Wednesday March 21, 2018
Navigating the Unrelated Business Income Tax – Part I
Under Sec. 501(c)(3), tax-exempt organizations must operate primarily for exempt purposes. Sec. 1.501(c)(3)-1(c)(1). This standard is known as the operational test and is designed to ensure that tax-exempt organizations are indeed operating for exempt purposes. However, the regulations recognize that organizations may engage in some non-exempt activity, so long as they are primarily operating for exempt purposes.
Exempt organizations do not pay taxes on income earned from exempt activities. However, income generated in furtherance of activities unrelated to exempt purposes may result in unrelated business income tax (UBIT). Sec. 511(a). The purpose of the UBIT rules is to prevent charities from competing with for-profit businesses and enterprises. The general UBIT rules are straightforward but are modified by a number of exclusions and exceptions. Exempt organizations should familiarize themselves with the UBIT rules so they may avoid any jeopardy to their tax-exempt status.
This is Part I in a two-part series covering the UBIT rules and their application to tax-exempt organizations. This first part will cover the basics of the UBIT rules, exceptions and exclusions. Part II will discuss situations in which the UBIT exclusions do not apply and the ways UBIT can affect planned giving vehicles, such as charitable remainder trusts and charitable lead trusts.
Overview of Unrelated Business Income Tax
Under Sec. 511, the unrelated business taxable income (UBTI) of exempt organizations is subject to tax. Unrelated business taxable income is defined as the gross income derived by any organization from any "unrelated trade or business" regularly carried on by the organization, less the allowable deductions directly connected with the conduct of that trade or business. Sec. 512(a)(1).
An exempt organization's activity will produce UBTI if the activity (1) is a trade or business, (2) that is regularly carried on and (3) is not substantially related to the exempt organization's purpose.
Trade or Business. The term "trade or business" is defined as "any activity which is carried on for the production of income from the sale of goods or the performance of services." Sec. 513(c). The term "trade or business" has the same meaning for UBIT purposes that it has in Sec. 162 relating to deductions for business expenses. Sec. 1.513-1(b).
Activities do not lose their identity as a trade or business merely because they are carried on within a larger aggregate of similar activities that may or may not be related to the organization's exempt purpose. For example, the Regulations cite the example of an exempt organization selling advertisements in its periodicals. In this case, the selling of advertisements is an activity that retains its status as a trade or business even though the periodicals contain material related to the organization's exempt purpose. Sec. 1.513-1(b).
Regularly Carried On. An exempt organization regularly carries on a business activity when it conducts the activity with the same frequency and continuity, and in the same manner, as a for-profit business. Consequently, if an activity is of a type that for-profit businesses carry on year round, but which an exempt organization only conducts for a period of a few weeks, such activity would not be considered "regularly carried on." Sec. 1.513-1(c)(2)(i). For example, the Regulations mention that a hospital auxiliary's operation of a sandwich stand for only two weeks at a state fair would not be deemed regularly carried on.
Conversely, where commercial organizations would generally conduct a business activity on a seasonal basis, the conduct of a similar activity by an exempt organization during a significant portion of the season would be the regular conduct of a trade or business. Sec. 1.513-1(c)(2)(i). For example, a church's operation of a Christmas tree lot during the same period that nonexempt businesses would operate such lots could be considered the regular conduct of a trade or business.
The Regulations also indicate that activities that are "engaged in only discontinuously or periodically will not be considered regularly carried on if they are conducted without the competitive and promotional efforts typical of commercial endeavors." Sec. 1.513-1(c)(2)(ii). For example, the publication of advertising in programs for sporting or music events generally will not be considered the regular conduct of a business.
In addition, when an exempt organization sells certain goods or services to a particular class of persons in pursuance of an organization's exempt purpose or "primarily for the convenience of such persons," casual sales in the course of such activity that are unrelated to the organization's exempt function will not be deemed regularly carried on. For example, the sale of unrelated goods or services at a college's bookstore may not be deemed the regular conduct of a business.
Not Substantially Related. The third element in the UBTI determination is one that typically requires a deeper analysis of the relationship between the activity and the accomplishment of an exempt organization's purposes. See Sec. 1.513-1(d)(1). This ordinarily requires a facts and circumstances analysis. The business activity must have a "causal" relationship to the achievement of an exempt organization's purposes (other than the production of income). Sec. 1.513-1(d)(2). For an activity to be "substantially related" to an exempt purpose, the activity must contribute importantly to the achievement of that purpose, taking into account the size and extent of the activity. Sec. 1.513-1(d)(2); (3).
