CHAPTER 8
The Unrelated Business Income Tax

  1. § 8.1 Introduction
  2. § 8.3 General Rule
  3. § 8.4 Statutory Exceptions to UBIT (Revised)
  4. § 8.5 Modifications to UBIT (Revised)
  5. § 8.7 Calculation of UBIT (Revised)

§ 8.1 INTRODUCTION

(b) Impact of UBIT and Reporting Trends

p. 579. Delete the first three sentences of this subsection and replace with the following (note that footnote 8 is deleted):

According to the Fall 2014 Statistics of Income Bulletin, reporting on information for the 2010 reporting year, 43,184 exempt organizations filed Form 990-T with $11 billion received as gross UBI, offset by $10.8 billion in deductions.5 Two percent more tax-exempt organizations filed the Form 990-T for 2010 and reported $341.3 million in unrelated business income tax liability.6 Total unrelated business income tax liability increased 28 percent from 2009.7

p. 579. In footnote 9, delete www.irs.gov.

p. 579. Insert the following to the end of the paragraph:

The primary reasons for the increases were disallowing expenses that were not connected to unrelated business activities, lack of profit motive, improper expense allocation, errors in computation or substantiation, and reclassifying exempt activities as unrelated. The majority of the adjustments came from the following activities: fitness, recreation centers, and sports camp; advertising; facility rentals; arenas; and golf.9.1

§ 8.3 GENERAL RULE

(b) The Definition of “Unrelated Trade or Business”

(i) Trade or Business.   p. 585. Insert the following at the end of footnote 45:

The exemption for low-cost articles is indexed annually for inflation and is set at $10.60 for 2016. See Rev. Proc. 2015-53.

(A) SEGREGATING A BUSINESS FROM WITHIN AN EXEMPT ACTIVITY

p. 589. Insert the following at the end of footnote 64:

See, for example, Losantiville Country Club v. Commissioner, T.C. Memo. 2017-158 (investment income held to be UBI when losses from nonmember sales activities not conducted with profit motive, inasmuch as they generated losses to offset income) citing Portland Golf Club v. Commissioner, 497 U.S. 154 (1990) (losses from nonmember sales may offset investment income only if sales were entered into for profit).

(ii) “Regularly Carried On.”

(A) THE REGULATIONS

p. 591. Insert the following at the end of footnote 75:

PLR 201644019 (a one-time sale of assets by a charity's wholly owned subsidiary LLC to an unrelated party was not UBI because the activity was not “regularly carried on”).

(iii) “Substantially Related.”

(A) THE REGULATIONS

p. 600. Insert the following Example after the first Example on this page:

§ 8.4 STATUTORY EXCEPTIONS TO UBIT (REVISED)

(b) Activities for the Convenience of Members

p. 604. Insert the following at the end of footnote 139:

Cf. Tax-exempt organization received fees from vendors that were held to be unrelated business income; court rejected argument that funds were royalties or payments made for convenience of members (New Jersey Council of Teaching Hospitals v. Commissioner, 149 T.C. 22 (2017)).

(h) Corporate Sponsorship

p. 610. Insert the following after the Example:

With regard to links to sponsors' websites referenced in the above example, a link from the university website to the sneaker manufacturer with no promotion or advertising would be viewed as a “qualified sponsorship payment” and not subject to UBIT. However, the inclusion of a statement that the university endorses the sneakers and gives permission for the endorsement to appear in its website could be viewed as a substantial return benefit and be subject to UBIT.

p. 612. Insert the following at the end of the first paragraph on the page:

In this regard, pay-per-view or click-through arrangements may be precluded from constituting qualified sponsorship arrangements. A click-through rate is the percentage of people visiting a web page who access a hypertext link to a particular advertisement. A moving banner may be considered advertising rather than sponsorship.

