AICPA sends IRS proposed guidelines on exempt organizations' expense allocations for dual-use facilities and/or personnel

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1 March 9, 2017 Tax Alert Exempt Organizations & Government Entities AICPA sends IRS proposed guidelines on exempt organizations' expense allocations for dual-use facilities and/or personnel The American Institute of CPAs (AICPA) has sent the IRS a letter setting forth proposed guidelines on how a tax-exempt organization should allocate expenses attributable to facilities and/or personnel that are used for both tax-exempt and unrelated business activities (dual-use facilities/personnel). The letter is an updated version of a comment letter sent in Each year, the IRS releases its Priority Guidance Plan identifying priority tax issues to be addressed through regulations, revenue rulings, revenue procedures, notices and other published administrative guidance during the IRS fiscal year (July-June). For the past several years (including the Plan ), the IRS has included in its priority guidance list "Guidance under Section 512 regarding methods of allocating expenses relating to [dual-use] facilities." The letter from the AICPA timely responds to the need for IRS guidance in this area. Specifically, for the IRS's consideration, the letter proposes seven guidelines for allocating unrelated business income (UBI) expenses for dual-use facilities/personnel: 1. Deductible expenses must bear a proximate and primary relationship to the conduct of the activity. 2. Deductible expenses include both direct costs and indirect costs. 3. Indirect costs include fixed expenses (those which do not change when the unrelated activity is conducted or not conducted) and variable expenses (those which increase or decrease when the unrelated activity is conducted or not conducted). 4. The methodology for allocating expenses relating to dual-use facilities/personnel is reasonable and consistently followed from year to year, and should not cause the double-counting of any expense. 5. The methodology for allocating expenses relating to dual-use facilities/personnel is based on the character of the expense involved. a. Facility costs (rent, mortgage interest, insurance, taxes, security, and utilities) are apportioned based on the portion of the facility used (square footage and time) for each activity. b. Personnel costs (salary, benefits, and taxes) are apportioned based on time spent on each activity. c. Information technology costs (software, computer services and internet) are apportioned based on the allocation of personnel to the activity. d. Office expenses (supplies, printing, postage, and subscriptions) are apportioned based on the allocation of personnel to the activity. Unrelated business income 1

2 6. The AICPA recommends that the IRS permit the use of gross revenue, from each respective activity, to allocate direct and/or indirect expenses if there is no difference in the prices charged to earn unrelated versus related revenue. This provision is intended for use by organizations that are unable, or for which it is administratively impractical, to maintain or create records for activities in which dual-use facilities/personnel are used and the associated expenses are clearly distinguished as related or unrelated. 7. The AICPA recommends that the IRS provide a simplified method for small businesses to determine expenses which are deductible against unrelated business income. Small organizations lack the resources to adequately document the information needed to identify expenses pertaining to dual-use facilities/personnel used in related and unrelated activities. The letter also includes six examples illustrating the application of these guidelines. Implications The AICPA is offering the IRS much-needed guidelines for allocating indirect costs in dual-use facilities, which are facilities that operate to serve both related exempt function activities and activities that generate unrelated business income. Current regulations require that an organization with dual use of facilities/personnel must allocate expenses "between the two uses on a reasonable basis" (see Reg. Section 1.512(a)-1(c)), provided that the expense is an otherwise allowable income tax deduction (e.g., allowable under Section 162 or Section 167). The lack of guidance regarding dual-use facility/personnel expenses has created varying methods for allocating costs, differing among industries and organizations. Expense allocations are commonly reviewed and oftentimes challenged by the IRS during its examinations of organizations' UBI calculations. The AICPA hopes the IRS will alleviate speculation within the industry by adopting these guidelines of how to fairly and appropriately allocate different indirect costs, based on a methodology that fairly represents the character of the expense, the unrelated use, and the administrative abilities of the organization. In past years, the IRS has been receptive and has welcomed comments and proposals related to tax-exempt organizations so it would not be surprising if some of the AICPA's recommendations are eventually incorporated in official IRS guidance. These guidelines have not been adopted by the IRS, however, so organizations should continue to monitor their own allocation practices and policies regarding dual-use facility/personnel expenses to make sure that they are reasonable and supportable. Please contact your Ernst & Young LLP tax professional with any questions. RELATED RESOURCES -- For more information about EY's Exempt Organization Tax Services group, visit us at Contact Information For additional information concerning this Alert, please contact: Tax-Exempt Organizations Group Mike Vecchioni (313) Mike Payne (602) Scott Tidwell (858) Unrelated business income 2

