In episode 48 of How Tax Works, Matt Foreman discusses Unrelated Business Taxable Income (UBTI), which is what can happen when nonprofit entities earn income from their operations, investments, and other sources.

 

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

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Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:11]:
Hello and welcome to the 48th episode of How Tax Works. I’m Matt Foreman. In this episode, I’m going to talk about unrelated business taxable income, or as it’s known by its acronym, UBTI. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising, and it is certainly not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions we all make. Before we get started, new episodes every 2 weeks.

Matthew Foreman [00:00:46]:
In 2 weeks, I’m going to talk about what is a hobby and what is a business under the hobby loss rules under Section 183. If you have any questions, comments, or constructive criticism, you can email me at my FRB email address you can find via your favorite search engine. Upcoming webinars, speaking engagements. Honestly, if you just connect with me on LinkedIn, I post every— I probably post once a week, maybe more, I don’t know, about things I write, podcasts, webinars, stuff like that. And I often have free passes to the webinars. So if you like, you know, need CLE, CPE, CE, or CFPCE, we can, you know, I can hook that up. I’ll give you free passes. I tend to have them.

Matthew Foreman [00:01:21]:
So ask me anyway. So we’re talking about UBTI. So what is, what is UBTI, right? What is unrelated business taxable income? And what it is, is income from conducting an active business that is unrelated to the basis for the exemption from tax. So I think for UBTI purposes, it’s important to give a little bit of history, perhaps some conjecture, perhaps some speculation involved, but history, right? So there’s a big case. Involving NYU Law, which owned a pasta factory, Mueller Pasta. And what it was was basically, look, like at the time, a nonprofit could just own an active business and paid no income tax, right, on its profit. And, and it was viewed as an unfair advantage to businesses, to that business, right, because there’s no income tax. So if you need, you know, a 20% post-tax profit margin but you’re not paying taxes, right, You have a 30% tax rate, you need 20% net profit.

Matthew Foreman [00:02:20]:
You need to make about 30%. If you don’t, you need to make 20%. So you can undercut your competitors, right? So there were complaints. There was lobbying. The story goes, if you go to NYU Law, as I did for my LLM, they will say that it was the alumni base of Columbia Law that complained. Throw in allegedly there, you decide if it’s true or not.. And the result was the passing of Sections 511, 512, 513, and 514, which created a tax schema to tax unrelated business taxable income. What they look for in the definition of it is in 513.

Matthew Foreman [00:03:00]:
This section, I’ve always found it kind of goes backward a lot of times, but it is what it is. The definition of UBTI is an unrelated trade or business, that is any trade or business that meets two specific requirements: one, regularly carried on by the exempt organization; and two, not substantially related, other than the need for money, to the organization’s exercise or performance of its exempt purpose or function. Okay, that’s really important. And I’ve always sort of found that one kind of important because it’s important to think about, you know, what, what that means. Okay. And what does it mean? Right. There’s two things that go into it. Regularly carried on, and regularly carried on, it means it looks at the frequency and continuity of the exempt organization’s activities with similar activities of businesses, taxable, taxable entities, right? An activity conducted intermittently or sporadically will generally not be considered regularly carried on.

Matthew Foreman [00:04:01]:
So frequency is really, really, really, really, really important. Okay. And then the second requirement is not substantially related. So that, that, that test, it looks at whether the activity contributes, I don’t want to say significantly, substantially, I don’t know, sometimes you hear the word importantly, to accomplishing the organization’s exempt purpose. The fact that it just generates money is not enough. It’s not really relevant, not terribly helpful, but there’s ones, you know, the regularly carried on, there’s actually some really good examples. Examples. And I think they also talk about the substantially related to, to some extent.

Matthew Foreman [00:04:36]:
So, you know, the most common one is used at university, college, right? Selling athletic merchandise. Look, they have a bookstore, they have whatever, they’re selling sweatshirts, selling hoodies, selling t-shirts, selling socks, whatever. Look, the operation is active only in a couple months a year, but they have a staff. Even, look, it could be open part of the year, all the year, whatever. You know, the commercial— this is the commercial business owned by a school, right? Has staffing, has advertising, etc. It, you know, it’s regularly carried on, you know, but it’s substantially related. It is substantially related, right? Maybe. So that one’s interesting.

