| Pub. 598, Tax on Unrelated Business Income of Exempt Organizations |
2005 Tax Year |
4. Unrelated Business Taxable Income
The term “unrelated business taxable income” generally means the gross income derived from any unrelated trade or business regularly carried
on by the exempt organization, less the deductions directly connected with carrying on the trade or business. If an organization
regularly carries on
two or more unrelated business activities, its unrelated business taxable income is the total of gross income from all such
activities less the total
allowable deductions attributable to all the activities.
In computing unrelated business taxable income, gross income and deductions are subject to the modifications and special rules
explained in this
chapter. Whether a particular item of income or expense falls within any of these modifications or special rules must be determined
by all the facts
and circumstances in each specific case. For example, if the organization received a payment termed rent that is in fact a
return of profits by a
person operating the property for the benefit of the organization, or that is a share of the profits retained by the organization
as a partner or
joint venturer, the payment is not within the income exclusion for rents, discussed later under Exclusions.
Generally, unrelated business income is taxable, but there are exclusions and special rules that must be considered when figuring
the income.
The following types of income (and deductions directly connected with the income) are generally excluded when figuring unrelated
business taxable
income.
Dividends, interest, annuities and other investment income.
All dividends, interest, annuities, payments with respect to securities loans, income from notional principal contracts,
and other income from an
exempt organization's ordinary and routine investments that the IRS determines are substantially similar to these types of
income are excluded in
computing unrelated business taxable income.
Exception for insurance activity income of a controlled foreign corporation.
This exclusion does not apply to income from certain insurance activities of an exempt organization's controlled foreign
corporation. The income is
not excludable dividend income, but instead is unrelated business taxable income to the extent it would be so treated if the
exempt organization had
earned it directly. Certain exceptions to this rule apply. For more information, see section 512(b)(17).
Other exceptions.
This exclusion does not apply to unrelated debt-financed income (discussed under Income From Debt-Financed Property, later) or to
interest or annuities received from a controlled corporation (discussed under Income >From Controlled Corporations, later).
Income from lending securities.
Payments received with respect to a security loan are excluded in computing unrelated business taxable income only
if the loan is made under an
agreement that:
-
Provides for the return to the exempt organization of securities identical to the securities loaned,
-
Requires payments to the organization of amounts equivalent to all interest, dividends, and other distributions that the owner
of the
securities is entitled to receive during the period of the loan,
-
Does not reduce the organization's risk of loss or opportunity for gain on the securities,
-
Contains reasonable procedures to implement the obligation of the borrower to furnish collateral to the organization with
a fair market
value each business day during the period of the loan in an amount not less than the fair market value of the securities at
the close of the preceding
business day, and
-
Permits the organization to terminate the loan upon notice of not more than 5 business days.
Payments with respect to securities loans include:
-
Amounts in respect of dividends, interest, and other distributions,
-
Fees based on the period of time the loan is in effect and the fair market value of the security during that period,
-
Income from collateral security for the loan, and
-
Income from the investment of collateral security.
The payments are considered to be from the securities loaned and not from collateral security or the investment of collateral
security from the
loans. Any deductions that are directly connected with collateral security for the loan, or with the investment of collateral
security, are considered
deductions that are directly connected with the securities loaned.
Royalties.
Royalties, including overriding royalties are excluded in computing unrelated business taxable income.
To be considered a royalty, a payment must relate to the use of a valuable right. Payments for trademarks, trade names,
or copyrights are
ordinarily considered royalties. Similarly, payments for the use of a professional athlete's name, photograph, likeness, or
facsimile signature are
ordinarily considered royalties. However, royalties do not include payments for personal services. Therefore, payments for
personal appearances and
interviews are not excluded as royalties and must be included in figuring unrelated business taxable income.
Unrelated business taxable income does not include royalty income received from licensees by an exempt organization
that is the legal and
beneficial owner of patents assigned to it by inventors for specified percentages of future royalties.
Mineral royalties are excluded whether measured by production or by gross or taxable income from the mineral property.
However, the exclusion does
not apply to royalties that stem from an arrangement whereby the organization owns a working interest in a mineral property
and is liable for its
share of the development and operating costs under the terms of its agreement with the operator of the property. To the extent
they are not treated as
loans under section 636 (relating to income tax treatment of mineral production payments), payments for mineral production
are treated in the same
manner as royalty payments for the purpose of computing unrelated business taxable income. To the extent they are treated
as loans, any payments for
production that are the equivalent of interest are treated as interest and are excluded.
Exceptions.
This exclusion does not apply to debt-financed income (discussed under Income From Debt-Financed Property, later) or to royalties
received from a controlled corporation (discussed under Income From Controlled Corporations, later).
Rents.
Rents from real property, including elevators and escalators, are excluded in computing unrelated business taxable
income. Rents from personal
property are not excluded. However, special rules apply to “ mixed leases” of both real and personal property.
Mixed leases.
In a mixed lease, all of the rents are excluded if the rents attributable to the personal property are not more than
10% of the total rents under
the lease, as determined when the personal property is first placed in service by the lessee. If the rents attributable to
personal property are more
than 10% but not more than 50% of the total rents, only the rents attributable to the real property are excluded. If the rents
attributable to the
personal property are more than 50% of the total rents, none of the rents are excludable.
