Tax Exemption and Unrelated Business Income Tax (UBIT): Rules, Modifications and Exceptions (Part 2 of 3)
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.”).