and to direct the organizations to which the corpus of the contributions is eventually to be given.507
(c) Private Foundations
A private foundation, then, is a charitable organization508 that is not one of the foregoing types of charitable organizations. It is essentially a charitable organization that is funded from one source (usually, one individual, family, or corporation); that receives its ongoing funding from investment income (rather than a consistent flow of charitable contributions); and that makes grants for charitable purposes to other persons rather than conducting its own programs.
§ 2.5 UNRELATED BUSINESS LAW
The unrelated business income rules that are applicable to charitable and other tax-exempt organizations were enacted in 1950, were significantly enhanced in 1969,509 and have been augmented by nearly every subsequent tax act. The objective of these rules is to prevent unfair competition between tax-exempt organizations and for-profit, commercial enterprises.510 The rules are intended to place the unrelated business activities of a tax-exempt organization on the same tax basis as the nonexempt business with which it competes.
(a) Overview of Law
Prior to enactment of the unrelated income rules, the federal law embodied the destination of income test.511 Pursuant to this standard, the law merely required that the net profits of organizations be used in furtherance of exempt purposes. That is, the test did not consider the source of the profits, thereby tolerating forms of unfair competition. Thus, in adopting and expanding these rules, Congress has not prohibited commercial ventures by nonprofit organizations. Rather, it struck a balance, as the U.S. Supreme Court characterized the matter, between “its two objectives of encouraging benevolent enterprise and restraining unfair competition.”512
Essentially, for an activity of a tax-exempt organization to be subject to tax, four tests must be satisfied. The activity must (1) constitute a trade or business, (2) be regularly carried on, (3) not be substantially related to the tax-exempt purposes of the organization, and (4) not be specifically exempted (or have the income from the activity specifically exempted) from taxation.513
Nearly all types of tax-exempt organizations, including charitable ones, are subject to the unrelated income rules.514 The unrelated income rules are also applicable “in the case of any college or university which is an agency or instrumentality of any government or any political subdivision thereof, or which is owned or operated by a government or any political subdivision thereof, or by any agency or instrumentality of one or more governments or political subdivisions,” as well as “in the case of any corporation wholly owned by one or more such colleges and universities.”515
To be tax-exempt, an organization must be organized and operated primarily for exempt purposes.516 The federal tax law allows an exempt organization to engage in a certain amount of activity unrelated to its exempt purposes.517 When the organization derives net income from one or more unrelated business activities, known as unrelated business taxable income, it is subject to tax on that income. An organization's tax exemption will be revoked if an inappropriate portion of its activities is not in furtherance of an exempt purpose.518
Business activities may preclude initial qualification of an otherwise exempt organization as a charitable or other entity. This would occur through its failure to satisfy the operational test, which looks to see whether the organization is being operated principally for exempt purposes.519 Likewise, an organization will not meet the organizational test if its articles of organization empower it, as more than an insubstantial part of its activities, to carry on activities that are not in furtherance of its exempt purpose.520
(b) Definition of Trade orBusiness
For purposes of the federal tax rules, the term trade or business, in this setting, includes “any activity which is carried on for the production of income from the sale of goods or the performance of services.”521 Accordingly, most activities that would constitute a trade or business under basic tax law principles522 are considered a trade or business for purposes of the unrelated trade or business rules.523
This definition of trade or business is broadly encompassing and embraces nearly every activity of a tax-exempt organization. Absent a specific exemption,524 only investment activities generally escape this classification.
In this sense, every tax-exempt organization is viewed as a bundle of activities, each of which is a trade or business. Thus, the IRS is empowered to examine each of the activities in the bundle in search of an unrelated business endeavor. As Congress chose to state the principle, “an activity does not lose identity as a trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of the organization.”525 This is known as the fragmentation rule.
Congress also enacted a rule stating, “Where an activity carried on for profit constitutes an unrelated trade or business, no part of such trade or business shall be excluded from such classification merely because it does not result in profit.”526
(c) Regularly Carried On Rule
To be considered an unrelated trade or business, an activity of a tax-exempt organization must be regularly carried on by the organization.527
Income from an activity of a tax-exempt organization is considered taxable only when, assuming the other criteria are satisfied, the activity is regularly carried on, as distinguished from sporadic or infrequent commercial transactions.528 The factors determining whether an activity is regularly carried on are the frequency and continuity of the activity and the manner in which the activity is pursued.529
These factors must be evaluated in light of the purpose of the unrelated business income tax: to place tax-exempt organizations' business activities on the same tax basis as those of their
