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).

• 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.

Note: Section 512(b)(1) lists five categories of passive income that are excluded from UBTI: dividends, interest, payments with respect to securities loans, amounts received or accrued as consideration for entering into agreements to make loans, and annuities. Although income from NPCs is not specifically mentioned in §512(b)(1), Treas. Reg. §1.512(b)-1(a)(1) does expressly identify income from NPCs as excludable passive investment income.

 What Are Notational Principal Contracts?

 An NPC is a financial agreement calling for the exchange of payments between two parties, at least one of which periodically pays amounts calculated by applying a rate determined by reference to a specified index to a notional principal amount in exchange for specified consideration or a promise to pay similar amounts.

 What Amendments Are Proposed?

 The proposed amendment to Treas. Reg. 1.512(b)-1(a)(1) is a conforming amendment to proposed amendments to Treas. Reg. §§1.1256(b)-1(a) and 1.446-3(c). Section 1256 provides special income tax treatment for section 1256 contracts, such as regulated futures contracts, that are marked to market and traded on a qualified board or exchange. Gain or loss on section 1256 contracts is generally treated as 60% long-term and 40% short-term capital gain or loss. Current §1256(b)(2)(B), added by the Dodd-Frank Act of 2010, provides that various types of swaps and similar contracts are not treated as section1256 contracts. The excluded contracts are almost identical to those listed as notational principal contracts under present Treas. Reg. §1.446-3(c), which discusses the recognition of income from NPCs that is necessary clearly to reflect income under §446.

 To resolve some uncertainties regarding the treatment of swaps that are traded on regulated exchanges, Proposed Treas. Reg. §1.1256(b)-1(a) provides that notational principal contracts described in Treas. Reg. §1.446-3(c) are excluded from treatment as section 1245 contracts. In turn, Proposed Treas. Reg. §1.446-3(c) clarifies some questions about NPCs and allows additional types of contracts to be classified as NPCs. For example, the proposed regulation provides that one party to a NPC must make a minimum of two payments to the other contracting party. The proposed regulation also includes as NPCs credit default swaps and swaps based on non-financial indices, such as weather-related swaps. Under the current regulation, a specified index includes only financial indices.

 What Is the Current Status of the Proposed Regulations?

 A public hearing about the proposed regulations was conducted on January 19, 2012, with 13 in attendance and one speaker.

 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.

In Ocean Pines Association, Inc. v. Commissioner, the Court of Appeals for the Fourth Circuit held that a tax-exempt social welfare organization conducted an unrelated business when it operated two parking lots and a beach club limited to members only. The case was not complex, and the outcome was predictable. The court’s opinion, however, illustrates a classic analysis of the distinction between related and unrelated businesses under the UBIT. 

 Facts. Ocean Pines was exempt from income taxes as a social welfare organization. Its primary activities involved overseeing a 3,500-acre subdivision with over 10,000 residents. Ocean Pines was more than a homeowners association. The organization maintained roadways, bulkheads, and parking lots within the subdivision, enforced zoning regulations, provided police and fire services, and operated numerous recreational facilities. All of the facilities and programs conducted by Ocean Pines were open to members and nonmembers. The organization also owned and operated a ocean-front beach club and two parking lots in a nearby beach location. Most of the club’s facilities and all of the parking spaces could be used only by the association’s members.

 Issue. Ocean Pines derived a profit from the parking lots. The beach club operated at a loss. The IRS sought to tax the net income from the parking lots and beach club as UBTI. To avoid the tax, the organization had to show that the activities constituted a related trade or business. The case is apparently one of first impression in that no prior case has examined potential unrelated business activities of a social welfare organization.

 Law. Whether a business conducted by an exempt organization is an unrelated trade or business depends upon the relationship between the actual conduct of the business and the accomplishment of the organization’s exempt purpose. To avoid the unrelated business income tax, the operation of the business must contribute importantly to the accomplishment of the exempt purpose. The fact that an exempt organization uses income from a business to further its exempt purposes does not make the business related for purposes of the UBIT.

