FOR LIVE PROGRAM ONLY Reporting UBTI and UBIT in...

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Reporting UBTI and UBIT in Partnerships and S Corporations:

Mastering K-1 Disclosures for Exempt Org Partners Key Box 20V Reporting, Footnotes and Separate Disclosures, and UDFI Exemptions

THURSDAY, SEPTEMBER 29, 2016, 1:00-2:50 pm Eastern

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mailto:[email protected]

Sept. 28 2016

Reporting UBTI and UBIT in Partnerships and S Corporations

William M. Funk, Esq.

Law Office of William M. Funk, New York

[email protected]

Elizabeth M. Mills, Senior Counsel

Proskauer Rose, Chicago

[email protected]



Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

Reporting UBTI and UBIT in

Partnerships and S

Corporations

Elizabeth M. Mills

Senior Counsel

September 29, 2016

6

Part I: UBTI Background, Overview and

Consequences

Reporting UBTI and UBIT in Partnerships

and S Corporations September 29, 2016

7

Definition of Exempt Organization

• Who are EOs

For purposes of our discussion: generally, tax-exempt

organizations described in Section 501(c)(3) of the Code

EOs include 501(c)(1) through 501(c)(29)

or, unless otherwise noted, pension trusts described in Section

401(a) of the Code

Governmental colleges and universities are also subject to

unrelated business income treatment to the extent income

would have been subject to tax for a tax-exempt organization



8

How EOs are subject to income tax

• EOs’ income is generally exempt from income tax

Code Section 501(a)

• However, income from trade or business not substantially related to

exempt purposes (“UBI”) is taxed

Code Section 501(b)

• UBI is addressed in Code Sections 511-514 and includes income

from a business, as well as investment income under some

circumstances

But a Section 401(a) trust’s UBI is income from any trade or business



9

So – What's not taxable

• Contributions, grants, and dues

• Income from activities that further exempt purposes (except

for Section 401(a) trusts)

• Investment income in most situations, per Section 512(b)

modifications (discussed later)



10


• UBI is income from an unrelated trade or

business

Trade or business for profit

Regularly carried on

Not substantially related to exempt purposes

Exceptions for volunteers, selling of donated

merchandise, and convenience (501(c)(3) only)



11


• An EO’s unrelated business taxable income (“UBTI”) is the net

income from unrelated trades or businesses

• For purposes of determining unrelated business income tax

(“UBIT”), all provisions of Code apply unless otherwise provided in

Subchapter F

• EO organized as corporation or trust pays tax at corporate or trust

respective rates with usual deductions

Form 990-T

Subject to estimated tax rules

• UBI rules apply regardless of use to which income is put

Outdated “destination of income” test



12

Special UBI rules for some organizations and

activities

• Section 501(c)(7) social clubs

Investment income is subject to tax

Gain on sale of property is usually taxed unless recycled to

member facility

• Section 501(c)(9) voluntary employee benefit associations

Investment income is subject to tax unless it is set aside to pay

benefits, subject to limits

• Special rules for advertising in exempt journals – Reg.

Section 1.512(a)-1(f)



13

Consequences of UBTI

• Tax

Usual deductibility limitations apply

In addition, per Code Section 512(a)(1), deductions can only be

expenses “directly connected” with the activity generating UBI

“Directly connected” means a “proximate and primary”

relationship to the carrying on of the business. Reg. Section

1.512(a)-1(a)

See GCM 39843 (4/15/91): a tax-exempt hospital’s deductions

from UBI are not equivalent to Medicare cost allocations;

Medicare-based costs should be disallowed unless taxpayer can

show deductions clearly reflect income

For example, costs for autopsies and ER clerks are not

administrative expenses allocable to the pharmacy



14


• UBTI losses can offset UBTI income, but losses from related

activities can’t

• Disallowed losses

Loss carrybacks and carryforwards are permitted under the

same rules as for taxable entities

However, to be allowed, a loss must be from a trade or business

carried on “for profit”

IRS looks at activities that continually generate losses as not

carried on “for profit” and disallows the losses

E.g. hospitals – reference laboratory income

IRS Colleges and Universities Compliance Project (completed

2013) reported many examinations disallowed UBTI loss carryovers



15


• In extreme cases, possible loss of exemption

An organization operated primarily to conduct an activity

unrelated to exempt purposes is not exempt

How much is too much?