3 Other Contacts Exempt Organizations Tax Services Markets and Region Leadership Scott Donaldson, Americas Director Phoenix (602) Mark Rountree, Americas Markets Leader Dallas (214) Bob Lammey, Americas Higher Education Markets Leader Boston (617) Lucille White, Central Region Chicago (312) Bob Vuillemot, Northeast Region Pittsburgh (412) Debra Heiskala, West Region San Diego (858) Joyce Hellums, Southwest Region Austin (512) Kathy Pitts, Southeast Region Birmingham (205) The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting or tax advice or opinion provided by Ernst & Young LLP to the reader. The reader also is cautioned that this material may not be applicable to, or suitable for, the reader's specific circumstances or needs, and may require consideration of non-tax and other tax factors if any action is to be contemplated. The reader should contact his or her Ernst & Young LLP or other tax professional prior to taking any action based upon this information. Ernst & Young LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein. Copyright , Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Unrelated business income 3

4 Ms. Victoria Judson Ms. Janine Cook February 23, 2017 Page 1 of 7 February 23, 2017 Ms. Victoria Judson Ms. Janine Cook Associate Chief Counsel (TE/GE) Deputy Associate Chief Counsel (TE/GE) Office of Chief Counsel Office of Chief Counsel Internal Revenue Service Internal Revenue Service 1111 Constitution Avenue, NW 1111 Constitution Avenue, NW Washington, DC Washington, DC Re: Unrelated Business Income Expense Allocation Methodologies for Dual Use Facilities Dear Mmes. Judson and Cook: The American Institute of CPAs (AICPA) appreciates the efforts by the Internal Revenue Service (IRS) Office of Chief Counsel to issue guidance for tax preparers and taxpayers on how a tax-exempt organization should allocate expenses attributable to facilities and/or personnel which are used for both tax-exempt activities and unrelated trade or business activities. To further this mission, we submit this letter with guidelines and examples for your consideration in addressing how to allocate unrelated business income (UBI) expenses for dual use facilities. Guidelines for allocation of indirect expenses 1. Deductible expenses must bear a proximate and primary relationship to the conduct of the activity. 2. Deductible expenses include both direct costs and indirect costs. 3. Indirect costs include fixed expenses (those which do not change when the unrelated activity is conducted or not conducted) and variable expenses (those which increase or decrease when the unrelated activity is conducted or not conducted). Unrelated business income 4

5 Ms. Victoria Judson Ms. Janine Cook February 23, 2017 Page 2 of 7 4. The methodology for allocating expenses relating to dual use facilities/personnel is reasonable and consistently 1 followed from year to year, and should not cause the double-counting of any expense. 5. The methodology for allocating expenses relating to dual use facilities/personnel is based on the character of the expense involved. a. Facility costs (rent, mortgage interest, insurance, taxes, security, and utilities) apportioned based on portion of facility used (square footage and time) for each activity. b. Personnel costs (salary, benefits, and taxes) apportioned based on time spent on each activity. c. Information technology costs (software, computer services, and internet) apportioned based on allocation of personnel to activity. d. Office expenses (supplies, printing, postage, and subscriptions) are apportioned based on allocation of personnel to activity. 6. The AICPA recommends that the IRS permit the use of gross revenue, from each respective activity, to allocate direct and/or indirect expenses if there is no difference in the prices charged to earn unrelated versus related revenue. This provision is intended for use by organizations that are unable, 2 or for which it is administratively impractical, to maintain or create records with respect to activities in which dual use facilities/personnel are used and the associated expenses are clearly distinguished as related or unrelated. 7. The AICPA recommends that the IRS provide a simplified method for small businesses to determine expenses which are deductible against unrelated business income. Small organizations lack the resources to adequately document the information needed to identify expenses pertaining to dual use facilities/personnel used in related and unrelated activities. Examples Example 1: Exempt Organization (EO) owns an office building which is subject to a mortgage. The portion of the building which is not used by the EO is rented to unrelated 1 Allocation methods are revised from time to time as the organization s activities and related expenses evolve over time. Such changes that enhance the accuracy of expense allocations do not violate the consistency principle. 2 See Examples 3 and 5 for cases in which an organization, despite reasonable efforts, is unable to create or maintain records segregating facility/personnel usage between related and unrelated uses due to the nature of the activity. Unrelated business income 5

6 Ms. Victoria Judson Ms. Janine Cook February 23, 2017 Page 3 of 7 third parties. Tenants have separately contracted for utilities. The EO s office manager is responsible for collecting rents and responding to the tenants requests for repairs. Under Internal Revenue Code (IRC or Code ) section 514, 3 a portion of the rent earned by the EO is treated as unrelated business taxable income. (This example is for purposes of illustrating the calculation to determine the costs attributable to the activity, and therefore, does not include the calculations required by section 514 to allocate a percentage of the revenue and expenses to UBTI based on the average debt/basis ratio.) Allocation of building costs based on square footage Total building square footage: 5,000 Rented square footage: 1,500 Annual building depreciation: $50,000 Annual building insurance: $20,000 Annual mortgage interest: $60,000 Allocated expenses: Depreciation = $50,000 (1,500 5,000) = $15,000 Insurance = $20,000 (1,500 5,000) = $6,000 Interest = $60,000 (1,500 5,000) = $18,000 Allocation of personnel time devoted to rental activity based on time spent Annual office manager compensation: $75,000 % time devoted to rental activities: 15% Allocated expenses: Personnel = $75,000 15% = $11,250 Allocation of overhead devoted to rental activity based on related personnel s office space Office manager s office square footage: 100 Annual utilities: $40,000 Allocated expenses: Depreciation = $50,000 (100 5,000) 15% = $150 Insurance = $20,000 (100 5,000) 15% = $60 Interest = $60,000 (100 5,000) 15% = $180 Utilities = $40,000 (100 5,000) 15% = $120 Total allocated expenses = $50,760 3 All references herein to section or are to the Internal Revenue Code (IRC) of 1986, as amended, or the Treasury Regulations promulgated thereunder. Unrelated business income 6

