The Unrelated Business Income Tax and the Future of the Online Librarybook Sales
by Keaton Oberst
Table of Contents
I. UBIT AND LIBRARY SALES ........................................................................................................ 1
II. BRIEF OVERVIEW OF TAX-EXEMPTION, UBIT, AND ITS APPLICABILITY ............................... 2
A. ORIGINS OF UBIT .................................................................................................................... 3
B. UBIT APPLIED ......................................................................................................................... 6
III. LIBRARY SALES—GENERAL BACKGROUND ........................................................................... 8
A. LIBRARY SALES GENERALLY ................................................................................................... 9
B. TAX ISSUES IN GENERAL LIBRARY SALES .............................................................................. 10
IV. ALTHOUGH ORGANIZATIONS CAN PLAN AROUND IT, UBIT SHOULD NOT APPLY TO
LIBRARY SALES TO BEGIN WITH................................................................................................. 13
V. CONCLUSION ............................................................................................................................ 14
I. UBIT AND LIBRARY SALES
The unrelated business income tax (UBIT) is a tax on certain income of otherwise taxexempt organizations. It applies, predictably, when the business has income that is not related to
its tax-exempt purpose. That unrelated business income, then, is taxed at the same marginal rates
as corporate income. The UBIT was enacted with the intention of putting taxable businesses and
tax-exempt organizations on the same competitive footing—at least where the tax-exempt
organization is competing with businesses and is not pursuing its tax-exempt purpose.1 The
UBIT sought in this way to eliminate unfair competition. The extra revenue was nice too.
Libraries frequently hold sales of donated and discarded books. As the internet promises
to tremendously increase the demand for obscure books, libraries are sure to capitalize on the
value of books that are no longer of use to them. Libraries should not rush to the internet in haste,
1
however, as doing so may draw the attention of the IRS and the application of UBIT. This paper
will discuss the UBIT, library sales, and how they interact. Then, it will discuss potential
methods for avoiding UBIT. Finally, this paper proposes that the application of UBIT to a
library’s sale of books is inconsistent with the purpose and intent of the tax. I will end by
discussing how transaction planners, courts, and Congress can address the situation.
II. BRIEF OVERVIEW OF TAX-EXEMPTION, UBIT, AND ITS APPLICABILITY
Groups that carry out library affiliated book sales are typically organized under I.R.C.
§501(c)(3) as §509(a)(2) publicly supported organizations. An entity may organize under
§501(c)(3) if it is organized and operated for a tax-exempt purpose, its earnings do not inure to a
private shareholder, and it does not dedicate a substantial amount of time to lobbying or other
political activities.2 A §501(c)(3) organization is considered a private foundation unless it
qualifies as a publicly supported organization under §509(a)(1)—(3).
An organization is publicly supported under §509(a)(2) when it satisfies that provision’s
two requirements. First, it must normally receive more than one-third of its support from public
sales related to the exempt purpose, admissions, membership fees, and similar undertakings.3
Second, it must not receive more than one-third of its income in the form of gross investment
income or unrelated business income.4 Library sale organizations are most often publicly
supported under this provision because they organize book sales for libraries in order to increase
public awareness for library services, encourage reading, and raise money to pass along to the
library.
1
Treas. Reg. § 1.513-1(b) (1967).
I.R.C. §501(c)(3) (2006).
3
I.R.C. §509(a)(2)(A) (2006).
2
2
A. ORIGINS OF UBIT
The Unrelated Business Income Tax was passed in the mid-twentieth century at the
behest of businesses that were competing head-to-head with tax-exempt organizations.5 The only
conceivable limitations on the income generating activities of a tax-exempt organization were the
requirements that are today embodied in the organizational test—that is, that an organization be
organized exclusively for its tax exempt purpose.6
It was at least arguable that an organization that was making money from activities
unrelated to its exempt purpose was not satisfying the organization test because it was engaging
in activities unrelated to its tax-exempt purpose.7 The actual rule however, was that organizations
paid no tax on income that was, in the end, used towards the exempt purpose of the
organization.8 Thus, charities could satisfy the test without regard to income-earning activity.
This end-use inquiry was known as the destination of income test.9
Interest in reworking the taxation of tax-exempt organizations came amid the uproar
surrounding New York University’s acquisition of the C.F. Mueller Company, a noodle factory.10
Businesses complained to Congress that the difference in taxation between the two types of
organizations constituted a subsidy that gave the tax-exempt business an unfair advantage over
4
I.R.C. §509(a)(2)(B) (2006).
