Welcome to the UBIT Blog

This is a blog about the unrelated business income tax (UBIT), which applies to most tax-exempt organizations. The blog will discuss new IRS and judicial developments and new and proposed legislation involving the UBIT. Attorneys, accountants, officers and directors of exempt organizations, and others interested in the UBIT will find the information useful and are welcome to comment.

Tax Reform 2017: UBIT Rates Would Decrease to Reflect Reduced Corporate and Trust Rates

One of the main goals of the current tax reform efforts is to reduce income tax rates on individuals and corporations. The tax on UBTI is calculated using the corporate tax rates, if the exempt organization is a corporation, or the trust tax rates, if the exempt organization is a trust. Thus, a reduction in the tax rates for corporations and trusts will result in lower taxes imposed on most exempt organizations with respect to their unrelated businesses. Whether the lower rates result in lower UBIT depends upon the deductions contained in the final legislation.

H.R.1, the proposed tax reform bill of the House of Representatives entitled “Tax Cuts and Jobs Act,” appears here. For a description of the Senate proposal, click here.

Corporations

The rate of tax for exempt organizations that are not trusts, and for state colleges and universities, is governed by the corporate income tax rates under §11. §511(a). Under present law, four graduated tax brackets apply:

  • 15% on taxable income that does not exceed $50,000 
  • 25% on taxable income that exceeds $50,000 but does not exceed $75,000 
  • 34% on taxable income that exceeds $75,000 but does not exceed $10,000,000, and 
  • 35% on taxable income that exceeds $10,000,000.

Additional income taxes of up to $11,750 or $100,000 are imposed if a corporation has taxable income exceeding $100,000 or $15,000,000, respectively.

Under both the House and Senate tax reform proposals, the four graduated rates under current §11 are repealed and replaced by a single corporate tax rate of 20%. H.R. 1, §3001(b)(1). Under the House proposal, the 20% rate would take effect for tax years beginning after December 31, 2017. Under the Senate version, the flat rate would apply for tax years beginning after December 31, 2018.

The proposed flat tax rate of 20% is greater than the rate currently imposed on UBTI not exceeding $50,000 but is less than the three other rates currently imposed when UBTI exceeds $50,000. Thus, most exempt organizations would have their UBIT rates reduced under the proposed plan.

 Example: Exempt organization Z is a charity that operates as a corporation. Z derives income from the regular conduct of an unrelated trade or business. During the tax year, Z derived $700,000 in gross income from the unrelated business and incurred $600,000 in expenses. Assume Z’s UBTI is $100,000. Under present law, Z would owe $22,250 unrelated business income tax before credits or any other adjustments. Under the proposed flat rate of 20%, Z’s unrelated business income tax would be $20,000 before credits or any other adjustments.

 Comment: The U.S. has traditionally had a progressive tax rate system with graduated tax rates. The arguments generally made in favor of graduated rates are that they reduce income inequality and promote fairness by placing the greatest burden on those able to pay more. Opponents argue that progressive rates inhibit economic growth by reducing savings and investment. The replacement of the graduated corporate tax rates with a flat rate represents a significant change in the area of corporate taxation.

Trusts

For those exempt organizations that operate in trust form, the current income tax rates range from 15% to 39.6%, with the highest rate payable on income exceeding $12,500. §1(e).The trust tax rates imposed in H.R. 1 range from from 12% to 39.6%, applied as follows:

  • 25% bracket threshold amount 2,550 §1(b)(1)(D)
  • 35% bracket threshold amount 9,150 §1(b)(2)(D)
  • 39% bracket threshold amount 12,500 §1(b)(3)(C)

These dollar amounts are adjusted for inflation for tax years beginning after 2018. §1(c).

Under the Senate’s proposed plan, the current brackets for trusts would be replaced by rates ranging from 10% to 38.5%, with the highest rate payable on income exceeding $12,500.

Thus, under either the 2017 tax reform plans, the UBIT on exempt organizations taxed as trusts would be only marginally reduced. Taking into account tax deductions that may no longer be available, exempt organizations taxed as trusts may actually see an increase in their UBIT.  