§ 8.5 MODIFICATIONS TO UBIT (REVISED)

(d) Royalties

p. 622. Insert the following at the end of footnote 246:

In PLR 201644019, a charity's wholly owned for-profit subsidiary formed an LLC with an unrelated party. The LLC paid the charity royalties for the use of the charity's trademarks, domain names, and social media handles. Because the charity did not directly or actively participate in the day-to-day management of the subsidiary or LLC, payments by the LLC to the charity constituted royalties exempt from UBIT. The subsidiary was in effect successfully functioning as a blocker entity, and the subsidiary's involvement in the LLC would not be attributed to the charity.

(g) Income from Internet Activities

p. 645. Insert the following at the end of footnote 339:

In this regard, pay-per-view or click-through arrangements are likely to be characterized as advertising. See subsection 8.4(h).

§ 8.7 CALCULATION OF UBIT (REVISED)

(a) General Rules

p. 659. Delete the second full paragraph and replace it with the following:381

Before January 1, 2018, tax-exempt organizations could calculate the amount of tax imposed on UBI based on the income of all the unrelated business activities regularly carried on less all the permissible deductions directly connected with the carrying on these activities.382 Therefore, losses that were generated by one trade or business could offset the income earned by a different trade or business.

Under the new law, a nonprofit must separately calculate the net UBIT for each unrelated trade or business, in effect creating “silos”; accordingly, any loss derived from one unrelated business activity may not offset the income from another unrelated trade or business.383 Furthermore, net operating loss deductions are only allowed to be used against income from the trade or business from which the loss arose.383.1 The Joint Committee on Taxation expects this provision will increase revenues from 2018 through 2027 by a total of $3.5 billion.383.2

The Act is not clear on how to determine whether an activity would constitute a single or multiple trade or business. There is little guidance as to the meaning of a “separate trade or business” in the Code.

The concept of “separate trade or business” within the realm of exempt organizations was first introduced by the IRS through regulations implementing the fragmentation principle in the mid-1960s.383.3 This concept was endorsed by the Supreme Court in United States v. American College of Physician, where the court hailed the concept as a “revolutionary approach” to identifying a trade or business.383.4 See Code § 513(c).383.5 Although fragmenting income within a business has become a common practice among nonprofits, the concept of separating lines of businesses is novel for exempt organizations and has no for-profit counterpart.

Although a for-profit corporation is not required to separate its businesses, it may elect to do so in order to implement multiple methods of accounting. A taxpayer engaged in more than one trade or business may, in computing taxable income, use a different method of accounting for each trade or business.383.8 No trade or business will be considered separate and distinct unless a complete and separable set of books and records is kept for such trade or business.383.9 Under these provisions, the default for corporate taxpayers is to treat all lines of business as a single trade or business and apply only one method of accounting. And, if the corporation prefers to use multiple methods of accounting, it would need to demonstrate that the books of each business are separable, that income would still be clearly reflected by the method of accounting that was chosen, and that there would be no shifting of profits and losses by reason of maintaining different accounting methods.383.10

Although “separate trade or business” is rarely applicable to corporations, it does arise more often in the context of individual taxpayers.383.11

The IRS has previously advocated for a “nature of the business” test when interpreting “separate trade of business” within the context of § 130.383.12 The basic theory of the “nature of the business” test is that if two enterprises of an individual are in the same line of business, then those enterprises should be treated as a single trade or business. In Collins, the IRS argued that the taxpayer was in the line of business of promoting professional football, so his New York Club and Boston Club should be in the same line of business. The court ultimately found for the taxpayer, stating that although the similarity of the activities may be a fact, this one factor may be outweighed by other considerations, including the separateness of the economic entities; the separate management; the different finance, currency controls, labor, and marketing conditions; and the maintenance of separate books. However, the Service nonacquiesced to the decision.

Although these factors may prove beneficial in determining how the IRS is likely to interpret “separate trade or business,” it is important to keep in mind that in all of these cases and statutes, the taxpayer was actively seeking to have the businesses treated as separate because there was a tax benefit in them being distinct. Under existing tax law, the exempt organizations will attempt to do the opposite and aggregate its activities into a single business as opposed to separate businesses. Section 13702 of the Tax Act appears to be the first implementation of “separate trade of business” where having a single business is more beneficial for the taxpayer.

