College and university bookstores.

How to tax what alma mater sells.

As exempt organizations, schools, colleges and universities constantly deal with unrelated business income problems. And as some colleges and universities grow and provide a multitude of goods and services to their students, many more of their activities are being subject to increased Internal Revenue Service scrutiny.

The net income derived from an activity is unrelated business income and subject to tax if the activity is not substantially related to the organization's exempt purpose, is a trade or business and is regularly carried on.

Most educational institutions operate stores that sell students the materials that are required for their course instruction or that otherwise further their education. Many also sell items that are somewhat unrelated--wearing apparel (with or without the school logo), small appliances, wristwatches, pennants, posters, cosmetics and a variety of other retail items. The IRS looks at such sales in light of two exceptions to the taxability of unrelated business income: the "substantially related" test and the "convenience" test.

SUBSTANTIALLY RELATED

The sale of items necessary for courses at an institution is considered substantially related to the institution's educational purposes. This includes books, general school supplies and athletic wear needed for the school's athletic and physical education programs. Because the IRS has said the availability of materials that further the intellectual life of the campus community also serves an educational purpose, it probably also includes books, tapes, records, compact disks and computer hardware/software (whether or not required for courses).

An area that has proved to be especially difficult to monitor has been computer sales. Selling one computer to a student or faculty member may be substantially related to educational purposes. However, the sale of multiple computers in a single year to a single student or the sale of a computer to someone who is not a student, officer or employee of the school may result in unrelated business income.

CONVENIENCE

The convenience exception to the unrelated business income standard has been used to exempt from taxation many types of merchandise found in school stores, including toiletries, wearing apparel, novelty items bearing a school's insignia and other items such as candy, cigarettes, magazines, greeting cards, film, cameras and small appliances. This exception also applies to the operation of on-campus food and drink vending machines and laundromat facilities.

In general, items low in cost and recurring in demand may be considered to be for the convenience of a school's students, officers and employees; in the absence of clearly established special circumstances, items not directly related to an institution's educational purpose that have an ordinary life of more than one year do not fall under this exception.

Note: The convenience exception does not apply to alumni.

The use of this exception is controversial and has been attacked on the basis that bookstores are unfairly competing with for-profit businesses--especially since the unrelated business income provisions were enacted to eliminate sources of unfair competition and to place exempt organizations on equal footing with nonexempt businesses. While the sale of books would not cause a controversy, the status of clothing, cosmetics, CDs and computers is not as clear.

COMPLIANCE

Another major problem (and challenge) facing exempt educational institutions centers on proper categorization of the various types of sales to students and employees, as well as those to alumni and the general public (which, in the case of well-known colleges and universities, may be extremely substantial). School, college and university bookstores must have the resources to track these various revenue streams, the appropriate direct costs and any deductions attributable to the dual use of personnel or facilities.

For a discussion of the IRS's audit guidelines for school, college and university bookstores, see the Tax Clinic, edited by Frank O'Connell, in the September 1996 issue of The Tax Adviser.

--Nicholas Fiore, editor

The Tax Adviser

Editor's Note 

The material discussed provides general information. Before you take any action in this area, the appropriate code sections, regulations, cases and rulings should be examined.