University may operate software business through taxable subsidiary

Plain-English summary

A tax-exempt university created a wholly owned for-profit subsidiary to develop and license software used for competency-based education. The subsidiary would have separate management, facilities, records, accounts, and day-to-day operations, while the university would exercise ordinary shareholder rights. The IRS ruled that the subsidiary would be respected as a separate taxable entity, so its activities and gross income would not be attributed to the university or harm the university's exemption under IRC § 501(c)(3). The subsidiary's income would not become unrelated business taxable income of the university under § 512(a)(1). Dividends paid to the university would be excluded from unrelated business taxable income under § 512(b)(1).

Ruling snapshot

• Question: Would forming and owning the taxable software subsidiary affect the university's exemption or create unrelated business taxable income?
• Outcome: Approved
• Key authorities: IRC §§ 501(c)(3), 511, 512, and 513; Treas. Reg. §§ 1.501(c)(3)-1 and 1.513-1

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION

Release Number: 201503018 Contact Person:
Release Date: 1/16/2015

Date: October 24, 2014 Identification Number:

Telephone Number:
Employer Identification Number:

Uniform Issue List Number:

501.03-00
511.00-00
512.00-00
512.01-00
512.10-00

Legend:

B =
State X =
State Y =
Date x =
Year x1 =
Year x2 =
Year x3 =
Program A =
Software X =
x1 =

Dear

We have considered your ruling request dated September 5, 2014. You have requested rulings
relating to the tax consequences under §§501(c)(3) and 512 of the Internal Revenue Code
stemming from your formation of B a wholly-owned for-profit subsidiary.

Facts:

You are a not-for-profit corporation organized under the laws of State X as of Year x1. You are
recognized as an organization exempt under §501(c)(3) of the Code as an educational
institution. You were formed in Year x2 as an accounting and secretarial school, and you have
now evolved into a multi-disciplinary institution.

You offer degrees at the associate’s, bachelor’s, masters’ and doctoral levels. You have

graduate and undergraduate programs in business, education, hospitality, community economic
development and liberal arts. There are approximately x1 full and part-time students currently
enrolled in various courses offered by you directly or through one of your divisions. Students
can participate in traditional campus daytime programs or evening and weekend part-time and
hybrid courses at your regional centers. You also offer all of your continuing education
programs online.

You launched Program A as a division of you and not a separate entity to improve educational
opportunities to working adults. Your financial activities are combined with that of Program A
and are reported in your annual Form 990 information returns.

Program A is an online educational program that allows students to enroll in educational
courses through a self-paced and self-directed model. This program differs from the traditional
class setting where students are required to take a pre-defined number of courses to graduate.
Before students can advance in Program A and obtain degrees they have to prove mastery in
certain core competencies related to the degree. At the time of implementing Program A, there
were no other universities offering degree programs based on this structure of competency-
based learning. Since this competency-based learning program was unique to Program A,
there was no existing computer architecture to run and track the program. Consequently, you
developed Software X as your own proprietary software.

There have been other unaffiliated educational institutions also interested in offering
competency-based programs that have inquired about licensing Software X from you. You are
in the process of determining whether the licensing of Software X to other entities could be a
viable commercial business. You formed B and it was incorporated in State Y on Date x to
further develop Software X and license it to other educational institutions and commercial
businesses. B currently does not have any employees or any activities.

You propose to contribute Software X to B while retaining a royalty-free license for use in your
own operations. B would determine and charge a fair market value for the license of Software X
to other unaffiliated organizations for use in creating their educational programs.

You will own 100% of the stock in B and will appoint all of its directors. The initial Board of
Directors of B will consist of three members of your Board of Directors. You plan to expand the
Board of Directors of B to include seven persons within six months of formation and prior to the
commencement of any substantial activities. Pursuant to B’s Bylaws a majority of the directors
shall not be employed by you nor be on your Board of Directors or related to a person employed
by, or on your Board. The president of B will not be either a person who is on your Board nor
one of your employees.

All compensation that B pays to its directors, officers, employees, and agents for services
rendered will be reasonable. Having a for-profit subsidiary such as B, you believe, will allow it to
attract and retain key employees with an equity-based compensation system. Thus, any equity
based compensation system for B’s directors and employees will conform to those offered by
comparable entities.

You will not actively participate in the day-to-day operations of B. B will also maintain separate
facilities, addresses, telephone numbers, telephone listings, and bank accounts and other
financial records. In the event that B does lease office space from you or receives
administrative services from you, then B, as required by its Bylaws, will reimburse you for fair
market value of such use. The dividends that you expect to receive from B will be an
insignificant percentage of your total support.

