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Avoiding unrelated business income on payments from a controlled entity.

In general, organizations that are exempt from tax under Sec. 501(a) are subject to tax on their unrelated business income (UBI)by Sec. 511. Unrelated business income is generally defined by Sec. 519. as income from a trade or business that is not substantially related to the organization's tax-exempt function and that is regularly carried on by the organization. This tax was imposed to place tax-exempt organizations on an equal footing with taxable organizations in relation to their business operations.

Interest, annuities, royalties and rents from real and certain personal property are specifically excluded from the definition of UBI by Sec. 512(b), absent the application of the debt-financed property rules of Sec. 514. Standing alone, these exclusions provide an opportunity to avoid the tax. Before Sec. 512(b)(13) was added to the Code by the Tax Reform Act of 1969, it was relatively easy for an exempt organization to create a controlled entity to which it loaned money or leased property. The interest and rent received was nontaxable to the exempt organization while deductible by the controlled entity, thereby reducing its income. Congress enacted Sec. 512(b)(13) to prevent this simple planning technique.

Sec. 512(b)(13) provides that interest, annuities, royalties and rents received from a controlled organization (as defined in Sec. 368(c) for purposes of corporate organization and reorganization) will be included in the recipient's unrelated business income. (1) The section limits the amount of includible income to the percentage of the controlled entity's taxable income that would have been taxable to the exempt organization had it earned all of the controlled entity's income directly.(2)

Although Sec. 512(b)(13)was designed to prevent tax avoidance, the Treasury has issued a number of letter rulings that provide a road map for organizations wishing to avoid this tax. This article will discuss these surviving tax planning opportunities and potential IRS attacks.

Noncontrolled Entities

IRS Letter Ruling 8303019(3) illustrates the direct application of Sec. 5 12(b)(13). In this ruling a tax-exempt foundation created a wholly owned subsidiary to operate an hotel. The foundation owned the real estate, which it leased to its subsidiary. The ruling concluded that the creation of the subsidiary was nontaxable under Sec. 351. It also concluded that the rent received by the foundation was UBI under Sec. 512(b)(13).

The ruling stated that the dividends received by the foundation from the subsidiary were not taxable under Sec. 512(b)(13). Since this provision was designed to prevent transactions that reduce or eliminate a subsidiary's taxable income without normally creating UBI, the omission of dividends from Sec. 512(b)(13)is reasonable since they do not reduce taxable income at the subsidiary level.

To avoid the result in Letter Ruling 8303019, one apparently simple tax planning strategy would be to create a for-profit corporation that is economically "controlled" by the exempt organization, but which does not meet the requirements of a controlled corporation in Sec. 512(b)(13). This path was chosen by the entity in IRS Letter Ruling (TAM) 8414001.(4)

In that ruling, N, a tax-exempt entity under Sec. 501(c)(3), created 0, a for-profit corporation. 0 sold 20,000 shares 110% 1 of its common stock to N and issued approximately 51.5% of its senior notes to N. To prevent Sec. 512(b)(13) from converting the interest income on the senior notes into UBI, N had O sell 100% of a newly authorized issue of nonvoting, nonparticipating, nonconvertible, cumulative preferred stock to A, a member of the governing bodies of both N and O. The IRS stated that "[t]he sale of preferred stock to A had been agreed upon by the governing body of N specifically to assure that N would not meet the technical definition of control contained in section 512(b)(13)." (Emphasis added by the IRS.) The District Office challenged the nontaxability of the interest directly on the basis that N controlled O and indirectly on the basis that the transactions were purely tax motivated. The issues were referred to the IRS National Office for technical advice.

The National Office rejected the tax avoidance argument. The ruling stated that Sec. 512(b)(13) is concerned with the degree of control and that the relationships among the parties is not relevant. If Congress had wanted this issue addressed, the Service reasoned, it could have included a "disqualified person" exception, as it did in other provisions. The Service concluded that the omission of this requirement precluded consideration of the relationships among the parties directly and the underlying intent of the transaction indirectly. Further, the transaction was not without substance because the preferred stock owned by A represented valuable rights that would result in benefit to A, not to N.