Property is placed in service when the lessee first may use it under the terms of a lease. For example, property subject
to a lease entered into on
November 1, for a term starting on January 1 of the next year, is considered placed in service on January 1, regardless of
when the lessee first
actually uses it.
If separate leases are entered into for real and personal property and the properties have an integrated use (for
example, one or more leases for
real property and another lease or leases for personal property to be used on the real property), all the leases will be considered
as one lease.
The rent attributable to the personal property must be recomputed, and the treatment of the rents must be redetermined,
if:
-
The rent attributable to all the leased personal property increases by 100% or more because additional or substitute personal
property is
placed in service, or
-
The lease is modified to change the rent charged (whether or not the amount of rented personal property changes).
Any change in the treatment of rents resulting from the recomputation is effective only for the period beginning with the
event that caused the
recomputation.
Exception for rents based on net profit.
The exclusion for rents does not apply if the amount of the rent depends on the income or profits derived by any person
from the leased property,
other than an amount based on a fixed percentage of the gross receipts or sales.
Exception for income from personal services.
Payment for occupying space when personal services are also rendered to the occupant does not constitute rent from
real property. Therefore, the
exclusion does not apply to transactions such as renting hotel rooms, rooms in boarding houses or tourist homes, and space
in parking lots or
warehouses.
Other exceptions.
This exclusion does not apply to unrelated debt-financed income (discussed under Income From Debt-Financed Property, later) or to rents
received from a controlled corporation (discussed under Income From Controlled Corporations, later).
Income from research.
A tax-exempt organization may exclude income from research grants or contracts from unrelated business taxable income.
However, the extent of the
exclusion depends on the nature of the organization and the type of research.
Income from research for the United States, any of its agencies or instrumentalities, or a state or any of its political
subdivisions is excluded
when computing unrelated business taxable income.
For a college, university, or hospital, all income from research, whether fundamental or applied, is excluded in computing
unrelated business
taxable income.
When an organization is operated primarily to conduct fundamental research (as distinguished from applied research)
and the results are freely
available to the general public, all income from research performed for any person is excluded in computing unrelated business
taxable income.
The term research, for this purpose, does not include activities of a type normally carried on as an incident to commercial
or industrial
operations, such as testing or inspecting materials or products, or designing or constructing equipment, buildings, etc. In
addition, the term
fundamental research does not include research carried on for the primary purpose of commercial or industrial application.
Gains and losses from disposition of property.
Also excluded from unrelated business taxable income are gains or losses from the sale, exchange, or other disposition
of property other than:
-
Stock in trade or other property of a kind that would properly be includable in inventory if on hand at the close of the tax
year,
-
Property held primarily for sale to customers in the ordinary course of a trade or business, or
-
Cutting of timber that an organization has elected to consider as a sale or exchange of the timber.
It should be noted that the last exception relates only to cut timber. The sale, exchange, or other disposition of
standing timber is excluded from
the computation of unrelated business income, unless it constitutes property held for sale to customers in the ordinary course
of business.
Lapse or termination of options.
Any gain from the lapse or termination of options to buy or sell securities is excluded from unrelated business taxable
income. The exclusion
applies only if the option is written in connection with the exempt organization's investment activities. Therefore, this
exclusion is not available
if the organization is engaged in the trade or business of writing options or the options are held by the organization as
inventory or for sale to
customers in the ordinary course of a trade or business.
Exception.
This exclusion does not apply to unrelated debt-financed income, discussed later under Income From Debt-Financed Property.
Gain or loss on disposition of certain brownfield property.
Gain or loss from the qualifying sale, exchange, or other disposition of a qualifying brownfield property (as defined
section 512(b)(18)(C)), which
was acquired by the organization after December 31, 2004, is excluded from unrelated business taxable income and is excepted
from the debt-financed
rules for such property. See sections 512(b)(18) and 514(b)(1)(E).
Income from services provided under federal license.
There is a further exclusion from unrelated business taxable income of income from a trade or business carried on
by a religious order or by an
educational organization maintained by the order.
This exclusion applies only if the following requirements are met.
-
The trade or business must have been operated by the order or by the institution since before May 27, 1959.
-
The trade or business must consist of providing services under a license issued by a federal regulatory agency.
-
More than 90% of the net income from the business for the tax year must be devoted to religious, charitable, or educational
purposes that
constitute the basis for the religious order's exemption.
-
The rates or other charges for these services must be fully competitive with the rates or other charges of similar taxable
businesses. Rates
or other charges for these services will be considered as fully competitive if they are neither materially higher nor materially
lower than the rates
charged by similar businesses operating in the same general area.
Exception.
This exclusion does not apply to unrelated debt-financed income (discussed later under Income From Debt-Financed Property).
Member income of mutual or cooperative electric companies.
For tax years beginning after October 22, 2004, income of a mutual or cooperative electric company described in section
501(c)(12) which is treated
as member income under subparagraph (H) of that section is excluded from unrelated business taxable income.
Dues of Agricultural Organizations and Business Leagues
Dues received from associate members by organizations exempt under section 501(c)(5) or section 501(c)(6) may be treated as
gross income from an
unrelated trade or business if the associate member category exists for the principal purpose of producing unrelated business
income. For example, if
an organization creates an associate member category solely to allow associate members to purchase insurance through the organization,
the associate
member dues may be unrelated business income.
