Rev. Rul. 58-547

Advice has been requested whether a lease between a charitable foundation as lessor and a nursery school as lessee, both exempt from Federal income tax under section 501(c)(3) of the Internal Revenue Code of 1954, will come within the exception to the definition of the term `business lease' provided for in section 514(b)(3)(A)(i) of the Code, notwithstanding that the lease would otherwise constitute a business lease within the meaning of section 514 of the Code.

The foundation, in the instant case, built a school building according to the designs requested by the nursery school. Upon its completion the building was leased for a period of ten years to the nursery school at a certain stipulated monthly rental. At the close of the current taxable year, there was a balance due on a construction loan obtained by the foundation for completion of the school building.

Section 511(a) of the Code imposes a tax on unrelated business taxable income of certain charitable, etc., organizations, otherwise exempt from tax under section 501(c)(3) of the Code. Such unrelated business taxable income includes income from a business lease as defined in section 514 of the Code.

Unrelated business taxable income, as defined by section 512(a) of the Code, means the gross income derived by any organization from any unrelated trade or business carried on by it, less the allowed deductions which are directly connected with such trade or business, both computed with certain exceptions, additions, and limitations.

With certain exceptions, section 513(a) of the Code defines the term `unrelated trade or business' as meaning, in the case of any organization subject to tax under section 511 of the Code, any trade or business the conduct of which is not substantially related to the exercise by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501 of the Code.

Section 514 of the Code states that the term `business lease' means a lease of real property for a term of more than five years by an organization if, at the close of the lessor's taxable year, there is a business lease indebtedness with respect to such real property. A business lease indebtedness is defined, with respect to any real property leased for a term of more than five years, as the unpaid amount of (1) the indebtedness incurred by the lessor in acquiring or improving such property; (2) the indebtedness incurred before the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement; and (3) the indebtedness incurred after the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement and the incurrence of such indebtedness was reasonably foreseeable at the time of such acquisition or improvement.

However, section 514(b)(3)(A)(i) provides that a lease shall not be considered a business lease if it is entered into primarily for purposes which are substantially related (aside from the need or use made of the rentals derived) to the exercise or performance of the charitable, educational, or other purpose or function constituting the basis for exemption of the lessor organization.

The lease of property under ordinary commercial arrangements does not constitute the exercise of an educational or charitable function in and of itself. Only when it is shown that the lease is for purposes substantially related to the exempt functions of the lessor does the above exception apply. The fact that the lessee may be an exempt educational organization does not cause the rental of space thereto to become a related activity on the part of the lessor who may be organized in part for educational purposes.

Therefore, the lease entered into between the exempt organization and the nursery school for a period of ten years, with respect to which there is a business lease indebtedness, is a business lease within the meaning of section 514(b)(1) of the Code for each year at the close of which an unpaid amount of the indebtedness incurred exists.

Accordingly, it is held that a lease, the parties to which are both exempt from tax under section 501(c)(3) of the Internal Revenue Code of 1954 and which otherwise constitutes a business lease within the meaning of section 514 of the Code, will not be considered as substantially related to the charitable, educational, etc., purposes of the lessor solely because the lessee is likewise an exempt organization.