15% often used as a rule of thumb

15% of what? Multi-factor measure

Revenues

Expenses

Staff time

Board time



16

Another Wrinkle – Division of 501(c)(3)

Organizations into PCs and PFs

• Every 501(c)(3) organization is either a public charity or a

private foundation (with some recent blurring at the edges)

• Section 509(a) defines a private foundation as an

organization other than those described in Code Sections

509(a)(1)-(4)

• Can qualify as public charity based on

Nature of activity

Financial support profile

“Supporting organization” relationship to a public charity

qualifying based on nature of activity or financial support profile

• Why do we care?



17

PF Restrictions Interact with UBI

• Restrictions are imposed through excise taxes in Chapter 42 of the

Code

First level is a percentage of the bad deed

Second level, if bad deed not corrected, is 100% or 200% of the

bad deed



18


• Code Section 4943: Excise tax on Excess Business Holdings

A foundation’s “excess business holdings” are the holdings in a

“business enterprise” that it would have to dispose of to a

person other than a disqualified person for its remaining

holdings to be permitted holdings (usually 20 percent of the

voting power of stock)

Disqualified persons’ holdings in a business enterprise are usually

combined with those of the foundation in determining whether the

20 percent limit is exceeded

For partnerships, the limit is 20% of profits interest

Any level of sole proprietorship (i.e. trade or business unrelated

to exempt purposes) can be an excess business holding



19


• Code Section 4943: Excise tax on Excess Business Holdings

Exclusions from “business enterprise”

Program-related investments

Primary purpose of investment is to further exempt purposes

No significant purpose is production of income or appreciation of property

An entity at least 95% of the income of which is passive activity (e.g., interest, dividends, rents)

Functionally related business as defined in Section 4942(j)(4)

An activity that is not an unrelated trade or business or

An activity that is an unrelated trade or business but is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which is related to exempt purposes

S corp stock doesn’t fit these, so is subject to excess business holdings limitations



20


• Disposing of Excess Business Holdings

Note that a private foundation’s disposition of stock to donors or

their related parties, or other disqualified persons, can create a

prohibited self-dealing transaction

If S corp stock is received by a private foundation as gift or

bequest, the private foundation has at least 5 years to dispose

of before excess business holdings penalties apply



21


• Code Section 4940: Excise tax on net investment income

2% of net investment income

Can be reduced to 1% if foundation has excess charitable

distributions

Paid annually; quarterly estimated installments may be required

Net investment income includes gains from disposition of

property of a type that is normally held for investment

• One bright spot: UBIT paid by a private foundation reduces

its required annual 5% payout



22

You Can’t Hide

• Public Inspection requirement applies to exemption

application and three most recently filed Forms 990 or

Forms 990-PF

Form 990 requires breakdown of UBI, but not UBTI

• For Section 501(c)(3) organizations only, Forms 990-T

are subject to disclosure like Forms 990

• Copies must be provided if requested



23

Part III: UBTI Exceptions



24

Section 512(b) Modifications

• General exclusions from UBI

512(b)(1): interest and dividends

512(b)(2): royalties

512(b)(3): rents from real property

512(b)(5): Gains and losses from the sale or other disposition of

property (other than stock in trade or property held primarily for

sale to customers in the ordinary course of trade or business)

• But Section 512(b)(4) provides that these exclusions don’t

apply to income from debt-financed property as defined in

Section 514



REPORTING UBTI AND UBIT IN

PARTNERSHIPS AND S CORPORATIONS

Strafford Continuing Education Webinars

September 29, 2016

William M. Funk, Esq. (212) 973-1100

[email protected]

