Case Name: RENSSELAER POLYTECHNIC INSTITUTE, Petitioner-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant
Court: United States Court of Appeals for the Second Circuit
Jurisdiction: United States
Decision Date: 1984-04-11
Citations: 732 F.2d 1058
Docket Number: No. 188, Docket 83-4101
Parties: RENSSELAER POLYTECHNIC INSTITUTE, Petitioner-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.
Judges: Before MANSFIELD, PIERCE and PRATT, Circuit Judges.
Reporter: Federal Reporter 2d Series
Volume: 732
Pages: 1058–1066

Head Matter:
RENSSELAER POLYTECHNIC INSTITUTE, Petitioner-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.
No. 188, Docket 83-4101.
United States Court of Appeals, Second Circuit.
Argued Nov. 4, 1983.
Decided April 11, 1984.
David I. Pincus, Atty., Tax Div., Dept, of Justice, Washington, D.C. (Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup, and Robert A. Bernstein, Attys., Tax Div., Dept, of Justice, Washington, D.C., of counsel), for respondent-appellant.
George C. Shattuck, Syracuse, N.Y. (Joseph P. Kubarek, Bond, Schoeneck & King, Syracuse, N.Y.), for petitioner-appellee.
Sheldon E. Steinbach, Washington, D.C., for amicus curiae American Council on Educ.
Christine Topping Milliken, Washington, D.C., for amicus curiae Nat. Institute of Independent Colleges and Universities.
Dorothy K. Robinson, New Haven, Conn. (Hughes, Hubbard & Reed, New York City, of counsel), for amicus curiae Yale University.
Before MANSFIELD, PIERCE and PRATT, Circuit Judges.

Opinion:
GEORGE C. PRATT, Circuit Judge:
The issue before us is not only one of first impression; it is also of considerable financial significance to many of our colleges and universities. When a tax-exempt organization uses one of its facilities, as in this case a fieldhouse, for both tax-exempt purposes and for the production of unrelated business income, what portion of its indirect expenses such as depreciation may it deduct from its unrelated business income pursuant to I.R.C. § 512 (1982)? May it allocate those expenses, as prescribed by Treas.Reg. § 1.512(a)-l(c), on any "reasonable" basis? Or must it first establish, as the commissioner here argues, that the expense would not have been incurred in the absence of the business activity? Finding no conflict between the regulation and the statute and finding no error in the determination of the tax court that RPI's method of allocation was reasonable, we reject the commissioner's position and affirm the tax court's judgment, which approved apportioning the fieldhouse's idle time in proportion to the hours devoted to exempt and non-exempt uses.
The facts are undisputed. Rensselaer Polytechnic Institute (RPI) is a non-profit educational organization entitled to tax-exempt status under I.R.C. § 501(c)(3). It owns and operates a fieldhouse which it devotes to two broad categories of uses: (1) student uses, which include physical education, college ice hockey, student ice skating, and other activities related to RPI's tax-exempt educational responsibilities; and (2) commercial uses, which include activities and events such as commercial ice shows and public ice skating, that do not fall within its tax-exempt function. For fiscal year 1974, the net income from commercial use of the fieldhouse constituted "unrelated business taxable income" which was subject to taxation under I.R.C. § 511(a)(1).
The dispute is over the amount of unrelated business tax due from RPI for 1974 and, since there is no disagreement over the gross income, $476,613, we must focus on the deductible expenses. The parties have classified RPI's applicable deductible expenses in three groups. The first group, "direct expenses", are those that can be specifically identified with particular commercial uses. For the year in question direct expenses amounted to $371,407, and the parties have always agreed to their deductibility.
The second group, "variable expenses", are those which vary in proportion to actual use of the fieldhouse, but which cannot be identified with particular events. They were originally in dispute before the tax court, but neither side has appealed that part of the decision below which (a) found the total variable expenses to be $197,210; and (b) allocated them on the basis of actual use, as claimed by RPI, rather than total availability, as claimed by the commissioner.
This appeal involves the third group, "fixed expenses", which do not vary in proportion to actual use of the facility. The amounts of fixed expenses incurred with respect to the fieldhouse were stipulated to be:
Salaries and fringe benefits . $ 59,415
Depreciation . 29,397
Repairs and Replacements . 14,031
Operating Expenditures . —hM®
$104,199
Narrowly stated, the issue is how these fixed expenses should be allocated between RPI's dual uses: the exempt student use and the taxable commercial use. RPI contends it is entitled to allocate the fixed expenses on the basis of relative times of actual use. Thus, in computing that portion of its deductible expenses, RPI multiplies the total amount of fixed expenses by a fraction, whose numerator is the total number of hours the fieldhouse was used for commercial events, and whose denominator is the total number of hours the fieldhouse was used for all activities and events — student and commercial combined.
