See Appendix B for a decision flowchart and examples of possible unrelated business activities.
10.1 Federal Income Tax Exemption
The Texas A&M University System is tax-exempt as an instrumentality of the State of Texas. The Internal Revenue Code provides that the exempt purposes of state universities include all purposes and functions described in Section 501(c)(3), and under Section 115 excludes gross income of states. Therefore, for federal income tax purposes, the university/agency may engage in activities that include charitable, scientific, testing for public safety, literary, educational, to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals. Universities/Agencies are not, however, exempt from tax imposed by IRC Sections 511, 512, and 513 on activities which are unrelated to those exempt purposes. All activities should be carefully reviewed to determine whether an exempt purpose is also being served.
10.2 Unrelated Business Income Tax Defined
The Internal Revenue Service anticipates that exempt organizations will engage in activities that may be in competition with private business endeavors; but to be non taxable, the activities must be substantially related to the purpose for which the organization has an exemption status. Therefore, System members derive taxable income from an activity if that activity is not related to its educational, scientific, literary, and charitable purposes. A college or university is generally deemed to have unrelated business taxable income (UBTI) when it realizes gross income from any regularly conducted trade or business that is not substantially related to its educational and other exempt purposes. (IRS Treasury Regulation 1.513-1(a)). In order to determine whether a particular activity that the university/agency engages in will generate taxable income, the following three criteria must all be present.
10.2.A Substantially Unrelated to the Exempt Purpose
The first criteria in determining whether an activity is taxable is to determine whether the activity is “substantially unrelated” to the exempt purpose of the organization. Conversely, to be considered related nontaxable income, there must be a substantial causal relationship between the activity that generates revenue and the exempt purpose of the organization (i.e., the activity must contribute importantly to the accomplishment of the exempt purpose other than the university’s need to produce income). (IRS Treasury Regulation 1.513-1(d)(2)).
The exempt purpose of colleges and universities includes (a) teaching and instruction, (b) research, and (c) public service. The mere fact that an activity generates a source of funds that are then used to carry out a mission-related activity does not mean that the activity is related to the mission.
Particular emphasis is placed on the size and extent of the activity. If an activity is conducted on a scale larger than reasonably necessary to carry out the exempt purpose, it is more likely to be treated as unrelated. (IRS Treasury Regulation 1.513-1(d)(3)). Use for both exempt and commercial purposes will not necessarily exempt the income derived from commercial use unless the business activity “contributes importantly” to the accomplishment of exempt purposes. (IRS Treasury Regulation 1.513-1(d)(4)(iii)).
10.2.B Trade or Business
Activities cannot be considered taxable unless they are deemed to be a “trade or business” as defined in IRC Section 162. Among other things, a trade or business has to exhibit an intent to profit from the activity (real economic profit). If the intent is to merely recover costs and indeed no realized profit exists, the activity lacks a profit motive and is not subject to taxation. In addition there must be a regularity of activities and income production that would be different than the level of activity found in a hobby-like activity. (IRS Treasury Regulation 1.513-1(b)).
10.2.C Regularly Carried On
The IRS Treasury Regulations consider the frequency and continuity of the activity and the manner in which it is pursued to determine if the activity is regularly carried on. Thus, the unrelated business income tax (UBIT) applies only to a business activity which is regularly carried on as distinguished from commercial transactions which are sporadic or infrequent. (IRS Treasury Regulation 1.513-1(c)(1)).
An activity should not be considered as regularly carried on if it is:
- on a very infrequent basis;
- for a short period of time during the year; or
- without competitive and promotional efforts.
Activities over a period of only a few weeks are not “regular” for an exempt organization if the activities are of a kind normally conducted by a nonexempt business on a year-round basis. Intermittent, casual or sporadic activities are generally not regular. However, year round activities are regular even if they are conducted only one day a week. Further, seasonal activities may be regularly carried on even though they are conducted only for a short period each year. (IRS Treasury Regulation 1.513-1(c)(2)).
The IRS expanded it’s definition of time period with the court case National Collegiate Athletic Association vs. Commissioner in July 1991 which looked at the duration of the event itself and not the preparation time involved.
10.2.D Unrelated Business Income
Activities that are determined to produce unrelated business income/loss (UBI) will be included in the System’s consolidated Exempt Organization Business Income Tax Return (Form 990-T), to be prepared each year for submission to the Internal Revenue Service.
