1. Dues Paid to Agricultural or Horticultural Organizations

 Agricultural and horticultural organization 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. The exclusion applies for tax years beginning in 2012 so long as:

•  Payment of dues is a condition of membership; and
• The required annual dues do not exceed $151.

 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 3.24 of Rev. Proc. 2011-52 provides that the inflation-adjusted amount for 2012 is $151. For tax years beginning in 2011, the §512(d)(1) limitation was $148.

 2) Limitation for Contributions Solicited Using Low Cost Articles

 Charitable organizations sometimes solicit contributions by mailing out low cost items to potential donors, hoping that receiving the items will spur the individual to make a contribution. Because the sale of goods constitutes a trade or business, contributions received in connection with mailings of 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 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 2012, a low cost article is an item that cost the organization $9.90 or less.

 When §513(h) was enacted in 1986, the exception applied to low cost articles of $5.00 or less. That number has been indexed for inflation since 1988. Section 3.25(1) of Rev. Proc. 2011-52 provides that the inflation-adjusted amount for 2012 is $9.90. For tax years beginning in 2011, the §513(h) limitation was $9.70 or less.

 Resources: Rev. Proc. 2011-52, 2011-45 I.R.B. 70; Rev. Proc. 2010-40, 2010-2 C.B. 663.

In Publication JCX-6-12, dated January 27, 2012, the Joint Committee on Taxation listed tax provisions that expired in 2011 and provisions slated to expire through 2022. Only one item mentioned in the publication applies to the UBIT. Section 512(b)(13)(E), regarding certain payments received from controlled subsidiaries, expired for payments made after December 31, 2011. 

 Although generally interest, annuities, royalties, and rents are excluded from UBTI, §512(b)(13) provides that such receipts are taxable when received by an exempt organization from an entity in which it owns 50% or more of the stock, partnership interest, or beneficial interest. Otherwise excluded interest, annuities, royalties, and rents are included in the UBTI of the controlling organization to the extent the payment reduces the net unrelated income (or increases any net unrelated loss) of the controlled entity, determined as if that entity were tax-exempt.

 The Pension Protection Act of 2006 enacted §512(b)(13)(E), which limits the amount of interest, annuities, royalties, and rents from a controlled entity that a controlling organization has to include in UBTI. The provision applies to post-2005 payments made pursuant to a binding written contract in effect on August 17, 2006, including renewals of such contracts under substantially similar terms. Such receipts have to be included in UBTI only to the extent that the payment exceeds the amount that would have been paid under an arm’s length standard. Under this provision, many exempt organizations did not have to include payments from controlled entities in UBTI.

 Section 512(b)(13)(E) was originally scheduled to expire for payments received or accrued after December 31, 2007. The Tax Extenders and Alternative Minimum Tax Relief Act of 2008 extended the provision for payments made through December 31, 2009. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 extended its application for payments received or accrued before January 1, 2012.

Once again, the IRS has ruled that an educational organization that owns an endowment fund and that is also trustee of an unrelated unitrust may unitize its endowment fund, exchange the assets of the unitrust for endowment fund units, and pay a contractual amount to the unitrust with respect to the units the unitrust owns. All without any adverse UBIT consequences to the educational organization or the unitrust. The purpose of such an arrangement is to allow the unitrust to take advantage of the large and well-diversified endowment fund, which earns a higher return than the unitrust can achieve investing on its own.

 PLR 201208038 is the latest ruling concerning a university that manages an endowment fund and also serves as trustee for various unrelated unitrusts. This post points out a few key points raised in the ruling.

 1. Investment Fee Prohibited. Typically, if an exempt organization provides investment services for another party, even another exempt organization, the activity is subject to the UBIT if regularly carried on. Thus, if the university charged the unitrust for its investment of the endowment fund, the fee would be taxable.  For the scenario described in the ruling to work, the university must furnish its services without charge. Because the university does not charge the unitrust for the services, the activity is not considered a trade or business because there is no profit motive.

 The university, in its capacity as trustee of the unitrust, can charge a trustee fee for its investment and other services to the unitrust.

