UNRELATED BUSINESS TAXABLE INCOME

Transcription

1 UNRELATED BUSINESS TAXABLE INCOME Anne K. Gerson Two Wall Street, New York, NY ,

2 ANNE K. GERSON Anne K. Gerson represents and counsels tax-exempt organizations on a variety of matters, including formation and choice of entity type; corporate governance and fiduciary issues; and establishment and preservation of tax exemption and status as a public charity, private foundation, or other tax-exempt entity. She frequently provides guidance on federal tax issues and issues specific to arts-related organizations. Ms. Gerson is admitted to practice in New York and California. She is a member of the American Bar Association and the Association of the Bar of the City of New York and currently serves as Secretary of the Non-Profit Organizations Committee of the Association of the Bar of the City of New York. Prior to joining Carter, Ledyard & Milburn LLP, she practiced at the Mann Legal Group, LLC in New York and at Adler & Colvin in San Francisco, specializing in the representation of tax-exempt organizations, and Simpson, Thacher & Bartlett in New York, specializing in taxation issues. Ms. Gerson graduated magna cum laude from the University of Pennsylvania as a Benjamin Franklin Scholar and was elected to Phi Beta Kappa. She holds both a JD and an LLM in Taxation from New York University School of Law and was the NYU Tax Policy fellow at the United States Department of Treasury in Two Wall Street, New York, NY , gerson@clm.com

3 Unrelated Business Taxable Income I. Treatment of Revenue Generated from Unrelated Activities. Organizations exempt from income tax under Section 501(c)(3) of the Internal Revenue Code (the Code ) are permitted to carry on activities that are unrelated to their exempt purpose. When these unrelated activities generate revenue for the organization, two questions arise: A. Do the activities jeopardize the exempt status of the organization? Section 501(c)(3) requires that exempt organizations be operated exclusively for exempt purposes. However, the Regulations soften this requirement and clarify that exempt organizations must only primarily engage in exempt activities in order to maintain their exemption. Treas. Reg (c)(3)-1(c). B. Do the activities generate taxable income? Section 511 provides an exception to the general exemption from income tax for Section 501(c)(3) organizations. It provides that the unrelated business taxable income generated by an exempt organization is subject to taxation under standard corporate tax rates. Section 511(a)(1). The imposition of this tax is often referred to as the Unrelated Business Income Tax, or UBIT. II. Unrelated Business Taxable Income Definition. Unrelated Business Taxable Income ( UBTI ) is defined in Section 512 as the income derived by an organization through: A. A trade or business, which is B. Regularly Carried On; and which is C. Not substantially related to the organization s exempt purpose. All three elements must be met in order for income to be treated as UBTI. An in-depth review of all three elements is warranted. III. Trade or Business. The phrase trade or business is defined in the Code to mean any activity which is carried on for the production of income from the sale of goods or the performance of services. Code Section 513(c). A. The broad scope of this definition captures any activity an exempt organization is likely to undertake and classifies it as a trade or business for all practical purposes. The Regulations further clarify that the definition relies upon the Two Wall Street, New York, NY , gerson@clm.com

4 definition of business defined by Section 162 in the context of business expense deductions. Treas. Reg (b). By relying upon the definition in Section 162, the Regulations further expand the definition of business in this context to include the expansive meaning of the word business in federal tax law generally. B. The phrase for the production of income has also been identified by the Supreme Court, in a different context, as an essential part of the definition trade or business. The primary purpose for engaging in the activity must be for income or profit in order for the activity to be considered a trade or business. Comm r v. Groetzinger, 480 U.S. 23,35 (1987). IV. Regularly Carried On. The Regulations provide that a trade or business is regularly carried on based upon the frequency and continuity with which the activities are conducted and the manner in which they are pursued. Treas. Reg, (c). A. There are no clear rules of application for what levels of frequency and continuity shall be considered regularly carried on. The analysis of whether an activity would be considered regularly carried on is based upon all of the facts and circumstances, but a helpful framework is to look at the method of carrying on similar for-profit businesses. The Regulations state that the goal of taxing unrelated business income is to place exempt organization business activities upon the same tax basis as the nonexempt business endeavors with which they compete. Treas. Reg (c). B. The Regulations and rulings offer some guidelines, although the analysis will always be primarily dependent upon the particular facts and circumstances. 1. If an activity is carried on for a few weeks every year, and taxable entities normally conduct such activities on a year-round basis, it is not likely to be considered regularly carried on. Treas. Reg (c)(2)(i). 2. If an income-producing activity is typically associated with a particular season, a tax-exempt organization carrying on such activity for a significant portion of that time of year shall be considered to be regularly carrying on a business. Tech. Adv. Mem (1981); Treas. Reg (c)(2). 3. An income-producing activity carried on once a week is considered to be regularly carried on. Treas. Reg (c)(2)(i). 4. Fundraising activities and events, even if carried on annually, are not regarded as regularly carried on. Treas. Reg (c)(2)(iii). 5. Income-producing activities engaged in sporadically or periodically will not be considered regularly carried on if they lack the competitive and promotional efforts of comparable activities by taxable entities, such as 4