7 Ms. Victoria Judson Ms. Janine Cook February 23, 2017 Page 4 of 7 Example 2: EO owns an office building which is subject to a mortgage. The building has a ballroom which is sometimes used by the EO for events related to its mission and at other times is rented to unrelated third parties. Under section 514, a portion of the rent earned by the EO is treated as unrelated business taxable income. (This example is for purposes of illustrating the calculation to determine the costs attributable to the activity and therefore does not include the calculations required by section 514 to allocate a percentage of the revenue and expenses to UBTI based on the average debt/basis ratio.) Allocation of fixed building costs to ballroom based on square footage Total building square footage: 10,000 Rented square footage: 2,000 Annual building depreciation: $40,000 Annual building insurance: $10,000 Annual mortgage interest: $30,000 Allocated expenses: Depreciation = $40,000 (2,000 10,000) = $8,000 Insurance = $10,000 (2,000 10,000) = $2,000 Interest = $30,000 (2,000 10,000) = $6,000 Allocation of fixed ballroom costs based on usage Days used by EO for its own exempt activities: 100 Days used by unrelated third parties for non-exempt purposes: 20 Total Days Used: 120 Allocated expenses 4 : Depreciation = $8,000 (20 120) = $1,333 Insurance = $2,000 (20 120) = $333 Interest = $6,000 (20 120) = $1,000 Allocation of variable ballroom costs based on usage (The costs below are attributable to the ballroom only and are incurred only when it is used) Janitorial services = $12,000 Utilities = $6,000 Allocated expenses: Janitorial services = $12,000 (20 120) = $2,000 Utilities = $6,000 (20 120) = $1,000 4 Rensselaer Polytechnic Institute v. Commissioner, 732 F.2d 1058 (2d Cir. 1984). Unrelated business income 7

8 Ms. Victoria Judson Ms. Janine Cook February 23, 2017 Page 5 of 7 Total allocated expenses = $5,666 Example 3: EO operates a facility which processes laboratory services for patients at its hospital facility and non-patients. The revenue earned from non-patient lab services is treated as unrelated business taxable income. Although customers are eligible for different discounts, the gross charges for each service are the same regardless of who receives the services. Assume the profit margin is consistent. Allocation of expenses based on revenue Total patient service revenue: $100,000 Gross revenue attributable to patient services: $80,000 Gross revenue attributable to non-patient services: $20,000 Total facility expenses: $75,000 Allocated expenses: Facility expenses = $75,000 ($20,000 $100,000) = $15,000 Total allocated expenses = $15,000 Example 4: EO operates a laundry facility which processes laundry for affiliated organizations and unrelated third parties. The revenue earned from unrelated third parties is treated as unrelated business taxable income. Charges for laundry services are based on the number of pounds processed. Allocation of expenses based on units of service Total annual pounds of laundry processed: 80,000 Annual pounds of laundry processed for affiliated organizations: 50,000 Annual pounds of laundry processed for unrelated third parties: 30,000 Total facility expenses: $200,000 Allocated expenses: Facility expenses: $200,000 (30,000 80,000) = $75,000 Total allocated expenses = $75,000 Example 5: EO operates a café which is accessible to those visiting the EO s museum exhibits as well as the general public. There is no difference in the amounts charged to museum visitors and the general public. Revenue from those customers not visiting the museum s exhibits is treated as unrelated business taxable income and coded by the café cashiers as such. Unrelated business income 8

