How Much UBI is Too Much?
How to Avoid Jeopardizing Your Association's Exempt Status

by Edward Gonzalez, Esq.

Date: January, 1995

Association Law and Policy
(American Society of Association Executives)

How much unrelated business income (UBI) can a trade association earn before it starts to jeopardize its tax-exempt status? Is it 20% of gross income? How about 15%? That's the figure the IRS informally uses as a rough indicator of "substantiality." Would 50% be O.K.? Or is that "pushing the envelope?"

As trade associations increasingly look for, and find ways to generate, new sources of income, some of that income will unavoidably fall into the UBI category. The question then frequently arises, "How much will endanger the organization's exemption?"

There is no one simple answer to this question. However, the amount of unrelated business income an organization generates can be an indicator of dangerous activity that can put an organization's exemption in jeopardy. Smart tax planning demands identifying the underlying activity generating the UBI, and deciding how much can legitimately be earned from that activity before going into the danger zone.

An examination of the problem begins with a review of exemption requirements for section 501(c)(6) status under the statute and regulations.

Section 501(c) (6) Section 501 (c)(6) provides for the exemption of "business leagues... not organized for profit and no part of the net earnings of which inures to the benefit of any private shareholder or individual."

The regulations define a business league as an "association of persons" having a "common business interest," whose purpose is to promote that common business interest and not to engage in a regular business, of a kind ordinarily carried on for profit.

The regulations go on to explain that the activities of a business league are directed to the improvement of business conditions of one or more lines of business rather than the performance of "particular services" for individual persons. The regulations have remained the same since 1928 and have been held to have the effect of law by virtue of successive reenactments of the statute.

Thus in order to comply with the requirements of the Code and regulations, an organization must meet the following basic tests:

1. It must be an association of persons having some common business interest, and its purpose must be to promote this common business interest;

2. It must not be organized for profit;

3. No part of its net earnings may inure to the benefit of any private shareholder or individual;

4. Its activities must be directed to the improvement of business conditions of one or more lines of business as distinguished from the performance of particular services for individual persons; and its purpose must not be to engage in a regular business of a kind ordinarily carried on for profit.

5. Furthermore, a section 501(c)(6) organization must be primarily engaged in activity constituting the basis for its exemption, or in other words a section 501(c)(6) organization's primary activity cannot be engaging in non-exempt activity.

Ways UBI Can Jeopardize 501(c)(6) Exemption
"Association of persons." It is the position of the IRS that an organization described in section 501(c)(6) must be a "membership organization." Whether that membership requirement is met is determined, in part, by the presence of "meaningful" membership financial support. The position is expressed in GCM 39108.

In the GCM, the IRS focused on an organization formed to improve business conditions of the horsebreeding industry in a particular state. Although the organization was primarily engaged in activity designed to encourage the breeding and racing of the horses, the organization also conducted an annual public sale of members' yearling horses, retaining a commission on each sale. Commissions from the sale were the organization's primary source of income.

The remaining portion of the income was derived from membership dues.

The issue presented was whether a trade association which derived its income primarily from unrelated trade or business was precluded from exemption under section 501(c)(6), even though the organization was primarily engaged in exempt activity.

From an examination of the legislative history, and the income sources of then-existing trade associations when the exempting statute was added, the IRS concluded that Congress intended to exempt membership organizations supported, in part, by dues. The GCM holds that an organization otherwise described in section 501 (c)(6) may not be exempt if it does not derive a "meaningful" amount of income from "membership sources."

However, the GCM draws no bright line test:
We do not think it is possible to draw an exact standard which will determine in all cases whether the association under consideration receives excessive unrelated income; such a single standard would likely be inadministerable and would be difficult to defend in litigation. However, we think that the Service can at least require that the organization be membership-supported to a meaningful extent.

Instead, the GCM proposes the following guidelines to determine "meaningful" membership support:

First, unrelated income should be excluded in measuring the extent of membership support. Any income derived from the performance of the organization's exempt functions or from "substantially related" activities should be treated as membership income. Second, contributions or gifts from the general public should be treated as membership income.

These principles should insure that only income from activities which are carried on for purposes unrelated to the basis for exemption will be considered inconsistent with the membership support requirement.

Hence, the GCM's definition of "membership support" is broad, including exempt function incomeand contributions from the public. Furthermore, the GCM expressly states that even UBIT compromising over 50% of the organizations gross will not necessarily jeopardize exemption, so long as there is some "meaningful" amount of "membership support."

The GCM concludes:

We believe that an organization described in section 501 (c)(6) must be a membership organization; whether the membership requirements satisfied is determined in part by the level of member-derived income. An organization which receives more than 50 percent of its income from unrelated trade or business may be exempt under section 501(c)(6), but only if its other sources of income indicate a meaningful degree of membership support.