5 V. Substantially Related. the publication of advertising in programs for sporting or cultural events. Treas. Reg (c)(2)(ii). The final prong of the test is whether an income-producing activity is substantially related to an organization s exempt purpose. The Regulations explain that there must be a substantial causal relationship between the conduct of the activity and the achievement of exempt purposes. Treas. Reg (d)(2). Another way of phrasing this is to say that the primary purpose for the activity must be to accomplish an exempt purpose. A. There are numerous cases and rulings that examine the question of when an activity is substantially related. Below are a few of the more generally applicable holdings: 1. Determining the primary purpose behind the conduct of an exempt activity is a question of the nature, scope and motivation of the conduct of such activity. Priv. Let. Rul The fragmentation rule : the IRS can parse, or fragment, the various offerings available in a shop, such as a museum gift shop, and determine some items are substantially related while other items generate UBTI when sold. Rev. Rul , C.B. 264; Tech. Adv. Mem (1995). 3. A tax-exempt organization whose charitable purpose was to enable needy women to support themselves [through handiwork] operated three businesses. Only the operation of one business was found to be substantially related to the organization s exempt purpose, the operation of a consignment shop. The operation of a gift shop satisfied the causal relationship requirement but not the substantial requirement and the operation of a tearoom was deemed unrelated. PLR VI. Modifications and Exceptions. The Code and published guidance includes a number of modifications and exceptions to the basic UBIT rules that serve to exclude or modify certain income produced by exempt organizations that would otherwise be UBTI. The major modifications and exceptions are highlighted below. A. Modifications. 1. Passive Income. Dividends, interest income, annuities, and income related to certain lending arrangements are not taxed as UBTI. Code Sec. 512(b)(1). 2. Royalties. Payments for the use of a valuable intangible right are not taxed as UBTI. Code Sec. 512(b)(2). There have been many rulings and 5

6 cases on the precise applications of the royalties exception, including cases related to affinity credit cards where the IRS unsuccessfully challenged several arrangements and in 2000, announced it was unlikely to continue to challenge them. 3. Rent. Rents from real property, and incidental amounts of personal property leased with the real estate, are not taxed as UBTI. Code Sec. 512(b)(3). The exception does not apply if the amount of rent depends on income or profits derived from the property leased, if the amount of personal property leased with real estate is more than incidental, or if the lease involves the provision of services beyond standard maintenance services offered by landlords. 4. Capital Gains. Gains from the sale, exchange, or other disposition of capital gain property are not taxed as UBTI. This exclusion does not extend to property held as inventory. Code Sec. 512(b)(5). B. Exceptions. (1) An exception to these modifications applies for interest, rents, and royalties received from a controlled entity. These forms of income are taxable as UBTI when received from an entity that the exempt organization controls. Code Sec. 512(b)(13). (2) Code Section 514 also provides an exception to the modifications for income derived from property acquired with debt financing. A portion of any such income may be UBTI. 1. Volunteers. When substantially all of the work in carrying out the income-producing activity is done by volunteers, the income is not taxed as UBTI. Code Sec. 513(a)(1). 2. Convenience. Income-producing activities carried on primarily for the convenience of members, students, patients, officers, or employees of an organization, such as cafeterias and bookstores do not give rise to income taxed as UBTI. Code Sec. 513(a)(2). 3. Contributions. Income from the sale of donated merchandise is not taxed as UBTI. Code Sec. 513(a)(3). 4. Trade Shows and State Fairs. Certain types of income earned at trade shows and state fairs are not taxed as UBTI. Code Sec. 513(d) 5. Bingo. Income from bingo games is not taxable as UBTI. Code Sec. 513(f). 6. Mailing Lists. Income from the rental of mailing lists to other nonprofit organizations is not taxable as UBTI. Code Sec. 513(h). 6