Matthew Foreman [00:05:09]:
A lot of, a lot of companies actually just— and I’ll get to this in a second— they just totally outsource it. They take royalties. Royalties are generally exempt. Talk about that later. But I think that’s really important to know how to do it right. Structuring is really important. Museum gift shop, right? Special exemption versus like Museum of Natural History, the Met, whatever. It’s regularly carried on.

Matthew Foreman [00:05:31]:
This could be, you know, this could be problematic, but also it supports the exempt purpose, right? So I think that you would have an issue with regularly carried on for a lot of these, but it is substantially related to the purpose. So depending on certain factors, I think you’re fine. Charity auction with a professional auctioneer is a really interesting one. You know, that one looked like it is not regularly carried on, right? Unless you’re doing weekly auctions. I think that’s an important one. There’s also stuff about like, you know, bingo, right? Bingo is generally exempted. I’ll talk about stuff like that in a little bit later. I think that’s a really interesting one.

Matthew Foreman [00:06:05]:
How is UBTI computed? Basically, it’s whatever taxable income is or would be for a for-profit business. There’s a $1,000 standard deduction, 512(b)(12), and, you know, there’s a number of exemptions and there’s that go into it that are in 513 exemptions and modifications that I think are really in discussion. The exemptions— there’s a number of types of income that are exempt from UBTI. What UBTI is looking for is an active business. So dividends, interest, annuities, royalties, rents from real property, and capital gains are, generally speaking, exempt from UBTI. There’s no tax imposed. And I think that that’s really important because I think those really carve out what you’re trying to, what you’re trying to do. Other exemptions and modifications: volunteer labor, donated goods, bingo, trade shows, conventions, stuff like that.

Matthew Foreman [00:06:56]:
Those are generally— income from those are generally exempted as well. But a lot of that’s in 513, and I think that’s really important. Look, what they’re looking for is a business, right? They’re not looking for a gift shop at a hospital or a museum. They’re looking for someone who who is operating a business with a nonprofit, and you’re like, well, you know, it’s interrupting with the idea. I think that’s really important. I’m going to come back in just a moment, and I’m going to talk about joint ventures, stuff like that, and debt-financed income, which is probably the biggest situation where something goes from not UBTI back into UBTI. So I’ll be back in just a moment. Hopefully you Enjoy.

Matthew Foreman [00:08:00]:
All right, hope you enjoyed the music. So let’s talk about debt finance income, which is basically the entirety of Section 514, right? So tax-exempt entities are taxed on income from assets that are acquired with debt financing. Basic rule. And I thought about going through the mechanics. I’ll talk about it later a little bit. But basically, the debt-financed percent is the percent that’s taxed, even if it’s otherwise exempt income. This prevents tax-exempt entities from creating a real estate empire, although— and throwing shade here— but Columbia University is the largest private landowner in New York City. Even with UBTI, right? So my assumption is low leverage gifts over time.

Matthew Foreman [00:08:40]:
It’s existed forever, right? Columbia University predates, you know, did different name but predates the revolution. If you saw Hamilton, you know, you know, that’s, that’s where Alexander Hamilton went. Aaron Burr went to Princeton. So, you know, which was at the time King’s and Queen’s College, right? So, you know, they’ve just been around for a while. So they’re going to have that. They’re going to have real estate. It’s going to be really important, and I think that’s an important kind of point. However, there’s kind of an exemption that exists.

Matthew Foreman [00:09:07]:
It’s in Revenue Ruling 7695, if my handwriting can be read, where that deals with joint ventures and debt. So fund borrows 30%, investors contribute 40%, tax-exempt entity contributes 30%, right? And that’s how the money goes into buy. It’s not UBTI. The idea is that basically in the agreement you’re going to include two things. One, you’re going to allocate the interest expense to the taxable, the non-tax-exempt partners, interest income, interest expense to them. And two, upon sale, the tax-exempt entity gets money as if there were no debt. So you just sort of close your eyes and you blink, but it’s about how you do it. The tax-exempt entity, which take on debt to put money in, that’s different, different fact pattern, not what’s going on there.

