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Exempt organization (EO) Future Tax Leader ProgramUnrelated business income update

February 21, 2019

Unrelated business income

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Your presenters

Joyce HellumsExecutive DirectorErnst & Young LLPAustin, TX

Mike CincottaSenior ManagerErnst & Young LLPBoston, MA

Jess WagenerManagerErnst & Young LLPChicago, IL


Agenda

► Introduction to unrelated business income (UBI)► Exclusions and modifications to UBI► Computing UBI – expense allocation► Common scenarios that can give rise to UBI► Effect of tax reform on UBI


Objectives

► Determine if an activity is an unrelated trade or business► Recognize the specific UBI exclusions and modifications► Recognize how to compute unrelated business taxable

income (UBTI) and recognize the common scenarios that can give rise to UBI

► Recognize the impact of tax reform on UBI


Introduction to unrelated business income


UBI basics: background and definitions

► IRC Section 511 – imposes a tax on UBTI of organizations described in IRC Sections 401(a) and 501(c), as well as state colleges and universities► The tax on UBTI was first enacted in 1950.► Purpose: to eliminate any unfair competitive advantage that exempt organizations

may have over their for-profit counterparts.

► IRC Section 512 – UBTI is composed of:► Gross income from unrelated trade or business (unrelated business

income), reduced by:► Allowable deductions directly connected to such trade or business


UBI basics: background and definitions (continued)

► IRC Section 513 – defines an unrelated trade or business as:► Any trade or business that is regularly carried on and the

conduct of which is not substantially related to the exercise of performance by such organization of its charitable, educational or other purpose or function constituting the basis for its exemption under IRC Section 501.

► Three components of UBI:► Trade or business► Regularly carried on► Not substantially related to exempt purpose


1. Unrelated?

2. Exclusion ormodification?

3. Compute $

Determining UBTI in three steps


Step 1: Is it unrelated?

► Is the activity:► A trade or business?► Regularly carried on?► Not substantially related to the organization’s exempt purposes?

1. Unrelated?


“Trade or business” requirement

► IRC Section 162 definition used► Any activity carried on for the production of income from the sale of goods

or performance of services ► Profit motive: an activity will not be considered an unrelated trade or

business unless the organization’s primary motive is to earn a profit.► Competition/commerciality:

► Activity must be of a type that presents sufficient likelihood of unfair competition with non-exempt business endeavors► It does not matter if actual competition with taxable entities takes place

► Activities consistently producing losses:► May be evidence of a lack of profit motive


“Regularly carried on” requirement

► Concept: ► There must be a frequency and continuity similar to the activities of a

comparable non-exempt commercial enterprise. ► Normal time span:

► If the exempt organization is acting in a manner similar to a taxpaying entity, then the business would be considered regularly carried on.► Where income-producing activities are of a kind normally conducted by

commercial entities on a year-round basis, the conduct by an EO of such activities over a period of a few weeks is not regularly carried on.

► Conduct of year-round activities of commercial enterprise for one day each week by an EO would constitute being regularly carried on.

► Seasonal activity:► If conducted during time of year that commercial entities would operate,

then regularly carried on (sale of Christmas trees)► Intermittent activities – can be considered regularly carried on


“Not substantially related” requirement

► In order for an activity to be “related” (as opposed to an unrelated activity), there must be a substantial causal relationship to the achievement of tax-exempt purposes:► Facts and circumstances determination► Activity is examined (not how income from the activity will be used)

► Type of relationship required: The activity must contribute importantly to the accomplishment of the organization’s exempt purposes.

► Size and extent of activities must be appropriate: If activities are conducted on a basis larger than necessary to accomplish exempt mission, the excess is taxable.


Polling question

► Which one of the following is not a required component of UBI?A. Not substantially related to exempt purposeB. Trade or businessC. Must result in a profit annuallyD. Regularly carried on


Exclusions and modifications to UBI


Step 2: Excluded?

► Section 513 provides specific UBTI exclusions.► Principal exclusions:

► Same-state rule► Convenience exception► Volunteer labor exception ► Donated goods exception

2. Exclusion?


Same-state exception

► Treas. Reg. Section 1.513-1(d)(4)(ii)► General rule:

► Gross income resulting from the sale of products that result from the performance of exempt functions will not be considered UBTI if the products are sold in substantially the same state that existed at the completion of exempt functions.

► Example:► Consider an experimental dairy herd maintained for scientific purposes by

a Section 501(c)(3) research organization. Income from the sale of milk and cream produced in the ordinary course of operations would not be UBTI. If the milk and cream were later used to manufacture ice cream and pastries, the gross income from the sale of such products would be UBTI, unless this also contributed importantly to the organization’s exempt purposes.


Convenience exception

► Section 513(a)(2)► General rule:

► UBTI does not include income from a trade or business carried on by the organization primarily for the convenience of its members, students, patients, officers or employees.

► Applies only to: ► Section 501(c)(3) organizations, and colleges and universities

subject to UBTI.► Certain sales by local association of employees under Section

501(c)(4).


Volunteer labor and donated goods exceptions

Volunteer labor exception► Section 513(a)(1): provides that any trade or business in which substantially

all the work in carrying on the trade or business is performed for the organization without compensation is not an unrelated trade or business:► “Substantially all”

► 85% or more – see PLR 8433010.► Without compensation

► Tips can be considered compensation.► Noncash fringe benefits, such as meals, can be considered compensation.

Donated goods exception► Section 513(a)(3): provides that UBTI does not include income from a trade

or business that involves the selling of merchandise substantially all of which was donated

► Example: thrift store


Sponsorship payments

► Code Section: §513(i)► Background: payments received from a corporation (or other business

entity) to sponsor an organization’s activity are often referred to as “corporate sponsorship payments.” If the payment constitutes a “qualified sponsorship payment’” it will be excluded from UBI under Section 513(i).► Nonqualified sponsorship payments may be treated as UBI.

► Definition of “qualified sponsorship payments”► Any payment made by any person engaged in a trade or business with

respect to which there is no arrangement or expectation that such person will receive any “substantial return benefit” other than the use or acknowledgment of the name, logo or product lines of such person’s trade or business in connection with the activities of the organization that receives such payment.


