Fee-for-service activities: Two paths to ‘substantially related’

By Randall S. Thomas, J.D., LL.M., and D. Greg Goller, CPA, Washington

Editor: Mary Van Leuven, J.D., LL.M.

Sec. 501(c)(3) organizations that engage in fee-for-service activities need to consider whether a given activity furthers or is "substantially related" to an exempt purpose—a conclusion that matters for determining whether an organization will qualify (or continue to qualify) for tax-exempt status and whether income is subject to the unrelated business income tax (UBIT). In general, services will not be treated as substantially related merely because they are performed for other tax-exempt organizations or at cost. A considerable body of IRS guidance and case law makes clear that services provided by a Sec. 501(c)(3) organization generally must either be provided substantially below cost or further the organization's exempt purposes to be considered substantially related.

In a recent letter ruling, the IRS determined that certain services provided for a fee were substantially related to a private operating foundation's exempt purposes and that income from the services would not be subject to UBIT (see Letter Ruling 201701002).This ruling illustrates the fact-intensive nature of a UBIT analysis as applied to a fee-for-service activity and, interestingly, blends two historically separate approaches for analyzing fee-for-service activities.


An organization described in Sec. 501(c)(3) must be organized and operated exclusively for one or more exempt purposes, generally requiring the organization to engage primarily in activities that further exempt purposes and allowing no more than an insubstantial part of its activities to be in furtherance of nonexempt purposes. If an organization's primary activity is a trade or business, the courts and the IRS will closely examine whether the activity appears to have a "commercial hue" or supplants for-profit businesses in determining whether the activity furthers an exempt purpose.

The following factors are considered in assessing the commerciality of fee-for-service activities: competition with for-profit entities, the nature of the services provided, the extent and degree of below-cost services provided, whether recipients of services are described in Sec. 501(c)(3), the relationship of the service provider to the recipient, and the extent to which the organization relies on charitable donations. The presence of for-profit organizations providing similar services, while not dispositive, tends to show that an activity is commercial. Conversely, the fact that an organization's services are unlike those offered by for-profit providers suggests that the activities further exempt purposes.

The IRS generally takes the position that while commercial activities do not further exempt purposes, these activities can be inherently charitable if conducted in a charitable manner. If a tax-exempt organization engages in an activity regularly carried on by commercial organizations, the IRS places particular emphasis on the charitable or for-profit identities of the service recipients and whether the organization charges substantially below cost. Neither the Code nor the regulations define "substantially below cost"; however, simply providing services at cost or marginally below cost is insufficient.

Unrelated business income tax

Sec. 511 imposes UBIT on the unrelated business taxable income (UBTI) of organizations described in Sec. 501(c). UBTI is the gross income derived from any unrelated trade or business regularly carried on, less allowable deductions directly connected with the trade or business. An unrelated trade or business generally is any trade or business not substantially related (aside from the need for income or funds) to the exempt purposes of the organization engaging in the trade or business.

A trade or business is related to an organization's exempt purposes only when the conduct of the business activity has a causal relationship to the achievement of an exempt purpose and is substantially related only if the causal relationship is a substantial one. Thus, for an activity to be substantially related to an organization's exempt purposes, the activity must contribute importantly to the accomplishment of those purposes.

Primary purpose: Carrying on a trade or business

Determining whether a trade or business is substantially related to an organization's exempt purposes involves essentially the same analysis that is used when determining whether an organization whose primary activity involves carrying on a trade or business qualifies for Sec. 501(c)(3) tax-exempt status. Treasury regulations state that an organization operating a trade or business as its primary activity will not fail to qualify for tax-exempt status so long as the trade or business (1) furthers the exempt purposes of the organization and (2) does not constitute an unrelated trade or business under the UBIT rules. IRS letter rulings and adverse determinations frequently confirm this overlap by relying on authorities that address tax-exempt status to analyze whether a fee-for-service activity generates UBTI. The same authorities generally can be used to analyze a fee-for-service activity regardless of whether the activity is insubstantial or an organization's primary activity—the only difference being whether UBIT exposure or tax-exempt status is at issue.

The ruling

The private operating foundation in Letter Ruling 201701002 furthered its charitable purpose of improving the lives of low-income children and their families by collecting, analyzing, interpreting, and sharing data to improve community decision-making. The foundation had data-usage agreements with government agencies that gave it access to raw data that was not available in the public domain or to commercial ventures. The foundation processed this information and provided on its website a free database of neighborhood indicators on key social issues. However, the foundation did not offer access to raw usage agreement data. 

The foundation also offered technical assistance to "social sector organizations"—not-for-profits, foundations, government agencies, and community organizations. This assistance involved requests that could not be met through an independent review of the information available on the foundation's website. The social sector organizations generally requested the foundation's technical assistance because they lacked the in-house technical or subject-matter expertise to perform the analysis they sought. The foundation screened potential "clients" to ensure that (1) each client was focused on improving the lives of low-income children and families and (2) each project would advance the foundation's mission.

