Unrelated Business Activities: Strategies for Coping

Transcription

1 Unrelated Business Activities: Strategies for Coping How much is too much? Options for Dealing with Unrelated Activities as They Become Substantial, including spinoff or organization of an unrelated activity, equity and other forms of compensation, and ongoing relations University of Texas School of Law Nonprofit Organizations Institute Austin, Texas January 17, :15 a.m. William H. Caudill

2 Table of Contents I. Introduction: Scope of Outline... 1 A. When does participation by a tax-exempt entity in a business or investment partnership with a non-exempt party jeopardize its tax-exempt status?... 1 B. Taxation of unrelated business taxable income notwithstanding general exemption C. Debt-financed income as a component of unrelated business taxable income. 1 D. Debt-financed real estate investments by qualified organizations E. Special problems of foundation partners F. Blocker entities to avoid unrelated business taxable income G. The uncertain efficacy of insurance company separate accounts H. Unrelated Business Activities... 1 II. Qualification for exemption A. Statutory definition B. Organizational test C. Operational test D. Application to partnerships and joint ventures E. Insubstantial part III. Significance of UBTI A. Information returns. Income tax on unrelated trade or business B. If a tax-exempt entity does earn UBTI C. Attitudes toward UBTI IV. Significant Exposure Items: A. Portfolio investments in pass-through entities/hedge funds B. Certain categories of fee income C. Limitations V. Unrelated Debt Financed Income A. Definition B. Sale of debt financed property within one year C. Acquisition indebtedness is debt D. Exception for certain qualified organizations E. Partnership considerations VI. Tax-exempt charities A. Generally not subject to federal income tax. Section 501(a) B. UBTI C. Private foundation excise taxes D. Impact on investment partnerships E. Impact on Charitable Remainder Trusts VII. Use of Blocker Corporation as technique for avoiding UBTI: A. Blocker entities to absorb the tax reporting and tax-paying obligations B. Blocker corporations above the fund C. Blocker corporations below the fund D. Parallel blockers VIII. Insurance company separate accounts A. Significance... 36

3 B. Fund an annuity using debt-financed property C. Definitional aspects D. Cautionary considerations and recent developments IX. Why form a taxable affiliate/choice of entity A. Corporations: B. Partnerships: C. Single member limited liability company (SMLLC): D. Subchapter S corporations X. Partnership interests A. Include its share of gross income and the partnership deductions B. No distinction between general and limited partners C. Partnership income will flow through to tax-exempt partners D. Investments made through corporations E. SMLLC treated as a division XI. Potential tax treatment of intercompany transactions A. Tax issues arising from formation of the new entity B. Potential UBTI from intercompany transactions C. Non-debt financed dividend income exempt from UBTI D. Potential disallowance of interest deductions under Section 163(j) for the taxable subsidiary E. Employment tax issues for sharing of employees/services F. Inability to file consolidated return G. Attribution of taxable affiliate s activities to the exempt H. Private inurement and intermediate sanctions concerns I. State tax considerations property taxes; sales/use J. May need to create a joint venture policy XII. Formation of affiliate: corporate subsidiary A. No gain or loss on formation B. Transfer of debt-financed property results in UBTI to the extent the debt exceeds the adjusted basis C. Any recapture property will trigger income pursuant to Sections 1245(b)(3) and 1250(d)(3) D. Similar treatment for contributions to capital E. The transfer of property funded with proceeds from an issuance of tax-exempt bonds F. Carryover basis of transferred property G. Carryover basis of the taxable subsidiary stock XIII. Formation of affiliate: partnership A. A partnership can be formed tax-free B. Carryover basis of a contributing partner s interest C. Carryover basis in partnership property contributed by a partner D. Various exceptions to non-recognition: XIV. Is the intercompany activity subject to tax? A. Examine the activity under the traditional rules B. If taxable, is taxable income correct? C. Is it properly reported?... 46

