Unrelated Business Income and the Commerciality Doctrine

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As is clearly determined (and as we’ve discussed several times on the Nonprofit Law Blog), in order to establish and maintain tax exemption under Section 501(c)(3), an organization must be primarily operated for an exempt purpose.  What is less clearly determined, however, is when a 501(c)(3)’s tax exempt status may be at jeopardy by operation of the “Commerciality Doctrine.”  The Commerciality Doctrine, a product of the courts, looks at whether a nonprofit organization is operating in a manner that is too commercial for purposes of determining whether the organization is operating primarily in furtherance of an exempt purpose.

In applying the Commerciality Doctrine, the IRS or the courts will generally look to whether a nonprofit is engaging in activities that are in direct competition with those of for-profits.  It will consider factors such as whether the organization is:

  • adopting pricing in order to maximize profits
  • engaging in commercial marketing methods
  • generating and accumulating unreasonable reserves
  • using paid staff rather than volunteers
  • discontinuing unprofitable programs
  • selling to the general public as opposed to a discrete charitable class
  • receiving substantial public charitable contributions

An interesting (and not yet clearly answered) question associated with the Commerciality Doctrine is how an activity related to an organization’s exempt purpose may become an unrelated activity due to the organization’s operation of the activity in an excessively commercial manner.  Income generated from an unrelated activity may be subject to the unrelated business income tax (“UBIT”) and, if too substantial, may impact whether an organization satisfies the operational test set forth above.

For example, it is fairly typical for a 501(c)(3) nonprofit university to charge its students tuition of $40,000 per year.  The activities associated with such tuition are related to the university’s educational purpose and do not result in unrelated business income.  However, if the same nonprofit university decides to charge $400,000 per year in tuition while offering the same curriculum, but with courses taught by the most respected professors in the world to much smaller classes, would the Commerciality Doctrine apply to make the university’s educational activities unrelated to its educational purpose?  In looking at the Commerciality Doctrine factors, we must consider whether the university is adopting pricing in order to maximize profits, engaging in commercial marketing methods, generating and accumulating unreasonably substantial reserves, and/or selling to the general public who can afford such tuition as opposed to a discrete charitable class.  If the Commerciality Doctrine applies, the university’s high-priced educational activities may threaten its exempt status and, at the very least, expose it to substantial UBIT.

As another example, Professor Thomas A. Kelley posted on the Nonprofit Law Prof Blog several years ago that a client of the Community Development Law Clinic he was supervising indicated in its application for 501(c)(3) exempt status that it would be operating a fast-food restaurant to serve as a classroom for its public health and nutrition-related educational activities in its community.  The IRS responded that it considered the restaurant to be too commercial of an activity to qualify the organization as exempt and instead suggested that the restaurant be operated as a soup kitchen.  According to Professor Kelley, it was ultimately agreed to that the restaurant would, among other things, post suggested donations for its food items, rather than fixed prices.  This example illustrates the way in which an activity related to an organization’s exempt purpose may quickly switch by operation of the Commerciality Doctrine to an unrelated activity, thereby potentially endangering the exempt status of the organization.

In short, whether engaging in an activity that is related to a 501(c)(3) organization’s exempt purpose in too commercial of a manner can subject the organization to UBIT or, worse, threaten the organization’s exempt status, is not an easily answered question.  Nonetheless, it is an issue of which 501(c)(3) organizations should be aware, particularly as they design and develop plans to market their revenue-generating activities.

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