Conclusion

The status of tax reform is changing daily. Lower income tax rates increase the federal deficit unless they are offset by spending cuts. Given the differing priorities of our representatives in Congress, compromises must be reached before any tax reform can be enacted. This post is just a reminder that lower income tax rates for individuals, trusts, and corporations will affect tax rates for purposes of the UBIT.

 

Additional Resources:

Andrew Kreighbaum, Taxing T-shirt Revenue, Inside Higher Education (November 13, 2017)

 

Net Operating Losses in an Unrelated Trade or Business

NOL Deduction

Like individuals and corporations, an exempt organization can incur a net operating loss (NOL) in the conduct of an unrelated trade or business. Subject to certain modifications, a net operating loss is the excess of the organization’s deductions over its gross income. A net operating loss can be carried back to the two tax years preceding the loss year and carried forward to the 20 tax years succeeding the loss year. Thus, a NOL can reduce taxable income in a carryback or carryover year. The net operating loss deduction is authorized under §172.

Section 512(b)(6) provides that the net operating loss deduction is allowed in determining an exempt organization’s UBTI. Two special rules apply. An organization’s NOL is determined without taking into account any item of income or deduction that is excluded in determining UBTI. In addition, an exempt organization cannot carry a NOL back or forward to a tax year in which the organization was not subject to the UBIT.

Multiple Unrelated Trades or Businesses

If an organization conducts more than one unrelated trade or business, UBTI is determined by aggregating the gross income from all the unrelated businesses and subtracting the deductions directly connected with the businesses. Thus, a loss in one unrelated trade or business may offset taxable income from another unrelated trade or business. If a loss remains after the income and deductions of all unrelated businesses are aggregated, then the net operating loss deduction becomes applicable.

Under the tax reform proposal announced by the U.S. Senate last week, each of an exempt organization’s unrelated businesses must be treated as a separate trade or business in determining UBTI. Under this approach, a NOL in one unrelated trade or business can be carried back or forward to offset future income from the same unrelated business but not from a different unrelated business. The proposal is disadvantageous to exempt organizations because they cannot use a loss from one unrelated business to offset income from a different unrelated business in the same tax year. If the Senate proposal becomes law, the net operating loss deduction will likely figure more prominently in computing UBTI of organizations with multiple unrelated businesses. Also, an exempt organization may decide to discontinue an unrelated business that consistently produces a loss because such loss cannot be used against income from another unrelated business.

The proposed Tax Cuts and Jobs Act proposed by the House of Representatives does not contain the ban on aggregation of items from separate trades or businesses.

Taxpayers Cannot Deduct UBIT Losses from Their IRAs

Pension plans and IRAs may incur unrelated business income tax liability if they invest in debt-financed assets. The portion of income or loss taken into account as UBTI is determined by applying a debt/basis percentage to the income and deductions from the property. §514(a). If there is a NOL in an IRA, for example, the loss could be carried back and forward under the net operating loss rules.

The Tax Court considered a case in which a taxpayer sought to use a NOL in his IRA to offset income on his personal income tax return. The taxpayer argued that an IRA is similar to a grantor trust in that income and deductions should pass through to the individual creating the account. Rejecting this contention, the Tax Court held that an IRA is a tax-exempt entity and not a pass-through entity. Thus, distributions from the IRA to the taxpayer were included in his income, but losses within the IRA were not available for his personal use. See Fish v. Commissioner, T.C. Memo 2015-176, aff’d, 2017 U.S. App. Lexis 20565 (9th Cir. 2017).

 

Tax Reform 2017: Senate Proposes Changes to the UBIT

On November 2, 2017, the U.S. House of Representatives released a proposed tax reform bill. The proposals in the House bill that affect the UBIT are described in Tax Reform 2017: House Proposes Changes to the UBIT. On November 9, 2017, the Senate Finance Committee announced the Senate version of tax reform, which is described by the Joint Committee on Taxation in a document scheduled for markup by the Finance Committee on November 13, 2017. Senate proposals that would affect the UBIT are described in this post.

