IRC 502 does not provide a basis for tax exemption. By providing that an organization operated for the primary purpose of carrying on a trade or business for profit cannot establish exemption on the basis that all its profits are payable to one or more organizations exempt from tax, it limits the type of entity that might otherwise qualify. IRC 502 applies to organizations described under any paragraph of IRC 501(c).

Prior to 1951, organizations whose sole activity was the conduct of a commercial business, "feeder organizations," were considered exempt from Federal income tax under the predecessor to IRC 501(c)(3) because their profits were payable to specified exempt organizations.

Congress dealt with this situation in the Revenue Act of 1950. (Revenue Act of 1950, 301b, 64 Stat. 906, 953.) This Act, in a two-pronged attack, attempted to counter the unfair advantage that businesses operated by exempt organizations had over for-profit competitors.

The Tax Reform Act of 1969 (69 TRA) extended to feeder organizations the exceptions contained in IRC 513(a). Congress imposed no tax on businesses in which substantially all the work was performed without compensation or which sold merchandise substantially all of which was donated. Whether these businesses were run directly, or indirectly through a subsidiary, they were not taxable.

IRC 502 states that an organization operated for the primary purpose of carrying on a trade or business for profit shall not be exempt from taxation under IRC 501 on the ground that all of its profits are payable to one or more organizations exempt from taxation under IRC 501.

For purposes of this section, the term "trade or business" shall not include—

Some organizations are not engaged in a business to make money for designated charitable organizations but are organized and operated to provide services for specific charitable organizations. If an exempt organization creates another organization to furnish it with certain services, the subsidiary organization may also qualify for exemption, even though, as a matter of accounting, the subsidiary’s books reflect a profit. However, the subsidiary will not qualify for exemption if the service provided would constitute the conduct of an unrelated trade or business if conducted directly by the parent. See Reg. 1.502–1(b).

A separate subsidiary formed to carry on a function for the benefit and convenience of its exempt parent in furtherance of the parent’s exempt purpose is also not a feeder entity within IRC 502. Rev. Rul. 58–194, 1958–1 C.B. 240, is a good example. It holds that a separately incorporated subsidiary operating a bookstore and cafeteria on a university campus is entitled to exemption as an organization described in IRC 501(c)(3).

An organization formed to furnish services to one or more exempt organizations will not qualify for exemption if the organizations served are not structurally related. The necessary relationship is not established merely because the organizations served hold the same kind of exemption or provide the same kind of service to the community.

Organizations are related if they consist of—

This relationship is illustrated in Rev. Rul. 68–26, 1968–1 C.B. 272, where a separately incorporated organization formed to print and sell educational material for a church parochial school system was determined not to be a feeder. Although there was no technical parent-subsidiary relationship between the church and the organization because of the organization’s non-stock character, the relationship was held to exist through control and close supervision of the organization’s affairs by the church. The organization was an integral part of the parent church. Furthermore, since the sole source of the organization’s profits was from sales made to the parochial schools which were components of the parent church, the profits were essentially a matter of accounting among the organizations involved.

Where there is no structural relationship among the parent organizations which the subsidiary is intended to serve, the subsidiary is not exempt by reason of IRC 502. In Rev. Rul. 54–305, 1954–2 C.B. 127, an organization formed to provide centralized purchasing services for a group of unrelated exempt hospitals and other charitable institutions was held nonexempt. Purchasing supplies and performing services for such unrelated charitable organizations are ordinary business activities rather than charitable activities.

Upon similar facts, the Court of Claims held in Hospital Bureau of Standards and Supplies, Inc. v. United States, 158 F. Supp. 560 (1958), that a bureau formed to provide services to a group of unrelated exempt hospitals was exempt. The court concluded that the organization was providing essential services to the hospitals rather than operating a business for profit. The Court also based its finding in part on a conclusion that, because the bureau served only charitable hospitals, the member organizations were "related" within the meaning of the regulations. The regulations have since been amended to clarify that organizations are not "related" merely because they engage in the same type of exempt activities.

IRC 501(e), discussed in a separate IRM Chapter, provides exemption for certain cooperative hospital service organizations for taxable years ending after June 28, 1968. Organizations outside the scope of IRC 501(e), such as those hospital service organizations providing laundry services, are still subject to IRC 502. See, HCSC-Laundry v. United States, 450 U.S. 1, 101 S. Ct. 836 (1981), Ct. D. 2005, 1981–1 C.B. 324.

IRC 502 was determined to preclude exemption in Rev. Rul. 69–528, 1969–2 C.B. 127 because the parent entities were not structurally related. The trust was created to manage the investments of several unrelated IRC 501(c)(3) organizations. Investment management was held to be a trade or business and the organization’s primary activity. The business was regularly carried on and would have been considered unrelated trade or business if conducted by any of the participating exempt organizations.