Exception.
Associate member dues received by an agricultural or horticultural organization are not treated as gross income from
an unrelated trade or
business, regardless of their purpose, if they are not more than the annual limit. The limit on dues paid by an associate
member is $127 for 2005.
If the required annual dues are more than the limit, the entire amount is treated as income from an unrelated business
unless the associate member
category was formed or availed of for the principal purpose of furthering the organization's exempt purposes.
To qualify as allowable deductions in computing unrelated business taxable income, the expenses, depreciation, and similar
items generally must be
allowable income tax deductions that are directly connected with carrying on an unrelated trade or business. They cannot be
directly connected with
excluded income.
For an exception to the “directly connected” requirement, see Charitable contributions deduction, under Modifications,
later.
To be directly connected with the conduct of an unrelated business, deductions must have a proximate and primary relationship
to carrying on that
business. For an exception, see Expenses attributable to exploitation of exempt activities, later.
Expenses attributable solely to unrelated business.
Expenses, depreciation, and similar items attributable solely to the conduct of an unrelated business are proximately
and primarily related to that
business and qualify for deduction to the extent that they are otherwise allowable income tax deductions.
For example, salaries of personnel employed full-time to carry on the unrelated business and depreciation of a building
used entirely in the
conduct of that business are deductible to the extent otherwise allowable.
Expenses attributable to dual use of facilities or personnel.
When facilities or personnel are used both to carry on exempt functions and to conduct an unrelated trade or business,
expenses, depreciation, and
similar items attributable to the facilities or personnel must be allocated between the two uses on a reasonable basis. The
part of an item allocated
to the unrelated trade or business is proximately and primarily related to that business, and is allowable as a deduction
in computing unrelated
business taxable income, if the expense is otherwise an allowable income tax deduction.
Example 1.
A school recognized as a tax-exempt organization contracts with an individual to conduct a summer tennis camp. The school
provides the tennis
courts, housing, and dining facilities. The contracted individual hires the instructors, recruits campers, and provides supervision.
The income the
school receives from this activity is from a dual use of the facilities and personnel. The school, in computing its unrelated
business taxable income,
may deduct an allocable part of the expenses attributable to the facilities and personnel.
Example 2.
An exempt organization with gross income from an unrelated trade or business pays its president $90,000 a year. The president
devotes
approximately 10% of his time to the unrelated business. To figure the organization's unrelated business taxable income, a
deduction of $9,000
($90,000 × 10%) is allowed for the salary paid to its president.
Expenses attributable to exploitation of exempt activities.
Generally, expenses, depreciation, and similar items attributable to the conduct of an exempt activity are not deductible
in computing unrelated
business taxable income from an unrelated trade or business that exploits the exempt activity. (See Exploitation of exempt functions under
Not substantially related in chapter 3.) This is because they do not have a proximate and primary relationship to the unrelated trade or
business, and therefore, they do not qualify as directly connected with that business.
Exception.
Expenses, depreciation, and similar items may be treated as directly connected with the conduct of the unrelated business
if all the following
statements are true.
-
The unrelated business exploits the exempt activity.
-
The unrelated business is a type normally carried on for profit by taxable organizations.
-
The exempt activity is a type normally conducted by taxable organizations in carrying on that type of business.
The amount treated as directly connected is the smaller of:
-
The excess of these expenses, depreciation, and similar items over the income from, or attributable to, the exempt activity,
or
-
The gross unrelated business income reduced by all other expenses, depreciation, and other items that are actually directly
connected.
The application of these rules to an advertising activity that exploits an exempt publishing activity is explained
next.
Exploitation of Exempt Activity — Advertising Sales
The sale of advertising in a periodical of an exempt organization that contains editorial material related to the accomplishment
of the
organization's exempt purpose is an unrelated business that exploits an exempt activity, the circulation and readership of
the periodical. Therefore,
in addition to direct advertising costs, exempt activity costs (expenses, depreciation, and similar expenses attributable
to the production and
distribution of the editorial or readership content) can be treated as directly connected with the conduct of the advertising
activity. (See
Expenses attributable to exploitation of exempt activities under Directly Connected, earlier.)
Figuring unrelated business taxable income (UBTI).
The UBTI of an advertising activity is the amount shown in the following chart.
The terms used in the chart are explained in the following discussions.
Gross advertising income.
This is all the income from the unrelated advertising activities of an exempt organization periodical.
Circulation income.
This is all the income from the production, distribution, or circulation of an exempt organization's periodical (other
than gross advertising
income). It includes all amounts from the sale or distribution of the readership content of the periodical, such as income
from subscriptions. It also
includes allocable membership receipts if the right to receive the periodical is associated with a membership or similar status
in the organization.
Allocable membership receipts.
This is the part of membership receipts (dues, fees, or other charges associated with membership) equal to the amount
that would have been charged
and paid for the periodical if:
-
The periodical was published by a taxable organization,
-
The periodical was published for profit, and
-
The member was an unrelated party dealing with the taxable organization at arm's length.
