IRS rules that stream mitigation credit sales are not unrelated business income

Plain-English summary

A nonprofit environmental organization operated a nature center and planned to create and sell stream mitigation credits. The IRS ruled that the organization's stream restoration and mitigation-bank activities were substantially related to its exempt purposes because they helped lessen the burdens of a governmental commission that had delegated conservation and mitigation responsibilities to the organization. The income from selling the credits therefore would not be unrelated business taxable income under section 512(a)(1). The conclusion depended on the facts, including the conservation easement, the commission's legal obligations, and the organization's role in planning, funding, monitoring, and selling the mitigation credits.

Ruling snapshot

• Question: Were the organization's stream mitigation activities substantially related to its exempt purpose, and was credit-sale income excluded from unrelated business taxable income?
• Outcome: Approved, mitigation credit income not treated as unrelated business taxable income
• Key authorities: IRC §§ 501(c)(3), 511, 512, and 513; Treas. Reg. §§ 1.501(c)(3)-1 and 1.513-1; Rev. Rul. 85-1 and Rev. Rul. 85-2

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Number: 201408031 Contact Person:

Release Date: 2/21/2014
Identification Number:

Date: November 27, 2013 Telephone Number:

Employer Identification Number:

Legend: UIL: 511.00-00; 512.00-00;
Watershed 513.00-00

Preserve
Commission
State

County

This is in response to your ruling request for a ruling as to whether certain activities
conducted by you constitute an unrelated trade or business and whether the sale of
proceeds derived from those certain activities are taxable as unrelated business taxable
income under sections 511 through 514 of the Internal Revenue Code (“Code”).

Facts:

You are a State non-profit corporation described in § 501(c)(3). You were organized for
cultural and other educational purposes within the meaning of § 501(c)(3) and were
specifically formed to educate individuals about the arts and natural sciences. You built
and manage a nature center, as well as related facilities including nature trails to
provide formal and participatory environmental education to students and the general
public. In furtherance of your exempt purpose, you educate the public about the
environment through museum exhibits, special programs, and interactive experiences in
Preserve. You serve over 30,000 students from more than 35 school systems and an
additional 25,000 visitors each year. You are supported by program fees,
memberships, fundraising events, museum admissions, and donations from
corporations and individuals.

You later amended your articles of incorporation to expand the description of your
exempt purposes. Your purposes now include protecting the natural and scenic spaces
of real property, protecting natural resources, and maintaining or enhancing water and
air quality. In furtherance of these amended purposes, you protect the natural
resources of Watershed, which includes Preserve. Preserve is owned by Commission
and is leased to you.

You have represented that Commission was created as a public corporation by the
State Legislature under an act of the general assembly of State, and Commission is
considered a political subdivision of State. An act of State Legislature passed in 1980
reads, “There is hereby created a body corporate and politic to be known as
[Commission under its former name], which shall be deemed to be a political
subdivision of [State] and a public corporation by that name...” An act of State
Legislature passed in 1988 reads, “The body corporate and politic...known as
[Commission under its former name], is hereby renamed as [Commission]... the general
purposes of the commission are declared to be: acquiring, constructing, equipping,
maintaining, and operating a recreational center and area or centers and areas... and
doing any and all things deemed by the commission necessary, convenient, or desirable
for and incident to the efficient and proper development and operation of such types of
undertakings." Further, nine of eleven members of Commission are appointed by
County or City. The 1988 Act reads, “[Commission] shall consist of 11 members...Four
of such members shall be appointed by the commissioners of [City] ..., five members
shall be appointed by the board of commissioners of [County]..., and two members shall

be appointed by [Commission].”

In Year 1, Commission entered into an agreement whereby it leased to County the
acreage necessary for constructing an environmental center on Preserve. Commission
then subleased this land back from County and assumed “total responsibility” for the
operation, regulation and maintenance of the center. Commission selected you as the
sole managing agent and operator of the center and leased that portion of land to you
for a substantial term. It also forbade you from making any capital improvements to the
land (other than regular maintenance) without first notifying and seeking its approval. In
Year 2, Commission leased additional acreage in the Watershed to you and extended
the term of your lease. This amended contract clarified that during the lease period you
may not “erect any currently unplanned substantial improvements, substantially alter the
topography, nor substantially alter the vegetation growing upon said leased premises
without the prior consent of Commission entered upon the Commission minutes.”

