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UBTI and UBIT for Exempt Organizations: Mastering Form 990-T

Getting Calculations Right and Avoiding Audit Traps

WEDNESDAY , MAY 24, 2017, 1:00-2:50 pm Eastern

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May 24, 2017

UBTI and UBIT for Exempt Organizations

Brenda A. Blunt, Tax Partner Eide Bailly, Phoenix bblunt@eidebailly.com Michael N. Fine, Partner Wyatt Tarrant & Combs, Louisville, Ky. mfine@wyattfirm.com Frank H. Smith, CPA, Partner Raffa, Washington, D.C. fsmith@raffa.com

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

UBTI and UBIT for Exempt Organizations: Mastering Form 990-T

Michael N. Fine Partner Wyatt, Tarrant & Combs LLP 500 W. Jefferson St. Suite 2800 Louisville, KY 40202

mfine@wyattfirm.com

Frank H. Smith CPA Raffa, P.C. 1899 L. Street, NW Suite 850 Washington, DC 20036

fsmith@raffa.com

Brenda A. Blunt, CPA, CGMA Tax Partner Eide Bailly LLP 1850 North Central Avenue, Suite 400 Phoenix, Arizona 85004

bblunt@eidebailly.com

Overview

Unrelated Business Taxable Income (“UBTI”) overview Form 990-T filing thresholds UBTI calculations and schedules

Tax computation Allocation of expense deductions Rent income (Schedule C) Unrelated debt-financed income (Schedule E) Exploited Activities (Schedule I) Advertising Income (Schedule J) Other Schedules

IRS Audit "Triggers" leading to increases in UBTI

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UBTI Overview

Section 501(c)(3) Limitation – Org. Test

Must be organized for one or more exempt purposes

Charitable, scientific, educational, religious

Must engage “primarily” in activities that further an exempt purpose

No “more than an insubstantial part” of total activities may be non-exempt purpose activities No “bright line” for determining insubstantial Subjective test comparing many factors

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UBTI Overview

Purpose: Eliminate unfair competition

Places business activities of EOs on the same tax footing as nonexempt business endeavors with which they compete

Applies to organizations exempt under IRC §§ 501(a), 501(c)(3), and 511(2)(A) Taxed on income derived from: Trade or Business Regularly Carried On Not Substantially Related to Tax-Exempt Purposes

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UBTI Overview

Trade or Business Any activity carried on for the production of income

Examples: Sale of goods or the performance of services Courts often look to profit motive, passivity, competition “Facts and circumstances” test

A single business activity may be divided into related and unrelated aspects Commercial activities do not lose their business identity because they are conducted by tax-exempt organizations Generating funds to be used for mission-related activities does not make a trade or business activity an exempt purpose activity Merely recovering costs without a profit motive ≠ trade or business

UBTI Overview

Regularly Carried On Frequency and continuity similar to comparable commercial activities of taxable organizations

Example: Hospital-operated sandwich stand at annual state fair

Not “regularly carried on”

Example: One-time lease of donated Boeing 747 jumbo jet

Not “regularly carried on”

Example: Christmas card program operated by veterans org.

Was “regularly carried on”

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UBTI Overview

Not Substantially Related Must demonstrate substantial causal relationship to exempt purposes

Activity must “contribute importantly” to accomplishing exempt purposes Scale matters: Retail grocery store as therapeutic program for emotionally disturbed adolescents

Substantially related: scale no larger than was reasonably necessary

Relationship must be substantial; not merely incidental

Proceeds from an art museum's sale of children's merchandise were not subject to UBIT But sale of scientific books and city souvenirs by museum of folk art considered unrelated trade or business

UBTI Overview

Common UBIT Activities Selling advertising

Example: Weekly bulletins, magazines, journals, or on websites

Selling merch. w/ no relationship to exempt purposes Leasing space in debt-financed buildings Earning income from parking lots open to the public

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UBTI Overview

Statutory Exclusions (1) Primarily for the convenience of patients or employees

– Example: Parking lot, cafeteria/coffee shop, pharmacy

(2) Substantially all of the work (approx. 85%) is done by volunteers

– Example: Gift shop staffed by auxiliary

(3) Substantially all of merchandise sold (approx. 85%) was donated

Example: Thrift Store

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UBTI Overview

Modifications Passive income with no active business participation or management

Examples: Dividends, interest, annuities, and royalties

Rent from real property

May include rental of “incidental” personal property Distinguish “rents” versus “fees for services”