 2. Contractual payments on units held by the unitrust excluded from UBTI. The university endowment fund invests in a range of fairly traditional investments. However, some income earned by the fund may be debt-financed income or otherwise subject to the UBIT. When the university determines an annual payout amount for the endowment, the unitrust receives a pro rata share based on the number of units it holds. The unitrust has no rights in the endowment fund except for the rights to receive contractual payout amounts and to redeem its shares for fair market value. Neither the payments from the fund nor the holding or redemption of the endowment units result in UBTI to the unitrust.

 Under §512(b)(1), dividends, interest, annuities and other specific types of investment income are excluded from unrelated business taxable income. The investment that generates such income is considered a passive activity rather than an active trade or business.The contractual payments made to the unitrust by the endowment fund are not specifically mentioned in §512(b)(1). Under Treas. Reg. §1.512(b)-1(a)(1), however, the exclusion is extended to other income substantially similar to the specified categories from ordinary investments to the extent determined by the Commissioner. The IRS regards the contractual payments on the endowment units to be income substantially similar to the categories expressly mentioned in §512(b)(1).

 The exclusion of the contractual payments is critical to the unitrust. A unitrust is exempt from income taxes so long as it does not have UBTI. If a unitrust has any UBTI whatsoever, all its income is subject to tax. Fortunately, any UBTI in the hands of the endowment fund does not retain its character as UBTI when paid to the unitrust as a contractual payment.

 3. Endowment fund units are capital assets. Although the contractual payments to the unitrust are ordinary income, the units themselves are capital assets. Thus, any redemption of the units by the unitrust will generate long-term or short-term capital gain, depending on the holding period.

 §512(a)(3)(E). Unrelated business taxable income for social clubs, VEBAs, and SUBs is calculated differently than for most other exempt organizations. The special rules are contained in §512(a)(3). All income of a social club, VEBA, or SUB is taxable except exempt function income. Exempt function income has two components.  First, member contributions to a social club, VEBA, or SUB are exempt function income. The second component of exempt function income includes is income set aside for charitable purposes. For VEBAs and SUBs, the second component also includes amounts set aside to provide for the payment of life, sick, accident, or other benefits; provided, however, that the amount set aside for payment of benefits is exempt function income only to the extent that the amount does not exceed the qualified asset account limit under §419A. The qualified asset account limit is the amount reasonably and actuarially necessary to fund claims incurred but unpaid at the close of the taxable year for member benefits, plus administrative costs with respect to such claims.

 Comment: The difference between the two components of exempt function income is noteworthy. The first component is income in the traditional sense in that it is received from members and employers to pay for benefits and administration. The second component pertains to other income, such as investment income, but the amount included as exempt function is determined not with reference to the amount received but rather is limited to amounts set aside for the specified purposes, subject to the §419A limit (not taking into account any permitted reserve to fund post-retirement medical benefits).

 Prior to the Deficit Reduction Act of 1984, exempt function income of a VEBA or SUB included all amounts set aside for charitable purposes and for the payment of benefits. The 1984 Act added §512(a)(3)(E), which is the §419A limitation, to prevent VEBAs and SUBs from accumulating excessive non-taxed investment income in a set aside account.

 Treas. Reg. §1.512(a)-5T, issued in 1986, explains the application of §512(a)(3)(E). According to the regulation, UBTI of a VEBA or SUB is generally the lesser of:

•  the income of the VEBA or SUB for the taxable year (excluding member contributions); or
• the excess of the total amount set aside as of the close of the taxable year (including member contributions) over the qualified asset account limit (calculated without regard to the otherwise permitted reserve for post-retirement medical benefits) for the taxable year.