 Analysis. The appellate court first examined the basis underlying the exemption of a social welfare organization from income tax. Social welfare organizations are nonprofit civic leagues or organizations which operate for the promotion of social welfare. The organization must engage primarily in promoting the common good and general welfare of the people of the community. Social welfare organizations are primarily concerned with civic betterments and social improvements.

 Thus, the question presented was whether the operation of the members-only parking lots and beach club contributed importantly to the promotion of social welfare, i.e., was there a community benefit from these activities? Not surprisingly, the Fourth Circuit held that the questioned activities constituted an unrelated trade or business. Unlike the facilities at the residential community, which were open to the general public, the beach facilities could only be used by members. A members only restriction is just not consistent with community benefit and common good.

 One of the association’s arguments pointed to the history of the UBIT, which was enacted primarily to prevent exempt organizations from using their tax exemption to compete unfairly with for-profit enterprises. Ocean Pines argued that its parking lots and club, being restricted to members only, did not compete with taxable businesses providing parking and entertainment to the general public. This argument has been raised, mainly unsuccessfully, in past cases. The court responded that, while the underlying rationale for the UBIT may have been to curb unfair competition, the clear language of the Code applies the tax to businesses which are not related to an organization’s exempt purpose. When the Code is not ambiguous, the use of the legislative history is inappropriate.

 Note: In Ocean Pines, the issue was whether a business carried on by an exempt organization was related or unrelated to its exempt purpose. The legislative history argument is more effective when the issue is whether an exempt organization is conducting a trade or business. If for-profit companies conduct a particular activity, the IRS will argue that an exempt organization conducting a similar activity is engaged in a trade or business. Conversely, an exempt organization may argue that a particular activity is not a trade or business because there are no taxable enterprises conducting a similar activity.

Resources: §513(a), Treas. Reg. §1.501(c)(4)-1(a)(2), Treas. Reg. §1.513-1(d).

 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.

In PLR 201147035, a charitable organization devoted to disaster relief and general charitable purposes amended its articles to permit ownership and operation of community activity centers throughout country. The proposed community centers would offer a broad range of programs designed to serve all community members and would be accessible to the public through memberships. The organization was controlled by a fraternal beneficiary society described in §501(c)(8).

 In the ruling, the organization proposed to acquire its first community center. The acquisition was financed primarily through the issuance of long-term bonds. The community center would offer the following activities: 

•  Exercise and fitness, with programs and classes to emphasize community health and wellness;
• Youth camps, sports camps, and other educational camps
• Charitable community services, such as meals-on-wheels, food bank drives, and blood drives
• Charity events and disaster relief activities
• Space for community events, community social activities, and school activities, such as swim meets
• After-school and tutoring programs for children
• Sports leagues

 The following uses of the community center were specifically examined:

1. Leasing not more than 10% of the total square footage of the center as office space to employees and independent contractors of the fraternal beneficiary society at fair rental value
2. Providing meeting space to local nonprofit organizations, such as American Red Cross chapters, chambers of commerce, and scouts, at actual cost
3. Leasing the banquet room to individuals and groups for private functions at fair rental value
4. Leasing not more than 15% of the total space in the center to the city to house its recreation department for a one-time unspecified payment

 Here are the issues raised by the facts of PLR 201147035:

 1) Because there is a change in the organization’s articles, the impact of the change on the organization exempt status

2) Because the center provides services, whether any of the services constitute unrelated trades or businesses

3) Because space in the center is leased to third parties, whether the rents received are covered by the rental exclusion to the UBIT

4) Because the property is financed, the application of the debt-financed income rules

 The IRS ruled that the ownership and operation of community centers was within the organization’s general charitable purposes and would not jeopardize its tax exemption. Moreover, all the bulleted activities listed above are substantially related to the organization’s exempt purposes. Income from memberships and other community activities would not generate UBTI, other than under the debt-financed income rules.