The District Office also contended that the preferred stock should be classified as debt under Sec. 385. This would have resulted in a finding that N owned 100% of the only class of stock outstanding. After reviewing Sec. 385 and the factors normally considered by the courts, the ruling held that the preferred stock was in fact stock. Therefore, N did not control O.

Although the entity in this ruling survived the challenge, it can be expected that the Sec. 385 issue will be raised again in future cases. Any entity trying to duplicate the outcome in Letter Ruling 8414001 should make certain that the instrument held by the minority party will be considered stock. Since this is usually a facts and circumstances determination, any recently litigated cases should be considered, and care must be exercised to ensure that all evidence points to stock. Note: Sec. 512(b)(13) refers to Sec. 368(c)and not to Sec. 1504(a)(2) for the definition of control. This is beneficial for taxpayers. Sec. 368(c) considers all stock, including the nonvoting, nonparticipating preferred stock used in Letter Ruling 8414001, while Sec. 1504(a)(2) would ignore these types of instruments.(5) In addition, Rev. Rul. 59-9.59(6) interprets the 80%-of-nonvoting-stock requirement of Sec. 368(c) as 80% of each class of nonvoting stock. Therefore, as long as the tax-exempt entity does not own 80% of any single class of nonvoting stock, it should not be treated as controlling the taxable corporation.

One additional aspect of Letter Ruling 8414001 should be noted. The National Office considered reclassifying the notes as stock under Sec. 385. It concluded that the notes were in fact debt in large part because the tax-exempt entity owned only 51.5%. Reclassification of the notes would have negated the tax planning by converting the interest income to dividend income. Although dividends are not UBI, they are not deductible by the corporation, thereby subjecting the income to at least one level of taxation. The success of the planning is dependent on having a "noncontrolled" corporation deduct payments to a tax-exempt entity that are not considered UBI to the tax-exempt entity.

In IRS Letter Ruling 8701051,(7) the taxpayer extended the opportunity created in Letter Ruling 8414001. Here the entity gave preferred stock to an affiliated tax-exempt organization rather than selling it. The Service concluded that by transferring the stock, the tax-exempt organization would no longer be in control of the corporation. The ruling implied that it is immaterial how the definition of control is avoided; as long as the corporation is not controlled, Sec. 512(b)(13) should not apply. One consequence of this technique, which was not addressed by the ruling due to the charitable status of the donee but must be considered, is the effect of the gift on the organization's tax-exempt status. A transfer of stock by other than sale at full fair market value (FMV) may result in a loss of tax-exempt status if any of the exempt organization's assets or income has inured to the benefit of a private party.

Many exempt organizations either cannot or prefer not to create a noncontrolled corporation or relinquish control of an existing corporation. An alternative planning opportunity may be available.

Second-Tier Subsidiary

Many organizations should consider creating a second-tier subsidiary. This organizational structure requires two taxable corporations. The tax-exempt entity controls the first taxable entity, which in turn controls the second taxable entity. The tax-exempt entity can then lease property or loan money to the second-tier subsidiary. Since the exempt organization does not directly control the second-tier subsidiary, Sec. 512(b)(13) should not apply to the lease or interest payments received by the exempt grandparent.

The only way the Service could apply Sec. 512(b)(13) would be for it to attribute control of the second-tier subsidiary from the first tier to the parent entity. In IRS Letter Ruling 9003060,(8) which addressed exempt status rather than Sec. 512(b)(13) directly, the Service concluded that the definition of control in Sec. 368(c)(the one used in Sec. 512(b)(13) does not require attribution of ownership. Therefore, the tax-exempt organization did not control the second-tier subsidiary.

