An Overview of Unrelated Business Taxable Income and Its Impact on Charitable Planning
Unrelated business income (UBI) is an unwelcome notion for charities since it requires the tax-exempt entity to pay unrelated business income tax (UBIT). It also has implications for planners, since gifts of assets generating UBI may have negative effects on gift results. The goal of the UBI tax, first instituted in 1950, is to put for-profit entities and not-for-profit entities in the same competitive position by requiring that the charity pay tax on the net profit from the business at the same rate that for-profit corporations are taxed.
Which assets or transactions generate UBI?
There are two types of UBI: i) income from the conduct of a regularly-carried on trade or business that is not substantially related to the charity’s discharge of its mission; and ii) debt-financed income. For planners, especially those without experience with UBI, the most difficult task may be to identify assets that generate UBI and anticipate how that income might affect the gift transaction.
An active trade or business includes any type of ongoing business from small proprietorships to larger enterprises. This may include partnerships engaged in timber farming or oil and gas production, or rental income tied to a percentage of the leasing business’s revenues. It also includes a business that has made a Subchapter S election. However, there are at least eight exceptions to this active trade or business definition that may impact the UBI determination; see IRC § 513 for detail.
Passive income is excluded from UBIT unless it is debt-financed. This would include interest, dividends, and even fixed rent from rental properties. Also, any income or gain on investments purchased with borrowed funds may be taxable, including income from partnerships that have debt-financed income. It may also include assets such as royalties or revenue from affinity cards, although these are not as easy to classify and depend upon fact and circumstance determinations. Check letter rulings on these gift types to get insight into the IRS perspective on these issues. (Ltr. Rul. 200715015 is the most recent on this topic.)
Debt-financed income is generally easier to identify although classification is also complicated by exceptions detailed in IRC §514. For example, an intervivos gift of real estate encumbered by a mortgage will not be taxed as UBI for ten years after receipt so long as i) the charity does not assume the debt, ii) the debt was placed on the property more than 5 years before the date of gift, and iii) the donor owned the property for more than five years before the date of gift. Testamentary gifts of debt-encumbered property will not be taxed as UBI for ten years following the gift.
When Should Planners Worry About UBIT?
Gift transactions most likely to be negatively impacted by UBI include the following:
- Gifts to charitable remainder trusts. Prior to January 1, 2007, any amount of UBI in a charitable remainder trust transformed the trust from a tax-exempt entity into a taxable complex trust. A provision in the Tax Relief and Health Care Act of 2006 changed that result. From January 1, 2007 forward, UBI in a charitable remainder trust will not cause the trust to lose its tax-exempt status but will result in a 100 percent excise tax on the UBI amount. While the change in law expands the asset options for donors and gift planners, it requires careful consideration of the assets used to fund the trust and management of gift timing to reduce the amount of UBI recognized by the trust.
- Gifts to non-grantor charitable lead trusts. Non-grantor charitable lead trusts are taxed as complex trusts and ordinarily receive an unlimited charitable deduction for income distributions to the charitable beneficiaries of the trust. This deduction is limited in years in which the trust receives UBI.
- Outright UBI gifts to charities. Some charities are better prepared to accept UBI gifts than others. Most sophisticated charities have a process for identifying and evaluating the gift before acceptance and set aside cash to cover the UBI tax. Smaller charities may not identify UBI and so may incur penalties for failing to file UBI quarterly estimates and the return (Form 990-T), or when filing the return, may not have reserved the cash to pay the tax. In addition, the tax reduces the net proceeds to the charity, and may result in a shortfall for the intended gift purpose. Planners should ensure the charitable recipient is aware of the pending UBIT and is in a position to pay the tax.
UBI is complicated and may have a significant impact on the gift planning result. While a detailed explanation of UBI is beyond the scope of this overview, knowing the basics may help identify potential problems and prevent unwelcome surprises.