To those not accustomed to dealing with subchapter F of the Code (pertaining to exempt organizations) it may seem contradictory that so-called exempt organizations are subject to the unrelated business income tax. And the UBIT is not the only tax that may apply to exempt organizations. Charitable organizations which are private foundations are taxed on their net investment income and are subject to a series of excise taxes designed to curb particular behaviors susceptible to abuse. Thus, exempt organizations, which are not subject to the regular income tax imposed under §§1 and 11, are distinguished from for-profit companies that must pay income taxes. For convenience, we refer to them as exempt organizations, even though we know that they may be liable for the UBIT or other specialized taxes.
Section 501 expressly recognizes that concept of tax-exempt organizations being subject to taxation. Exemption from taxation is provided under §501(a) for organizations described in §501(c), §501(d), and §401(a). These organizations are charities and 28 other categories of organizations described in §501(c), religious and apostolic organizations described in §501(d), and qualified retirement plans described in §401(a).
Section 501(b) states that an organization exempt from taxation under §501(a) is subject to tax as provided in parts II (taxes on private foundations), III (the UBIT), and VI (taxes on political organizations) of subchapter F. Notwithstanding parts II, III, and VI of subchapter F, however, such an organization is “considered an organization exempt from income taxes for purposes of any law referring to organizations exempt from income taxes.”
The Tax Court recently considered this seemingly straightforward Code provision in Research Corporation v. Commissioner, 138 T.C. No. 7 (2012).
Research Corporation, founded in 1912, was an exempt charitable organization that had paid UBIT for five years of its existence. The organization established a qualified retirement plan for its employees in 1961 and terminated the plan in 2002. Part of the fund was transferred to a successor fund and the balance was distributed to the organization. The IRS gave the organization a private ruling stating that the reversion did not constitute UBTI. The question addressed by the Tax court was whether the organization was liable for a 20% excise tax under §4980(a) on the qualified plan assets distributed to itself. Section 4980(c)(1)(A) expressly provides that the excise tax does not apply if the employer “has, at all times, been exempt from tax under subtitle A…” Because subtitle A of the Code contains the income taxes provisions, the reference in §501(b) to “organizations exempt from income taxes” is the same as the reference in §4980(c)(1)(A) to “exempt from tax under subtitle A.”
Research Corporation muddied the waters by paying a portion of the excise tax equal to the percentage of the UBTI it received during its existence over its total income. Thus, on a distribution of $4,411,395, the organization calculated a proportionate distribution of $14,055 and paid an excise tax of $2,811. The IRS sought to collect $879,468 in additional tax and a penalty on the entire amount distributed to the organization.
Given the language of §501(b) and §4980(c)(1)(A), there does not appear to be an issue here. Both the Research Corporation and the Commissioner were in error. In fact, because the organization has always been exempt from income taxes, its plan was excluded from the scope of qualified plans subject to the excise tax. Seemingly grasping at straws, the IRS argued that, because the UBIT is imposed under subtitle A and further because the organization had paid the tax on five occasions during its existence, then the organization was not exempt from tax under subtitle A. The Tax Court held that §501(b) was clear and unambiguous and that the organization did not owe the excise tax.
For a detailed discussion of the Tax Court’s opinion in Research Corporation, see Pension Plan Terminations for Exempt Organizations with Unrelated Business Income by James R. Malone, Jr.