Revenue from research activities

Distinguish scientific research from ordinary and routine testing All research revenue, including commercially sponsored research Extends to SMLLC owned by the org. (PLR 200223067)

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UBTI Overview

Pass-through Entities and UBTI

Partnership, LLC (two or more members), most REITs

Taxed as pass-through entities No entity level tax but activities are attributed to partners/members Income and expenses retains character to you as a partner/member Note special rules for S Corporations

Possible UBI issues:

Activities may adversely impact tax-exempt status of partner/member Pass-through income may, or may not, be taxable as UBI Cash distributions may not match with income recognition Pass-through share of UBI loss may not be deductible

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UBTI Overview

Debt-Financed Income

Taxed on dividends, interest, royalties, & rent if from “debt-financed” property Applies to property subject to “acquisition indebtedness” Property “substantially related” to the organization’s exempt purpose is not subject to the debt-financed property rules Leasing debt-financed MOB was ‘substantially related’ (Rev. Rul. 69- 464):

Makes medical care more accessible Improves the proximity of doctors to the hospital Increases use of the hospital’s facilities Makes it easier to admit patients Improves patient care

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UBTI Overview

Advertising versus Qualified Sponsorship Payments

Soliciting, selling, and publishing commercial advertising is a trade

• r business that generates UBTI

Advertising includes:

Endorsements Inducements to purchase, sell, or use the products or services Messages containing qualitative or comparative language, price information, or other indications

• f savings or value

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UBTI Overview

Advertising versus Qualified Sponsorship Payments Qualified Sponsorship

Recognizes a sponsor as a benefactor Uses or acknowledges the sponsor’s business name, logo, or product lines

You can:

Use logos or slogans that are part of the sponsor’s established identity Acknowledge a program underwriter on the air or during the broadcast

Payment cannot be contingent on broadcast ratings or other factors indicating the degree of public exposure

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UBTI Overview

Advertising versus Qualified Sponsorship Payments

Links to Website

Link to sponsor’s website without any endorsement = qualified sponsorship Link to sponsor’s website with an endorsement = advertising

Banner Advertisements

Used generally on the website = advertising Used as part of an online periodical = advertising, but deductions available

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UBTI Overview

Report UBTI on IRS Form 990-T May deduct expenses, both direct and indirect, attributable to the activity Must allocate “dual use” expenses (i.e., overhead) on a reasonable basis Losses from one unrelated activity may offset other UBTI Use excess losses from unrelated activities in prior years to offset UBTI Remaining UBTI, if any, is reduced by a $1,000 exemption Balance is taxed at regular income tax rates for corporations Exempt organizations required to make quarterly estimated payments

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UBTI Overview

Parting Thoughts

• Too much UBTI can jeopardize your tax-

exempt status Avoid using S Corporations (where possible) If any single unrelated and taxable activity begins to become a significant part of your

• rganization’s operations, consider creating

a separate, taxable legal entity to house that activity If an unrelated activity generates continuous losses sustained over a number of years, it may not have sufficient profit motive, and therefore, may not be available to offset income from profitable unrelated activities

www.eide ba i l l y . co m

Brenda A. Blunt, CPA, CGMA Tax Partner

bblunt@eidebailly.com 602-264-5844

UBIT Calculations and Schedules

www.eide ba i l l y . co m

Form 990-T Filing Thresholds

Deadlines and Payments

• Due date = 15th day of the 5th month
• Due date for employee’s trusts (including IRA’s, Coverdell

ESA and Archer MSA accounts) = 15th day of the 4th month

• Six month extension available
• $1,000 Exclusion
• Estimate tax payments
• Annualized method
• Large organizations
• Due the 15th day of the 4th, (5th for private foundations) 6th, 9th

and 12th months

• Payments required to be made electronically (EFTPS)
• Proxy tax on lobbying and political expenditures

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Form 990-T Filing Thresholds

Organizations with $10,000 or less in total UBI income only need to the header; Part I, lines 1-13 for Col A; Part I, line 13 for Col B and C; Part II, lines 29-34; Parts III-V and the signature area.

