Sec. 501(c)(3) organizations engaging in fee-for-service activities must determine whether these activities advance or are “substantially related” to their exempt purpose. This distinction is critical for maintaining tax-exempt status and avoiding the unrelated business income tax (UBIT). Generally, services are not considered substantially related simply because they are provided to other tax-exempt organizations or offered at cost. IRS guidelines and case law emphasize that such services must either be provided substantially below cost or directly advance the organization’s exempt purposes to qualify as substantially related.
In a recent letter ruling (Letter Ruling 201701002), the IRS determined that certain fee-based services aligned with a private operating foundation’s exempt purposes, and the income from these services was not subject to UBIT. This ruling illustrates the complex and fact-specific nature of UBIT analyses for fee-for-service activities, blending two traditionally distinct approaches for evaluating these activities.
Commerciality
Organizations under Sec. 501(c)(3) must operate exclusively for one or more exempt purposes, with only an insubstantial portion of their activities advancing nonexempt purposes. Courts and the IRS scrutinize whether a primary activity is commercial in nature, evaluating if it resembles for-profit enterprises or competes with such businesses.
Key factors considered in assessing commerciality include:
- Competition with For-Profit Entities: If similar services are offered by for-profit businesses, the activity may be deemed commercial.
- Nature of Services Provided: Unique services distinct from those of for-profit entities suggest alignment with exempt purposes.
- Below-Cost Services: The extent and degree of services provided substantially below cost.
- Service Recipients: Whether the recipients are defined under Sec. 501(c)(3).
- Organizational Relationships: The connection between the service provider and the recipient.
- Dependence on Donations: Reliance on charitable contributions over commercial revenue.
While commercial activities do not inherently further exempt purposes, they can qualify as charitable if conducted in a charitable manner. For instance, activities regularly performed by commercial organizations are scrutinized based on the charitable identity of service recipients and whether the fees charged are substantially below cost. Notably, neither the tax code nor regulations precisely define “substantially below cost.”
Unrelated Business Income Tax
Sec. 511 imposes UBIT on the unrelated business taxable income (UBTI) of Sec. 501(c) organizations. UBTI comprises gross income from any unrelated trade or business regularly carried on, minus allowable deductions. For a trade or business to be substantially related to an organization’s exempt purposes, it must contribute significantly to achieving those purposes. The activity must demonstrate a causal relationship that is substantial.
Primary Purpose: Carrying on a Trade or Business
Evaluating whether a trade or business is substantially related involves a similar analysis used to determine if an organization primarily engaged in such activity qualifies for Sec. 501(c)(3) status. According to Treasury regulations, a trade or business must further the organization’s exempt purposes and avoid classification as an unrelated trade or business under UBIT rules. IRS rulings often confirm this overlap, relying on similar legal authorities to analyze whether fee-for-service activities generate UBTI. This analysis applies whether the activity is insubstantial or the organization’s primary focus.
The Ruling
In Letter Ruling 201701002, a private operating foundation aimed to improve the lives of low-income children and families by collecting, analyzing, interpreting, and sharing data to enhance community decision-making. The foundation’s data agreements with government agencies provided access to exclusive raw data. The processed information was publicly shared via a free database, but raw data were not disclosed.
The foundation also offered technical assistance to “social sector organizations,” such as nonprofits, government agencies, and community organizations, which lacked in-house expertise for specific analyses. Potential clients were screened to ensure alignment with the foundation’s mission. While the foundation initially offered these services free of charge, it introduced a reasonable fee structure to sustain its capacity for providing assistance. Pricing was adjusted based on client ability to pay, with some services offered below cost.
Analysis
The IRS ruled that the technical services furthered the foundation’s exempt purposes, concluding that the fee-for-service activities were substantially related. The analysis also acknowledged characteristics demonstrating the services were delivered charitably.
- Furthering Exempt Purposes: The services contributed to the foundation’s own research and grant-making activities, generating new publicly available information.
- Charitable Delivery: The services enabled other organizations to advance their charitable objectives, and fees were occasionally set below cost. These factors distinguished the foundation from entities offering commercial consulting services.
However, the IRS did not solely rely on the below-cost pricing. Existing guidelines require services to be priced substantially below cost to qualify as inherently charitable, which the foundation’s occasional below-cost pricing did not meet. Additionally, the IRS recognized that providing services to charitable organizations, even at cost, does not inherently further an exempt purpose.
Observations
This ruling provides a strategic framework for organizations seeking to align fee-for-service activities with exempt purposes and avoid UBIT. The IRS’s acknowledgment of both exempt-purpose advancement and charitable delivery reflects a nuanced analysis. Nevertheless, organizations should approach these rulings cautiously, as the IRS might reach different conclusions if services fail to directly further exempt purposes.
The ruling’s reliance on the foundation’s exclusive data access raises additional considerations. The absence of commercial competitors appeared less related to the unique nature of the services and more to the foundation’s exclusive data agreements. This exclusivity may limit the applicability of the ruling to other organizations lacking similar advantages.
Ultimately, while the hybrid approach of blending exempt-purpose alignment and charitable delivery offers insights, prudent organizations should ensure their fee-for-service activities robustly meet the substantially related test through direct contributions to their exempt purposes.