The amount used to allocate membership receipts is the amount shown in the following chart.
For this purpose, the total periodical costs are the sum of the direct advertising costs and the readership costs,
explained under Periodical
Costs, later. The cost of other exempt activities means the total expenses incurred by the organization in connection with its
other exempt
activities, not offset by any income earned by the organization from those activities.
Example 1.
U is an exempt scientific organization with 10,000 members who pay annual dues of $15. One of U's activities is publishing
a monthly periodical
distributed to all of its members. U also distributes 5,000 additional copies of its periodical to nonmembers, who subscribe
for $10 a year. Since the
nonmember circulation of U's periodical represents one-third (more than 20%) of its total circulation, the subscription price
charged to nonmembers is
used to determine the part of U's membership receipts allocable to the periodical. Thus, U's allocable membership receipts
are $100,000 ($10 times
10,000 members), and U's total circulation income for the periodical is $150,000 ($100,000 from members plus $50,000 from
sales to nonmembers).
Example 2.
Assume the same facts except that U sells only 500 copies of its periodical to nonmembers, at a price of $10 a year. Assume
also that U's members
may elect not to receive the periodical, in which case their dues are reduced from $15 a year to $6 a year, and that only
3,000 members elect to
receive the periodical and pay the full dues of $15 a year. U's stated subscription price of $9 to members consistently results
in an excess of total
income (including gross advertising income) attributable to the periodical over total costs of the periodical. Since the 500
copies of the periodical
distributed to nonmembers represent only 14% of the 3,500 copies distributed, the $10 subscription price charged to nonmembers
is not used to
determine the part of membership receipts allocable to the periodical. Instead, since 70% of the members elect not to receive
the periodical and pay
$9 less per year in dues, the $9 price is used to determine the subscription price charged to members. Thus, the allocable
membership receipts will be
$9 a member, or $27,000 ($9 times 3,000 copies). U's total circulation income is $32,000 ($27,000 plus the $5,000 from nonmember
subscriptions).
Direct advertising costs.
These are expenses, depreciation, and similar items of deduction directly connected with selling and publishing advertising
in the periodical.
Examples of allowable deductions under this classification include agency commissions and other direct selling costs,
such as transportation and
travel expenses, office salaries, promotion and research expenses, and office overhead directly connected with the sale of
advertising lineage in the
periodical. Also included are other deductions commonly classified as advertising costs under standard account classifications,
such as artwork and
copy preparation, telephone, telegraph, postage, and similar costs directly connected with advertising.
In addition, direct advertising costs include the part of mechanical and distribution costs attributable to advertising
lineage. For this purpose,
the general account classifications of items includable in mechanical and distribution costs ordinarily employed in business-paper
and
consumer-publication accounting provide a guide for the computation. Accordingly, the mechanical and distribution costs include
the part of the costs
and other expenses of composition, press work, binding, mailing (including paper and wrappers used for mailing), and bulk
postage attributable to the
advertising lineage of the publication.
In the absence of specific and detailed records, the part of mechanical and distribution costs attributable to the
periodical's advertising lineage
can be based on the ratio of advertising lineage to total lineage in the periodical, if this allocation is reasonable.
Readership costs.
These are all expenses, depreciation, and similar items that are directly connected with the production and distribution
of the readership content
of the periodical.
Costs partly attributable to other activities.
Deductions properly attributable to exempt activities other than publishing the periodical may not be allocated to
the periodical. When expenses
are attributable both to the periodical and to the organization's other activities, an allocation must be made on a reasonable
basis. The method of
allocation will vary with the nature of the item, but once adopted, should be used consistently. Allocations based on dollar
receipts from various
exempt activities generally are not reasonable since receipts usually do not accurately reflect the costs associated with
specific activities that an
exempt organization conducts.
If an exempt organization publishes more than one periodical to produce income, it may treat all of them (but not less than
all) as one in
determining unrelated business taxable income from selling advertising. It treats the gross income from all the periodicals,
and the deductions
directly connected with them, on a consolidated basis. Consolidated treatment, once adopted, must be followed consistently
and is binding. This
treatment can be changed only with the consent of the Internal Revenue Service.
An exempt organization's periodical is published to produce income if:
-
The periodical generates gross advertising income to the organization equal to at least 25% of its readership costs, and
-
Publishing the periodical is an activity engaged in for profit.
Whether the publication of a periodical is an activity engaged in for profit can be determined only by all the facts and circumstances
in each
case. The facts and circumstances must show that the organization carries on the activity for economic profit, although there
may not be a profit in a
particular year. For example, if an organization begins publishing a new periodical whose total costs exceed total income
in the start-up years
because of lack of advertising sales, that does not mean that the organization did not have as its objective an economic profit.
The organization may
establish that it had this objective by showing it can reasonably expect advertising sales to increase, so that total income
will exceed costs within
a reasonable time.
Example.
Y, an exempt trade association, publishes three periodicals that it distributes to its members: a weekly newsletter, a monthly
magazine, and a
quarterly journal. Both the monthly magazine and the quarterly journal contain advertising that accounts for gross advertising
income equal to more
than 25% of their respective readership costs. Similarly, the total income attributable to each periodical has exceeded the
total deductions
attributable to each periodical for substantially all the years they have been published. The newsletter carries no advertising
and its annual
subscription price is not intended to cover the cost of publication. The newsletter is a service that Y distributes to all
of its members in an effort
to keep them informed of changes occurring in the business world. It is not engaged in for profit.
