Why is there a tax on unrelated business income for exempt entities?
Congress does not want a tax-exempt entity to use its tax exemption to put for-profit companies out of business. If a tax-exempt entity is doing something that a for-profit company does and competing with for-profit companies, it should not get the benefit of its tax exemption to compete with the for-profit companies. For example, if a charity provides food and housing for a reduced fee to low-income families, the provision of those services and the collection of donations to fund those services to the low-income families should be tax exempt. However, if the charity runs a restaurant for paying customers, the activities related to paying customers will likely be subject to tax.
What is an unrelated trade or business?
Under Internal Revenue Code (“IRC”) Section 513, an unrelated trade or business is any trade or business which is regularly carried on and is not substantially related to the exempt purpose of the entity. However, fundraising activities that are used to finance the exempt purpose of the entity are not “unrelated.”
What type of exempt entity should be concerned with unrelated business taxable income (“UBTI”)?
Most types of exempt entities are subject to UBTI:
- Charitable, religious, scientific and other organizations exempt under IRC Section 501(c), including IRC Section 501(c)(3) ;
- Employee trusts forming part of a pension, profit-sharing or stock bonus plan under IRC Section 401(a);
- Individual retirement arrangements (IRAs), including traditional IRAs, Roth IRAs, simplified employee pensions (SEP-IRAs), and savings incentive match plans for employees (SIMPLE IRAs);
- State and municipal colleges and universities;
- 529 and 529A plans;
- Medical savings accounts under IRC Section 220(d); and
- Coverdell savings accounts.
Can UBTI apply when an exempt entity invests in a real estate investment partnership?
Yes. An investment in a real estate partnership is at risk of being subject to UBTI because real estate investments are usually debt financed.
Are there exceptions from the UBTI under IRC Section 512 that would apply to real estate investment partnerships?
Yes. There are several exceptions for UBTI that may be earned by real estate investment partnerships.
- Passive type income: Dividends, interest, royalties, payments with respect to securities loans, amounts are excluded from UBTI.
- Rents from real property: Generally, rents from real property are excluded from UBTI, but they should be included in UBTI if:
- More than 50% of the total rent received under the lease is attributable to personal property; or
- The amount of the rent depends on income derived by any person from the rented property.
- Rents from personal property: Rents from personal property should be included in UBTI if:
- The personal property is rented with real property and the rents from personal property are more than an incidental amount of the total rents;
- More than 50% of the total rent received under the lease is attributable to personal property; or
- If the amount of the rent depends on the income derived by any person from the rented property.
- Gains or losses from property: Gains and losses from the sale, exchange or other disposition of property are generally excluded. In addition, when in connection with the taxpayer’s investment activity, gains or losses from the following are also excluded from UBTI:
- Gains or losses from the lapse or termination of options on securities or real property; or
- Gains or losses from the forfeiture of good-faith deposits for the purchase, sale or lease of real property.
However, the following specified gains and losses are included in UBTI: gains or losses from the sale, exchange or other disposition of stock in trade, inventory, or property held primarily for sale to customers in the ordinary course of the trade or business.
Will those exceptions protect tax-exempt investors from the UBTI in a real estate partnership?
Unfortunately, if the assets of a real estate partnership include debt-financed property, IRC Section 514 will bring you into the scope of UBTI, notwithstanding any of the exceptions above. In other words, even if the above exceptions on rent and gains exclude the income from UBTI, if the assets of the partnership are debt-financed then the income of the partnership will probably create UBTI for the tax-exempt partners.
Debt-financed property is property that is held to produce income and that has acquisition indebtedness. Under IRC Section 514(c), “acquisition indebtedness” is basically any debt that is incurred before, during or after the acquisition or improvement of property, if the debt would not have been incurred but for such acquisition or improvement. Where property is acquired subject to a mortgage, that is also considered debt-financed property, even if the organization did not assume or agree to pay such indebtedness.
The UBTI calculation for debt-financed property is made by taking a percentage of the total gross income derived from the property. The percentage is meant to represent the proportion of the property that is debt financed. It is calculated using a fraction with the average acquisition indebtedness over the average amount of the adjusted basis of such property over the year. Related deductions are also allowed by using the same percentage.
Would the “fractions rule” help a tax-exempt partner avoid UBTI on debt-financed property?
The fractions rule is part of one of the paths to avoid UBTI in a labyrinth of requirements under IRC 514(c)(9). Unfortunately, it is a long and difficult road to go through the rules and conclude that an exempt investor would be able to avoid UBTI in a real estate partnership that invests in debt-financed property.
The general rule under IRC 514(c)(9) states that acquisition indebtedness does not include debt incurred by a “qualified organization.” So far, so good. Unfortunately, there are significant restrictions to this general rule.
First, to avoid UBTI on debt financed property, the taxpayer must be a “qualified organization” and a “qualified organization” is a limited definition, which includes only:
- A “real” school under IRC Section 170(b)(1)(A)(ii) that maintains a regular faculty, curriculum and a regularly enrolled body of students, or one of its affiliated supporting organizations;
- A qualified trust under IRC Section 401(a), which means a trust which is part of a stock bonus, pension or profit-sharing plan of an employer;
- An organization under IRC 501(c)(25), which is an organization that holds real estate and remits the income from that real estate to a 501(c)(3) organization, a 401 qualified trust, a governmental plan or the federal or state government; or
- A retirement account under IRC Section 403(b)(9), which is a retirement income account provided by a church.
Second, even if the tax-exempt entity is a qualified organization, under IRC Section 514(c)(9)(B) there are numerous exceptions to the general rule of exclusion for debt incurred by a qualified organization. For instance, debt-financed property would be included in UBTI calculation of a qualified organization if the price for the acquisition is not a fixed amount determined as of the date of the acquisition or the completion of the improvement. It would also be included in UBTI if the real property is leased to person who sold the property to the organization or an entity related to the organization. A real estate partnership would have to make sure it does not fall into any of these of these exceptions.
Third, in addition to avoiding the exceptions in the previous paragraph, if the property is held by a partnership, then the partnership must meet one of the following requirements in order to exclude the income from UBTI.
- All of the partners must be “qualified organizations” as defined above.
- Each allocation to a partner which is a qualified organization must be a qualified allocation within the meaning of IRC Section 168(h)(6). Generally, this means that the qualified organization must be allocated a fixed and unchanging share of each item of income, gain, loss, deduction, credit and basis in the partnership.
- The partnership must comply with the fractions rule. The fractions rule requires that:
- Each allocation must have substantial economic effect; and
- The allocation of items to any qualified organization cannot result in that organization having a percentage share of overall partnership income for any tax year that is greater than the partner’s percentage share of the overall partnership loss for the tax year in which that share of loss will be smallest.
This fractions rule is further elaborated in the regulations.
What can be done to avoid UBTI from investments in real estate partnerships?
The only option may be to avoid investments in real estate partnerships altogether. Alternatively, the partnership could avoid financing its property with debt or possibly use a blocker corporation. Otherwise, if the entity is a qualified organization, it could engage the services of a tax expert who could very carefully draft the partnership documents to try to avoid UBTI by going through the maze of exceptions available in the Code. However, the other partners may not be inclined to agree to the strict restrictions required.
If you have inquiries about this article, please contact any member of the tax team at FGMK:
Adam Handler Christie R. Galinski
Senior Manager Senior Manager
Tax Practice Specialty Tax Practice
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