10.3 Exclusions from UBIT
Even if an activity is considered to be taxable based on the above three criteria, there are a number of modifications to income and statutory exceptions that are available under the UBIT regulations. These include the following:
- passive income such as dividends, interest, annuities, and royalties where no active business participation and management is involved;
- rents from real property (contingent with debt finance issue) and some personal property;
- income from certain forms of research;
- income generated from donated services or property;
- income produced from sales made primarily for the convenience of the organization’s members, students, and employees (including faculty and staff); and
- special situations.
A royalty may be generally defined as a tax, duty or compensation paid to owners of a patent, copyright, mineral interest, or other property right for the use of it or the right to exploit it. The royalty exclusion includes overriding royalties, net profit royalties, and royalty income received from licenses by the university/agency as the legal and beneficial owner of patents assigned to it by inventors. (IRC Section 512(b)(2); IRS Treasury Regulation 1.512(b)-1(b)).
10.3.A.1. Licensing Agreements
The IRC Section 512(b)(2) royalty exclusion is commonly used by exempt organizations to exclude licensing fees from UBIT. The IRS generally agrees with this result, so long as the exempt organization plays a passive role in the licensing arrangement. However, where the exempt organization’s involvement is active, the IRS will not characterize the payment as a royalty, excluded from UBIT.
One such situation is when the exempt organization is providing endorsements or services that are important to the success of the arrangement. In such cases, the IRS views the royalty payment as consideration for services performed and not a royalty. The IRS has recently begun to focus on this theory in deciding whether an exempt organization’s licensing arrangement will be treated as a royalty. See IRS Letter Ruling 9527031 for an example of the IRS’ rationale in regards to the provision of services.
10.3.A.2. Mailing Lists and Affinity Cards
Based on recent court cases (Mississippi State University Alumni Association, Inc. v. Commissioner; Sierra Club v. Commissioner; Alumni Association of the University of Oregon, Inc. v. Commissioner), a rough set of guidelines now exists for exempt organizations to rely upon in structuring a viable affinity credit card program. (Tax Court Memos 1993-199, 1996-33, and 1996-34).
- Mailing lists of potential card users should be made available on a selective basis, and minimal staff time and expenses should be allocated to maintenance and marketing of the list.
- Organizations should avoid providing specific services (i.e., advertising, promotion, endorsements, etc.) other than reviewing the materials for quality control. The agreement should expressly provide that the organization will not provide specific services.
- When services are provided, make sure they are “de minimis” or “courtesy” services.
- If the arrangement necessitates the provision of substantial services, create a separate agreement for the service component and allocate a portion of the income to services. This will avoid “tainting” the entire amount of income thus avoiding the full amount to be considered UBI.
- Prepare a separate mailing list agreement. If income from a mailing list is ultimately determined to be UBIT, then the intertwining of the mailing list with any other component of the licensing program may taint the entire transaction and cause all the income to be subject to UBIT. (IRS Letter Ruling 9029047).
- By specifically terming the arrangement a “licensing agreement” and referring to the payments as “royalties”, the exempt organization can avoid a certain amount of discrepancy.
- Any expenses incurred by the exempt organization in connection with the production, preparation or mailing of solicitation materials should be reimbursed by the bank, financing institution, or other commercial entity, so as to minimize the risk that these activities are deemed to make up part of the consideration for the licensing payments. (Tax Court Memos 1993-199, 1996-33, and 1996-34).
10.3.B.1 Real Property
Rents from real property not debt financed are excluded from taxable income. (IRS Treasury Regulation 1.512(b)-1(c)(ii)(a)) provided:
- Property is not debt financed;
- Additional services are not rendered; and
- Are not dependent on a percentage of profits.
Amounts received by the University/Agency do not qualify as excludable rents if the University/Agency renders services for the convenience of the occupant. Services are considered rendered to the occupant if they are primarily for his or her convenience and are other than those usually rendered in connection with the rental of rooms or other space for occupancy only. (IRS Treasury Regulation 1.512(b)-1(c)(5)).
Rents dependent on profits or income derived by the University from real property do not qualify for the exclusion unless they are based on a fixed percentage of gross receipts or sales. Rents based on a percentage of net profits are taxable. (IRS Treasury Regulation 1.512(b)-1(c)(2)(iii)).