As previously discussed in Section 8.3, the ultimate goal of UBIT was to eliminate unfair competition by taxing the unrelated business activities of exempt organizations on the same basis as their nonexempt competitors.383.13

Before January 2018, after applying the fragmentation rule and separating out the businesses that produce related income, a nonprofit could aggregate all the gains and losses from all the unrelated businesses to determine their total net income tax liability. Now, however, an exempt organization must silo each separate trade or business. And in determining whether activities constitute separate trade or businesses, the IRS will examine all the facts and circumstances, with the most significant factors being the nature of the businesses and the interrelationship of the businesses; the IRS should accept the characterizations of the exempt organization, so long as they are not artificial or unreasonable.

In the context of nonprofits investing in private investment funds, if it were not treated as a single business, the exempt organization could use blocker corporations to prevent having to silo each individual portfolio investment.

To conclude, despite the new code provision that requires exempt organizations to calculate UBIT for each separate trade or business, tax-exempt organizations still have multiple options when it comes to reducing their tax liability. Although exempt organizations may have more income in total that is subject to UBIT, the reduction of the corporate rate from 35 percent to 21 percent may result in an overall lower tax liability. Furthermore, exempt organizations can also take advantage of lower corporate rates by dropping their unrelated business activities into for-profit subsidiaries. By using blocker corporate subsidiaries, the exempt organizations can net all their gains and losses without having to silo the income and losses from separate businesses. Furthermore they can receive dividends without incurring UBIT. An exempt organization can also place a business that would independently qualify for tax-exempt status into a supporting organization under § 509(a)(3). See Section 6.4.

As previously explained, in the context of the new UBTI “silo” rule, tax-exempt organizations are often partners in partnerships that directly or indirectly conduct more than one trade or business. The IRS recently issued an interim guidance, Notice 2018-67,383.14 which is effective until Treasury issues regulations on the UBTI silo rules. It provides that a tax-exempt organization may rely on “a reasonable, good-faith interpretation” of sections 511 through 514 in determining whether it has more than one unrelated trade or business based on all facts and circumstances.

A tax-exempt organization that is a joint venture taxed as a partner in a partnership may treat a “qualifying partnership interest” as a single trade or business and may further aggregate all of its qualifying partnership interests together as one trade or business.383.15

A qualifying partnership interest is a partnership interest that satisfies either the “de minimis” test or the “control” test. Under the de minimis test, the tax-exempt organization may hold directly no more than 2 percent of the profits interests and no more than 2 percent of the capital interests in the partnership. Under the control test, the tax-exempt organization may hold directly no more than 20 percent of the capital interest in the partnership and does not have control or influence over the partnership. For the control test, control or influence exists if (i) the tax-exempt organization is able to require the partnership to perform or prevent the partnership from performing any act that significantly affects the operations of the partnership; (ii) the tax-exempt organization's officers, directors, trustees, or employees have rights to participate in the partnership's management or operations; or (iii) the tax-exempt organization has the power to appoint or remove the partnership's officers, directors, trustees, or employees.

Under both the de minimis test and the control test, a tax-exempt organization's percentage interest is the average of the organization's percentage interest held at the beginning and the end of the taxable year specified on the organization's Schedule K-1.383.16

According to Notice 2018-67, the IRS does not consider providing fringe benefits as an unrelated trade or business, and thus, UBTI generated by providing such fringe benefits is not subject to the UBTI silo rule. See § 512(a)7.

