How much unrelated business activity is too much?

• Author: Quesenberry, Preston J.

Tax practitioners are used to dealing with uncertainty when applying fuzzy qualitative thresholds such as "substantial" and "primary." However, when it comes to determining how much unrelated business activity is permissible for tax-exempt organizations described in Sec. 501(c)(3), practitioners face an even bigger challenge: They do not know what the qualitative threshold is. Specifically, sparse and poorly written guidance and conflicting authorities leave unclear whether unrelated business activity must be an "insubstantial part" of a Sec. 501(c)(3) organization's total activities or, rather, whether it may be substantial so long as it is not an organization's "primary purpose." This discussion reviews the long-held IRS position that the better answer is to allow the unrelated activities to be substantial so long as they are not the organization's "primary purpose," while also acknowledging that there is widespread confusion and uncertainty on this point.

The primary-purpose test

To qualify as a tax-exempt entity described in Sec. 501(c)(3), an organization must be organized and operated exclusively for exempt purposes. The Sec. 501(c)(3) regulations regard an organization as operated exclusively for one or more exempt purposes only if it engages primarily in activities that accomplish those purposes. The regulations state that an organization "will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose." This "no more than an insubstantial part" threshold, from Regs. Sec. 1.501(c)(3)-1(c)(1), is commonly known as the "operational test" and is referred to in this item as the "substantiality threshold."

The Sec. 501(3) regulations directly address unrelated business activity in Regs. Sec. 1.501(c)(3)-1(e)(1):

An organization may meet the requirements of section 501(c)(3) although it operates a trade or business as a substantial part of its activities, if the operation of such trade or business is in furtherance of the organization's exempt purpose or purposes and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business, as defined in section 513.

One interpretative question raised by this language is whether it means that an unrelated trade or business may be a substantial part of a Sec. 501(c) (3) organization's activities so long as it is not the organization's "primary purpose," or, rather, whether it means only businesses that are not unrelated may cross the substantiality threshold. This, in turn, raises the question of whether an unrelated trade or business may be in "furtherance of" an...