Transactions among Tax-exempt and Taxable Organizations

This article describes how to analyze certain transactions among nonprofit organization described in IRC section 501(c)(3) (such as MIT) and one or more other organizations, whether taxable or tax-exempt. 

I. Overview

The transactions analyzed here go by many names, including management and services agreements, joint ventures, “contractual” joint ventures, joint operating agreements, consortiums, fiscal sponsorship agreements, and sponsored research. These transactions will generally be referred to in this article as “the Transaction.”

The analysis, while complex, can appear disarmingly simple.  Two principal provisions of the Internal Revenue Code must be addressed: first, whether anything in the relationship among the parties jeopardizes the Section 501(c)(3)  tax exempt status of any of the organizations involved; and second, whether the relationship gives rise to unrelated business taxable income (UBTI) under IRC Sections 511-514 to any of the tax-exempt organizations involved.

II. Tax analysis

This article discusses the basic tax analysis of the relationships and transactions  listed  above. It does not discuss routine transactions (such as the day-to-day purchase of goods and services), although even there this basic analysis can be helpful.

III. Tax status of the parties

This article applies when at least one of the parties involved in the Transaction is a Section 501(c)(3) organization. It is important to first understand the basis of that tax exempt status.  A university is generally tax-exempt (if it elects that status) simply because educational organizations are directly described in section 501(c)(3). An organization providing management or healthcare services, by contrast, might or might not be tax-exempt depending on all of the facts and circumstances.

Understanding tax-exempt status in the context of a Transaction is a multi-faceted analysis, but the following questions (among others) should be asked.

1. Is the organization broadly described in Section 501(c)(3)?  (E.g. religious, charitable, scientific, educational etc.) 
2. Has the organization been recognized by the IRS as tax-exempt?  When and on what basis?  Have the activities of the organization changed substantially since the IRS recognition of tax exemption?
3. Does the organization run afoul of the limitations on legislative lobbying or political activities?
4. Is the organization organized and operated exclusively for charitable purposes (i.e. those purposes described in Section 501(c)(3))?  In answering this question, note that the word “exclusively” has been broadly defined by the IRS in regulations as meaning “primarily”, although the IRS has further stated in regulations  that no more than an insubstantial part of the organization’s activities can be for a non-exempt purpose. This lack of consistency has been part of the regulatory scheme for decades.
5. Are the organization’s charitable activities commensurate with the amount of its assets?
6. Is there any indication of private inurement or private benefit, such as through excessive compensation or favorable transactions with related parties

IV. Does the Transaction jeopardize the tax-exempt status of any party to the Transaction?

Assuming the organization clears all these steps, is there anything about the proposed Transaction that would cause the answers to any of these questions to be changed?

Common questions include the following:

1. Is the Transaction at fair market value? If not, why not?
2. Is the transaction a joint venture? A joint venture for this purpose includes either a formal or informal partnership or a limited liability company taxed as a partnership (LLC). 
3. Is the transaction a “contractual” joint venture? This generally means that no new entity has been created, but be aware that such a relationship may well constitute a partnership for tax purposes.

The IRS generally regards the activities of a partnership (or an LLC taxed as a partnership) as imputed to the partners. While the position of the IRS with respect to joint ventures has involved some shape shifting, two very broad concepts stand out.  First, if participation in the partnership or joint venture constitutes the basis for tax exemption (such as an organization whose primary activity is participating in an LLC operating a hospital) the exempt organization must be able to control the activities of the LLC.

Second, if the joint venture activity is insubstantial compared to the overall activities of the organization (such as a university participating in a joint venture to develop online education) the joint venture will generally not jeopardize tax exempt status of the university and if the university (in this example) controls the content of the online education the activity will not give rise to unrelated business taxable income.

V. Unrelated business taxable income

Two primary concepts stand out when analyzing a Transaction for UBTI.  First, the activities of a partnership or LLC are deemed to have been conducted by the partners or members.  This yields a fairly straightforward analysis—if the activity in question would give rise to UBTI if conducted directly by the organization, the same result will attain if the partnership or LLC income passes through to the organization.  Second, the direct provision of routine goods or services to tax-exempt organizations does not qualify as “related” income for UBTI purposes simply because a charitable organization is purchasing the services.  Hence routine back office services, testing services, business consulting services or the sale of goods would generally not qualify as related, unless there was something more present.  For example, the consulting services might be considered educational and hence within the tax exempt purposes of some organizations.  Or testing services might be so unique that only a handful if tax exempt organizations can conduct them.  Or the goods or services are provided at a significant mark-down.