However, NOLs arising in a taxable year beginning before January 1, 2018, that are carried forward are not subject to the UBTI silo rule and can be applied to UBTI generally. Notice 2018-67 suggests that post-2017 NOLs may be calculated and taken before pre-2018 NOL carryovers are taken.383.17

(b) Expenses

(ii) Exploited Activity Rule.   p. 663. Insert the following at the end of footnote 398:

See, for example, Fish v. Commissioner (9th Cir. 2017) (pass-through of UBI losses to an IRA beneficiary's personal tax return not permitted).

p. 663. Add the following new subparagraph at the end of this subsection:

(iii) Ownership Change.   In the context of an ownership change, an issue arises as to whether the net operating losses of a tax-exempt entity can be used by a surviving tax-exempt corporation in a merger. Code section 382 limits the amount of income that can be offset by NOLs where there has been a change in ownership of the taxpayer with an existing NOL in order for its NOL carryovers to be allowed as deductions (after the ownership change pursuant to the annual section 382 limitation398.1). The determination of whether there has been an ownership change is expressed in terms of stock ownership, as the provision was intended to apply to for-profit entities where there is a significant ownership change, that is, more than 50 percent.398.2 The annual section 382 limitation generally equals the fair market value of the stock of the corporation that experienced the ownership change (calculated immediately before the ownership change) multiplied by the applicable federal long-term tax-exempt rate as of the date of the ownership change.398.3 In general, an ownership change occurs where more than 50 percent of a corporation's stock is sold within a three-year period,398.4 as well as changes that occur incident to redemptions, recapitalizations, and reorganizations.398.5

The Code section 382 rules and the Treasury Regulations thereunder do not specifically encompass or exclude beneficial ownership of loss corporation stock held by nonstock organizations,398.6 and there is limited authority that speaks to whether Code section 382 should apply to tax-exempt entities.398.7 The authority that exists is contained in private letter rulings issued by the IRS, which technically cannot be relied on as precedent by persons other than the taxpayers requesting the ruling.398.8 These rulings contain complex fact patterns and, in most cases, little or no reasoning by the IRS. In the rulings, the IRS holds that there was no ownership change under Code section 382 in the context of mergers within related tax-exempt groups where the parent had control of one or more subsidiaries with NOLs.398.9 In the rulings, the loss entity (the entity with the NOL) was transferred to a tax-exempt entity that was under the same control as the transferor tax-exempt entity. Therefore, based on the private letter rulings, it seems that there should be no ownership change.

For example, PLR 200028005, July 17, 2000, concerned a healthcare system with three Code section 501(c)(3) entities that were the sole corporate members of one or more exempt subsidiary affiliates, some of which owned the stock of for-profit subsidiaries that performed services398.10 for the group and that had NOLs at the time certain mergers took place. The number of affiliated entities and the mergers were complex; there was no reasoning or analysis by the IRS, other than a recitation that the entities complied with local law governing distribution of assets upon dissolution by tax-exempt organizations. The ruling held:

The merger of Tax Exempt 1 with Tax Exempt 3 followed by the merger of Tax Exempt 2 with the surviving entity (together with the changes in the corporate membership and governing instruments of the various tax-exempt entities pursuant thereto) does not result in an ownership change within the meaning of § 382(g) of Parent Corp or any other loss corporation owned by an exempt subsidiary affiliate of the former Tax Exempt 1 or Tax Exempt 2, or Tax Exempt 3 systems.398.11

The IRS has issued other PLRs involving similar fact patterns, that is, exempt organizations controlled by one or more exempt parents that implement a merger involving controlled subsidiaries, some of which have NOLs.398.12 Where state law governing such mergers is satisfied, along with compliance regarding requisite dissolution clauses and prohibitions on impermissible inurement or private benefit, the IRS rules that there is no “ownership change.”

Based on these facts, the author believes that for U.S. federal income tax purposes, it is more likely than not that a merger that meets the control test will not constitute an “ownership change” within the meaning of Code § 382(g) and Treasury Regulation § 1.382-2T. However, because the only indication of the IRS position is found in private letter rulings, there is a possibility that the IRS may challenge the use of an NOL carryforward by a newly formed exempt organization, depending on the facts as to whether there has, in effect, been no “ownership change.”

p. 663. Insert the new subsection:

(c) Tax on Transportation Fringe Benefits: Qualified Parking, etc.