The code contains an exception to the debt-financed property rules for the acquisition of real estate by “qualified organizations”, including educational institutions.
The term “acquisition indebtedness” does not include debt incurred by a qualified organization to purchase real property where the following conditions are present:
- the purchase price is a fixed amount;
- the amount of an indebtedness and the time for payment of such indebtedness is not dependent on revenue, income, or profits derived from the real property;
- the real property is not leased back to the seller or a party related to the seller; or
- if the real property is held by a partnership and one or more of the partners is not a qualified organization, then allocations to the partners must be qualified allocations or must not have as a principal purpose the avoidance of income tax. (IRC Section 514(c)(9)(c)(i)).
The possible classification of compensation received from privatization contracts as taxable should not dictate acceptance or denial of the contracts, but it should be an important consideration. A recent example of terminology used in a contract provided rent based on “cash net receipts” which was not well defined. If net cash receipts are defined as gross sales less applicable state and local sales taxes, no taxation of the contract occurs. On the other hand, if net cash receipts are defined as gross sales less any operating expenses, the compensation received is subject to the unrelated business income tax.
Oftentimes, the only action necessary is the clarification of a few contract terms to allow the compensation received to be non-taxable. Whether or not compensation is taxable to the university/agency generally has no effect on the vendor, and they may be willing to alter terms of the contract slightly to help the university/agency avoid taxation. Please forward copies of any “privatization”-type contracts prior to acceptance so that the System Office of Budgets and Accounting may review the UBIT implications. See section 11.0 for additional tax implications related to privatization contracts.
10.3.B.2 Personal Property
Rents from personal property are excluded only if there is a mixed lease and the rents attributable to the personal property are an “incidental” part of the total rents received under the lease. The following rules apply to personal property rents:
- 10% or less is considered incidental and not subject to tax;
- 11-50% is considered taxable in proportion to the percent of personal property rents to the total rents; and
- 51% or more is considered 100% taxable. (IRS Treasury Regulation 1.512(b)-1(c)(ii)(b)).
Income from certain research grants or contracts may be exempt from the unrelated business income tax depending on the type of research. The following types of research are exempt:
- research performed for any level of government (IRC Section 512(b)(7));
- research performed by a college, university, or hospital “for any person” (IRC Section 512(b)(8)); and
- research performed for any person in the case of an organization operated primarily for purposes of carrying on “fundamental” research (as distinguished from “applied”), the results of which are freely made available to the general public (IRC Section 512(b)(9)).
The regulations further limit these exclusions by providing that research does not include activities of a type ordinarily carried on as an incident to commercial or industrial operations. Ordinary testing and inspection of products or materials is not exempt. (IRS Treasury Regulation 1.512(b)-1(f)(4)).
10.3.C.1 Sale of By-Products
The sale of products resulting from research activities may or may not be exempt from UBIT. If the product is sold in substantially the same state it is in on completion of the research, the sale does not constitute unrelated business income. However, if further manufacture or processing of the product occurs, the gross income is considered unrelated. (IRS Treasury Regulation 1.513-1(d)(4)).
An example of their distinction is as follows. An experimental dairy herd maintained for scientific purposes by a research organization produces milk and cream in the ordinary course of operation of the project. The sale of the milk and cream would not be gross income from conduct of unrelated trade or business. On the other hand, if the research organization were to utilize the milk and cream in the further manufacture of food items such as ice cream, pastries, etc., the gross income from the sale of such products would be from the conduct of unrelated trade or business unless:
- the manufacturing activities themselves contribute importantly to the accomplishment of the exempt purpose of the organization (i.e. education of students); or
- the research produces more raw milk than can be sold as milk in its normal period of shelf life. This causes further processing to be done of the excess raw milk to obtain products that have a longer shelf life to avoid spoilage.
10.3.D Donated Services or Property
10.3.D.1 Volunteer Labor
Any activity in which substantially all (approximately 85%) of the work of the trade or business is performed without compensation is exempt from tax. In assessing the contribution made by volunteers, the IRS considers such factors as the monetary value of the respective services rendered, the number of hours worked, the intrinsic importance of the volunteer work performed, and the degree of reliance placed upon volunteers. (IRS Treasury Regulation 1.513-1(e)(1)).
