Key point. Federal law imposes a tax on the unrelated business income of churches and other tax—exempt organizations. There are some exceptions to this tax, including the sale of books that directly promote a church's tenets. But if the activity is primarily commercial, the tax on unrelated business income may be due.
The IRS concluded that a religious organization had to pay unrelated business income tax on net earnings from its publishing activities. The organization was established to conduct an institution of learning for the general education of students. The charter further provides that the organization is authorized to engage in all matters incidental to these purposes, including the publishing and dissemination of textbooks, curriculum, and other materials related to schools of Christian training. The organization has no affiliation with a particular church or religion, and describes its materials as promoting a Christian—based philosophy. Books published by the organization are instructional in nature with a Christian perspective. The organization began publishing textbooks for a school it established, but in time many other private Christian schools expressed an interest in these materials and wanted to buy them. By 1973, the organization had set up a separate publishing division which began to write and publish Christian textbooks for its students. These materials were also sold to other Christian schools. The market for these materials has increased significantly over the years. Today, the publications are sold in all 50 states as well as in a number of foreign countries. As of 1989, the organization sold its textbooks to over 17,000 Christian schools throughout the world. The organization estimates that 600,000 elementary and secondary school students are educated using its materials. It now offers video instructional materials for home or classroom use and also operates a correspondence school. As a result of the profits generated by its publishing division, the organization has been able to expand its operations in a number of other areas.
The publishing division markets its textbooks throughout the world. It advertises its textbooks and curricula in Christian magazines, in Christian newspapers, at Christian trade shows and, most importantly, through a program of direct mailing of catalogs and brochures. It maintains a sales force of 40 people, who receive a base salary plus bonuses and commissions based on sales volume. It also employs from 24 to 59 individuals to handle its toll—free phone bank.
The IRS audited the organization, and while it determined that the publishing activities did not affect the organization's tax—exempt status, it concluded that these activities did generate unrelated business taxable income. The IRS noted that section 512(a)(1) of the Code defines the term "unrelated business taxable income" as the gross income derived by any organization from any unrelated trade or business regularly carried on by it, less allowable deductions. Section 513(a) of the Code defines the term "unrelated trade or business" 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 profits derived) to the exercise or performance by such organization of its charitable, educational, or other purpose or function forming the basis for its exemption. Section 513(c) of the Code provides that the term "trade or business" includes any activity which is carried on for the production of income from the sale of goods or the performance of services. Section 1.513—1(d)(2) of the regulations provides that a trade or business is "related" to exempt purposes only where the conduct of the business activities has a direct relationship to the achievement of exempt purposes (other than through the production of income) and is "substantially related" only where the direct relationship is a substantial one. In other words, the production of goods or the performance of services from which gross income is derived must contribute importantly to the accomplishment of the organization's exempt purposes. Section 1.513—1(d)(3) of the regulations provides that in determining whether activities contribute importantly to the accomplishment of an exempt purpose, the size and extent of the activities involved must be considered in relation to the nature and extent of the exempt function which they purport to serve. Where income is realized by an exempt organization from activities which are in part related to the performance of its exempt functions, but which are conducted on a larger scale than is reasonably necessary for the performance of such functions, the gross income attributable to that portion of the activities in excess of the needs of exempt functions constitutes gross income from the conduct of unrelated trade or business.
The IRS concluded that the publishing activity did not result in the loss of the organization's exempt status since "there is no evidence that any of the funds generated by M were not properly used to further the organization's educational purposes in some manner." However, the IRS concluded that the net earnings from the publishing activity were subject to the unrelated business income tax. It observed
It has been noted that [the publishing division] customarily has profits as high as 75% of gross receipts. The organization acknowledges that its pricing of materials is probably comparable to ordinary commercial prices, but states that it has never done a comparison study on this point ….
In this case, the organization's sales activity … constitutes an activity carried on for the production of income from the sale of goods. All of the relevant information indisputably establishes that the sales of textbooks, curricula and other materials are carried on in a manner consistent with a profit motive …. The subject organization's sales activities are carried on with the dominant hope and intent of realizing a profit and otherwise possess the characteristics of a trade or business. In viewing the overall operation, we can only conclude that [the organization's] activities are indistinguishable from those of a commercial religious publisher. Therefore, it is our conclusion that the organization's operation of [the publishing division] constitutes a trade or business within the meaning of section 513 of the Code.