Sale or Licensing of Exempt Organization’s Name or Logo

Income from passive sources, such as dividends, interest, royalties, certain rents, and gain from the sale of property, is generally excluded from the scope of the UBIT. Under present law, if an exempt organization licenses its name or logo to a for-profit company in return for a fee, the fee is treated as an excluded royalty payment, so long as the organization is not required to render considerable services under the arrangement.

The Senate proposal retains the general exclusion of royalties from the UBIT but eliminates the exclusion for income derived by an exempt organization from selling or licensing its name or logo. Specifically, the Senate version treats the sale or licensing of a name or logo as an unrelated trade or business that is regularly carried on by the organization. Moreover, income from licensing a name or logo is expressly included in an organization’s unrelated business taxable income, regardless of any provisions that exclude various categories of passive income, such as royalties. The Joint Committee description does not state that income from the sale of an organization’s name or logo is expressly included in UBIT, but that would be the logical result of treating the sale of a name or logo as a regularly conducted trade or business.

Many exempt organizations will be adversely affected if income from licensing their names and logos becomes taxable. The taxation of such licensing income seems inconsistent with the underlying structure and purpose of the UBIT. Most passive income is expressly excluded from the scope of the tax. The exclusion covers dividends, interest, royalties, some rents, and gains from the sale of property, so long as the passive income is not derived from debt-financed property. A fee paid for the use of an exempt organization’s name or logo is a classic royalty payment, provided that the organization does not render excessive services under the license agreement.

Moreover, ever if licensing a name or logo were treated as a trade or business, at least some name and logo licensing would be considered a related trade or business not subject to the UBIT. For example, when a university licenses its name and logo to a company that makes apparel, students, alumni, and friends of the university purchase the items to show their loyalty and school spirit. The appearance of the name and logo promotes the university and its programs, which is a purpose that is related to the educational function of the university. In contrast, if an exempt organization licenses its name and logo to an insurance company for the purposes of selling insurance policies to the organization’s members, the relationship between the promotion of the insurance and the organization’s exempt function is likely too tenuous for purposes of the UBIT. Even so, however, the licensing fee continues to be a royalty, which has always been excluded from the scope of the tax.

UBTI of Multiple Unrelated Trades or Businesses Separately Computed

Some exempt organizations carry on more than a single unrelated trade or business. When there are multiple unrelated businesses, UBTI is computed by aggregating the gross income of the organization from all unrelated businesses and subtracting the deductions directly connected with such businesses. Thus, deductions from one unrelated trade or business would be used to offset income from a different unrelated trade or business.

Under the Senate proposal, each of an exempt organization’s unrelated businesses is treated as a separate business for purposes of determining UBTI. Thus, deductions from an unprofitable unrelated business could not be used to reduce taxable income of another unrelated business. An exempt organization may use a single specific deduction of $1,000, however, irrespective of the number of unrelated businesses it conducts. After the net income or loss is calculated for each trade or business separately, the specific deduction applies. Moreover, net operating losses from a particular unrelated trade or business can only be carried forward to offset income of that same unrelated business in future tax years, in accordance with the net operating loss rules of §172.

Effective Date

The Senate proposals are effective for taxable years beginning after December 31, 2017.

Comparison of House and Senate Proposals

Regarding the UBIT, the House and Senate tax reform proposals are different. The House proposal clarifies that state and local tax-exempt entities, such as pension funds of state organizations, are subject to the UBIT. In addition, the House bill seeks to narrow somewhat one of the exclusions for research income. Addressing neither of these topics, the Senate proposal seeks to tax gain or royalties from the sale or licensing of an exempt organization’s name or logo and eliminates the ability of an exempt organization to aggregate the income and deductions of multiple trades or businesses when computing its UBTI.

As the relatively minor proposed changes to the UBIT are taking a back seat to the talk of individual and corporate rate reductions and the elimination of popular deductions, we may not know which, if any, of the proposed changes to the UBIT will become law if and until a new tax law is passed.

Additional Resource:

Andrew Kreighbaum, “Taxing T-shirt Revenue,” Inside Higher Education (November 13, 2017)

Tax Reform 2017: House Proposes Changes to the UBIT

The draft tax reform bill released by the House of Representatives contains provisions that, if enacted, will affect the unrelated business income tax. While it is uncertain that any tax reform law will be enacted and unlikely that the House bill will be enacted as proposed, we will keep track of the proposed changes affecting the UBIT during the tax reform negotiations.