9 Ms. Victoria Judson Ms. Janine Cook February 23, 2017 Page 6 of 7 Allocation of expenses based on revenue: Total gross revenue: $500,000 Gross revenue attributable to museum visitors: $400,000 Gross revenue attributable to general public: $100,000 Total food costs: $200,000 Total personnel costs: $150,000 Total facility expenses: $75,000 Allocated expenses: Food costs = $200,000 ($100,000 $500,000) = $40,000 Personnel costs = $150,000 ($100,000 $500,000) = $30,000 Facility expenses = $75,000 ($100,000 $500,000) = $15,000 Total allocated expenses = $85,000 Example 6: EO is a country club that includes a golf course, swimming pool, restaurant, and tennis facilities. Members pay monthly dues that allow them access to all of these amenities. Non-members are permitted to use the golf course. Non-members pay a standard greens fee for 18 holes of golf. The greens fees are treated as unrelated business taxable income. Certain golf course operating and maintenance expenses are allocable to the non-member use of the golf course. Since members dues pay for access to all of the amenities, the allocation of golf course expenses based on revenues (members dues/non-member s greens fees) does not produce an equitable method. Instead, expenses are allocated based on the number of rounds played by members compared to the number of rounds played by non-members. Allocation of expenses based on number of rounds Total number of rounds played: 10,000 Number of rounds played by members: 8,500 Number of rounds played by non-members: 1,500 Total personnel costs: $35,000 Total maintenance & fertilizer costs: $20,000 Total insurance costs: $8,000 Total depreciation expense: $15,000 Allocated expenses: Personnel = $35,000 x (1,500 10,000) = $5,250 Maintenance & Fertilizer = $20,000 x (1,500 10,000) = $3,000 Insurance = $8,000 x (1,500 10,000) = $1,200 Depreciation = $15,000 x (1,500 10,000) = $2,250 Unrelated business income 9

10 Ms. Victoria Judson Ms. Janine Cook February 23, 2017 Page 7 of 7 Total allocated expenses = $11,700 ****** The comments and recommendations included in this letter were developed by the AICPA Exempt Organizations Taxation Technical Resource Panel and approved by the AICPA Tax Executive Committee. The AICPA is the world s largest member association representing the accounting profession with more than 418,000 members in 143 countries and a history of serving the public interest since Our members advise clients on federal, state and international tax matters and prepare income and other tax returns for millions of Americans. Our members provide services to individuals, not-for-profit organizations, small and mediumsized businesses, as well as America s largest businesses. We appreciate your consideration of our recommendation and welcome the opportunity to discuss this issue further. If you have any questions, please feel free to contact me at (408) , or annette.nellen@sjsu.edu; Elizabeth E. Krisher, Chair, AICPA Exempt Organizations Taxation Technical Resource Panel, at (412) , or bkrisher@mdcpas.com; or Ogochukwu Eke-Okoro, Lead Manager AICPA Tax Policy & Advocacy, at (202) , or ogo.eke-okoro@aicpa-cima.com. Sincerely, Annette Nellen, CPA, CGMA, Esq. Chair, AICPA Tax Executive Committee Unrelated business income 10

11 January 13, 2017 Tax Alert Exempt Organizations & Government Entities Charitable foundation's charging of fee for services does not result in unrelated business taxable income In Private Letter Ruling , the IRS has ruled that a charitable foundation's charging of fees for certain technical assistance services provided to other tax-exempt and governmental organizations does not constitute an unrelated trade or business. In its ruling, the IRS considered significant factors to be that the services provided are in furtherance of the charitable foundation's exempt charitable purposes and that the foundation sets its fees at a reasonable rate, at a charge based on each entity's ability to pay. On a case-by-case basis, it will charge fees at less than cost. Facts Foundation, a tax-exempt private operating foundation, was formed for the charitable purpose of improving the lives of low-income families and children. It furthers its charitable purpose, in part, through collecting, analyzing and sharing neighborhood data in its region of operation to improve community decision-making. The Foundation has data usage agreements with local government agencies and school districts to obtain information not publicly available. Combining this information with publicly available information from the US Census and other sources, Foundation is able to analyze various community issues and trends. It maintains on its website a free, user-friendly database of some portions of the neighborhood information that allows users to get information on key social issues. The Foundation also offers technical assistance to social sector organizations (including nonprofits, foundations, government agencies and community organizations) when the information an organization needs is not readily available on Foundation's website and the organization does not have the expertise to do the analysis on its own. Such organizations request these services from Foundation, and Foundation ensures that each project it agrees to undertake supports its own charitable purposes. Unless there are privacy restrictions, the Foundation also makes certain information from the projects publicly available. In addition, the information gained from such projects also directly helps Foundation to identify community needs and pursue its charitable purpose. Foundation historically has absorbed the costs of providing such technical assistance. Doing so, however, has severely limited the number of projects it can undertake. Foundation now proposes to charge a reasonable fee for such technical assistance requests. It will not charge for smaller requests (requiring less than four hours of staff time) and will tailor its fee to clients' ability to pay charging fees, in some cases, at less than cost. In addition, the contract between Foundation and the requesting organizations will provide that the information cannot be used for purposes other than the exempt purposes agreed to by Foundation. Ruling and analysis Foundation requested rulings on whether its provision of technical assistance services for a fee, as described, would constitute an unrelated trade or business under Section 513, subjecting Foundation to Unrelated business income 11