In Letter Rulings (TAM) 8439001(9) and 9016072,(10) the Service ruled directly that Sec. 512(b)(13) does not apply to interest, rent and royalties paid to a tax-exempt entity from a second-tier subsidiary. In Letter Ruling 8439001, the two-tier structure was created by transferring ownership of one taxable entity to the other. In Letter Ruling 9016072, the tax-exempt organization transferred funds to the first-tier subsidiary to create the second tier in a nontaxable Sec. 351 transaction. In Letter Ruling 9104023,(11) the IRS ruled that mergers and liquidation of subsidiaries (one purchased and one created under See. 351) did not generate UBI or jeopardize the entity's exempt status. A similar conclusion was reached in Letter Ruling 9003060. Therefore, a tax-exempt organization should be able to create the two-tier structure in a bona fide business transaction regardless of how the taxable organization was created or acquired and without concern that Sec. 512(b)(13) will apply to subsequent transactions.

In Letter Ruling (TAM)9045003,(12) a tax-exempt entity created a taxable subsidiary, which in turn established a second-tier subsidiary. The tax-exempt organization then loaned a large amount of money on an interest-free basis to the second-tier subsidiary. The loans were necessary to establish the company. For bookkeeping purposes, the exempt organization booked the transaction as a loan to its controlled subsidiary, which booked a loan to its subsidiary. The ruling concluded that the imputed interest income will be treated as paid from the second-tier subsidiary to the grandparent, thereby avoiding Sec. 512(b)(13).

The ruling ignored the bookkeeping entries because the tax-exempt entity was able to establish that the actual loan repayment was made from the lower tier subsidiary directly to the grandparent. In addition, the exempt organization was able to prove that the first-tier subsidiary was neither a shell nor a sham and that it had "an economic and operational life of its own."

It is not suggested that any organization replicate the facts of Letter Ruling 9045003, although it does demonstrate the extent to which the Service will honor the two-tier organizational structure. It is important to note that the Service has stated that to fulfill congressional intent, it will give Sec. 512(b)(131 "a broad and expansive reading," and that "the scope of [Sec.] 512(b)(13) is broader than the written language .... "

Potential Problems

The creation of a formal uncontrolled subsidiary or second-tier subsidiary may not be sufficient to guarantee avoidance of Sec. 512(b)(13). The Service could attack the planning either on the basis that it is a sham or under Sec. 482. Avoiding these potential challenges is essential to avoiding the unrelated business income tax (UBIT).

* Shams

The Service can raise the issue of a sham by challenging either the corporation or the transaction.

In Letter Ruling 9108016,(13) the IRS ruled that the nonexempt activities of a subsidiary would not be attributed to the tax-exempt parent. However, the Service was careful to state that the subsidiary was separate and distinct from the parent organization so long as it carried on business activities. Therefore, the separate existence of the subsidiary was honored pursuant to Moline Properties(14) The ruling warned that "where the parent corporation so controls the affairs of the subsidiary that it is merely an instrumentality of the parent, the corporate entity of the subsidiary may be disregarded. "(15)

This issue is most likely to be raised when the tax-exempt entity is using a second-tier subsidiary. If the Service treats the first-tier subsidiary as a sham, the exempt organization may be treated as receiving payments directly from a controlled corporation and subject to Sec. 512(b)(13).

To reduce the chances of this problem arising, the exempt organization should be extremely careful to honor the subsidiary's separate existence. The Service addressed the separate existence of a taxable corporation from its exempt parent in GCM 39326.(16) Separate books and records should be maintained and the subsidiaries should have independent boards of trustees or an independent majority if at all possible. At a minimum, the subsidiaries should operate under separate day-to-day management. The first-tier subsidiary should engage in business activities in addition to owning the stock of the second-tier subsidiary. Finally, it is important to demonstrate a business purpose for the creation of the two subsidiaries separate from the tax savings. The existence of the business purpose will aid in avoiding attribution of the subsidiary's activities to the exempt parent. Such attribution could cause the loss of the organization's exempt status.

