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Nonprofit Teaching Hospitals Subject to Income Tax on Fees from Third-Party Vendors

(Parker Tax Publishing January 2018)

The Tax Court held that fees received by a nonprofit membership organization, whose members consist primarily of teaching hospitals operating in New Jersey, under contracts with third parties were not excluded from unrelated business taxable income as either (1) royalties under Code Sec. 512(b)(2), or (2) amounts received in a trade or business carried on primarily for the convenience of the organization's members under Code Sec. 513(a)(2). New Jersey Council of Teaching Hospitals v. Comm'r, 149 T.C. No. 22 (2017).

Those revenues, the court said, were derived from an unrelated trade or business that the nonprofit regularly carried on and thus constituted unrelated business taxable income subject to the unrelated business income tax.

The New Jersey Council of Teaching Hospitals (NJCTH) is a membership organization whose members consist primarily of teaching hospitals operating in New Jersey. It is a tax-exempt charitable organization under Code Sec. 501(c)(3) whose exempt purposes include promoting health care and medical education. During its calendar tax years 2004-2007, NJCTH contracted with third-party vendors to provide its members (hospitals and a medical school) access to debt-collection services and group purchasing programs. NJCTH received fees from the vendors in exchange for administering these programs and promoting the programs to its members.

On its Forms 990, Return of Organization Exempt From Income Tax, NJCTH treated all of these receipts as "substantially related" to the conduct of its tax-exempt purposes, and thus as exempt from federal income tax. The IRS audited NJCTH's returns and determined that the fees it received from the third-party vendors constituted unrelated business taxable income (UBTI) subject to unrelated business income tax (UBIT) under Code Sec. 511(a)(1) and Code Sec. 512(a).

In reaching these determinations, the IRS rejected NJCTH's reliance on Code Sec. 513(a)(2), which provides that an unrelated trade or business does not include an activity which is carried on by the organization primarily for the convenience of its members. NJCTH's efforts to secure economic benefits due to bulk marketing, the IRS said, did not constitute an activity under taken primarily for its members' convenience. The IRS likewise rejected NJCTH's reliance on Code Sec. 512(b)(2), which excludes royalties from UBIT. In the IRS's view, the third-party vendors were paying fees to NJCTH, not for the use of its intangible property, but for its services in endorsing, marketing, and administering those programs. The IRS concluded that a charity's need for revenues to accomplish its charitable mission does not make a questioned activity related to its exempt purposes.

The Tax Court agreed with the IRS and held that the fees NJCTH received from the third-party vendors represented payments for services and thus did not constitute "royalties" within the meaning of Code Sec. 512(b)(2). The court noted that, while the term "royalties" is not defined in the Code or regulations, case law has defined the term as "payments for the right to use intangible property" and NJCTH did not receive fees from the vendors for the use of intangible property. The Tax Court also held that the business activities that gave rise to the fees NJCTH received from the third-party vendors were not carried on primarily for the convenience of its members within the meaning of Code Sec. 513(a)(2). The court concluded that, given the inapplicability of the exclusions in Code Sec. 512(b)(2) and Code Sec. 513(a)(2), the fees NJCTH received from the third-party vendors were subject to UBIT because they were derived from an unrelated trade or business that NJCTH regularly carried on.

For a discussion of the unrelated business income tax, see Parker Tax ¶66,100.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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