Tax Exemption And Unrelated Enterprise Revenue Tax (UBIT): Guidelines, Modifications And Exceptions (Half 2 Of three) – Revenue Tax

This Insights blog is Part 2 of a 3-Part series focused
on the unrelated business income tax rules for the nonprofit
organization that is tax-exempt pursuant to section 501(c)(3) of
the Internal Revenue Code (the “Code”).

Part 1-Tax Exemption and Unrelated Business
Income Tax (UBIT): The Framework
-provided an overview
of the organizational and operational tests of section 501(c)(3) of
the Code and alluded to the trigger for unrelated business income
rules.

This Part 2 dives deeper into the unrelated business income tax
rules.

Summary of Unrelated Business Income Tax Laws and
Regulations

Generally, a tax-exempt organization must pay income tax on
income classified as unrelated business income. 26 U.S.C. §
511(a). An unrelated trade or business is any trade or business,
regularly carried on, the conduct of which is not substantially
related to the organization’s exempt purpose. 26 U.S.C. §
513(a). Modifications, exclusions, and exceptions exist.

Section 512 of the Code contains several exceptions and about 20
modifications to general rule for taxation of unrelated business
taxable income. Section 512 excludes from the definition of
unrelated business taxable income from passive investments,
royalties, and rent from real property and personal property rented
with real property, provided no more than an incidental amount of
the rent payment is allocated to the rental of the personal
property.

The applicability of a particular exception or modification will
depend on the numerous facts and circumstances of the
income-driving trade or business in issue, the type of organization
that conducts such trade or business, and other factors contained
in or required by the Code and related Treasury Regulations.

General Rule of Unrelated Business Taxable Income

If an organization that is exempt from federal income taxes
under section 501(a) of the Code produces income from an unrelated
trade or business, that income is called unrelated business income
and is taxable, unless a modification, exclusion or exception
applies. See 26 U.S.C. §§ 511(a)(1), 512-514;
see also IRS Unrelated Business Income Tax (providing
guidance on the subject).

“Unrelated Trade or Business” and “Unrelated
Trade or Business Taxable Income”

Generally, an activity is an unrelated business if the activity
meets three requirements: (1) it is a trade or
business, (2) it is regularly carried on and
(3) it is not substantially related to furthering
the exempt purposes of the organization.

Section 513 of the Code defines an
unrelated trade or business as “any trade or
business the conduct of which is not substantially related (aside
from the need of such organization for income or funds or the use
it makes of the profits derived) to the exercise or performance by
such organization of its charitable, educational, or other purpose
or function constituting the basis for its exemption under section
501(.)” See 26 U.S.C.
§ 513(a).

The term “unrelated business taxable
income
” means the gross income derived by any
organization from any “unrelated trade or business” (as
defined in section 513) regularly carried on by the organization,
less applicable deductions connected with the carrying on of such
trade or business, computed with the modifications in
subsection 512(b)
. See 26 U.S.C. § 512(a)(1).

Regularly Carried On

Whether a trade or business for these purposes is
“regularly carried on” is determined by
evaluation of the frequency and continuity with which the
activities productive of the income are conducted and the manner in
which those activities are pursued. Specific business activities of
an exempt organization will ordinarily be deemed to be
“regularly carried on” if, for example,
“they manifest a frequency and continuity, and are pursued in
a manner, generally similar to comparable commercial activities of
nonexempt organizations.” 26 C.F.R. § 1.513-1(c)(1).

What is “regular” from a timing or performance
perspective depends on the industry involved, any non-exempt market
performance of similar activities, and the type of activity. The
Treasury Regulations provide these rules and examples:

Where income producing activities
are of a kind normally conducted by nonexempt commercial
organizations on a year-round basis, the conduct of such activities
by an exempt organization over a period of only a few weeks does
not constitute the regular carrying on of trade or business. For
example, the operation of a sandwich stand by a hospital auxiliary
for only 2 weeks at a state fair would not be the regular conduct
of trade or business. However, the conduct of year-round business
activities for one day each week would constitute the regular
carrying on of trade or business. Thus, the operation of a
commercial parking lot on Saturday of each week would be the
regular conduct of trade or business. Where income producing
activities are of a kind normally undertaken by nonexempt
commercial organizations only on a seasonal basis, the conduct of
such activities by an exempt organization during a significant
portion of the season ordinarily constitutes the regular conduct of
trade or business. For example, the operation of a track for horse
racing for several weeks of a year would be considered the regular
conduct of trade or business because it is usual to carry on such
trade or business only during a particular season.

Id. at § 1.513-1(c)(2)(i).

Exceptions to “Unrelated Trade or Business”

Certain activities are expressly excepted from the meaning of
“unrelated trade or business.” For the exceptions to
apply, the organization and the activity producing the income must
be evaluated.

For example, “unrelated trade or business” does not
include (1) qualified fair or exposition public entertainment
activities of certain organizations which regularly conduct, as one
of its substantial exempt purposes, an agricultural and educational
fair or exposition; (2) qualified convention and trade show
activities that attract persons in an industry generally as well as
members of the public for the purpose of displaying industry
products or to simulate interest in the particular industry.
Qualified hospital services, qualified bingo games, and, of course,
certain pole-rental activities are also excluded from the meaning
of “unrelated trade or business” for organizations
described in these carve outs set forth in section 513. See
id. at § 513(d)-(h).

Qualified sponsorship payments are also excepted from the
meaning of “unrelated trade or business.” A
“qualified sponsorship payment” is any payment made by
any person engaged in a trade or business with respect to which
there is no arrangement or expectation that such person will
receive any substantial return benefit other than the use or
acknowledgement of the name or logo of such person’s trade or
business in connection with the activities of the organization that
receives such payment. Limitations apply, such as conditioning the
payment on factors relating to the degree of public exposure to a
particular event. See id. at § 513(i)-(i)(3).