Under these circumstances, Y may consolidate the income and deductions from the monthly and quarterly journals in computing
its unrelated business
taxable income. It may not consolidate the income and deductions from the newsletter with the income and deductions of its
other periodicals, since
the newsletter is not published for the production of income.
Net operating loss deduction.
The net operating loss deduction (as provided in section 172) is allowed in computing unrelated business taxable income.
However, the net operating
loss for any tax year, the carrybacks and carryovers of net operating losses, and the net operating loss deduction are determined
without taking into
account any amount of income or deduction that has been specifically excluded in computing unrelated business taxable income.
For example, a loss from
an unrelated trade or business is not diminished because dividend income was received.
If this were not done, organizations would, in effect, be taxed on their exempt income, since unrelated business losses
then would be offset by
dividends, interest, and other excluded income. This would reduce the loss that could be applied against unrelated business
income of prior or future
tax years. Therefore, to preserve the immunity of exempt income, all net operating loss computations are limited to those
items of income and
deductions that affect the unrelated business taxable income.
In line with this concept, a net operating loss carryback or carryover is allowed only from a tax year for which the
organization is subject to tax
on unrelated business income.
For example, if an organization just became subject to the tax last year, its net operating loss for that year is
not a carryback to a prior year
when it had no unrelated business taxable income, nor is its net operating loss carryover to succeeding years reduced by the
related income of those
prior years.
However, in determining the span of years for which a net operating loss may be carried back or forward, the tax years
for which the organization
is not subject to the tax on unrelated business income are counted. For example, if an organization was subject to the tax
for 1996 and had a net
operating loss for that year, the last tax year to which any part of that loss may be carried over is 2011, regardless of
whether the organization was
subject to the unrelated business income tax in any of the intervening years.
Charitable contributions deduction.
An exempt organization is allowed to deduct its charitable contributions in computing its unrelated business taxable
income whether or not the
contributions are directly connected with the unrelated business.
To be deductible, the contribution must be paid to another qualified organization. For example, an exempt university
that operates an unrelated
business may deduct a contribution made to another university for educational work, but may not claim a deduction for contributions
of amounts spent
for carrying out its own educational program.
For purposes of the deduction, a distribution by a trust made under the trust instrument to a beneficiary, which itself
is a qualified
organization, is treated the same as a contribution.
Deduction limits.
An exempt organization that is subject to the unrelated business income tax at corporate rates is allowed a deduction
for charitable contributions
up to 10% of its unrelated business taxable income computed without regard to the deduction for contributions.
An exempt trust that is subject to the unrelated business income tax at trust rates generally is allowed a deduction
for charitable contributions
in the same amounts as allowed for individuals. However, the limit on the deduction is determined in relation to the trust's
unrelated business
taxable income computed without regard to the deduction, rather than in relation to adjusted gross income.
Contributions in excess of the limits just described may be carried over to the next 5 tax years. A contribution carryover
is not allowed, however,
to the extent that it increases a net operating loss carryover.
Specific deduction.
In computing unrelated business taxable income, a specific deduction of $1,000 is allowed. However, the specific deduction
is not allowed in
computing a net operating loss or the net operating loss deduction.
Generally, the deduction is limited to $1,000 regardless of the number of unrelated businesses in which the organization
is engaged.
Exception.
An exception is provided in the case of a diocese, province of a religious order, or a convention or association of
churches that may claim a
specific deduction for each parish, individual church, district, or other local unit. In these cases, the specific deduction
for each local unit is
limited to the lower of:
This exception applies only to parishes, districts, or other local units that are not separate legal entities, but
are components of a larger
entity (diocese, province, convention, or association) filing Form 990-T. The parent organization must file a return reporting
the unrelated business
gross income and related deductions of all units that are not separate legal entities. The local units cannot file separate
returns. However, each
local unit that is separately incorporated must file its own return and cannot include, or be included with, any other entity.
See Title-holding
corporations in chapter 1 for a discussion of the only situation in which more than one legal entity may be included on the same Form
990-T.
Example.
X is an association of churches and is divided into local units A, B, C, and D. Last year, A, B, C, and D derived gross income
of, respectively,
$1,200, $800, $1,500, and $700 from unrelated businesses that they regularly conduct. X may claim a specific deduction of
$1,000 with respect to A,
$800 with respect to B, $1,000 with respect to C, and $700 with respect to D.
Partnership Income or Loss
An organization may have unrelated business income or loss as a member of a partnership, rather than through direct business
dealings with the
public. If so, it must treat its share of the partnership income or loss as if it had conducted the business activity in its
own capacity as a
corporation or trust. No distinction is made between limited and general partners.
Thus, if an organization is a member of a partnership regularly engaged in a trade or business that is an unrelated trade
or business with respect
to the organization, the organization must include in its unrelated business taxable income its share of the partnership's
gross income from the
unrelated trade or business (whether or not distributed), and the deductions attributable to it. The partnership income and
deductions to be included
in the organization's unrelated business taxable income are figured the same way as any income and deductions from an unrelated
trade or business
conducted directly by the organization.