Matthew Foreman [00:09:49]:
Also, if there’s a guarantor, it’s recourse debt. That one’s Plantation Patterns, 462 Fed. 2nd 712, which was a Fifth Circuit case. So basically like you put in money or it’s debt financed, but the taxable entity is a guarantor. That is recourse to them. That will actually take it out of the debt financing rules. So what they’re really looking for is the idea that yes, it’s a joint venture. Yes, there’s a business element to it, but all they’re getting is dividends, you know, well, maybe not dividends, but all they’re getting is royalty, all they’re getting is rents, and therefore that’s not an issue.

Matthew Foreman [00:10:28]:
Debt finance percent. I really thought about— actually have it in my notes to some extent— the idea of going into detail on how determining the debt finance percentage. But I made the decision to keep this one as a slightly shorter episode because I think it’s important and I don’t think it needs that much detail. But the debt finance rules are in 514(c)(7) and Treasury Reg 1.514(a)-1. Those are really important. It’s really important. They’re very mechanical, specific rules that go through it, how it’s done, how it’s computed, etc. I always tell people that this is one of the ones where the devil’s really in the details and it’s not that bad.

Matthew Foreman [00:11:06]:
But again, the debt finance percentage is the percentage of your EBTI is the percentage that’s taxable. So I think it’s really important to think through it and say, all right, this isn’t that much, right? UBTI and real property, 512(b)(3). Generally speaking, you know, rents from real property or sale of real property is not UBTI. However, I have seen it where nonprofits own a fair amount of real estate and they create a service entity to deal with their real estate. That’s fine. That’s fine. But then they also start managing other people’s real estate in the area because they’re good at it and brings in money. That could be UBTI.

Matthew Foreman [00:11:44]:
That’s the 512(a)(3)(b), (a)(3)(cap)(b). And I think that’s a really important one. People talk about what about fees, service fees and things like that. So, you know, it depends. There’s a lot of examples in this. Fees for being on a board, right? So somewhat like a non, you know, there’s fees that are paid to a nonprofit for giving advice to another nonprofit or to a profit or whatever. That’s generally UBTI, it’s a service. Management fee for something, likely service.

Matthew Foreman [00:12:12]:
So watch out for stuff like that, right? And think about the structuring there, what you’re doing. Sometimes it’s worth it. Look, you know, at the end of the day, tax is not a 100%, you know, they do exist, but there’s very few taxes that are 100% or sufficiently punitive to say don’t take the income. And I think that’s a sample. I also want to talk about reporting requirements. All of this goes on to IRS Form 990-T. There may be a state corollary. It’s due the 15th day of the 5th month.

Matthew Foreman [00:12:38]:
So generally May 15th for a calendar year taxpayer or exempt organization. Two things. One, people somehow are like, well, it’s a tax-exempt organization, so I just didn’t file a tax return. That seems to be a common problem fact pattern, which has always sort of fascinated me. I run into that at least once a year. And it’s really important to make sure to file your returns. If you don’t file your returns, you lose your exempt status. And then the whole UBTI thing is kind of pointless because then you’re a for-profit business.

Matthew Foreman [00:13:06]:
The default people are like, oh, well, I’ve held it out as a nonprofit, therefore it should be a nonprofit. And the answer is no. You have to actually meet the requirements and file and be a nonprofit legally, right? So you have to— IRS and states have requirements and registration. Most states just say, oh, well, you know, IRS said yes, so we’re fine. So I think it’s really important to know and to think through this. And make sure that you meet the requirements and that you do it. You know, UBTI, I know this is sort of pigeonholed here, but UBTI is kind of a pointless conversation if you’re not a nonprofit. We’re going to have some more music.

Matthew Foreman [00:13:40]:
Like I said, it’s a short one. Then we’re going to bring it home with some structuring and we’re going to close it out. So not the longest one I’ve had, but I think it’s an important one. Hey, we’re back. So let’s talk about structuring, okay? This, this is kind of an important one that one of the things that I get in terms of questions is nonprofits are like, you know, one of the people we have, they want to give us a business, they want to give us a cash-producing asset, you know, whatever. Sometimes business nonprofits will do scientific research and they’ll end up with a patent. And they’re like, well, we kind of want to do more research and we want to start exploiting it. And royalties are not a problem.