 Case Law. The computation of UBTI for VEBAs was the subject of recent litigation. Three VEBAs argued that the §419A limit applies to amounts accumulated in a set aside account at year’s end and not to amounts expended on benefits during the year. The VEBAs claimed that they used investment income, rather than member contributions, to pay benefits during the taxable year. Under their arguments, investment income would not be taxable if it was used by a VEBA during the taxable year to provide benefits. The VEBA prevailed in Sherwin-Williams Co. Employee Health Plan Trust v. Commissioner, 330 F.3d 449 (6^th Cir. 2003), nonacq., AOD 2005-02. VEBAs in two other cases lost similar arguments. In CNG Transmission Mgmt. VEBA v. United States, 588 F.3d 1376 (Fed. Cir. 2009), a VEBA argued that its investment income was used first to provide member benefits, leaving member income which is expressly included in exempt function income. The Federal Circuit Court of Appeals in CNG Transmission distinguished in part and rejected in part Sherwin-Williams, holding the §419A limitation applies to all amounts set aside for member benefits, whether or not actually expended during a taxable year. In Northrop Corp. Employeee. Ins. Benefit Plans Master Trust v. United States, 99 Fed. Cl. 1 (Cl. Ct. 2011), the federal claims court followed the Federal Circuit in rejecting the VEBA’s attempt to avoid UBIT on its investment income.

 Particularly given that the Congressional intent for enacting §512(a)(3)(E) was to limit the ability of VEBAs and SUBs to collect untaxed investment income in set aside accounts, the CNG Transmission and Northrop cases properly construe §512(a)(3)(E). As the IRS pointed out in its nonacquiescence to Sherwin-Williams:

 We disagree with the Sixth Circuit’s conclusion that investment income can be set aside and used separately before the end of a taxable year to pay the reasonable costs of administering health care benefits and thereby avoid the limits imposed by 512(a)(3)(E) on exempt function income. As discussed above, the statutory provisions are not dependent upon a determination as to whether particular sources of income were used to pay the costs of administration in any particular year.

 Treas. Reg. §1.512(a)-5T. In Sherwin-Williams, the Sixth Circuit referred to Treas. Reg. §1.512(a)-5T as supporting its conclusion that the §419A limitation applies to the amount of investment income remaining at the close of the taxable year. The court quoted the statement in Treas. Reg. §1.512(a)-5T, A-3(a) that the limitation applies to amounts set aside to pay benefits “as of the close of the taxable year.”

 In contrast, in CNG Transmission and Northrop, the VEBAs argued that Treas. Reg. 1.512(a)-5T was invalid. The Tax Court in CNG Transmission held that §512(a)(3)(E) was ambiguous and that Treas. Reg. §1.512(a)-5T was a reasonable interpretation of the statute that supports the government’s position. On appeal, the Federal Circuit concluded that the statutory language in §512(a)(3)(E) was not ambiguous; but even if §513(a)(3)(E) were ambiguous, Treas. Reg. §1.512(a)-5T was a reasonable interpretation of the statute entitled to deference.  As to the validity of the regulation, the Federal Circuit in CNG Transmission declined to consider the issue because it was not timely raised by the VEBA at trial.

 The Northrop court declared itself bound by the conclusion of the Federal Circuit in CNG Transmission that §512(a)(3)(E) was clear and unambiguous. Thus, any arguments that the temporary regulation is invalid or arbitrary were immaterial to the analysis in Northrop. The claims court acknowledged the VEBA’s arguments against the validity of Treas. Reg. §1.512(a)-5T, but declined to “indulge in an analysis of the status of” the temporary regulation that would be pure “dicta.”

  Section 512(a)(3)(E)  does not contain a reference to ”the close of the taxable year.” According to §512(a)(3)(E)(i), a VEBA or SUB may treat a set aside to pay benefits to members as exempt function income only to the extent that the set aside does not result in an amount of assets set aside for such purpose in excess of the account limit determined under §419A for the taxable year. Given the language of §512(a)(3)(E)(i), it seems that the phrase “as of the close of the taxable year” in Treas. Reg. §1.512(a)-5T refers to the time frame for applying §512(a)(3)(E) rather than to the balance existing at the close of the taxable year.

 To clarify the point, the final regulation could either replace the reference to the close of the taxable year with the wording of §512(a)(3)(E) or state that the limitation applies to amounts “used or set aside” by a VEBA or SUB as of the close of the taxable year.

 In its 2011-2012 Priority Guidance Plan, the IRS includes regulations under §512 explaining how to compute the UBTI of a VEBA as a priority under Employee Plans – Executive Compensation, Health Care, and Other Benefits, and Employment Taxes. Given the support for the regulation in CNG Transmission and Northrop, it is unlikely that the final regulation will differ significantly from its temporary predecessor.