10.3.D.2 Donated Merchandise
Any unrelated activity engaged in the selling of merchandise, substantially all (approximately 85%) of which was received as gifts or contributions is exempt regardless of whether the labor to operate the activity is paid or volunteered. (IRS Treasury Regulation 1.513-1(e)(3)).
10.3.E Convenience of University/Agency Students, Faculty, and Staff
Sales of otherwise taxable items may be exempt from tax under the “convenience” exception if sold to students, faculty, and staff (members). The convenience exception is applicable only to members of the university/agency. Any sales to non-members (e.g., the general public) are taxable unless the sales are not “regular”. (IRS Treasury Regulation 1.513-1(e)(2)). The IRS auditors will contend that merely by making sales “more convenient” than purchasing from a taxable entity does not fall within the scope of the exception. The IRS position is that the convenience exception does not apply to items with useful lives of more than 1 year. The convenience exception normally applies to the operation of on-campus vending machines, the sale of sundry items by campus bookstores, and the laundering of dormitory linens and student clothing. (IRS Treasury Regulation 1.513-1(e)(3)).
10.3.F Special Circumstances
There are special circumstances in which an unrelated activity may be recognized as serving an exempt purpose. The IRS will decide whether such unique circumstances exist on a case-by-case basis. The following are examples of unique circumstances (IRS Revenue Ruling 85-110, 1985-2 CB 166):
- services or facilities otherwise unavailable in the community that fulfill an important community or medical need (see section 10.19); and
- services, facilities, or equipment which are technically advance or unique.
The sale of advertising may be taxable even if the activity is carried on within a larger complex of other endeavors that are substantially related to an organization’s exempt purpose (e.g. the publication of a newsletter, magazine, scholarly journal, or website, or the sale of advertising in sports programs). (IRC Section 513(c)).
Related advertising (acknowledgments) are incidental recognitions of sponsorship with no qualitative or comparative bases. This form of advertising is not subject to UBIT. Advertising in a college newspaper as part of an instructional program or advertising that serves an “informational function” (as opposed to serving a means of stimulating demand for products) may be considered related to an organization’s exempt purpose. (IRS Revenue Ruling 82-139).
Taxable advertising provides a more tangible benefit such as promotion of the sponsor’s name according to negotiated terms of a contract, linking amount of payment received to the amount of exposure the sponsor receives, or done making publicized qualitative and/or quantitative statements or comparisons about the sponsor and their goods and/or services. Also, the IRS considers general consumer advertising in an exempt organization’s journal as “trade or business” since it does not “contribute importantly” to its exempt purpose.
10.4.A Student Participation
Consumer advertising may be regarded as related to the exempt purpose if students are actively involved in the solicitation, sale and publication of the advertising under the supervision and instruction of the university/agency. For example, a campus newspaper operated by students publishes paid advertising. Although the services rendered to the advertisers are of a commercial character, the advertising business contributes importantly to the university’s educational program through the training and participation of students involved. (IRS Treasury Regulation 1.513-1(d)(4)(iv) Example 5).
However, just because students are involved, the activity is not automatically considered exempt from taxable income. The deciding factor lies with the overall purpose of the program. For example, a university acquires a radio station that serves as a laboratory for training students in the radio industry. The radio station also provides a source of income to the school, serves as a medium for advertising the university, and serves as a medium for adult education. If the greatest portion of time is devoted to the activities conducted by regularly constituted commercial radio stations and not student training, the advertising activity will be deemed taxable. (IRS Revenue Ruling 55-676, 1955-2 CB 266).
10.5 Cost Allocation Process
10.5.A Cost Allocation Methodology
Auditors will operate under the theory that the burden of proof rests on the institution when claiming that expenses are “primary and proximate” to the production of unrelated income. The auditors may require documentary verification of expense allocation bases that were not questioned in prior IRS audits. The IRS will request “proof” of cost allocation relationships including (a) allocation of administrative salaries, (b) allocation of utility costs, and (c) allocation of general administrative overhead. The IRS will question any allocations that are based on percent of sales as they are looking for cost accounting allocations based on number of units, square footage, actual usage, etc.
10.5.B Dual Use Facility Cost Allocation
The IRS is not following the precedent Rensselaer Polytechnic case. The IRS wants facility costs to be allocated based on a 24 hour/day, 365-day/year basis usage theory, rather than based on number of days a facility is actually used.