Example.
An exempt educational organization is a partner in a partnership that operates a factory. The partnership also holds stock
in a corporation. The
exempt organization must include its share of the gross income from operating the factory in its unrelated business taxable
income, but may exclude
its share of any dividends the partnership received from the corporation.
Different tax years.
If the exempt organization and the partnership of which it is a member have different tax years, the partnership items
that enter into the
computation of the organization's unrelated business taxable income must be based on the income and deductions of the partnership
for the
partnership's tax year that ends within or with the organization's tax year.
S Corporation Income or Loss
An organization that owns S corporation stock must take into account its share of the S corporation's income, deductions,
or losses in figuring
unrelated business taxable income, regardless of the actual source or nature of the income, deductions, and losses. For example,
the organization's
share of the S corporation's interest and dividend income will be taxable, even though interest and dividends are normally
excluded from unrelated
business taxable income. The organization must also take into account its gain or loss on the sale or other disposition of
the S corporation stock in
figuring unrelated business taxable income.
Special Rules for Foreign Organizations
The unrelated business taxable income of a foreign organization exempt from tax under section 501(a) consists of the organization's:
-
Unrelated business taxable income derived from sources within the United States, but not effectively connected with the conduct
of a trade
or business within the United States, plus
-
Unrelated business taxable income effectively connected with the conduct of a trade or business within the United States,
whether or not
this income is derived from sources within the United States.
To determine whether income realized by a foreign organization is derived from sources within the United States or is effectively
connected with
the conduct of a trade or business within the United States, see sections 861 through 865 and the related regulations.
Special Rules for Social Clubs, VEBAs, SUBs, and GLSOs
The following discussion applies to:
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Social clubs described in section 501(c)(7),
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Voluntary employees' beneficiary associations (VEBAs) described in section 501(c)(9),
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Supplemental unemployment compensation benefit trusts (SUBs) described in section 501(c)(17), and
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Group legal services organizations (GLSOs) described in section 501(c)(20).
These organizations must figure unrelated business taxable income under special rules. Unlike other exempt organizations,
they cannot exclude
their investment income (dividends, interest, rents, etc.). (See Exclusions under Income, earlier.) Therefore, they are
generally subject to unrelated business income tax on this income.
The unrelated business taxable income of these organizations includes all gross income, less deductions directly connected
with the production of
that income, except that gross income for this purpose does not include exempt function income. The dividends received deduction
for corporations is
not allowed in computing unrelated business taxable income because it is not an expense incurred in the production of income.
Losses from nonexempt activities.
Losses from nonexempt activities of these organizations cannot be used to offset investment income unless the activities
were undertaken with the
intent to make a profit.
Example.
A private golf and country club that is a qualified tax-exempt social club has nonexempt function income from interest and
from the sale of food
and beverages to nonmembers. The club sells food and beverages as a service to members and their guests rather than for the
purpose of making a
profit. Therefore, any loss resulting from sales to nonmembers cannot be used to offset the club's interest income.
Modifications.
The unrelated business taxable income is modified by any net operating loss or charitable contributions deduction
and by the specific deduction
(described earlier under Deductions.
Exempt function income.
This is gross income from dues, fees, charges or similar items paid by members for goods, facilities, or services
to the members or their
dependents or guests, to further the organization's exempt purposes. Exempt function income also includes income that is set
aside for qualified
purposes.
Income that is set aside.
This is income set aside to be used for religious, charitable, scientific, literary, or educational purposes or for
the prevention of cruelty to
children or animals. In addition, for a VEBA, SUB, or GLSO, it is income set aside to provide for the payment of life, sick,
accident, or other
benefits.
However, any amounts set aside by a VEBA or SUB that exceed the organization's qualified asset account limit (determined
under section 419A) are
unrelated business income. Special rules apply to the treatment of existing reserves for post-retirement medical or life insurance
benefits. These
rules are explained in section 512(a)(3)(E)(ii).
Income derived from an unrelated trade or business may not be set aside and therefore cannot be exempt function income.
In addition, any income set
aside and later spent for other purposes must be included in unrelated business taxable income.
Set-aside income is generally excluded from gross income only if it is set aside in the tax year in which it is otherwise
includible in gross
income. However, income set aside on or before the date for filing Form 990-T, including extensions of time, may, at the election
of the organization,
be treated as having been set aside in the tax year for which the return was filed. The income set aside must have been includible
in gross income for
that earlier year.
Nonrecognition of gain.
If the organization sells property used directly in performing an exempt function and purchases other property used
directly in performing an
exempt function, any gain on the sale is recognized only to the extent that the sales price of the old property exceeds the
cost of the new property.
The purchase of the new property must be made within 1 year before the date of sale of the old property or within 3 years
after the date of sale.
This rule also applies to gain from an involuntary conversion of the property resulting from its destruction in whole
or in part, theft, seizure,
requisition, or condemnation.
Special Rules for Veterans' Organizations
Unrelated business taxable income of a veterans' organization that is exempt under section 501(c)(19) does not include the
net income from
insurance business that is properly set aside. The organization may set aside income from payments received for life, sick,
accident, or health
insurance for the organization's members or their dependents for the payment of insurance benefits or reasonable costs of
insurance administration, or
for use exclusively for religious, charitable, scientific, literary, or educational purposes, or the prevention of cruelty
to children or animals. For
details, see section 512(a)(4) and the regulations under that section.
