In Letter Ruling 202635004, the IRS determined that a public university's development, manufacture and supply of active pharmaceutical ingredients (APIs) for a commercial health care company do not constitute an unrelated trade or business because the activities contribute importantly to the university's educational and scientific purposes. Accordingly, the income from the agreement is not unrelated business taxable income (UBTI) under IRC Section 512 and is not subject to the tax imposed by IRC Section 511.

Background

The taxpayer is a public university established under a state constitution that has not been recognized as an IRC Section 501(c)(3) organization, but whose income is exempt under IRC Section 115. As a state university, however, the taxpayer is subject to the unrelated-business-income-tax rules applicable to state colleges and universities under IRC Section 511(a)(2)(B). The university's principal purposes include education, scientific research and health care.

The university operates accredited higher educational institutions, a hospital system, a cancer center, several research parks and a nuclear research reactor (Research Reactor). The Research Reactor is a constituent unit of the university rather than a separate legal entity and conducts research, educational and training activities that support faculty, scientists and students from numerous academic disciplines. Research Reactor's work provides opportunities for faculty research and publication and supports the university's broader research mission.

Among its activities, Research Reactor (1) conducts pharmaceutical research involving radioisotopes used to detect and treat life-threatening diseases, (2) develops research-grade isotopes and APIs, and (3) provides irradiation services. According to the university, development of these products requires highly specialized personnel, including medicinal chemists, pharmacologists, radiologists, biologists, engineers and other advanced-degree scientists.

Research Reactor enters into development, supply and irradiation-services agreements with governmental, academic and commercial customers. One such agreement involved a health care company engaged in the research, development, manufacture and commercialization of pharmaceutical products. Under the agreement, Research Reactor would develop, manufacture and supply certain APIs that the company would use in researching, developing, manufacturing and commercializing a treatment for a life-threatening disease. The university's relationship with the health care company was purely contractual and did not constitute a partnership or joint venture.

The agreement stated that the collaboration would further Research Reactor's public mission by expanding scientific research opportunities for faculty and students, advancing scientific knowledge through sharing research with the scientific community and promoting public health through the development of pharmaceutical products. Although intellectual property rights related to the API product would be transferred to the company or its affiliates, Research Reactor would retain rights to manufacture, distribute, sell and use the product for non-commercial purposes, including academic research, clinical research and clinical trials.

Before entering the arrangement, the university reviewed the agreement under its financial policies and concluded that the services:

• Were necessary to its educational and research programs
• Contributed to its educational, research and public-health objectives
• Improved operational efficiency
• Addressed services that were not otherwise conveniently available

The university further concluded that the agreement was an indirect result of accomplishing the university's core educational and scientific mission, rather than for the sole purpose of making a profit.

Applicable law and analysis

IRC Section 511 imposes tax on UBTI, and IRC Section 511(a)(2)(B) specifically applies those rules to state colleges and universities. UBTI is generally defined by IRC Section 512 as income from an unrelated trade or business. Under IRC Section 513(a), a trade or business is unrelated if it is not substantially related to the organization's exempt purposes, disregarding the organization's need for funding or its use of the resulting profits. Activities that further purposes described in IRC Section 501(c)(3), including educational and scientific purposes, may be treated as substantially related.

Under Treas. Reg. Section 1.513-1(d)(2), a trade or business is substantially related only if the activity has a substantial causal relationship to the accomplishment of exempt purposes. The activity must "contribute importantly" to those purposes rather than merely generate income that is later used to support them. The IRS therefore focused on whether Research Reactor's API development activities contributed importantly to accomplishing the university's educational and scientific purposes.

In evaluating that issue, the IRS analyzed whether the activities constituted scientific research rather than activities ordinarily conducted as part of commercial operations. Treas. Reg. Section 1.501(c)(3)-1(d)(5) provides that scientific research includes research carried out in the public interest, while excluding ordinary testing and other activities commonly conducted as incidents of commercial or industrial operations. Several authorities cited in the ruling distinguish scientific research from commercial testing based on the nature of the work performed and the expertise required.

The IRS concluded that Research Reactor's activities resembled the scientific research described in Midwest Research Institute v. United States, 554 F. Supp. 1379 (W.D. Mo. 1983) and IIT Research Institute v. United States, 9 Cl. Ct. 13 (1985). Like the organizations in those cases, Research Reactor's activities required advanced scientific and technical expertise and involved research and development intended to increase scientific knowledge. The IRS emphasized that Research Reactor was developing pharmaceutical ingredients while the commercial sponsor remained responsible for manufacturing, distribution and commercialization of the final product.

The IRS also distinguished the arrangement from those in which an organization primarily performs routine testing or serves private commercial interests. Unlike the clinical drug-testing activities described in Revenue Ruling 68-373, Research Reactor's work involved scientific research and development rather than ordinary testing performed to determine whether products met existing specifications. Similarly, the arrangement differed from the industry-sponsored research described in Revenue Ruling 69-632 because Research Reactor's activities advanced broader educational, scientific and public-health objectives rather than primarily benefiting a limited group of industry participants.

The IRS further noted that the research provided meaningful educational benefits by creating research opportunities for faculty and students and supporting the university's scientific mission. The ruling also emphasized that scientific research does not lose its character merely because it is conducted under contract with a private company or because the commercial sponsor receives rights to the resulting technology. Consistent with Revenue Ruling 76-296 and Midwest Research Institute, the IRS concluded that private sponsorship and subsequent commercialization by the company did not convert otherwise qualifying scientific research into an unrelated trade or business.

As a result, the IRS determined that Research Reactor's activities contributed importantly to the university's educational and scientific purposes and therefore were substantially related to those purposes under IRC Section 513(a). Accordingly, the income generated under the agreement was not UBTI under IRC Section 512 and was not subject to tax under IRC Section 511.

Implications

While this ruling applies to a state university, the unrelated-business-income analysis may apply more broadly to private universities and other tax-exempt public charities that engage in research with taxable entities.

Universities and other tax-exempt organizations that conduct research with taxable third parties should consider identifying and reviewing all current and pending industry-sponsored research contracts to assess whether they would meet the standards articulated in the ruling and related IRS guidance. This review should focus on how the research itself contributes to the organization's educational and scientific mission and whether the research primarily furthers that mission rather than commercial interests. Exempt organizations involved in such research activities should consider confirming that their agreements with third parties (e.g., for commercialization of the research) preserve the organization's right to publish research findings, subject to reasonable sponsor review periods for IP protection.

Universities and other tax-exempt organizations that conduct research with taxable third parties should also consider reassessing whether income from existing research agreements currently reported as UBTI may qualify for exclusion under the substantially related standard, and conversely, whether any arrangements currently excluded should be reconsidered. If a research arrangement evolves over time from genuine research and development into routine production or testing, the UBTI analysis may change.