However, an activity otherwise related to an exempt purpose conducted on a larger scale than is reasonably necessary to carry out such purpose can result in it becoming unrelated. In this case, the portion of the income in excess of what is necessary to achieve the exempt purpose will be considered income from an unrelated activity. Sec. 1.513-1(d)(3).
An activity may not be "substantially related" if the activity is unrelated to the exempt purposes of the specific exempt organization involved. Consequently, an organization performing an activity that would otherwise achieve a legitimate exempt purpose can nonetheless be considered unrelated if the activity does not serve a stated exempt purpose of the organization. For example, in Rev. Rul. 73-105, a museum's sale of science and city-related souvenirs was considered unrelated to the museum's stated exempt purposes. Rev. Rul. 73-105, 1973-1 C.B. 264.
Unrelated Trade or Business Exceptions
The unrelated business taxable income rules contain a number of exceptions to the general definition of unrelated business income.
Volunteer Labor. Any activity where substantially all of the work is performed for the exempt organization without compensation will be excluded from the definition of a trade or business. Sec. 513(a)(1). For example, a church's operation of a Christmas tree lot during the holiday season would ordinarily be considered a trade or business. However, if volunteers perform all of the work, then the church's operation of a Christmas tree lot would not be considered a trade or business.
Convenience of Members. Also excluded from the definition of a trade or business is any activity or service performed by an exempt organization primarily for the convenience of its members, students, patients, officers or employees. Sec. 513(a)(2). An example of this exception is a hospital operating a cafeteria for the convenience of its employees and patients.
Selling Donated Merchandise. Any activity that consists of the selling of donated merchandise will not be considered a trade or business. This is known as the "thrift shop" exception. For this exception, "substantially all" of the merchandise must have been received by the organization as gifts or contributions. Sec. 513(a)(3).
Qualified sponsorship payments. One area of potential ambiguity relates to sponsorship payments. Generally, advertising income will generate UBTI. However, the acknowledgement of donations is not considered advertising. It can sometimes be unclear where the line should be drawn between an advertisement and an organization's acknowledgment of a donation.
Fortunately, Sec. 513(i) specifies that a qualified sponsorship payment (QSP) is not treated as UBTI. Therefore, a charity may agree to use or acknowledge a sponsor's name, logo or product line in return for a payment from the sponsor. So long as the sponsor does not expect to receive a "substantial" benefit in return other than the use or acknowledgement of its name, logo or product line, the money received by the charity is not subject to UBIT. Sec. 513(i).
A substantial benefit includes goods or services such as complimentary tickets, donor receptions, exclusive provider agreements or links to a website that endorses the sponsor's product. A substantial benefit does not include goods or services with insubstantial value (not more than 2% of sponsorship payment), exclusive sponsor agreements or links to a website about the sponsor where there is no promotion or advertising of the sponsor's product. Sec. 1.513-4(c)(2)(ii).
There are two limits on what can constitute a QSP. First, the amount of a sponsor's payment cannot be contingent upon the level of attendance at an event, broadcast ratings or other factors indicating the degree of public exposure to a sponsored event or activity. Second, a QSP does not include any payment entitling the sponsor to the use or acknowledgment of the name or logo of the sponsor's trade or business in a periodical. A periodical is defined as "regularly scheduled and printed material published by or on behalf of the exempt organization that is not related to and primarily distributed in connection with a specific event conducted by the exempt organization." Sec. 1.513-4(b).
Other Exceptions. The UBIT rules also contain a few other exceptions that apply in specific circumstances. First, certain bingo games conducted by exempt organizations will not generate UBTI. Sec. 513(f). Second, organizations performing services described in Sec. 501(e)(1)(A) to tax-exempt hospitals will not generate UBTI for those services. Sec. 513(e). Finally, income generated by exempt organizations at conventions or trade shows that meet the requirements of Sec. 513(d) is also excluded.