Rulings Requested:

1) Your ownership of B will not have an adverse effect on your tax-exempt status under
§501(c)(3) .

2) The gross income realized by B will not be treated as unrelated business taxable income to
you under §512(a)(1).

3) The dividends that you may receive from B will be excluded under §512(b)(1) from the
computation of unrelated business taxable income under §512(a)(1).

Law:

Section 501(c)(3) of the Code provides for exemption from federal income tax of organizations
organized and operated "exclusively" for religious and other specified exempt purposes, "no part
of the net earnings of which inures to the benefit of any private shareholder or individual,” and
which does not engage in substantial lobbying activities or proscribed political activities.

Section 1.501(c)(3)-1(c)(1) of the regulations provides that an organization will be regarded as
"operated exclusively" for one or more exempt purposes only if it engages primarily in activities
which accomplish such purposes. An organization will not be so regarded if more than an
insubstantial part of its activities is not in furtherance of an exempt purpose.

Section 511 of the Code imposes a tax on the unrelated business taxable income (defined in
section 512) of organizations exempt from tax under section 501(c).

Section 512(a)(1) of the Code defines the term "unrelated business taxable income" to mean
the gross income derived by any organization from any unrelated trade or business (defined in
section 513) regularly carried on by it, less the allowable deductions which are directly
connected with the carrying on of such trade or business, both computed with the modifications
provided in subsection (b).

Section 512(b)(1) of the Code provides, in part, that all dividends shall be excluded from the
computation of unrelated business taxable income.

Section 512(b)(13) of the Code provides special rules for treatment of income an exempt
organization receives from a controlled entity.

Section 512(b)(13)(A) of the Code provides that notwithstanding sections 512(b)(1), (2) and (3)
of the Code an organization (controlling organization) receiving a specified payment from
another entity which it controls (controlled entity) shall include such payment as an item of gross
income derived from an unrelated trade or business to the extent such payment reduces the

net unrelated income of the controlled entity (or increases any net unrelated loss of the
controlled entity). There shall be allowed all deductions of the controlling organization directly
connected with amounts treated as derived from an unrelated trade or business under the
preceding sentence.

Section 512(b)(13)(C) of the Code provides that the term "specified payment" means any
interest, annuity, royalty, or rent.

Section 512(b)(13)(D)(i) of the Code provides, in part, that the term “control” means in the case
of a corporation, ownership (by vote or value) or more than 50 percent of the stock of such
corporation, and in any other case (other than a corporation or a partnership) ownership of more
than 50 percent of the beneficial interests in the entity.

Section 513(a) of the Code provides that the term "unrelated trade or business" means, in the
case of any organization subject to the tax imposed by section 511, any trade or business the
conduct of which is not substantially related to the exercise or performance by such organization
of its charitable, educational, or other purpose or function constituting the basis for its
exemption.

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

Section 1.513-1 (a) of the regulations provides, in part, that unless one of the specific
exceptions of section 512 or 513 of the Code applies, the gross income of an exempt
organization subject to the section 511 tax 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(d)(2) of the regulations provides, in part, that in determining whether a trade or
business is “regularly carried on”, 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.

Section 1.513-1(d)(2) of the regulations provides that a trade or business is "related" to exempt
purposes only where the conduct of the business activities has a causal relationship to the
achievement of exempt purposes (other than through the production of income). Further, it is
"substantially related," for purposes of section 513, only if the causal relationship is a substantial
one. For this relationship to exist, the production or the performance of the service from which
the gross income is derived must contribute importantly to the accomplishment of exempt
purposes. Whether the activities productive of gross income contribute importantly to such
purposes depends, in each case, upon the facts and circumstances involved.

In Better Business Bureau v. United States, 326 U.S. 279, 66 S. Ct. 112;90 L. Ed. 67 (1945),
1945 C.B. 375, the Supreme Court when construing the meaning of the phrase “ exclusively for
educational purposes’ stated, “this plainly means that the presence of a single non-educational
purpose, if substantial in nature, will destroy the exemption regardless of the number or
importance of truly educational purposes.”

In Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438-39, 63 S. Ct. 1132, 87 L.Ed.
1499, 1943 C.B. 1011 (1943), the Supreme Court ruled on the issue of whether a corporation
was a separate taxable entity. It was reasoned by the court that a parent corporation and its
subsidiary are separate taxable entities, as long as the purpose for which the subsidiary is
incorporated are the equivalent of business activities or the subsidiary subsequently carries on
business activities.

In Britt v. United States, 431 F.2d 227, 234 (5th Cir. 1970), the court had to decide whether the
business activities of each corporation to which plaintiff taxpayers had transferred partnership
property were sufficient to require recognition of the corporations as separate taxable entities.
The court considered the purpose for which the corporation was organized to determine if its
bona fide intention was to have some real and substantial business function and reasoned that
it did and thus its existence should not generally disregarded for tax purposes.