12 unrelated business income tax under Section 511, and whether this would constitute a business enterprise under Section 4943(d)(3), subjecting Foundation to excise taxes on excess business holdings under Section In its analysis, the IRS compared Foundation's circumstances to those presented in Revenue Ruling and B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352 (1978). In Revenue Ruling , the IRS ruled that an organization's regular provision of certain managerial and consulting services to tax-exempt organizations at cost was not a charitable activity under Section 501(c)(3). Similarly, in B.S.W. Group, the Tax Court concluded that an organization formed to provide consulting services to nonprofit organizations was not exempt under Section 501(c)(3), because the organization was not substantially different from similar commercial businesses, it had no plans to charge fees below cost, and it failed to limit its clientele to Section 501(c)(3) organizations. Unlike the organizations in Revenue Ruling and B.S.W. Group, the IRS concluded Foundation's technical assistance services are substantially related to its own charitable purpose. The IRS noted that the technical assistance services fit with Foundation's community data analysis activities, with the additional projects giving Foundation access to new data and research. In addition, the IRS noted that Foundation ensures that the projects it undertakes will further its charitable purpose. Furthermore, Foundation makes the results publicly available and ensures clients do not sell the results or use them for non-exempt activities. Finally, Foundation will provide its services below cost on a case-by-case basis. Accordingly, the IRS ruled that Foundation's technical assistance services will not constitute an unrelated trade or business nor be subject to unrelated business income tax. The IRS added that the term "business enterprise" in Section 4943(d)(3) does not include a functionally related business as defined in Section 4942(j)(4). Under Section 4942(j)(4), a functionally related business includes a trade or business that is not an unrelated trade or business under Section 513. Accordingly, because Foundation's activities do not constitute an unrelated trade or business, the IRS ruled they do not constitute a business enterprise subject to the tax on excess business holdings under Section Implications While this is not necessarily a new application of law, this ruling serves as a good synopsis of basic unrelated business income concepts relevant to not only private foundations, but all tax-exempt organizations. As the ruling points out, tax exempt organizations may be able to offer certain consulting or related services for a fee to unrelated non-profit organizations and the services will not constitute an unrelated trade or business if they contribute importantly to the accomplishment of the organization's exempt purpose. Moreover, these services ought to be distinguishable from those offered by commercial enterprises. In this ruling, the IRS cited several factors in its determination that the services furthered the Foundation's mission, and was therefore not taxable as an unrelated trade or business. Prior to providing the services, the Foundation used a screening process to evaluate the potential project to ensure it would provide information and insight to advance the Foundation's tax-exempt mission. Additionally, the Foundation took steps to ensure its clients would not use the services to further any commercial purpose. Further, the Foundation distinguished its services from commercial businesses in several ways. The Foundation's pricing structure was based partially on its clients' ability to pay, and at all times was reasonably priced. In some cases this meant that services were provided at less than cost, as determined on a case-by-case basis. Moreover, the Foundation would continue to provide other information to the public without charge. Finally, whenever possible, the Foundation would make the results of each project publicly available on its website, including both information gained from publicly available sources as well as information learned during the project work. A private letter ruling is a written statement issued to a particular taxpayer that interprets and applies tax laws to the taxpayer's specific, represented set of facts, and may not be used or cited as precedent by Unrelated business income 12

13 other taxpayers or by IRS personnel. Although the ruling is instructive on how the IRS might rule regarding a particular matter, organizations are cautioned not to rely on the ruling as authority, and to consult with their tax advisors to determine the tax consequences of their own facts and circumstances. Please contact your Ernst & Young LLP tax professional with any questions. RELATED RESOURCES -- For more information about EY's Exempt Organization Tax Services group, visit us at Contact Information For additional information concerning this Alert, please contact: Tax-Exempt Organizations Group Mike Vecchioni (313) Tricia Johnson (513) Jennifer Rhoderick (317) Mike Payne (602) Scott Tidwell (858) Other Contacts Exempt Organizations Tax Services Markets and Region Leadership Scott Donaldson, Americas Director Phoenix (602) Mark Rountree, Americas Markets Leader Dallas (214) Bob Lammey, Americas Higher Education Markets Leader Boston (617) Lucille White, Central Region Chicago (312) Bob Vuillemot, Northeast Region Pittsburgh (412) Debra Heiskala, West Region San Diego (858) Joyce Hellums, Southwest Region Austin (512) Kathy Pitts, Southeast Region Birmingham (205) The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting or tax advice or opinion provided by Ernst & Young LLP to the reader. The reader also is cautioned that this material may not be applicable to, or suitable for, the reader's specific circumstances or needs, and may require consideration of non-tax and other tax factors if any action is to be contemplated. The reader should contact his or her Ernst & Young LLP or other tax professional prior to taking any action based upon this information. Ernst & Young LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein. Copyright , Ernst & Young LLP. Unrelated business income 13