7 (1) This exception was added to the Code after the IRS had successfully challenged that the rental of mailing lists was not passive royalty income. Following that, the IRS unsuccessfully challenged several mailing list transactions on the question of related services provided with the rental of lists. 7. Corporate Sponsorship Payments. Income from certain qualified sponsorship payments is not taxed as UBTI. Code Sec. 513(i). VII. Corporate Sponsorship Payments. A. Qualified Sponsorship Payment. A payment is not taxable as a qualified sponsorship payment when it is (i) made by a person engaged in trade or business, and (ii) there is no arrangement or expectation that such person will receive a substantial return benefit in exchange. Code Sec. 513(i). 1. The form of payment can be money, in-kind transfer of property, or provision of services. Treas. Reg (c)(1). 2. The First Pass Exception: Income for a sponsorship payment that does not qualify as a qualified sponsorship payment is not necessarily taxable as UBTI unless the UBTI analysis is met. B. Substantial Return Benefit. A substantial return benefit means any benefit received in exchange for the sponsorship payment other than (i) use or acknowledgment of the sponsor s name or logo, or (ii) a disregarded benefit. Treas. Reg (c)(2). 1. Use or Acknowledgment. Permitted use or acknowledgements include: a. Exclusive sponsorship arrangements. b. Logos and slogans, provided that they do not contain qualitative or comparative descriptions, unless the logo and slogan containing such language is an established part of the sponsor s identity. c. Information about the sponsor s locations, telephone numbers, or website, including hyperlinks on the organization s website. d. Displays or visual depictions of the sponsor s products, services, brand, trade-names, or product lists. e. Value-neutral descriptions, including displays or visual depictions, of the sponsor s products or services. 2. Disregarded Benefit. Return benefits received in exchange for the sponsorship payment by the sponsor or persons designated by the sponsor will be disregarded benefits if the aggregate fair market value of all the 7

8 benefits provided to sponsor, as indicated, in connection with the payment during the organization s taxable year are equal to or less than 2% of the amount of the payment. a. If the fair market value of all the benefits exceeds 2%, the entire amount of the return benefit, not simply the excess over 2%, is considered a substantial return benefit. 3. Examples of Potential Substantial Return Benefits: The following items are not considered to be acknowledgements, and would be considered substantial return benefits if the benefit does not qualify as a disregarded benefit: C. Exceptions. a. Advertising. Any message that promotes or markets any trade or business, service, facility or product. A single message that contains both advertising and an acknowledgment is deemed to be advertising. Treas. Reg (c)(2)(iv). b. Exclusive provider arrangements. Distinct from permissible acknowledgement of an exclusive sponsor arrangement, an arrangement that limits the sale, distribution, availability or use of competing products, services, or facilities in connection with the organization s activity is a likely substantial return benefit. Treas. Reg (c)(2)(vi). c. Goods, facilities, services, or other privileges. Treas. Reg (c)(2)(iii). d. Exclusive or non-exclusive rights to use an intangible asset, such as a logo or trademark, of the organization. Treas. Reg (c)(2)(iii). 1. Contingent Payments. A payment that is contingent on the level of attendance at one or more events, broadcast ratings, or other factors indicating the degree of public exposure cannot be considered a qualified sponsorship payment. Notably, payments can be contingent on a sponsored event or activity actually occurring and still be considered qualified sponsorship payments. Code Sec. 513(i)(2)(B)(i). 2. Periodicals. A payment that entitles the sponsor to use or acknowledgment of their name or logo in regularly scheduled and printed material published by the organization cannot be considered a qualified sponsorship payment. Note that this does not apply to printed material that is related to and primarily distributed in connection with a specific event. Code Sec. 513(d)(2)(B)(ii). 8

9 3. Convention or Trade Show Activities. A payment made in connection with a qualified convention or trade show cannot be considered a qualified sponsorship payment. The definition of a qualified convention or trade show is found in Code Sec. 513(d)(2)(B)(ii). D. Allocation of Payments. If the exempt organization establishes in advance that the sponsor (i) will receive a substantial return benefit, and (ii) the payment will exceed the fair market value of such benefit, only then is the excess portion of the payment considered a qualified sponsorship payment. Code Sec. 513(i)(3); Treas. Reg (d). 9