Reporting UBTI and UBIT in Partnerships and S Corporations: Mastering K-1 Disclosures for Exempt Org Partners Key Box 20V Reporting, Footnotes and Separate Disclosures, and UDFI Exemptions THURSDAY, SEPTEMBER 29, 2016, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection (no sharing) if you need to register additional people, please call customer service at 1-800-926-7926 x10 (or 404-881-1141 x10). Strafford accepts American Express, Visa, MasterCard, Discover. Listen on-line via your computer speakers. Respond to five prompts during the program plus a single verification code. You will have to write down only the final verification code on the attestation form, which will be emailed to registered attendees. To earn full credit, you must remain connected for the entire program. FOR LIVE PROGRAM ONLY WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10) For Assistance During the Live Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.
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Reporting UBTI and UBIT in Partnerships and S Corporations Sept. 28 2016 William M. Funk, Esq. Law Office of William M. Funk, New York wfunk@funklawsite.com Elizabeth M. Mills, Senior Counsel Proskauer Rose, Chicago emills@proskauer.com
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Reporting UBTI and UBIT in Partnerships and S Corporations Elizabeth M. Mills Senior Counsel
Part I: UBTI Background, Overview and Consequences 6 Reporting UBTI and UBIT in Partnerships and S Corporations
Definition of Exempt Organization Who are EOs For purposes of our discussion: generally, tax-exempt organizations described in Section 501(c)(3) of the Code EOs include 501(c)(1) through 501(c)(29) or, unless otherwise noted, pension trusts described in Section 401(a) of the Code Governmental colleges and universities are also subject to unrelated business income treatment to the extent income would have been subject to tax for a tax-exempt organization 7 Reporting UBTI and UBIT in Partnerships and S Corporations
How EOs are subject to income tax EOs income is generally exempt from income tax Code Section 501(a) However, income from trade or business not substantially related to exempt purposes ( UBI ) is taxed Code Section 501(b) UBI is addressed in Code Sections 511-514 and includes income from a business, as well as investment income under some circumstances But a Section 401(a) trust s UBI is income from any trade or business 8 Reporting UBTI and UBIT in Partnerships and S Corporations
So What's not taxable Contributions, grants, and dues Income from activities that further exempt purposes (except for Section 401(a) trusts) Investment income in most situations, per Section 512(b) modifications (discussed later) 9 Reporting UBTI and UBIT in Partnerships and S Corporations
How EOs are subject to income tax UBI is income from an unrelated trade or business Trade or business for profit Regularly carried on Not substantially related to exempt purposes Exceptions for volunteers, selling of donated merchandise, and convenience (501(c)(3) only) 10 Reporting UBTI and UBIT in Partnerships and S Corporations
How EOs are subject to income tax An EO s unrelated business taxable income ( UBTI ) is the net income from unrelated trades or businesses For purposes of determining unrelated business income tax ( UBIT ), all provisions of Code apply unless otherwise provided in Subchapter F EO organized as corporation or trust pays tax at corporate or trust respective rates with usual deductions Form 990-T Subject to estimated tax rules UBI rules apply regardless of use to which income is put Outdated destination of income test 11 Reporting UBTI and UBIT in Partnerships and S Corporations
Special UBI rules for some organizations and activities Section 501(c)(7) social clubs Investment income is subject to tax Gain on sale of property is usually taxed unless recycled to member facility Section 501(c)(9) voluntary employee benefit associations Investment income is subject to tax unless it is set aside to pay benefits, subject to limits Special rules for advertising in exempt journals Reg. Section 1.512(a)-1(f) 12 Reporting UBTI and UBIT in Partnerships and S Corporations
Consequences of UBTI Tax Usual deductibility limitations apply In addition, per Code Section 512(a)(1), deductions can only be expenses directly connected with the activity generating UBI Directly connected means a proximate and primary relationship to the carrying on of the business. Reg. Section 1.512(a)-1(a) See GCM 39843 (4/15/91): a tax-exempt hospital s deductions from UBI are not equivalent to Medicare cost allocations; Medicare-based costs should be disallowed unless taxpayer can show deductions clearly reflect income For example, costs for autopsies and ER clerks are not administrative expenses allocable to the pharmacy 13 Reporting UBTI and UBIT in Partnerships and S Corporations