10.6 Bookstore, Museum Gift Shop, and other Merchandise Operations
In general, bookstore operations are related activities and not subject to UBIT. The IRS will typically fragment sales into three major categories:
- directly educational materials (nontaxable);
- non-educational, convenience exception (nontaxable); and
- other merchandise sales (taxable).
10.6.A Exempt Sales
The IRS College and University Audit Examination Guidelines indicate items that are “required or otherwise necessary” for participation in a course of instruction and other educational materials that “further the unstructured intellectual life of the campus community”, such as books, tapes, records, CD’s, computer hardware and software, would not be taxable. Non-educational items that may fall under the convenience exception include items that are low in cost and in recurrent demand.
In Technical Advice Memorandum 9550003, the IRS provided additional detail guidance with respect to merchandise sold at a museum gift shop. The ruling held that “it is necessary to ascertain the museum’s primary purpose” for selling the items. Where the primary purpose is to further the organization’s exempt purpose, the sale is related. It is only where the primary purpose is to generate income that the sale is taxable. However, the IRS determined that simply printing the organization’s name on an item is generally not enough to have the income treated as exempt from tax. In order to show that the primary purpose of the sale is in furtherance of the exempt purpose, the IRS suggested the organization must:
- sell instructional materials that pertain to that organization , its activities, or its collections;
- sell “accurate reproductions or adaptations” of items in the organization’s collection;
- imprint items with “detailed and accurate pictures” of something in the organization’s collection; or
- sell items that are clearly for the convenience of the patrons, such as food and beverage, etc.
10.6.B Taxable Sales
The IRS holds that the “convenience exception” does not apply to items with a useful life of more than one year, unless it is a logo novelty item or logo clothing. (IRS Private Letter Ruling 8025222; General Counsel Memorandum 35811). These items may include the sale of novelty items, bathroom articles, non-logo apparel, candy, cigarettes, magazines, film, radios, and appliances.
In IRS Private Letter Ruling 9720002 and 8326003, the IRS has taken the position that an art museum’s gift shop sales of interpretive teaching items with artistic themes furthered the museum’s educational purpose. Thus, items that develop artistic ability were considered substantially related to the museum’s educational purpose. However other items that merely develop motor skills were judged to be unrelated and were subject to UBIT.
10.7 Food Service Agreements
Often a food services department will cater special functions such as wedding receptions, birthdays, anniversary parties, dances, etc. to the general public. These services are considered UBI. (IRC Section 513(a)(2); IRS Revenue Ruling 78-98). If commissions are received from outside contractors for the rental of a facility, the financial agreement should be reviewed to determine if rent includes building (real property) and/or equipment (personal property). The personal property commissions may be subject to UBIT. (See Section 10.3.B.2).
10.7.B Museum Restaurant
Use of a museum restaurant by individuals that are neither visitors nor employees of the museum is considered general public usage subject to unrelated business income tax. (IRS Private Letter Ruling 9720002).
10.8 Artistic, Entertainment and Theatrical Events
10.8.A Educational Purposes
Auditors will review contracts with performance artists to determine if they were consummated for related educational purposes.
10.8.B Distinguishable from Commercial Productions
The IRS is specifically looking for events that are produced by the institutions that are not distinguishable from those efforts of a commercial promoter and arena.
10.8.C Advertising Income
Advertising revenues from the sale of programs, signage, etc., is generally taxable to the extent that revenues exceed the direct cost of publication. Expenses can only be deducted up to the amount of revenues received from advertising. (See section 10.6).
10.9 Alumni Usage
IRS Letter Ruling 9645004 issued November 8, 1996, established the IRS’s position that “there is no principle reason” to treat alumni differently than the general public. The convenience exception is limited to the classes of individuals specifically mentioned in IRC Section 513(a)(2) – members, students, patients, officers, or employees. Thus amounts received from alumni usage constitute income from an unrelated trade or business within the meaning of IRC Section 513(a).
10.10 Computer Sales to Faculty/Staff/Students
Auditors will review the sales of computers and other related products to determine if these sales should be considered as taxable. Refer to comments regarding the “convenience” exception at 10.3.E above. The IRS is contending that there must be some direct evidence that such sales programs lead to the enhanced computer literacy of the organization’s membership (faculty, staff, and students). The IRS College and University Audit Guidelines advise agents to closely review computer sales made by a university. These guidelines state that while the sale of a single computer to a student or faculty member is not taxable, sales of multiple computers to such individuals and sales of a single computer to alumni and members of the general public may be taxable.
