The exceptions noted by NJCTH were that the income generated was royalties and that it carried on business for the convenience of its members. The Tax Court ultimately concluded that the fees received by NJCTH were deemed to represent payments for services holding that an Internal Revenue Code (“IRC”) §501(c)(3) tax-exempt organization was subject to tax on fees paid to it by vendors for providing debt collection services and for purchasing programs for its members.
Background
IRC §513(a) states that unrelated business income is defined as “any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profit derived) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under IRC §501)”.
This statute provides three exceptions in IRC §513(a)(2). NJCTH claimed in its argument that unrelated business income does not include a trade or business carried on “primarily for the convenience of its members, students, patients, officers or employees.” Additionally, under IRC §512(b)(5), most passive income, including dividends, interest and capital gains, is excluded from unrelated business income under IRS rules and regulations. In addition, certain royalties under IRC §512(b)(2) are also excluded as passive income, whether measured by production or by income from the property.
Facts
NJCTH is an IRC §501(c)(3) tax-exempt member organization and a Type III nonprivate foundation, supporting organization under IRC §509(a)(3) whose charitable purpose is to “further undergraduate and graduate medical education, to coordinate such education with the clinical programs available in its affiliated hospitals, and to help provide innovative and cost-efficient health delivery systems in New Jersey.” During the years under consideration in this case (2004-2007), NJCTH’s members consisted of nine to eleven tax-exempt teaching hospitals, one nonteaching hospital, and one medical school operating in New Jersey.
During the years 2004 through 2007, NJCTH’s expenses exceeded its membership dues collected, resulting in losses of approximately $500,000 per year. In addition to membership dues, NJCTH generated additional income from contracting with third parties to run programs for NJCTH members. NJCTH offered various programs to its members, including a program whereby, if members patronized or contracted with these third parties that ran these programs, the third parties compensated NJCTH based on total receipts.
NJCTH contracted with OSI Collection Services (“OSI”), which provides debt collection services; and the Greater New York Hospital association (‘GNYHA”) which provides, as one of its services, group purchasing programs.
NJCTH advised its members that OSI was one of their selected vendors for collection services. NJCTH listed OSI in the member services section of its website, along with their logo, link and a description of their services. During the years examined, just three members participated in this OSI program.
GNYHA provided discounted group purchasing for products and services that hospitals typically purchase including medical and surgical supplies, pharmaceuticals, imaging and cardiology products. NJCTH was paid for “sales related administrative fees” for promoting the program to its members and to assist in administration of the program. GNYHA was also listed in the member services section of NJCTH’s website including contact information and a link to its website.
Court Decision
Although NJCTH maintained that the OSI fees met the royalty exception and were for the convenience of its members, the Tax Court ruled against the claim and concluded that these third party fees constituted unrelated business income.
There is no definition of royalty in the IRC; however, the Tax Court cited case law relative to royalties under IRC §512(b)(2); that royalties were payments for the right to use intangible assets, such as name, logo, service marks and membership lists and “cannot include compensation for services rendered by the owner of the property.” In addition, the Tax Court would not consider OSI’s placement of its logo on NJCTH’s website as use of intangible property; rather it was deemed a rendition of a service.
The Tax Court also rejected the claim that fees received by NJCTH from OSI and GNYHA met the unrelated business income exception for being for the convenience of its members. NJCTH maintained that the GNYHA contract provided MJCTH members with discounts and services and furthermore that the revenue derived from this contract was in support of its mission on behalf of its members insisting that its relationship with GNYHA was primarily for member convenience. The Tax Court rejected this claim arguing that helping members to save time and money or directing them to low-cost and/or high-quality vendors was not serving the convenience of members.
Conclusion
This case takes a hard look at unrelated business income and how important it is for exempt organizations to review the language in their licensing agreements to minimize the risk of being challenged by the IRS. Exempt organizations should take a proactive look at their activities that they identify as a convenience exception to determine and document how those activities benefit members within the parameters set forth in this case.
Author: Linda Gnesin, CPA | [email protected]
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