Unrelated Business Income Internal Revenue Code §512(b)
2nd in a Series
This tax tip is the second in a series of tax tips on unrelated business income (“UBI”) and addresses certain types of income as modifications that may be excluded from a tax-exempt organization’s calculation of UBI as addressed in the provisions of Internal Revenue Code (“IRC”) §512(b).
BACKGROUND
Under IRC §512(a), UBI is income that is not substantially related to the purpose for which tax-exempt status is granted to an organization. Income will be considered to be UBI if it is:
- Derived from a “trade or business”;
- “Regularly carried on” and;
- “Not substantially related” to the tax-exempt organization’s primary purpose and operations.
Once a tax-exempt organization has concluded that the income from an activity constitutes UBI, it should then review the modifications outlined in IRC §512(b) to determine if any of this income can be excluded under one of these provisions. These exceptions include, but are not limited to, the following:
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Certain Investment Income
Under IRC §512(b), one of the most significant modifications of income excluded from UBI is certain types of investment income. In determining UBI, dividends, interest, payments with respect to securities loans, annuities and other substantially similar income derived from ordinary investments are excludable. If the organization is financing the purchase of investments with borrowed funds, some or all of the investment income derived could be subject to UBI. A future tax tip in this series will address IRC §514 with respect to UBI and unrelated debt-financed income.
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Royalty Income
Under IRC §512(b)(2), all royalty income and associated expenses are excluded from UBI. IRC §512(b)-1(a)(2) provides that this modification to income allows royalty income to be excluded in full “whether measured by production or by gross or taxable income from the property, and all deductions directly connected with such income, are excluded from unrelated business taxable income.” However certain royalties related to debt-financed property must be included in the computation of unrelated business income.
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Rents
Under the provisions of IRC §512(b)(3), rents from real property, not debt-financed, are generally excludable from UBI, provided certain restrictions are met. If a landlord provides significant additional services, the income may be taxable. Additionally, if the rental arrangement is conditional, in whole or part, based upon an indeterminate event, the income may be taxable.Rents received from the rental of personal property are excludable only if leased together with real property and the rental income attributable to the personal property is considered incidental. For purposes of this provision incidental is defined as 10% or less of the total rental income. Any income generated from the rental of personal property in these types of situations which is not considered incidental would need to be analyzed for possible inclusion as UBI. In particular, if the rental income derived from personal property is in excess of 50% then none of the rental income, for both real and personal property, would be eligible to be excluded from UBI.
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Capital Gains
IRC §512(b)(5) states that gains or losses from the sale or other disposition of property are generally subject to tax as UBI. The exclusions as outlined in the code section do not apply to any inventory or property held primarily for sale to customers in the ordinary course of a trade or business.
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Research
Under the provisions of IRC §512(b)(7), (8) and (9), income derived from certain types of research are excludable from UBI. There are three primary types of research excludable from UBI. The first is research performed for the United States, any governmental agency or its instrumentalities. The second is research performed by any college, university or hospital performed “for any person”. The third type would be income derived by tax-exempt organizations which operate primarily for scientific research purposes and make the research results available to the public free of charge.Clinical trial and drug testing may be exempt as long as the overall purpose includes medical training or patient care. The IRS has released several private-letter rulings to clarify these healthcare exemptions. For example, in IRS PLR 8230002, the IRS addressed both “for benefit” and “not for benefit” drug testing. Any drug testing completed under the Food and Drug Administration (“FDA”) that offers experimental drugs to patients who are a carrier of a disease for which eventual commercial use of that particular drug is intended is exempt from UBI. However, the testing of drugs exclusively to meet FDA requirements may be taxable.These private letter rulings make several exceptions to a hospital’s medical education program. Testing services and experimental construction provided under this educational program are also exempt from unrelated business income.
IRC §512(b)(13)
IRC §512(b)(13) provides special rules that apply to certain types of income derived from controlled organizations. If a controlled organization is present, any interest, rents, annuities and royalties paid to the controlling exempt organization may be subject to tax as income from an unrelated business; according to the percentage of the income of the controlled organization that is unrelated business taxable income or would be unrelated business taxable income if the controlled organization were exempt.
However, please note that the Pension Protection Act of 2006 provides an exception to this rule wherein any interest, dividends, rents, annuities and royalties received from an IRC §512(b)(13) controlled organization are excluded from UBI if the arrangement is fair market value pursuant to arm’s length negotiations. This exception has been extended through December 31, 2013.
CONCLUSION
As noted in a previous tax tip, continued IRS interest and scrutiny in this area will continue to subject organizations to questions and examinations with respect to their UBI reporting and activities. All organizations should carefully consider reviewing their existing business activities to determine if any may constitute UBI and any new business ventures for UBI reporting. It is critical for tax-exempt organizations to understand these modifications to eliminate or reduce any potential UBI in these instances. Tax-exempt organizations should be cognizant that the intention of the provisions of IRC §512(b) is to prevent “loop-holes” in the tax system; by over or under valuing a tax deduction where the parties are not dealing in an arm’s-length transaction.
A complete copy of IRC §512(b) can be accessed in our Resource Center.
For more information on the topics discussed or services we can provide, please contact:
Scott Mariani, JD, Partner
Practice Leader
973.898.9494 ? [email protected]
Questions or comments?
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To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
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