Under Sec. 501(c)(3), tax-exempt organizations must operate primarily for exempt purposes. Reg. 1.501(c)(3)-1(c)(1). This standard is known as the operational test and is designed to ensure that tax-exempt organizations are indeed operating for exempt purposes. However, the regulations recognize that organizations may engage in some non-exempt activity, so long as they are primarily operating for exempt purposes.
Exempt organizations do not pay taxes on income earned from their exempt activities. However, income generated in furtherance of unrelated activities may result in unrelated business income tax (UBIT). Sec. 511(a). The purpose of the UBIT rules is to prevent charities from competing with for-profit businesses and enterprises. The general UBIT rules are straightforward, but are modified by a number of exclusions and exceptions. Exempt organizations should familiarize themselves with the UBIT rules so they may avoid any jeopardy to their tax-exempt status.
This is Part II in a two-part series covering the UBIT rules and their application to tax-exempt organizations. The first part covered the basics of the UBIT rules and the UBIT exceptions. Part II will discuss situations in which UBIT exceptions do not apply and UBIT's special application to charitable remainder trusts and charitable lead trusts.
UBIT Exclusion Exceptions
While some types of income are excluded from the computation of unrelated business taxable income (UBTI), there are two situations where otherwise excluded income is still considered UBTI. These are unrelated debt-financed income and income from controlled subsidiaries.
Unrelated Debt-Financed Income
Passive income—such as interest, dividends, rents from real property, royalties and capital gains—is not considered UBTI. Sec. 512(b). However, passive income may still result in UBTI to the extent it is derived from debt-financed property. Sec. 514(a)(1). Under this rule, the percentage of passive income that is debt-financed is dependent on the ratio that the average acquisition indebtedness bears to the average adjusted basis in the underlying property. Sec. 514(a)(1).
A charitable organization pays $100,000 for a parcel of real estate, borrowing $20,000 to acquire it. The real estate generates rental income of $10,000 during the year. The rental income ordinarily qualifies as passive income excluded from UBTI. Because the $20,000 mortgage is considered acquisition indebtedness, a portion of the rental income will be UBTI. The ratio that the acquisition indebtedness of $20,000 bears to the charity's $100,000 cost basis is 20%. Therefore, 20% of the $10,000 rental income, or $2,000, will be UBTI.
Definition of Debt-Financed Property
For the purposes of the debt-financed income rules, "debt-financed property" means property (1) that is held to produce income and (2) for which, with respect to such property, there is acquisition indebtedness at any time during the year (or if the property is disposed, within which there is acquisition indebtedness within a 12-month period prior to the disposition). Sec. 514(b)(1). There are a number of exceptions which limit the scope of the definition of "debt-financed property."
First, property will not be considered debt-financed property if "substantially all" of the property's use is substantially related to the performance of an organization's exempt purpose. Sec. 514(b)(1)(A). For purposes of this rule, "substantially all" means that 85% or more of the property is devoted to the exempt organization's purposes. Reg. 1.514(b)-1(b)(1)(ii). This determination is made on the basis of all the facts and circumstances, including (1) a comparison of the portion of time the property is used for exempt purposes with the total time the property is used, (2) a comparison of the portion of the property used for exempt purposes with the portion of the property used for all purposes, or (3) both (1) and (2). Reg. 1.514(b)-1(b)(1)(ii).
Second, property used in an unrelated trade or business is not considered debt-financed to the extent the income is derived from an unrelated trade or business. Sec. 514(b)(1)(B). The capital gain on the sale of such property that is not otherwise included in income from an unrelated trade or business is considered debt-financed. Reg. 1.514(b)-1(b)(2)(i).
Third, income that is otherwise included in the computation of UBTI will not be considered debt-financed income. Reg. 1.514(b)-1(b)(2)(ii). For example, rental income from personal property or rental income from controlled organizations would otherwise be considered UBTI. Reg. 1.514(b)-1(b)(2)(ii).
Fourth, property used in a trade or business that meets the volunteer, convenience of employees, or "thrift shop" exceptions of Sec. 513(a) is excluded from the definition of debt-financed property. Sec. 514(b)(1)(D).
The term "acquisition indebtedness" generally refers to any debt that an exempt organization incurs when acquiring or improving property. Sec. 514(c)(1). When an exempt organization acquires property subject to a mortgage or other lien, the amount of the mortgage is considered acquisition indebtedness, even if the exempt organization does not assume or agree to pay the indebtedness. Sec. 514(c)(2)(A).