10.11 Leased Parking Spaces/Lots
Income generated by the operation of parking lots and parking garages that are necessary for the normal conduct of the university’s mission (i.e. for the use of students, faculty, staff, vendors and others on premises for official university business or to participate in university programs) would be nontaxable. Parking revenues that are generated from the general public for non-university events would likely be treated as taxable by the IRS, depending on factors such as whether the parking spaces were leased to an independent contractor and if additional services were performed. (General Counsel Memorandum 39825).
Leased parking spaces/lots to the general public may be considered rental real estate and not subject to UBIT if additional services are not offered. If services beyond the furnishing of heat and light, the cleaning of public entrances, exits, stairways, and lobbies, and the collection of trash, are provided, the additional service may cause the rental to be subject to taxation.
10.12 Recreational and Athletic Facility Membership Fees
As mentioned in 10.9 above, IRS Letter Ruling 9645004 states that usage to students, faculty, and staff are considered for the convenience of the members. However, it was determined by the IRS that the following groups constitute income from an unrelated trade or business within the meaning of Section 513(a) of the IRC: (1) spouses and children of students, (2) spouses and dependents of university employees, (3) alumni of the university, and (4) guests of members of the facility. If membership fee income is collected from spouses, dependents, alumni, or guests, then that income is subject to UBIT.
10.13 Summer Dormitory Rentals and Food Service for Conferences
The IRS has held that rentals of dormitory space were exempt income as the university’s mission was not necessarily limited to its own students, but could encompass students of another organization that utilized its facilities. (IRS Letter Ruling 9014069). Particularly, if the university leases space to another educational organization having the identical charitable purposes and they use the facility in a noncommercial manner, then UBI does not occur. The IRS is beginning to challenge the educational mission of some summer conferences and camps. The greater the participation of the university in such camps (i.e., university used its own personnel to conduct the camp), the stronger the link to the educational mission of the university. When the university merely contracts with an outside individual or organization to operate the camp, a closer look is needed at the specific agreement to determine taxability. As in section 10.11 above, additional services play a key role in the UBI determination.
10.14 Service Centers
Service department’s primary users should be internal System departments. Use by private organizations should be secondary or incidental to the operation of the service department. Service departments should not compete with established community businesses for private customers or users. If sales of goods and/or services to individuals or non-System organizations and entities occur, the activities should be reviewed for UBIT considerations.
10.15 Privatized Housing Contracts
The UBIT “convenience” exception applies to privatized housing contracts for dormitory/apartment space available to students. The housing is providing a basic need to bona fide members (students) of the organization. However, recommendation is to submit contract for review and structure contract to be based on fixed amounts or a percentage of gross receipts. (See 10.3.B.1 above).
10.16 Long Distance Carrier Commissions
Commissions received from a long distance carrier may be subject to UBIT, even if students purchase services directly and no marketing or promotion of the service is conducted by the university for the benefit of the long distance carrier. Often, contracts possess many different factors and need to be reviewed individually for UBI considerations.
10.17 Childcare Centers
If purchasers of the service are students, faculty, and staff, and the childcare facility is provided for their convenience, the income is not subject to UBIT. However, if the service is available to the general public as well, the portion attributable to general public usage may be subject to UBIT depending upon other factors such as education training and college credit given for student participation. (IRC Section 513(a)(2); IRS Revenue Ruling 78-98).
10.18 Joint Ventures
Generally, income from a joint venture will not be taxable if it contributes importantly to the exempt purpose or if it is carried on for the convenience of university/agency members. However, joint venture relationships have been scrutinized by the IRS to ensure that a tax-exempt organization is not serving the private purpose of the for-profit entity.
10.19 Hospital Services
10.19.A Hospital Services Provided to Non-patients
Revenue generated from hospital pharmacy sales to non-patients and laboratory testing of non-patient specimens is considered unrelated business income. However, if the services are provided for the convenience of patients and employees of the hospital then the income is not taxable. (IRC Section 513(a)(2)).
Hospital pharmacy sales to the public directly compete with commercial pharmacies and are considered an unrelated trade or business unless the activity exists primarily for the convenience of patients and hospital staff. Additionally, the proceeds from sales made by a tax-exempt hospital pharmacy to private patients have been determined to be unrelated business income where sales are far from casual, and the profits are “substantial”. (IRC Section 513(a)(2)).
