Friday April 26, 2024

7.1.3 Unrelated Business Income Taxation (UBIT) Exceptions

UBIT Exceptions

Rents from Real Property:  Rents received for the use of, or the right to use, real property are passive income excluded from UBIT.

Rents from Personal Property:  Rents received for the use of, or the right to use, personal property (e.g., computer or medical equipment) are passive income only if they are derived from a mixed lease (a lease that includes both real and personal property) and the rents attributable to the personal property are "incidental" (less than 10% of the total rents received under the lease).

Royalties:  Royalties are passive income excluded from UBIT.

Qualified Sponsorship Payments:  A charity may agree to use or acknowledge a sponsor's name, logo or product line in return for a payment from the sponsor.

UBI For Rents and Royalties from Controlled Subsidiaries:  Exempt charities normally do not pay income tax, unless they have unrelated business taxable income (UBI).

UBI From Active Business Assets Transferred to Unitrusts:  A common challenge for business owners who would like to use a charitable trust is that the business is an ongoing activity that may not be held tax-free in a charitable trust.

Charities Including Churches Must Disclose UBIT Returns:  In Notice 2007-45, the IRS issued Sec. 6104(d) requirements for disclosure by charities.
Certain types of income are specifically excluded from the application of unrelated business income taxation (UBIT). The most common is passive investment income. Passive income includes dividends, interest, annuities, rents, royalties and capital gain unless such income is generated by depreciable or debt-financed property. (For a discussion of debt-financed property issues, see GiftLaw Pro 7.1.4)

In addition to passive income, income from the following sources is specifically excluded from UBIT:
  • any activity where substantially all of the labor is performed by unpaid volunteers;

  • any activity carried on by a charity primarily for the convenience of members, students, patients, officers or employees (e.g., an income from items sold through vending machines at the charity to employees of the charity);

  • any activity which consists of selling donated merchandise (e.g., income from a thrift store operated by a charity where all items in the thrift store are donated);

  • conventions or trade shows;

  • certain qualified sponsorship payments that do not constitute advertising; and

  • bingo, but not instant or pull-tab bingo.
Sec. 512 - Sec. 514.

Rents from Real Property
Rents received from the use of, or the right to use, real property are passive income excluded from UBIT. The definition of "rents" in this context can be a troublesome spot for charities. If the facts and circumstances indicate that a charity provides significant services or incurs substantial costs in managing real property, income collected may not be classified as "rents," but instead will be considered income from the active conduct of a real estate management business and will be subject to UBIT.

If a charity owns rental property and does not want rents from that property to be subject to UBIT, a good solution is to execute a net lease where a third party leases and manages the property. Rents from net leases are not derived from the active trade or business of renting property, and therefore, are passive investment income.

Rents from Personal Property
Rents received from the use of, or the right to use, personal property (e.g., computer or medical equipment) are passive income only if they are derived from a mixed lease (a lease that includes both real and personal property) and the rents attributable to the personal property are "incidental" (less than 10% of the total rents received under the lease). If the amount attributable to personal property is more than incidental but not more than 50% of the total, the real property rent is excludable and the personal property rent is not. However, if the personal property rent exceeds 50% of the total, none of the rent is excludable from UBIT.

Example 7.1.3A

Charity owns a dental building that is fully furnished and includes built-in dental equipment. Charity rents the building and its contents to a dental partnership. Facts and circumstances suggest that 23% of the rent is attributable to the furnishings and dental equipment. Because this amount is more than "incidental," the 23% rent attributable to the furnishings and dental equipment is not passive income excluded from UBIT. The remaining 77% of the rent is, however, passive income excluded from UBIT.

Royalties
Royalties are passive income excluded from UBIT. The definition of a royalty is exceedingly broad and extends to virtually all payments for the right to use intangible property including income for the use of intellectual property (i.e., patents, trademarks and copyrights).