NICHOLAS P. CAFARDI & JACLYN FABEAN CHERRY, TAX EXEMPT ORGANIZATIONS: CASES AND MATERIALS 823 (2d
ed. 2008).
6
Ethan G. Stone, Adhering to the Old Line: Uncovering the History and Political Function of the Unrelated
Business Income Tax., 54 EMORY L. J. 1475, 85 (2005).
7
Id.
8
Trinidad v. Sagrada Orden de Predicadores, 263 U.S. 578 (1924).
9
54 Emory L. J. at 1485.
10
Mark J. Cowan, Taxing and Regulating College and University Endowment Income: The Literature’s
Perspective, 34 J. OF U. & C. L. 507, 540 (2008).
5
3
taxable businesses. UBIT was signed into law in 1950. The law was tweaked in various ways up
until 1969, when the rules took their current form.11
Commentators recognize two important rationales for the imposition of a UBIT tax.12
The first rationale is that it actually makes the competition between exempt and non-exempt
organizations unfair. The second rationale implicates the revenue lost when the market share of
exempt organizations increases and that of taxed businesses decreases.13
The first rationale pertains to fairness in competition. This, of course, depends on what
one considers “fair.” One view of fair is that it means equal tax treatment. On the other hand fair
does not necessarily mean equal.14 If fair meant equal, all activities that compete with business
would be taxable. But if fair is not equal, then the question of where to draw the line between
those entities that are taxed and those that are not essentially boils down to a policy judgment.
This contemplates the assumption that, at the very least, the disparity supposedly caused by the
imposition of tax is not unfair where the tax-exempt organization’s business furthers its exempt
purpose. In this sense, fairness could become a function of how valuable we perceive an
11
54 Emory L. J. at 1484.
Id at FN 24. (citing BRUCE R. HOPKINS, THE LAW OF TAX-EXEMPT ORGANIZATIONS 744 (8th ed. 2003); Bittker &
Rahdert, supra note 20, at 316-20; Evelyn Brody, Of Sovereignty and Subsidy: Conceptualizing the Charity Tax
Exemption, 23 J. CORP. L. 585, 605-06 (1998); John Copeland & Gabriel Rudney, Business Income of Nonprofits
and Competitive Advantage, 33 TAX NOTES 747, 749-50 (1986); Harvey P. Dale, About the UBIT..., 18 N.Y.U.
CONF. ON TAX PLANNING FOR 501(C)(3) ORG. 9-1, 9-3 to 9-8 (1990); Kenneth C. Eliasberg, Charity and Commerce:
Section 510(c)(3)--How Much Unrelated Business Activity?, 21 TAX. L. REV. 53, 74-76 (1965); Mark A. Hall &
John D. Colombo, The Donative Theory of the Charitable Tax Exemption, 52 OHIO ST. L.J. 1379, 1442-43 (1991);
Richard L. Kaplan, Intercollegiate Athletics and the Unrelated Business Income Tax, 80 COLUM. L. REV. 1430,
1432-34 (1980); Donald L. Sharpe, Unfair Business Competition and the Tax on Income Destined for Charity:
Forty-Six Years Later, 3 FLA. TAX REV. 367, 370-71, 380-85 (1996); Note, The Macaroni Monopoly: The
Developing Concept of Unrelated Business Income of Exempt Organizations, 81 HARV. L. REV. 1280, 1280-82
(1968); Comment, Colleges, Charities and the Revenue Act of 1950, 60 YALE L.J. 851, 853 (1951). Of these,
Eliasberg's is the only serious historical study.)
13
Id. at 1485.
14
4 OKLA. PRAC. § 13:2 (2008) (division of marital property that is equitable is not necessarily equal).
12
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organization’s exempt purpose to be. In practice, however, no distinctions exist between
organizations based on exempt purpose.
The second rationale for UBIT goes to tax-exemption’s costs.15 The idea is that exempt
organizations take up market share that would otherwise be occupied by revenue generating
businesses.16 This idea may have some force, but it assumes a lot. Primarily, one must presume
that exempt organizations are going to carry on businesses in established, low-growth sections.
Exempt organizations probably aren’t well equipped to compete with these companies, as
discussed below.
The unfair competition rational is problematic in other respects as well. For instance, if
the business is one not allowed to incorporate under state, there is no corporate tax, thus there is
no disparity in taxation. The income that passes through to the partners in a law firm, for
example, is taxed in same as the income as that of lawyers working at Legal Aid. Furthermore,
businesses that do not require the capital structure of a large corporation can now elect pass
through tax treatment. Thus, businesses that are not growth-oriented, such as locally owned
shops, along with those that do not require equity financing cannot claim much harm due the tax
treatment of exempt organizations.
