The Unrelated Business Income Tax and the Future of the Online Library-book Sales
byKeaton Oberst
Table of Contents
I. UBIT and Library Sales
II. Brief Overview of Tax-exemption, UBIT, and its Applicability
A. Origins of UBIT
B. UBIT Applied
III. Library Sales—General Background
A. Library Sales Generally
B. Tax Issues in General Library Sales
IV. Although Organizations Can Plan Around It, UBIT Should Not Apply to Library Sales to Begin With
V. Conclusion
I.UBIT and Library Sales
The unrelated business income tax (UBIT) is a tax on certain income of otherwise tax-exempt organizations. It applies, predictably, when the business has income that is not related to its tax-exempt purpose. That unrelated business income, then, is taxed at the same marginal rates as corporate income. The UBIT was enacted with the intention of putting taxable businesses and tax-exempt organizations on the same competitive footing—at least where the tax-exempt organization is competing with businesses and is not pursuing its tax-exempt purpose.[1] The UBIT sought in this way to eliminate unfair competition. The extra revenue was nice too.
Libraries frequently hold sales of donated and discarded books. As the internet promises to tremendously increase the demand for obscure books, libraries are sure to capitalize on the value of books that are no longer of use to them. Libraries should not rush to the internet in haste, however, as doing so may draw the attention of the IRS and the application of UBIT. This paper will discuss the UBIT, library sales, and how they interact. Then, it will discuss potential methods for avoiding UBIT. Finally, this paper proposes that the application of UBIT to a library’s sale of books is inconsistent with the purpose and intent of the tax. I will end by discussing how transaction planners, courts, and Congress can address the situation.
II.Brief Overview of Tax-exemption, UBIT, and its Applicability
Groups that carry out library affiliated book sales are typically organized under I.R.C. §501(c)(3) as §509(a)(2) publicly supported organizations. An entity may organize under §501(c)(3) if it is organized and operated for a tax-exempt purpose, its earnings do not inure to a private shareholder, and it does not dedicate a substantial amount of time to lobbying or other political activities.[2] A §501(c)(3) organization is considered a private foundation unless it qualifies as a publicly supported organization under §509(a)(1)—(3).
An organization is publicly supported under §509(a)(2) when it satisfies that provision’s two requirements. First, it must normally receive more than one-third of its support from public sales related to the exempt purpose, admissions, membership fees, and similar undertakings.[3] Second, it must not receive more than one-third of its income in the form of gross investment income or unrelated business income.[4] Library sale organizations are most often publicly supported under this provision because they organize book sales for libraries in order to increase public awareness for library services, encourage reading, and raise money to pass along to the library.
A.Origins of UBIT
The Unrelated Business Income Tax was passed in the mid-twentieth century at the behest of businesses that were competing head-to-head with tax-exempt organizations.[5] The only conceivable limitations on the income generating activities of a tax-exempt organization were the requirements that are today embodied in the organizational test—that is, that an organization be organized exclusively for its tax exempt purpose.[6]
It was at least arguable that an organization that was making money from activities unrelated to its exempt purpose was not satisfying the organization test because it was engaging in activities unrelated to its tax-exempt purpose.[7] The actual rule however, was that organizations paid no tax on income that was, in the end, used towards the exempt purpose of the organization.[8]Thus, charities could satisfy the test without regard to income-earning activity. This end-use inquiry was known as the destination of income test.[9]
Interest in reworking the taxation of tax-exempt organizations cameamid the uproar surrounding New York University’s acquisition of the C.F. Mueller Company, a noodle factory.[10]Businesses complained to Congress that the difference in taxation between the two types of organizations constituted a subsidy that gave the tax-exempt business an unfair advantage over taxable businesses. UBIT was signed into law in 1950. The law was tweaked in various ways up until 1969, when the rules took their current form.[11]
Commentators recognize two important rationales for the imposition of a UBIT tax.[12] The first rationale is that it actually makes the competition between exempt and non-exempt organizations unfair. The second rationale implicates the revenue lost when the market share of exempt organizations increases and that of taxed businesses decreases.[13]
The first rationale pertains to fairness in competition. This, of course, depends on what one considers “fair.” One view of fair is that it means equal tax treatment. On the other hand fair does not necessarily mean equal.[14] If fair meant equal, all activities that compete with business would be taxable. But if fair is not equal, then the question of where to draw the line between those entities that are taxed and those that are not essentially boils down to a policy judgment. This contemplates the assumption that, at the very least, the disparity supposedly caused by the imposition of tax is not unfair where the tax-exempt organization’s business furthers its exempt purpose. In this sense, fairness could become a function of how valuable we perceive an organization’s exempt purpose to be. In practice, however, no distinctions exist between organizations based on exempt purpose.
