Category Archives: General

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

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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Under both the House and Senate tax reform proposals, the four graduated rates under current §11 are repealed and replaced by a single corporate tax rate of 20%.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)

 

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

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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.

 

IRS Releases Revised Publication 598

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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.