Under a Declaration of Conservation Covenants and Restrictions, Commission
covenants to maintain the majority of this additional land as stream buffers.

Commission then executed a Deed of Conservation Easement to you in which the entire
acreage is subject to your management for conservation purposes.

Thus, you hold a perpetual conservation easement over Preserve and some additional
tracts in Watershed that contain streams. You indicate that this perpetual easement

ensures that Preserve is kept undeveloped and its conservation values are preserved
by maintaining the woodland and natural character of the property. Additionally, you are
responsible for complying with Commission's covenant regarding maintaining stream
buffers.

A few years ago, you hired a consultant to perform an environmental assessment of
Watershed. The assessment pointed out significant problems with the stream quality in
Watershed and determined the steps necessary to remediate Watershed’s waterways.
You received a Clean Water Act Section 319 grant to address certain storm water
detention and stream restoration, and could possibly obtain other such grants in the
future. A national program to address nonpoint sources of water pollution provides
funds for the grants that originate from the Federal government, and are then allocated
to state nonpoint source agencies. The state agencies may award the grants to
awardees such as you. The state agencies must ensure that awardees comply with
Federal laws and that their projects are designed in compliance with those laws.
However, since grant funding may be sporadic, in order to complete the remediation
activities, you plan to form a stream mitigation bank with support of Commission.

By conducting stream mitigation activities to restore deeply eroded, degraded streams
to a functional form, as part of operating the stream mitigation bank, you will generate
mitigation credits that can be sold within an environmental conservation program
created and managed by various state and Federal agencies. More specifically, as
inducement to invest in the significant costs associated with stream restoration, the U.S.
Army Corps of Engineers (“Corps”), with the cooperation and participation of other
Federal and state agencies, oversees a program, pursuant to authority under Section
404 of the Clean Water Act or Section 10 of the Rivers and Harbors Act of 1899, that
allows the owner of impaired streams to create value by restoring and preserving the
streams and receive “credits” from the restoration and preservation activities. A stream
mitigation bank is the legal structure that provides the mitigation credits. The creation of
credits occurs under a mitigation banking instrument that must be approved by the
Corps, and the number of credits to be awarded for completed work is established in the
mitigation banking instrument. Releases of credits in the mitigation bank occur when
the work has been satisfactorily performed under the requirements of the mitigation
banking instrument. Once all of the mitigation credits are sold, as discussed below,
there are no additional proceeds from the mitigation bank. However, the owner/sponsor
of the mitigation bank is responsible for the monitoring and maintenance of the restored
stream reaches for seven years after completion of the final phase. In your case, after
this seven year period, you, as Trustee for the Preserve, are charged with management
of the water resources in perpetuity.

The mitigation credits generated by your stream mitigation activities can be sold to
private developers or governmental units who have projects which may cause any
stream disturbance or impact on a stream somewhere else in the primary service
watershed. Such projects include the construction of bridges or piped road crossings.
The Corps is responsible for providing permits to developers as pertinent to stream

effects, and for public review and comment of permits. In order to receive construction
permits, the Corps requires developers to mitigate the environmental impacts of their
projects as feasible. The intent of the Corps in its mitigation programs is to ensure that
there is “no net loss” to the stream or wetland environments. Mitigation credits serve as
a preferred option for meeting the requirements. If the developer proposes this option,
the amount of credits a developer must buy is dependent on the length and severity of
the impact on the given streams within a developer's project, and is determined by the
Corps. The pricing of mitigation credits is market-driven. The Corps does not regulate
the pricing of the mitigation credits. However, the Corps is the entity that issues the
mitigation credits when the mitigation work is completed in accordance with the terms of
the mitigation banking instrument. Sale of mitigation credits is restricted to developers
of projects in the primary service area watershed or, after certain penalties are applied,
in secondary zones.