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Tax Computation

Tax rates

• Normal corporate/trust tax rules and

rates

• Trusts use Sch D to calculate tax on

capital gains

• Alternative Minimum Tax rules apply
• Controlled group rules also apply
• Proxy tax rate = 35%

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Tax Computation – Credits allowed

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Allocation of Expense Deductions

• Deductions not taken elsewhere
• Directly connected expenses
• Charitable contributions
• Overhead allocations / dual use property
• “Regular” tax rules apply to depreciation, section 179, inventory

capitalization, method of accounting, meals & entertainment, etc.

• Reasonable, necessary and consistent
• Documentation is key!
• Activities lacking a profit motive cannot generate losses

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Rent Income (Schedule C)

Definition and Exclusions

• Rents from real property are generally excluded from

UBTI, unless the rent is based on a percentage of the net income or profits of the lessee

• Real property is broadly defined
• Ex. Rooftop sites from telecommunications antennae

are considered rents from real property

• Rent received where exempt organization provided

services for the convenience of the renter is not exempt

• Ex. Renting parking spaces in a garage or lot does

not constitute rent from real property

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Unrelated Debt-Financed Income (Schedule E)

• Rents derived from debt-financed property not related to

the organization's exempt purpose are not excluded from UBTI

• Debt financed property:
• Property held to produce income; and
• Presence of acquisition indebtedness: debt incurred in connection with

the purchase or improvement of real estate, whether incurred before, after, or at the time of the acquisition

• Amount received that is taxable is the amount

corresponding to the ratio of the amount of the indebtedness relative to the organization's adjusted basis in the property

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Unrelated Debt-Financed Income (Schedule E)

Report on Sch E: Gross Rents (Col 2) Directly Connected Expenses (Col 3a and 3b) Note: Depreciation must use straight line method

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Unrelated Debt-Financed Income (Schedule E)

Average Acquisition Indebtedness (Col. 4)

• Outstanding debt on the first day of each month
• Add together
• Divide by the total number of months the
• rganization held the property (including any months

the property is owned after pay-off)

• In the year of disposition, use the highest debt

balance during the preceding 12 months.

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Unrelated Debt-Financed Income (Schedule E)

Average Adjusted Basis (Col. 5) Adjusted Basis – Cost, plus additions less depreciation, (allowed or allowable) since acquisition. Use depreciation for all years the property was owned, not just subject to UBI. Average Adjusted Basis – Adjusted Basis at the beginning and end of the year divided by 2.

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Unrelated Debt-Financed Income (Schedule E)

• Col. 6 (Leverage)

Average Acquisition Indebtedness (Col 4) Average Adjusted Basis of the Rental Property (Col 5)

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Unrelated Debt-Financed Income (Schedule E)

Debt-Financed Property Taxable Income

• Col. 6 (Leverage)

Gross Income (Col. 2) Gross Reportable Income

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Unrelated Debt-Financed Income (Schedule E)

Debt-Financed Property Taxable Income

• Col. 6 (Leverage)

Total Deductions (Col. 3a + 3b) Allocable Deductions

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Interest, Royalties and Rents from Controlled Organizations (Schedule F)

General Principle: When the organization has income from interest, annuities, royalties and rents that it received from a controlled organization subject to income tax, the income is UBI to the reporting exempt organization, if it reduces unrelated taxable income of the controlled

• rganization. (IRC §512(b)(13))

Only UBI if amounts exceeded FMV (Transfer Pricing rules) and paid pursuant to a written binding contract in place at 8/17/06

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Interest, Royalties and Rents from Controlled Organizations (Schedule F)

An entity is a “Controlled Organization” if the reporting entity owns:

• By vote OR by value more than 50% of a

corporation’s stock;

• More than 50% of a partnership’s profits OR capital

interest; or

• More than 50% of the beneficial interest in an
• rganization.
• Ability to control more than 50% of the vote (through the

power of appointment or otherwise) of an exempt

• rganization.

The constructive ownership rules of §318 apply. Use similar principles to determine interests in other

• rganizations.

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Exploited Activities (Schedule I)

• An unrelated activity that is connected to and “exploits” a

related activity

• Examples:
• Website
• Conference brochures and other non-periodical publications
• Career center
• Allowed to offset net unrelated income with net loss from

exploited activity

• Not a lot of guidance on how narrow or broad to define “exploited”
• Need to be able to identify exploited income and expenses

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Advertising Income (Schedule J)

• Is it really advertising?
• Advertising (call to action, comparative language, pricing,

endorsement)

• Acknowledgements
• Qualified sponsorship payments
• Marketing services/Affinity contracts
• Third party publishing contracts
• Does the publication qualify as a periodical?
• Can you consolidate the periodicals?
• Can electronic/website activities be considered

periodicals?