Although an exempt organization will generally have acquisition indebtedness on property it acquires that is subject to a mortgage, there are a couple exceptions allowing the exempt organization to avoid treating the debt as acquisition indebtedness for a period of time. Neither exception will apply if the exempt organization assumes and agrees to pay the indebtedness secured by the mortgage, or if the organization makes any payment for the equity in the property owned by the decedent or the donor. Sec. 514(c)(2)(B).
First, property a charity acquires by bequest or devise will not be treated as acquisition indebtedness for a 10 year period following the date of acquisition. Sec. 514(c)(2)(B). Second, an exempt organization that receives encumbered property by gift will not have to treat the property as acquisition indebtedness for 10 years after the date of gift if the encumbered property passes the "Five and Five" rule. Under this rule, the mortgage must have been placed on the property more than five years before the gift and the donor must have held the property for more than five years before the gift. Sec. 514(c)(2)(B).
A charitable organization receives a charitable gift of real estate worth $1,000,000. The property is encumbered by a $200,000 mortgage. The mortgage is 15 years old, dating back to when the donor purchased the property. This mortgage amount is acquisition indebtedness to the charitable organization, unless an exception applies. Under the Five and Five rule, an exempt organization will not have acquisition indebtedness on property it received by gift if the debt had been on the property for at least five years and the donor owned the property for at least five years at the time of the gift. Here, the debt was 15 years old and the donor had owned the property for 15 years. Therefore, the charitable organization will not have to treat the property as acquisition indebtedness for 10 years. This will give the organization time to sell the property or pay off the debt within that time period.
Finally, there are two other situations in which exempt organizations will not have acquisition indebtedness on property they acquire. First, there will not be acquisition indebtedness where the debt incurred is inherent in the performance or exercise of the exempt organization's purpose. Sec. 514(c)(4). The regulations cite the example of the indebtedness an exempt credit union incurs in accepting deposits from members. Second, acquisition indebtedness generally does not include the obligation an exempt organization incurs under a gift annuity contract. Sec. 514(c)(5).
Income from Controlled Organizations
Rents, royalties and annuities are normally considered passive income and thus excluded from UBTI. However, rents, royalties and annuities may still be considered UBTI if the income comes from a controlled subsidiary of an exempt organization. Sec. 512(b)(13). The purpose of this rule is to prevent the shifting of taxable income to an exempt organization. In this context, the exempt organization is called a "controlling organization" and the entity shifting taxable income is known as the "controlled organization."
Income received by a controlling organization from a controlled organization is deemed income derived from an unrelated trade or business to the extent the income reduces the net unrelated income (or increases any net unrelated loss) of the controlled organization (determined as if the entity were tax exempt). Under this definition, only the excess income over the fair market value defined under Sec. 482 is deemed UBTI to the parent charity. Sec. 512(b)(13)(E).
In addition, there is a 20% penalty on the excess amount. The UBTI rule applies only to payments made pursuant to a binding written contract in effect on the date of enactment, or renewal of such a contract on substantially similar terms. Sec. 512(b)(13)(E)(iii). A tax-exempt organization that receives interest, rents, annuity, or royalty payments from a controlled entity must report such payments on its annual information return. Sec. 6033(h)(1).
Definition of Controlled Organization
Whether a subsidiary of an exempt organization is a controlled organization depends on the level of control the exempt organization exerts over the subsidiary. For purposes of these rules, "control" depends on the business entity of the subsidiary. Sec. 512(b)(13)(D). Thus, "control" is defined as:
- In the case of a corporation, ownership—by vote or value—of more than 50% of the stock in the corporation.
- In the case of a partnership, ownership of more than 50% of the profits interests or capital interests in the partnership.
- In the case of any other entity, ownership of more than 50% of the beneficial interests in the entity.
Planned Giving Applications
The unrelated business income tax has the ability to affect charitable organizations in a wide variety of ways. Organizations need to be wary of the kind of activities they engage in and the type of property they own. This article series has mostly focused on how the unrelated business income tax affects exempt organizations. However, UBIT can also affect planned giving vehicles where both donors and charitable organizations benefit. The unrelated business income tax has special application to two planned giving vehicles: charitable remainder trusts and charitable lead trusts.