Common business interest. To qualify as a section 5Ol(c)(6) organization, members of the group must have a "common business interest" - shared business or professional problems that call for group solutions. Individuals who come together to facilitate their own enterprises do not have a common business interest.

As the IRS moves to characterize associate member dues as unrelated business income, associations should be alert to the fact that this could also impact exemption requirements calling for membership with a "common business interest."

No private inurement. It is a fundamental principle of the law of non-profit organizations that no private individual or entity can participate in the net earnings or have an equity interest in a non-profit organization. Yet, when a section 501(c)(6) organization earns UBI, does that not monetarily benefit members whose dues are reduced by such outside earnings?

Before 1950, the general position was that net earnings inured to the members through a reduction in dues made possible by earnings from a business ordinarily carried on for profit.

However, the unrelated business income tax provisions (Sections 511-515), added by the Revenue Act of 1950 were made specifically applicable to Section IRC 50l(c)(6) organizations. Thus it is clear, that at least since 1950, exempt business leagues may receive business income without necessarily losing exemption. The receipt of business income does not in itself constitute inurement, even though it may indirectly benefit the members. However, it is also clear that if the organization's income is distributed directly to the members, or if the organization's funds are used to pay members' personal or business expenses, there will be inurement of income to the benefit of individuals and exemption will be lost.

No unrelated business activity primarily. By definition, an activity which generates unrelated business income must be a nonexempt activity. Furthermore, if such non-exempt activity constitutes the primary activity of the organization, it will disqualify the group from section 501(c)(6) status.
Rev. Rul. 78-70 illustrates this principle looking at a board of trade which provided members and nonmembers with laboratory services. It was held not to be exempt because its principal activity, and only source of income, was from a business of a kind ordinarily carried on for profit.

What is important to note in applying the primary purpose rest is that a percentage of UBI greater than 50% as a part of gross income is not dispositive. A variety of factors are taken into account to determine if the primary purpose test is violated.

PLR 7902006 is an illustration of the IRS' approach to applying the primary purpose test. In the PLR, the IRS was asked to rule on the taxability of income from seven programs of an exempt business league: Sales of signs, embossed tags, supplies and forms, sales tax kits, and trade-in guides; administration of a group life, health, accident and hospital insurance plan for members; and sale of advertising space in publications.

The IRS ruled that each constituted particular services, and hence, the organization was engaged in an unrelated trade or business. However, in ruling on the exempt status of the organization, the IRS looked not only at the organization's gross receipts, but also its expenses and the employee time devoted to the non-exempt activity. For the years in question, more than half of the group's gross income, expenses, and employee time was related to non-exempt business activity. The IRS found the organization failed the primary purpose test, and recommended revocation of exemption under section 501(c)(6). On the other hand, where the non-exempt activity is not primary, exemption will not be denied.

In addition, the IRS takes the position that where the business income is related to the organization's exempt function, it can constitute the organization's principal means of support and yet not jeopardize exemption. For example, Rev. Rul. 80-294 holds exempt a sports promotion organization that sells television rights to tournaments it conducts as its primary source of support because it is a related activity staring that the "sponsorship of tournaments and the sale of broadcasting rights with respect thereto by the organization directly promotes the interests of those engaged in the sport by encouraging participation in the sport and by enhancing awareness of the general public of the sport as a profession."

The revenue ruling clarifies Rev. Rul. 58-502, to remove the implication that the sale of broadcasting rights to an organization's tournaments furthers IRC 501(c)(6) purposes only when the amount of the income derived therefrom is insignificant in amount.

No particular services primarily. Closely related to the unrelated business problem is that of "particular services." Particular services can be considered a subset of unrelated business, in that particular services are usually a business activity designed to serve the convenience of individual members. Examples include employment referral programs for members of a professional association, or assistance in meeting common business tasks.

An interesting twist in this area is that, in distinguishing particular services benefiting individuals from exempt programs benefiting the industry as a whole, courts sometimes look to the way in which the participant's fee is charged as a factor. In Professional Insurance Agents of Michigan v. Commissioner, the court noted that "[s]ervices which render benefits according to the fee that is paid for them are taxable business activities, not tax exempt services." Likewise, in MIB, Inc. v. Commissioner, an appellate court reversed a lower court opinion finding on the particular service nature of an insurance organization's program for exchanging underwriting information on applicants. The appellate court held that a major factor in distinguishing particular services was the existence of fees charged in proportion to the benefit received. This would seem to indicate that programs generating income based on fees charged in proportion to the benefit conferred on the individual member could be subject to classification as particular services.

A final note. In summary, excessive amounts of UBI, even amounts that make up greater than 50% of an organization's income, are not necessarily fatal to exemption (assuming there is at least some "meaningful" non-UBI "membership" support). The key to planning around UBI is to recognize that it is not so much the UBI itself, but what the UBI indicates about the type and extent of unrelated programs run by an organization that can jeopardize its exemption.