 Regarding the numbered activities, the leasing of office space to employees and contractors of the fraternal beneficiary organization was a related use under a special rule. Reg. 1.514(b)-1(c)(2) provides that use of an exempt organization’s property by a related exempt organization constitutes a related use to the extent the property is used by either organization in furtherance of its exempt purposes. Organizations are considered related if one organization controls the other. Thus, use of the organization’s community center by the fraternal beneficiary society constitutes a related use by the organization.

 According to the ruling, however, the other numbered activities were not related uses. Thus, the use of office space by the city recreation department, the use of meeting rooms by local nonprofit organizations, and the use of the banquet hall by private parties were not substantially related to the organization’s exempt purposes and would constitute unrelated trades or businesses. Absent the debt-financed income rules, however, the rental payments for the unrelated uses would be covered by the exclusion of rents for real property under §512(b)(3).

 Notwithstanding the related uses and the rental exclusion for the unrelated uses, the debt-financed income rules require income from debt-financed property to be included in UBTI to the extent the property is debt-financed. The long-term bonds used to finance the center constitute acquisition indebtedness. Thus, unless an exception applies to exclude the property from being treated as debt-financed property, part of the income from the community center is debt-financed income.

 There is a two-part exception under §514(b)(1) under which substantially related use property is not treated as debt-financed property. First, property acquired by an exempt organization is not debt-financed property if substantially all of the use of the property is substantially related to the organization’s exempt purposes. Second, even if substantially all of the use of property is not substantially related to the organization’s exempt purposes, the property is not debt-financed property to the extent that its use is substantially related. To the extent property is not treated as debt-financed property, rents and other income from the property are not debt-financed income subject to taxation under the UBIT.

 The organization in the ruling was able to satisfy the first and most favorable part of the substantially related use exception, with the result that no part of the community center was treated as debt-financed property. Under Reg. §1.514(b)-1(b)(1), property satisfies the first part of the substantially related use test if 85% or more of the property is devoted to a substantially related use. In the ruling, the unrelated uses represent less than 15% of the total use of the community center. Thus, none of the rentals were debt-financed income subject to the UBIT. 

 Because the unrelated uses did not cause any of the property to be treated as debt-financed property, the characterization of the use by the city recreation department and the local nonprofit organizations did not prejudice the exempt organization requesting the ruling. For the sake of discussion, however, there are good arguments that uses of the community center by the city and some of the nonprofit groups were substantially related uses.

Regarding the occupation by the city recreation department, the organization and the city had a written agreement under which the city was responsible for hiring, supervising, and directing all personnel working at the center. The organization had the right to provide input to the city concerning the employment of the center’s manager, programmer, and marketing director. In connection with this agreement, the city relocated the administrative offices of its recreation department to the center. It appears that over half of the activities to be conducted at the center involve community recreation. Having the city recreation department on the premises would contribute importantly to the center’s ability to offer recreation services. Considering that the city also employed the management and staff of the center, it appears that the city purposes were so intertwined with the organization’s charitable purpose in operating the center that the one-time payment from the city could well be considered income from a related trade or business and that use of the center by the city could be a substantially related use.

 There is also a reasonable argument that leasing meeting space to some community nonprofit organizations is also substantially related to the organization’s charitable purposes. Here are the local groups to which the center would lease meeting space: local chapters of the American Red Cross, the United Way and its affiliated agencies, local chambers of commerce, boy scouts, and local historical associations. Allowing the Red Cross to meet at the center is directly related to the organization’s disaster relief purpose and its community benefit purpose. Similarly, scouts groups are community organizations involving children, who are important recipients of the center’s recreational and educational services. In contrast, chambers of commerce benefit the community only in a commercial sense; their use of the facility would not seem to constitute a related use. At a minimum, the leases to the nonprofit groups should be evaluated on an organization-by-organization basis.