distribution is accomplished is distinguishable from ordinary commercial pub- lishing practices.
The organization involved in Revenue Ruling 67-4 was held to satisfy the foregoing requirements and therefore to qualify under section 501 (c) (3) as an educational and scientific organization. The possible "literary" rationale for granting the organization exemption was not mentioned. The same was true of a ruling involving an organization that prepared and distributed abstracts of scientific and medical literature.551 In these two rulings the distribution of the publications was accomplished either free of charge552 or at a charge below cost.553 This factor appears to have been significant in the conclusion of the IRS that the organizations were distinguishable from ordinary commercial publishing operations.
In contrast to these situations, a nonprofit corporation that published a foreign language magazine containing fiction, poetry, book reviews, and articles of a literary, scientific, and educational character in order to provide a vehicle for the creative activity of writers and scholars emigrating from a foreign country was denied exemp- tion because the manner of publication and sale of the magazine, which was available to the general public through regular paid subscriptions, was not distinguishable from ordinary commercial publishing practices.554 Similarly, a nonprofit organization created to meet the need for more satisfactory college teaching materials and text- books in economics and related fields by sponsoring the preparation of such materials was denied exemption because it shared the royalties from sales of the published materials with the authors. For this reason, the IRS treated the organization as one conducted in an essentially commercial manner.555
Testing for Public Safety
The final purpose for which a 501 (c) (3) organization may be organized and operated is "testing for public safety." This is the only purpose enumerated in sec- tion 501 (c) (3) that is not also listed in the "charitable deduction" sections of the Code. Accordingly, although organizations engaged exclusively in testing for public safety are exempt from income tax under section 501 (c) (3), contributions to such organizations are not deductible for income, gift, or estate tax purposes.5 5 6
Prior to 1954, the Internal Revenue Code did not specifically exempt organiza- tions engaged in testing for public safety, and therefore such an organization could qualify under the predecessor of section 501 (c) (3) only by meeting the criteria that applied to charitable, scientific, or educational organizations. In the leading case to be decided with respect to this issue under prior law, exemption was denied to an organization sponsored by an association of fire insurance companies that conducted experiments and investigations into the causes of fires and the resistance to hazards of various manufactured electrical products.557 The organization also provided a testing service to manufacturers to determine if their products met standards devel- oped by the organization, and its income was derived primarily from fees paid by the manufacturers who used this service. In denying the organization exemption, the court held that the primary purpose of the organization was to serve the business interest of the insurance companies and manufacturers and that any benefit inuring to the public was merely incidental.
This decision was in effect overruled by Congress in 1954 by the reference in section 501 (c) (3) to organizations engaged in testing for public safety.558 The regulations specifically define the term "testing for public safety" to include "the testing of consumer products, such as electrical products, to determine whether they are safe for use by the general public."5 5 9 Under this provision exemption has also been granted to a membership organization formed by a group of marine underwriting companies and boat manufacturers for the purpose of inspecting, evaluating, and
1980
testing for safety products intended for use in the manufacture of small pleasure boats.560
By its very nature, the testing of consumer products for public safety will ordinarily confer a benefit not only upon the public, but also upon the manufacturers whose products are tested. In deciding to include testing for public safety as an exempt pur- pose under section 501 (c) (3), Congress in effect determined that for purposes of granting tax exemption, the benefit to the public is sufficiently great to outweigh the private benefit to the manufacturers. However, the IRS has taken the position that this does not apply where the testing is intended to meet Food and Drug Administra- tion requirements that drugs be tested for safety and efficacy before they can be marketed.5 6 * The reasoning of the IRS in support of this position is that since a drug is not a "consumer product" available for use by the public until it is approved for marketing by the FDA, the testing of a drug for the purpose of obtaining such ap- proval serves primarily the interest of the manufacturer rather than the public and thus is not exempt.
It is interesting to note that the IRS has specifically ruled that a "public testing"
organization can qualify for exemption under section 501 (c) (3) even though it is supported entirely by charges paid by manufacturers who make use of its testing facilities and services.5 6 2
VIII
BUSINESS ACTIVITIES OF 501 (c) (3) ORGANIZATIONS
A question that frequently arises in connection with the administration of section 501 (c) (3) is the extent to which a 501 (c) (3) organization may engage in income- producing activities and still maintain its tax-exempt status. It is a problem inherent in the statute itself, since the granting of income tax exemption to specified categories of organizations constitutes an implied acknowledgment that they may have income that would be subject to tax in the absence of such exemption.