Prior to the 2017 Tax Act, tax-exempt organizations were able to provide employees with certain fringe benefits, free from income tax at both the employer and employee levels. Pursuant to new Code § 512(a)(7), UBTI is increased by amounts paid or incurred for qualified transportation fringe benefits (including qualified parking and transit passes) or any on-premises athletic facilities where such amounts would not be deductible under Code § 274. The tax applies to amounts paid or incurred after December 31, 2017.

Because Code § 512(a)(7) has been quite controversial as a result of requiring tax-exempt organizations that have never previously to file Form 990-T to now file it, there has been much criticism of the provision and discussion of its repeal, particularly in regard to religious organizations, but it's difficult to predict if any action will be taken.

NOTES

  1. 5 Fall 2014 Statistics of Income Bulletin, available at https://www.irs.gov/pub/irs-soi/soi-a-eoub-id1403.pdf.
  2. 6 Ibid.
  3. 7 Ibid.
  4. 9.1 Id.
  5. 114.1 TAM 201544025 (Oct. 30, 2015). The organization at issue here, College of the Desert Alumni Association, Inc., has appealed the IRS's decision to the Tax Court. See College of the Desert Alumni Association, Inc. v. IRS.
  6. 381 The analysis in this subsection is based on research prepared by Nina Roca, Esq. and is adapted from her graduate tax paper at Georgetown University Law Center, Advanced Topics in Exempt Organizations.
  7. 382 I.R.C. § 512 (2017).
  8. 383 T.C.J.A. § 13702.
  9. 383.1 T.C.J.A. § 13702(b).
  10. 383.2 Joint committee on Taxation, Estimated Budget Effects Of The Conference Agreement For H.R.1, The “Tax Courts and Jobs Act.” (Dec. 18, 2017) (https://www.jct.gov/publications.html?func=startdown&id=5053).
  11. 383.3 Treatment of Income from Unrelated Trade or Business, 32 FR 17657.
  12. 383.4 United States v. Am. Coll. of Physicians, 475 U.S. 834 (1986); Am. Med. Ass'n v. United States, 887 F.2d 760 (7th Cir. 1989).
  13. 383.5 Tax Reform Act of 1969, Pub. L. No. 91-172, § 121(c). See § 8.3.
  14. 383.6 I.R.C. § 11.
  15. 383.7 See Id.
  16. 383.8 See Code § 446, Treas. Reg. 1.446-1(d)(2).
  17. 383.9 Treas. Reg. § 1.446-1(d)(2).
  18. 383.10 Id.
  19. 383.11 The Code embraces the concept of “separate trade or business” for individuals in various provisions, including §§ 130 (1939), 183, 446, and 1348. Some of the clearest guidance is provided in regulation § 1.183-1, which states that the activity or activities of the taxpayer must be ascertained, and, where the taxpayer is engaged in multiple activities, it must first be determined if the activities constitute one undertaking or several undertakings. Ascertaining the activities is a facts and circumstances based test, with the most significant factors, generally, being “the degree of organizational and economic interrelationship of various undertakings, the business purpose which is (or might be) served by carrying on the various undertakings separately or together in a trade or business or in an investment setting, and the similarity of various undertakings.” Furthermore, the regulation provides that the Service will generally accept the characterization by the taxpayer of the several undertakings as either a single activity or separate activities, unless the characterization is artificial and not reasonably supported under the facts and circumstances. Further guidance can be found throughout case law. See Roselle v. C.I.R., T.C. Memo 1981-394 (1981); Californians Helping to Alleviate Medical Problems, Inc. v. C.I.R., 128 T.C. 173, 183 (2007).
  20. 383.12 Collins v. C.I.R., 34 T.C. 592, 594 (1960), nonacq., IRS Announcement Relating to Collins (IRS ACQ Dec. 31, 1964); Davis v. C.I.R., 29 T.C. 878, 887-88 (1958), acq. In part, IRS Announcement Relating to Davis (IRS ACQ Dec. 31, 1959).
  21. 383.13 See § 1.513-1(b), Footnote 43 supra.