Sponsorship payments (continued)

► “Substantial return benefit” is defined as any benefit other than:► Use or acknowledgement of the payor’s name or logo in connection with

the exempt organization’s activities, or► Certain “benefits” with insubstantial value (2% test) provided to the payor

in connection with a payment to the exempt organization ► If the benefits are insubstantial (FMV of benefits are <= 2% of total payments):

they are disregarded► If the benefits are substantial (FMV of benefits are > 2% of total payments): the

total FMV of the benefits is considered a substantial return benefit and may be subject to UBI

► The term “benefits” may include:► Advertising► Exclusive provider arrangements► Goods, facilities, services or other privileges; and► Exclusive or nonexclusive rights to use an organization’s intangible assets,

such as trademark, patent, logo or designation


Sponsorship payments (continued)

► Special rules► Contingent payments

► The term qualified sponsorship payment does not include any payment the amount of which is contingent, by contract or otherwise, upon the level of attendance at one or more events, broadcast ratings or other factors indicating the degree of public exposure to the sponsored activity.

► Determining public support under §170(b)(1)(A)(vi) and §509(a)(2):► Qualified sponsorship payments are treated as contributions received

by the exempt organization.


Hospital services under IRC Section 513(e)

► The term “unrelated trade or business” does not include the furnishing of one or more support services described in Section 501(e)(1)(A) to other unrelated exempt hospitals described in Section 170(b)(1)(A)(iii) if such services:► Are furnished solely to such hospitals that have no more than

100 inpatient beds► Would, if performed on its own behalf by the recipient hospital, constitute

an activity consistent with that hospital’s exempt purposes► Are provided at a fee or cost that does not exceed the actual cost of

providing such services► The list of excludable support services is specific. It includes many

common services (e.g., data processing, billing, personnel), but not laundry.


Hospital services under IRC §513(e)

► Exempted services under IRC Section 513(e) – refer to IRC Section 501(e):► Data processing► Purchasing (including purchase of insurance on a group basis)► Warehousing► Billing and collection► Food► Clinical► Industrial engineering► Laboratory► Printing► Communications► Record center► Personnel services


UBTI: other statutory exclusions

► Certain qualified public entertainment activities. IRC Section 513(d)(2)

► Certain qualified convention and trade show activities. IRC Section 513(d)(3)

► Certain bingo games. IRC Section 513(f)► Certain pole rentals by mutual or cooperative telephone or

electric companies. IRC Section 513(g)► Certain rentals and exchanges of mailing lists among

certain exempt organizations. IRC Section 513(h)► Qualified corporate sponsorship payments. IRC Section

513(i)


Polling question

► Which of the following benefits would likely not be considered a “substantial return benefit” for purposes of determining if qualified sponsorship payment is required to be treated as UBI by the recipient?A. Use or acknowledgment by the recipient organization of the name,

logo or product lines of the sponsorB. Sporting event tickets with a fair-market value greater than 2% of

the value of the sponsorship paymentC. An exclusive-provider arrangement


UBTI: modifications

► Section 512(b) specifies modifications that carve out certain types of income from UBTI.

2. Modification?


UBTI: modifications (continued)

► Principal modifications:► Interest and dividends► Royalties► Rents► Gains and losses from the sale, exchange or other disposition of

property► Income from research activities► Income from S corporations

► Flow-through income from S corporation is treated as UBTI► Gain or loss from the sale of an S corporation interest is treated as

UBTI


Passive income

► Generally, passive income is not considered UBTI.► This rule applies to interest, dividends, annuities, royalties

or rents received (Sections 512(b)(1)-(3)). ► There are several exceptions with respect to passive

income: ► Income received from controlled organizations (Section

512(b)(13))► This exception does not apply to dividends.

► Income from debt-financed property (Section 512(b)(4))


Royalties

► Royalties are generally excluded under IRC Section 512(b)(2).► To be a royalty, a payment must relate to the use of a valuable

intellectual property right (e.g., copyright, trademark, trade name).► Royalties do not include payments for personal services.

► A royalty is, by definition, “passive”, and thus cannot include compensation for services rendered by the owner of the property.► Key question: Are services being performed in conjunction with the use of a

“valuable right?”

► An exempt organization is permitted to perform certain types of services to protect/safeguard its licensed property rights without jeopardizing the royalty exclusion.► Example: quality control rights (i.e., retaining the right to approve the

quality or style of the licensed product)


Rental income

► Generally, rents of real property are excluded from UBI under IRC Section 512(b)(3); rents of personal property are not excluded.► Special rules apply when rents are received from personal

property leased with real property (mixed lease). See next slides.► Exceptions to rental exclusion (see next slides for detail):

► Rents based on net income or profit ► Substantial services ► If rents are derived from controlled organizations (Section 512(b)(13))

or debt-financed property (Section 514), they are included in computing UBI to the extent provided in those sections.


Rents from real property: mixed leases with personal property

► Rents from personal property leased with real property (mixed leases) are excluded where the rent from personal property is an “incidental” amount of the total rent.► Rent from personal property is considered incidental if the rent attributable to it

does not exceed 10% of the total rents from all the leased property.► Where the rent attributable to the personal property is more than 10% but does not

exceed 50% of the total rent, only the rental income attributable to the real property is excluded from UBI.

► Where the rent attributable to the personal property is more than 50%of the total rent, none of the rent (including the rent from real property)is excluded.

► Summary of mixed leases:► Personal property ≤ 10% = all rents excluded► Personal property > 10% but ≤ 50% = only real property rents excluded► Personal property > 50% = no rents excluded


Rents from real property based on net profits

► Rental income exclusion does not apply if real or personal property rentals are measured by reference to the net income or profits from the property.► However, a lease based on a fixed percentage of the gross

receipts or sales will not be taxed solely by reason of such lease. IRC Section 512(b)(3)(B)(ii)


Rents from real property: rendering of personal services

► General rule: Payments for the use or occupancy of rooms or other space where services are also rendered to the occupant do not constitute rent from real property.

► Services are considered rendered to the occupant if they are primarily for his/her convenience and are different from those usually or customarily rendered in connection with the rental of rooms or space for occupancy only.► Example: supplying of maid services

► The furnishing of heat and light; the cleaning of public entrances, exits, stairways and lobbies; and the collection of trash are not considered services rendered to the occupant.


Income from controlled organizations

► Generally, passive income (interest, annuities, royalties and rents) is excluded from UBI.