Commission entered into a contractual agreement with you authorizing you to form a
stream mitigation bank (Bank). Commission appointed you as the manager of Bank
and delegated to you the authority to negotiate the banking instrument with the Corps
and other state and Federal agencies. You and Commission submitted the mitigation
banking instrument to the Corps, the U.S. Environmental Protection Agency, the U.S.
Fish and Wildlife Service, and the State Department of Natural Resources. The banking
instrument was approved and is administered by the Corps on behalf of itself and the
other agencies. Under the terms of the banking instrument, Commission is the sponsor
of Bank. The banking instrument makes clear that as the sponsor, Commission is
solely responsible for “planning, funding, developing, managing and monitoring Bank in
accordance with the Mitigation Banking instrument.” As noted above, in addition to
signing the banking instrument, Commission also executed the Deed of Conservation
Easement and restrictive covenant related to Watershed to you. As manager of the
Bank and under the Deed and contractual agreement with Commission, you provide the
financing, supervision and future monitoring of preservation construction requirements,
and conduct and fund the mitigation activities. Commission authorized you to sell all the
mitigation credits generated from Bank.

You state that your activity of protecting Watershed lessens the governmental burdens
of Commission, “to care for [Preserve] and [Watershed].” You state that the effect of the
Deed of Conservation Easement is to require you to perform the obligations of
Commission, as owner of the Preserve, including those requiring affirmative action
under the Declaration of Conservation Covenants and Restrictions and those arising
under the Bank instrument. You represent that this arrangement with Commission was
in accordance with all laws of State, including contracting provisions. You expect to
spend several million dollars in performing your obligations to Commission. In addition,
a commitment has been made by you, County, and City to address storm water
management issues in the developed areas surrounding Preserve.

Rulings Requested:

1. That your stream mitigation activities are substantially related to your exempt
   purpose under § 501(c)(3) of the Code and do not constitute an unrelated trade or
   business within the meaning of § 513(a).

2. That the income you receive from the sale of credits by Bank is not unrelated
   business taxable income under § 512(a)(1).

Law:

Section 501(c)(3) of the Code provides in part for the exemption from federal income tax
of organizations organized and operated exclusively for religious, charitable, or
educational purposes.

Section 511(a) imposes a tax on the unrelated business taxable income of
organizations described in § 501(c).

Section 512(a)(1) defines the term “unrelated business taxable income” as the gross
income derived by any organization from any unrelated trade or business regularly
carried on by it, less certain allowable deductions and modifications.

Section 513(a) defines the term “unrelated trade or business” as any trade or business
the conduct of which is not substantially related (aside from the need of such
organization for income or funds or the use it makes of the profits derived) to the
exercise or performance by such organization of the functions constituting the basis for
its exemption.

Section 513(c) provides that the term "trade or business" includes any activity which is
carried on for the production of income from the sale of goods or the performance of
services.

Section 1.501(c)(3)-1(d)(1)(i) of the Income Tax Regulations (“Treas. Reg.”) provides
that an organization may be recognized as an organization described in § 501(c)(3) of
the Code if it is operated exclusively for one or more of the following purposes: religious,
charitable, scientific, testing for public safety, literary, educational, or prevention of
cruelty to children or animals.

Section 1.501(c)(3)-1(d)(2) of the Treas. Reg. provides a definition of the term
“charitable” as it is used in § 501(c)(3) of the Code. The term “charitable” is used in its
generally accepted legal sense and includes lessening of the burdens of government.

Section 1.513-1(a) of the Treas. Reg. provides that gross income of an exempt
organization subject to the tax imposed by § 511 of the Code is includible in the
computation of unrelated business taxable income if: (1) it is income from a trade or
business; (2) such trade or business is regularly carried on by the organization; and (3)

the conduct of such trade or business is not substantially related (other than through the
production of funds) to the organization’s performance of its exempt functions.

