In a recent private letter ruling (PLR 200852036), an exempt organization proposed to fund clinical testing of drugs to find a cure for an “orphan” disease, i.e., a disease to which commercial organizations otherwise may not devote significant resources in light of the dearth of potential patients and the relatively low likelihood of developing a marketable treatment. (Caution: a private letter ruling does not constitute binding precedent for anyone other than the taxpayer requesting the ruling; but it can help illuminate the IRS’s position on certain legal issues under specific facts and circumstances.)

The IRS ruled that the organization’s funding of such clinical testing would not jeopardize its exemption from federal income tax under section 501(c)(3) of the Internal Revenue Code. In reaching this conclusion, the IRS noted that the exempt purposes enumerated in Code section 501(c)(3) include certain scientific activities.  Corresponding Treasury Regulations provide that for an activity to qualify as scientific, the activity must satisfy three requirements: 

  • The activity must be truly scientific, which has been defined by various courts as “a process by which knowledge is systematized or classified through the use of observation, experimentation, or reasoning.”
  • The organization must actively engage in research.  That is, to constitute research, the activities must be centered on determining the validity of particular research principles.  Scientific research does not include activities that ordinarily are carried on as an incident to commercial operations (e.g., ordinary testing or inspection of materials). In this regard, testing should be based on patient needs rather than market or commercial applications, and the selection of compounds generally should be undertaken by the exempt organization rather than the owner (s) of the drugs.
  • The scientific research must be in the public interest, e.g., for the purpose of discovering a cure for a disease.

The IRS also observed that pursuant to the Treasury Regulations, under certain circumstances scientific research will be in the public interest even if a commercial sponsor retains the rights to intellectual property generated by the research.

This is an area of great complexity, and the facts matter. Nevertheless, this three-part inquiry represents a useful starting point in analyzing whether clinical testing activities would jeopardize an organization’s federal income tax exemption or subject it to unrelated business income tax on revenue generated by the activities.