A volunteer fire department located in Green County holds tax-exempt status. As a way of raising funds to support its firefighting activities, the department obtained the permission of the owners of three taverns located in Green County to place "tip jars" in the taverns. A tip jar is a gambling device from which patrons purchase sealed pieces of paper containing numbers, series of numbers, or symbols that may entitle the patron to cash or other prizes. The tip jars are legal under state law and under the county ordinance for tax-exempt organizations.
Under the county ordinance, the tax-exempt organization must receive at least 70% of the net proceeds after the winnings are paid, and the business where the tip jar is located must receive no more than 30%. Under the arrangement with the three taverns, the volunteer fire department received 80%.
The three taverns included the 20% they received in their gross income in calculating their taxable income. Because the volunteer fire department is tax-exempt, it did not pay Federal income taxes on the 80% it received.
The IRS determines that the tip jar income received by the volunteer fire department is unrelated business income and issues a deficiency notice. Evaluate the position of the IRS.