► Exception under IRC Section 512(b)(13) for qualified specified payments (if met, then the income is UBI):► Interest, annuities, royalties and rents (net of any directly connected

deductions) received or accrued by a controlling entity from a controlled entity

► To the extent the payment reduces the net unrelated income of the controlled entity (or increases net unrelated loss):► Net unrelated income for an exempt organization is its UBI► For a non-EO entity, the portion of its taxable income that would be UBI

if the taxable entity were exempt and had the same purposes as thecontrolling organization

► Exception to this exception: payments made at arm’s length pursuant to a written binding contract in effect on August 17, 2006


Income from controlled organizations

► Control defined► An entity is a “controlled” organization if the controlling

organization owns:► By vote or value more than 50% of the corporation’s stock► More than 50% of a partnership’s profits or capital interests► More than 50% of the beneficial interests in an organization (other

than a corporation or partnership)► An exempt parent organization is treated as controlling any

subsidiary in which it holds more than 50% of the voting power or value, whether directly (as in first-tier sub) or indirectly (as in second-tier sub).

► To determine the ownership of a corporation, a partnership or any other organization, apply the principles of Section 318 (constructive ownership).


Gains or losses from dispositions of property: IRC §512(b)(5)

► General rule: Gains or losses from the sale, exchange or other disposition of property do not constitute UBI.► Exceptions:

► Stock in trade or other property of a kind that would properly be includable in inventory if on hand at the end of the tax year

► Property held primarily for sale to customers in the ordinary course of the trade or business

► If gain/loss is derived from the sale or other disposition of debt-financed property, it is included in UBI to the extent provided in Section 514.


Research activities

► General rule – income from research activities is excluded in computing UBI if the research is performed:► For the United States, or any of its agencies or instrumentalities, or any state or

political subdivision thereof (IRC Section 512(b)(7))► For any person by a college, university or hospital (IRC Section 512(b)(8))► For any person by an organization operated primarily for the purpose of carrying on

fundamental research; the results of such research must be freely available to the general public; the key consideration with respect to this modification is that the nature of the research is “fundamental” rather than “applied” (IRC Section 512(b)(9))

► The term “research” is not defined in the IRC. However, the Treasury regulations indicate that research does not include activities of a type ordinarily carried on as an incident to commercial or industrial operations; for example, the ordinary testing or inspection of materials or products, or the designing or construction of equipment or buildings.


IRC Section 512(e): special rule applicable to S corporations

► General rule – if a Section 501(c)(3) organization (or trust which is part of a Section 401(a) qualified plan) holds stock in an S corporation:► Such interest shall be treated as an interest in an unrelated trade

or business.► All items of income, loss or deduction, as well as any gain or loss

on the disposition of the stock in the S corporation, are treated as unrelated business income.


IRC Section 512(b)(4) and Section 514: debt-financed property

► Income from debt-financed property is taxable in proportion to which the property is debt-financed.

► Debt-financed property:► Usually associated with real property and improvements to real property► Definition: all property held to produce income with respect to which there

is an “acquisition indebtedness” at any time during the tax year► Examples: rental real estate, tangible personal property and corporate stock

► Deductions directly connected with the property or its income are allowed in the same proportion.

► Depreciation must be computed on the straight-line method.


Exceptions to debt-financed property

► Property with a substantially related use: the term “debt-financed property” does not include:► Any property in which substantially all (at least 85%) of its use is related to

the organization’s tax-exempt purpose.► Thus, up to 15% of the use of the property can be unrelated and avoid UBI.

► If the foregoing provision does not apply, any property to the extent that the use of the property is substantially related.

► Examples:► A hospital constructs a 10-story building with borrowed funds and leases

out one floor to an unrelated tenant. Since at least 85% of the building (9 of 10 floors, or 90%) is used by the hospital in carrying out its exempt functions, the rental income will not be subject to the debt-financed property rules.

► If less than 85% of the building is used by the hospital, a portion of the rental income would be UBI (portion attributable to use which is not substantially related to the hospital’s exempt purpose).


Exceptions to debt-financed property rules

► Substantial use for exempt purpose IRC Section 514(b)(1)(A)

► Neighborhood land rule IRC Section 514(b)(3)(A)► Used by related exempt organizations IRC Section

514(b)(2)► Research activities IRC Section 512(b)(1)(C)► Medical clinics IRC Section 514(b)-1(c)(1)► Life income contracts IRC Section 514(b)-1(c)(3)► Income already included in UBI IRC Section 512(b)(1)(B)


Polling question

► Which of the following items of income would be considered UBI?A. Gain from the sale of publicly held securitiesB. Income from debt-financed property, substantially all of which is

used in furtherance of the organization’s exempt purposesC. Interest, rents and royalties from non-controlled organizationsD. Rental of property where more than 50% of the property rented is

personal property (i.e., not real property)


Computing UBTI


Step 3: Computing UBTI

Three baskets of expenses:► Directly connected to UBTI activity – proximate and primary – deduct

in full► Exempt/related expenses – do not deduct ► Dual-use – allocate on a reasonable basis

3. Compute $ Gross income (after modifications and exclusions)Less:

“Directly connected” deductionsSpecific deduction (generally, $1,000)= UBTI


Unrelated business income deductions: allocation methodology

► Treas. Reg. Section 1.512(a)-1(a) imposes two criteria for deductionagainst UBI:► Only deductions allowed under the IRC (e.g., 162, 167) may be taken

against UBI.► Deductions must be “directly connected with” activity that produced

the UBI.► Direct connection: Costs have proximate and primary relationship to the

carrying on of the business that generated the UBI.► The IRS has argued that for an expense to be directly connected with an

activity, it must be one that would not have been incurred in the absence of the activity.

► The Tax Court has placed the burden on the taxpayer to prove direct connection to deductions. CORE Special Purpose Fund v. Comm’r, TC Memo 1985-48 (Tax Court disallowed deductions – taxpayer did not prove actual incurrence of expenses, or that the expenses were directly connected with an unrelated trade or business activity that generated UBI).


Unrelated business income deductions: related expenses

► Identify those expenses that are strictly for exempt purposes and do not use those expenses to offset unrelated business income. Also, do not use those expenses in management and general and administrative that are program- or fundraising-related.

► Examples:► Development officer and fundraising expenses► Government relations► Community benefit studies


Unrelated business income deductions: dual-use property

Dual use of facilities or personnel► Where facilities or personnel are used for both exempt

functions and the conduct of unrelated trade or business, the expenses, depreciation and similar items attributable to such facilities or personnel must be allocated between the two uses on a reasonable basis. See Reg. Section 1.512(a)-1(c).