Qualified Sponsorship Payments
A charity may agree to use or acknowledge a sponsor's name, logo or product line in return for a payment from the sponsor. So long as the sponsor does not expect to receive a "substantial" benefit in return other than the use or acknowledgement of its name, logo or product line, the money received by the charity is not subject to UBIT.

A substantial benefit includes things such as complimentary tickets, donor receptions, exclusive provider agreements or links to a website that endorses the sponsor's product. A substantial benefit does not include goods or services with insubstantial value (not more than 2% of sponsorship payment), exclusive sponsor agreements or links to a website about the sponsor where there is no promotion or advertising of the sponsor's product.

UBI For Rents and Royalties from Controlled Subsidiaries
Exempt charities normally do not pay income tax, unless they have unrelated business taxable income (UBI). Rents, royalties and annuities are considered passive income and usually excluded from UBI. Sec. 512(b)(13). However, because of the potential for moving taxable income to a non-taxable entity, a portion of the rent from a taxable controlled subsidiary paid to a parent charity is deemed UBI. Only the excess over the fair market value defined under Sec. 482 is be deemed UBI to the parent charity, to the extent that such excess reduced the net unrelated income (or increased any net unrelated loss) of the controlled entity (determined as if the entity were tax exempt). Sec. 512(b)(13)(E)(i).

In addition, there is a 20% penalty on the excess amount. The UBI 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. A tax-exempt organization that receives interest, rent, annuity, or royalty payments from a controlled entity must report such payments on its annual information return. Sec. 6033(h)(1).

UBI From Active Business Assets Transferred to Unitrusts
A common challenge for business owners who would like to use a charitable trust is that the business is an ongoing activity that may not be held tax-free in a charitable trust. Charitable trusts are exempt from tax under Sec. 501(a) and Sec. 508(e). They also are subject to the private foundation rules on self-dealing, excess business holdings and taxable expenditures. Sec. 4947(a)(2).

Charities and charitable trusts are normally tax exempt. However, if they are regularly conducting a trade or business that is not substantially related to the exercise of their exempt purpose, they are subject to unrelated business income tax. Sec. 513(a).

Since a charitable trust will never be able to claim that an active trade or business is related to its exempt purpose, the transfer of an operating business to a charitable remainder trust results in unrelated business income. See Newhall v. Commissioner.

However, there are exceptions to the unrelated business rules. Among the various exceptions are the receipt of rent from real property and the payment of royalties and lease returns. These exceptions require the payouts to be fixed. If the payments are dependent upon earnings and profits, then the trust is in effect a partner and again subject to UBI. Sec. 512(c).

If an active trade or business is involved, transfer of these assets to a CRT could subject the unitrust to a 100% excise tax on the UBI. Sec. 664(c)(2)(A). While the tax may not be large if the asset is sold quickly, many grantors may prefer to avoid the tax on UBI.

To avoid UBI, a donor who plans to contribute active business assets to a CRT can lease those assets to a third party prior to making the contribution. If this lease is in place before the assets are contributed to a CRT, the only income the CRT will ever receive from the assets is fixed rent from the lease. Fixed rent payments are passive income and not taxable UBI. Sec. 512(c).

Therefore, there are two possible solutions for active businesses. First, if there is a buyer "waiting in the wings," then the business interest may be transferred into a charitable trust and sold in an expeditious manner to the buyer waiting in the wings. While it will be essential to avoid a prearranged sale, the time that the business is held in the trust may be just a few days. As a result, there may be a very modest amount of unrelated business income subject to the 100% excise tax.

The "near zero" tax of a unitrust for the sale of an operating business will provide over 99% of the unitrust benefits to business owners. There still will be the bypass of capital gain and a charitable income tax deduction, plus the favorable tax benefits of an operating unitrust. With the possible cost of very modest excise tax when the trust is created, nearly all business properties may now be sold with a "near zero tax" unitrust.

Alternatively, the grantor may prefer to lease the assets to a third party and completely avoid the UBI excise tax.