Although large corporation might be impacted by tax-exempt competition, corporations
enjoy distinct competitive advantages which help to minimize concern. Primarily, corporate
executives and employees may be compensated by company stock. The private inurement rule
prohibits exempt organizations from doing the same.
15
16
54 EMORY L. J. at 1490.
Id at 1491.
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B. UBIT APPLIED
Income is “unrelated” for the purpose of UBIT when it comes from a regularly carried on
trade or business that is not substantially related to an organization’s tax-exempt purpose.17 It is
important to remember that there are also many exceptions to UBIT. These exceptions are also
discussed below.
The “trade or business” requirement is the primary embodiment of the competition
rationale originally conceived of as the basis for the UBIT tax. A “trade or business” refers to an
organization’s money making activities—those “carried on for the production of income.”18
Trade or business is defined by reference to the competition rationale for UBIT. Treasury
regulations promulgated under IRC §512 thus identify several circumstances where a tax-exempt
organization’s money making activities are not considered a trade or business within the meaning
of IRC §512.19 For instance, your local NPR station that gives you a coffee mug when you
become a member does not have unrelated business income because it is a “low-cost article
incidental to the solicitation of charitable contributions” and as such is not a competitive threat to
taxpaying businesses.20 In contrast, a hospital pharmacy that sells to the general public does have
unrelated business income because it competes with taxpaying pharmacies.21
UBIT’s “regularly carried on” requirement also furthers the competition rationale by
assessing the way that a tax-exempt organization conducts its trade or business. The metrics for
17
I.R.C. §§511, 512 (2008).
Treas. Reg. §1.512(b)—1 (1992).
19
I.R.C. §513(h) (2006); Treas. Reg. §1.513-1(b) (1983).
20
I.R.C. §513(h); §1.513-1(b).
21
I.R.C. §513(h); §1.513-1(b).
18
6
determining how a business is carried on are frequency and continuity.22 While an organization
that conducts the same money making activity every Saturday is regularly carrying on,23 an
organization that holds an annual fundraiser on the same day is not.24
Finally, to avoid UBIT, a money making activity must be substantially related to the
organization’s pursuit of the purpose that forms the basis for its tax-exempt status.25 A
substantial relationship is a question involving the relatedness of the activity and the purpose,
along with the comparative size and the scope of the organization and the activity.26 With respect
to relatedness, the money making activity must “contribute importantly to the organization’s
accomplishment of its exempt purpose.”27 This inquiry into the nature of the relationship
between an organization’s purpose and a given money making activity is a based on the facts and
circumstances of each individual case.28
An example from the regulation explains that a theater school, tax-exempt for the purpose
of training children as stage performers, makes money from admission ticket sales. Performance
in front of people is an important component of training children as stage performers. Therefore,
the income from the ticket sales is not unrelated business income because of the close
relationship between the purpose of the school and the importance of the experience of
performing in front of people.29
22
Treas. Reg. §1.513—1(c)(1).
Treas. Reg. §1.513—1(c)(2)(i).
24
Treas. Reg. §1.513—1(c)(2)(iii).
25
Treas. Reg. §1.513—1(d)(1).
26
Treas. Reg. §1.513—1(d)(1).
27
Treas. Reg. §1.514(d)—1(2) (1972).
28
Treas. Reg. §1.514(d)—1(2).
29
Treas. Reg. §1.513(d)—1(4)(i).
23
7
Similarly, an activity’s size and scope must be appropriate to the organization’s purpose.
30
An activity will not satisfy the substantial relationship requirement if the size and scope of the
activity exceed what is necessary for the organization to accomplish its purpose.31 Finally, a trade
or business is not substantially related to the organization’s accomplishment of its purpose
merely because the profits from the activity go to that purpose.32
Even if an organization’s activities result in unrelated business income, a number of
exceptions may nevertheless exempt it from the unrelated business income tax. The exceptions
relevant to this article are found in IRC §513(a). They set out below.
Section 513 provides three exemptions from UBIT without regard to actual relatedness to
an organization’s purpose. First, UBIT is not applicable when the income involves the use of
“substantially all” work is conducted by unpaid volunteers. Second, UBIT does not apply to
businesses that exists “primarily for the convenience” of patrons and employees of 501(c)(3)
organizations and private institutes of higher education. This would cover laundry machines in a
dorm basement or a restaurant operated on museum grounds during museum hours. Finally,
income is not unrelated when the income is from sales of merchandise “substantially all” of
which is donated to the organization. Thrift shops are illustrative of this exception.
