Section 172. On March 27, 2020, Congress amended Section 172 (Net

Operating Loss Deduction) with the (CARES Act). The CARES Act provides that any net operating loss arising in a taxable year beginning after December 31, 2017, and before January 1, 2021 (CARES Act NOLs), may be carried back to the five taxable years preceding the taxable year of such loss, which includes taxable years prior to the enactment of Section 512(a)(6). If applied in a pre2018 year, the NOL may be carried back to that non-silo year against aggregate UBTI. If applied in a post-2017 year, the NOL may be carried back to that silo year against the corresponding separate UBTI silo. The CARES Act also

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suspended the 80% limitation (also known as the excess business loss limitation) for tax years beginning before January 1, 2021, The 80% limitation was enacted under the TCJA. As a reminder, this limited the allowable NOL deduction to 80% of taxable income, calculated as described in Section 172(a)(2) net operating loss deduction. Additionally, an organization may waive the CARES Act NOL carryback by attaching a statement to Form 990-T as described in Revenue Procedure 2020-24. The Priority Guidance Plan states that regulations under Section 512 would address how changes made to Section 172 net operating losses by section 2303(b) of the CARES Act apply for purposes of Section 512(a)(6).

(1) A deduction for expenses paid or incurred for recreational, social, or similar

activities (including facilities therefor) isn’t disallowed under Section 274 if the athletic facility is primarily for the benefit of the tax-exempt organization’s employees and doesn’t discriminate in favor of highly compensated employees. See Section 274(e)(4).

(1) Generally, the unrelated business taxable income provisions cover situations

where an exempt organization itself pursued the unrelated trade or business as a part of its overall activities. If an exempt organization is a member of a partnership, however, it must treat its share of the partnership income in the same fashion as if it had conducted the business activity in its own capacity as a corporation or trust. See Section 512(c).

(2) Section 512(c) provides that if an organization to which Section 511 applies is a

member of a partnership regularly engaged in a trade or business which is an unrelated trade or business with respect to such organization, the exempt entity must include in its unrelated business taxable income that portion of its share of the partnership gross income (whether or not distributed), and the deductions attributable thereto, which is derived from the unrelated trade or business.

(3) The exceptions, additions and limitations contained in Section 512(b) also apply

to partnership income and will, therefore, be taken into account for purposes of this computation. For instance, if an exempt educational institution is a partner in a partnership which operates a factory, and if such partnership also holds stock in a corporation, the exempt organization must include its share of the gross income from the operation of the factory in its unrelated business taxable income but may exclude its share of any dividends received by the partnership from the corporation. See Treas. Reg. 1.512(c)-1.

(4) If the exempt organization and the partnership of which it is a member have

different taxable years, the partnership items which enter into the computation of the organization’s unrelated business taxable income must be based on the income and deductions of the partnership for the taxable year of the partnership which ends within the organization’s taxable year. See Section 512(c)(2).

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(5) In Service Bolt & Nut Co. v. Commissioner, 724 F.2d 519 (6th Cir. 1983), the

court considered whether amounts received from limited partnership interests constitute unrelated business taxable income. Qualified profit-sharing trusts exempt under Section 501(a) as organizations described in Section 401(a) received income from limited partnerships. The court cited Section 512(c), which provides that an exempt organization can be taxed on its share of the income received from a partnership of which it is a member, even though the partnership and not the exempt organization is the entity actively engaged in carrying on a trade or business. Refusing to distinguish between general partners and limited partners, the court concluded that income derived from limited partnership interests constitutes unrelated business taxable income. See also Rev. Rul. 79-222, 1979-2 C.B. 236.

(6) Section 512(c) applies to any organization (such as an LLC) treated as a

partnership for Federal tax purposes. See, for example, Rev. Rul. 2004-51, 2004-1 C.B. 974 (summarized above in Part II.C.1).

(7) The term "unrelated business taxable income" doesn’t include income from a

limited partnership interest derived by certain testamentary trusts, if a number of highly restrictive conditions are met. For further details, see section 1951(b)(8) of the Tax Reform Act of 1976, Pub. L. No. 94-455.

(1) As discussed above, an organization’s investment activities are treated

collectively as a separate unrelated trade or business for purposes of Section 512(a)(6). Investment activities include qualifying partnership interests.

(2) Per the final regulations for tax years beginning on or after December 2, 2020,

Treas. Reg.1.512(a)-6(c)(8), the qualifying partnership interest rules don’t apply to social clubs described in Section 501(c)(7). See Part IV of this document for a discussion of the UBTI of organizations subject to Section 512(a)(3), which includes social clubs.