Unrelated business income deductions: allocation methodology

► Examples of categories of expenses that may be allocated on a “reasonable basis”:► Depreciation► Personnel costs► Rent for dual-use space► Utilities► Maintenance

► Examples of what may constitute “reasonable allocation” ► Hours spent: to allocate payroll taxes, employee benefits and pensions

related to persons performing both related and unrelated activities ► Square footage: to allocate depreciation, maintenance, utilities and other

fixed expenses of a facility in which unrelated functions are conducted continually in designated areas

► Gross receipts: variable expenses, such as cost of goods sold


Calculating unrelated debt-financed income

► Step 1: Determine the average adjusted basis► Step 2: Calculate the average acquisition indebtedness ► Step 3: Calculate the debt/basis percentage► Step 4: Apply the debt/basis percentage to the income

generated by the property in order to determine the amount of UBI


Step 1: Calculate the average adjusted basis

► Average adjusted book basis of property as of first and last day during tax year organization holds property

► Example: office building purchased on July 10, 2017 for $510,000 using $100,000 of borrowed funds

► During 2017, $20,000 taken for depreciation ► As of December 31, 2017, the adjusted basis of the

building is $490,000► Average adjusted basis = ($510,000 + $490,000)/2 =

$500,000


Acquisition indebtedness §514(c)(1)

► Unpaid amount of debt incurred:► To acquire or improve property► Before acquiring or improving property if debt would not have been

incurred except for acquisition or improvement► After acquiring or improving property if:

► Debt would not have been incurred except for acquisition or improvement

► Incurring debt was reasonably foreseeable when property was acquired or improved


Acquisition indebtedness (continued)

► Change in use► If organization converts property from an exempt purpose to an unrelated

purpose, outstanding principal debt on property, if any, is treated as acquisition indebtedness

► Continued debt► If organization sells property without paying off debt, and buys property

with proceeds, unpaid debt from original property is acquisition indebtedness for new property

► Property acquired subject to mortgage or lien► Outstanding principal debt is treated as acquisition indebtedness

► If title to property is encumbered by lien, the lien is treated as acquisition indebtedness

► Exception► For property acquired by gift/bequest/devise


Debt that is not acquisition indebtedness

► Debts incurred in performing an exempt purpose §514(c)(4)

► Annuity obligations §514(c)(5)► Security loans (unless EO incurred debt to buy the loaned

securities) §514(c)(8)► Real property debts of qualified organizations §514(c)(9)

► Qualified pension or retirement plan under Section 401(a)► Educational organization described in 170(b)(1)(A)(ii)► Title-holding company described in 501(c)(25)


Step 2: calculate the average acquisition indebtedness

► Add outstanding principal balances as of first day in each month and divide sum by number of months property was held during year (partial months treated as full months)

► What is average acquisition indebtedness for 2017 with respect to the office building?► Math time!

► Therefore: (average acq. indebted. $900k)/(12 months) = $75k

Month Indebt. on first day of monthJanuary $100k

February $100k

March $100k

April $100k

May $100k

June $100k

July–December $50k – because $50,000 of the debt was paid off in July


Selling debt-financed property

► Must use the highest acquisition indebtedness with respect to the property for the 12-month period before the date of the disposition.

► If acquisition indebtedness is paid off more than 12 months preceding the sale of the property, none of the gain on the property disposition is taxable.


Step 3 and Step 4: calculation of income generated from debt-financed property

► The average acquisition indebtedness for the year is $100,000

► The average adjusted basis is $500,000► 514 debt/basis ratio = $100,000/$500,000 = 20%► Assume yearly rent amount is $100,000 generated from

the office building► UBI generated from the debt-financed property =

20% * $100,000 = $20,000


Polling question

► True or false: Debt must be considered “acquisition indebtedness,” as described in §514(c)(1), in order for income from property financed with the debt to be considered UBI?


Common scenarios that can give rise to UBI


Specific categories of UBI

► Laboratory services► Pharmacy sales► Cafeteria► Parking facilities► Fitness facilities/health clubs► Gift shops► Sale of durable medical equipment (DME)► Management and other administrative services► Medical office buildings (MOBs)► Alternative investments► Joint ventures ► Telemedicine and accountable care organizations (ACOs)


Laboratory services

► The IRS has adopted a patient/non-patient approach to determining the taxation of laboratory services. Lab services performed for:► Patients – not UBI ► Non-patients – generally is UBI

► Private patients of hospital staff physicians are not patients.

► A “patient” is defined in Rev. Rul. 68-376.


Laboratory services (continued)

► Definition of a patient (Rev. Rul. 68-376):► A person admitted to the hospital as an inpatient► A person receiving general or emergency diagnostic, therapeutic or

preventive health services from outpatient facilities of the hospital► A person directly referred to the hospital’s outpatient facilities by his

or her private physician for specific diagnostic or treatment procedures

► A person refilling a prescription written during the course of his or her treatment as a patient of the hospital

► A person receiving medical services as part of a hospital-administered home care program

► A person receiving medical care and services in a hospital-affiliated extended care facility


Laboratory services (continued)

► Provision of lab services to patients of affiliated entities in a health system generally will not result in UBI► PLR 9102035, 9837031, 9102034

► Exceptions to non-patient rules:► Training/education – testing contributes importantly to nurses,

medical students, interns, residents or physicians► Isolated rural area not adequately served by

commercial laboratories► Specialized facilities/capabilities – technologically advanced

facilities that perform tests that could not be adequately performed at other medical laboratories, or, in emergency, necessary tests performed faster than by other medical labs in area


Pharmacy sales

► Sale of pharmaceutical supplies by a tax-exempt hospital’s pharmacy to “patients” is not UBI (see Rev. Rul. 68-376):► Same definition of patient including exceptions applies

► Sales to general public (non-patients) will likely be UBI: ► Example: if a hospital maintains pharmacy on the ground level of

the building, giving the general public access from the street, and such sales are frequent and continuous► However, hospital pharmacy sales to the general public where the

sales are not promoted by the hospital, do not occur with frequency and represent only an insignificant portion of the pharmacy’s sales are likely to not be considered UBI.