Income From Controlled Organizations
The exclusions for interest, annuities, royalties, and rents, explained earlier in this chapter under Income, may not apply to a payment
of these items received by a controlling organization from its controlled organization. The payment is included in the controlling
organization's
unrelated business taxable income to the extent it reduced the net unrelated income (or increased the net unrelated loss)
of the controlled
organization. All deductions of the controlling organization directly connected with the amount included in its unrelated
business taxable income are
allowed.
Net unrelated income.
This is:
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For an exempt organization, its unrelated business taxable income, or
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For a nonexempt organization, the part of its taxable income that would be unrelated business taxable income if it were exempt
and had the
same exempt purposes as the controlling organization.
Net unrelated loss.
This is:
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For an exempt organization, its net operating loss, or
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For a nonexempt organization, the part of its net operating loss that would be its net operating loss if it were exempt and
had the same
exempt purposes as the controlling organization.
Control.
An organization is controlled if:
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For a corporation, the controlling organization owns (by vote or value) more than 50% of the stock,
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For a partnership, the controlling organization owns more than 50% of the profits or capital interests, or
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For any other organization, the controlling organization owns more than 50% of the beneficial interest.
For this purpose, constructive ownership of stock (determined under section 318) or other interests is taken into account.
Therefore, an exempt parent organization is treated as controlling any subsidiary in which it holds more than 50%
of the voting power or value,
whether directly (as in the case of a first-tier subsidiary) or indirectly (as in the case of a second-tier subsidiary).
Income From Debt-Financed Property
Investment income that would otherwise be excluded from an exempt organization's unrelated business taxable income (see Exclusions under
Income earlier) must be included to the extent it is derived from debt-financed property. The amount of income included is proportionate
to
the debt on the property.
In general, the term “debt-financed property” means any property held to produce income (including gain from its disposition) for which there
is an acquisition indebtedness at any time during the tax year (or during the 12-month period before the date of the property's
disposal, if it was
disposed of during the tax year). It includes rental real estate, tangible personal property, and corporate stock.
For any debt-financed property, acquisition indebtedness is the unpaid amount of debt incurred by an organization:
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When acquiring or improving the property,
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Before acquiring or improving the property if the debt would not have been incurred except for the acquisition or improvement,
and
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After acquiring or improving the property if:
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The debt would not have been incurred except for the acquisition or improvement, and
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Incurring the debt was reasonably foreseeable when the property was acquired or improved.
The facts and circumstances of each situation determine whether incurring a debt was reasonably foreseeable. That an organization
may not have
foreseen the need to incur a debt before acquiring or improving the property does not necessarily mean that incurring the
debt later was not
reasonably foreseeable.
Example 1.
Y, an exempt scientific organization, mortgages its laboratory to replace working capital used in remodeling an office building
that Y rents to an
insurance company for nonexempt purposes. The debt is acquisition indebtedness since the debt, though incurred after the improvement
of the office
building, would not have been incurred without the improvement, and the debt was reasonably foreseeable when, to make the
improvement, Y reduced its
working capital below the amount necessary to continue current operations.
Example 2.
X, an exempt organization, forms a partnership with A and B. The partnership agreement provides that all three partners will
share equally in the
profits of the partnership, each will invest $3 million, and X will be a limited partner. X invests $1 million of its own
funds in the partnership and
$2 million of borrowed funds.
The partnership buys as its sole asset an office building that it leases to the public for nonexempt purposes. The office
building costs the
partnership $24 million, of which $15 million is borrowed from Y bank. The loan is secured by a mortgage on the entire office
building. By agreement
with Y bank, X is not personally liable for payment of the mortgage.
X has acquisition indebtedness of $7 million. This amount is the $2 million debt X incurred in acquiring the partnership
interest, plus the $5
million that is X's allocable part of the partnership's debt incurred to buy the office building (one-third of $15 million).
Example 3.
A labor union advanced funds, from existing resources and without any borrowing, to its tax-exempt subsidiary title-holding
company. The subsidiary
used the funds to pay a debt owed to a third party that was previously incurred in acquiring two income-producing office buildings.
Neither the union
nor the subsidiary has incurred any further debt in acquiring or improving the property. The union has no outstanding debt
on the property. The
subsidiary's debt to the union is represented by a demand note on which the subsidiary makes payments whenever it has the
available cash. The books of
the union and the subsidiary list the outstanding debt as interorganizational indebtedness.
Although the subsidiary's books show a debt to the union, it is not the type subject to the debt-financed property rules.
In this situation, the
very nature of the title-holding company and the parent-subsidiary relationship shows this debt to be merely a matter of accounting
between the two
organizations. Accordingly, the debt is not acquisition indebtedness.
Change in use of property.
If an organization converts property that is not debt-financed property to a use that results in its treatment as
debt-financed property, the
outstanding principal debt on the property is thereafter treated as acquisition indebtedness.
Example.
