In determining whether the UBTI rules apply, a tax-exempt organization must first determine whether the income is from a trade or business. Any activity that is carried on for production of income and possesses the characteristics required to constitute a trade or business within the meaning of Sec. 162 will generally be considered a trade or business under the UBTI rules (Regs. Sec. 1.513-1(b)). The phrase “production of income” is important, as the regulations note that activities entered into with the intention to produce income will still be classified as a trade or business even if they generate a loss. Normally, investment income is not subject to UBTI tax such as interest income, dividends, and payments with respect to securities loans however, such income is taxable if it is derived from debt-financed property. In general, the term “debt-financed property” means any property held to produce income (including gain from its disposition) for which there is an acquisition indebtedness at any time during the tax year (or during the 12-month period before the date of the property’s disposal, if it was disposed of during the tax year). It includes rental real estate, tangible personal property, and corporate stock.
Second, any activity generating business income must be regularly carried on for its income to be considered UBTI. The regulations consider an activity to be regularly carried on if it has frequency and continuity, and is pursued in a manner, similar to comparable activities of nonexempt organizations (Regs. Sec. 1.513-1(c)(1)).
Lastly, to avoid classification as UBTI, the conduct of the trade or business that produces the income must be substantially related (other than the production of funds) to the purposes for which the exemption is granted (Regs. Sec. 1.513-1(d)(1)). An activity is related to the organization’s exempt purpose if it contributes importantly and bears a substantial causal relationship to the achievement of the exempt purpose (Regs. Sec. 1.513-1(d)(2)). UBTI effects tax-exempt organizations such as State colleges and universities, qualified pension, profit-sharing and stock bonus plans under Sec 401, Individual retirement accounts (IRSs) including Roth and SEP IRAs and Charitable remainder trust to name a few. These entities, in general, do not pay income taxes so the idea is to keep tax-exempt entities from competing unfairly with taxable businesses.
UBTI create reporting requirement for all pass-through entities. Pass-through entities have to inform their tax-exempt partners/members of any UBTI to enable them to compute their share and pay unrelated business income tax on that income using the regular corporate tax rates filed on Form 990T.
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.