It is relatively easy to avoid the sham corporation attack. The sham transaction attack, however, is more elusive and more potent.

In GCM 38878,(17) the Treasury responded to a request for technical assistance concerning Sec. 512(b)(13). It concluded that this section would not directly apply to the stated facts, but that it was broad enough in scope to cover transactions between brother-sister corporations. It pointed out a potential attack if the transaction was a sham, citing Mabee Foundation(18) and Crosby Value & Gage Co.(19) for the proposition that mechanical avoidance of Sec. 512(b)(13) is insufficient to avoid UBI. The fact that a first-tier subsidiary is interposed between the payor and the exempt organization or that the cash flow does not go directly to the exempt organization will be disregarded if the transaction is a sham whose function is to circumvent the intent of Congress. The Service has the authority to reallocate income or cash flow to a tax-exempt organization to reflect the economic reality of the transaction. Thus, a payment between brother-sister corporations could be treated as a payment to an exempt parent followed by a contribution to the related corporation. This would subject the payment to reclassification under Sec. 512(b)(13).

Once again, the existence of a valid business reason for the structure selected is vital to the exempt organization in overcoming any challenge on the grounds that the transaction is a sham. In addition, all payments should be for an amount equal to the FMV of the benefit conferred. An arm's-length transaction at a fair value will aid in preventing reclassification as a sham as well as eliminating an attack under Sec. 482.

* Sec. 482

Even if the transaction and the corporations are held not to be shams, the Service may be able to create UBI under Sec. 482. This section authorizes the IRS to allocate or apportion any item of income or deduction between two controlled businesses or organizations to prevent tax avoidance. Control for purposes of this section can be direct or indirect and will be presumed to exist if income or deductions have been arbitrarily shifted(20)

In Letter Ruling 8303019, previously discussed, the Service ruled that Sec. 512(b)(13) did not apply to an uncontrolled subsidiary. The ruling stated that the applicability of Sec. 489, was the subject of a different ruling request and that the instant ruling did not address the application of that section to the transaction. (The authors were unable to locate a Sec. 489, ruling that addressed the facts of Letter Ruling 8303019.)

The Service considered the reallocation of dues between a tax-exempt organization and a taxable subsidiary in Letter Ruling 8839009,.(21) The ruling concluded that no reallocation was necessary since the transactions between the two entities were at arm's length.

Although none of the currently available rulings have reallocated income under Sec. 489, and thereby created UBI under Sec. 512(b)(13), the fact that the rulings mention the possibility means that exempt organizations must be cognizant of the potential for reallocation. As in Letter Ruling 8839002, the transaction should be at arm's length. All payments should be at FMV, and a business purpose should exist for the transaction. If the exempt entity adheres to these guidelines, there should be little chance that the Service can sustain a challenge under either a sham theory or Sec. 482. However, several additional considerations should be noted when planning these transactions. Additional Considerations.

* Sec. 337

In Letter Ruling 9104023, previously discussed, a combination of mergers and liquidations was used to reorganize a two-tier subsidiary structure. Any organization that follows this ruling by using corporate liquidations, to create either a two-tier structure or an uncontrolled subsidiary, should carefully review Sec. 337(b)(2) and (d).

Sec. 337(a)provides, in general, that when a subsidiary distributes assets to its parent corporation in a complete liquidation no gain or loss will be recognized. Sec. 337(b)(2) contains an exception that results in the recognition of gain or loss under Sec. 336 if the parent corporation is a tax-exempt entity. This exception does not apply if the tax-exempt organization uses the assets it receives immediately after the liquidation in an activity generating income subject to UBIT. In this situation, the deferred gain will be recognized when the activity is no longer subject to UBIT or the assets are disposed of.

