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You're tax-exempt? That doesn't always mean you're tax-exempt

September 29, 2011

While the tax law provides many entities the opportunity to be tax-exempt, there are limits. The government doesn't want tax exempt entities to use their exemption to compete with taxable businesses. It wouldn't be fair to the taxable entities, and it would cut into the government's action.

That's why we have the "Unrelated Business Income Tax." This tax can be understood as the corporation income tax applied to business activity of otherwise tax-exempt entities. It's something exempt entities, including IRAs and pension funds, should be careful of any time they have income from things other than interest, dividends and capital gains. And it can crop up in surprising ways, as the National Education Association learned yesterday in Tax Court.

The NEA publishes two magazines for its members, and it generates unrelated business income from selling ads. The NEA deducted its circulation costs against this income. The IRS said that because the magazines are available to all NEA members, it was required to allocate a portion of its dues income to its income from the magazines. The Tax Court sided with the IRS, saying the tax law

...requires an allocation of membership dues to circulation income if the exempt organization's members have a legal right to receive the publications. For the years at issue, NEA members had such a legal right to receive the periodicals. The fact that NEA also made most of the content of the periodicals available on the Internet does not change this conclusion. Consequently, the IRS was correct in requiring NEA to allocate a portion of its membership dues to circulation income.

The decision, unless reversed on appeal, will cost NEA $1.1 million. It reminds us that tax exempt status has its limits, and that exempt organizations need to be careful with investments that aren't plain-vanilla.

Cite: National Education Association of the United States, 137 T.C. No. 8

Tags: Judge Gustafson.tax court.UBIT.