The commissioner argues that the allocation of fixed expenses must be made not on the basis of times of actual use, but on the basis of total time available for use. Thus, he contends the denominator of the fraction should be the total number of hours in the taxable year. In practical terms, the difference between the two methods of allocation amounts to $9,259 in taxes.
Below, the tax court agreed with RPI's method of allocating on the basis of actual use, finding it to be "reasonable" within the meaning of Treas.Reg. § 1.512(a)-l(c). The commissioner appeals, contending (a) that the tax court's otherwise reasonable allocation based on actual use does not satisfy the statutory requirement that in order to be deductible an expense must be "directly connected with" the unrelated business activity; (b) that the eases the tax court relied on below, dealing with allocation of home office expenses between business and personal use, are inapposite; and (c) that strict application of the "directly connected with" language of the statute is "necessary to prevent serious abuse of the tax exemption privilege."
It has been the consistent policy of this nation to exempt from income taxes a corporation, like RPI, that is "organized and operated exclusively for educational purposes ". I.R.C. § 501(c)(3). This preferred treatment to educational, as well as religious, charitable, and scientific institutions, was established simultaneously with the first income tax- enacted by congress in 1913, and has been continued in identical language through a series of revenue acts down to and including the current provision contained in I.R.C. § 501. E.g., 1954 — ch. 1, § 501, 68A Stat. 163; 1936— ch. 690, § 101, 49 Stat. 1673; 1934 — ch. 277 § 101, 48 Stat. 700; 1932 — eh. 209, § 103, 47 Stat. 193; 1928 — ch. 852, § 103, 45 Stat. 812; 1926 — ch. 27, § 231, 44 Stat. 39; 1924 —ch. 234, § 231, 43 Stat. 282; 1921 — ch. 136, § 231, 42 Stat. 253; 1919 — ch. 18, § 231, 40 Stat. 1076; 1916 — ch. 463, § 11, 39 Stat. 766; 1913 — ch. 16, § II G(a), 38 Stat. 172. So firm was the policy shielding educational institutions from taxation that, despite repeated challenges by the commissioner, the statute was consistently interpreted to exempt from taxation all income earned by an exempt corporation, even that obtained from activities unrelated to its tax-exempt educational purposes. See Mueller Co. v. Commissioner, 190 F.2d 120 (3d Cir.1951).
Recognizing, however, the unfair competitive advantage that freedom from income taxation could accord tax-exempt institutions that entered the world of commerce, congress, in 1950, extended the income tax to the "unrelated business income" of certain tax-exempt institutions, including educational corporations. Pub.L. No. 81-814, § 301, 64 Stat. 906, 947 (1950) (codified at I.R.C. § 511-513). Its objective in changing the law was to eliminate the competitive advantage educational and charitable corporations enjoyed over private enterprise, without jeopardizing the basic purpose of the tax-exemption. See H.R.Rep. No. 2319, 81st Cong., 2d Sess. 36-38; S.Rep. No. 2375, 81st Cong., 2d Sess. 28-30; see also Louisiana Credit Union League v. United States, 693 F.2d 525, 539-40 (5th Cir.1982).
With this historical background in mind, we turn to the applicable statute and regulations. Section 512 of the code defines as "unrelated business taxable income" gross income derived from unrelated business activities less deductions "directly connected with" such activities. Treas.Reg. § 1.512(a)-l(a) further defines the term "directly connected with", and provides that "to be 'directly connected with' the conduct of unrelated business for purposes of section 512, an item of deduction must have proximate and primary relationship" to' that business. Two subsequent subsections of that regulation define "proximate and primary relationship" in the contexts of (a) items that are attributable solely to the unrelated business, Treas.Reg. § 1.512(a)-l(b); and (b) as in this case, items that are attributable to facilities or personnel used for both exempt and unrelated purposes, Treas.Reg. § 1.512(a)-l(c). The latter regulation provides:
(c) Dual use of facilities or personnel. Where facilities are used both to carry on exempt activities and to conduct unrelated trade or business activities, expenses, depreciation and similar items attributable to such facilities (as, for example, items of overhead), shall be allocated between the two uses on a reasonable basis. Similarly, where personnel are used both to carry on exempt activities and to conduct unrelated trade or business activities, expenses and similar items attributable to such personnel (as, for example, items of salary) shall be allocated between the two uses on a reasonable basis. The portion of any such items so allocated to the unrelated trade or business activity is proximately and primarily related to that business activity, and shall be allowable as a deduction in computing unrelated business taxable income in the manner and to the extent permitted by section 162, section 167 or other relevant provisions of the Code.
