In PLR 201147035, a charitable organization devoted to disaster relief and general charitable purposes amended its articles to permit ownership and operation of community activity centers throughout country. The proposed community centers would offer a broad range of programs designed to serve all community members and would be accessible to the public through memberships. The organization was controlled by a fraternal beneficiary society described in §501(c)(8).
In the ruling, the organization proposed to acquire its first community center. The acquisition was financed primarily through the issuance of long-term bonds. The community center would offer the following activities:
- Exercise and fitness, with programs and classes to emphasize community health and wellness;
- Youth camps, sports camps, and other educational camps
- Charitable community services, such as meals-on-wheels, food bank drives, and blood drives
- Charity events and disaster relief activities
- Space for community events, community social activities, and school activities, such as swim meets
- After-school and tutoring programs for children
- Sports leagues
The following uses of the community center were specifically examined:
- Leasing not more than 10% of the total square footage of the center as office space to employees and independent contractors of the fraternal beneficiary society at fair rental value
- Providing meeting space to local nonprofit organizations, such as American Red Cross chapters, chambers of commerce, and scouts, at actual cost
- Leasing the banquet room to individuals and groups for private functions at fair rental value
- Leasing not more than 15% of the total space in the center to the city to house its recreation department for a one-time unspecified payment
Here are the issues raised by the facts of PLR 201147035:
1) Because there is a change in the organization’s articles, the impact of the change on the organization exempt status
2) Because the center provides services, whether any of the services constitute unrelated trades or businesses
3) Because space in the center is leased to third parties, whether the rents received are covered by the rental exclusion to the UBIT
4) Because the property is financed, the application of the debt-financed income rules
The IRS ruled that the ownership and operation of community centers was within the organization’s general charitable purposes and would not jeopardize its tax exemption. Moreover, all the bulleted activities listed above are substantially related to the organization’s exempt purposes. Income from memberships and other community activities would not generate UBTI, other than under the debt-financed income rules.
Regarding the numbered activities, the leasing of office space to employees and contractors of the fraternal beneficiary organization was a related use under a special rule. Reg. 1.514(b)-1(c)(2) provides that use of an exempt organization’s property by a related exempt organization constitutes a related use to the extent the property is used by either organization in furtherance of its exempt purposes. Organizations are considered related if one organization controls the other. Thus, use of the organization’s community center by the fraternal beneficiary society constitutes a related use by the organization.
According to the ruling, however, the other numbered activities were not related uses. Thus, the use of office space by the city recreation department, the use of meeting rooms by local nonprofit organizations, and the use of the banquet hall by private parties were not substantially related to the organization’s exempt purposes and would constitute unrelated trades or businesses. Absent the debt-financed income rules, however, the rental payments for the unrelated uses would be covered by the exclusion of rents for real property under §512(b)(3).
Notwithstanding the related uses and the rental exclusion for the unrelated uses, the debt-financed income rules require income from debt-financed property to be included in UBTI to the extent the property is debt-financed. The long-term bonds used to finance the center constitute acquisition indebtedness. Thus, unless an exception applies to exclude the property from being treated as debt-financed property, part of the income from the community center is debt-financed income.
There is a two-part exception under §514(b)(1) under which substantially related use property is not treated as debt-financed property. First, property acquired by an exempt organization is not debt-financed property if substantially all of the use of the property is substantially related to the organization’s exempt purposes. Second, even if substantially all of the use of property is not substantially related to the organization’s exempt purposes, the property is not debt-financed property to the extent that its use is substantially related. To the extent property is not treated as debt-financed property, rents and other income from the property are not debt-financed income subject to taxation under the UBIT.
The organization in the ruling was able to satisfy the first and most favorable part of the substantially related use exception, with the result that no part of the community center was treated as debt-financed property. Under Reg. §1.514(b)-1(b)(1), property satisfies the first part of the substantially related use test if 85% or more of the property is devoted to a substantially related use. In the ruling, the unrelated uses represent less than 15% of the total use of the community center. Thus, none of the rentals were debt-financed income subject to the UBIT.
Because the unrelated uses did not cause any of the property to be treated as debt-financed property, the characterization of the use by the city recreation department and the local nonprofit organizations did not prejudice the exempt organization requesting the ruling. For the sake of discussion, however, there are good arguments that uses of the community center by the city and some of the nonprofit groups were substantially related uses.
Regarding the occupation by the city recreation department, the organization and the city had a written agreement under which the city was responsible for hiring, supervising, and directing all personnel working at the center. The organization had the right to provide input to the city concerning the employment of the center’s manager, programmer, and marketing director. In connection with this agreement, the city relocated the administrative offices of its recreation department to the center. It appears that over half of the activities to be conducted at the center involve community recreation. Having the city recreation department on the premises would contribute importantly to the center’s ability to offer recreation services. Considering that the city also employed the management and staff of the center, it appears that the city purposes were so intertwined with the organization’s charitable purpose in operating the center that the one-time payment from the city could well be considered income from a related trade or business and that use of the center by the city could be a substantially related use.
There is also a reasonable argument that leasing meeting space to some community nonprofit organizations is also substantially related to the organization’s charitable purposes. Here are the local groups to which the center would lease meeting space: local chapters of the American Red Cross, the United Way and its affiliated agencies, local chambers of commerce, boy scouts, and local historical associations. Allowing the Red Cross to meet at the center is directly related to the organization’s disaster relief purpose and its community benefit purpose. Similarly, scouts groups are community organizations involving children, who are important recipients of the center’s recreational and educational services. In contrast, chambers of commerce benefit the community only in a commercial sense; their use of the facility would not seem to constitute a related use. At a minimum, the leases to the nonprofit groups should be evaluated on an organization-by-organization basis.