Appeal from the United States District Court for the Northern District of Illinois, Eastern Division. No. 82 Ch. 7213-Milton I. Shadur, Judge.
Cudahy, Manion and Kanne, Circuit Judges.
This case involves the allocation of income and expenses between a charitable organization's tax-exempt activities and its taxable business endeavors for purposes of computing the charity's "unrelated business income tax" under 26 U.S.C. sections 511 to 513. The American Medical Association (the "AMA"), a tax-exempt charitable organization, filed suit in the Northern District of Illinois seeking a refund for the tax years 1975 through 1978. The AMA argued that the Internal Revenue Service (the "IRS") had improperly calculated its income from the non-exempt unrelated business of publishing advertising in the organization's publications. In a series of opinions, reported at 668 F. Supp. 1085 (1987), 668 F. Supp. 1101 (1987), 688 F. Supp. 358 (1988) and 691 F. Supp. 1170 (1988), the district court substantially agreed with the AMA's statutory and regulatory arguments, and ordered the United States to pay the AMA the full amount of the refund requested. We affirm in part and reverse in part.
The AMA is a tax-exempt membership organization under section 501(c)(6) of the Internal Revenue Code.*fn1 Its charitable function is "to promote the science and art of medicine and the betterment of public health." In aid of this purpose the AMA publishes the Journal of the American Medical Association ("JAMA") and the American Medical News ("AM News"). Most of the AMA's members pay annual dues to belong to the organization. Between 1975 and 1978, AMA members received JAMA and AM News at no additional cost as a benefit of membership.
JAMA and AM News both contain articles of relevance to the practice of medicine. But the journals also contain paid advertising. During the relevant period the AMA sent complimentary copies of JAMA and AM News to targeted groups of physicians who make up an especially desirable audience for firms likely to advertise in the journals. The parties stipulated that the AMA's sole purpose in engaging in this complimentary "controlled circulation" was to increase advertising revenues. Many of the AMA's dues-paying members were also on the controlled circulation list and therefore would have been entitled to receive JAMA and AM News even if they were not AMA members. However, the AMA apparently did not inform these physicians that they were entitled to complimentary copies of the journals. Nor did the AMA refund any portion of these physicians' membership dues in recognition of the fact that they need not have paid for the periodicals.
Between 1975 and 1978, the AMA placed a portion of the membership dues it received in an "association equity" account, which was intended to serve as a reserve fund to offset any deficit which might occur in future years if the association's revenues were insufficient to cover expenses. The amounts deposited in the association equity account remained on the AMA's books as a reserve until 1985, when the AMA withdrew some of these funds to compensate for a shortfall in its revenue.
There is no dispute that the editorial or readership content of the two periodicals furthers the AMA's charitable mission, and therefore any revenue attributable to the publication and distribution of articles in JAMA and AM News is exempt from taxation. And the AMA has admitted that the advertising in JAMA and AM News is a business endeavor unrelated to the AMA's charitable purpose, and is therefore taxable. This case presents several questions involving the allocation of income and expenses between the exempt and taxable aspects of JAMA and AM News, and the allocation of membership dues between these periodicals and the AMA's other (exempt) activities.
The statutory scheme applicable to these journals is fairly straightforward. Section 511 of the Code provides that the "unrelated business taxable income" of a charitable organization is subject to the tax applied to corporate income under section 11. Section 512(a)(1) defines "unrelated business taxable income" as
the gross income derived by any organization from any unrelated trade or business (as defined in section 513) regularly carried on by it, less the deductions allowed by this chapter which are directly connected with the carrying on of such trade or business. . . .
(emphasis added). Finally, section 513(a) defines an "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 its charitable . . . purpose or function constituting the basis for its exemption under section 501. . . .
In a provision added in 1969, and significantly titled "Advertising, etc., activities," section 513(c) further explains:
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. For purposes of the preceding sentence, an activity does not lose identity as a trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of the organization.
