Sierra Club: Rationalizing the Royalty Exception to the Unrelated Business Income Tax

Fordham Law Review Volume 63 Issue 5 Article 17 1995 Sierra Club: Rationalizing the Royalty Exception to the Unrelated Business Income Tax Jennifer Anne Spiegel Follow this and additional works at: https://ir.lawnet.fordham.edu/flr Part of the Law Commons Recommended Citation Jennifer Anne Spiegel, Sierra Club: Rationalizing the Royalty Exception to the Unrelated Business Income Tax, 63 Fordham L. Rev. 1697 (1995). Available at: https://ir.lawnet.fordham.edu/flr/vol63/iss5/17 This Article is brought to you for free and open access by FLASH: The Fordham Law Archive of Scholarship and History. It has been accepted for inclusion in Fordham Law Review by an authorized editor of FLASH: The Fordham Law Archive of Scholarship and History. For more information, please contact . Sierra Club: Rationalizing the Royalty Exception to the Unrelated Business Income Tax Cover Page Footnote The author wishes to express her thanks to Professor Jeffrey M. Colon for his encouragement and thoughtful comments. This article is available in Fordham Law Review: https://ir.lawnet.fordham.edu/flr/vol63/iss5/17 NOTES SIERRA CLUB: RATIONALIZING THE ROYALTY EXCEPTION TO THE UNRELATED BUSINESS INCOME TAX JENNIFER ANNE SPIEGEL* The obligationattached to a gift itself is not inert. Even when abandoned by the giver, it stillforms a partof him. Through it he has a hold over the recipient .... INTRODUCrION Tax exemption is a subsidy that society confers on certain nonprofit organizations. 2 There are many reasons for granting tax-exempt status to nonprofit organizations. 3 For example, nonprofit organizations may be financially unable to fulfill their nonprofit objectives without the subsidy that tax exemption provides.' Similarly, tax exemption assists a nonprofit in performing a function that the government * The author wishes to express her thanks to Professor Jeffrey M. Colon for his encouragement and thoughtful comments. 1. Marcel Mauss, The Gift- Forms and Functions of Exchange in Archaic Societies 9 (Ian Cunnsion trans., 1967). 2. A tax-exempt entity is synonymous with a nonprofit institution. The term nonprofit, however, can be misleading. The designation "nonprofit" means that an entity is prohibited from distributing its net earnings to the individuals who control the entity, it does not imply that the entity may not earn a profit. Henry B. Hansmann, The Role of Nonprofit Enterprise,89 Yale L.J. 835, 838 (1980) [hereinafter Hansmann, Nonprofit Enterprise]. Under § 501(a) of the Internal Revenue Code, a trust that forms a qualified pension, profit-sharing or stock bonus plan as well as organizations listed in § 501(c) and § 501(d) are exempt organizations. I.I.C. § 501(a)(1995). Examples of organizations qualifying for exemption under § 501(c) are fraternal societies, recreation clubs, labor organizations, civic leagues, corporations organized to promote amateur sports or competition, and most importantly, § 501(c)(3) organizations, corporations organized exclusively for religious, charitable or scientific purposes. Id. § 501(c). A § 501(c)(3) organization, a charitable organization, can be distinguished from other nonprofit or tax-exempt institutions. For example, a donor may generally deduct contributions made to a charitable organization pursuant to § 170, but may not deduct contributions to other § 501(c) organizations. See Tax-Exempt Organizations: Organization, Operation and Reporting Requirements, Tax Mgmt. (BNA), No. 464-3rd, at A-1 (July 13, 1992). Throughout the remainder of this Note, references to exempt organizations or nonprofits will include charitable organizations. 3. See Boris I. Bittker & George K. Rahdert, The Exemption of Nonprofit Organizations from Federal Income Taxation, 85 Yale LJ. 299, 304 (1976); Henry Hansmann, The Rationalefor Exempting Nonprofit Organizationsfrom CorporateIncome Taxation, 91 Yale L. J. 54, 55 (1981) [hereinafter Hansmann, Rationalefor Exemption]; Hansmann, Nonprofit Enterprise,supra note 2, at 843-45. 4. See Hansmann, Rationalefor Exemption, supra note 3, at 74; James T. Bennett, Unfair Competition and the UBIT, 41 Tax Notes 759, 762 (1988) ("Unless they receive government subsidies, for-profit firms will not produce pure public goods because of the 'free rider' problem."); see also Hansmann,Nonprofit Enterprise,supra 1697 1698 FORDHAM LAW REVIEW [Vol. 63 would otherwise be forced to undertake itself, such as health care or aid to the poor.5 Moreover, tax exemption is an appropriate subsidy because nonprofits, which are prohibited from distributing their profits to their owners, are more trustworthy providers of goods and services than are for-profits. 6 Finally, nonprofits confront social problems using innovative approaches that, because of bureaucratic and political constraints, government would not be free to pursue.7 Whatever the specific rationale for tax exemption may be, the public that confers a subsidy through tax exemption expects a service to society in return for this subsidy. The unrelated business income tax ("UBIT") ensures that tax exemption will be used to fulfill this expectation by limiting the privilege of exemption to income derived from activities related to a nonprofit organization's exempt purpose.8 Income is subject to UBIT9 where a nonprofit (1) engages in a trade or business that (2) is regularly carried on and (3) is not substantially related to the organization's exempt purpose. 10 Exempt purposes encompass a large variety of objectives, including education, Congress health, scientific research, and professional association. enacted UBIT, sections 511 through 514 of the Internal Revenue note 2, at 848-49 (arguing that profit-seeking firms are not as trustworthy providers of public goods as are nonprofits). 5. Hansmann, Rationalefor Exemption, supra note 3, at 66. Bittker and Rahdert distinguish between two types of exempt organizations, "public service" organizations and "mutual benefit" organizations. See Bittker & Rahdert, supra note 3, at 305-06. Public service organizations include charitable organizations, educational institutions, social welfare organizations, churches, and other religious organizations. Id. at 305. Mutual benefit organizations, on the other hand, are formed primarily so that members may pursue their own objectives. Id. at 306. Mutual benefit organizations include social clubs, labor unions, and trade associations. Id. at 305-06. 6. According to Bennett: When consumers find it difficult to judge a product's quality before purchasing it-as with health care, for instance-consumers are said to be at the mercy of suppliers and the market is said to "fail." In such cases, profitseeking firms supposedly will take advantage of consumer ignorance and increase their profits by offering lower-quality and higher-priced goods and services. Because of this tendency, nonprofits are widely held to be a more appropriate vehicle for the provision of certain types of services. Bennett, supra n (...truncated)