Charitable Remainder Trusts
A charitable remainder trust (CRT) is an irrevocable trust that pays income to a donor or other beneficiary for a lifetime or a term of years; at the end of that time, the remainder goes to charity. Charitable remainder trusts have an interesting history with the UBIT rules. Because CRTs are tax-exempt, one of the great benefits of a CRT is that an individual can transfer a highly appreciated asset to the trust and sell it tax free. While CRTs are tax-exempt, for a brief time in the mid-to-late 1990s, it appeared that CRTs could lose their tax-exempt status for any year in which they had UBTI.
In Newhall v. Commissioner
(9th Cir. 1997), the Ninth Circuit upheld a Tax Court case holding that CRTs lose their tax-exempt status for any year in which they have UBTI. Newhall
involved a CRT that invested in some publicly traded limited partnerships. The partnership interests produced income. Because the partnerships engaged in active farming operations, the Service determined that this income was UBTI. Citing Sec. 664(c), the Ninth Circuit held that the UBTI caused the CRT to lose its tax-exempt status for the year.
Because of Newhall
, Sec. 664(c) was amended to state that a trust with UBTI will be subject to a 100% excise tax on the UBTI while allowing the CRT to otherwise retain its exempt status. Sec. 664(c)(2)(A). Therefore, CRTs can hold active business interests or other assets producing UBTI, but it is prudent to dispose of those assets as quickly as possible to minimize the UBTI consequences.
Charitable Lead Trusts
In contrast with CRTs, which are normally exempt from trust income taxation, lead trusts are taxable. A lead trust is in many ways the opposite of a CRT. The trust pays income to charity for a period of time and then the remainder passes to the donor or other beneficiaries. There are two types of lead trusts: grantor and non-grantor. With a grantor lead trust, the trust's income is taxable to the grantor (or donor), who is the remainder beneficiary. For a non-grantor lead trust, the remainder passes to the donor's family or other beneficiaries. It is taxed as a complex trust, files its own Form 1041 and pays taxes on its ordinary income and capital gains. Because a grantor trust's income is taxable to the grantor, it makes no difference whether the trust earns income that would be considered UBTI to an exempt organization. However, UBTI can pose a problem for a non-grantor lead trust.
While a non-grantor lead trust is taxable, it can be carefully designed to pay little or no income tax. This is because a non-grantor lead trust receives an unlimited income tax deduction for distributions to qualified charities. Sec. 642(c). Therefore, if the distribution to charity each year is equal to or greater than trust income, the lead trust will pay no tax on its income.
However, the presence of UBTI will prevent a non-grantor lead trust from receiving an unlimited deduction for distributions to qualified charities. Consequently, it is important to ensure that a non-grantor lead trust does not have UBTI under Sec. 512. Otherwise, the deduction for distributions of UBTI to charity will be limited to 50% of the contribution base under Sec. 170. See Sec. 681. This could result in the trust paying tax on some of its income.
Sam plans to create a $2 million non-grantor charitable lead annuity trust (CLAT). The CLAT will have a fixed payout of $100,000 per year for a 10-year term with Sam's children as the remainder beneficiaries. Sam has a choice between two assets he could contribute. First, he has $2 million worth of stock with a $400,000 cost basis. Second, he has a commercial building that he leases. Sam's accountant, Norm, has indicated that the lease payments include a net profits interest and therefore are UBTI.
If Sam funds the lead trust with the stock, the annual annuity payment will consist of dividend income and realized capital gains, totaling $70,000. Because the trust will pay out $100,000 to charity each year, it will be able to deduct the entire $70,000 from its taxable income. If the trust is funded with the commercial building, the lease income of $100,000 will be UBTI. Under Sec. 681, the trust's deduction for amounts paid to charity will be reduced to 50% of the contribution base. Consequently, the trust will pay tax on $50,000 of its annual $100,000 lease income. Therefore, the best result is for Sam to fund the lead trust with the stock.
The unrelated business income tax is designed to ensure exempt organizations are operating primarily for exempt purposes. Fortunately, under the UBIT rules, there is a passive income exclusion for income such as interest, dividends, rents from real property, royalties and capital gains. This income can still be considered UBTI in two situations: if it is derived from debt-financed property or if it is income from a controlled organization. Both of these exceptions have complex rules, so advisors should be well aware of them when advising clients and charities. Unrelated business income also has special application to two planned giving vehicles: charitable remainder trusts and charitable lead trusts. As such, advisors should be familiar with how UBTI affects these planned gifts and the ways in which these trusts can be designed to minimize any negative consequences.