Pharmacy sales (continued)

► Additional exceptions for pharmacy sales are:► Pharmacy sales to employees (convenience exception)► Note: sale of pharmacy services to patients of affiliated entities

under common control should not generate UBI. See PLR 9241055


Cafeteria

► In Rev. Rul. 69-268, the IRS held that the operation of a cafeteria and coffee shop primarily for employees and medical staff by a tax-exempt hospital does not constitute an unrelated trade or business.

► The IRS also held that permitting use of the cafeteria by visitors to the hospital does not constitute an unrelated trade or business, since such usage would enable visitors to spend more time with the patients and such support is a vital component of therapy.

► Promotion to general public: One of the premises of Rev. Rul. 69-268 was that the general public was not encouraged to use the cafeteria.

► Potential UBI is catering services.


Parking facilities (Tax reform/new Section 512(a)(7) discussed later)

► Use by patients, visitors and staff does not constitute an unrelated trade or business. See Rev. Rul. 69-269

► Use by the general public: operation of a parking lot or garage that is open to the public generally results in unrelated business income, unless the activity satisfies one of the exceptions or exclusionsfrom UBI:► Substantially related activity ► Not regularly carried on► Convenience exception► Volunteer services

► Changes stemming from tax reform (new Section 512(a)(7)) discussed later


Fitness facility/health club (Tax reform/new Section 512(a)(7) discussed later)

► IRS rulings in this area indicate that operation of a health club in a manner similar to a commercial business (a fee structure that restricts membership to a small community segment) constitutes UBI.

► In Rev. Rul. 79-360, the IRS stated that the operation of a health club would not be considered an unrelated trade or business if it is distinguishable from commercial health clubs.


Fitness facility/health club (Tax reform/new Section 512(a)(7) discussed later)

► Factors that distinguish a fitness facility from a commercial health club:► Fitness center integrated into other health care-providing activities

(rehab for patients of affiliated hospital)► Fee structure that permits significant segment of the community to

be able to afford► Scholarship programs for individuals who cannot afford► Accessible to and/or equipped for the handicapped

► Other mitigating factors:► Proximity to primary health care providers► Fees below comparable commercial fitness centers


Gift shops

► Substantially related to exempt purposes► E.g., promotes welfare of patients (if in a health care setting)

► Convenience exception► Operates for the convenience of employees and visitors

► Could be UBI if competing with for-profit business► Gift shops located in medical office buildings ► Internet sales to the public


Medical office buildings

► Rental of debt-financed space generally generates UBI, unless an exception to the debt-financed rules applies.

► The IRS has ruled that leasing an adjacent office building to physicians was a substantially related activity of the hospital.► Rev. Rul. 69-464

► The IRS has also ruled that leasing of an adjacent office building, along with furnishing certain office services (nursing, secretarial, billing, collections and recordkeeping services) to a hospital-based medical group, was a substantially related activity of the hospital.► Rev. Rul. 69-463


Management and administrative services

► The IRS generally takes the position that management and administrative-type services provided by a charitable organization to an unrelated organization constitute an unrelated trade or business. ► See Rev. Rul. 72-369, where the IRS ruled that an organization formed to

provide managerial and consulting services at cost to unrelated exempt organizations did not qualify for tax-exempt status, because the provision of those services constituted a trade or business that would ordinarily be carried on for profit.

► See also Rev. Rul. 69-633 and BSW Group v. Commissioner, 70 T.C.352 (1978).

► Administrative services provided to closely affiliated exempt organizations are generally not UBI.► See PLRs 8626102, 8649081, 8909056 and 9016053.


Alternative investments

► What is an alternative investment? Investments in non-traditional asset classes:► Hedge funds► Private equity funds► Venture capital funds► Real estate partnerships and trusts► Commodities

► Many may be structured as partnerships or similar “pass-through” entities.


UBI from alternative investments

► Three ways that a fund organized as a pass-through entity may generate UBI:► Operation of a trade or business

► Example: a timber partnership► Borrowing to make investments

► Example: a commodities fund that borrows 9X capital to make large investments in future contracts

► Flow-through from other investments► Example: a fund of funds that invests in other partnerships

► UBTI information by a partnership► Section 6031(d) of the Internal Revenue Code:

► “The information required … to be furnished to its partners shall include such information as is necessary to enable each partner to compute its distributive share of partnership income or loss … in accordance with Section 512(a)(1)”.


Telemedicine

► What is telemedicine?► Telemedicine seeks to improve a patient’s health by providing two-

way, real-time interactive communication between the patient and a physician at a distant site.

► Delivery models► Real-time interactions between a patient and a provider► Provider remotely monitors the patient► Provider reviews images, test results, samples

► Asynchronous (store and forward)► Provider-to-provider consult

► With the passage of the Affordable Care Act (ACA), the use of telemedicine is expected to grow.


Telemedicine (continued)

► Telemedicine and unrelated business income► To date, there has not been any IRS guidance or rulings on the

unrelated business income treatment of telemedicine services.► Presumably, the IRS will apply existing principles when analyzing

telemedicine services.► Traditional approach to patient care services: patient/non-patient

approach► Services provided to a patient: not UBI► Services provided to a non-patient: UBI

► Patient/non-patient approach focuses on whether the hospital (its employees or agents) is providing “hands-on” health care services

► Alternative theory: IRC §513(a)(2) – a trade or business carried on by IRC §501(c)(3) “primarily for the convenience of its … patients” is not considered an unrelated trade or business


Effect of tax reform on UBI


Tax Cuts and Jobs Act (TCJA): Most significant tax legislation in 30 years

► Seven brackets: 10%, 12%, 22%, 24%, 32%, 35%, 37%► Standard deduction set at $24k for joint returns, $12k for

single filers; personal exemptions repealed► Net capital gains and qualified dividends retain current law;

subject to 3.8% net investment income tax► Individual AMT retained; exemption amount increased;

estate tax exclusion increased to $10m► Child tax credit increased to $2k, $1,400 refundable; phase-

out increased to $200k (single) and $400k (MFJ)► Principal cap on deductible home mortgage interest for new

mortgages (after 12/15/17) reduced from $1m to $750k; deduction retained for second homes but no longer available for home equity lines

► Itemized deductions subject to 2% floor repealed► Medical expense deduction would apply to expenses that

exceed 7.5% of AGI in 2017 and 2018 and 10% after► 50% AGI limitation for charitable contributions increased to

60% for gifts of cash to specified organizations► State and local deduction available for $10k of property and

income (or sales) taxes► ACA “shared responsibility payment” reduced to $0

► 21% corporate rate, beginning 2018; corporate AMT repealed

► 20% deduction for domestic “qualified business income” from a partnership, S corporation or sole proprietorship

