Industry Insights

Product Sales Deemed Unrelated Business Income

September 2016

On August 12, 2016, the IRS issued Technical Advice Memorandum (TAM) 201633032, which concluded that a conservation organization’s product sales online, in a catalog and at various, unrelated retail outlets constitute gross income from the conduct of an unrelated trade or business.

Regulation Section 1.513-1 defines unrelated business income as income from a trade or business regularly conducted by an exempt organization and not substantially related to the organization’s exempt purpose or function, except that the organization uses the profits. The organization didn’t dispute that its sales are a trade or business or that they regularly occur. As such, the IRS focused on determining whether the sales contributed importantly to accomplishing the organization’s exempt purpose.

To determine whether the sales were substantially related, the IRS examined the relationship between the sales and the accomplishment of the organization’s exempt purpose. In determining whether the activities contributed importantly to accomplishing the organization’s exempt purpose, the activities’ size and extent were considered in relation to the exempt function’s nature and extent.

The IRS examined the product(s) and product packaging. It determined the product itself didn’t impart any information, the front of the package showed a picture of the product, and the back of the package was similar to a for-profit commercial product, containing instructions for use. The organization’s office and web addresses also were listed on the back. It also was noted that the annual catalog of products was similar to a commercial seller’s, except for a few pages devoted to the organization and its program descriptions. 

The IRS analysis said products were marketed and sold similarly to those of a for-profit business. As such, the IRS considered whether the sales contributed importantly to the organization’s charitable and scientific purpose. The IRS concluded that the sales weren’t associated with the organization’s exempt purpose of conserving and preserving the products in question.

By-product of exempt purpose also was evaluated. The IRS found that about 20 percent of the products sold were generated through the organization’s operations and employees. The other sales appeared to be produced by and purchased for resale from an unrelated third party. The organization inspects and monitors quality control of those third-party products. The IRS concluded that the sold products didn’t result from the performance of exempt functions. It also was noted that if the sold products were merely by-products or remains in furtherance of the organization’s exempt purpose and not excessive, gross income from the sales wouldn’t be considered gross income from the conduct of unrelated trade or business.

In determining whether the activities contribute importantly to accomplishing an exempt purpose, the activities’ size and extent were considered in relation to the exempt function’s nature and extent, also taking into account the activities’ scale. The IRS concluded that the organization maintained a stock of product needed to sustain a commercially viable and profitable business. As such, it was found that such sales were conducted on a larger scale than is reasonably necessary for the organization’s exempt purpose.

In summary, the IRS evaluated the product, packaging and catalog and concluded that the organization’s product sales don’t contribute importantly to the educational purposes of preservation and conservation. It also found that there’s no substantial relationship between the product sales and the organization’s exempt purpose, as the products were marketed and sold in a manner similar to a for-profit business. The products were evaluated to determine whether the products sold were by-products or remains resulting from the organization’s preservation functions to further its exempt purpose, also taking into account the scope of those sales. The IRS determined that the products were primarily not by-products or remains from the organization’s conservation efforts and that the sales were conducted on a larger scale than necessary for the organization’s exempt functions. The IRS found that the organization’s sales constituted gross income from an unrelated trade or business. 

While a TAM is specific to the taxpayer and may not be used or cited as a precedent, it provides insight into IRS analysis of similar situations.

For questions or additional information on how this memorandum could affect you, contact your BKD advisor.

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