Tax Exemption And Unrelated Business Income Rules (UBIT): "Substantially Related" (Part 3 Of 3)

• Published date: 07 June 2022
• Subject Matter: Tax, Income Tax, Tax Authorities
• Law Firm: Freeman Law
• Author: Cory Halliburton

This Insights blog is Part 3 of a 3-Part series focused on the unrelated business income tax rules for the nonprofit organization that is tax-exempt pursuant to section 501(c)(3) of the Internal Revenue Code (the "Code").

Part 1'Tax Exemption and the Framework for the Unrelated Business Income Rules'provided an overview of the organizational and operational tests of section 501(c)(3) of the Code and alluded to the trigger for unrelated business income rules. Part 2-Unrelated Business Income Tax Rules, Modifications, and Exceptions'dived deeper into, well, the specific rules, modifications, and exceptions.

This Part 3 will dive deeper into the meaning of a trade or business that is "substantially related" to an exempt purpose of the tax-exempt organization.

"Substantially Related."

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. In determining the existence or nonexistence of such primary purpose, all the circumstances must be considered, including the size and extent of the trade or business and the size and extent of the activities which are in furtherance of one or more exempt purposes.

See 26 C.F.R. ' 1.501(c)(3)-1(e) (emphasis added).

A trade or business is "substantially related" (and therefore not an "unrelated" trade or business for unrelated business income tax rules) only if the production or distribution of the goods or the performance of the services from which the gross income is derived contributes importantly to the accomplishment of the purposes for which exemption was granted. "A 'substantially related' trade or business 'has causal relationship to the achievement of exempt purposes' and 'must contribute importantly to the accomplishment of those purposes.'" Ocean Pines Ass'n v. Comm'r, 672 F.3d 284, 287-289 (4th Cir. 2012) (quoting 26 C.F.R. ' 1.513-1(d)(2)). Section 1.513-1(d)(2) of the Treasury Regulations provides as follows:

Type of relationship required. Trade or business is related to exempt purposes, in the relevant sense, only where the conduct of the business activities has causal relationship to the achievement of exempt purposes (other than through the production of income); and it is substantially related, for purposes of section 513, only if the causal relationship is a substantial one. Thus, for the conduct of trade or business from which a particular amount of gross income is derived to be substantially related to purposes for which exemption is granted, the production or distribution of the goods or the performance of the services from which the gross income is derived must contribute importantly to the accomplishment of those purposes. Where the production or distribution of the goods or the performance of the services does not contribute importantly to the accomplishment of the exempt purposes of an organization, the income from the sale of the goods or the performance of the services does not derive from the conduct of related trade or business. Whether activities productive of gross income contribute importantly to the accomplishment of any purpose for which an organization is granted exemption depends in each case upon the facts and circumstances involved.

26 C.F.R. ' 1.513-1(d)(2)(emphasis in bold added).

In determining whether an activity is "substantially related" to an exempt purpose, the courts look to the...