Inasmuch as DAV.s rental of its donor lists was the product of "intensive business activity" by DAV (such as preparing rate cards, sending the rate cards to list brokers, and providing the information on magnetic tape or labels), the Court held that the rental income from the mailing list did not fit within the types of passive income set forth in ' 512(b). In Prv. Ltr. Rul. 9724006, the IRS held that income received by a tax exempt organization (M) under an affinity credit card arrangement should be treated as UBTI because M was not simply furnishing a mailing list to two other parties (S and T) but was actively supporting and promoting the Member Card Program among its membership. A separate sheet to the Agreement entitled "M Support of the Program" began, "Active Support and promotion of the Member Card Program is encouraged by to ensure maximum participation by members". The IRS held that the following activities were considered "active" participation: annually meeting with the representatives of the credit card to review their marketing plans; provide mailing lists (anywhere from one to six times per year), depending on the card issuer.s marketing plan requirements; if members request information on the affinity credit card, M staff will provide them with the card issuer.s toll-free number; in rare instances where credit card applications are sent to M by the member, M will forward these to the credit card issuer. Note that M does not actively encourage its members to participate in the affinity credit card program; M only mentions in the membership materials that such a credit card is available (along with other membership benefits) and provides the toll-free phone number for anyone wishing to pursue this benefit. In total, the M staff who administer the affinity credit card program spend less than 100 hours per year in staff time performing the above activities. Most of this time is spent by one person who has responsibility for the affinity credit card program, along with his many other responsibilities. The IRS found that such active participation belied the alleged "passive" role of M. Prv. Ltr. Rul. 9724006.
E. Facility Rental.
The next issue concerns the renting of an aquarium.s facilities for private parties such as balls, benefit dinners, award ceremonies, and the like. The IRS considers the rental of museum facilities to corporate and business patrons for special events to constitute an unrelated trade or business. In a Technical Advice Memorandum (TAM), while acknowledging that there are educational aspects to the museum.s rental of its facilities for business and social functions such as business meetings, awards dinners, cocktail parties and dinner dances, the IRS pointed out that these educational aspects are clearly ancillary to the events. principal business and social purposes. Tech. Adv. Mem. 9702003; 1999 C.P.E. Guide Topic N-I-7. A Tax Court distinguished the case above where an "outdoor" museum was organized for the "stimulation, promotion and development of the interest of the general public in every manner of art forms through organization and operation of outdoor and indoor museums, the holding and sponsorship of music concerts, art exhibitions and theatrical and dance performances, all for cultural and educational purposes". Periodically, members of the community held special events at the museum, such as wedding receptions or bar mitzvahs, in the spaces provided by the building owners. The IRS argued that the revenues received by the museum from the special event leasing were subject to UBIT. The court held, however, that the amount earned by this museum ($31,000 from 1985 to 1989) was not significant; the revenues earned from this activity barely exceeded the related expenses, and in some years the museum actually suffered losses. For the court, this fact lent credence to the museum.s argument that the leasing activity was performed mainly to expose the artwork to people who otherwise would not have seen it, rather than as a revenue-generating activity. Furthermore, the Tax Court determined that by offering the building spaces for special events, the artwork in the museum was exposed to an audience who normally would have not come to the place to view the exhibits. Therefore, the court held that the revenue generated by this activity was not UBTI. However, the court stated that one particular long-term lease was UBTI. The court reasoned that the lease was not a short-term arrangement, the amphitheater could seat 18,000 patrons, and the museum was required to make parking and security arrangements under the lease. The court emphasized that the amount of money involved was substantial, and the tenant put on performances by popular performers and commanded high prices (which does not go to further the exempt purposes of the organization . to educate the public on art). John W. Madden, Jr., et al. v. Commissioner, T.C. Memo. 1997-395.
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