Treas.Reg. § 1.512(a)-l(c) (emphasis added).
Thus, when allocated "on a reasonable basis", expenses attributable to such facilities or personnel — which expressly include such "indirect expenses" as depreciation and overhead — are by definition "proximately and primarily related" to the business. They are therefore "directly connected with" the unrelated business activity and expressly made deductible by the regulation.
Under this regulation, therefore, the critical question is whether the method of allocation adopted by RPI was "reasonable". The tax court found that it was, and, giving due regard to its expertise in this area, ABKCO Industries, Inc. v. Commissioner, 482 F.2d 150, 155 (3d Cir.1973), we see no error in that conclusion. Apportioning indirect expenses such as depreciation on the basis of the actual hours the facility was used for both exempt and taxable purposes sensibly distributes the cost of the facility among the activities that benefit from its use. In addition, the method is consistent with that followed by the tax court in the most common dual-use situation, home office deduction cases. See Browne v. Commissioner, 73 T.C. 723 (1980); Gino v. Commissioner, 60 T.C. 304, rev'd, 538 F.2d 833 (9th Cir.1976), cert. denied, 429 U.S. 979, 97 S.Ct. 490, 50 L.Ed.2d 587 (1976); International Artists, Ltd. v. Commissioner, 55 T.C. 94 (1970).
Indeed, the commissioner does not claim that RPI's allocation method is factually unreasonable, but instead contends solely that the method is not "reasonable", because by permitting depreciation during "idle time", when the fieldhouse is not being used at all, it contravenes the statutory requirement that deductible expenses be "directly connected with" RPI's unrelated business activities. By advancing this argument, however, the commissioner ignores his own definition of. the concept "directly connected with" included in Treas.Reg. § 1.512(a)-l(a) discussed above. In addition, the commissioner would have us adopt a more stringent interpretation of "directly connected with" in § 512 than has been applied for over sixty years to the same concept in the commissioner's regulations governing the deductibility of ordinary and necessary business expenses. See Treas.Reg. § 1.162-l(a). Moreover, the logical extension of his position would require the commissioner to deny depreciation deductions to all businesses for those periods when their assets are idle. Such a view, however, would contravene the basic concepts underlying the commissioner's elaborate regulations governing depreciation generally. See Treas.Reg. § 1.167(a)-l et seq.
For an expense to be "directly connected with" an activity, the commissioner argues that it must be one that would not have been incurred in the absence of the activity. But whether or not the fieldhouse is actually put to any business use, depreciation of the facility continues. We cannot accept the commissioner's argument, therefore, because it would in effect eliminate entirely all deductions for indirect expenses such as depreciation, a result that is not required by statute and that is directly contrary to the regulation.
The commissioner relies on Pittsburgh Press Club v. United States, 579 F.2d 751 (3d Cir.1978), to support his argument that indirect expenses that would have been incurred regardless of business use may not properly be deducted from unrelated business income. That case, however, arose under § 501(c)(7), which prohibited an exempt social club from engaging in any business activities. It is inapplicable here, because RPI, as an exempt educational institution, is permitted by statute to engage in unrelated business activities. The issue before us is not whether a business was carried on, but what is the proper allocation of indirect expenses, such as depreciation, between two uses, one a taxable business use and the other tax-exempt.
Furthermore, to apply the statute as the commissioner interprets it would not fulfill the congressional purpose of placing private enterprise on an equal level with competing businesses run by tax-exempt institutions, but would place RPI at a competitive disadvantage. Unlike business enterprises, it would be unable to allocate any of its indirect expenses to those periods when the fieldhouse was not being used at all.
Some concern has been expressed that RPI's allocation method would provide an incentive for educational institutions to abuse their tax-exempt status. The argument is a red herring. Use of educational facilities for producing unrelated business income is not tax abuse; on the contrary, as we have pointed out above, such non-exempt activities have been consistently permitted and, since 1950, expressly approved by congress. Moreover, should the trustees of a particular tax-exempt educational institution so pervert its operations that the institution no longer "engages primarily in activities which accomplish [its exempt purposes]", Treas.Reg. § 1.501(c)(3)-1(c)(1), the commissioner has adequate remedies available to correct any abuse or even terminate the exemption.
The judgment appealed from is affirmed.