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Advertising Income (Schedule J)

Calculations

• Separate activities into “buckets”
• Advertising income
• Circulation income
• Subscriptions and reprints
• Allocation of membership dues
• Expenses
• Direct advertising
• Direct editorial
• Allocable costs (page count)

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Advertising Income (Schedule J)

• Net income from advertising can be offset by excess

readership costs

• Periodicals can be consolidated if advertising

income>25% of readership costs

• If third party publishing contract is an active

business, gather documentation that allows you to correctly determine treatment

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• G. Other Schedules
• Cost of Goods Sold (Schedule A)
• Investment income of 501(c)(7), (9) or (17)
• rganizations (Schedule G)
• Compensation of Officers, Directors and Trustees

(Schedule K)

• Percentage of time and compensation related to UBI

activities

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www.eide ba i l l y . co m This presentation is presented with the understanding that the information contained does not constitute legal, accounting or other professional advice. It is not intended to be responsive to any individual situation or concerns, as the contents of this presentation are intended for general informational purposes only. Viewers are urged not to act upon the information contained in this presentation without first consulting competent legal, accounting or other professional advice regarding implications of a particular factual situation. Questions and additional information can be submitted to your Eide Bailly representative, or to the presenter of this session.

IRS Audit Experiences

Frank H. Smith Partner, Tax

IRS Audit Triggers

• Referrals
• Form 990 Indicators

– High Number of Errors – Foreign Activities – Political Activities – High Executive Compensation – Excess Benefit Transactions – Fundraising Discrepancies

• UBI Related Triggers

– Continual Losses – Debt Financing – Advertising/Marketing/Royalties – Subsidiaries/Controlled Organizations/Pass-through Entities 48

Continued Losses

• IRS will scrutinize the continual reporting of losses

stemming from unrelated activities

–IRS wants to ensure deductions are properly allocated to unrelated activities –If business is consistently losing money, IRS may contend there is no requisite profit motive, and therefore organization cannot claim losses from that activity –May be legitimate reasons for continued losses: activity was in start up phase, competition, business cycle, etc.

• Important to document in case of audit

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Allocation of Deductions

• Expenses (such as overhead or facilities cost) may

be allocable to exempt activities and non-exempt activities.

–Allocation must be made on a reasonable basis, such as time –Important to substantiate and document consistent method and legal justification for allocating costs between exempt and non-exempt purpose

• Protects organization in the event of an audit

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Debt Financing Red Flags

• Rental or other passive income

AND

• Mortgage or signs of other debt

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Advertising/Marketing/Royalties

• Questions to ask

–What does the contract say?

• What terms are used?
• What is the nonprofit obligated to do?

–What does the nonprofit actually do? –Who is communicating with members? –How is the payment calculated?

• Separate Contract?
• Bifurcation?
• Lump sum amount?
• Percentage of income earned?

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Subsidiaries and Pass-through Entities

• If a subsidiary is an agent or instrumentality of a

non-profit, then subsidiary's activities are attributed to the exempt organization

–Consider relationship and terms of agreements between parties –Independence of subsidiary's directors –Ability of parent's ability to direct day-to-day activities

• Controlled Organizations
• Pass-through Organizations

–S Corps –K-1 Issues

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Excessive UBTI

• UBTI Constituting Substantial Portion of Total

Revenue

–If the activities leading to the generation of UBTI takes up substantial staff time or charitable resources, the

• rganization's exemption may be threatened
• Exempt organizations should ensure that UBTI makes up no more

than 25-30% of the organization's total revenue

–If an exempt organization generates considerable UBTI, it and its tax advisers should consider placing that business in a for-profit subsidiary –Must ensure for-profit subsidiary is not controlled by exempt parent

• Subsidiary's directors must be independent
• Parent should not direct day-to-day activity of subsidiary

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Contact Info

Frank H. Smith Partner, Tax Raffa

Helping Great Organizations Thrive T: 202.955.6735 F: 877.289.8541 Raffa.com LinkedIn: http://www.linkedin.com/in/frankhsmith

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