Serving Two Masters: Commercial Hues and Tax Exempt Organizations(fn*)

• Publication year: 1984

UNIVERSITY OF PUGET SOUND LAW REVIEWVolume 8, No. 1FALL 1984

Serving Two Masters: Commercial Hues and Tax Exempt Organizations(fn*)

Lawrence Zelenak(fn**)

No man can serve two masters: for either he will hate the one, and love the other; or else he will hold to the one and despise the other. Ye cannot serve both God and mammon.

Matthew 6:24

Many organizations claiming tax exempt status under section 501(c)(3) of the Internal Revenue Code(fn1) (I.R.C.) engage solely or primarily in activities that both directly accomplish an exempt purpose and earn a profit. A hospital, for example, directly accomplishes an exempt charitable purpose by serving the medical needs of its community, but it also may make a profit from the fees it charges for its services. A college directly accomplishes an exempt educational purpose by teaching its students, but it may also make a profit from tuition receipts. The Internal Revenue Service (the Service) and the courts have had difficulty analyzing whether such organizations, which attempt to do well and to do good at the same time, are entitled to exempt status. The Service and the courts are concerned that the pursuit of profit may be incompatible with operation exclusively for exempt purposes; it is the old problem of serving two masters.

In B.S.W. Group, Inc. v. Commissioner,(fn2) the Tax Court explained the approach that it takes in ruling on the exempt status of an organization whose sole or primary activity of selling goods or services for a profit directly furthers an exempt purpose:The fact that petitioner's activity may constitute a trade or business does not, of itself, disqualify it from classification under section 501(c)(3), provided the activity furthers or accomplishes an exempt purpose. Rather, the critical inquiry is whether petitioner's primary purpose ... is an exempt purpose, or whether its primary purpose is the nonexempt one of operating a commercial business producing net profits for petitioner. This is a question of fact to be resolved on the basis of all the evidence. . . . Factors such as the particular manner in which an organization's activities are conducted, the commercial hue of those activities, and the existence and amount of annual or accumulated profits are relevant evidence of a forbidden predominant purpose.(fn3) In one respect, this analysis has been modified by later Tax Court decisions, which hold that an organization is not qualified for exemption if it has a substantial nonexempt commercial purpose. The commercial purpose need not be primary in order to disqualify the organization.(fn4) Regardless of how the test is articulated, however, an organization whose activities strike the Service and the courts as having too much of a "commercial hue" will be denied tax exempt status on the theory that it has a substantial nonexempt commercial purpose.(fn5)

The test described by the Tax Court in B.S. W. Group, Inc. is not justified by the terms of section 501(c)(3). This article will describe the statutory and regulatory framework of section 501(c)(3), examine how the test has been applied, criticize the test, and suggest a test more in keeping with the language and the spirit of section 501(c)(3). The proposed test is this: If the questioned activity directly accomplishes an exempt purpose of the organization, and if all profits from the activity are used in a manner consistent with the organization's exempt purposes,(fn6) then the organization should be granted exempt status, whether or not the organization's activities are imbued with a "commercial hue."(fn7)

I. The State of the Law

A. The Statutory and Regulatory Framework

Organizations described in I.R.C. section 501(c)(3) are exempt from federal income tax under section 501(a)(fn8) and are also eligible to receive tax deductible charitable contributions under section 170. In order to be described in section 501(c)(3), an organization must satisfy four statutory requirements. First, it must be organized exclusively for one or more exempt purposes (religious, charitable, scientific, testing for public safety, literary, educational, promoting amateur sports, or preventing cruelty to animals).(fn9) Second, it must be operated exclusively for one or more exempt purposes.(fn10) Third, no part of its net earnings may inure to the benefit of any private individual.(fn11) Fourth, it must observe the statutory restrictions on involvement in legislative lobbying and political campaigns.(fn12)

The Service may challenge an organization engaged in business activities for not satisfying the second of these requirements, the "operational test," which mandates that the organization be operated exclusively for exempt purposes. Under the operational test, the organization's purposes, rather than its activities, must qualify as exempt. The statutory language requires that the organization be "operated exclusively" for exempt "purposes."(fn13)

No activity is inherently exempt or nonexempt. Whether an activity is consistent with exempt status depends on the organization's purpose for engaging in that activity. The regulations emphasize this crucial distinction between purpose and activity by stating that an organization satisfies the operational test if its activities accomplish one or more of the exempt purposes specified in section 501(c)(3).(fn14) Although the language of the statute literally requires operation Exclusively for exempt purposes, the regulations indicate that an insubstantial nonexempt purpose will not destroy an organization's exempt status.(fn15)

It follows from the focus on purposes rather than on activities, that the fact that an organization earns income by engaging in a business should not automatically make it ineligible for exemption.(fn16) Engaging in a business is an activity that, like many other activities, can be undertaken for exempt or nonexempt purposes. The regulations acknowledge that an organization operating a trade or business may meet the requirements of

section 501(c)(3) if the operation of the trade or business is in furtherance of the organization's exempt purposes (unless the organization's primary purpose is the carrying on of an unrelated trade or business).(fn17)

Section 513(a) defines an unrelated trade or business as a trade or business that is not substantially related to the accomplishment of the organization's exempt purposes (aside from the use the organization makes of the profits).(fn18) Such unrelated trade or business income is taxed under I.R.C. sections 511-514.(fn19)

This article considers business activities that are substantially related to the accomplishment of an organization's exempt purposes, and to which the tax on unrelated business income therefore does not apply. Two examples of substantially related business activities are the operation of a hospital by a charitable organization and the operation of a college by an educational organization. When the tax on unrelated business income applies, it permits a compromise solution: imposition of a tax on unrelated business income, but tax exemption for other income and eligibility to receive deductible charitable contributions. Such a compromise solution is not statutorily available when the organization's major activity is conducting a business substantially related to the organization's exempt purposes. Either the organization is totally tax exempt, or it is not exempt at all.

B. Rulings and Case Law

The Service has emphasized its objection to exempt organizations' commercial hues in several published rulings. In I960(fn20) the Service ruled that a nonprofit organization that published a foreign language magazine containing literary, scientific, and educational articles was not exempt because the magazine was sold to the general public through paid subscriptions. The ruling explained: "[T]he corporate activities . . . are, per se, business activities. They are devoted to publishing a magazine and selling it to the general public in accordance with ordinary commercial practices."(fn21) This decision was cited with approval in a 1967 ruling,(fn22) which stated that an organization engaged in publishing scientific and medical literature could qualify for exempt status only if, among other things, "the manner in which the distribution is accomplished is distinguishable from ordinary commercial publishing practices."(fn23) In 1977 the Service relied on that reasoning in ruling that a nonprofit organization publishing an ethnic newspaper was not entitled to exemption because the organization's activities of publishing the newspaper, soliciting advertising, and selling subscriptions, were "indistinguishable from ordinary commercial publishing practices."(fn24)

The analysis underlying these rulings is also reflected in the Service's position in the reported cases. The Service has challenged, with mixed results, the exemptions of organizations involved in many different kinds of business activities, on the basis that the organizations possessed forbidden commercial hues. Challenged activities have included producing plays,(fn25) commercial farming,(fn26) operating a pharmacy,(fn27) manufacturing and selling pyrometric cones,(fn28) aiding artists and artisans by selling their works,(fn29) aiding the blind by selling their handicrafts,(fn30) teaching and disseminating economic information by selling publications containing...