Charities Including Churches Must Disclose UBIT Returns
In Notice 2007-45, the IRS issued Sec. 6104(d) requirements for disclosure by charities. This section requires public charities to have available for inspection their current Form 990. If the charity is required because of unrelated business income tax (UBIT) to file Form 990-T, that is also now a mandatory disclosure item.

Since churches are generally exempt from filing Form 990, these disclosure provisions have not previously applied to churches. However, a church or state educational institution that has unrelated business income tax is required to file Form 990-T. In this case, disclosure is required.

Reg. 301.6014(d)-1 also notes that Form 990 and Form 990-T must be "widely available." The IRS considers a charity in compliance with the widely available requirement "if it posts its Form 990-T on a PDF file on the organization's website."

Case Studies on Unrelated Business Income Taxation (UBIT) Exceptions

Lucky Lucy Lindstrom's "Ultimate Control" Charity :   Lucy Lindstrom finished college and headed west. She started as a financial analyst with a large company in Seattle. After just four years, she became a Registered Investment Advisor (RIA) and began advising clients. Lucy also managed her own investments. With her keen insight into financial markets, Lucy soon began to move from traditional stocks and bonds into futures and commodities markets. Lucy was so successful in these markets that she now only manages her own large personal portfolio.

Somewhat late in life, Lucy discovered the wonderful world of philanthropy. She volunteered at her favorite charity and learned that giving someone in need a helping hand is even more gratifying than making another million in the futures market. Lucy invested $1,000,000 in a "penny stock" company. Recently, the stock rose from the $1 per share that she paid to over $5 per share. Lucy was delighted with her gain and decided to give the $5,000,000 in stock to a charitable foundation to help those in need.

Lucy discussed several options with her attorney and her favorite charity. She could create a private foundation (PF), or she could set up a supporting organization (SO) with her favorite charity. If the supporting organization were created, her favorite charity wants to elect three of the five directors, and Lucy would elect two directors. Since the SO would be controlled by her favorite charity, it would also qualify as a public charity. Lucy could give the stock and take a deduction up to 30% of her adjusted gross income, with a five-year carry-forward for the excess value.

Lucy thought about the SO but was also very interested in a private foundation (PF). She asked her attorney for reasons to select one or the other. Her attorney noted that private foundations are usually more expensive to operate, appreciated gifts are deductible only to 20% of AGI, deductions for gifts of real estate to a PF are limited to basis, there is usually a 2% excise tax on investment income and the PF is subject to various rules on self-dealing, minimum distributions and excess business holdings. "Wow!" said Lucy, "there are a lot of negatives about private foundations. So why do some of my friends set up private foundations?"

Private Letter Rulings

PLR 200033049 "Out of the Box" Casket Sales Are Not UBI:   A creative monastery has developed an "Out of the Box" idea to obtain and sell wooden caskets. The casket sales will be accompanied by written materials explaining the monastic values regarding funeral rights and burial. The handcrafted wood caskets will be manufactured and sold for approximately 20% less than other caskets. These wooden caskets will be sold to members of the affiliated church body, alumni of affiliated religious schools and other persons. No caskets will be sold through funeral directors or funeral homes.

PLR 200151061 Income Produced from Charity's Golf Course is Not UBI:   School is a Sec. 501(c)(3) organization that rehabilitates court-referred juvenile males. Most of School's students come from low-income, single-parent households in economically depressed neighborhoods. School's purpose is to change its students' behavior from anti-social to pro-social and help develop the students' life skills. School achieves these goals through extensive instruction in pro-social behaviors, academic skills and vocational skills. School offers vocational training in many areas such as autobody repair, graphic art, journalism and golf course maintenance.

PLR 200151062 Charity's Sale of its Timber will not be UBTI:   Charity is a Sec. 501(c)(4) tax-exempt organization whose activities consist mainly of social welfare projects. Many years ago, Charity purchased a parcel of undeveloped, heavily wooded real property. Charity subsequently cleared portions of the property to further its exempt purposes. Charity now has been advised by a state conservation commission that the remaining forested property should be thinned (i.e., timber cut) for conservation purposes. Charity is in need of funds to further its exempt purposes and, therefore, would like to use the funds generated from the cutting and sale of its timber. The timber to be cut has been held by Charity for more than one year.