Note: The tax reform bill is H.R. 1, entitled Tax Cuts and Jobs Act. To read the entire text of the proposed bill, click here.

Application of UBIT to State and Local Entities

Section 501(c) lists numerous categories of exempt organizations that are exempt from income taxes. Notwithstanding the exemptions, most exempt organizations are nevertheless subject to the unrelated business income tax. State instrumentalities are not mentioned in §501(c) but are exempt from taxation under §115. The exemption applies to income derived from a public utility or the exercise of any essential governmental function and accruing to a state or political subdivision thereof, or the District of Columbia.

The UBIT applies to organizations described in §501(a), employer provided pension plans described in §401(a), and state colleges and universities. Because the UBIT expressly applies to state colleges and universities but not to other state instrumentalities, state and local entities, including pension plans, had been thought to be outside the scope of the UBIT.

The proposed House bill specifically states that an organization or trust shall not fail to be treated as exempt from taxation under this subtitle by reason of section 501(a) solely because such organization is also exempt, or excludes amounts from gross income, by reason of any other provision of this title. H.R. 1, §5001(a). Thus, for purposes of the UBIT, state and local entities are treated as described in §501(a) notwithstanding the fact that their income is also excluded under §115.

Limitation on Exclusion for Research Income

Section 512(b)(9) contains an exclusion from UBTI that applies to organizations operated primarily for purposes of carrying on fundamental research the results of which are freely available to the general public. Under present law, such organizations can exclude from UBTI all income from research performed for any person. The requirement that the organization be operated primarily to carry on fundamental research that is made freely available to the general public means that the organization remains eligible for the exclusion when it performs fundamental research that is not made freely available to the general public so long as the primary purpose requirement is met.

The proposed bill would narrow the exclusion to cover only income from research the results of which are freely available to the general public. H.R. 1, §5002(a) Thus, if an organization operated primarily for purposes of carrying on fundamental research with results freely available to the general public performs fundamental research that is not made freely available, income from such research is subject to the UBIT.

Effective Date

The proposed effective date for both amendments is December 31, 2017.

Inflation Adjusted Items for 2017

 Rev. Proc. 2016-55 provides exempt organizations with two inflation adjustments for 2017.

1. Dues Paid to Agricultural or Horticultural Organizations

Agricultural and horticultural organizations described in §501(c)(5) are exempt organizations subject to the UBIT. Section 512(d) contains a special rule under which no portion of member dues paid to an agricultural or horticultural organization can be treated as UBTI by reason of benefits or privileges to which members are entitled. For tax years beginning in 2017, the exclusion applies so long as:

  •     Payment of dues is a condition of membership; and
  •     The required annual dues do not exceed $162.          !

When §512(d) was enacted in 1996, effective for tax years beginning after Dec. 31, 1986, the dollar limitation was $100. The limitation has been adjusted for inflation for taxable years beginning after 1995. Section 3.29 of Rev. Proc. 2016-55 provides that the inflation adjusted amount for 2017 is $162.

2. Limitation for Contributions Solicited Using Low Cost Articles

Charitable organizations sometimes solicit contributions by mailing out low cost items to potential donors. For example, the envelope containing the solicitation may state “A Free Gift For You Inside.” The organization hopes that the reference to the gift may motivate the recipient to open the envelope and that receipt of the item will spur the recipient to respond with a contribution. Typical low cost articles furnished with solicitations include calendars, pens, greeting cards, note pads, and mailing labels. Because the sale of goods constitutes a trade or business for purposes of the UBIT, contributions received in connection with low cost articles might be considered a taxable sale of the items by the organization to the extent of the value of the items. To prevent this result for inexpensive items, §513(h) provides that the activities relating to the distribution of low cost articles are not an unrelated trade or business if the distribution is incidental to the solicitation of charitable contributions. For taxable years beginning in 2017, a low cost article is an item that cost the organization $10.70 or less.