The second rationale for UBIT goes to tax-exemption’s costs.[15] The idea is that exempt organizations take up market share that would otherwise be occupied by revenue generating businesses.[16] This idea may have some force, but it assumes a lot. Primarily, one must presume that exempt organizations are going to carry on businesses in established, low-growth sections. Exempt organizations probably aren’t well equipped to compete with these companies, as discussed below.
The unfair competition rational is problematic in other respects as well. For instance, if the business is one not allowed to incorporate under state, there is no corporate tax, thus there is no disparity in taxation. The income that passes through to the partners in a law firm, for example, is taxed in same as the income as that of lawyers working at Legal Aid. Furthermore, businesses that do not require the capital structure of a large corporation can now elect pass through tax treatment. Thus, businesses that are not growth-oriented, such as locally owned shops, along with those that do not require equity financing cannot claim much harm due the tax treatment of exempt organizations.
Although large corporation might be impacted by tax-exempt competition, corporations enjoy distinct competitive advantages which help to minimize concern. Primarily, corporate executives and employees may be compensated by company stock. The private inurement rule prohibits exempt organizations from doing the same.
B.UBIT Applied
Income is “unrelated” for the purpose of UBIT when it comes from a regularly carried on trade or business that is not substantially related to an organization’s tax-exempt purpose.[17] It is important to remember that there are also many exceptions to UBIT. These exceptions are also discussed below.
The “trade or business” requirement is the primary embodiment of the competition rationale originally conceived of as the basis for the UBIT tax. A “trade or business” refers to an organization’s money making activities—those “carried on for the production of income.”[18] Trade or business is defined by reference to the competition rationale for UBIT. Treasury regulations promulgated under IRC §512 thus identify several circumstances where a tax-exempt organization’s money making activities are not considered a trade or business within the meaning of IRC §512.[19] For instance, your local NPR station that gives you a coffee mug when you become a member does not have unrelated business income because it is a “low-cost article incidental to the solicitation of charitable contributions” and as such is not a competitive threat to taxpaying businesses.[20] In contrast, a hospital pharmacy that sells to the general public does have unrelated business income because it competes with taxpaying pharmacies.[21]
UBIT’s “regularly carried on” requirement also furthers the competition rationale by assessing the way that a tax-exempt organization conducts its trade or business. The metrics for determining how a business is carried on are frequency and continuity.[22] While an organization that conducts the same money making activity every Saturday is regularly carrying on,[23] an organization that holds an annual fundraiser on the same day is not.[24]
Finally, to avoid UBIT, a money making activity must be substantially related to the organization’s pursuit of the purpose that forms the basis for its tax-exempt status.[25] A substantial relationship is a question involving the relatedness of the activity and the purpose, along with the comparative size and the scope of the organization and the activity.[26] With respect to relatedness, the money making activity must “contribute importantly to the organization’s accomplishment of its exempt purpose.”[27] This inquiry into the nature of the relationship between an organization’s purpose and a given money making activity is a based on the facts and circumstances of each individual case.[28]
An example from the regulation explains that a theater school, tax-exempt for the purpose of training children as stage performers, makes money from admission ticket sales. Performance in front of people is an important component of training children as stage performers. Therefore, the income from the ticket sales is not unrelated business income because of the close relationship between the purpose of the school and the importance of the experience of performing in front of people.[29]
Similarly, an activity’s size and scope must be appropriate to the organization’s purpose. [30]An activity will not satisfy the substantial relationship requirement if the size and scope of the activity exceed what is necessary for the organization to accomplish its purpose.[31] Finally, a trade or business is not substantially related to the organization’s accomplishment of its purpose merely because the profits from the activity go to that purpose.[32]
Even if an organization’s activities result in unrelated business income, a number of exceptions may nevertheless exempt it from the unrelated business income tax. The exceptions relevant to this article are found in IRC §513(a). They set out below.
Section 513 provides three exemptions from UBIT without regard to actual relatedness to an organization’s purpose. First, UBIT is not applicable when the income involves the use of “substantially all” work is conducted by unpaid volunteers. Second, UBIT does not apply to businesses that exists “primarily for the convenience” of patrons and employees of 501(c)(3) organizations and private institutes of higher education. This would cover laundry machines in a dorm basement or a restaurant operated on museum grounds during museum hours. Finally, income is not unrelated when the income is from sales of merchandise “substantially all” of which is donated to the organization. Thrift shops are illustrative of this exception.