September 29, 2016 © Law Office of William M. Funk 26

ABOUT THE SPEAKER

William M. Funk is a tax attorney with over ten years of experience working for law firms and a global accounting firm prior to opening his own practice. He has delivered highly-rated tax presentations to accountants for Continuing Professional Education credit, to attorneys for Continuing Legal Education credit, and to business professionals. He also has written numerous articles on tax issues. His current practice includes representing hedge funds, real estate businesses, individuals and nonprofits with cross-border operations. Representative transactions include structuring hedge funds, real estate joint ventures with tax-exempt organizations, U.S. investments by foreign persons and executive compensation. He received his LL.M. in Taxation from New York University Law School, his J.D. from Vanderbilt Law School and his A.B. from University of Chicago. For additional information, please visit www.funklawsite.com.


TOPICS COVERED

Partnerships, S Corporations, Joint

Ventures etc.

Unrelated Debt Financed Income

For-Profit Subsidiaries


PARTNERSHIPS, S CORPORATIONS,

JOINT VENTURES ETC.

Important considerations for pass-through entities.

Pass-through entities include partnerships, limited liability companies (“LLCs”) and S corporations

Activities of partnerships are attributed to its members.

Importance of assessing how substantial the involvement of the tax-exempt is.



JOINT VENTURES ETC.

Partnerships (including LLCs)

Complete flexibility of how money and property is distributed.

Allocation of net income and net loss must either have substantial economic effect or reflect partners’ interests in the partnership, or else risk reallocation by the Internal Revenue Service.

Can have differences in timing of cash and allocations, priorities and back-ends.



JOINT VENTURES ETC.

S Corporations

C corporations + S election.

One class of stock.

Limitations on who may be S corporation holder without causing S corporation elections:

United States and resident alien individuals, estates, certain testamentary trusts and tax-exempt organizations. Code Section 1361(b)

NB: All S corporation income is UBTI. Code Section 512(e).



JOINT VENTURES ETC.

Important considerations for joint ventures.

Two-prong analysis (when the tax-exempt organization is a general partner or managing member or the activity uses or requires a substantial portion of tax-exempt assets or activities):

Does the joint venture expose the assets of the tax-exempt to unacceptable risk?

Does the joint venture agreement specifically permits the tax-exempt organization “to act exclusively in furtherance of its tax-exempt purpose and only incidentally” for for-profit investors.

Ancillary joint ventures have a more relaxed test.

April 22, 2014 © Law Office of William M. Funk 32


JOINT VENTURES ETC.

Special industries

Real estate

Health care

Accountable Care Organizations (“ACOs”)

Consumer Operated and Oriented Plans (“Co-Ops”)

Education



JOINT VENTURES ETC.

Real Estate

UBTI Issues (discussed above)

Tax Credits

Useless for tax-exempts

Tax-exempt use property rules (more than 35 percent of floor space)

“Sales” of tax credits

Tax-exempt entity leasing rules



JOINT VENTURES ETC.

Real Estate

Tax Credit Issues

Historic Boardwalk

Virginia Historic Tax Credit Fund, 2001

Route 231, LLC

UNRELATED DEBT-FINANCED INCOME

UBIT is imposed on Unrelated Debt-Financed

Income (“UDFI”).

UDFI may be generated from passive

investments as well as other property.

Key to analysis is “debt-financed property”.

Code Section 514




Debt-financed property

Property held to produce income.

Acquisition indebtedness during the taxable year.

But not to extent that use of property is substantially

related to the organization’s exempt purpose.

And not to extent income already accounted for in

unrelated trade or business income.



Acquisition Indebtedness

- Debt incurred “in connection with” acquisition or improvement of property.

- Includes debt that would not have been incurred but for acquisition or improvement.

- Includes debt for which need was reasonably foreseeable at time of acquisition or improvement.