Although the foundation previously provided the technical-assistance services for free, it determined that absorbing all costs limited its ability to provide these services and proposed to charge a "reasonable fee" for technical-assistance requests. The foundation would (1) not charge for requests that required less than four hours of staff time; (2) set its pricing in alignment with clients' ability to pay; and (3) charge fees less than cost on a case-by-case basis.


The foundation requested four rulings, two of which concerned whether the technical services were substantially related to its exempt purposes. The IRS determined that the technical services furthered the foundation's exempt purposes. Although this conclusion would have been sufficient to rule that the fee-for-service activity was substantially related, the IRS also took note of facts that tended to show the services were conducted in a charitable manner.

The technical services furthered the foundation's exempt purposes because the data and analysis produced by the technical services would be used by the foundation for its own research and grant-making purposes, and each project would provide new information that the foundation would make publicly available on its website. Because the foundation's activities had a primarily charitable purpose, the IRS was able to distinguish adverse authorities holding that consulting services that neither accomplish charitable objectives nor are provided in a charitable manner (e.g., substantially below cost) do not further exempt purposes.

The IRS went on to highlight how specific characteristics of the foundation's services weighed in favor of finding them inherently charitable. For instance, the foundation's services helped the social sector organizations perform their own charitable activities (i.e., improving the lives of low-income children and their families). Additionally, the foundation's pricing—potential fees below cost on a case-by-case basis—was contrasted with negative authorities in which organizations did not qualify for tax-exempt status because, in part, services were not provided substantially below cost.


The analysis in Letter Ruling 201701002 offers a road map of sorts for organizations that intend to treat fee-for-service activities as substantially related to exempt purposes (and thereby avoid UBIT). While the foundation's advantageous facts permitted the IRS to conclude that the fee-for-service activity would further its exempt purposes, the IRS's incomplete evaluation of whether the services were inherently charitable—and could thus independently merit the same result—has the potential to mislead readers.

The foundation established to the IRS's satisfaction that its fee-for-service activity would further its own exempt purposes, which generally would be sufficient to meet the substantially related test. The ruling then listed the ways in which the services were inherently charitable. For example, the IRS recognized that the foundation would help other organizations further charitable purposes and that the foundation's fees would occasionally be less than cost. Yet, the ruling does not appear to rely on these factors, and it is not clear whether the IRS was merely noting positive facts or whether it was using these facts to prop up the foundation's strongest argument—that it furthered its own exempt purposes by engaging in the activity.

Even though the IRS seemed to endorse the foundation's pricing strategy, existing authorities require that fee-for-service activities be priced "substantially below cost" to be considered inherently charitable, and the foundation's approach of sometimes offering services at a price below cost probably would not amount to "substantially below cost." Therefore, it appears that the foundation could not have obtained a favorable ruling based on pricing alone. Additionally, the IRS noted that the foundation's activities permitted the social sector organizations to further their own exempt purposes. However, several authorities (including one cited by the IRS in Letter Ruling 201701002) clarify that merely providing services to charitable organizations, even at cost, does not further an exempt purpose.

Importantly, the IRS did not clarify whether the manner in which the foundation provided services would have qualified it for tax-exempt status if its services had not furthered its own exempt purposes. Although authorities analyzing fee-for-service activities typically focus on whether the services further exempt purposes or whether they are delivered in a charitable way, this ruling presents an unusual merger of those two approaches. Despite the hybrid analysis, prudent organizations should not read the "inherently charitable" analysis in the ruling as determinative, because the IRS may have reached a different result if the foundation's services had not furthered its exempt purposes.

Finally, a curious aspect of the ruling is the reliance placed on the distinctive nature of the foundation's services. An organization's ability to differentiate its services from those offered by for-profit providers tends to show the services are not commercial. The foundation established that its activity was unique; however, it is not clear that the exclusivity of the foundation's technical services should have been probative of an absence of commerciality. It could be the case that the absence of commercial competitors had little to do with the nature of the foundation's actual services and was instead attributable to the fact that only the foundation had access to the data (by reason of the governmental agreements).

Further, although the ruling suggests that the foundation's expertise in processing the data motivated the service requests from social sector organizations, it appears that these organizations could not have obtained the analysis any other way because the foundation's database did not offer access to raw usage agreement data. That is, the requisite data were not available to the social sector organizations irrespective of whether they possessed the technical resources to analyze them. Without knowledge of additional facts, it is impossible to determine whether the uniqueness of the foundation's technical services was properly attributable to actual technical expertise or instead to its exclusive access to the data.


Mary Van Leuven is a director, Washington National Tax, at KPMG LLP in Washington.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. ©2017 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

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