02 January 2018 Fees a supporting organization received from vendors providing debt-collection and group purchasing programs to members are subject to UBIT, Tax Court holds In New Jersey Council of Teaching Hospitals v. Commissioner, 149 T.C. No. 22, the Tax Court has held that a Section 501(c)(3) supporting organization is liable for unrelated business income tax (UBIT) on fees paid by third-party vendors to provide debt-collection services and group purchasing programs to the supporting organization's Section 501(c)(3) members. The fees did not qualify for exemptions from UBIT, the court ruled, concluding the fees represented payments for services, not royalties under Section 512(b)(2), and the business activities involved were not carried on primarily for the convenience of the members. Since its incorporation in 1986, the New Jersey Council of Teaching Hospitals (NJCTH) has been a membership organization, primarily for teaching hospitals operating in New Jersey. The IRS issued NJCTH a determination letter in November 1988, recognizing the organization as exempt under Sections 501(a)(1) and (c)(3) and as a supporting organization under Section 509(a)(3)(A). On its exemption application, NJCTH explained its charitable purposes as furthering undergraduate and graduate medical education, coordinating this education with clinical programs available at its member hospitals, and helping to provide an innovative and cost efficient health care delivery system in New Jersey. On its Forms 990 for the years at issue (2004-2007), NJCTH stated its exempt purposes included "promoting health care, medical education and technology by studying and improving graduate medical education" and "articulat[ing] a vision of a superior healthcare system for all New Jerseyans." During the years at issue, NJCTH's membership consisted of 11 teaching hospitals, one nonteaching hospital and one medical school, each paying dues. NJCTH's expenses well exceeded its dues income each year. In addition to dues income, NJCTH received fees from contracts with third parties that offered programs and services to NJCTH's members and then paid NJCTH fees based on the revenues generated. During the years at issue, these programs and services included credit cards, internet services, research and polling services, equipment maintenance, transportation, debt collection and group purchasing. Specifically, OSI Collection Services Inc. (OSI) provided debt collection services and the Greater New York Hospital Association (GNYHA) provided group purchasing programs. Under a service agreement with OSI, NJCTH agreed to endorse OSI to members as a collection agency and a selected vendor. To fulfill this obligation, NJCTH listed OSI on the member services section of its website and included a hotlink to OSI's website, along with a one-paragraph explanation of OSI's services. The parties had no agreement that gave OSI permission to use NJCTH's intellectual property (IP) or that obligated NJCTH to make its IP available to OSI. OSI agreed to pay NJCTH 3% of the amount collected from sales to NJCTH members. For the years at issue, these fees totaled more than $540,000. The number of NJCTH members participating in the OSI program during these years varied: in 2004, 3 of 9 dues-paying members; in 2005, 3 of 10 dues-paying members; in 2006, 3 of 11 dues-paying members; in 2007, 4 of 10 dues-paying members. Members that did not utilize OSI could contract with any other debt-collection company. Under a management agreement with GNYHA, Health Alliance Inc. (a for-profit affiliate of NJCTH) was to receive a share of fees that GNYHA received from enrolling NJCTH members in certain group purchasing programs. By 2004, Health Alliance Inc. had assigned its rights and obligations under this agreement to NJCTH, so NJCTH received the fee payments during the tax years at issue. During the years at issue, GNYHA provided two portfolios (national and regional) from which hospitals in New York, New Jersey, and Connecticut could select purchasing agreements for discounted products and services, including medical supplies, pharmaceuticals, imaging and cardiology products, nutrition services, surgical instruments, and certain capital equipment. NJCTH's financial statements labeled the fees received from GNYHA as "commissions," which totaled more than $1.7 million for the years at issue. Participation in the GNYHA program by NJCTH members during these years amounted to: in 2004, 3 of 9 hospital members; in 2005, 6 of 10 hospital members; in 2006, 6 of 11 hospital members; in 2007, 7 of 10 hospital members. Member hospitals that did not participate could enter into purchasing agreements directly or participate in other group purchasing arrangements. Although GNYHA charged participants the same regardless of whether they enrolled individually or through NJCTH, it did not pay fees to hospitals that enrolled individually. After auditing NJCTH's Forms 990 for the years at issue, the IRS concluded that the fees NJCTH received from OSI and GNYHA constituted unrelated business income (UBI), taxable under Sections 511(a)(1) and 512(a). The IRS asserted that NJCTH had "marketed and administered" the GNYHA group purchasing program and that these activities were not related to the supporting organization's exempt purpose. The IRS rejected NJCTH's assertion that the OSI and GNYHA activities were carried on primarily for the convenience of NJCTH's members and therefore qualified under Section 513(a)(2) as an exception from the definition of an unrelated trade or business. The IRS also rejected NJCTH's assertion that the OSI and GNYHA fees constituted royalties, exempt from the definition of unrelated business taxable income (UBTI) under Section 512(b)(2). Before the Tax Court, NJCTH acknowledged that the activities generating the OSI and GNYHA fees constituted a "regularly carried on" trade or business that was not substantially