United States v. Am. Bar Endowment - 477 U.S. 105, 106 S. Ct. 2426 (1986)

Rule:

The Internal Revenue Code imposes a tax, at ordinary corporate rates, on the income that a tax-exempt organization obtains from an unrelated trade or business regularly carried on by it. I.R.C. §§ 512(a)(1), 511(a)(1). An unrelated trade or business is 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. I.R.C. § 513(a).

Facts:

Respondent American Bar Endowment (ABE), a tax-exempt organization, raised money for its charitable work by providing group insurance policies, underwritten by insurance companies, to its members. Because the cost of the insurance was based on the group's claims experience and because the members of the organization had favorable mortality and morbidity rates, the result was an insurance cost substantially lower than the premiums paid. The difference between the higher premiums and the insurance cost was refunded by the insurance companies as dividends to the organization, which required the participants in the insurance program to permit the organization to keep the dividends, which the organization used for its charitable purposes. The Internal Revenue Service advised the organization that its insurance program was an "unrelated trade or business" and that the profits thereon were subject to tax under 511-513 of the Code (26 USCS 511-513), providing for the taxation of the income of exempt organizations derived from the conduct of a trade or business not related to their charitable or other purpose constituting the basis for their exemption. The Internal Revenue Service assessed a tax deficiency on the organization's net revenues from the insurance program. After paying the tax and exhausting administrative remedies, the organization sued for a refund in the United States Claims Court. At about the same time, some members who were participants in the program and who had not deducted any part of the premiums as charitable contributions also sued for refunds in the Claims Court. The suits were consolidated, and the court entered judgment for the organization, finding that the insurance program was not a "trade or business" subject to tax, but decided for the government on the members' claims, holding that they had not shown that they bought goods or services for more than their economic value with the intention that the excess be used to benefit a charitable enterprise. The United States Court of Appeals for the Federal Circuit affirmed as to the organization's taxes but reversed and remanded as to the members for a redetermination of whether the relationship between the organization and the members was predominantly of a business nature or whether the transaction had a substantial charitable component. Petitioner, United States, appealed.  

Issue:

1. Was the respondent’s revenue from the refunded premiums an “unrelated business income” subject to tax? 
2. Were the association members entitled to a charitable deduction for excess premium payments?

Answer:

1) Yes. 2) No.

Conclusion:

The United States Supreme Court held that the income of the organization from its insurance program constituted "unrelated business income" subject to tax under 511-513 of the Code, because the organization's insurance program was within the literal definition of "trade or business" in 513(c), defining the term as any activity carried on for the production of income from the sale of goods or the performance of services. Moreover, the Court held that the members could not claim a charitable deduction for the portion of their premium payments that exceeded the actual cost to the organization of providing insurance, because, in failing to show that they could have purchased similar policies at a lower cost, they did not establish that any portion of their payments constituted a charitable contribution. Accordingly, the judgment of the lower court was reversed.