When the low cost articles exception was enacted in 1986, the exception applied to articles costing $5.00 or less. The amount has been indexed for inflation since 1988. Section 3.30(1) of Rev. Proc. 2016-55 provides that the inflation-adjusted amount for 2017 is $10.70.

Resources: Rev Proc. 2016-55, 2016-2 C.B. 707

Colleges and Universities UBIT Compliance Project: IRS Final Report (Part 1)

In 2008, the IRS commenced a multi-year project to assess UBIT compliance by colleges and universities. The IRS sent out questionnaires to 400 randomly selected institutions and, based on the responses, selected 34 institutions for audit. Released in 2013, the Final Report analyzes the results of the questionnaires and examinations conducted as part of the Compliance Project. In general, the IRS found significant underreporting of UBIT. While the Compliance Project discussed in the Final Report deals exclusively with colleges and universities, the compliance issues uncovered by the audits may be instructive to other exempt organizations as well.

This article summarizes the highlights of the Final Report concerning the UBIT. Succeeding posts will examine in greater detail the most common compliance errors made by colleges and universities in determining UBTI.

Of the 34 institutions selected for audit, a whopping 90% had increases to UBTI, including more than 180 adjustments representing about $90 million in unpaid taxes. More than one half of the adjustments involved the following activities:

  • Fitness and recreation centers and sports camps
  • Advertising
  • Facility rentals
  • Arenas
  • Golf courses

The adjustments related not only to the underreporting of income from unrelated trades or businesses but also to excessive losses and net operating losses. Over $600 million losses and NOLs were disallowed on 75% of the examined returns.

 Note: The colleges and universities were selected for examination because responses to their questionnaires indicated potential noncompliance on UBIT issues. Thus, the institutions audited are not a representative sample of all colleges and universities. The Final Report cautions that the results apply only to the institutions examined and should not be generalized as representative of other colleges and universities.

 The most common adjustments made in the examinations involved the following issues:

  • Misclassification as a trade or business due to lack of profit motive
  • Misallocation of expenses between exempt and nonexempt activities
  • Errors in computation or substantiation of NOLs
  • Misclassification of unrelated activities as related activities
  • Failure to seek professional advice about the treatment of potentially unrelated activities

In Part 2 of this article, we will discuss how an exempt organization might underreport UBTI as a result of misclassifying an activity lacking a profit motive as a business activity subject to the UBIT.

 

A UBIT for New York City?

In its 2012 budget options report for New York City, the Independent Budget Office offers 72 options for balancing the city budget. One of the options discussed is an unrelated business income tax on exempt organizations in New York City. The city UBIT would be in addition to the federal and New York state taxes on unrelated business taxable income.

 Note: An exempt organization that carries on an unrelated trade or business in the state of New York is subject to a 10% tax on its UBTI. N.Y. TAX. LAW § 290

 The city UBIT would use the same definition of UBTI as the federal tax and would involve similar computations. Thus, the tax would only apply to income from a regularly conducted trade or business that is unrelated to an organization’s exempt purposes.

 According to the report, an 8.85% tax rate on UBTI of exempt organizations in New York City would generate $10 million annually. The 8.85% tax rate corresponds to New York City’s corporate tax rate. A city UBIT would require approval by the New York legislature.

 Potential advantages of a city UBIT include leveling the playing field for taxable corporations. Also, because the city UBIT would parallel the federal and state taxes, the additional administration burdens for exempt organizations would be nominal. The primary objection to a city UBIT is likely to be further erosion of the resources of exempt organizations when demand for their services is increasing due to unfavorable economic conditions.

 

The UBIT Impact of Acquiring an Investment Before or After Borrowing Funds to Conduct Charitable Programs: ABA Taxation Section Requests Guidance

In a letter, dated April 11, 2012, to IRS Commissioner Shulman, the ABA Section on Taxation requested additional guidance concerning the application of the debt-financed income rules when an exempt organization borrows funds to conduct charitable programs or pay administrative expenses either before or after purchasing investment property. The Section on Taxation proposed examples that illustrate how the debt-financed income rules apply in four contemporary fact settings.