III. LIBRARY SALES—GENERAL BACKGROUND
There are thousands of library support organizations in the United States. Hundreds,
possibly thousands, hold book sales. This section contains two parts. The first part briefly
30
Treas. Reg. §1.513(d)—1(3).
Treas. Reg. §1.513(d)—1(3).
32
Treas. Reg. §1.514(d)—1(2).
31
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describes some of general aspects of library sales, as well facts relevant to tax issues. The
relevance of these legal facts is discussed in part two.
A. LIBRARY SALES GENERALLY
Many support organizations exist to raise money for the improvement of libraries.33 Often
these organizations are referred to as “Friends of the Library.” Friends organizations may be
concerned with generating public interest in library services, in increasing the quality and
quantity of library collections, or in improving the facilities housing library collections. To
achieve their exempt purposes, many of these organizations hold annual or semiannual book
sales on one or two weekends a year to raise money for their libraries. These sales vary in size
but the support organizations typically make money from a combination of two sources—
membership fees34 and book sales.
The books one is likely to find at a library sale vary widely from fiction and children’s
books, to all sorts of nonfiction, paperback to hardbound. A book sale is likely comprised both of
books that are donated to the support organization by the general public and of books that are
discarded by the library. A library discards books as the result of combing its collection. When a
library combs its collection, it is weeding out unwanted books and thus making room for new
books. As I will discuss, below, a book that is not in demand in the local community may
33
A search on Guidestar.org for “friends of” and “library” returns 4,729 hits.
http://www.guidestar.org/pqShowFastResults.do;jsessionid=239A30047CD9ABAB63A877B865B6DF43.web06Wo
rker.web06Worker?partner=guidestar&source=homepage, accessed Dec. 4, 2008.
34
Anecdotally, these membership fees are offered in consideration for early admission to the sale. This article does
not address this issue, except to mention briefly two points. First, people who purchase memberships in exchange for
“first dibs” at a book sale are probably not eligible for the charitable deduction because there is a bargained-for
exchange. The presence of consideration negates the charitable intent necessary to take the deduction. Second, an
organization selling tickets to enter an event under the guise of “memberships” may run into UBIT problems. For
instance, the sale of tickets to an event may qualify as a trade or business while membership payments, in contrast,
are essentially gifts.]
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nevertheless command significant value. This idea relates to the so-called “Long Tail”—the idea
that, thanks to the internet, market niches are much easier to identify and therefore demand for
unique items will increase.35
Most library sales are organized and run by unpaid, volunteers. In fact, library support
organizations that do not manage investments are unlikely to have any paid staff at all.
B. TAX ISSUES IN GENERAL LIBRARY SALES
Without question, UBIT does not apply to your typical library sale. There are several
reasons. Most library sales do not satisfy the definition of unrelated business income as the term
is defined in §512. First, annual library sales are not regularly carried on within the meaning of
Treasury Regulation §1.513(c). While they are often held on the same weekend each year, this,
standing alone, does not establish regularity. A library’s sale of books in the community is also
arguably consistent with the purpose of library support organizations that are savvy enough to tie
their exempt purpose to literacy and reading in the community.
Even those organizations that have unrelated business income, such a support
organizations that hold weekly or monthly sales, or those who operate stores, will likely fall
within one of the UBIT exceptions listed above. But libraries relying solely on the exceptions to
avoid the UBIT should tread cautiously. First, organizations often make use of free labor, thus
satisfying the volunteer requirement. A library wishing to rely on this exception must make sure
that any “first dibs” options or free books offered to volunteers remain trivial and incidental.
Second, an organization might argue that its sale falls under the donation exception because
35
See generally CHRIS ANDERSON, THE LONG TAIL: WHY THE FUTURE OF BUSINESS IS SELLING LESS OF MORE
(2006).
10
“substantially all” of the goods it sells are donated. This exception is an unreliable basis for
avoiding UBIT and would require cautious planning.
To begin with, a sale organizer must insure that “substantially all” of the books it sells are
donated. One complicating issue is that it is questionable whether, in the instance of a library
transferring ownership of its discarded books to a library sale organizer, such a transfer of
ownership is donative. The library is giving up the books with the expectation that they will be
sold and that the support organization will either remit the money to the library or spend the
profits for its benefit. That sounds like a sale in kind, with the selling organization taking as a
basis the fair market value of the collection.36
The money that a sale organizer raises as a result of the subsequent sale is arguably the
basis of the collection of books.37 A sale organizer will typically sell many books, but will also
have many leftover. Library sales typically sell their books for anywhere between twenty-five
cents and one dollar. The basis of the collection as a whole, however, is significantly less than
the sale price of each book because one must count on having plenty of leftovers. In any event,
the basis would never exceed the fair market value of the books because it will never earn more
from a sale than it actually earns. And because the basis is defined with regard to this number,
there is not income.