► Limits interest deduction to 30% of earnings before interest, tax, depreciation and amortization (EBITDA) for four years, thereafter 30% of earnings before interest and tax (EBIT); worldwide debt limit removed

► Bonus depreciation increased from 50% to 100% for “qualified property” placed in service after 9/27/17; starting in 2023, phase-down of 20% for five years

► Establishes exemption for dividends received by US corporations from 10%-owned foreign corporations

► Transition tax on deferred foreign earnings – 15.5% (cash)/8% (non-cash)

► New broad-based anti–deferral provision taxes global intangible low-taxed income (GILTI) on a current basis at 10.5% effective tax rate (some FTCs available)

► New deduction for “foreign-derived intangible income”► New base erosion anti-abuse tax (BEAT) provision; minimum

tax of 10% (5% transition rate in 2018) applied on income determined after adding back deductible payments made to related foreign persons

Top individual provisions Top business provisions


Key provisions directly affecting tax-exempt organizations


Overview of provisions that are in the TCJA

► The bill contains numerous changes to the business and individual sections of the IRC, including the following provisions of key interest to tax-exempt organizations:► Changes to charitable giving incentives, including increasing the standard

deduction and the estate and gift tax exemptions► An excise tax on the investment income of private colleges and

universities► An excise tax on certain compensation paid by tax-exempt organizations► Treating expenses of certain fringe-benefit programs as UBTI► Requiring UBTI to be calculated on a per-business, rather than per-entity,

basis► Repeals tax-exempt status of advance refunding bond issuances► Reducing business tax rates, limiting net operating loss deductions, and

providing for immediate expensing of certain property


Provisions not in the TCJA but might resurface

► Clarification of UBTI treatment of entities treated as exempt from taxation under Section 501(a) (“dual-status” entities)

► Income from sale or license of name or logo treated as UBTI► Simplification of excise tax on private foundation investment income► Exemption from private foundation excess business holding tax for

certain independently operated philanthropic business holdings► Modifications to tax on excess benefit transactions► Modifications to prohibition of candidate support or opposition by

Section 501(c)(3) organizations► Repeal of exempt status of private activity bonds► Disclosure and/or payout requirements for donor-advised funds

(DAFs)


UBTI to be separately computed for each trade or business


UBTI to be separately computed for each trade or business

► Prior law: UBTI is calculated by aggregating the gross income from all unrelated trades and businesses and then subtracting the aggregate deductions directly connected with producing that income.

► New provision: Section 512(a)(6) requires an organization subject to the unrelated business income tax under Section 511, with more than one unrelated trade or business, to calculate UBTI separately with respect to each trade or business. The provision is effective for tax years starting after December 31, 2017.► Net operating losses (NOLs) of a particular business can offset future income from

that business, but not from other businesses.► However, NOLs arising in a tax year beginning before January 1, 2018 that are

carried forward to a tax year beginning after such date are not subject to provision and can be applied to UBTI generally.

► Key takeaway: Overall UBTI burden of organizations may increase due to inability to offset losses from one unrelated trade or business against the gains of another.


UBTI to be separately computed for each trade or business (continued)

► Considerations:► What constitutes a separate business?

► Will all investment income of an exempt organization be treated as a single business, or is each investment separate?

► How to allocate expenses to each business? ► If the separate computation would significantly increase UBTI, is it

possible to transfer the unrelated business activities to a taxable corporation that would be able to net the gains and losses on an aggregate basis?


UBTI to be separately computed for each trade or business (continued)

► Net operating losses► New 80% limit placed on the use of NOLs for each separate trade

or business.► The new tax act limits the NOL deduction to 80% of taxable income

(unrelated business taxable income).► NOLs can be carried forward indefinitely.► No NOL carrybacks.► These provisions apply to NOLs generated in taxable years

beginning after December 31, 2017.


IRS Notice 2018-67: IRS releases guidance on separate trades or businesses for UBTI

► In Notice 2018-67 (released August 21, 2018), the IRS issued interim guidance, described planned regulations and solicited comments on new Section 512(a)(6).

► The notice contains guidance on multiple issues including but not limited to:► Identification of separate trades or businesses► The treatment of income described in Section 512(b)(4), (13) and (17)► General principles surrounding income from partnerships► Interim and transition rules for aggregating income from partnerships and

debt-financed income from partnerships► UBTI described in Section 512(a)(7) (taxation of certain fringe benefits)► Net operating losses


Separate trade or business

► The IRS intends to issue proposed regulations on determining whether an EO has more than one unrelated trade or business and how to identify separate trades or businesses.

► Until those regulations are issued, organizations may rely on a reasonable good-faith interpretation of Sections 511 through 514, considering all the facts and circumstances, when determining whether an EO has more than one unrelated trade or business.

► Safe harbor: The IRS has identified the use of the North American Industry Classification System (NAICS) 6-digit codes as a reasonable good-faith method for determining separate trades or businesses:► This applies to activities not in the nature of investments.

► IRS requests comments on determining separate trades or businesses.


NAICS 6-digit codes

► The NAICS codes may not be so clear for other activities.► Example: Would a museum gift shop that sells reproductions, posters, postcards, books,

jewelry, scarves, t-shirts, mugs, pencils and toys be a gift novelty and souvenir store (453220); a jewelry store (448310); a book store (451211); a hobby, toy and game store (451120); or a miscellaneous store retailer (453000)?

► Example: Consulting services provided by a physician director of a nursing home to a medical device manufacturer on better interface on hospital’s beds for seniors:► 621111 – Offices of physicians► 621340 – Offices of physical, occupational and speech therapists and audiologists► 622110 – General medical and surgical hospitals► 623110 – Nursing care facilities (skilled nursing facilities)► 623311 – Continuing care retirement communities► 339112 – Surgical and medical instrument manufacturing► 334118 – Computer terminal and other computer peripheral equipment manufacturing► 541690 – Other scientific and technical consulting services► 541990 – All other professional, scientific, and technical services► 337127 – Institutional furniture manufacturing

Is the determination based on who is doing the consulting, who is paying for the consulting or what is being consulted about?


Investment activities

► IRS intends to issue proposed regulations treating certain partnership “investment activities” as a single trade or business.

► Investment activities should capture only partnership interest in which the EO does not significantly participate in any partnership trade or business.