Matthew Foreman [00:14:34]:
But if it becomes a for-profit business, right, people are like, well, what do you do? Right. And if, you know, if the only income that’s going to be generated is excluded from UBTI. So we’re going back— dividends, interest, annuities, royalties, rents from real property, right? Not rents from tangible property. And capital gains. Then you can hold it directly. You can, you know, you probably want to pass through just for liability protection purposes. Obviously, you know, follow the rules, don’t get the corporate veil pierced, etc., etc. But what if it’s an active business, right? This is, this is Mueller Pasta, or maybe it’s Mueller Pasta, I don’t know.

Matthew Foreman [00:15:07]:
What you do is you just put the business into a C corp. That’s it. Look, you just segregate it. The dividend’s tax-free, the C corp gets taxed. Passes it back up, a little less efficient than you’d like, but that’s the deal. And I think it’s really important, you know, people say, oh, it’s UBTI, so what? And, you know, because the UBTI tax rate, I have not mentioned this yet, but the UBTI tax rate is actually right at the corporate tax rate. That’s what it is statutorily, definitionally. So it’s not a huge deal from a tax perspective, right? 21% federal plus whatever state rate would be.

Matthew Foreman [00:15:42]:
So it’s not like a huge issue from like, oh, you’re adding so much tax. Because it’s just adding the corporate, or you get a C-Corp and you do it. Where it adds in tax is when you don’t need an entity, right? You’re just getting, you know, you’re exploiting a royalty or whatever. It’s not that bad. But the, the thing that I always point out is to be a nonprofit under Section 501(c), one of the 501(c)s, you have to have, you know, nonprofit purpose, etc., etc. But also, if you make too much money, not from your members, not from your purpose, et cetera, then what happens is you actually lose your exemption. And exemptions are more than just income tax. They’re sales tax too.

Matthew Foreman [00:16:24]:
And I think that that’s a really important point that you could just— and then the money from your members becomes taxable. It’s not deductible for 501(c)(3). Remember, there are 501(c)(4)s, (7)s. There’s 30, 40, 50 of them. There’s a lot of them. I never remember exactly how many. I rarely get out of the single digits. Most people don’t.

Matthew Foreman [00:16:43]:
’cause they’re really specific. So, you know, it’s important to sort of watch UBTI as a proxy for, are we running into other problems elsewhere? And I think that that’s really important. It’s just a C corp, right? Don’t mess it up, don’t do anything stupid. And the biggest area where people mess this up, and this will be my final thought on UBTI, is really a very direct one, which is that A lot of times you have these private clubs, university clubs, VFW, whatever. And what happens is they, they make money by hosting events, Halloween party, wedding, whatever. And in doing that, if they have too much income, A, that can be UBTI, and B, that also can be, you know, especially if it’s considered regular, right? We’re going back to the beginning thing. My beginning point about, you know, the regularity which is carried on and it’s not substantially related. And in doing that, do it too much, make too much money, you can blow your nonprofit status and you’re going to hit by taxes, UBTI, and then you lose it and really go sideways from there.

Matthew Foreman [00:17:54]:
So watch out for that. That’s an important thing to do. And that’s where if you’re going to do it, look, have a C corp, really focus on it, do what you’re doing. Make sure this whole thing works. And I think that that’s really important. All right, well, that was the 48th episode of How Tax Works. I hope you enjoyed it. Hope you learned something.

Matthew Foreman [00:18:10]:
I’ll be back in 2 weeks with a little more technical one with the 49th episode. We’re gonna talk about the hobby loss rules. It’s a pretty good one. I think it’s a little more, definitely more detailed than this one, but there’s a lot more going on here. Although the UBTI rules can be really, really detailed if you’re digging into it. But I thought sort of the as opposed to doing like a 6-credit class, I thought the 2-credit survey made more sense. So I hope you enjoyed it, and, uh, have a nice day.