The effect of Sec. 337(b)(9) is to tax the unrealized appreciation if assets are transferred from a subsidiary to a tax-exempt parent company. In many cases the current tax burden would offset the future tax savings from the restructuring. This would defeat the tax planning. In those cases in which taxes are not currently imposed, future asset disposition must be monitored to prevent the recognition of gain under Sec. 337(b)(2)(B)(ii).

If the parent organization is tax exempt it is best to avoid Sec. 337 to prevent inadvertent gain recognition. This may not be possible because the liquidation rules of Secs. 339, and 337 override the reorganization rules of Sec. 361 on transfers from a subsidiary to a parent. Therefore, it is critical that Sec. 337 be considered before the liquidation or "merger" of a subsidiary. In addition, Sec. 337(d) provides that the Secretary will issue regulations to prevent taxpayers from structuring transactions in order to circumvent the repeal of Genera1 Utilities.

* Net operating loss

It has been suggested that an exempt organization does not have to include any amount in income under Sec. 512(b)(13) and therefore does not have to do any tax planning if the controlled entity has a net operating loss (NOL). The Service has considered and rejected this conclusion.

In Letter Ruling 8439001, previously discussed, the Service addressed the taxpayer's contentions that Sec. 512(b)(13) does not apply if the controlled entity has an NOL and that the regulations, if applied, would result in no UBI to the exempt organization. The ruling concluded that the existence of an NOL is immaterial. The Treasury issued GCM 39286(22) to comment on the proposed version of Letter Ruling 8439001.

GCM 39286 demonstrates the Treasury's interpretation of how the formula in Regs. Sec. 1.512(b)-1(1)(3) could and should be applied to a controlled entity with a net operating loss. Since the formula can be used, and "because there is no contrary result indicated in the statute, regulations, or legislative history, section 512(b)(13) applies when a controlled non exempt corporation has a net operating loss without regard to amounts paid to a controlling exempt organization."

Both GCM 39286 and Letter Ruling 8439001 reached the same conclusion concerning the formula in the regulations. GCM 399.86 stated that when a controlled entity that incurs an NOL receives amounts that would be related income if received by the exempt organization, a ratio of one should be used even though the actual ratio exceeds one. The end result is that all amounts will be taxed as UBI when recognized by the exempt organization in the form of interest, rents, royalties or annuities. Although the existence of related income will decrease the amount of UBI when the subsidiary has taxable income, the method applied by the Service to loss situations will not decrease the amount of UBI and therefore contradicts what appears to be the intended result of the statute. Therefore, these organizations should plan to minimize their tax as indicated above and not rely on an NOL unless they are prepared to fight the Service's interpretation of the statute.

* Accounting methods

If the exempt entity is required to report UBI, the timing must be considered. The Service's position is that the income must be reported under the entity's normal accounting method.

In IRS Letter Ruling 8223006,(23) both the tax-exempt entity and the controlled entity used the cash method of accounting. However, the controlled entity was on a June 30 fiscal year, while the exempt entity was on a calendar year. The Service concluded that the exempt entity had to report its UBI for all amounts actually and constructively received during the calendar year under Sec. 451. The fact that the ratio required in Regs. Sec. 1.512(b)(-1(1)(3) is calculated using the controlled entity's financial data from the year ending the following June 30 is immaterial. The tax-exempt entity can request an extension of time to file its Form 990-T, Exempt Organization Business Income Tax Return. The ruling rejected any analogy to partnership or trust taxation since Sec. 512(b)(13) does not contain any statutory exception similar to Sec. 652(c) or Sec. 706. Therefore, accounting problems that the entity may encounter are immaterial to the decision.

The Service discussed the application of Sec. 512(b)(13) to an accrual method entity in Letter Ruling 8439001. The ruling concluded that the tax-exempt entity must accrue interest and rent income and cannot delay reporting UBI until the cash is received. A different conclusion, according to the Service, would permit manipulation and avoidance--which the section was designed to prevent.