The Supreme Court construed these provisions in United States v. American College of Physicians, 475 U.S. 834, 89 L. Ed. 2d 841, 106 S. Ct. 1591 (1986). American College involved a charitable organization's medical journal which, as here, contained both articles which furthered the organization's exempt function and paid advertisements. The Supreme Court held that section 513(c) clearly indicated Congress' intent to treat advertising in an otherwise tax-exempt publication as a separate "trade or business," which may be taxable if the "conduct of [the advertising business] is not substantially related . . . to the . . . performance by such organization of its charitable . . . purpose." Id. at 839-40. To determine whether the advertising content of a journal is "substantially related" to the organization's educational mission, the IRS must look to the manner in which the advertising is selected and displayed; i.e., whether only advertising of new technologies or medications is allowed, whether the charity coordinates the subject matter and content of the ads, etc. Id. at 848-50. The organization's tax exemption extends to its publication of advertising only if the advertisements "contribute importantly" to the charity's exempt purpose. Id. at 847; see also United States v. American Bar Endowment, 477 U.S. 105, 109-16, 91 L. Ed. 2d 89, 106 S. Ct. 2426, 58 A.F.T.R.2d (P-H) 5190 (1986).
American College specifically endorsed the so-called "fragmentation" principle, whereby a charitable organization's publications are divided into two components: (1) the tax-exempt publication of the journal's "editorial" or "readership content"; and (2) the taxable enterprise of selling and publishing advertising. The United States and the AMA agree on these general principles; in fact, the AMA has even conceded that the advertisements in JAMA and AM News are not "substantially related" to the AMA's educational mission, and therefore constitute an "unrelated" business under American College. The parties' disagreement centers on the application of the "fragmentation" principle to the facts of this case.
The IRS has adopted detailed regulations which govern the allocation of revenues and expenses between a journal's exempt editorial and non-exempt advertising activities. Regulation 1.512(a)-1(f)(6) provides for division of a periodical's costs into two categories:
(ii)(a) The direct advertising costs of an exempt organization periodical include all expenses, depreciation and similar items of deduction which are directly connected with the sale and publication of advertising. . . . The items allowable as deductions under this subdivision do not include any items of deduction attributable to the production or distribution of the readership content of the periodical.
(iii) The "readership" costs of an exempt organization periodical include expenses, depreciation or similar items which are directly connected with the production and distribution of the readership content of the periodical. . . . Readership costs include all the items of deduction attributable to an exempt organization periodical which are not allocated to direct advertising costs under subdivision (ii) . . .
26 C.F.R. § 1.512(a)-1(f)(6). "Direct advertising costs" are fully deductible from gross advertising income, Reg. (f)(2)(i); "readership costs" are only deductible from gross advertising income to the extent they exceed circulation income. Reg. (f)(2) (ii)(b). "Circulation income," in turn, is defined as
the income attributable to the production, distribution or circulation of a periodical (other than gross advertising income). . . . Where the right to receive an exempt organization periodical is associated with membership . . . in such organization for which dues . . . are received (hereinafter referred to as "membership receipts"), circulation income includes the portion of such membership receipts allocable to the periodical (hereinafter referred to as "allocable membership receipts").
Reg. 1.512(a)-1(f)(3)(iii). Regulation (f)(3)(iii) goes on to explain that "allocable membership receipts" should generally represent the amount which a taxable organization would have charged for the periodical in an arms-length transaction with the member. The regulation refers taxpayers to regulation (f)(4) "for a discussion of the factors to be considered in determining allocable membership receipts." Regulation (f)(4) provides three methods for determining the share of membership receipts which should be deemed to constitute a member's payment for the right to receive the periodical. Only the third method of calculating allocable membership receipts is applicable to JAMA and AM News. That method is described as a "pro rata allocation."
Since it may generally be assumed that membership receipts and gross advertising income are equally available for all of the exempt activities (including the periodical) of the organization, the share of membership receipts allocated to the periodical, where [methods 1 and 2] do not apply, shall be an amount equal to the organization's membership receipts multiplied by a fraction the numerator of which is the total periodical costs and the denominator of which is such costs plus the costs of other exempt activities of the organization.
Reg. 1.512(a)-1(f)(4)(iii). Therefore, the amount of dues to be allocated to circulation income under the pro rata allocation method equals total membership receipts multiplied by the ratio of total ...