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									   The Unrelated Business Income Tax and the Future of the Online Library-
                                 book Sales
                                                      by Keaton Oberst
                                                      Table of Contents
I. UBIT AND LIBRARY SALES ........................................................................................................ 1

   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
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 tax-

exempt 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,

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.

           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


  Treas. Reg. § 1.513-1(b) (1967).
  I.R.C. §501(c)(3) (2006).
  I.R.C. §509(a)(2)(A) (2006).
        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

  I.R.C. §509(a)(2)(B) (2006).
ed. 2008).
  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).
  Trinidad v. Sagrada Orden de Predicadores, 263 U.S. 578 (1924).
  54 Emory L. J. at 1485.
   Mark J. Cowan, Taxing and Regulating College and University Endowment Income: The Literature’s
Perspective, 34 J. OF U. & C. L. 507, 540 (2008).
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

   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.)
   Id. at 1485.
   4 OKLA. PRAC. § 13:2 (2008) (division of marital property that is equitable is not necessarily equal).
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.

     54 EMORY L. J. at 1490.
     Id at 1491.
        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

   I.R.C. §§511, 512 (2008).
   Treas. Reg. §1.512(b)—1 (1992).
   I.R.C. §513(h) (2006); Treas. Reg. §1.513-1(b) (1983).
   I.R.C. §513(h); §1.513-1(b).
   I.R.C. §513(h); §1.513-1(b).

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

   Treas. Reg. §1.513—1(c)(1).
   Treas. Reg. §1.513—1(c)(2)(i).
   Treas. Reg. §1.513—1(c)(2)(iii).
   Treas. Reg. §1.513—1(d)(1).
   Treas. Reg. §1.513—1(d)(1).
   Treas. Reg. §1.514(d)—1(2) (1972).
   Treas. Reg. §1.514(d)—1(2).
   Treas. Reg. §1.513(d)—1(4)(i).
           Similarly, an activity’s size and scope must be appropriate to the organization’s purpose.
     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

   Treas. Reg. §1.513(d)—1(3).
   Treas. Reg. §1.513(d)—1(3).
   Treas. Reg. §1.514(d)—1(2).
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.

         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

   A search on Guidestar.org for “friends of” and “library” returns 4,729 hits.
rker.web06Worker?partner=guidestar&source=homepage, accessed Dec. 4, 2008.
   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.]
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.

       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

“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

   I.R.C. §1012 (2008).
   I.R.C. §1012.
   I.R.C. §1015.
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

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 record-

keeping 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.

                         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

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.


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