14 All rights reserved. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Unrelated business income 14

15 Private Letter Ruling, PLR (2017) PLR (IRS PLR), 2017 WL Internal Revenue Service (I.R.S.) IRS PLR Private Letter Ruling Issue: January 6, 2017 October 5, 2016 Section Taxes on Failure to Distribute Income Taxes on Failure to Distribute Income Operating Foundations Functionally Related Business Section Excise Taxes on Excess Business Holdings Excise Taxes on Excess Business Holdings Section Tax on Unrelated Business Income of Charitable, etc, Organizations (Taxable v. Not Taxable) Tax on Unrelated Business Income of Charitable, etc, Organizations (Taxable v. Not Taxable) Section Unrelated Business Taxable Income (Taxable v. Not Taxable) Unrelated Business Taxable Income (Taxable v. Not Taxable) Section Unrelated v. Not Unrelated Trade or Business Unrelated v. Not Unrelated Trade or Business CC:TEGE:EOEG:EO1 PLR Legend Foundation = State = City = Dear ***: This letter responds to a letter from your authorized representative dated March 18, 2016, as well as subsequent correspondence, submitted on behalf of the Foundation, requesting rulings that: (1) Fees received by the Foundation for technical assistance services described in the ruling request will not cause the Foundation to be treated as being engaged in an unrelated trade or business as defined in section 513 of the Internal Revenue Code (Code), because the services have a substantial causal relationship to the achievement of the Foundation's exempt purpose; (2) The income derived from such fees will not be subject to unrelated business income tax imposed by section 511 of the Code; (3) The services will not constitute a business enterprise within the meaning of section 4943(d)(3) of the Code because they will qualify as a functionally related business within the meaning of section 4942(j) of the Code; and 2017 Thomson Reuters. No claim to original U.S. Government Works. 1 Unrelated business income 15

16 Private Letter Ruling, PLR (2017) (4) Because the services will not be a business enterprise within the meaning of section 4943(d)(3) of the Code, the Foundation's provision of the Services will not subject the Foundation to excise taxes on excess business holdings under section 4943 of the Code. FACTS The Foundation is a tax-exempt organization described in section 501(c)(3) of the Code and classified as a private operating foundation under sections 509(a) and 4942(j)(3). It was formed for the charitable purpose of improving the lives of low income children and their families in State. The Foundation represents that, among other exempt activities, it furthers this charitable purpose through the collection, analysis, interpretation, and sharing of City metro region neighborhood data to improve community decision-making. The Foundation represents that the data usage agreements entered into with government agencies and school districts give the Foundation access to raw data that is not typically available in the public domain and is not available to commercial ventures. The Foundation maintains a repository containing the usage agreement data, along with publicly available data obtained from the U.S. Census Bureau, Internal Revenue Service (Service), and U.S. Department of Housing and Urban Development, which enables it to conduct proactive, in-depth analysis of community issues and cover a wide array of information about the people, education, and health of the metro City area. The Foundation maintains on its website a free, user-friendly searchable database tool of neighborhood indicators based on information in its repository, but the searchable database does not reveal raw usage agreement data. The searchable database allows users to find information on key social issues affecting the City metro region neighborhoods. In addition to collecting and making neighborhood data publicly available through its searchable database tool, the Foundation offers technical assistance to social sector organizations nonprofits, foundations, government agencies, and community organizations. The Foundation defines technical assistance as a request that cannot be met through independent review of the tools on the Foundation's website. The Foundation represents that a client social sector organization seeks technical assistance because it does not have the in-house technical or subject-matter expertise to run the type of analysis it is requesting. A social sector organization seeking the Foundation's services initiates a project request to the Foundation. The Foundation represents that it administers an extensive screening process similar to its grantmaking screening process to ensure that each project it agrees to undertake for a client social sector organization will provide information and insight to advance the Foundation's mission, in addition to ensuring that the services will be provided only to those specific social sector organizations that are focused on improving the lives of low-income children and their families. The Foundation represents that, except in the case where there are privacy restrictions on the data source, all of the data and information provided by the client for the project is added to the Foundation's repository for use in other projects as needed by the Foundation. The Foundation represents that these projects provide the Foundation with data about the health and well-being of City metro region children, their families, and their communities so that the Foundation can better understand community needs and highlight the greatest potential for impact. The additional data informs the Foundation's grantmaking activities and assists the Foundation with tracking community change occurring as a result of its funding efforts. The Foundation represents that completed projects are made available to the public on its website. The Foundation previously absorbed all costs of providing technical assistance, but absorbing all costs severely limits the number of projects that the Foundation engages in each year. In order to enable it to engage in more projects that bring in valuable new data and identify research questions not previously explored, the Foundation proposes to charge a reasonable fee for technical assistance requests. The Foundation will not charge for requests that require less than four hours of staff time. In addition, the Foundation represents that it will scope its pricing in alignment with clients' ability to pay. The Foundation represents that, on a case by case basis, it will charge fees less than cost Thomson Reuters. No claim to original U.S. Government Works. 2 Unrelated business income 16