PLR 200222030 Charity's operation of "Village" restaurant and meeting facility will not produce UBI -- however, operation of "Village" gift shop will produce UBI:   Charity is a 501(c)(3) organization organized to educate the public, to acquire artifacts for its museum and to conserve natural resources and wildlife. Charity began operating a "village" as an extension of its museum program.

PLR 200425050 Tax-Exempt Organization Forms For-Profit Software Company:   Gerry's Geriatric Center (GGC) is a Sec. 501(c)(3) tax-exempt organization dedicated to improving the quality of life for the elderly by operating a multi-service geriatric center. GGC created Gerry Tracker, a software program to track the services it provides and its sources of funding. GGC proposes to create GT Software, Inc., a for-profit subsidiary to market and sell Gerry Tracker. GGC will own all of the stock of GT Software, Inc. and will select the initial directors of GT Software, Inc. Only one of five GT Software, Inc. directors will be an employee of GGC. GGC requests a ruling that its formation and ownership of GT Software, Inc. will not adversely affect its tax-exempt status and that any dividends paid to GGC by GT Software, Inc. will not be taxable unrelated business taxable income (UBTI).

PLR 200506025 Charity May Operate Legal Information Service:   Charities are normally not permitted to operate businesses without payment of tax on unrelated business taxable income. See Reg. 1.513-1(a). A group of businesses from many different nations has organized a Sec. 501(c)(6) business league. As part of its services, it created an entity to operate "an exclusive online legal information service." The exempt business league requests a ruling from the Service that the fees received for the legal information service will not be unrelated business taxable income and that the level of revenue from the online tax service will not cause the charity to lose its exempt status.

PLR 200510029 Sale of Nine Land Parcels Not UBI:   A school for disadvantaged children held farmland that is now suitable for development. The school proposes to sell the land in nine different parcels, and requests a ruling that this sale will not be unrelated business taxable income.

PLR 200512025 Golf Course Deemed Unrelated Business:   M is a non-profit that is organized for religious, charitable, educational and scientific purposes. M operates a large facility that includes a number of activities and services. Part of M's operations include an activity center where visitors can learn through workshops and hands-on interaction about various flowers, trees and fruits and vegetables. M also offers for sale produce that is grown on-site and also produce that is grown off-site. M operates a gift shop that sells a variety of items including books and Christmas decorations. As a convenience to its visitors, M has a location where it sells food and drinks. M also hosts events at its location including weddings, banquets and conferences at which it provides the catering services. To help preserve the atmosphere and overall enjoyment of the facilities for its visitors, which M states would encourage the visitors to come and increase the length of their stay, M has developed a buffer zone in the form of a golf course that completely surrounds its location.

PLR 200532058 Construction of Ice Arena Not UBI:   Private Foundation proposes to build, maintain and lease a public ice arena for the purpose of promoting the health and welfare of the community and to lessen government burdens. In order to build the arena, the private foundation plans to create an LLC. The private foundation will be the sole owner of the LLC. The financing of the arena will consist of a contribution to capital and/or loan from the private foundation to the LLC, government grants and loans from third party banking institutions.

PLR 200619024 Proceeds From College's Sale of Property Not Subject to UBIT:   Donors gave an undivided one-half interest in unimproved real property to C, a state community college. C held the property for 12 years and made no improvements.

PLR 200625035 School Renting Living Quarters Not Subject to UBIT Unless Renting to General Public:   School is a Sec. 509(a) private non-operating foundation, providing theological education to students and scholars.

PLR 200638007 Rental Income Not Passive:   X is a Subchapter S corporation. X has 100% ownership interest in three rental properties. X provides various services to the tenants of each property including site inspections, assisting tenants with the sub-leasing of units, maintenance and repairs relating to tenant space improvements and janitorial services.