VI. Feeder Organizations and the Integral Part Test

Some Transactions involve the creation of a new tax exempt organization, whether a subsidiary or an affiliate, and you need to analyze the relationship between the old and new organizations.  This is a highly technical area.

In 1924 the US Supreme Court held that when evaluating the non-exempt business activities of a tax-exempt organization, the key issue was not the conduct of the business activities per se, but the destination of the income.  If the income was dedicated to the otherwise charitable organization conducting the business then tax exemption was not forfeited. The seminal case involved NYU and the Mueller Macaroni business operated by NYU.  The IRS struggled with this rule for decades until Congress enacted IRC Section 502 which provides in part that “(a) An organization operated for the primary purpose of carrying on a trade or business for profit shall not be exempt from taxation under section 501 on the ground that all of its profits are payable to one or more organizations exempt from taxation under section 501.”

While section 502 closed one door, the regulations under that section opened another, the so-called “integral part” doctrine.  The regulation defines the doctrine as follows: 

“If a subsidiary organization of a tax-exempt organization would itself be exempt on the ground that its activities are an integral part of the exempt activities of the parent organization, its exemption will not be lost because, as a matter of accounting between the two organizations, the subsidiary derives a profit from its dealings with its parent organization, for example, a subsidiary organization which is operated for the sole purpose of furnishing electric power used by its parent organization, a tax-exempt educational organization, in carrying on its educational activities.”

The regulation further provides as follows:

“[I]f the organization is owned by several unrelated exempt organizations, and is operated for the purpose of furnishing electric power to each of them, it is not exempt since such business would be an unrelated trade or business if regularly carried on by any one of the tax-exempt organizations.”

These regulations serve two important purposes.

First, the “integral part” reference confirmed that an organization conducting routine commercial activities can be tax exempt because it is performing an activity that is integral to the operations of its tax exempt parent organization.  A separately incorporated university investment office could obtain tax exemption under this doctrine.

Second, while the regulation states that a service provider created by a group of unrelated organizations cannot generally obtain tax exempt status, the regulation is unclear as to when a group of closely affiliated exempt organizations, albeit not directly controlled by a common parent, may create a new organization and benefit from the integral part doctrine, both to support tax exempt status and to avoid UBTI. See Letter Ruling 9849027 (commonly attributed to the Claremont Colleges).

VII. Supporting Organizations

Sometimes the Transaction being examined will raise the question of whether one tax-exempt organization is “supporting” another by virtue of its relationship with the other charity and its activities.

A tax-exempt organization is a “private foundation” unless it satisfies one of several conditions that entitles it to what is commonly referred to as “public charity” status.  Private foundations are subject to a fairly elaborate set of rules that make operations difficult.  An organization that satisfied the integral part test described above will commonly qualify as a public charity as well.  These “supporting organizations” can be formed as subsidiary organizations of the supported charity, as “brother-sister” organizations under common control, or (least favorably) when they are organized to support the supported organization without being under common control. In each of these instances a separate “integral part” test is applied to ensure that the supporting organization is in fact supporting in a meaningful manner the supported charity.  This can lead to confusion because separate integral part tests can be applied (i) to establish 501(c)(3) status of an organization and (ii) to create public charity status.

VIII. When to maintain arm’s length among organizations

The obverse of the integral part test(s) is that in some cases it is important to not have one organization serve as the integral part of the other, but to maintain a strict arm’s length relationship between the parties. This issue commonly arises when a section 501(c)(3) organization seeks to coordinate with a section 501(c)(4) organization or a political action committee to conduct legislative lobbying or political activity that would be prohibited to the 501(c)(3) organization.  

IX. Conclusion

Even though other issues may arise in a Transaction, the basic issues of tax exemption, UBTI and the tax status of affiliated organizations are almost always important.  In addition, the same issues described here can be relevant to ancillary areas such as employment taxes and tax-exempt bonds, which will often depend on understanding the basis of tax exemption and whether or not proposed activities give rise to UBTI.