17 Private Letter Ruling, PLR (2017) The Foundation will continue to perform certain data activities without charge, including making data publicly available through its web-based searchable database tool, engaging in local and national partnerships to improve the data repository, and encouraging data-based decision-making. The Foundation represents that, if it accepts a technical assistance request, the contract between the Foundation and the client social sector organization will provide that the client will not use the resulting product or information for any purpose other than the exempt purpose for which the Foundation agreed to provide the product or information, and will not resell the product or information. LAW AND ANALYSIS Ruling Requests 1 & 2 Section 511 of the Code imposes a tax on a section 501(c)(3) organization's unrelated business taxable income (as defined in section 512 of the Code). Section 512 defines the term unrelated business taxable income as the gross income derived by an organization from any unrelated trade or business (as defined in section 513) regularly carried on by it, less allowable deductions, both computed with the modifications provided in section 512(b). Generally, income will be treated as derived from the conduct of an unrelated trade or business if: (1) it is income from trade or business; (2) such trade or business is regularly carried on by the organization; and (3) the conduct of such trade or business is not substantially related (other than through the production of funds) to the organization's performance of its exempt functions. See (a) of the regulations. Under (d)(2) of the regulations, a substantial causal relationship must exist between the conduct of the organization's trade or business activities that generated the income and the achievement of the organization's exempt purpose. A substantial causal relationship exists where the production or distribution of the goods or the performance of the services (from which the income is derived) contributes importantly to the accomplishment of the organization's exempt purpose. See (d)(2). Therefore, where the goods or services do not contribute importantly to the accomplishment of the organization's exempt purposes, the income earned is not derived from the conduct of related trade or business. See (d)(2). Rev. Rul , C.B. 245, held not exempt under section 501(c)(3) of the Code an organization formed to provide managerial and consulting services at cost to unrelated section 501(c)(3) organizations. The services consisted of writing job descriptions and training manuals, recruiting personnel, constructing organizational charts, and advising organizations on specific methods of operation. These activities were designed for the individual needs of each client organization. Receipts of the organization were from services rendered. Disbursements were for operating expenses. The Service reasoned that providing managerial and consulting services on a regular basis for a fee is a trade or business ordinarily carried on for profit. The fact that the services were provided at cost and solely for exempt organizations was not sufficient to characterize the activity as charitable within the meaning of section 501(c)(3) of the Code. Furnishing the services at cost lacked the donative element necessary to establish the activity as charitable. The case was distinguished from Rev. Rul , where an organization controlled by a group of exempt organizations provided investment management services for a charge substantially less than cost solely to that group. Similarly, in B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352 (1978), the court concluded that a corporation formed to provide consulting services to nonprofit organizations was not exempt under section 501(c)(3) of the Code because its activities constituted the conduct of a trade or business that is ordinarily carried on by commercial ventures organized for profit. Its primary purpose was not charitable, educational, nor scientific, but rather commercial. The court explained that the corporation had completely failed to demonstrate that its services were not in competition with commercial businesses. Also, the organization's financing did not resemble that of the typical organization described in section 501(c) 2017 Thomson Reuters. No claim to original U.S. Government Works. 3 Unrelated business income 17

18 Private Letter Ruling, PLR (2017) (3) of the Code. It had not solicited, nor had it received, voluntary contributions from the public. Its only source of income was from fees from services, and those fees were set high enough to recoup all projected costs, and to produce a profit. Moreover, it did not appear that the corporation ever planned to charge a fee less than cost. And finally, the corporation had failed to limit its clientele to organizations that were section 501(c)(3) exempt organizations. In this case, the Foundation's technical assistance services are substantially related to the performance of its exempt functions. The services are part of the organization's exempt data activities. The Foundation's screening process ensures that it only undertakes projects that will provide valuable research and data to serve its charitable mission of improving the lives of low income children and their families. Performing the data analysis and interpretation services related to each project gives the Foundation access to new data and identifies new research questions related to its charitable mission. The Foundation makes the results of each project publicly available on its website. It also requires that its clients never sell the results of any project or use the results for any purpose other than the exempt purpose for which the Foundation agreed to provide its products or services; namely, to improve the lives of low income children and their families. The Foundation is not like the organizations in B.S.W. Group, Inc. v. Commissioner and Rev. Rul , because its technical assistance services have a primarily charitable purpose and differ from those available through commercial ventures. In B.S.W. Group, Inc., as in Rev. Rul , the consulting services served the individual needs of the clients, but the services themselves were not inherently charitable, nor did they further the charitable purpose of the organization itself. In this case, the technical assistance services themselves further charitable purposes. Further, providing the technical assistance furthers the Foundation's own charitable purposes because the Foundation uses resulting data and analysis for its own research and grantmaking purposes, in addition to assisting client social sector organizations to perform their own charitable activities. In addition, the Foundation's services differ from those commercially available because the Foundation has access to raw data that is not available to commercial ventures and its activities are performed by employees of the Foundation who have developed particular knowledge and extensive understanding of issues facing low income children and their families in City metro region and perform such functions as part of other activities that further the Foundation's exempt purposes. Finally, unlike the organization in B.S.W. Group, Inc., which did not appear to charge any fee less than cost, and the organization in Rev. Rul , which charged fees at cost, the Foundation will determine on a case-by-case basis whether to charge a fee below cost to complete the project. Therefore, the Foundation's technical assistance services will not constitute an unrelated trade or business under section 513 of the Code. Furthermore, the income derived from those activities will not be subject to the unrelated business income tax imposed by section 511. Ruling Requests 3 & 4 Section 4943(a) of the Code imposes a tax equal to 10 percent of the value of any excess business holdings of a private foundation in a business enterprise. Section 4943(d)(3) provides that the term business enterprise does not include a functionally related business (as defined by section 4942(j)(4)). Section 4942(j)(4) defines a functionally related business as: (1) a trade or business which is not an unrelated trade or business (as defined in section 513); or (2) an activity which is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which is related (aside from the need of the organization for income or funds or the use it makes of the profits derived) to the exempt purposes of the organization. In this case, the technical assistance services constitute a functionally related business because they are a trade or business which is not an unrelated trade or business as defined in section 513 of the Code. Thus, the Foundation will not be subject to tax under section 4943(a). CONCLUSION 2017 Thomson Reuters. No claim to original U.S. Government Works. 4 Unrelated business income 18