(3) A partnership interest, including an interest in a single partnership with multiple

trades or business conducted directly or through lower-tier partnerships, is a qualifying partnership interest if it meets either the "de minimis test" or the ‘participation test.’ See Treas. Reg. 1.512(a)-6(c)(2)(i).

a. De minimis Test - A partnership interest generally meets the de minimis

test if the exempt organization holds directly or indirectly no more than two percent of the profits interest and no more than two percent of the capital interest in the partnership.

b. Participation Test - A partnership interest generally meets the

requirements of the participation test if the organization holds directly (within the meaning of Treas. Reg. 1.512(a)-6(c)(2)(i)) or indirectly (within the meaning of Treas. Reg. 1.512(a)-6(c)(2)(ii)(C))) no more than 20 percent of the capital interest during the organization's taxable year with which or in which the partnership's taxable year ends and the organization

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doesn’t significantly participate in the partnership within the meaning of Treas. Reg. 1.512(a)-6(c)(4)(iii). See Treas. Reg. 1.512(a)-6(c)(4)(ii) for rules regarding combining related interests.

c. Significant Participation - An organization significantly participates in a

partnership if: (i) the organization, by itself, may require the partnership to perform, or may prevent the partnership from performing, any act that significantly affects the operations of the partnership; (ii) any of the organization's officers, directors, trustees, or employees have rights to participate in the management of the partnership at any time; (iii) any of the organization's officers, directors, trustees, or employees have rights to conduct the partnership's business at any time; or (iv) the organization, by itself, has the power to appoint or remove any of the partnership's officers or employees or a majority of directors.

(4) For purposes of the de minimis test and the participation test, an organization

determines its percentage interest by taking the average of the organization's percentage interest at the beginning and the end of the partnership's taxable year, or, in the case of a partnership interest held for less than a year, the percentage interest held at the beginning and end of the period of ownership within the partnership's taxable year. See Treas. Reg. 1.512(a)-6(c)(5)(iii).

(5) In determining the exempt organization’s percentage interest in a partnership,

the exempt organization may rely on the Schedule K-1 it receives from the partnership if the form lists the organization's percentage profits interest or its percentage capital interest, or both, at the beginning and end of the year.

(6) A typical pooled investment fund is treated as a partnership for federal tax

purposes therefore most interests in these funds apply the qualifying partnership interest rules to treat them as a single trade or business.

(7) Transition Rule: An organization may choose to apply the following transition

rule if the partnership interest (acquired prior to August 21, 2018) doesn’t meet either the de minimis test or participation test described above. An exempt organization may treat each such partnership interest as comprising a single unrelated trade or business for purposes of Section 512(a)(6) whether or not there is more than one trade or business directly or indirectly conducted by the partnership or lower-tier partnerships.

(1) Section 1361(c)(6) allows organizations described in Section 501(c)(3) or

Section 401(a) and exempt from tax under Section 501(a) to own stock in an S Corporation without causing the corporation to lose its S Corporation status.

(2) However, under Section 512(e), the items of income, deduction or loss that are

considered to be distributed by the S Corporation to a shareholder that is a taxexempt organization will in all cases be treated as unrelated business taxable income by the exempt organization, regardless of the source or nature of the income, deduction, or loss. In addition, any gain or loss on the disposition of the

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S Corporation stock by the exempt organization will be treated as unrelated business taxable income.

(1) Associate member dues are amounts paid to membership organizations by

persons who may or may not receive all the rights and privileges afforded full members. Many organizations have long had various classes of members; however, associate membership became a significant issue in certain instances where exempt organizations created an associate (or limited benefit) member class in order for such individuals to qualify for insurance coverage, and their dues payments were essentially payments for such insurance. See American Postal Workers Union, AFL-CIO v. United States, 925 F.2d 480 (D.C. Cir. 1991), National Association of Postal Supervisors v. Commissioner, 944 F.2d 859 (Fed. Cir. 1991) and National League of Postmasters of the United States v. Commissioner, 86 F.3d 59 (4th Cir. 1996), all of which held that sponsoring and providing access to health insurance programs for associate or limited benefit members constitutes an unrelated trade or business. As discussed in Part II.A.3 of this document, an exempt organization’s provision of services for a fee to full-fledged members related to the purchase of group insurance may be an unrelated business.

(2) Rev. Proc. 95-21, 1995-1 C.B. 686, provides that dues payments from

associate members of Section 501(c)(5) organizations won’t be treated as gross income from the conduct of an unrelated trade or business unless the associate member category was formed or availed of for the principal purpose of producing unrelated business income. Rev. Proc. 97-12, 1997-1 C.B. 631, amplifies and modifies Rev. Proc 95-21 with two significant clarifying provisions. First, the newer revenue procedure discusses Section 512(d), which applies to the treatment of dues paid to Section 501(c)(5) agricultural or horticultural organizations (see below), and secondly, it extends the application of Rev. Proc. 95-21 to organizations described in Section 501(c)(6), such as business leagues, chambers of commerce, real estate boards and boards of trade.

