How much unrelated business activity is too much?

By Preston J. Quesenberry, J.D., Washington, D.C.

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

Tax practitioners are used to dealing with uncertainty when applying fuzzy qualitative thresholds such as "substantial" and "primary." However, when it comes to determining how much unrelated business activity is permissible for tax-exempt organizations described in Sec. 501(c)(3), practitioners face an even bigger challenge: They do not know what the qualitative threshold is. Specifically, sparse and poorly written guidance and conflicting authorities leave unclear whether unrelated business activity must be an "insubstantial part" of a Sec. 501(c)(3) organization's total activities or, rather, whether it may be substantial so long as it is not an organization's "primary purpose." This discussion reviews the long-held IRS position that the better answer is to allow the unrelated activities to be substantial so long as they are not the organization's "primary purpose," while also acknowledging that there is widespread confusion and uncertainty on this point.

The primary-purpose test

To qualify as a tax-exempt entity described in Sec. 501(c)(3), an organization must be organized and operated exclusively for exempt purposes. The Sec. 501(c)(3) regulations regard an organization as operated exclusively for one or more exempt purposes only if it engages primarily in activities that accomplish those purposes. The regulations state that an organization "will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose." This "no more than an insubstantial part" threshold, from Regs. Sec. 1.501(c)(3)-1(c)(1), is commonly known as the "operational test" and is referred to in this item as the "substantiality threshold."

The Sec. 501(3) regulations directly address unrelated business activity in Regs. Sec. 1.501(c)(3)-1(e)(1):

An organization may meet the requirements of section 501(c)(3) although it operates a trade or business as a substantial part of its activities, if the operation of such trade or business is in furtherance of the organization's exempt purpose or purposes and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business, as defined in section 513.

One interpretative question raised by this language is whether it means that an unrelated trade or business may be a substantial part of a Sec. 501(c)(3) organization's activities so long as it is not the organization's "primary purpose," or, rather, whether it means only businesses that are not unrelated may cross the substantiality threshold. This, in turn, raises the question of whether an unrelated trade or business may be in "furtherance of" an organization's exempt purposes by producing income to fund its charitable programs, or, rather, whether only activities that are "substantially related (aside from the need of [an] organization for income or funds or the use it makes of the profits derived)" to an organization's exempt purposes (to quote Sec. 513) may be in furtherance of such purposes.

In a series of general counsel memoranda (GCMs) spanning decades, the IRS appeared to answer yes to both questions. In these GCMs, the IRS interpreted Regs. Sec. 1.501(c)(3)-1(e)(1) to mean that "an organization may meet the requirements of exemption under section 501(c)(3) although it operates an unrelated trade or business as a substantial part of its activities . . . provided there is clear proof of charitable purpose manifested in its actual operations" (GCM 32689).TheIRS acknowledged that an inconsistency could be perceived to exist between the Regs. Sec. 1.501(c)(3)-1(c)(1) substantiality threshold and the Regs. Sec. 1.501(c)(3)-1(e)(1) primary-purpose test, given that unrelated business activities could be construed to "not in themselves further an exempt purpose" (GCM 34176). However, the IRS repeatedly concluded that "for the purpose of resolving [these] internal inconsistencies in the present regulations, the 'primary purpose' test enunciated in section 1.501(c)(3)-1(e) should be given controlling force in determining what limitations on the conduct of unrelated business are to be considered applicable," as it is the provision specifically addressing unrelated business activity (GCM 34682; see also GCM 34176 ("controlling weight"); GCM 37596 (in considering the apparent inconsistency, Regs. Sec. 1.501(c)(3)-1(e)(1) "should control"); IRS, "IRC 502 — Feeder Organizations," at pp. 8-9, available at

These GCMs also concluded that a Sec. 501(c)(3) organization could "derive the bulk of its income from unrelated trade or business activities without jeopardizing its exempt status" (GCM 38742). Indeed, the IRS concluded that, under the primary-purpose test, "there is no quantitative limitation on the 'amount' of unrelated business an organization may engage in under section 501(c)(3), other than that implicit in the fundamental requirement of charity law that charity properties must be administered exclusively in the beneficial interest of the charitable purpose to which the property is dedicated," which could include "putting property to business use for the production of income for such purpose" (GCM 34682).

The IRS's one attempt to clarify Regs. Sec. 1.501(c)(3)-1(e)(1) in an authority on which taxpayers may rely is Rev. Rul. 64-182. In this revenue ruling, the IRS considered an organization that derived its income "principally" from the rental of space in a large commercial office building that it owned, maintained, and operated. The IRS "deemed [the organization] to meet the primary-purpose test of section 1.501(c)(3)-1(e)(1)" so long as it carried on "a charitable program commensurate in scope with its financial resources" (including "income from its business activities and other sources" (GCM 32689)).

More than 30 years later, the IRS was still setting forth this interpretation of Regs. Sec. 1.501(c)(3)-1(e)(1), noting the following in IRS Technical Advice Memorandum 9521004:

[An organization's] exemption is not jeopardized merely because it conducts an unrelated business as a substantial part of its total activities, as section 1.501(c)(3)-1(e)(1) of the regulations indicates. The key issues are the reason why the business is carried on and the organization's primary purpose. A purpose to raise funds to support the organization's exempt functions is a legitimate reason for an organization to conduct a business, although it would have to pay tax on any unrelated business taxable income derived from [the] business. . . . As long as the conduct of such business is not the organization's primary purpose, as determined by the facts and circumstances, the organization may conduct such business consistent with section 501(c)(3).