 Acquisition Indebtedness Defined

 Under §514, acquisition indebtedness is:

  •  Debt incurred to acquire or improve property;
  • Debt incurred before the acquisition or improvement of property, if the debt would not have been incurred but for the acquisition or improvement; or
  • Debt incurred after the acquisition or improvement of property if the debt would not have been incurred but for the acquisition or improvement and incurring the debt was reasonably foreseeable at the time of the acquisition or improvement.

 Thus, the scope of acquisition indebtedness is not limited to debt acquired simultaneously with an asset purchase, such as with a purchase money mortgage. Indebtedness incurred before or after the acquisition of an asset may be treated as acquisition indebtedness with respect to the asset if certain conditions are present. The applicable rules depend on whether the debt is incurred before or after the asset is acquired.

 When debt is incurred before the acquisition of investment property, a “but for” test is applied. The indebtedness is acquisition indebtedness if the debt would not have been incurred but for the purchase of the property. When debt is incurred subsequent to a property acquisition, there is a two-fold test. The first part of the test is the same “but for” test applied when debt is incurred before the acquisition. The second part of the test asks whether having to incur the debt was reasonably foreseeable at the time of the purchase. These rules prevent exempt organizations from circumventing the debt-financed income rules by artificially timing incurrence of debt either before or after the acquisition of property.

 Debt Incurred Before Property Acquisition

 Reg. §1.514(c)-1(a)(2), Example (1) illustrates acquisition indebtedness incurred prior to the acquisition of investment property. An exempt organization pledges investment assets to secure a loan. Subsequently, the organization uses the borrowed funds to purchase property with a nonexempt use. The organization would not have borrowed the money but for the acquisition of the property. Thus, the loan is acquisition indebtedness and the purchased property is debt-financed property.

 Compare the foregoing example with an example proposed by the Section on Taxation:

 A an exempt school holds $ Z in money market funds in addition to the amount of working capital necessary to continue current operations. The organization needs approximately $ Z to construct a new classroom building. The current interest rates are quite low, and a lender is willing to provide a construction loan that will ultimately be converted into long-term loans secured by the new classroom building. Rather than using the $ Z in its money market funds, the organization decides to take out a construction loan, secured by a general pledge of its assets, to finance the construction of its new building. After taking out the loan and beginning the project, the organization is presented with an attractive investment opportunity that it did not foresee at the time of the borrowing, and it decides to use funds from the money market account to make that investment.

 The Section of Taxation correctly distinguishes its example from Example (1) of Reg. §1.514(c)-1(a)(2). In the example from the regulations, the exempt organization secures a loan but does nothing with the loan proceeds until it purchases the new nonexempt property. We are given no reason why the organization would borrow funds other than to make the subsequent purchase. The organization would not have borrowed the funds but for the purchase of the new property. In contrast, the ABA example gives the exempt organization an independent reason for financing the new classroom facility. Given the current interest rates, it makes business sense to finance the building rather than use the money market funds for the construction. The organization would have borrowed the funds even if the subsequent investment opportunity had not surfaced. Thus, there is no “but for” connection between the loan and the investment.

 Debt Incurred After Property Acquisition

 Example (2) of Reg. §1.514(c)-1(a)(2) illustrates acquisition indebtedness incurred after the acquisition of investment property. An exempt scientific organization used its working capital to remodel an office building which the organization leases for a nonexempt use. Subsequently, the organization mortgages its laboratory to replace the funds it used to remodel the building. Because the mortgage is on exempt use property, the organization may feel like the debt is not acquisition indebtedness. Under the two-fold rule discussed above, however, the organization would not have mortgaged its lab but for the remodel of the office building. Moreover, because the organization used its working capital to remodel the building, it was reasonably foreseeable that it would have to incur debt in order to fund its charitable programs. Thus, the mortgage is acquisition indebtedness with respect to the office building.