Consequences of UBTI UBTI losses can offset UBTI income, but losses from related activities can t Disallowed losses Loss carrybacks and carryforwards are permitted under the same rules as for taxable entities However, to be allowed, a loss must be from a trade or business carried on for profit IRS looks at activities that continually generate losses as not carried on for profit and disallows the losses E.g. hospitals reference laboratory income IRS Colleges and Universities Compliance Project (completed 2013) reported many examinations disallowed UBTI loss carryovers 14 Reporting UBTI and UBIT in Partnerships and S Corporations
Consequences of UBTI In extreme cases, possible loss of exemption An organization operated primarily to conduct an activity unrelated to exempt purposes is not exempt How much is too much? 15% often used as a rule of thumb 15% of what? Multi-factor measure Revenues Expenses Staff time Board time 15 Reporting UBTI and UBIT in Partnerships and S Corporations
Another Wrinkle Division of 501(c)(3) Organizations into PCs and PFs Every 501(c)(3) organization is either a public charity or a private foundation (with some recent blurring at the edges) Section 509(a) defines a private foundation as an organization other than those described in Code Sections 509(a)(1)-(4) Can qualify as public charity based on Nature of activity Financial support profile Supporting organization relationship to a public charity qualifying based on nature of activity or financial support profile Why do we care? 16 Reporting UBTI and UBIT in Partnerships and S Corporations
PF Restrictions Interact with UBI Restrictions are imposed through excise taxes in Chapter 42 of the Code First level is a percentage of the bad deed Second level, if bad deed not corrected, is 100% or 200% of the bad deed 17 Reporting UBTI and UBIT in Partnerships and S Corporations
PF Restrictions Interact with UBI Code Section 4943: Excise tax on Excess Business Holdings A foundation s excess business holdings are the holdings in a business enterprise that it would have to dispose of to a person other than a disqualified person for its remaining holdings to be permitted holdings (usually 20 percent of the voting power of stock) Disqualified persons holdings in a business enterprise are usually combined with those of the foundation in determining whether the 20 percent limit is exceeded For partnerships, the limit is 20% of profits interest Any level of sole proprietorship (i.e. trade or business unrelated to exempt purposes) can be an excess business holding 18 Reporting UBTI and UBIT in Partnerships and S Corporations
PF Restrictions Interact with UBI Code Section 4943: Excise tax on Excess Business Holdings Exclusions from business enterprise Program-related investments Primary purpose of investment is to further exempt purposes No significant purpose is production of income or appreciation of property An entity at least 95% of the income of which is passive activity (e.g., interest, dividends, rents) Functionally related business as defined in Section 4942(j)(4) An activity that is not an unrelated trade or business or An activity that is an unrelated trade or business but is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which is related to exempt purposes S corp stock doesn t fit these, so is subject to excess business holdings limitations 19 Reporting UBTI and UBIT in Partnerships and S Corporations
PF Restrictions Interact with UBI Disposing of Excess Business Holdings Note that a private foundation s disposition of stock to donors or their related parties, or other disqualified persons, can create a prohibited self-dealing transaction If S corp stock is received by a private foundation as gift or bequest, the private foundation has at least 5 years to dispose of before excess business holdings penalties apply 20 Reporting UBTI and UBIT in Partnerships and S Corporations
PF Restrictions Interact with UBI Code Section 4940: Excise tax on net investment income 2% of net investment income Can be reduced to 1% if foundation has excess charitable distributions Paid annually; quarterly estimated installments may be required Net investment income includes gains from disposition of property of a type that is normally held for investment One bright spot: UBIT paid by a private foundation reduces its required annual 5% payout 21 Reporting UBTI and UBIT in Partnerships and S Corporations
You Can t Hide Public Inspection requirement applies to exemption application and three most recently filed Forms 990 or Forms 990-PF Form 990 requires breakdown of UBI, but not UBTI For Section 501(c)(3) organizations only, Forms 990-T are subject to disclosure like Forms 990 Copies must be provided if requested 22 Reporting UBTI and UBIT in Partnerships and S Corporations
Part III: UBTI Exceptions 23 Reporting UBTI and UBIT in Partnerships and S Corporations