10.19.A.2 Lab Testing
As with pharmacy sales, laboratory testing of specimens from outside patients is potentially in competition with commercial enterprises performing the same function. This activity will be considered an unrelated trade or business unless the testing exists primarily for the benefit of the exempt hospital’s patients and employees. (IRC Section 513(a)(2)).
10.19.A.3 Community Need Exception
An exempt hospital’s testing of non-patient specimens may fulfill an important community medical need and thus serve the hospital’s exempt purpose. (IRS Revenue Ruling 85-110, 1985-2 CB 166). For example, if testing facilities are otherwise unavailable in the community for a particular type of test, and the diagnosis or treatment of the non-patient would be hindered or jeopardized by referral of the specimen to another location, then the hospital’s testing would serve as an important community need.
10.19.A.4 Hospital Patients
The following persons will be considered “patients” of a hospital for purposes of IRC Section 513(a)(2) and (Revenue Ruling 68-376, 1968-2 CB 246): Inpatients; outpatients (receiving general or emergency diagnostic, therapeutic, or preventative health services); a former patient refilling a prescription; and a person receiving medical services as part of a hospital administered home care program, or receiving medical care and services in a hospital affiliated extended care facility. (IRC Section 501(e)(1)(A)).
The IRS has ruled that private patients of doctors who are affiliated with the hospital but engaged in private practice in a nearby building are to be regarded as the general public.
10.19.B Services Provided to Another Tax-Exempt Hospital
Hospitals often perform services (i.e. data processing, purchasing, warehousing, billing and collection, food, laundry, laboratory, personnel, printing, clinical, communications) for other hospitals. Under certain circumstances, these services may not result in unrelated trade or business income for the hospital providing the services. Such services performed by an exempt hospital for another exempt hospital do not constitute unrelated business income if the:
- services are provided as a fee that does not exceed actual costs including straight line depreciation and a reasonable rate of return on capital goods used to provide the service;
- services are furnished solely to hospitals serving not more than 100 inpatients; or
- services are consistent with the recipient hospital’s exempt function.
10.19.C Services Provided to a Hospital not Tax-Exempt
As with services provided to non-patients, the income received from services provided to a hospital which is not tax exempt will be considered unrelated.
10.20 Clinical Trial/Drug Test Agreements
10.20.A Student Training
Definition: According the Internal Revenue Service interpretations and rulings, “students” are defined as anyone receiving instruction or training through a bona fide university educational program. In addition to undergraduate and graduate students, the term “students” includes the interns and residents of a university teaching hospital. Doctors, nurses, medical technologists and technicians and other allied health professionals may also be considered students of a teaching hospital if they are receiving recurrent or additional instruction in their respective fields such as through a continuing education program.
10.20.B Patient Care
There are six categories of individuals who are considered patients of a hospital for purposes of defining tax-exempt patient care. These are (1) inpatients, (2) outpatients, (3) persons directly referred to the hospital’s outpatient facilities by their private physicians for specific diagnostic or treatment procedures, (4) persons refilling prescriptions written during their treatment as hospital patients, (5) persons in a hospital administered home care program, and (6) persons receiving medical care in a hospital affiliated extended care facility.
10.20.C IRS Rulings
10.20.C.1 Rulings Directly Relating to Clinical Trial/Drug Test Activities
10.20.C.1a FDA Drug Testing for Benefit of Patients is Exempt
A teaching and research hospital served as the principal clinical unit of the schools of medicine and dental medicine of a university. The hospital performed some large scale testing (Phase III) of drugs prior to obtaining Food and Drug Administration (FDA) approval of the drug for marketing. Primarily research and clinical fellows under the supervision of staff physicians performed the testing. The results were presented and discussed at departmental and scientific meetings and were also published in medical journals.
The clinical tests were conducted both “for benefit” and “not for benefit” of hospital patients. According to IRS interpretations, “for benefit” drug testing includes those studies in which drugs are offered to hospital patients who have the disease for which eventual commercial use of a particular drug is intended. “Not for benefit” drug testing of patients includes studies involving patients receiving care for unrelated medical reasons.