Four years ago a university borrowed funds to acquire an apartment building as housing for married students. Last year, the
university rented the
apartment building to the public for nonexempt purposes. The outstanding principal debt becomes acquisition indebtedness as
of the time the building
was first rented to the public.
Continued debt.
If an organization sells property and, without paying off debt that would be acquisition indebtedness if the property
were debt-financed property,
buys property that is otherwise debt-financed property, the unpaid debt is acquisition indebtedness for the new property.
This is true even if the
original property was not debt-financed property.
Example.
To house its administration offices, an exempt organization bought a building using $600,000 of its own funds and $400,000
of borrowed funds
secured by a pledge of its securities. The office building was not debt-financed property. The organization later sold the
building for $1 million
without repaying the $400,000 loan. It used the sale proceeds to buy an apartment building it rents to the general public.
The unpaid debt of $400,000
is acquisition indebtedness with respect to the apartment building.
Property acquired subject to mortgage or lien.
If property (other than certain gifts, bequests, and devises) is acquired subject to a mortgage, the outstanding principal
debt secured by that
mortgage is treated as acquisition indebtedness even if the organization did not assume or agree to pay the debt.
Example.
An exempt organization paid $50,000 for real property valued at $150,000 and subject to a $100,000 mortgage. The $100,000
of outstanding principal
debt is acquisition indebtedness, as though the organization had borrowed $100,000 to buy the property.
Liens similar to a mortgage.
In determining acquisition indebtedness, a lien similar to a mortgage is treated as a mortgage. A lien is similar
to a mortgage if title to
property is encumbered by the lien for a creditor's benefit. However, when state law provides that a lien for taxes or assessments
attaches to
property before the taxes or assessments become due and payable, the lien is not treated as a mortgage until after the taxes
or assessments have
become due and payable and the organization has had an opportunity to pay the lien in accordance with state law. Liens similar
to mortgages include
(but are not limited to):
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Deeds of trust,
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Conditional sales contracts,
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Chattel mortgages,
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Security interests under the Uniform Commercial Code,
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Pledges,
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Agreements to hold title in escrow, and
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Liens for taxes or assessments (other than those discussed earlier in this paragraph).
Exception for property acquired by gift, bequest, or devise.
If property subject to a mortgage is acquired by gift, bequest, or devise, the outstanding principal debt secured
by the mortgage is not treated as
acquisition indebtedness during the 10-year period following the date the organization receives the property. However, this
applies to a gift of
property only if:
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The mortgage was placed on the property more than 5 years before the date the organization received it, and
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The donor held the property for more than 5 years before the date the organization received it.
This exception does not apply if an organization assumes and agrees to pay all or part of the debt secured by the
mortgage or makes any payment for
the equity in the property owned by the donor or decedent (other than a payment under an annuity obligation excluded from
the definition of
acquisition indebtedness, discussed later under Debt That Is Not Acquisition Indebtedness).
Whether an organization has assumed and agreed to pay all or part of a debt in order to acquire the property is determined
by the facts and
circumstances of each situation.
Modifying existing debt.
Extending, renewing, or refinancing an existing debt is considered a continuation of that debt to the extent its outstanding
principal does not
increase. When the principal of the modified debt is more than the outstanding principal of the old debt, the excess is treated
as a separate debt.
Extension or renewal.
In general, any modification or substitution of the terms of a debt by an organization is considered an extension
or renewal of the original debt,
rather than the start of a new one, to the extent that the outstanding principal of the debt does not increase.
The following are examples of acts resulting in the extension or renewal of a debt:
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Substituting liens to secure the debt,
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Substituting obligees whether or not with the organization's consent,
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Renewing, extending, or accelerating the payment terms of the debt, and
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Adding, deleting, or substituting sureties or other primary or secondary obligors.
Debt increase.
If the outstanding principal of a modified debt is more than that of the unmodified debt, and only part of the refinanced
debt is acquisition
indebtedness, the payments on the refinanced debt must be allocated between the old debt and the excess.
Example.
An organization has an outstanding principal debt of $500,000 that is treated as acquisition indebtedness. The organization
borrows another
$100,000, which is not acquisition indebtedness, from the same lender, resulting in a $600,000 note for the total obligation.
A payment of $60,000 on
the total obligation would reduce the acquisition indebtedness by $50,000 ($60,000 X $500,000/$600,000) and the excess debt
by $10,000.
Debt That Is Not Acquisition Indebtedness
Certain debt and obligations are not acquisition indebtedness. These include the following.
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Debts incurred in performing an exempt purpose.
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Annuity obligations.
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Securities loans.
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Real property debts of qualified organizations.
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Certain Federal financing.
Debt incurred in performing exempt purpose.
A debt incurred in performing an exempt purpose is not acquisition indebtedness. For example, acquisition indebtedness
does not include the debt an
exempt credit union incurs in accepting deposits from its members or the debt an exempt organization incurs in accepting payments
from its members to
provide them with insurance, retirement, or other benefits.
Annuity obligation.
The organization's obligation to pay an annuity is not acquisition indebtedness if the annuity meets all the following
requirements.
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It must be the sole consideration (other than a mortgage on property acquired by gift, bequest, or devise that meets the exception
discussed
under Property acquired subject to mortgage or lien, earlier in this chapter) issued in exchange for the property |
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