In Krivo Industrial Supply Co. v. National Distillers and Chemical Corp., 483 F.2d 1098, 1106
(5th Cir. 1973) it was stated by the court that the control required for liability under the
“instrumentality” rule is where there is total domination of the subsidiary to the extent the
subsidiary manifests no separate corporate interests and functions solely to achieve the
purpose of the dominant corporation.

Analysis:

You are an organization recognized as exempt under §501(c)(3). Any income you produce is
exempt from federal income taxes if it is related to your exempt purpose. If an exempt
organization receives income from a trade or business that is regularly carried on unrelated to
its exempt purpose it is potentially subject to tax under §511.

B was formed as a separate legal entity. B will have its own activities and management apart
from you. B’s establishment as a for-profit corporation needs to be analyzed to determine
whether its planned activities or its income will be attributed to you as the parent.

For federal income tax purposes, a parent corporation and its subsidiary are considered
separate taxable entities, so long as the purposes for which the subsidiary is incorporated are
the equivalent of business activities or the subsidiary subsequently carries on

business activities. Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438 (1943); Britt v.
United States, 431 F.2d 227, 234 (5th Cir. 1970). That is, where a corporation is organized with
the bona fide intention that it will have some real and substantial business function, its existence
may not generally be disregarded for tax purposes. Britt, supra at 234. However, where the
parent corporation so controls the affairs of the subsidiary that it is merely an instrumentality of
the parent, the corporate entity of the subsidiary may be disregarded. Krivo Industrial Supply
Co. v. National Distillers and Chemical Corp., 483 F.2d 1098, 1106 (5th Cir. 1973).

You represent that you formed B for the bona fide business purpose of licensing Software X to
other educational institutions and commercial businesses in hopes of developing it into a viable
commercial business. B will further develop Software X to enable you to run and track Program
A. B's licensing of the use of Software X to other educational institutions will allow them to offer

similar competency-based programs. B will have a real and substantial business purpose.
Therefore, its existence should not be disregarded for federal income tax purposes.

B will not be a mere instrumentality of you. B’s Board of Directors will not consist of a majority
of your Board members. A majority of B’s directors will not be by employed by you nor be on
your Board of Directors or related to any person employed by any of your directors. You will not
actively participate in the day-to-day affairs of B for you will only exercise your normal rights as
a shareholder and as permitted in your Bylaws. You represent that B will maintain separate
books and records including maintaining separate bank accounts and financial records. B will
also maintain separate facilities and addresses apart from you, as well as telephone numbers
and telephone listings. Also, to the extent B leases office space from you, then you will be
reimbursed the fair market value of the usage. Likewise, to the extent you provide
administrative services to B, you will receive reimbursement for the fair market value of your
services.

Based on the facts and representations stated above, B should be treated as a separate entity
for tax purposes. Thus, B's activities and income should not be attributed to you as the parent
to adversely affect your tax-exempt status under §501(c)(3). Likewise, none of B’s gross
income should result in any unrelated business taxable income to you under §512(a)(1). B’s
activities and operations are conducted solely by B and are not attributed to you and therefore
are not considered to be a trade or business that is “regularly carried on” by you. See Section
1.513-1(a); see also Section 1.513-1(c)(1).

Whether the dividends you may receive from B should be excluded from the computation of
unrelated business taxable income under §512(a)(1) would depend on if the dividends are an
allowable modification permitted in subsection (b) and not a specified payment within the
meaning of subsection (c). In accordance with §512(b)(13), if a controlling entity receives or
accrues a specified payment from another entity it controls then such payment is included in
gross income as derived from an unrelated trade or business to the extent it reduces the net
unrelated income of the controlled entity. For purposes of §512(b)(13), B would be considered
a controlled entity, since you own more than 50 percent of the vote and value of B’s stock.
However, dividend income is not a specified payment. Inasmuch as B is a separate tax entity,
any dividends you receive from B would be a modification under §512(b)(2). Accordingly, any
dividend income that you may receive from B will not be subject to the unrelated business
income tax.

Rulings:

1) Your ownership of B will not have an adverse effect on your tax-exempt status under
§501(c)(3) .

2) The gross income realized by B will not be treated as unrelated business taxable income to
you under §512(a)(1).

3) Any dividends you may receive from B will be excluded under §512(b)(1) from the
computation of unrelated business taxable income under §512(a)(1).

This ruling will be made available for public inspection under section 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) of the Code
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. Because it could help resolve 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.

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,

Michael Seto
Manager, EO Technical

Enclosure
Notice 437