The methods used in selling the textbooks are indistinguishable from ordinary commercial sales practices. The commission method of remuneration of sales personnel, the use of extensive direct mail and magazine and newspaper advertising, and the toll free telephone order operation would bear this out. Remuneration paid to key individuals within the organization, while in earlier years quite modest, is now comparable to remuneration that might be found in the for—profit sector. Although such compensation appears to be reasonable for purposes of section 501(c)(3) of the Code, it is obvious that amounts of compensation have increased and parallel increasing profits in recent years.
The IRS further concluded that "in general the organization's educational purposes are furthered by [its] sales only through the provision of income to support the other activities of the organization. Thus, it cannot be said that the production and sale of the items in question contribute importantly to the organization's exempt purposes. Accordingly, the substantial causal relationship required by section 1.513—1(d)(2) of the regulations is not present."
The IRS reviewed a number of previous cases and rulings addressing the tax consequences of religious publishing:
Presbyterian and Reformed Publishing Company v. Commissioner, 743 F.2d 148 (3rd Cir. 1984). A federal appeals court held that the accumulation of capital for physical expansion and the increased profit due to unexpected increases in popularity of one of the publisher's authors did not show a substantial non—exempt purpose. That organization was affiliated with a branch of the Presbyterian Church and generally espoused tenets of that branch. The court concluded that the organization met the requirements for exemption under section 501(c)(3) of the Code.
Incorporated Trustees of the Gospel Worker Society v. United States, 510 F. Supp. 374 (D.D.C. 1981). A federal court determined that an organization that published religious literature of a non—denominational nature as its exclusive activity did not qualify for exemption under section 501(c)(3) of the Code. The organization paid its top personnel large salaries, accumulated substantial profits, and was in direct competition with a number of commercial publishers.
Pulpit Resource v. Commissioner, 70 T.C. 594 (1979). The Tax Court held that where an organization published religious literature to promote its beliefs, the activity may be religious in character even though that activity produces an operating profit. The organization's purpose was to assist ministers of all persuasions in improving their sermon writing abilities. The court noted that the activity was unique, and so not in competition with commercial entities.
Fides Publishers Association v. United States, 263 F. Supp. 924 (N.D. Ind. 1967). A federal court determined that a religious publishing house operated in a commercial manner which was independent of any religious body or organization and carried on no other activities, was not qualified for exemption under section 501(c)(3). The court acknowledged that its operations furthered the exempt purpose of educating individuals in a given area, but concluded that there was a substantial non—exempt purpose present-the publication and sale of religious literature at a profit. The organization in question generated consistent operating profits and employed a commercial pricing pattern.
Scripture Press Foundation v. United States, 285 F.2d 800 (Ct. Cl. 1961). A man and his wife, deeply interested in religion, formed a corporation devoted to the publication and sale of religious literature designed to upgrade the quality of existing teaching materials for Bible instruction and Sunday schools. The publications enjoyed increasing sales and returned rising profits. The government argued that the organization was not exclusively organized and operated for religious purposes because the sale of religious literature was not an activity qualified for tax exemption. The government asserted, and the court agreed, that large profits by an organization claiming exemption are some evidence indicative of a commercial character. The court phrased the proper test as follows: "was the sale of religious literature by the plaintiff in this case incidental to the plaintiff's religious purposes or were plaintiff's religious objectives incidental to the sale of religious literature?" Although Scripture Press asserted that its religious instructional activities were more important to it than its selling activities, that the people in charge of its activities were devout and of intense religious conviction, and that the evidence supported such assertions, the court stated:
the intensity of the religious convictions of the plaintiff's members and officers cannot operate to exempt them from the tax laws if the activities of the plaintiff cannot in themselves satisfy such an exemption. Piety is no defense to the assessment of the tax collector.
The court concluded, on the basis of a comparison of the funds accumulated by the Scripture Press as the result of its sale of religious literature and the funds expended for religious instructional activities, that the sale of religious literature was its primary activity to which the instructional phase of Scripture Press was incidental and that, consequently, the organization did not qualify for exemption under section 501(c)(3) of the Code. IRS Letter Ruling 9636001. [ Federal Taxation of Unrelated Business Income of Churches]