related to the performance of NJCTH's educational purposes. Nonetheless, NJCTH contended that the fees were exempt from UBTI as royalties, and because they resulted from activities carried on primarily for the convenience of members. The court noted that royalties are payments for the right to use IP and "cannot include compensation for services rendered by the owner of the property." The agreements with OSI and GNYHA did not address IP rights or royalties, the court emphasized, concluding that NJCTH was not being paid for use of its IP. Turning to the convenience exception under Section 513(a)(2), the court noted that although neither the Code nor the regulations defines the scope of the exception or the term "convenience," the regulations provide three examples of activities that qualify. A college bookstore that sells books to students on campus operates for the convenience of the students and the school; a hospital pharmacy sells medication and medical supplies for the convenience of patients and the hospital; and a college-operated laundry washing dormitory linens and students' clothing operates for the convenience of the students and the college. Additional examples, provided in a series of revenue rulings, include vending machine facilities on a college campus and college-operated cafeterias. Examples of activities that do not qualify for the convenience exception include an exempt hospital's sales of pharmaceutical supplies to members of the general public or to private patients of physicians practicing in a building the hospital owns. "Read together," the court explained, "these examples suggest that a business conducted by a university or hospital will be regarded as carried on for the convenience of its students or patients if the business activity assists those individuals in their capacity as such … by helping them be better students or healthier patients." The court was not persuaded by NJCTH's argument that its activities (1) under the GNYHA contract were performed to provide members with access to discounted supplies and services and to generate non-dues revenue, and (2) under the OSI contract were performed to refer members to "'a vetted and reliable collections vendor.'" These activities did not serve NJCTH members in their capacity as members (as would, for example, providing travel assistance to help members attend NJCTH conferences). NJCTH had not established that the activities benefited members in any meaningful way, the court concluded. The court emphasized that "there is no legal support for the notion that saving money, without more, is enough to qualify for the 'convenience' exception," pointing out NJCTH's "money saving" theory is hard to reconcile with Congress's purpose in enacting the UBTI provisions, which was "to eliminate unfair competition between tax-exempt and taxpaying businesses." The court also rejected the contention that the OSI and GNYHA contracts were entered into primarily for the convenience of NJCTH's members, concluding that the resulting fees, which made up approximately 23% of the organization's total revenue, indicated that "petitioner's primary purpose for engaging in these activities was to raise revenue for itself." Section 512(b)(2) excludes royalties from the definition of "unrelated business taxable income." However, courts and the IRS have ruled that "royalties" for purposes of Section 512(b)(2) do not include income from licensing arrangements in which the exempt organization provides substantial services in exchange for the licensing fee. Such services include advertising or actively promoting the licensee's services, or helping to conduct the licensee's trade or business. In New Jersey Council of Teaching Hospitals, the Tax Court ruled that NJCTH was compensated by OSI in exchange for its administrative services to OSI and for its promotion of OSI's services on its web site, rather than for licensing IP. The court noted that the agreement between the parties was a service agreement, and did not reference royalties being paid for licensing NJCTH's IP. This case underscores the need for exempt organizations to carefully structure licensing arrangements to minimize the risk of incurring UBTI. For instance, licensing agreements can be drafted to make clear that the exempt organization is licensing its name, logo, or other IP in exchange for a royalty, but will not be performing any services. The agreement can provide that the exempt organization, in order to safeguard its IP, may review and approve any materials that include that IP before the licensee makes such materials available to the public. Exercising such quality control rights would not jeopardize the organization's ability to exclude royalty income from UBTI. The Tax Court narrowly construed the convenience exception under Section 513(a)(2), holding that activities conducted to benefit members don't qualify for the Section 513(a)(2) exception simply because the activities help save their members time and money. Rather, the court noted that a trade or business conducted by an exempt organization will be regarded as carried on for the convenience of its members, employees, students or patients only if the activity assists them in their capacity as members, employees, students or patients, respectively. Accordingly, exempt organizations that operate cafeterias, bookstores, laundromats, pharmacies, and other activities that primarily benefit their members, students, patients, or employees should determine and document how those activities are designed to benefit those persons. Proactively connecting the activity to the employee/member/student/patient benefit would strengthen the organization's position that the activity is excluded from the definition of an unrelated trade or business under Section 513(a)(2). — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg.
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