► Request comments on what activities should be included in the category of investment activities.

► Certain interim and transition rules apply pending proposed regulations.


Interim rule for aggregating partnership interests

► Pending regulations, an EO may aggregate all “qualifying partnership interests” and treat them as a single trade or business for purposes of Section 512(a)(6).

► An interest is considered a “qualifying partnership interest” if one of the following two tests is met:► A de minimis test, which the exempt organization satisfies if it holds directly no

more than 2% of the profits interest and no more than 2% of the capital interest of the partnership

► A control test, which the exempt organization satisfies if it directly holds no more than 20% of the capital interest and does not have control or influence over the partnership

► Also, an EO may aggregate its UBTI from its interest in a single partnership with multiple trades or businesses, including trade or business conducted by lower-tier partnerships, as long as the directly held interest in the partnership meets the requirements of either the de minimis test or control test.


Control or influence under the control test

► Control or influence under the control test includes the ability to:► Require the partnership to perform or prevent the partnership from

performing any act significantly affecting the operations of the partnership

► Participate in management:► If any of the EO’s officers, directors, trustees or employees have the

right to participate in the partnership’s management activities► Having the power to appoint or remove any of the partnership’s

officers, directors, trustees or employees


Transition rule for partnership interests

► For a partnership interest acquired prior to August 21, 2018 (date of Notice 2018-67), an EO may treat each partnership interest as a single trade or business for purposes of Section 512(a)(6), regardless of whether it meets the de minimis or control test and regardless of whether or not there is more than one trade or business directly or indirectly conducted by the partnership or lower-tier partnerships:► Partnership interests that are treated as separate trades or businesses

under the transition rule cannot be further aggregated into a single trade or business.

► This means that you do not have to look through the partnership to the activities being carried on by the partnership.


Treatment of statutory UBIT

► Section 512(a)(7): Notice provides that the provision of fringe benefits is not a trade or business and, therefore, amounts subject to unrelated business income tax (UBIT)under Section 512(a)(7) are not subject to the Section 512(a)(6) silo rules.

► Debt-financed income (under Section 512(b)(4)), payments from controlled entities (under Section 512(b)(13)) and insurance income (under Section 512(b)(17)) are subject to the silo rules under Section 512(a)(6):► The IRS is seeking comments regarding the treatment under

Section 512(a)(6) of income that is not from a partnership but is included in UBTI under these provisions.


Other matters addressed in the notice

► Treatment of NOLs:► Section 512(a)(6)(A) does not apply to any pre-2018 NOLs; pre-

2018 NOLs are taken against total UBTI calculated under Section 512(a)(6)(B).

► Post-2017 NOLs are calculated separately with respect to each trade or business and can be deducted only with respect to a trade or business from which the loss arose.


Applying Notice 2018-67

► Example 1:► Hospital A’s pharmacy sales to the general public generate $100,000 of unrelated taxable

business losses.► Hospital A’s alternative investments generate $50,000 of UBTI.► In 2017, Hospital A would have an overall unrelated business loss ($100,000 - $50,000), but in

2018, Hospital A would have UBTI of $50,000 and a $100,000 loss that will only be available to offset future pharmacy UBTI (if any).

► Example 2: ► Private Foundation B acquired prior to August 21, 2018 a 5% capital interest in an investment

fund structured as a partnership that invested in multiple trades or businesses through lower-tier partnerships. One of B’s directors manages the fund. In 2018, the fund generates $1 million of UBTI due to a sale of leveraged property and $1 million of unrelated business losses.

► B’s investment in the fund does not qualify under the de minimis test because B owns more than a 2% interest in the partnership and does not qualify under the control test because one of B’s directors has control over the investment fund.

► However, if B applied the transition rule, it could treat the investment fund as a single trade or business and would be permitted to offset the unrelated business losses against the UBTI.


Polling question

► True or false: If an organization desires to aggregate its interest in a partnership with similar investments, it must meet both the “de minimis” and “control” tests?


UBTI increased by amount of certain fringe expenses


UBTI increased by amount of certain fringe expenses

► Provision summary: New Section 512(a)(7) provides that, effective for amounts paid after December 31, 2017, organizations subject to the unrelated business income tax rules must increase their UBTI by their expenses of providing certain fringe benefits that would be nondeductible for a taxable entity under Section 274.

► Fringe benefits subject to the rule:► Expenses for commuter highway vehicle, transportation transit passes and qualified

parking increase UBTI if the benefits are excludable from employee income under Section 132(f).

► On-premises athletic facility expenses increase UBTI if the facility is primarily for the benefit of highly compensated employees.

► Tied to the deduction disallowance rules for taxable organizations under Section 274.

► Other considerations:► Many organizations may be subject to state or local laws requiring employers to

provide some form of transportation subsidy.


IRS Notice 2018-99: IRS releases guidance on determining the amount of parking expenses for qualified transportation fringes

► The notice provides interim guidance to allocate qualified parking expenses for purposes of Section 274 deduction disallowance and Section 512(a)(7) UBTI income inclusion.

► Permits organizations to use any reasonable method, including the one deemed reasonable by the notice.► Treats certain methods as unreasonable, including:

► Using the value of employee parking to determine the allocable expense► Allocating no expense to reserved employee parking

► Expenses include:► Parking lot attendant expenses/security► Repairs/maintenance/landscaping► Cleaning and removal of snow, ice, leaves and trash► Utility costs► Rent or lease payments or a portion of rent or lease payments► Insurance, property taxes, interest

► Expenses do not include depreciation.



► Payments to third parties ► If amounts for parking are paid to a third party, then the increase in UBTI is the total

annual cost paid to the third party, up to the current cap of $265 per employee per month.

► Amounts in excess of $265 are treated as compensation to the employee and should not be treated as UBTI.

► Expenses of owned or leased parking facilities► Four-step method deemed reasonable to deduction disallowance

► Allocate UBTI expense to reserved employee spots► Determine applicability of public use exception► Allocate non-UBTI expenses to reserved nonemployee spots► Allocate remaining expense based on typical usage of remaining spots

► Examples in the notice conclude that a payment to third parties for the value of parking over the $265 cap that is imputed in employees’ income is not disallowed as a deduction (based on Section 274(e)(2) exception) and should not be treated as UBTI; this principle should apply equally for owned or leased parking facilities but is not addressed in the notice.



