Baylor Law SchoolBaylor Law SchoolNonprofit OrganizationsNonprofit Organizations

Spring 2005 CourseSpring 2005 CourseUnrelated Business Taxable Income

Prepared By:

Darren B. MooreBourland, Wall & Wenzel,

A Professional Corporation

Attorneys and Counselors

City Center Tower II

301 Commerce Street, Suite 1500

Fort Worth, Texas 76102

(817) 877-1088

(817) 877-1636 (facsimile)

E-mail: dmoore@bwwlaw.com

©Bourland, Wall & Wenzel, P.C.

UBTI defined

• I.R.C. Section 512: “the gross income derived by an organization from any unrelated trade or business regularly carried on by it” less certain deductions.

Unrelated trade or business defined

• I.R.C. Section 513: “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 . . .”

Requirements to be taxable

• Must be a trade or business

• Must be regularly carried on

• Not substantially related to exempt purposes– If engage in business substantially related to

exempt purposes, no tax

Engaging in Commercial Activities(4) - Overview

1. Insubstantial and related (i.e. furthers exempt purpose): okay

2. Insubstantial and unrelated: UBTI

3. Substantial and related: okay to a point

4. Substantial and unrelated: Loss of exempt status

Question: At what point does 3 become 4? (See Living Faith v. Comm’r)

Commerciality Doctrine

• Business activities grow too large in relation to charitable activities such that they become a substantial purpose

• “Commercial hue”– Direct competition with commercial firms (esp. in

same locales)– Pricing structure designed to produce a profit– Extensive advertising and use of commercial

advertising materials– Annual accumulated profits

• Infer purpose from activities (IRS considers above “useful indicia”)

Trade or business

• Any activity carried on for the production of income from the sale of goods or provision of services

• Regulations state that an activity does not lose its identity as a trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may or may not be related to the exempt purposes of the organization (e.g. weekday rental of church parking lot; commercial advertising in an exempt organization’s newsletter (cf. qualified sponsorship payments)

Regularly carried on

• Relates to the frequency and continuity of the activity as compared with similar activities of non-exempt organizations– Keeping in mind the purpose of the tax to

prevent unfair competetion• E.g. if the activity is one normally carried on year-

round by a non-exempt organization, the conduct of such activity by an exempt org over the period of a few weeks is not regularly carrying on (cf. seasonal activities for non-exempt organizations)

Not substantially related

• To be substantially related the activity must contribute importantly to the accomplishment of the exempt purposes– Depends on the facts and circumstances– Look to size and extent of activity in relation to

the nature and extent of the exempt function it purports to serve

UBTI Exceptions

• Volunteer exception– Where substantially all the work in carrying on the

trade or business is performed for the exempt organization without compensation

• Convenience exception– Primarily for the convenience of its members,

students, patients, officers or employees (e.g. dining hall)

• Selling of donated merchandise (e.g. thrift store)

UBTI Exclusions

• Passive income such as dividends and interest, annuities, royalties, capital gains and losses and rents from real property– Two limitations:

• Debt-financed property• Passive income received from controlled

organizations (beyond scope of class)

Debt-Financed Income

• Exclusion of passive income does not apply in the case of unrelated debt-financed property– Any property held to produce income and with respect

to which there is acquisition indebtedness– Acquisition indebtedness – debt incurred in

connection with acquisition or improvement of property (e.g. mortgage)

- Examples: House bought for future growth that is rented out; shopping center that is rented out on a new church site

Exceptions to debt-financed property rules

• 85% rule – substantially all (85% or more) of the property is used for exempt purposes (beware destination of income)

• Income from debt-financed property is otherwise taken into account in computing the gross income of any unrelated trade or business

• Property used in trade or business that meets one of the UBTI exceptions

• Neighborhood land rule (complicated rule relating to intended future use)

• Demolition rule (relates to neighborhood land rule)

UBTI Issues

– Taxed at highest corporate rate– Could result in loss of exemption if substantial– If gross unrelated business income is greater

than $1000, the organization must file Form 990-T and estimated taxes by May 15 of the following year

– Applies to virtually all 501(c)

Next Week

Final Exam

April 29 at 8:00 a.m.