Section 1.513-1(c)(1) of the Treas. Reg. provides that in determining whether trade or
business from which a particular amount of gross income derives is “regularly carried
on,” within the meaning of § 512 of the Code, regard must be had to the frequency and
continuity with which the activities productive of the income are conducted and the
manner in which they are pursued. For example, specific business activities of an
exempt organization will ordinarily be deemed to be “regularly carried on” if they
manifest a frequency and continuity, and are pursued in a manner, generally similar to
comparable commercial activities of non-exempt organizations.

Section 1.513-1(d)(1) of the Treas. Reg. provides that gross income derives from
“unrelated trade or business” within the meaning of § 513(a) of the Code if the conduct
of the trade or business which produces the income is not substantially related (other
than through the production of funds) to the purposes for which exemption is granted.

Section 1.513-1(d)(2) of the Treas. Reg. provides that a trade or business is “related” to
exempt purposes, in the relevant sense, only where the conduct of the business
activities has a causal relationship to the achievement of exempt purposes, and it is
“substantially related” only if the causal relationship is a substantial one. For the
conduct of trade or business from which a particular amount of gross income is derived
to be substantially related to purposes for which exemption is granted, the production or
distribution of the goods or the performance of the services from which the gross
income is derived must contribute importantly to the accomplishment of those purposes.

Rev. Rul. 85-1, 1985-1 C.B. 177 and Rev. Rul. 85-2, 1985-1 C.B. 178, recognize as
charitable certain organizations that assist state and local governments in carrying out
their functions. The criteria for determining whether an organization’s activities lessen
the burdens of government are first, whether the governmental unit considers the
organization’s activities to be its burden; and second, whether these activities actually
lessen the burden of the governmental unit. An activity is a burden of the government if
there is an objective manifestation by the governmental unit that it considers the
activities of the organization to be its burden. The interrelationship between the
governmental unit and the organization may provide evidence that the governmental
unit considers the activity to be its burden. Whether the organization is actually
lessening the burdens of government is determined by considering all of the relevant
facts and circumstances. A favorable working relationship between the government and
the organization is strong evidence that the organization is actually “lessening” the
burdens of the government. However, the fact that the government or an official of the
government expresses approval of an organization and its activities is not sufficient to
establish that the organization is lessening the burdens of government. See Rev. Rul.
85-2, supra (concluding that the organization’s activity of training guardians ad litem
actually lessens the burdens of the juvenile court, in part because the court uses the
volunteers trained by the organization). Thus, the functions that constitute the burdens

of government must be identified and the organization’s activities must actually lessen
those burdens.

In Virginia Professional Standards Review Foundation v. Blumenthal, 466 F. Supp.
1164 (D.D.C. 1979) (“Virginia PSRO”), two organizations were formed pursuant to a
federal law that provided for the establishment of professional standards review
organizations (“PSROs’) to ensure the effective, efficient and economic delivery of
health care services to Medicare and Medicaid beneficiaries. The Department of
Health, Education, and Welfare was charged with implementation of the PSRO
program. The district court stated that “[t]ne legislative history of the statute indicates
that the PSRO programs were created essentially to act in the government's place in
ensuring the ‘effective, efficient and economic’ delivery of health care services to
Medicare and Medicaid beneficiaries.” Id. at 1166. The court also stated that “[i]t is well
established that a corporation which provides a community benefit...or lessens the
burdens of government...may be regarded as engaged in charitable activities.” Id. at
1170. The court concluded that these organizations operated exclusively for charitable
purposes under § 501(c)(3) of the Code.

In Professional Standards Review Organization of Queens County, Inc. v.
Commissioner, 74 T.C. 240 (1980), acq., 1980-2 C.B. 2 (‘Queens County PSRO”), the
Tax Court held that an organization created pursuant to a federal statute that reviewed
the appropriateness and quality of healthcare services provided to Medicare and
Medicaid recipients was exempt under § 501(c)(3) of the Code because it lessened the
burdens of government. The Tax Court held that the PSRO’s activities of lessening the
burdens of the Federal Government and promoting public health far outweighed any
incidental benefit that individual physicians, or even the profession as a whole, would
derive from petitioner's purposes and activities.