The problem generally arises when a 501 (c) (3) organization derives income from the conduct of business activities similar to those ordinarily carried on by commercial enterprises for profit.5 6 3 Rules have been developed for determining when activities of this type are of such a nature and magnitude as to result in either (1) loss of exemp- tion by the organization that carries on the activity, or (2) taxation of the income de- rived from the activity (without loss of exemption by the organization). These rules will now be examined, beginning with their legislative and judicial history. Because this report is concerned primarily with the criteria for exemption under section 501 (c) (3), the following discussion will focus mainly on the first of these two aspects of business activities of 501 (c) (3) organizations, namely, the circumstances under which such activities will result in loss of tax exemption. A detailed discussion of the rules relating to taxable business activities of 501 (c) (3) organizations (the tax on un- related trade or business income) is beyond the scope of this report.
Historical Background of the Rules Relating to Business Activity
Prior to the Revenue Act of 1950, the business activities of exempt organizations were governed by rules of judicial rather than legislative or administrative creation.
In 1924, in its opinion in Trinidad v. Sagrada Orden,56* the Supreme Court stated with respect to a statutory predecessor to section 501 (c) (3): "First, it recognizes that a corporation may be organized and operated exclusively for religious, charitable, scientific or educational purposes, and yet have a net income. Next, it says nothing about the source of the income, but makes the destination the ultimate test for exemption."5 6 5 With this language the Supreme Court created the "destination of income" test under which an organization would be treated as organized and operated
1981 exclusively for exempt purposes if its income was applied to charitable or other exempt purposes.
By 1950 the courts were unanimously of the view that organizations engaging directly in substantial charitable, educational, religious, or other exempt activities were exempt from tax as to the whole of their income, notwithstanding the fact that they also carried on profitable business activities that were not related to their exempt purposes.566 In addition, by 1950 the "destination of income" test had been ex- tended by a majority of courts to "feeder organizations," that is, those engaged ex- clusively in business activities but required to distribute their income to other organi- zations that were admittedly exempt under section 501 (c) (3).5 6 7
The legal atmosphere was changed by the Revenue Act of 1950. In an effort to create more specific rules to deal with the tremendous growth in the number and activities of exempt organizations after World War I I ,5 6 8 Congress enacted a group of new Code provisions. For purposes of this discussion, the most important effects of the 1950 act were (l) to subject to tax the income derived by exempt organiza- tions from business activities that were not related to their exempt purposes,569 and (2) to deny exemption to feeder organizations.5 7 0
These provisions were intended primarily to solve the problem of unfair competi- tion which had arisen under prior law because charitable and other exempt organiza- tions were permitted to engage in business activities in competition with private eco- nomic enterprise without being subject to income tax on the profits derived from such activities.571 As stated in the Senate Finance Committee's report on the act:
The problem at which the tax on unrelated business income is directed is pri- marily that of unfair competition. The tax-free status of section 101 [prede- cessor to section 501 ] organizations enables them to use their profits tax-free to expand operations, while their competitors can expand only with the profits remaining after taxes. Also, a number of examples have arisen where these organizations have, in effect, used their tax exemptions to buy an ordinary business. That is, they have acquired the business with little or no investment on their own part and paid for it in installments out of subsequent earnings — a procedure which usually could not be followed if the business were taxable.
In neither the House bill nor your committee's bill does this provision deny the exemption where the organizations are carrying on unrelated active business enterprises, nor require that they dispose of such businesses. Both provisions merely impose the same tax on income derived from an unrelated trade or business as is borne by their competitors. . . .5 7 2
Concept of Unrelated Business Activity
As indicated in the preceding discussion, the general approach of the 1950 act was to tax the unrelated business income of exempt organizations to the same extent as the income earned by their nonexempt competitors. It was not intended that the tax imposed on unrelated business income would have any effect on an organization's tax-exempt status.5 7 3
The tax is imposed by section 511 on the "unrelated business taxable income" of all 501 (c) (3) organizations,574 that is, the net income derived by any such organi- zation from any unrelated trade or business regularly carried on by i t .5 7 5 Section 513 defines an unrelated trade or business576 as " . . . any trade or business the conduct of which is not substantially related (aside from the need of such organization for in- come or funds or the use it makes of the profits derived) to the exercise or perform- ance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501. . . ."
Thus, three distinct questions must be answered affirmatively before a 501 (c) (3) organization will be found to be carrying on an unrelated trade or business whose