"Passive Income" Exclusion
When the UBIT rules were created in the 1950s, they were designed to prevent exempt organizations from competing with for-profit businesses. However, Congress did not intend to prevent exempt organizations from receiving income from passive sources. The Senate report discussing the new UBIT rules in 1950 made this point clear. The report provided that "investment-producing incomes of these types have long been recognized as a proper source of revenue for educational and charitable organizations." S. Rep. No. 2375, 81st Cong., 2d. Sess. 30-31. Thus, passive income is excluded from UBTI. Sec. 512(b). For the purposes of the UBIT rules, passive income includes interests, dividends and annuities; capital gains; rents from real property; and royalties.
Interest, Dividends and Annuities. Income that includes interest, dividends, annuities, payments with respect to securities loans as defined in Sec. 512(a) and other substantially similar income from ordinary and routine investments is excluded from UBTI. Sec. 512(b)(1). This category of income includes many traditional investment sources. It does not include realized capital gains or losses from the sale, exchange, or other disposition of property, which is covered by a separate exclusion. Sec. 1.512(b)-1(a)(2).
Capital gains. The general rule is that capital gains or losses from the sale, exchange or other disposition of property are excluded from the definition of UBTI. Sec. 512(b)(5). However, some capital gains may still generate UBTI. This would include gains from property that would be includible in inventory or property primarily held for sale to customers in the ordinary course of a trade or business. Sec. 512(b)(5)(b).
Rents from Real Property. Rents received from the use of, or the right to use, real property are passive income excluded from UBTI. Sec. 512(b)(3). The definition of "rents" in this context can be a troublesome spot for charities. Rents are not excluded from UBTI if the rent "depends in whole or in part on the income or profits derived by any person from the property leased." Sec. 512(b)(3)(B)(ii). Thus, fixed payment leases will generally be properly classified as "rents" and therefore excluded from UBTI.
Even where an exempt organization receives fixed-payment rent, it may nonetheless have UBTI if the charity renders personal services in connection with the lease. Consequently, if the facts and circumstances indicate that a charity provides significant services or incurs substantial costs in managing real property, income collected may not be classified as "rents," but instead will be UBTI. For example, income from the use or occupancy of hotels and apartment houses furnishing hotel services, or the use of space in parking lots and storage garages, will constitute UBTI. Sec. 1.512(b)-1(c)(5).
If a charity owns rental property and does not want rents from that property to be subject to UBTI, a good solution is to execute a net lease where a third party leases and manages the property. Rents from net leases are not derived from the active trade or business of renting property, and therefore, are passive investment income.
Rents from Personal Property. Rents received from the use of, or the right to use, personal property (e.g., computer or medical equipment) are passive income only if they are derived from a mixed lease (a lease that includes both real and personal property) and the rents attributable to the personal property are "incidental" (less than 10% of the total rents received under the lease). Sec. 1.512(b)-1(c)(2)(ii)(b). If the amount attributable to personal property is more than incidental but not more than 50% of the total, the real property rent is excludable and the personal property rent is not. However, if the personal property rent exceeds 50% of the total, none of the rent is excludable from UBTI. Sec. 1.512(b)-1(c)(2)(iii)(a).
Royalties. Royalties are passive income excluded from UBTI. Sec. 512(b)(2). The definition of a royalty is exceedingly broad and extends to virtually all payments for the right to use intangible property, including income for the use of intellectual property (i.e., patents, trademarks and copyrights) and mineral royalties. Sec. 1.512(b)-1(b).
Regarding mineral royalties, exempt organizations must be careful if they own, or are considering owning, a working mineral interest. Because a working interest is normally held by the company that actually drills and extracts the minerals, such an interest will generate UBTI. Even with a working interest, it is possible to create an override royalty interest. The override royalty is also a passive interest that does not produce UBTI. Sec. 512(b)(3). This is because an override royalty relieves the interest holder from any share in the development costs of the operator that owns the working interest. Sec. 1.512(b)-1(b).
Congress grants charitable organizations exempt status as part of the United States' long history of encouraging philanthropy. However, exempt organizations are not to use their exempt status to engage in non-exempt activities. The unrelated business income tax is one way to prevent non-exempt behavior. Furthermore, because exempt organizations should operate primarily for exempt purposes, too much unrelated business income may be a sign that an organization is operating for non-exempt purposes and thus in danger of losing its exempt status. Legal and professional advisors armed with a solid understanding of the unrelated business income tax rules can help exempt organizations ensure they minimize unrelated business income. This in turn allows exempt organizations to focus on performing the exempt purposes for which they were created.
Published March 1, 2017