In Columbia Park and Recreation Assoc. v. Commissioner, 88 T.C. 1 (1987), affd
without published opinion, 838 F.2d 465 (4th Cir. 1998), the court of appeals upheld the
decision of the Tax Court that the organization did not lessen any burden of government
and thus, was not exempt under § 501(c)(3) of the Code. The organization provided a
wide range of services and facilities to the residents of Columbia, Maryland. The
organization contended that if it did not provide these services and facilities the local or
state government would have to provide them. The Tax Court stated that this assertion
does not mean that the organization's activities are, in fact, a burden of government.
Instead, the organization must demonstrate that the State of Maryland and/or the county
accept the organization’s activities as their responsibility and recognize the organization
as acting on their behalf. In addition, the organization must further establish that its
activities actually lessen the burden of the state or local government.

In Indiana Crop Improvement Association, Inc. v. Commissioner, 76 T.C. 394 (1981),
acq. 1981-2 C.B. 1, the Tax Court found that the organization was described in §
501(c)(3) of the Code because, among other purposes, it was lessening the burdens of
government. The organization’s primary activity was the certification of crop seed within

the State of Indiana; a substantial amount of time was also spent conducting scientific
research in seed technology and providing instruction in modern seed technology in
conjunction with Purdue University. The State of Indiana did not have a department of
agriculture to regulate agricultural products within the State and delegated by law
agricultural regulatory functions to Purdue University and the director of the Purdue
University Agricultural Experiment Station; the function of seed certification was in turn
delegated by Purdue University to Indiana Crop Improvement Association, Inc. The Tax
Court found that as the official seed certifying agency for the State of Indiana, the
organization was directly assisting the U.S. Department of Agriculture in enforcing the
standards and procedures established under federal statute rather than primarily
promoting the economic interests of commercial seed producers and commercial
farmers.

In Better Business Bureau of Washington, D.C. v. United States, 326 U.S. 279, 283, 66
S. Ct. 112, 90 L. Ed. 67, 1945 C.B. 375 (1945), the Court stated that “the presence of a
single . . . [nonexempt] purpose, if substantial in nature, will destroy the exemption
regardless of the number or importance of truly . . . [exempt] purposes.”

Analysis:

You have requested a ruling that your stream mitigation activities in Watershed are
substantially related to your exempt purposes and do not constitute an unrelated trade
or business within the meaning of § 513(a) of the Code.

“Unrelated business taxable income’ is gross income derived from any unrelated trade
or business that is regularly carried on by the organization. Section 512(a)(1). Gross
income of an exempt organization is taxable income if: (1) it is income from a trade or
business; (2) such trade or business is regularly carried on by the organization; and (3)
the conduct of such trade or business is not substantially related (other than through the
production of funds) to the organization’s performance of its exempt functions. Section
1.512-1(a) of the Treas. Reg.

A trade or business is an activity carried on for the production of income from the sale of
goods or the performance of services. Section 513(c) of the Code. You will sell credits
from Bank to a variety of entities and intend to receive income from that activity.
Therefore, it meets the definition of a trade or business under § 513(c).

Under § 1.513-1(c)(1) of the Treas. Reg., we examine the frequency and continuity of
the activities and the manner in which they are conducted to determine whether a trade
or business is “regularly carried on.” While the ultimate number of credits that you can
sell is finite, you will be selling the credits regularly to various parties over a period of
several years. Therefore, this activity is regularly carried on within the meaning of the
Code and Regulations. See § 1.513-1(c)(1).

The remaining issue is whether the sale of these credits is substantially related to your
exempt purposes. A trade or business is substantially related to exempt purposes if the

business activities have a substantial causal relationship or contribute importantly to the
achievement of exempt purposes. Section 1.513-1(d)(2).

Under the terms of the conservation easement, you are required to protect the
conservation values of Watershed and Preserve on behalf of Commission. Through the
arrangements discussed above, this responsibility was bestowed upon you by
Commission, a political subdivision of State. By conducting stream mitigation activities,
you are undertaking activities that lessen the burdens of government. Lessening the
burdens of government is regarded as an exempt purpose. Rev. Rul. 85-1, supra; Rev.
Rul. 85-2, supra; Virginia Professional Standards Review Foundation v. Blumenthal,
supra; and Professional Standards Review Organization of Queens County, Inc. v.
Commissioner, supra. The issue is whether your activities in creating a mitigation bank
and selling the resulting mitigation credits is related to this purpose.