III.Library Sales—General Background
There are thousands of library support organizations in the United States. Hundreds, possibly thousands, hold book sales. This section contains two parts. The first part briefly describes some of general aspects of library sales, as well facts relevant to tax issues. The relevance of these legal facts is discussed in part two.
A.Library Sales Generally
Many support organizations exist to raise money for the improvement of libraries.[33] Often these organizations are referred to as “Friends of the Library.” Friends organizations may be concerned with generating public interest in library services, in increasing the quality and quantity of library collections, or in improving the facilities housing library collections. To achieve their exempt purposes, many of these organizations hold annual or semiannual book sales on one or two weekends a year to raise money for their libraries. These sales vary in size but the support organizations typically make money from a combination of two sources—membership fees[34] and book sales.
The books one is likely to find at a library sale vary widely from fiction and children’s books, to all sorts of nonfiction, paperback to hardbound. A book sale is likely comprised both of books that are donated to the support organization by the general public and of books that are discarded by the library. A library discards books as the result of combing its collection. When a library combs its collection, it is weeding out unwanted books and thus making room for new books. As I will discuss, below, a book that is not in demand in the local community may nevertheless command significant value. This idea relates to the so-called “Long Tail”—the idea that, thanks to the internet, market niches are much easier to identify and therefore demand for unique items will increase.[35]
Most library sales are organized and run by unpaid, volunteers. In fact, library support organizations that do not manage investments are unlikely to have any paid staff at all.
B.Tax Issues in General Library Sales
Without question, UBIT does not apply to your typical library sale. There are several reasons. Most library sales do not satisfy the definition of unrelated business income as the term is defined in §512. First, annual library sales are not regularly carried on within the meaning of Treasury Regulation §1.513(c). While they are often held on the same weekend each year, this, standing alone, does not establish regularity. A library’s sale of books in the community is also arguably consistent with the purpose of library support organizations that are savvy enough to tie their exempt purpose to literacy and reading in the community.
Even those organizations that have unrelated business income, such a support organizations that hold weekly or monthly sales, or those who operate stores, will likely fall within one of the UBIT exceptions listed above. But libraries relying solely on the exceptions to avoid the UBIT should tread cautiously. First, organizations often make use of free labor, thus satisfying the volunteer requirement. A library wishing to rely on this exception must make sure that any “first dibs” options or free books offered to volunteers remain trivial and incidental. Second, an organization might argue that its sale falls under the donation exception because “substantially all” of the goods it sells are donated. This exception is an unreliable basis for avoiding UBIT and would require cautious planning.
To begin with, a sale organizer must insure that “substantially all” of the books it sells are donated. One complicating issue is that it is questionable whether, in the instance of a library transferring ownership of its discarded books to a library sale organizer, such a transfer of ownership is donative. The library is giving up the books with the expectation that they will be sold and that the support organization will either remit the money to the library or spend the profits for its benefit. That sounds like a sale in kind, with the selling organization taking as a basis the fair market value of the collection.[36]
The money that a sale organizer raises as a result of the subsequent sale is arguably the basis of the collection of books.[37] A sale organizer will typically sell many books, but will also have many leftover. Library sales typically sell their books for anywhere between twenty-five cents and one dollar. The basis of the collection as a whole, however, is significantly less than the sale price of each book because one must count on having plenty of leftovers. In any event, the basis would never exceed the fair market value of the books because it will never earn more from a sale than it actually earns. And because the basis is defined with regard to this number, there is not income.
Meanwhile, with respect to donated books, the seller’s basis is the donor’s basis.[38]Because the donor almost always paid more for a book than it will garner at a sale, there is no income. And again, if the sale is comprised of “substantially all” donated books the sale is exempted from UBIT in any event.
This is all straightforward enough. What makes things confusing is that, in practice, the books in a sale comprise a mix of donated and discarded books. When within the collection there is a noteworthy collection of discarded books treated like a sale, the collection as a whole may no longer be “substantially all” donated. The UBIT exception for donated goods would not apply. And while a sale would still not have income, it is important to note that technically UBIT will apply if there is income.
While libraries still want to benefit from the publicity and goodwill of their traditional sales. But they are increasingly beginning to realize that they can cost-effectively sell a relatively small proportion of their books on the internet and still sell the vast majority of the popular books at their traditional sales. Updating, or the constant manual or computer-based readjusting of the prices of books listed online, is an important component to staying competitive with downward trending online marketplace prices. As libraries begin to realize the potential for selling online, they will realize that they are unequipped to compete with online bookselling businesses. Primarily, frequent price readjustments, accurate condition listing, and consistent, daily shipping are all labor intensive and difficult to maintain in a volunteer-based organization. Accordingly, smart organizations will pay experts to run their online bookselling businesses.