Modifications to “Unrelated Business Taxable
Income”

“Except as otherwise provided in this subsection, the term
“unrelated business taxable income” means the
gross income derived by any organization from any unrelated trade
or business (as defined in section 513) regularly carried on by it,
less the deductions allowed . . . which are directly connected with
the carrying on of such trade or business, both computed
with the modifications provided in subsection (b)
.”
26 U.S.C. § 512(a)(1) (emphasis added).
Generally, gross income from an unrelated trade or business, and
the applicable deductions related to that income, are computed the
same way in which corporate income taxes are calculated.
See 26 U.S.C. §§ 511(a) (corporate rates
applicable), 162 (trade or business expenses), 167
(depreciation).

There are about 20 modifications contained in subsection 512(b).
They include the following:

  • Dividends and Interest. Subsection section
    512(b)(1) excludes dividends, interest income, and payments with
    respect to securies loans, amounts received or accrued as
    consideration for entering into agreements to make loans, and
    annuities, and all deductions directly connected with such
    income.
  • Royalties. Subsection 512(b)(2) excludes all
    royalties, and all deductions directly connected with such
    income.
  • Rents Attributable to Real Property.
    Subsection 512(b)(3)(A)(i) excludes from unrelated business taxable
    income rents attributable to real property, provided that an
    exception to the exclusion does not apply, including the
    debt-financed property exception.
  • Rents from Personal Property. Subsection
    512(b)(3)(A)(ii) excludes from unrelated business taxable income
    all rents from personal property leased with such real property, if
    the rents attributable to such personal property are an incidental
    amount of the total rents received or accrued under the lease (and
    provided that an exception to the exclusion does not apply).
  • Research. Income from research performed for
    any federal or state governmental agency, or from research
    performed by a college, university, or hospital for any person is
    excluded. id. at § 512(b)(7)-(9).
  • $1,000 Deduction. With limited exception, the
    Code permits a specific deduction of $1,000 of any unrelated
    business taxable income. And, in the case of a diocese or
    convention of churches, there is also allowed, with respect to each
    individual church, a specific deduction equal to the lower of
    $1,000 or the gross income derived from any unrelated trade or
    business regularly carried on by such individual church.
  • Controlled Entities and Receipts from Foreign
    Corporations.
    Subsection 512(b)(13) provides special rules
    and modifications to unrelated business taxable income for amounts
    received from controlled entities.

Exceptions to the Modifications Applicable to Real Property and
Personal Property

In the case of personal property leased with real property
(which is commonly referred to as a “mixed lease”) the
rental income is excludable from unrelated business taxable income
if the rents that are attributable to the personal property are not
more than 10% of the total rents received under the lease.
See
26 C.F.R. § 1.512(b)-1(C)(2)(ii)(b). Moreover, the
exclusions from unrelated business taxable income for rental income
in subsection 512(b)(3)(A) (i.e., rents from real property and
personal property) shall not apply: (i) if more than 50 percent of
the total rent received or accrued under the lease is attributable
to personal property, or (ii) if the determination of the amount of
such rent depends in whole or in part on the income or profits
derived by any person from the property leased (other than an
amount based on a fixed percentage or percentages of receipts or
sales). See 26 U.S.C. § 512(b)(3)(B)(i).

Debt-Financed Property Exceptions to the Modifications

As noted above, subsection 512(b)(3)(A)(i) excludes from
unrelated business taxable income rents attributable to real
property. However, exceptions apply. Section 514 of the Code
provides special (and complex) rules for inclusion of income
derived from real property that is debt-financed. The term
“debt-financed property” means any property which is held
to produce income and with respect to which there is an acquisition
indebtedness at any time during the taxable year. See id.
at § 514(b)(1).

When income is derived through the use of borrowed funds,
section 514 is triggered, and the income-while perhaps once
excluded or modified for taxation purposes by section 511, 512, or
513-may be brought back into the taxable category. See id.
at § 514(a)-(b).

If, for example, a church receives leases debt-financed property
to a third party for a purpose that is not substantially related to
the exempt purposes of the church, the rent from that activity is
likely includable in unrelated business taxable income.

Similarly, if an exempt organization purchases securities with
borrowed funds, the dividends or interest earned on those
securities is likely subject to the unrelated business taxable
income rules. (Exceptions apply, such as in the case of tax-exempt
bond issuances or tax-exempt loans, but that is a whole other can
of tax worms for another future blog.)

Exceptions to Unrelated Business Income Tax Rules

In addition to the modifications, section 513 of the Code
expressly excepts any trade or business-

  • in which substantially all the work in carrying on such trade
    or business is performed for the organization without compensation
    (e., a volunteer-run business); or
  • which is carried on by the organization
    primarily for the convenience of its members,
    students, patients, officers, or employees; or
  • which is the selling of merchandise, substantially all of which
    has been received by the organization as gifts or contributions
    (e., sale of donated goods).

See id. at § 513(a)-(a)(3).

Closing of Part 2

That is a wrap for this Part 2 – Tax Exemption and
Unrelated Business Income Tax (UBIT): Rules, Modifications and
Exceptions
. Stay tuned for Part 3 of this 3-Part series
where we will dive deeper into these unrelated business income
rules and what is meant by a trade or business that is
“substantially related” to a tax-exempt
organization’s exempt purposes. See Continuing Life Communities Thousand Oaks
LLC v. Comm’r, T.C. Memo. 2022-31 |April 6,
2022
?|Holmes, J. | Dkt. No.
4806-15
(“One way to think about tax law is to
view it as a series of general rules qualified by exceptions, and
exceptions to those exceptions, and exceptions to those exceptions
to those exceptions.”).

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.