 In contrast, the Section of Taxation proposes the following scenario:

 A charitable organization traditionally makes grants of $ X each year and funds those grants from interest, dividends, and capital gains on its investments. Due to increased need among the charitable class the organization serves, it decides to increase its grantmaking. In a particular year, interest, dividends and capital gains are insufficient to enable the organization to increase its grants and pay its administrative expenses. The Trustees reasonably determine that it would not be advantageous to liquidate any of the organization’s various investments at this time. On that basis, the Trustees decide to fund the organization’s grants and administrative expenses by borrowing from a line of credit secured by the organization’s existing investments. When the investments were purchased, the organization did not anticipate that it would later need to increase its grants at a time when its income was insufficient to fund its programs and when it was also reasonable to hold its investments rather than to liquidate them. Accordingly, any income from the existing investments will not generate UBIT solely because of the funds borrowed under the line of credit.

 Once again, the example proposed by the Section of Taxation is distinguishable from the example in the regulations. In Example (2) of Regs. §1.514(c)-1(a)(2), the organization knew it would have to borrow funds for its charitable activities when it used working capital to renovate a nonexempt use building. In contrast, in the Section on Taxation example, the organization anticipated its charitable giving levels would remain consistent when it purchased the investments. Due to the recession, however, the needs of the beneficiaries it served increased, causing it to need more than anticipated in its exempt activities. It was the increased need, rather than the earlier purchase of the investments, that motivated the borrowing. Although the organization could have sold the investments rather than borrowing, it was advised not to sell the investments at a depressed value. Thus, neither part of the two-part test for later borrowing is satisfied. It was not the existing investments that motivated the organization to borrow funds for its charitable activities. Moreover, when the organization purchased the investments, it was not reasonably foreseeable that a need would later arise to step up its grantmaking.

 Conclusion

 The letter from the Section of Taxation to the Commissioner Shulman raises some practical factual settings that exempt organizations may be facing currently. The examples proposed in the letter are well thought out and consistent with the language of §514 and the examples in Reg. §1.514(c)-1(a)(2). If adopted by the IRS, the examples would be helpful to exempt organizations in the conduct of their exempt activities and investments.

How UBIT Blockers Avoid Debt-Financed Income

Recent publicity about former Governor Mitt Romney’s $23 million IRA and its investments in foreign tax havens has raised the profile of so-called UBIT blocker corporations. What is a UBIT blocker and how does it work to the advantage of retirement accounts and other exempt organizations?

 Income from Debt-Financed Property is UBTI

 If an exempt organization borrows funds to acquire an asset, income from the asset is treated as debt-financed income to the extent of the debt financing. Debt-financed income is included in the organization’s UBTI, unless an exception applies. For example, rents from real property are generally excluded from UBTI. If, however, an exempt organization leases mortgaged property as an investment, part of the rental income is treated as debt-financed income. Similarly, if an exempt organization invests in a partnership that uses borrowed funds to acquire an asset, the debt-financed income rules apply to the organization’s distributive share of the partnership’s income from the asset. Because most alternative asset investments, such as hedge funds, use debt financing, exempt organizations cannot invest directly in hedge funds and other non-traditional investments without incurring UBTI.

Note: Under a special exception, debt incurred by educational organizations and qualified pension and retirement plans to purchase or improve real property is not treated as acquisition indebtedness. Thus, the real property is not debt-financed property and income from the property is excluded from UBTI. The exception is limited to real property and does not apply to hedge fund investments.

 Blocking Debt-Financed Income

 The debt-financed income rules reduce an exempt organization’s ability to take advantage of leveraged investments without suffering adverse UBIT consequences. Seeking to get around this restriction, some exempt organizations have interposed a corporation between themselves and the investment partnership. The result of such an arrangement is that dividends paid from the corporation to the exempt organization are treated as excludible dividends rather than debt-financed income. The taint of the debt financing does not flow through from the partnership to the corporation to the exempt organization.

Increasing the Advantage by Using Foreign Corporations

 Where do tax havens come in? If the UBIT blocker is a U.S. corporation, the corporation will owe income tax on its distributive share of the partnership income. To minimize the income taxation at the corporate level, exempt organizations use a foreign corporation to invest in the partnership owning the mortgaged property. Income of foreign corporations is not taxed until the income is repatriated to the U.S. Some foreign jurisdictions do not impose corporate taxes on corporations owned by non-citizens. Other countries impose very limited corporate taxes. Either way, by using a foreign corporation, an exempt organization can eliminate or minimize the tax payable at the corporate level, reducing the overall cost of the UBIT avoidance strategy.

