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).

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:

1. 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
2. Providing meeting space to local nonprofit organizations, such as American Red Cross chapters, chambers of commerce, and scouts, at actual cost
3. Leasing the banquet room to individuals and groups for private functions at fair rental value
4. 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.