Meanwhile, with respect to donated books, the seller’s basis is the donor’s basis.38
Because the donor almost always paid more for a book than it will garner at a sale, there is no
36
I.R.C. §1012 (2008).
I.R.C. §1012.
38
I.R.C. §1015.
37
11
income. And again, if the sale is comprised of “substantially all” donated books the sale is
exempted from UBIT in any event.
This is all straightforward enough. What makes things confusing is that, in practice, the
books in a sale comprise a mix of donated and discarded books. When within the collection there
is a noteworthy collection of discarded books treated like a sale, the collection as a whole may no
longer be “substantially all” donated. The UBIT exception for donated goods would not apply.
And while a sale would still not have income, it is important to note that technically UBIT will
apply if there is income.
While libraries still want to benefit from the publicity and goodwill of their traditional
sales. But they are increasingly beginning to realize that they can cost-effectively sell a relatively
small proportion of their books on the internet and still sell the vast majority of the popular books
at their traditional sales. Updating, or the constant manual or computer-based readjusting of the
prices of books listed online, is an important component to staying competitive with downward
trending online marketplace prices. As libraries begin to realize the potential for selling online,
they will realize that they are unequipped to compete with online bookselling businesses.
Primarily, frequent price readjustments, accurate condition listing, and consistent, daily shipping
are all labor intensive and difficult to maintain in a volunteer-based organization. Accordingly,
smart organizations will pay experts to run their online bookselling businesses.
To begin with, online bookselling would almost certainly qualify as a regularly carried on
trade or business that is not substantially related to organization’s exempt purpose. It is possible
that the sale organizer will satisfy the IRS that its broadly articulated purpose (say, promoting
12
literacy in general) is substantially furthered by selling books that people will then read. Of
course, Borders could pair up with the Library of Congress and say the same thing. Moreover,
UBIT application in these instances is supported by the general purpose behind UBIT.
There are at least two ways that a careful sale planner can nevertheless avoid UBIT. First,
the sale planner may want to divide the sales operations into donated books and then discarded
books. By doing this, they may sell the donated books under the thrift shop exception. The
discards would still be taxed according to their bases.
As discussed above, the basis of discarded books could become complex. In the relatively
rare but nevertheless regular event that a book’s used value exceeds its cost basis, the amount is
clear. But usually, books sell for less than their cost basis. And because market values fluctuate
with such frequency, it is difficult, if not impossible to accurately affix the fair market value of
the books until they are sold. The easiest way to determine basis is to use the lowest sale price at
the time the library transfers the book to the seller. But this will result in prohibitive recordkeeping requirements and will thus probably deter many sellers.
A better solution might be to consider the basis of discarded books as a lot, rather than
individually. Many books sell on sites like Ebay for wholesale prices. Moreover, if organizations
outsourced their online book sales to professional sellers, they’d be able to avoid UBIT and treat
the sale as the sale of a lot, without reference to individual prices.
IV. ALTHOUGH ORGANIZATIONS CAN PLAN AROUND IT, UBIT SHOULD NOT APPLY TO
LIBRARY SALES TO BEGIN WITH
The fair competition rationale, as applied to exempt booksellers, should not concern
policymakers. Most FOLs will only collect books from their local communities. That is a
13
significant limitation on their growth. Thus, similarly situation booksellers, with no prospects of
venturing outside of a local community, would probably not be organized as a taxable
corporation to begin with.
Second, although the merits of an organization’s exempt function do not weigh on the
question of fairness from the legal perspective, the libraries that FOLs support are particularly
worthy. Libraries are important focal points in the community in that they often provide outreach
to the disenfranchised and elderly, for instance, in winter and summer. Private funding of
libraries help alleviate the taxpayer’s burden for things that we’d certainly have to pay for in
some form or another. Thus, this also helps to mitigate any revenue lost by allowing for library
tax exemption.
V. CONCLUSION
FOL organizations that sell their books online may run into UBIT problems. These
problems may be addressed in part through careful planning. In any event, imposing UBIT on
libraries is inconsistent with the tax’s purpose because unfair competition is not present because
library booksellers would not typically compete with businesses that are subject to corporate tax
and the revenue they earn will go to government, as would a tax. Therefore, the IRS or Congress
should reconsider its treatment of the issue.
14