Acquisition Indebtedness

Purchasing property subject to a mortgage is acquisition indebtedness. (Note: can avoid by prepayment of debt. Rev. Rul. 76-95)

Liens and other encumbrances are debt for the acquisition indebtedness rules. Including margin purchases.

Acquisition indebtedness of property acquired by partnership.

But not debt incurred when “inherent” part of performance of exempt purpose (example, 501(c)(3) bonds).



Acquisition Indebtedness – Special Real Estate Exception

To preserve the ability of pension funds and other investors to have passive investments in real estate, certain exempt organizations may invest in real estate without being subject to UDFI.

Organizations Covered (“Qualified Organizations”)

Organizations exempt under Code Section 401(a)

Retirement Accounts under Code Section 403(b)(9)

Title-holding organizations under Code Section 501(c)(25)

Educational organizations

Affiliated support organizations of educational organizations.

September 29, 2016 © Law Office of William. M. Funk 40


Special Real Estate Exception (continued)

Exception is for debt incurred by a qualified organization to acquire or improve real property.

Restrictions:

Purchase/sale price of real property must be fixed as of date of sale (unless a purchase of

foreclosure property from a financial institution).

No equity-kickers: Debt obligations may not be conditioned on future income/profits/revenues from property (unless from foreclosure property purchased from a financial institution).

Sale-leaseback with seller or related-party not permitted.

Qualified trust may not purchase property from person related to plan under which the trust was formed.

Financing by a related party must be provided on commercially reasonable terms.

© Law Office of William M. Funk



Special Real Estate Exception (continued)

Application to investment through partnership.

Exception available if the investment meets one of these conditions:

All investors are Qualified Organizations.

Qualified allocations of Code Section 168(h)(6) are met.

Fractions Rule (watch the exceptions).



Computing UDFI

Not all income from debt-financed property is UDFI.

Based on debt/basis percentage.

Average acquisition indebtedness for year divided by

average basis of debt-financed property.

Based on principal indebtedness on first day of every month of taxable year.



Computing UDFI

Allowable deductions are also based on debt/basis percentage.

NB: Depreciation of property permitted only on straight-line basis. Code

Section 514(a)(3).

Special rules for gain or loss on disposition of property.

Required to use highest amount of acquisition indebtedness for 12-month

period before disposition of property.

Remember passive activity and at-risk rules.

K-1, Line 20, Code V and Statements.


FOR-PROFIT SUBSIDIARIES

Reasons for establishing for-profit subsidiaries.

Preserve exemption of organization / avoid disqualification.

Preserving assets of one set of operations against liabilities of other set of obligations.

Clarifying missions of nonprofit managers and business managers.

Cleaner accounting and tax reporting.



Taxation

Corporate subsidiaries are fully taxable as corporations under

Code Section 502.

Dividends from for-profit subsidiary are exempt as passive income.

Interest, annuities, royalties and rents from for-profit subsidiaries are subject to UBIT.

Assets in subsidiaries subject to tax on deemed sale on distribution to tax-exempt. Treas. Reg. Section 1.337(d)-4.



Which for-profit subsidiaries are subject to special rules of Code Section 512(b)(13)?

For a corporation, ownership by vote or value of 50 percent of more of stock.

Constructive ownership rules of Code Section 318 apply.

Amount subject to UBIT is an amount equivalent to the reduction in taxable income of the for-profit subsidiary.


ON AND OVER THE HORIZON --

HYBRIDS

Benefit Corporations

Authorized in New York 2012.

Not a new tax designation.

Impact on UBIT analysis?

Low-Profit Limited Liability Corporations

Not authorized in New York.

Not a new tax designation.

Impact on private foundations?


CONTACT INFORMATION

William M. Funk, Esq.

Law Office of William M. Funk

275 Madison Avenue, 11th Floor

New York, NY 10016

Phone: (212) 973-1100

Fax: (917) 210-3513

E-mail: [email protected]

www.funklawsite.com

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