4 XV. Is the activity subject to tax? administrative support services A. The provision of management and support services by an exempt entity to an affiliated taxable entity B. Management fees on examination C. The services could be exempt if they are furthering the exempt purposes D. This applies to corporate and partnership ventures XVI. Certain amounts from controlled entities A. Interest, rent, royalty and annuity payments received or accrued from a controlled organization XVII. Income from controlled organizations A. Even if the activity that generates the income does not represent a trade or business or is not regularly carried on B. Prevents tax-exempt orgs from converting taxable income into nontaxable passive income C. Warrant does generate taxable income in the tax-exempt parent D. Transition Rule XVIII. Foreign captive insurance companies A. Subpart F Income shall be treated as derived from an unrelated trade or business to the extent that amount is attributable to insurance income XIX. Foreign Insurance Income A. Exception B. Definition of affiliate XX. S corporations A. If exempt organization or pension plan holds stock in an S corporation: B. Not applicable to employee stock options plans XXI. Conversion from taxable to tax-exempt A. The activities of your taxable corporation have evolved or were in furtherance of a tax-exempt purpose B. Issue for conversion or liquidation. The transaction may be treated as a taxable sale of the corporate subsidiary s assets C. Transfer of appreciated property D. Exceptions XXII. Tax-exempt to taxable conversion A. Can be structured taxable or tax-free B. Step up in basis for taxable transaction presents challenges to valuation of assets C. Intermediate sanctions, private benefit/inurement exposure if third parties involved D. Dissolution clause in governing documents E. Allowable under state law and appropriate notices F. Tax-exempt bonds XXIII. Contribution of employees A. Lending employees to exempt organizations B. Is compensation paid to donated employees deductible as a business expense or charitable contribution C. Most corporations would prefer business expense... 51

5 D. Facts and circumstances E. Employees are performing services to exempt organization for an extended period... 51

6 I. Introduction: Scope of Outline. A. When does participation by a tax-exempt entity in a business or investment partnership with a non-exempt party jeopardize its taxexempt status? B. Taxation of unrelated business taxable income ( UBTI ) notwithstanding general exemption. C. Debt-financed income as a component of unrelated business taxable income. D. Debt-financed real estate investments by qualified organizations. E. Special problems of foundation partners. F. Blocker entities to avoid unrelated business taxable income. G. The uncertain efficacy of insurance company separate accounts. H. Unrelated Business Activities A section 501(c)(3) organization can engage in activities unrelated to its exempt purpose as long as it is primarily engaged in activities in furtherance of its exempt purposes. 1. How Is Unrelated Activity Level Measured? In this regard, the amount of income generated by the unrelated trade or business has been ruled not to be the sole factor in determining whether or not the exempt status is jeopardized. The Internal Revenue Service (the Service ) looks at all the facts and circumstances, including the amount of the organization s expenses allocable to the activity. Priv. Ltr. Rul (May 28, 1980). In this regard, Priv. Ltr. Rul (Aug. 17, 1978) concluded that the appropriate measure of business activity is gross income (rather than gross receipts). 2. How Much Is Too Much? The organization in Priv. Ltr. Rul , which was exempt under Section 501(c)(6) of the Internal Revenue Code of 1986, as amended (hereinafter all section references are to the Code), derived 40% of its gross income and incurred 40% - 1 -

7 of its expenses on unrelated business activities, and was held not to lose its exempt status as a result. In Priv. Ltr. Rul , a Section 501(c)(3) organization whose unrelated business activities ( UBI ), sale of prosthetic devices to the public, constituted 46% of its gross income and activities was held to retain its exempt status. Also, where as much as 66 to 70% of an organization s gross income and 52 and 66% of the organization s expenses relate to unrelated business activities, the Service has taken the position that the organization is not primarily engaged in activities directed toward the fulfillment of its exempt purpose. Priv. Ltr. Rul (Sept. 22, 1978). See also Orange County Agricultural Society, Inc. v. Commissioner, 893 F.2d 529 (2d Cir. 1990); Rev. Rul , C.B. 316; Indiana Retail Hardware Association, Inc. v. United States, 366 F.2d 998 (Ct. Cl. 1966); People s Educational Camp Society, Inc. v. Commissioner, 331 F.2d 923 (2d Cir. 1964); and G.C.M (Sept. 17, 1973). In the Orange County Agricultural Society case, a section 501(c)(3) organization lost its tax-exempt status because one-third of its revenues were derived from unrelated business income. For approximately two weeks a year, the Society operated a racetrack and concession during its annual fund-raiser fair as a qualified public entertainment activity. During the rest of the year, the racetrack and concession activity is unrelated to the exempt purpose of the society. The revenue comprised one-third of the Society s revenues. In affirming the Tax Court, the Court of Appeals held that because the activity was substantial and was not in furtherance of its exempt purpose, the Society was not exempt. The court also found that interest-free loans from the Society to a corporation, whose shareholders were the Society s majority shareholders, constituted inurement of earnings to the private corporation receiving the loans. In G.C.M , a cemetery s exempt status was revoked where it regularly offered and sold plants and flowers grown in its greenhouse to the general public. The memorandum states that UBI of greater of 15% of gross income could be used as an administrative rule of thumb for determining UBI as being substantial, thereby threatening an organization s exempt status