► Taxpayer owns or leases all or a portion of a parking facility (four steps)► Step 1: Calculate the disallowance for reserved employee spots

► Determine the number of reserved employee spots as a percentage of total parking spaces. That percentage of the cost is disallowed.

► Step 2: Determine the primary use of remaining spots (the “primary use test”)► Look at the remaining spots. If more than 50% of the spots can be used by the

public, none of the expenses attributable to the rest of the parking facility are disallowed or considered UBTI.

► Step 3: Calculate the allowance for reserved nonemployee spots► Look at spots reserved for customers and other nonemployees. This

percentage of the cost is always deductible (and thus not UBI).► Step 4: Determine remaining use and allocable expenses

► If there are spots left over after the first three steps, Step 4 requires the employer to use a reasonable method to determine employee use during normal business hours on a normal day.



Deemed reasonable method for allocating expenses for owned/leased parking

1. Expenses of reserved employee spots: (reserved employee spots/total spots) x expense = UBTI

► That percentage of the expenses is UBTI► Until March 31, 2019, organizations can change their

parking arrangements, retroactive to January 1, 2018

► Employer leases 500 spots in parking facility at cost of $10,000► 50 spots are reserved for employees► $1,000 (50/500 x $10,000) is UBTI ► Remaining unallocated expense: $9,000

2. Applicability of public use exception to remaining spots: public use spots/remaining spots

► If more than 50% of spots are typically used by general public, no additional UBTI

► General public: customers, visitors, suppliers, vacancies

► Certain aggregation permitted

► Same facts► Of remaining 450 spots, 100 are typically used by general public► 100/450 = 22%► Public use exception is not available

3. Expenses of reserved nonemployee spots: (reserved nonemployee spots/remaining spots) x expense = not UBTI

► That percentage is not UBTI ► Same facts► 50 spots are reserved for nonemployees► $1,000 (50/450 x $9,000) is not UBTI► Remaining unallocated expense: $8,000

4. Remaining expenses: (typical employee spots/remaining spots) x expense = UBTI

► Remaining costs are allocated based on typical usage during normal hours of organization's activities on typical day

► Same facts► Of remaining 400 spots, 350 are typically used by employees► $7,000 (350/400 x $8,000) is UBTI



► Example 1: garage at capacity, majority employee parking► Hospital A owns a parking garage adjacent to its hospital with 500 spots, none are

reserved and all are filled on a typical day. A has approximately 260 employees and 240 patients and visitors parking in the garage on a typical day.

► A’s tax year is the calendar year and it incurs $10,000 of total parking expenses for this garage during 2018.

► 52% of the spots are employee use, therefore A has $5,200 of parking UBTI (52% of $10,000).

► Example 2: garage has spare capacity► Hospital B recently built a new parking garage adjacent to its hospital with 600

spots, none are reserved. B has approximately 260 employees and 240 patients and visitors parking in the garage on a typical day, with 100 spots typically empty.

► B’s tax year is the calendar year and it incurs $1,500,000 of total parking expenses for this new, shiny garage during 2018.

► 43% of the spots are employee use, therefore the garage is primarily used by the general public and B has zero parking UBTI.



► Example 3: reserved employee parking► College A owns several parking lots on its campus with 1,000 spots, 100 of which

are reserved for faculty. On a typical day, the remaining 900 spots are filled by 700 students or visitors and 100 faculty, leaving 100 empty spots.

► A’s tax year ends June 30 and it incurs $20,000 of total parking expenses for these lots from January 1, 2018 to June 30, 2018.

► 10% of the spots are reserved for employee use, therefore A has $2,000 of parking UBTI (10% of $20,000) for the reserved faculty spots.

► Of the remaining spots, 88.8% are for the general public (800/900), therefore the remaining spots are primarily for the general public and A has zero additional UBTI.

► Example 4: removing reserved parking► Same facts as above, but College A removes the “faculty only” signs from the 100 reserved

spots on February 15, 2019. ► A has zero UBTI for 2018 because no spots are reserved due to the sign removal being

treated as retroactive to January 1, 2018 and 80% of the spots are for the general public (800/1,000), therefore the parking is primarily for the general public.



► Employers with reserved spots have until March 31, 2019 to reduce the number of, or remove, the reserved designation. These changes will be effective retroactive to January 1, 2018.

► The notice also provides that if the sum of a nonprofit's gross income from unrelated trades or businesses and its UBTI increase under Section 512(a)(7) is less than $1,000, the organization need not file Form 990-T.


IRS Notice 2018-100: relief from additions to tax for underpayment of estimated income tax for tax-exempt organizations that provide qualified transportation fringes

► Provides a waiver of the addition to tax under Section 6655 for underpayment of estimated income tax for certain organizations ► The underpayment must result from the changes to the tax treatment of qualified

transportation fringes under Section 512(a)(7) ► To qualify, the tax-exempt organization:

► Must not have been required to file a Form 990-T, Exempt Organization Business Income Tax Return for the taxable year preceding the organization’s first taxable year ending after December 31, 2017

► Must provide qualified transportation fringe benefits (as defined in Section 132(f)) to an employee for which estimated income tax payments, affected by changes to Sections 274 and 512, would otherwise be required to be made on or before December 17, 2018

► Must timely file Form 990-T ► Must timely pay the amount reported for the taxable year for which relief is granted

► Organizations that do not qualify for relief under this notice may avoid the addition to tax if they meet one of the general safe harbor/exception provisions


Polling question

► Which of the following methods is considered to be a reasonable method for determining UBI under section 512(a)(6)?

A. Excluding costs related to transportation fringe benefits the organization is required to provide under state lawB. 4-step process outlined in Notice 2018-99C. Using the value of employee parking to determine the allocable expenseD. Allocating no expense to reserved employee parking


Questions


You should now be able to…

► Determine if an activity is an unrelated trade or business► Recognize the specific UBI exclusions and modifications► Recognize how to compute unrelated business taxable

income (UBTI) and recognize the common scenarios that can give rise to UBI

► Recognize the impact of tax reform on UBI

EY | Assurance | Tax | Transactions | Advisory

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Ernst & Young LLP is a client-serving member firm ofErnst & Young Global Limited operating in the US.

© 2019 Ernst & Young LLP.All Rights Reserved.

1902-3051956

US SCORE no. 05678-191USED None

This material has been prepared for general informational purposesonly and is not intended to be relied upon as accounting, tax or otherprofessional advice. Please refer to your advisors for specific advice.

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