A denominational agency publishes educational resources for affiliated churches and pastors. It also publishes religious books that it markets to the general public. Some of these books have been best-sellers, and have resulted in substantial earnings. The denomination uses these earnings to further its religious purposes. Should it be concerned about the application of the federal "unrelated business income tax" to these earnings?

Take the quiz first, then read the article for all the details.

1. A tax-exempt organization is not taxed on its income from any activity that is substantially related to the religious, charitable, educational, or other purposes.
   True or False
   
   
2. If a denominational agency regularly carries on a trade or business that is not substantially related to its exempt purpose, it may be subject to the federal "unrelated business income tax" on any net earnings that it generates.
   True or False
   
   
3. A denominational agency sells religious books to the general public, and generates substantial earnings. So long as it applies all net earnings to its religious mission, the earnings will not be subject to the unrelated business income tax.
   True or False
   
   
4. A denomination publishes a monthly journal for its pastors, and educational literature for affiliated churches that promote the denomination's religious tenets. The denomination generates substantial net income from the sale of these publications. The net income is subject to the unrelated business income tax because it is a substantial source of revenue.
   True or False
   
   
5. Same facts as question #4, except that the denomination also publishes general interest religious books that it sells to the general public. The sale of these books makes all of the denomination's publication income subject to the unrelated business income tax.
   True or False
   
   
6. Denominational agencies that engage in an unrelated trade or business will not jeopardize their tax-exempt status so long as they pay the unrelated business income tax on any net earnings from such a business.
   True or False
   
   

Executive Summary
Many denominational agencies publish books and literature for affiliated churches. Some expand their audience to include other churches and the general public. Are the net earnings from such activities subject to the federal tax on "unrelated business income"? This question is addressed in this week's lesson.

Weekly Lesson

Overview
A tax-exempt organization such as a denominational agency is not taxed on its income from any activity that is substantially related to the religious, charitable, educational, or other purposes that are the basis for its exemption. Such income is exempt even if the activity is a trade or business. However, if an exempt organization regularly carries on a trade or business that is not substantially related to its exempt purpose, except that it provides funds to carry out that purpose, the organization is subject to tax on its income from that unrelated trade or business. The tax is known as the "unrelated business income tax," and it generally reflects the same rates of taxation as the corporate income tax. The idea is this: if a charity realized income from an activity that is unrelated to its exempt purposes, it should have to pay taxes on that income. The term trade or business generally includes any activity carried on for the production of income from selling goods or performing services.

A business activity is not substantially related to an organization's exempt purpose if it does not contribute importantly to accomplishing that purpose (other than through the production of funds). Whether an activity contributes importantly depends in each case on the facts involved. In determining whether activities contribute importantly to the accomplishment of an exempt purpose, the size and extent of the activities involved must be considered in relation to the nature and extent of the exempt function that they intend to serve. For example, to the extent an activity is conducted on a scale larger than is reasonably necessary to perform an exempt purpose, it does not contribute importantly to the accomplishment of the exempt purpose. The part of the activity that is more than needed to accomplish the exempt purpose is an unrelated trade or business.

Religious publishing
Many denominations publish books and periodicals, as well as educational resources for churches. Do such publishing activities constitute an unrelated trade or business? Are any net earnings from such activities subject to the unrelated business income tax? That will depend on the circumstances of each case. The IRS has observed,

An exempt organization engages primarily in activities that further its exempt purposes. It also owns the publication rights to a book that does not relate to any of its exempt purposes. The organization exploits the book in a commercial manner by arranging for printing, distribution, publicity, and advertising in connection with the sale of the book. These activities constitute a trade or business regularly carried on. Because exploiting the book is unrelated to the organization's exempt purposes (except for the use of the book's profits), the income is unrelated business income. However, if the organization transfers publication rights to a commercial publisher in return for royalties, the royalty income received will not be unrelated business income.

Several courts have ruled that religious publishing is a commercial, nonexempt activity regardless of religious motivation if literature is sold to the general public at a profit. The IRS Exempt Organizations Technical Guidelines Handbook states:

Publishing literature is an important method of disseminating religious views. However, publishing may also be a business operating in competition with commercial enterprises. The IRS has held that publishing and distributing a monthly newspaper carrying church news of interdenominational interest accomplishes a charitable purpose by contributing to the advancement of religion. In that case subscriptions were obtained through individual churches and church associated groups and revenues did not cover the costs of operation.

Example. The Tax Court ruled that a publishing company that sold a large volume of religious literature, periodicals, and Sunday school supplies at a substantial profit was not exempt. The court found that operating profits and accumulated earnings were disproportionately large and there was no clear purpose to further any particular religious beliefs. The general character of the operation was that of a commercial publishing house catering to religious customers. As a result, the court concluded it was a trade or business and not exempt. The existence of a modest program of expenditures for religious and educational purposes unconnected with the publishing did not have a decisive effect.

Example. A federal court ruled that a corporate publisher of religious books priced at commercial levels that showed moderate but consistent operating profits was not exempt. The court said that although the "publishing activities further the exempt purpose of educating the lay apostolate," nevertheless, there was a substantial nonexempt purpose "the publication and sale of religious literature at a profit."

Example. A federal court ruled that an organization that published religious literature no longer qualified as tax exempt in view of an abrupt increase in salaries of top personnel, a large amount of accumulated profits, and the fact that the company was in direct competition with a number of commercial publishers. The facts showed that the organization's primary purpose was to operate as a commercial business producing net profits.

But if a religious organization publishes literature to promote its own beliefs, and revenues are used to defray expenses and to further the religious purposes of the organization, the activity is considered to be religious. The IRS, in its Exempt Organizations Technical Guidelines Handbook, acknowledges that "in cases where religious literature is published by an organization to promote its beliefs, the activity may further exclusively religious purposes even though it produces an operating profit."

Example. A federal appeals court upheld the exempt status of a religious publishing organization that was closely associated (though not legally affiliated) with the Orthodox Presbyterian Church, and whose primary purpose was the publication of books furthering the reformed faith, concluding that its accumulation of capital for physical expansion and its increased profit due to unexpected increases in popularity of one of the publisher's authors did not show a substantial non-exempt purpose.

Tax returns
An exempt organization subject to the tax on unrelated business income must file its income tax return on Form 990-T (Exempt Organization Business Income Tax Return) and attach any required supporting schedules and forms. The return is filed with the appropriate IRS Service Center. This return is required only if the gross income from an unrelated trade or business is $1,000 or more.

Quiz answers: 1) T  2) T  3) F  4) F  5) F  6) F 

This article appeared in "Staff &Volunteer Training," October 15, 2005, at www.churchlawtoday.com.

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