Is endowment investment income subject to UBIT?

This item focuses on the applicability of the unrelated business income tax (UBIT) basics to endowment investments. Tax advisers should consider the UBIT rules when structuring investment opportunities.

The endowment portfolios of tax-exempt charitable organizations have risen, declined and risen again in value over the last decade, with increased diversity in both the types and forms of investments held. Ten years ago, only the larger endowments held investments that are now common (e.g., interests in hedge funds, private equity and offshore funds). Tax advisers should work more closely with their clients to inform them of both the tax consequences and opportunities that these options present. If the basics are kept in mind, delivering this advice is much less complicated than it might otherwise seem.

UBIT Modifications

Sec. 512 sets forth a definition of unrelated business taxable income (UBTI) that generally includes gross income from activities unrelated to an organization's exempt function. Such activities constitute a trade or business regularly carried on by the organization. The income is subject to directly connected deductions and modifications as provided in Sec. 512(b), as well as to exceptions found in Sec. 513.

Certain unrelated income streams are excluded from UBTI. For instance, Sec. 512(b)(1) excludes all dividends, interest, annuities and payments for securities loans (as defined in Sec. 512(a)(5)) from UBTI. Kegs. Sec. 1.512(b)-1(a)(1) excludes substantially similar income from ordinary and routine investments to the extent determined by the IRS. For example, distributions out of the earnings and profits of a real estate investment trust were dividends exempt in computing UBTI (Rev. Rul. 66-106).

Sec. 512(b)(2) excludes royalties, whether measured by production or by gross or taxable income from the underlying property. Sec. 512(b)(3) excludes, generally, rents from real property and certain rents from personal property. Sec. 512(b)(5) excludes all gains or losses from the sale, exchange or other disposition of property not stock in trade, inventory or held for sale to customers in the ordinary course of trade or business. Also, Sec. 512(b)(5) excludes all gains or losses recognized from investment activities or from the lapse or termination of options to buy or sell securities or real property; see Letter Ruling 200041038 for a discussion of a related trade or business and Sec. 512(b)(5)'s applicability to timber cutting. Note: Sec. 512(b)(13) provides special rules for the types of payments mentioned previously, when made by an entity controlled more than 50% by an exempt organization. Under Sec. 512(a)(3), these modifications and exclusions am generally unavailable to Sec. 501(c)(7), (9), (17) and (20) organizations.

Debt-Financed Income Rules

Although the types of income listed above are generally not subject to UBIT, that characterization could change if the underlying assets are acquired with debt. Under Sec. 512(b)(4), income of the type excluded from UBTI under Sec. 512(b)(1)-(3) and (5) is included if from debt-financed property.

Sec. 514(b)(1) defines "debt financed property" as any property held to produce income and for which there is an "acquisition indebtedness" at any time during the tax year or during the 12-month period prior to the property's disposition. Debt can be both internal and external for a particular investment. For example, there may he both debt used to acquire a partnership interest and debt allocated to the partner inside the partnership, used to acquire partnership assets. There are exceptions under Sec. 514(b)(2) and (3) to the debt-financed income rules, such as for related-use property and neighborhood land.

Sec. 514(c) defines acquisition indebtedness as (1) the unpaid amount of debt incurred to acquire or improve debt-financed property, or (2) debt incurred before or after the property's acquisition or improvement, if it would not have been incurred but for such acquisition or improvement. Under Sec. 514(c) (9)(B), acquisition debt does not include:

* Debt incurred by a "qualified organization," to acquire or improve real property, defined by Sec. 514(c)(9)(C) as an organization described in Sec. 170(b)(1)(6)(ii) (i.e., a school) and its affiliated supporting organizations; a qualified trust under Sec. 401(a); or a title-holding company described in Sec. 501(c)(25).

* Debt incurred when the price for the acquisition or improvement is not a fixed amount determined at the acquisition or improvement date.

* Debt to acquire or improve property held by a partnership, if (1) all of the partners are qualified organizations, (2) all allocations to partners are qualified under Sec. 168(h)(6) or (3) the partnership does not allocate income greater than the qualified partner's share of the loss and each allocation has substantial economic effect under Sec. 704(b).

Partnerships and Other Passthroughs

Sec. 512(c)(1) provides that if a trade or business regularly carried on by a partnership of which an organization is a member is unrelated as to such organization, its share of the partnership's income (and directly connected deductions) will be included in computing the organization's UBTI. Limited liability companies (LLCs) are treated similarly to partnerships. The activities of a single-member LLC are attributable to its tax-exempt member. For interests in S corporations, Sec. 512(e) provides that any such interests held by organizations and all resulting income and loss from operations, as well as S stock dispositions, will be taken into account in computing UBTI.

Offshore Investments

Over the last few years, there has been an increase in the number of exempt organizations that have used offshore corporations to make investments in debt-financed property and hedge funds employing leverage, which activity would otherwise result in potential UBTI. An offshore corporation is formed in a country in which it is not subject to tax. Because the corporation is not a passthrough entity, any UBTI does not pass through to shareholders. While such investments do have less UBTI exposure than comparable U.S. investments, organizations must be aware of the applicability of U.S. tax filing requirements for U.S. persons investing abroad. Failure to comply with these requirements can be very costly and unintentionally reduce the financial benefit of the offshore corporation.

Contribution Deductions

Some charitable organizations (e.g., private foundations) may be able to offset a portion of their UBTI through a charitable deduction under Sec. 170 for contributions made to another organization. Under Sec. 512 (b)(10), organizations set up as corporations are subject to a contribution limit of 10% of UBTI (computed without regard to the contribution(s)). Organizations set up as trusts are subject to contribution limits under Sec. 512(b)(11), similar to the limits imposed on individual contributors under Sec. 170(b)(1)(A) and (B); however, these limits are computed without regard to the contributions.

Conclusion

Tax advisers should keep these rules in mind when advising clients of the investment opportunities available to endowments. Frequently, organizations approach UBTI with trepidation and shy away from it, potentially passing up valuable opportunities in the process. Organizations might he better off making their investments based on the quality of a particular opportunity, reduced by the tax costs, if any. If given the chance, advisers can work to minimize those costs.

FROM RICHARD L. RUVELSON

J.D.

SEATTLE, WA