The IRS held that this testing was distinguishable from the testing described in IRS Revenue Ruling 68-373 based on the relationship to patient need. With respect to “for benefit” testing, the IRS stated that “although the testing serves the business purposes of the sponsoring drug company by enabling the manufacturer to meet FDA requirements for marketing, the testing also serves patient care purposes and adds to the body of available scientific knowledge concerning drug use.” Accordingly, the IRS concluded “for benefit” drug testing is not ordinary testing as an incident to commercial operations of the drug company, but rather is an activity that “bears a substantial causal relationship to the hospital’s exempt purposes”. “Not for benefit” testing, however, was determined to be unrelated activity subject to the UBIT. (IRS Letter Ruling 8230002).
10.20.C.1b Testing of Drugs Solely to Meet FDA Requirements is Taxable
A nonprofit organization was primarily engaged in testing drugs for commercial pharmaceutical firms. The clinical testing was performed for the companies to meet FDA requirements before marketing of the drug. The test results were freely available for publication. It was not established that the testing contributed to the training of students or to patient care.
The IRS held that the clinical testing of a drug for safety and efficacy in order to enable the manufacturer to meet FDA requirements is not “testing for public safety” but is merely a service performed for the manufacturer. The fact that highly qualified professionals must perform the testing does not change its commercial nature. Accordingly, the IRS determined that the organization failed to qualify for exemption under Federal income tax. (IRS Revenue Ruling 68-373).
10.20.C.2 Analogous Rulings Regarding Training and Testing Activities
10.20.C.2a Non-patient Lab Testing Involving Student Training
A hospital organized to operate a school for teaching medical students, interns, residents, medical technologists, and nurses performed laboratory testing for non-patients. The outside testing services provided the hospital with an additional supply of human tissue samples needed for the training of these medical professionals. Interns and residents performed and interpreted the tests and made diagnoses based on the results. Abnormal test results were also discussed in weekly conferences with the interns and residents.
The IRS held that the hospital was not engaged in an unrelated trade or business where the outside testing services contributed importantly and substantially to the hospital’s medical education program. (IRS Revenue Ruling 85-109).
Where the performance of diagnostic laboratory testing is otherwise available within the community, testing of specimens from private office patients of the hospital’s staff physicians constituted an unrelated trade or business subject to UBIT. (IRS Revenue Ruling 85-110).
10.20.C.2b Normally Taxable Drug Testing Conducted by Students is Exempt
A medical college undertook studies for five pharmaceutical manufacturers to explore the effects of certain drug products on the diagnosis and treatment of various human afflictions. In all five studies, the medical college was responsible for the design and management of the studies including data collection and analysis. The studies were conducted by the professors, technicians, and graduate students of the college. The results of the studies were subsequently published in scholarly journals and used in the instruction of graduate students. The IRS determined that the studies were not merely quality control programs but were central to the college’s “basic purposes of promoting and teaching medical science”. Consequently, the studies did not constitute unrelated business activities. (IRS Letter Ruling 7936006).
10.20.C.2c Production Testing by Students is Exempt
A state university offered use of its radiation and nuclear science laboratories to pharmaceutical companies and other commercial entities to generate income for research. Experimental construction and production testing were conducted for the companies within the laboratories. Undergraduate and graduate students either actively participated in the experiments contracted for by the industries or were brought in as observes to review the results of each new project cycle. Moreover, the projects generated numerous publications, presentations, and a series of seminars. Fifty-six undergraduates and postgraduate degrees were also a direct result of the major service projects.
The IRS held that this contribution to the university’s educational purpose was more than incidental and therefore, the income generated from these service contracts was not unrelated business income. (IRS Letter Ruling 8445007).
10.20.C.2d Clinical Testing of Developmental Equipment is Taxable
A university entered into a contract with a for-profit entity for the purpose of conducting research into blood smear testing. The commercial entity had developed an automatic blood-testing instrument and was interested in seeing it work and tested in a clinical setting. During a one-year period, the university conducted experiments using the instrument and compared its results with current methods of blood smear study. It was not established that students were involved in the experiments. The research results were available for publication.
The IRS determined that while the experiments conducted using the instrument were clearly related to the university’s research purpose, the primary purpose of the research contract between the parties was the development and perfection of an instrument for marketing. Consequently, the Service held that income derived from the research was subject to the UBIT. (IRS Letter Ruling 7902019).