PLR 200642009 Mobile Home Park for Poor Not UBI:   Z is a public charity classified under Sec. 501(c)(3) of the Code. Z was established for the purpose of providing housing to the elderly, infirm, and low-income persons.

PLR 200717019 Interest and Rent Collected by a Supporting Organization is Not UBTI:   B is a supporting organization under Sec. 509(a)(3). B owns land on a hospital campus. B leases its parcel of land to G. G is a limited partnership owned by B. G borrowed money to build a medical office building on, and to make improvements to, B's parcel. G leases substantially all of the office building to several affiliates and subsidiaries of B.

PLR 200722028 Sale of Merchandise Not UBI:   M, a qualified 501(c)(3) tax-exempt organization, is operated to promote education and public awareness on breast cancer prevention and research. M operates a website and also publishes a semi-annual newsletter among other media outlets to spread its message.

PLR 200724034 Administration of Employee Health Plan Doesn't Jeopardize Tax Status or Trigger UBIT:   501(c)(3) Charity's exempt purpose is to promote and support federal agency M's research program. Charity operates at M, manages fellowship and research grants supporting M's programs and also administers group health and other types of insurance for employees, contractors and volunteers of M who do not qualify for federal health insurance.

PLR 201049047 Trust's Sale of Real Estate Will Not Generate Business Taxable Income:   Trust was funded under the will of N for the education of the people of P. N requested that Trust maintain the bequest of real property intact, selling property only when absolutely necessary.
PLR 201106019 Rental to Public Constitutes UBTI:   ORG is tax-exempt under Sec. 501(c)(3) and classified as an educational organization. Rooms are offered on an overnight basis in building H on ORG's campus. Although rooms are used for campus purposes, such as temporary housing for students until long-term housing becomes available and accommodations for official visitors to the campus, rooms are also available to the general public.
PLR 201108037 Sale of Building Not UBI:   Org. is tax-exempt under Sec. 501(c)(3) and was originally classified as a public charity. In subsequent years, Org. petitioned the Service to amend its status as a private foundation under Sec. 509(a)(1).
PLR 201113035 Sale Will Not Jeopardize Tax-Exempt Status:   O was created as a charitable trust by the will of N. N desired that O retain as much of the funding property as possible, only selling parcels off when necessary. O still owns most of the original property.
PLR 201206018 Debt-Financed Land Exempt From UBI:   Church, a recognized Sec. 501(c)(3) charity, financed the purchase of land in the surrounding neighborhood with a loan. Church developed approximately half of the property with new facilities. The other half of the property has been left undeveloped and leased to a local rancher for grazing livestock.
PLR 201214034 Operational Changes Won't Jeopardize Exemption:   A regional transmission organization (RTO) is a tax-exempt, nonprofit organization under Sec. 501(c)(3). RTO is charged, by the Federal Energy Regulatory Commission (FERC), with providing independent, open and fair access to electricity transmission systems and other responsibilities that lessen the burdens of government.
PLR 201223021 Endowment Shares Not UBTI:   M is a tax-exempt educational organization under Secs. 501(c)(3) and 509(a)(1). M is the remainder beneficiary and trustee of a number of charitable remainder trusts (CRTs).

PLR 201246040 Church's Property Is Exempt From Debt-Financed Property Provision:   Church was incorporated in a particular state on Date 1. Church purchased three parcels of land. Parcel One was purchased on Date 2, Parcel Two on Date 3 and Parcel Three on Date 4.

PLR 201250025 Organization's Income From Clinical Database Won't Generate UBIT:   Taxpayer is classified as a tax-exempt organization under Sec. 501(c)(3) and a Type I supporting organization under Sec. 509(a)(3). Taxpayer was formed to benefit, perform the functions of, and carry out the public purposes of twelve supported organizations.