Reasons for doubt

All the above authorities suggest that a Sec. 501(c)(3) organization may engage in substantial unrelated business activities and even derive its income "principally" from those activities, so long as it can demonstrate a real and substantial charitable program commensurate in scope with its financial resources. However, substantial uncertainty on this point remains for at least three reasons.

First, the language in Regs. Sec. 1.501(c)(3)-1(e)(1) is admittedly quite confusing, especially the caveat that a trade or business may be substantial only if it is in "furtherance of the organization's exempt purpose." Many practitioners are not comfortable with the position that producing income to fund an exempt purpose "furthers" that exempt purpose, because the available authorities do not obviously support this position (but see Easter House, 12 Cl. Ct. 476 (1987) (providing funding for an exempt activity can "in and of itself constitute an exempt activity") and IRS Letter Ruling 200021056 (in interpreting Regs. Sec. 1.501(c)(3)-1(e)(1), noting that "[o]ne way in which a trade or business may be in furtherance of exempt purposes is to raise money for the exempt purposes of the organization, notwithstanding that the actual trade or business activity may be taxable under sections 511 through 513")).

If the IRS had wanted to preclude the production of income to fund an exempt purpose from qualifying as "in furtherance of" that exempt purpose, it could have expressly carved out the need of an "organization for income or funds or the use it makes of the profits derived," as Sec. 513 does. Alternatively, it could have referred to a trade or business that "is not an unrelated trade or business (within the meaning of section 513)," as Sec. 509(a)(2) does. Regs. Sec. 1.501(c)(3)-1(e)(1)'s initial reference to a "substantial" trade or business does neither.

Second, only one of the authorities interpreting Regs. Sec. 1.501(c)(3)-1(e)(1) that are cited above may be relied upon, and the meaning of that authority, Rev. Rul. 64-182, is not particularly clear. This lack of clarity arises in part from the fact that the unrelated business considered in Rev. Rul. 64-182 was the renting of real property, an activity that typically generates income expressly excluded from unrelated business taxable income under Sec. 512(b)(3).

While some tax-exempt practitioners might feel comfortable relying on Rev. Rul. 64-182 for the principle that a Sec. 501(c)(3) organization may derive its income principally from rents or other passive investment income, they often feel less comfortable extending this logic to active trade or business activity. This reluctance exists despite the fact that the IRS made clear in GCMs that it viewed the commercial leasing activity described in Rev. Rul. 64-182 as "necessarily an unrelated trade or business," (GCM 32689) and did not view the conclusion in Rev. Rul. 64-182 to be "limited to situations involving real estate operations" (GCM 34682). Indeed, in GCMs, the IRS applied the principles in Rev. Rul. 64-182 to business operations such as department stores and farms (see GCMs 34682 and 34176).

Third, the courts have issued opinions that further confuse the issue. A large number of the reported cases assess the impact of commercial, fee-based activity on Sec. 501(c)(3) status (typically, when this activity is the predominant (or even only) activity), but none of the cases apply the test in Rev. Rul. 64-182 to assess whether the organization in question conducts a charitable program that is commensurate in scope with the organization's financial resources (including the income earned from the commercial activity). Rather, the courts in these cases have examined the fee-based activity in question to determine if it was carried out in a "manner not significantly distinguishable from a commercial endeavor" and, if the manner was not so distinguishable, have denied exemption based on a "substantial nonexempt purpose" in the form of a "nonexempt commercial purpose" (Airlie Foundation, 283 F. Supp. 2d 58 (D.D.C. 2003) (and the line of cases cited therein)).

While not inconsistent with the conclusion that would result from applying the primary-purpose test, the focus in these cases on a "substantial nonexempt commercial purpose" could give some readers the impression that the substantiality threshold applies to business activities carried on in a commercial manner. Even worse, at least one court has upheld the revocation of an organization's tax-exempt status at least in part because the organization was engaged in a commercial activity (auto races) that "exceeded the benchmark of insubstantiality" (Orange County Agricultural Society, Inc., 893 F.2d 529 (2d Cir. 1990)).

Recommended changes

To alleviate the uncertainty that exists regarding the appropriate test to apply to unrelated business activity, Treasury and the IRS should amend Regs. Sec. 1.501(c)(3)-1(e)(1) to state one of two things: either (1) "An organization may meet the requirements of section 501(c)(3) although it operates an unrelated trade or business as a substantial part of its activities, if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business"; or (2) "An organization will not meet the requirements of section 501(c)(3) if it operates an unrelated trade or business as more than an insubstantial part of its activities." Either amendment would still leave significant uncertainty as to how either "insubstantial" or "primary purpose" should be measured for this purpose — e.g., by time, expenses, revenue, assets, or other metrics — and what proportionate amount either threshold constitutes. But at least practitioners could agree on the applicable qualitative standard.


Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.

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

Contributors are members of or associated with KPMG LLP.

The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of Section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information 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. The articles represent the views of the author or authors only, and do not necessarily represent the views or professional advice of KPMG LLP.

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