Fee-for-service activities: two paths to 'substantially related'.

• Author: Thomas, Randall S.

Sec. 501(c)(3) organizations that engage in fee-for-service activities need to consider whether a given activity furthers or is "substantially related" to an exempt purpose--a conclusion that matters for determining whether an organization will qualify (or continue to qualify) for tax-exempt status and whether income is subject to the unrelated business income tax (UBIT). In general, services will not be treated as substantially related merely because they are performed for other tax-exempt organizations or at cost. A considerable body of IRS guidance and case law makes clear that services provided by a Sec. 501(c)(3) organization generally must either be provided substantially below cost or further the organization's exempt purposes to be considered substantially related.

In a recent letter ruling, the IRS determined that certain services provided for a fee were substantially related to a private operating foundation's exempt purposes and that income from the services would not be subject to UBIT (see Letter Ruling 201701002). This ruling illustrates the fact-intensive nature of a UBIT analysis as applied to a fee-forservice activity and, interestingly, blends two historically separate approaches for analyzing fee-for-service activities.

Commerciality

An organization described in Sec. 501(c) (3) must be organized and operated exclusively for one or more exempt purposes, generally requiring the organization to engage primarily in activities that further exempt purposes and allowing no more than an insubstantial part of its activities to be in furtherance of nonexempt purposes. If an organization's primary activity is a trade or business, the courts and the IRS will closely examine whether the activity appears to have a "commercial hue" or supplants for-profit businesses in determining whether the activity furthers an exempt purpose.

The following factors are considered in assessing the commerciality of fee-for-service activities: competition with for-profit entities, the nature of the services provided, the extent and degree of below-cost services provided, whether recipients of services are described in Sec. 501(c)(3), the relationship of the service provider to the recipient, and the extent to which the organization relies on charitable donations. The presence of for-profit organizations providing similar services, while not dispositive, tends to show that an activity is commercial. Conversely, the fact that an organization's services are unlike those offered by for-profit providers suggests that the activities further exempt purposes.

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The IRS generally takes the position that while commercial activities do not further exempt purposes, these activities can be inherently charitable...