Chapter 13 - § 13.3 • MODIFICATIONS, EXCEPTIONS, AND EXCLUSIONS

• Jurisdiction: Colorado

§ 13.3 • MODIFICATIONS, EXCEPTIONS, AND EXCLUSIONS

§ 13.3.1—In General

I.R.C. §§ 512 and 513 provide for more than 20 modifications, exclusions, and exceptions to the general definition of UBTI. Given the number and breadth of these exclusions, in evaluating whether a particular revenue stream is subject to the unrelated business income tax, practitioners may find it easier to begin their analysis with the exclusions, before applying the general definition of UBTI. These exclusions often have brighter lines than the elements of the general UBTI definition, and they offer plenty of opportunity for planning. Structuring a revenue stream to fall within an exclusion can mean significant tax savings.

§ 13.3.2—Businesses Relying on Volunteers and Donated Goods or Operated for Convenience of Patrons

I.R.C. § 513(a) provides three very important exceptions for income generated from businesses that rely substantially on volunteers and donated goods, and from businesses that are operated primarily for the convenience of members or patrons. In particular, the exceptions cover:

1) Any trade or business where substantially all the work is performed without compensation (e.g., an exempt orphanage operating a retail store where uncompensated volunteers perform substantially all the work), I.R.C. § 513(a)(1) and Treas. Reg. § 1.513-1(e);
2) Any trade or business involving the selling of merchandise, substantially all of which was contributed to the organization (e.g., a thrift shop selling contributed books, old clothes, furniture, and so forth, with the proceeds going to the exempt organization), I.R.C. § 513(a)(3) and Treas. Reg. § 1.513-1(e); and
3) Any trade or business carried on by a § 501(c)(3) organization "primarily for the convenience of its members, students, patients, officers, or employees" (e.g., a laundry operated by a college for cleaning dormitory linens and students' clothing), I.R.C. § 513(a)(2) and Treas. Reg. § 1.513-1(e).

Practice Pointer
An activity can avoid being classified as unrelated for multiple reasons, and if one of those reasons is then eliminated, the tax-exempt nature can remain. For example, a sheltered workshop can be exempt because it is primarily engaged in selling donated merchandise, and also because its exempt purpose is the training of developmentally challenged individuals to allow them to maintain employment. If the organization then has to purchase merchandise for resale, it can still be exempt because the training of individuals constitutes a core part of its exempt function.

§ 13.3.3—Dividends, Interest, and Capital Gains

I.R.C. § 512(b) excludes from the definition of UBTI: (1) dividends, interest, and annuities, I.R.C. § 512(b)(1) and Treas. Reg. § 1.512(b)-1(a); and (2) gains or losses from the sale or disposition of property, I.R.C. § 512(b)(5) and Treas. Reg. § 1.512(b)-1(d). The exclusion for gains or losses does not extend to the sale or disposition of stock in trade or inventory, or to property held primarily for resale to customers. I.R.C. § 512(b)(5) and Treas. Reg. § 1.512(b)-1(d).

Practice Pointer
Because of the exclusion for gains from the sale of property, practitioners should be cautious about activities that change the character of property from a capital asset to property held for sale in the normal course of a trade or business. For example, if a tax-exempt organization holds an apartment building for passive rentals, and later redevelops and converts the building into condominiums, the development activity could recharacterize the condominium units as properties developed and held for sale in the ordinary course of business, making all of the gain from the condominium units UBTI. The same character change can be found in undeveloped land that is subdivided.

These forms of investment income may, nevertheless, be taxable as debt-financed income pursuant to I.R.C. § 514 (see § 13.5 of this chapter). In addition, the exclusion for interest may be modified to the extent that it is received from a "controlled entity" (see § 13.4.2).

§ 13.3.4—Royalties

I.R.C. § 512(b) excludes royalties from UBTI. I.R.C. § 512(b)(2). A royalty is broadly defined as a payment for the use of a valuable right. See Sierra Club, Inc. v. Comm'r, 65 T.C.M. 2582 (1993), and Sierra Club, Inc. v. Comm'r, 103 T.C. 307 (1994). The most common examples are royalties paid for the use of intellectual property, although the exclusion also covers certain mineral royalties. Treas. Reg. § 1.512(b)-1(b). Thus, payments for the use of trademarks, trade names, service marks, or copyrights are ordinarily classified as royalties. Rev. Rul. 81-178, 1981-2 C.B. 135. Similarly, payments for the use of a professional athlete's name, photograph, likeness, or facsimile signature are ordinarily characterized as royalties. Id. As discussed further below, however, the provision of certain types of services by the tax-exempt organization in connection with the royalty arrangement can cause the entire payment to lose its character as a royalty, and to become taxable as UBTI.

Royalties may be taxable to the extent they constitute debt-financed income (see § 13.5). In addition, the exclusion for royalties may be limited to the extent that they are received from a "controlled entity" (see § 13.4.2).

Mailing Lists

I.R.C. § 513(h)(1)(B) has, for some time, provided an express exclusion from UBTI for the rental of mailing lists by an organization described in I.R.C. §§ 170(c)(2) or 170(c)(3) (generally a charity or veterans' organization) to another such organization. There were years of litigation between the IRS and other tax-exempt entities, however, dealing with the question of whether the royalty exclusion covered all mailing list rentals, regardless of the tax-exempt classification of the licensor or the licensee. The IRS appears to have conceded the issue. Thus, mailing list rentals are excluded from UBTI as royalties (provided that the impermissible services are not provided as part of the royalty arrangement), regardless of the type of organization that rents its list and regardless of the type of organization that uses the list (provided that the impermissible services are not provided as part of the royalty arrangement).

The U.S. Court of Appeals for the Ninth Circuit has confirmed that an exempt organization may rent its mailing list, for example, to a credit card company, and the compensation that it receives will be a royalty. However, to the extent that the compensation is also for services provided by the exempt organization, such compensation is not a royalty and may be taxable as UBTI. See Or. State Univ. Alumni Ass'n, Inc. v. Comm'r, 193 F.3d 1098 (9th Cir. 1999); Sierra Club, Inc. v. Comm'r, 86 F.3d 1526 (9th Cir. 1996). See also Miss. State Univ. Alumni, Inc. v. Comm'r, T.C. Memo 1997-397 (1997).

Certain services may be disregarded. These are generally the type of services that the tax-exempt organization may be expected to do for its own purposes or to protect its interests. For example, services associated with maintaining mailing lists, establishing rates for their rental, and approving the content of mailings using the list is generally disregarded. However, active marketing of the list, sorting the list, or providing the list on labels may be considered personal services to which some of the "royalty" revenue must be allocated. See Or. State Univ. Alumni Ass'n, Inc., 193 F.3d 1098. This suggests that these activities are best left to a third-party mail house. See Planned Parenthood Fed'n of Am., Inc. v. Comm'r, T.C. Memo 1999-206 (1999); Common Cause v. Comm'r, 112 T.C. 332 (1999).

Logos and Trademarks

If properly structured, the licensing of an organization's logo or other trademarks will result in nontaxable royalty revenue. This is the case even if the logo or trademarks are used by the licensee in a commercial business (e.g., as with affinity arrangements). In Revenue Ruling 81-178, 1981-2 C.B. 135, the IRS ruled that a tax-exempt trade association for professional athletes received...