19 Private Letter Ruling, PLR (2017) Based solely on the facts and representations submitted, we rule that the Foundation's technical assistance services are substantially related to the Foundation's exempt purpose and will not be subject to unrelated business income tax under section 511 of the Code or excess business holdings tax under section 4943(a). The rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an individual with authority to bind the taxpayer, as specified in Rev. Proc , I.R.B. 1, 7.01(15)(b). The office has not verified any of the material submitted in support of the request for rulings, and such material is subject to verification on examination. The Associate Office will revoke or modify a letter ruling and apply the revocation retroactively if there has been a misstatement or omission of controlling facts; the facts at the time of the transaction are materially different from the controlling facts on which the ruling is based; or in the case of a transaction involving a continuing action or series of actions, the controlling facts change during the course of the transaction. See Rev. Proc , No ruling is granted as to whether Foundation qualifies as an organization described in section 501(c) of the Code or section 4942(j)(3), and, except as expressly provided above, no opinion is expressed or implied concerning the federal income tax consequences of any other aspects of any transaction or item of income set forth in the ruling letter. This ruling letter is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent. In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to your authorized representative. Sincerely, Mary Jo Salins Acting Branch Chief Exempt Organizations Branch 1 Associate Chief Counsel (Tax Exempt and Government Entities) cc: Section 6110(j)(3) of the Internal Revenue CodeThis document may not be used or cited as precedent.. PLR (IRS PLR), 2017 WL End of Document 2017 Thomson Reuters. No claim to original U.S. Government Works Thomson Reuters. No claim to original U.S. Government Works. 5 Unrelated business income 19

20 Nonprofit NJ Hospitals Dispute IRS Tax Bill Over Group Buys - Law360 Page 1 of 2 Portfolio Media. Inc. 111 West 19th Street, 5th floor New York, NY Phone: Fax: customerservice@law360.com Nonprofit NJ Hospitals Dispute IRS Tax Bill Over Group Buys By Michael Macagnone Law360, Washington (February 8, 2016, 5:17 PM EST) -- A New Jersey hospital group on Thursday pushed back against an Internal Revenue Service tax bill on administrative fees for a group purchasing organization, telling the U.S. Tax Court that its purchasing groups went to the heart of providing more cost-effective care at the state's teaching hospitals. The New Jersey Council of Teaching Hospitals said the IRS should have allowed write-offs for administrative fees for group medical supply and patient collections contracts as they were for the convenience of its membership. In all, the hospital urged the tax court to take out a $761,000 tax bill related to revenue from the two group purchasing organizations on behalf of its membership from 2004 through Petitioner s members thereby gained access to discounts and to equipment and technology available through the group purchasing organization that they otherwise would have been unable to access, the filing said. Petitioner engaged in this activity primarily for the convenience of its members and provided this opportunity only to its members. The hospital group contends it has always used the revenue from the collections agency contract, started in 1992 and purchasing group contract, started in 2002, to support teaching hospitals in the state and defray membership dues. However, the agency first objected to the group purchasing revenue after the hospital group established a political action committee in Over the course of more than a year of investigation, the agency recommended revoking the hospital group s 501(c)(3) status in favor of making it a trade group under 501(c)(6). The two sides reached a deadlock over when to officially transition, which could require the group to pay taxes on the administrative fees it collected, according to the suit. The hospital group argued for 2009, as making the switch any earlier could bankrupt the organization, according to Thursday s tax filing. The agency contended it couldn t pick the hospital group s preferred date, and pushed for The two sides attempted to work through the IRS s Fast Track Settlement Program. In 2014, the group worked out corrective action on the PAC, but remained at loggerheads with the IRS over the group purchasing revenue. After the Fast Track Settlement proceedings fell apart, and the hospital group declined to extend the statute of limitations, the IRS started pursuing the $761,000 bill with a notice of deficiency in November. Counsel and representatives for the hospital group could not be immediately reached for comment Monday. Unrelated business income 20 7/10/2017