Section 512(b) Modifications General exclusions from UBI 512(b)(1): interest and dividends 512(b)(2): royalties 512(b)(3): rents from real property 512(b)(5): Gains and losses from the sale or other disposition of property (other than stock in trade or property held primarily for sale to customers in the ordinary course of trade or business) But Section 512(b)(4) provides that these exclusions don t apply to income from debt-financed property as defined in Section 514 24 Reporting UBTI and UBIT in Partnerships and S Corporations
REPORTING UBTI AND UBIT IN PARTNERSHIPS AND S CORPORATIONS Strafford Continuing Education Webinars William M. Funk, Esq. (212) 973-1100 wfunk@funklawsite.com
ABOUT THE SPEAKER William M. Funk is a tax attorney with over ten years of experience working for law firms and a global accounting firm prior to opening his own practice. He has delivered highly-rated tax presentations to accountants for Continuing Professional Education credit, to attorneys for Continuing Legal Education credit, and to business professionals. He also has written numerous articles on tax issues. His current practice includes representing hedge funds, real estate businesses, individuals and nonprofits with cross-border operations. Representative transactions include structuring hedge funds, real estate joint ventures with tax-exempt organizations, U.S. investments by foreign persons and executive compensation. He received his LL.M. in Taxation from New York University Law School, his J.D. from Vanderbilt Law School and his A.B. from University of Chicago. For additional information, please visit www.funklawsite.com. Law Office of William M. Funk 26
TOPICS COVERED Partnerships, S Corporations, Joint Ventures etc. Unrelated Debt Financed Income For-Profit Subsidiaries Law Office of William M. Funk 27
PARTNERSHIPS, S CORPORATIONS, JOINT VENTURES ETC. Important considerations for pass-through entities. Pass-through entities include partnerships, limited liability companies ( LLCs ) and S corporations Activities of partnerships are attributed to its members. Importance of assessing how substantial the involvement of the taxexempt is. Law Office of William M. Funk 28
PARTNERSHIPS, S CORPORATIONS, JOINT VENTURES ETC. Partnerships (including LLCs) Complete flexibility of how money and property is distributed. Allocation of net income and net loss must either have substantial economic effect or reflect partners interests in the partnership, or else risk reallocation by the Internal Revenue Service. Can have differences in timing of cash and allocations, priorities and back-ends. Law Office of William M. Funk 29
PARTNERSHIPS, S CORPORATIONS, JOINT VENTURES ETC. S Corporations C corporations + S election. One class of stock. Limitations on who may be S corporation holder without causing S corporation elections: United States and resident alien individuals, estates, certain testamentary trusts and tax-exempt organizations. Code Section 1361(b) NB: All S corporation income is UBTI. Code Section 512(e). Law Office of William M. Funk 30
PARTNERSHIPS, S CORPORATIONS, JOINT VENTURES ETC. Important considerations for joint ventures. Two-prong analysis (when the tax-exempt organization is a general partner or managing member or the activity uses or requires a substantial portion of tax-exempt assets or activities): Does the joint venture expose the assets of the tax-exempt to unacceptable risk? Does the joint venture agreement specifically permits the tax-exempt organization to act exclusively in furtherance of its tax-exempt purpose and only incidentally for for-profit investors. Ancillary joint ventures have a more relaxed test. Law Office of William M. Funk 31
PARTNERSHIPS, S CORPORATIONS, JOINT VENTURES ETC. Special industries Real estate Health care Accountable Care Organizations ( ACOs ) Consumer Operated and Oriented Plans ( Co-Ops ) Education Law Office of William M. Funk 32 April 22, 2014
PARTNERSHIPS, S CORPORATIONS, JOINT VENTURES ETC. Real Estate UBTI Issues (discussed above) Tax Credits Useless for tax-exempts Tax-exempt use property rules (more than 35 percent of floor space) Sales of tax credits Tax-exempt entity leasing rules Law Office of William M. Funk 33
PARTNERSHIPS, S CORPORATIONS, JOINT VENTURES ETC. Real Estate Tax Credit Issues Historic Boardwalk Virginia Historic Tax Credit Fund, 2001 Route 231, LLC Law Office of William M. Funk 34
UNRELATED DEBT-FINANCED INCOME UBIT is imposed on Unrelated Debt-Financed Income ( UDFI ). UDFI may be generated from passive investments as well as other property. Key to analysis is debt-financed property. Code Section 514 Law Office of William M. Funk 35
UNRELATED DEBT-FINANCED INCOME Debt-financed property Property held to produce income. Acquisition indebtedness during the taxable year. But not to extent that use of property is substantially related to the organization s exempt purpose. And not to extent income already accounted for in unrelated trade or business income. Law Office of William M. Funk 36
