On the Record: All that Glitters Isn't Tax Exempt
While the goal of any good fundraiser is to raise funds, it’s important to know that not all gifts are created equal. For instance: An alum gives his cattle ranch to his college or a patron gives the controlling interest of her business to the local art museum. These gifts might be of great value, but they also might have unexpected income-tax consequences for the receiving organizations.
Even though an organization is exempt from federal income tax, that doesn’t mean it never pays income tax. If the college retains the ranch or the museum keeps controlling interest in the business, the income generated by the gifts most likely will be characterized as unrelated business taxable income. As a consequence, the college or museum will be subject to unrelated business income tax (UBIT) at the regular corporate or trust rate on income it receives from the ranch or business.
If an exempt organization receives a donation of a business interest or other income-producing asset and sells it, no UBIT issue should arise. However, a prompt sale might not always be possible. The market for a particular asset might be depressed, or the asset might have restrictions on how and even if it can be transferred.
What UBIT is
UBIT is income earned by an organization from a regularly carried-on business that is not substantially related to the organization’s exempt purpose. Just because the organization uses the profits from the business to fulfill its mission, that doesn’t make the business substantially related to the organization’s exempt purposes. For example, even though all of the profits from a museum’s gift shop are used to support the museum, different income-tax rules apply to various types of merchandise. The museum will not be subject to UBIT on income from the sale of items such as posters of museum paintings, but it will be subject to UBIT from the sale of items not specifically related to the museum, such as sunglasses, mugs and other gift items.
Passive investment income such as interest, dividends and royalties generally is exempt from UBIT(1). However, special rules apply when an exempt organization owns an interest in a pass-through entity, such as stock in an S company or an interest in a partnership. If an exempt organization is given stock in an S corporation, all of the income attributable to the donated stock will be subject to UBIT. In addition, all of the income recognized by an exempt organization upon the sale of its stock in an S corporation is subject to UBIT, whereas the gain on the sale by an exempt organization of stock in a C corporation is not(2).
In some circumstances, exempt organizations will have UBIT by owning stock in an S corporation but would not have UBIT if it directly owned the asset owned by the S corporation. For example, if an exempt organization owns a bond, all of the interest income and capital gains on its sale are exempt from any tax. However, if the exempt organization owns shares in an S corporation that owns the bond, the exempt organization’s share of the S income attributable to the interest and capital gain on the bond is subject to UBIT.
Despite the passive investment exception, the income attributable to an exempt organization’s investment in a limited liability company or partnership could be subject to UBIT. In the case of an investment in a partnership, either as a general partner or as a limited partner, or in an LLC, an exempt organization must treat its share of the partnership or LLC income or loss as if it had conducted the business in which the partnership or LLC engages. Therefore, if the partnership or LLC actively conducts a business, the exempt organization’s income attributable to its ownership interest will be treated as UBIT, even if the income is not distributed to the exempt organization, and even if the exempt organization is merely a limited partner or a passive member of an LLC.
What UBIT is not
Numerous exceptions to the basic UBIT rule exist. The most common are:
- a business conducted substantially by volunteers, such as a PTA conducting a bake sale;
- a business conducted by a 501(c)(3) organization, such as a college or university, primarily for the convenience of its members, students, patients, officers or employees (a laundry service conducted by a university, for example); and
- an organization selling merchandise that has been donated for the purpose of sale (such as a school-operated thrift store or a bingo event).
All gains from the sale, exchange or other disposition of property other than inventory and property held primarily for sale to customers in the ordinary course of trade or business is not subject to UBIT. Consequently, the sale by an exempt organization of its investment portfolio is exempt from the tax.
Rental income received by an exempt organization from real property is exempt from UBIT. However, rental income from personal property is subject to the tax. Therefore, if a donor gives a vacant lot to the church next door and the church rents the real property to a third party, the rental income is not subject to UBIT. If a lease includes both personal property and real property, the amount of the rental income that could be subject to UBIT would be determined on a sliding scale tied to how the rental income is allocated between the personal and real property(3).
UBIT vs. CRUT
Charitable Remainder Unitrusts, which we discussed in our last column, are especially affected by the UBIT rules. In Newhall Unitrust v. Commissioner, 104 TC 236 (1995), the CRUT received unrelated business income from three of its investments. The U.S. Tax Court ruled that if a CRUT receives any amount of unrelated business income, the CRUT’s entire income for the year is subject to UBIT.
An exempt organization should be aware that if it is the remainder beneficiary of a CRUT and the CRUT receives unrelated business income, the CRUT will be subject to UBIT and, as a consequence, the potential remainder interest might be diminished.
Danger to exempt status
Finally, too much UBIT could cost an organization its exempt status. The permitted purposes of an exempt organization are spelled out within the Internal Revenue code and regulations, and those purposes do not include maintaining a business. The regulations stipulate that an organization will be exempt only if it is “both organized and operated exclusively” for exempt purposes and that only an “insubstantial part of its activities” can be unrelated to its exempt purposes. If not, the IRS could treat the organization as a business rather than an exempt entity.
In seeking or accepting a gift of a business interest, an exempt organization should consider whether the business is related to its purpose. (A donation of a working farm to an agricultural college might be sufficiently related.) If it is unrelated, organizations should gauge whether the income received from the business will be exempt under the many exceptions to the UBIT rules. The decision to accept an offered donation should be an informed one.
That way, if an otherwise generous donor wants to give the local orchestra a race horse, the orchestra can determine whether it wishes to accept the gift and its potential UBIT consequences, or whether it should look the gift horse in the mouth and respectfully decline.
1. An exception to this rule arises if the payment is made by an entity controlled by the exempt organization. That question and the operation of this rule are complex matters that are beyond the scope of this column.
2. Unlike a C corporation where the corporation pays taxes on its income and shareholders pay taxes on dividends received from the C corporation, an S corporation does not pay income taxes on its income but instead the income is passed to and taxed in the hands of the shareholder.
3. Debt-financed property presents a whole other array of UBIT issues, again, beyond the scope of this article. If an exempt organization is the beneficiary of an asset on which there is a mortgage it should be aware of the interplay between the debt-financed characteristics and the rules governing UBIT.
Kathleen Stephenson is of counsel with the Philadelphia office of Pepper Hamilton llp. Lisa B. Petkun is a partner in the Tax Department of Pepper Hamilton. “On the Record” keeps readers up to date on the latest tax and planning issues pertaining to fundraising endeavors and charitable organizations.