Rev. Rul. 69–528 was distinguished by Rev. Rul. 71–529, 1971–2 C.B. 234, involving a nonprofit organization providing assistance in the management of participating colleges’ and universities’ endowment or investment funds for a charge substantially below cost. Because the services were provided substantially below cost, the organization’s activities were not considered a regularly carried on trade or business within the purview of IRC 502.

IRC 501(f), discussed in a separate IRM Chapter, provides exemption for certain cooperative investment service organizations organized and controlled by organizations described in either IRC 170(b)(1)(A)(ii) (schools) or IRC 170(b)(1)(A)(iv) (certain organizations that support schools) for the collective investment of their funds in stocks and securities. IRC 501(f) applies only to taxable years ending after December 31, 1973. Cooperative investment organizations may be recognized as exempt for prior years depending on the facts and circumstances of individual cases. See Rev. Rul. 71–529, discussed above.

Purchasing agency— A corporation organized and operated for the primary purpose of maintaining a purchasing agency for the benefit of its otherwise unrelated exempt members, is engaged in business activities which would be unrelated activities if carried on by any one of the tax-exempt organizations served. The corporation is a feeder and not entitled to exemption under section 101(6) of the 1939 Code. See Rev. Rul. 54–305, 1954–2 C.B. 127.

Construction and sale of houses— The construction and sale of houses by an exempt charitable foundation over a period of 18 months for the sole purpose of raising funds for the support of a church constitutes an unrelated trade or business activity. Where such activity is the primary activity of the foundation, it is a feeder and not entitled to exemption. See Rev. Rul. 55–449, 1955–2 C.B. 599.

Home show conductor— A corporation organized for the purpose of promoting and conducting home shows, the net earnings of which are payable to the county recreational board in the form of rent for the use of its premises, is not exempt from tax. See Rev. Rul. 57–52, 1957–1 C.B. 196.

Rental income of office building— A corporation organized exclusively for charitable purposes which derives its income principally from the rental space in a large commercial office building which it owns, maintains, and operates and uses such income to aid other charitable organizations through contributions and grants is entitled to exemption under IRC 501(c)(3) where it is shown to be carrying on, through such contributions and grants, a charitable program commensurate in scope with its financial resources. It’s primary purpose was not considered to be the conduct of a trade or business for profit. See Rev. Rul. 64–182, 1964–1 (part 1) C.B. 186.

Printing and selling educational and religious material— An organization controlled by a church to print and sell educational and religious material to its parochial school system is not a feeder. It is providing a service to its parent and falls within Reg. 1.502–1(b). See Rev. Rul. 68–26 1968–1 C.B. 272.

Thrift Shop— A separately incorporated organization where volunteer workers sell donated goods to raise funds for a charitable organization named in its charter is engaged in a trade or business under IRC 502. See Rev. Rul. 68–439, 1968–2 C.B. 239. Revoked by Rev. Rul. 71–581, 1971–2 C.B. 236.

Investment services— An organization regularly carrying on an investment service that would be unrelated trade or business if carried on by any of the exempt organizations on whose behalf it operates is not exempt under IRC 501(c)(2) or 501(c)(3). See Rev. Rul. 69–528 1969–2 C.B. 127.

Laundry services operated for hospitals— The criteria to be met in determining the tax consequences of operating laundry services for hospitals are outlined in Rev. Rul. 69–633, 1969–2 C.B. 121.

Investment management services for colleges and universities— A nonprofit organization that provides assistance in the management of participating colleges’ and universities’ endowment or investment funds for a fee substantially below the cost of providing such service is not engaged in a trade or business and qualifies for exemption. Rev. Rul. 69–528 distinguished. See Rev. Rul. 71–529, 1971–2 C.B. 234.

Thrift Shop— Operation of a separately incorporated thrift shop to raise funds for a group of specified exempt organizations may qualify for exemption under section 501(c)(3) of the Code. See Rev. Rul. 71–581, 1971–2 C.B. 236.

Investment management services— An organization formed to provide managerial and consulting services at cost to unrelated exempt organizations does not qualify for exemption under IRC 501(c)(3). Rev. Rul. 71–529 distinguished. See Rev. Rul. 72–369, 1972–2 C.B. 245.

Commercial printing corporation— A church-controlled commercial printing corporation whose business earnings are periodically paid to the church, but which has no other significant charitable activity, is a feeder organization and does not qualify for exemption. See Rev. Rul. 73–164, 1973–1 C.B. 223.

Thrift Shop— Organization that operates a thrift shop substantially all of the work of which is performed without compensation is not a feeder. The sale of items on consignment does not result in prohibited inurement. See Rev. Rul. 80–106, 1980–1 C.B. 113.