In Ocean Pines Association, Inc. v. Commissioner, the Court of Appeals for the Fourth Circuit held that a tax-exempt social welfare organization conducted an unrelated business when it operated two parking lots and a beach club limited to members only. The case was not complex, and the outcome was predictable. The court’s opinion, however, illustrates a classic analysis of the distinction between related and unrelated businesses under the UBIT.
Facts. Ocean Pines was exempt from income taxes as a social welfare organization. Its primary activities involved overseeing a 3,500-acre subdivision with over 10,000 residents. Ocean Pines was more than a homeowners association. The organization maintained roadways, bulkheads, and parking lots within the subdivision, enforced zoning regulations, provided police and fire services, and operated numerous recreational facilities. All of the facilities and programs conducted by Ocean Pines were open to members and nonmembers. The organization also owned and operated a ocean-front beach club and two parking lots in a nearby beach location. Most of the club’s facilities and all of the parking spaces could be used only by the association’s members.
Issue. Ocean Pines derived a profit from the parking lots. The beach club operated at a loss. The IRS sought to tax the net income from the parking lots and beach club as UBTI. To avoid the tax, the organization had to show that the activities constituted a related trade or business. The case is apparently one of first impression in that no prior case has examined potential unrelated business activities of a social welfare organization.
Law. Whether a business conducted by an exempt organization is an unrelated trade or business depends upon the relationship between the actual conduct of the business and the accomplishment of the organization’s exempt purpose. To avoid the unrelated business income tax, the operation of the business must contribute importantly to the accomplishment of the exempt purpose. The fact that an exempt organization uses income from a business to further its exempt purposes does not make the business related for purposes of the UBIT.
Analysis. The appellate court first examined the basis underlying the exemption of a social welfare organization from income tax. Social welfare organizations are nonprofit civic leagues or organizations which operate for the promotion of social welfare. The organization must engage primarily in promoting the common good and general welfare of the people of the community. Social welfare organizations are primarily concerned with civic betterments and social improvements.
Thus, the question presented was whether the operation of the members-only parking lots and beach club contributed importantly to the promotion of social welfare, i.e., was there a community benefit from these activities? Not surprisingly, the Fourth Circuit held that the questioned activities constituted an unrelated trade or business. Unlike the facilities at the residential community, which were open to the general public, the beach facilities could only be used by members. A members only restriction is just not consistent with community benefit and common good.
One of the association’s arguments pointed to the history of the UBIT, which was enacted primarily to prevent exempt organizations from using their tax exemption to compete unfairly with for-profit enterprises. Ocean Pines argued that its parking lots and club, being restricted to members only, did not compete with taxable businesses providing parking and entertainment to the general public. This argument has been raised, mainly unsuccessfully, in past cases. The court responded that, while the underlying rationale for the UBIT may have been to curb unfair competition, the clear language of the Code applies the tax to businesses which are not related to an organization’s exempt purpose. When the Code is not ambiguous, the use of the legislative history is inappropriate.
Note: In Ocean Pines, the issue was whether a business carried on by an exempt organization was related or unrelated to its exempt purpose. The legislative history argument is more effective when the issue is whether an exempt organization is conducting a trade or business. If for-profit companies conduct a particular activity, the IRS will argue that an exempt organization conducting a similar activity is engaged in a trade or business. Conversely, an exempt organization may argue that a particular activity is not a trade or business because there are no taxable enterprises conducting a similar activity.
Resources: §513(a), Treas. Reg. §1.501(c)(4)-1(a)(2), Treas. Reg. §1.513-1(d).