Letter Rulings 8223006 and 8439001 mandate that the tax-exempt entity's normal tax method must be used, and any attempt to circumvent this requirement will be carefully scrutinized under the substance versus form and sham transaction doctrines.

* Sec. 163(j)

In Letter Ruling 8414001, previously discussed, an exempt entity was able to avoid the application of Sec. 512(b)(l3) to interest income received because it created a noncontrolled subsidiary. Taxpayers attempting to duplicate this result must consider Sec. 163(j), which was added by the Revenue Reconciliation Act of 1989.

Sec. 163(j) denies a deduction for interest paid in certain "earnings stripping" transactions. The normal transaction involves the payment of deductible interest by a fully taxable U.S. corporation to a nontaxable, or low tax, related foreign corporation. The section is broad enough to apply to interest paid to a tax-exempt organization by a taxable subsidiary.

Sec. 163(j) applies to payments between related parties as defined in Sec. 267(b) or 707(b)(1), which include more-than-50% owners. Therefore, a taxable subsidiary that is outside Sec. 512(b)(13) because it is not 80% owned may still be related under the more-than-50% definition used for Sec. 163(j). This may result in a deferral of all or part of the interest deduction.

Even if the taxable entity is related for purposes of Sec. 163(j), the current deduction can be salvaged by maintaining a debt-to-equity ratio of no more than 1.5 to 1, or by keeping the net interest expense at or below 50% of the payor corporation's adjusted taxable income.

Conclusion

Sec. 512(b)(13) was enacted to prevent tax-exempt organizations from avoiding the UBIT by creating controlled corporations. The provision can be avoided by either creating uncontrolled subsidiaries or second-tier subsidiaries. In all cases, taxpayers must be aware of several potential IRS attacks and additional considerations.

(1) It is immaterial that the amount received was not derived from a trade or business.

(2) See Regs. Sec. 1.512(b)-1(b)(2) and (3) for examples of the computations including deductible expenses.

(3) IRS Letter Ruling 8303019 (10/14/82).

(4) IRS Letter Ruling (TAM) 8414001 (no date given).

(5) Although Sec. 368(c) includes all stock, it does not include stock owned constructively under Sec. 318.

(6) Rev. Rul. 59-259, 1959-2 CB 115,

(7) IRS Letter Ruling 8701051 (no date given).

(8) IRS Letter Ruling 9003060 (10/30/89).

(9) IRS Letter Ruling (TAM) 8439001 (5/25/84).

(10) Letter Ruling 9016072 (1/24/90).

(11) IRS Letter Ruling 9104023 (10/29/90).

(12) IRS Letter Ruling [TAM) 9045003 [no date given).

(13) IRS Letter Ruling 9108016 (11/21/90).

(14) Moline Properties, 319 US 436 (19431(30 AFTR 1291, 43-1 USTC [paragraph] 94641.

(15) For a recent example of a corporation being disregarded, see Jesse C. Bollinger, Jr., 485 US 340 (19881(61 AFTR2d 88-793, 88-1 USTC [paragraph] 9233).

(16) GCM 39326 (8/31/84).

(17) GCM 38878 (5/21/82).

(18) The LE. and L.E. Mabee Foundation, Inc., 533 F2d 521 (10th Cir. 1976)(37 AFTR2d 76-1174, 76-1 USTC [paragraph] 9349).

(19) Crosby Value & Gage Co., 380 F2d 146 (1st Cir. 1967)(19 AFTR2d 1731, 67-2 USTC [paragraph]9529), cert, denied,

(20) Regs. Sec. 1.482-1(a)(3).

(21) IRS Letter Ruling 8839002 (6/14/88).

(22) GCM 39286 (4/23/84)

(23) IRS Letter Ruling (TAM)8223006 (2/19/82).
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Author:Brock, Elizabeth A.
Publication:The Tax Adviser
Date:Nov 1, 1992
Words:4344
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