  22. 383.14 The Notice requests comments regarding the application of § 512(a)(6) to exempt organizations with more than one unrelated trade or business, including distinguishing between trades and businesses under § 512(a)(6); the provision of administrable model for identifying an exempt organization's separate trades or businesses; and response to the use of NAICS as a method for identifying separate trades or businesses.
  23. 383.15 The tax-exempt organization may also aggregate any unrelated debt-financed income (discussed later) that arises in connection with a qualifying partnership interest with other income generated by such qualified partnership interest.
  24. 383.16 The de minimis test and the control test take into account the interest in the same partnership owned by a disqualified person (within the meaning of § 4958(f)), a supporting organization (within the meaning of § 509(a)(3)), or a controlled entity (within the meaning of § 512(b)(13)(D)).
  25. 383.17 Parts of the material in this subsection have been derived from PowerPoints presented by Amanda H. Nussbaum, partner at Proskauer, entitled “UBTI in PE Practice, Qualified Transportation Fringe Benefits and Qualified Sponsorship Payments,” a copy of which is held by the author, and was presented to the graduate tax class at Georgetown University Law Center on April 16, 2019.
  26. 398.1 Code § 382; Treasury Regulation § 1.382-2T.
  27. 398.2 Robert Mason, Mark Roundtree, and Howard Levenson, “Applying Section 382 to Loss Corporation Affiliates of Exempt Organizations,” Journal of Taxation of Exempt Organizations 12, no. 3 (Jan./Feb. 2001) (“Taxation of Exempt Organizations Section 382 Article”).
  28. 398.3 Code § 382(b).
  29. 398.4 Code § 382(g); Treasury Regulation § 1.382-2T. Note that the calculation of whether an ownership change has occurred may be subject to more complex rules that are irrelevant for purposes of this memorandum.
  30. 398.5 Code § 382(g). Determination of ownership change is measured by changes in stock holdings of shareholders owning 5 percent or more during the period in question. Id.
  31. 398.6 Temp. Reg. § 1.382-2T(h)(2)(iii).
  32. 398.7 Code § 382 appears to measure ownership as referring to owners that participate in corporate growth, a concept inconsistent and inapposite to the fundamental concept of tax-exempt organization principles that no earning can inure to the benefit of individuals (“Taxation of Exempt Organizations Section 382 Article”).
  33. 398.8 Code § 6110(k)(3).
  34. 398.9 PLR 200027013 (no ownership change when one tax-exempt entity transferred a for-profit entity's stock to another tax-exempt entity that was also under the control of the transferor tax-exempt entity); PLR 200227014 (no ownership change when one tax-exempt entity distributed stock of a company, which had NOLs, to another tax-exempt entity, which controlled the transferor tax-exempt entity).
  35. 398.10 The services were “substantially unrelated” to the group's exempt purposes.
  36. 398.11 Id.
  37. 398.12 See PLR 9001063, Oct. 13, 1989 (a section 501(c)(3) hospital has four supporting organizations under Code § 509(a)(3). The discussion relates to control of the related entities by the parent and within the group. Subsidiary 1's board must be comprised of at least 60 percent of members of the parent's executive committee or officers of the parent. The board of subsidiary 4 is appointed by subsidiary 1 as its sole member, with 60 percent of the board having to consist of members of the parent's executive committee or officers of the parent. Subsidiary 1 owns all of the outstanding stock of a for-profit loss corporation and is also the sole member of another nonprofit supporting organization of the hospital. The IRS ruled that the transfer of the loss corporation's stock from subsidiary 1 to subsidiary 4 will not constitute an ownership change); PLR 9222028 (Feb. 27, 1992).
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