PLR 201251019 Revenue From Literacy Promotion Not UBTI:   Taxpayer is classified as a tax-exempt organization under Sec. 501(c)(3) and as a non-private foundation under Sec. 509(a)(2). Taxpayer was formed to educate, promote, encourage and aid children and adults in the appreciation of reading and literacy.
PLR 201306023 Foundation's Exempt Status Not Affected By Condo Sales:   Foundation is a private foundation organized under the laws of State. Its primary purpose is to benefit orphans and other destitute children in State. Foundation operates nine children's centers in State that provide counseling, support and education to children and their families or caregivers.
PLR 201407022 Disposition of IP Rights Won't Result in UBIT:   Org is a tax-exempt supporting organization under Sec. 501(c)(3) that operates a telecommunications network serving a public university system. Several decades ago Org received several million IPv4 addresses, which it uses as part of its exempt activities.

PLR 201408032 No UBTI When Issuing Endowment Units to Trust:   M is an educational organization under 170(b)(1)(A)(ii) of the Code. M is the trustee of 145 charitable remainder trusts and is the sole remainder beneficiary of 140 of those trusts.

PLR 201409009 Assn's Exemption Not Affected by Transactions With For-Profit Subsidiary:   Association operates a non-profit cemetery under Sec. 501(c)(13). Association intends to create a wholly owned, for-profit subsidiary corporation that will operate a funeral home (Subsidiary).


PLR 201429029 Gift Shop Proceeds Not Unrelated Business Income:   Org is a tax exempt organization under Sec. 501(c)(3) whose purpose is the operation of a museum and research center pertaining to subjects involving outer space.

PLR 201613015 Trust's Investment in Endowment Won't Produce UBTI:   Trust is a charitable remainder unitrust (CRUT) under Sec. 664(d)(2). College, an educational institution recognized as tax exempt under Sec. 501(c)(3), is the only remainder beneficiary of Trust.

PLR 201729013 No UBTI on Endowment Units to Trust:   College is a tax-exempt educational organization recognized under 501(c)(3) and 170(b)(1)(A)(ii) of the Code. College manages its endowment, which is invested to provide a growing stream of income to support College's programs.

PLR 9616039 Real Estate Subdivision, Sale of Lots and UBI:   When a charity or a charitable trust receives a property, it is important to examine the potential unrelated business income (UBI) upon sale of the property. If the maximization of return requires sale of the property in lots or parcels, then the question is whether or not this dividing and selling would cause the charity to be entering into the real estate business and generating UBI under Secs. 512 through 514 of the Code.

Related Topics on Unrelated Business Income Taxation (UBIT) Exceptions

4.10.2  Lease and Debt Solutions:    A common challenge for business owners who would like to use a charitable trust is that the business is an ongoing activity that is not allowed to be held in a charitable trust.

4.7.2  Mortgage or Debt:    The majority of real estate is encumbered by debt. If contributed real estate is subject to a mortgage, the donor will receive a charitable deduction equal to only the equity portion of the gift. In other words, the donor may not claim a deduction for the encumbered portion of the property.

4.7.5  Charitable Remainder Trusts:    A charitable remainder unitrust (CRUT) is an excellent option for donors with appreciated real estate. A CRUT provides a charitable income tax deduction, an income stream and a tax-free sale of the real estate.

Bartels Trust:    A supporting organization for the University of New Haven called the Bartles Trust was established in 1988. During the years 1991, 1992 and 1993, the Bartles Trust invested in securities on margin. The trust paid unrelated business income tax (UBIT) on the income from the margin investments and later sought a refund.

Ocean Pines Association CA4th:    In Ocean Pines Association Inc. v. Commissioner; No. 11-1029 (2 Mar 2012), the Fourth Circuit affirmed a Tax Court decision that a beach club and parking lots were private assets that created unrelated business taxable income.

Caricci:    In Michael T. Caracci, et ux., et al. v. Commissioner, 118 T.C. No. 25, several cases involving the Sta-Home Health Agency conversion from a nonprofit to a for-profit were consolidated. Judge Laro determined that the conversion of the nonprofit Sta-Home entity to a for-profit did indeed result in Sec. 4958 excess benefit transactions for various Caracci family members.


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