UBIT Blockers Are Not Illegal

 The strategy of using UBIT blocker corporations is not illegal or contrary to any tax laws. Large retirement funds and exempt organizations are seeking to diversify their investment portfolios into non-traditional investments and to increase their returns using leveraged investments. Under the tax laws, income of foreign corporations owned by U.S. citizens or corporations is not subject to U.S. income tax until the income is brought into the country. Giant multinational corporations routinely use these tax principles to avoid billions in U.S. income tax on income of their foreign subsidiaries. The avoidance is permanent if the corporations use the income in their foreign operations rather than repatriate it. In contrast to business corporations, tax-exempt organizations may repatriate dividends from a foreign corporation without adverse UBIT consequences because of the dividend exclusion.

 Despite their legal status, the use of UBIT blockers by exempt organizations has resulted in millions of dollars in lost taxes that would have been paid as unrelated business income tax if exempt organizations made direct investments or invested in partnerships without using the intervening corporation. Federal legislators are well aware of the lost revenues resulting from UBIT blockers. In the current political climate emphasizing deficit reduction, Congress may act to reduce or eliminate the use of UBIT blockers by exempt organizations. More than likely, any changes will come as part of an overhaul of the whole system for taxing foreign income and will occur after the election year.

 For other articles discussing the use of UBIT blockers by exempt organizations, see Weisman, Romney’s Returns Revive Scrutiny of Lawful Offshore Tax Shelters (Feb. 2012); David Wheeler Newman, Recent Rulings Illustrate Creative Strategies to Deal with UBTI (2011); Council on Foundations, Statement Regarding Unrelated Debt-Financed Income and “Blocker Corporations” (2007)

 For a more detailed discussion of the UBTI and debt-financed income rules in the context of UBIT blockers, see Joint Committee on Taxation, Present Law and Analysis Relating to Tax Treatment of Partnership Carried Interests and Related Issues, Part II (2007).

IRS Releases Revised Publication 598

The IRS has released revised Publication 598, Tax on Unrelated Business Income of Exempt Organizations, effective as of March 2012. The publication covers four main topics:

  • Organizations subject to the tax
  • Tax and filing requirements
  • Unrelated trade or business
  • Unrelated business taxable income

 The section entitled “Unrelated Trade or Business” goes over the basic principles from the Code and Regulations concerning the basic requirements for taxatiion under the UBIT.  More importantly, it focuses on the sometimes tricky issue of whether a business is related or unrelated to an organization’s exempt purposes by using examples. The discussion contains numerous common examples of specific businesses and explains why these activities are related or unrelated for purposes of the UBIT. The “Unrelated Trade or Business” section also briefly discusses businesses that are expressly excluded from treatment as unrelated trades or businesses, such as businesses conducted by volunteers, sale of donated items, and the distribution of low cost articles incident to the solicitation of charitable contributions.

 The longest and most detailed section of Publication 598 is entitled “Unrelated Business Taxable Income.” It first discusses the categories of income that are excluded from UBTI. This part covers numerous modifications and special rules, including the treatment of advertising in periodicals, the deductions allowed in computing UBTI, rules for social clubs, VEBAs, and SUBs, income from partnerships and S corporations, and income from controlled organizations. The section concludes with a detailed discussion of the debt-financed property rules with several helpful examples.

 The IRS also maintains a web page on Publication 598. In a Recent Developments section, the IRS will post any changes that occur after the publication date of one revised edition and before the publication date of the following revision. For example, the Publication 598 prior to the current version was revised as of March 2010, applicable beginning with the 2009 tax year. In April of 2011, the IRS alerted taxpayers to the changes for the 2010 tax year. If the next revision of Publication 598 does not come out until March of 2014, an alert on this web page will likely be issued containing the changes for 2012.

 The IRS website has Publication 598 for the following revision dates: 2012, 2010, 2009, 2007, 2005, 2000, 1998, and 1995. If you need to know a UBIT provision applicable for a prior tax year, checking Publication 598 for the appropriate time period may be a good place to start.