UNRELATED DEBT-FINANCED INCOME Acquisition Indebtedness - Debt incurred in connection with acquisition or improvement of property. - Includes debt that would not have been incurred but for acquisition or improvement. - Includes debt for which need was reasonably foreseeable at time of acquisition or improvement. Law Office of William M. Funk 37
UNRELATED DEBT-FINANCED INCOME Acquisition Indebtedness Purchasing property subject to a mortgage is acquisition indebtedness. (Note: can avoid by prepayment of debt. Rev. Rul. 76-95) Liens and other encumbrances are debt for the acquisition indebtedness rules. Including margin purchases. Acquisition indebtedness of property acquired by partnership. But not debt incurred when inherent part of performance of exempt purpose (example, 501(c)(3) bonds). Law Office of William M. Funk 38
UNRELATED DEBT-FINANCED INCOME Acquisition Indebtedness Special Real Estate Exception To preserve the ability of pension funds and other investors to have passive investments in real estate, certain exempt organizations may invest in real estate without being subject to UDFI. Organizations Covered ( Qualified Organizations ) Organizations exempt under Code Section 401(a) Retirement Accounts under Code Section 403(b)(9) Title-holding organizations under Code Section 501(c)(25) Educational organizations Affiliated support organizations of educational organizations. Law Office of William M. Funk 39 April 22, 2014
UNRELATED DEBT-FINANCED INCOME Special Real Estate Exception (continued) Exception is for debt incurred by a qualified organization to acquire or improve real property. Restrictions: Purchase/sale price of real property must be fixed as of date of sale (unless a purchase of foreclosure property from a financial institution). No equity-kickers: Debt obligations may not be conditioned on future income/profits/revenues from property (unless from foreclosure property purchased from a financial institution). Sale-leaseback with seller or related-party not permitted. Qualified trust may not purchase property from person related to plan under which the trust was formed. Financing by a related party must be provided on commercially reasonable terms. Law Office of William. M. Funk 40
UNRELATED DEBT-FINANCED INCOME Special Real Estate Exception (continued) Application to investment through partnership. Exception available if the investment meets one of these conditions: All investors are Qualified Organizations. Qualified allocations of Code Section 168(h)(6) are met. Fractions Rule (watch the exceptions). Law Office of William M. Funk 41
UNRELATED DEBT-FINANCED INCOME Computing UDFI Not all income from debt-financed property is UDFI. Based on debt/basis percentage. Average acquisition indebtedness for year divided by average basis of debt-financed property. Based on principal indebtedness on first day of every month of taxable year. Law Office of William M. Funk 42
UNRELATED DEBT-FINANCED INCOME Computing UDFI Allowable deductions are also based on debt/basis percentage. NB: Depreciation of property permitted only on straight-line basis. Code Section 514(a)(3). Special rules for gain or loss on disposition of property. Required to use highest amount of acquisition indebtedness for 12-month period before disposition of property. Remember passive activity and at-risk rules. K-1, Line 20, Code V and Statements. Law Office of William M. Funk 43
FOR-PROFIT SUBSIDIARIES Reasons for establishing for-profit subsidiaries. Preserve exemption of organization / avoid disqualification. Preserving assets of one set of operations against liabilities of other set of obligations. Clarifying missions of nonprofit managers and business managers. Cleaner accounting and tax reporting. Law Office of William M. Funk 44 April 22, 2014
FOR-PROFIT SUBSIDIARIES Taxation Corporate subsidiaries are fully taxable as corporations under Code Section 502. Dividends from for-profit subsidiary are exempt as passive income. Interest, annuities, royalties and rents from for-profit subsidiaries are subject to UBIT. Assets in subsidiaries subject to tax on deemed sale on distribution to tax-exempt. Treas. Reg. Section 1.337(d)-4. Law Office of William M. Funk 45
FOR-PROFIT SUBSIDIARIES Which for-profit subsidiaries are subject to special rules of Code Section 512(b)(13)? For a corporation, ownership by vote or value of 50 percent of more of stock. Constructive ownership rules of Code Section 318 apply. Amount subject to UBIT is an amount equivalent to the reduction in taxable income of the for-profit subsidiary. Law Office of William M. Funk 46
ON AND OVER THE HORIZON -- HYBRIDS Benefit Corporations Authorized in New York 2012. Not a new tax designation. Impact on UBIT analysis? Low-Profit Limited Liability Corporations Not authorized in New York. Not a new tax designation. Impact on private foundations? Law Office of William M. Funk 47
CONTACT INFORMATION William M. Funk, Esq. Law Office of William M. Funk 275 Madison Avenue, 11th Floor New York, NY 10016 Phone: (212) 973-1100 Fax: (917) 210-3513 E-mail: wfunk@funklawsite.com www.funklawsite.com Law Office of William M. Funk 48