Commission was created as a public corporation by the State Legislature under an act
of the general assembly of State to oversee all activities within Preserve. As a political
subdivision, Commission is a governmental unit.

You are lessening the burdens of Commission because (1) there is an objective
manifestation that Commission considers the activity of operating Bank, including the
water remediation activities conducted through Bank in Watershed, to be its burden;
and (2) you are actually lessening Commission’s burden by operating Bank on behalf of
Commission. See Rev. Rul. 85-2, and Columbia Park and Recreation Assoc. v.
Commissioner, supra.

Under a Declaration of Conservation Covenants and Restrictions, Commission agreed
to maintain a significant part of the Preserve land as stream buffers. Furthermore, as a
signatory to the banking instrument and the listed sponsor of Bank, Commission is
legally obligated to plan, fund, develop, manage, and monitor the Bank. By assuming
this specific obligation in addition to its general conservation obligations, Commission
demonstrated that it considers the activity of operating Bank, including the stream
remediation activities in Watershed performed as a part of Bank, to be its burden.

In addition, Commission assigned its conservation obligations contained in the
conservation easement to you, requiring you to maintain the land in essentially pristine
condition and seek Commission’s approval before making any capital improvements.
Commission authorized you to negotiate the mitigation banking instrument and
remediate these waterways. Furthermore, Commission delegated the operation of
Bank, its legal obligation as sponsor of Bank, to you through a contractual agreement.
In meeting minutes, Commission specified that it wanted you to be responsible for all
“financing, supervision and future monitoring of preservation and construction
requirements” associated with Bank. Commission also provided that you were
authorized to sell all credits generated by Bank. You have assumed all responsibilities
for the planning, funding, developing, and monitoring of Bank as well as the authority to
sell credits generated by Bank. By carrying out these activities, you are fulfilling

Commission’s conservation and legal obligations and lessening Commission's burden.
Rev. Rul. 85-1, supra; Rev. Rul. 85-2, supra.

In order for the income derived from the sale of the credits to be taxable to you as
unrelated business income under § 512(a)(1) of the Code, the income must be derived
from an unrelated trade or business that is regularly carried on by you. Because the
sale is not an unrelated trade or business as defined by § 513, any mitigation credit
income you receive would not be taxable. Here, the activity is substantially related to
your exempt purposes within the meaning of § 513(a) because it lessens the burdens of
government.

Ruling:

1. Your stream mitigation activities are substantially related to your exempt purpose
   under § 501(c)(3) of the Code and do not constitute an unrelated trade or
   business within the meaning of § 513(a).

2. The income you receive from the sale of mitigation credits created by Bank is not
   unrelated business taxable income under § 512(a)(1).

This ruling will be made available for public inspection under § 6110 of the Code after
certain deletions of identifying information are made. For details, see enclosed Notice
437, Notice of Intention to Disclose. A copy of this ruling with deletions that we intend to
make available for public inspection is attached to Notice 437. If you disagree with our
proposed deletions, you should follow the instructions in Notice 437. This ruling is
directed only to the organization that requested it. Section 6110(k)(3) provides that it
may not be used or cited by others as precedent.

This ruling is based on the facts as they were presented and on the understanding that
there will be no material changes in these facts. This ruling does not address the
applicability of any section of the Code or regulations to the facts submitted other than
with respect to the sections described. In particular, this ruling does not address
whether the sale of any other form of credits would be considered unrelated business
income and be taxable as such.

Because it could help resolved questions concerning your federal income tax status,
this ruling should be kept in your permanent records.

If you have any questions about this ruling, please contact the person whose name and
telephone number are shown in the heading of this letter.

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In accordance with the Power of Attorney currently on file with the Internal Revenue
Service, we are sending a copy of this letter to your authorized representative.

Sincerely,

Ronald J. Shoemaker
Manager, Exempt Organizations
Technical Group 2
Enclosure
Notice 437

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