(1) Section 512(d) provides a "safe harbor" from unrelated business taxable income

for dues of $100 or less, indexed for inflation, paid to Section 501(c)(5) agricultural or horticultural organizations. Under Section 512(d), if an organization requires the payment of annual dues and the amount of the dues doesn’t exceed $100, the dues won’t be treated as derived from an unrelated trade or business. The statute provides that the $100 dues ceiling will be indexed according to a cost-of-living adjustment for tax years beginning in a calendar year after 1995. Per Rev. Proc. 2022-38, for taxable years beginning in 2023, the limitation under Section 512(d)(1), regarding the exemption of annual dues required to be paid by a member to an agricultural or horticultural organization, is $191 . An annual revenue procedure is published with updated inflation-adjusted amounts. Per Rev. Proc. 2018-18, section 3.29 "dues" is

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defined as any payment, whether or not specifically designated as dues, that is required to be made in order to be recognized as a member of the organization. See Section 512(d)(3).

(1) In addition to the credits listed below, the Inflation Reduction Act of 2022, Public

Law No. 117-169, also provides for a number of new credits generally relating to the promotion of clean energy and available to exempt organizations as well as other taxpayers. Under Section 6417, “any organization exempt from the tax imposed by subtitle A” may make an election with respect to an applicable credit to treat it as payment against tax. Under Section 6418, any taxpayer other than an applicable entity that makes the election under Section 6417 may sell its credit to an unrelated taxpayer.

(2) The general business tax credit isn’t a single separate credit. Instead, it

represents several specific tax credits that promote certain business activities as described below. The general business credit for the current year consists of the carryforward of business credits from prior years plus the total of the current year business credits. In addition, the general business credit for the current year may be increased later by the carryback of business credits from later years. The credit is subtracted directly from UBIT. See Section 38 and Form 3800, General Business Credit. The following credits are applicable to exempt organizations and meet the requirements of the general business tax credit.

(1) Section 45B(a) provides that, for purposes of Section 38, the employer social

security credit is an amount equal to the “excess employer social security tax” paid or incurred by the taxpayer during the taxable year. The term “excess employer social security tax” means any tax paid by an employer under Section 3111 (both social security tax and Medicare tax) with respect to tips received by an employee to the extent (i) the tips are deemed to be paid by the employer pursuant to Section 3121(q) (without regard to whether the employees reported the tips to the employer pursuant to Section 6053) and (ii) the tips exceed the amount by which the wages (excluding tips) paid by the employer to the employee during such month are less than the total amount which would be payable (with respect to such employment) at the minimum wage rate.

(2) When determining the amount of the “excess employer social security tax,” only

tips received from customers in connection with providing, delivering, or serving food or beverages for consumption when tipping is customary shall be taken into account. See Section 45(B)(b)(2).

(3) Employers may claim or elect not to claim the credit any time within three years

from the due date of the tax return on either the original return or an amended return. The credit is a general business tax credit and is claimed on Form 8846, Credit for Employer Social Security and Medicare Taxes on Certain Employee Tips. Since it is an income tax credit claimed on an income tax return (for

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example, Form 990-T), employers may use it to offset any income tax liability, but not employment tax liabilities. Employers can’t claim both the Section 45B credit AND take an income tax deduction for any amount taken into account in determining the Section 45B credit. The Section 45B credit isn’t refundable which means if the credit reduces the employer’s income tax (UBIT) below zero, to a negative amount, the negative amount isn’t sent as a tax refund. However, it is subject to carry back and carryforward provisions as described in Section 38.

(4) In computing UBIT, it is proper for a social club described in Section 501(c)(7)

to claim the credit under Section 45B for the portion of employer social security taxes paid with respect to employee tips received above the minimum wage amount from both members and nonmembers. These tips meet the requirements under Section 45B(b)(2) because the tips were received in connection with food and beverage service and tipping of employees is customary. Section 45B doesn’t prohibit social clubs described in Section 501(c)(7) from claiming the credit, nor does it limit the credit to social security taxes paid in connection with a social club's unrelated trade or business. Therefore, a social club described in Section 501(c)(7) may calculate the Section 45B credit on the basis of all tips received by its employees, not only the tips received by employees from nonmembers. See Rev. Rul. 2003-64 2003-1 C.B. 1036.

(1) Employers use Form 8882, Credit for Employer-Provided Childcare Facilities

and Services, to claim the credit for qualified childcare facility and resource and referral expenditures. For purposes of Section 38, the employer-provided childcare credit determined under this Section for the taxable years is an amount equal to the sum of:

a. 25 percent of the qualified childcare expenditures, and

b. 10 percent of the qualified childcare resource and referral expenditures of

the taxpayer for such taxable year. See Section 45F(a).

(2) The credit allowable under Section 45F(a) for any taxable year shall not exceed

$150,000. See Section 45F.

(1) Section 45R offers a tax credit to certain small employers, including tax-exempt

employers, that provide health insurance coverage to their employees (eligible small employer). The credit generally is available for taxable years beginning after December 31, 2009. For taxable years beginning after December 31, 2013, the credit is available only with respect to premiums paid by a small employer for a qualified health plan offered by the employer to its employees through a Small Business Health Options Program (SHOP) Exchange and is

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available only for a period of two consecutive taxable years. Additionally, for taxable years beginning after December 31, 2013, the maximum credit rate is increased to 50 percent from 35 percent for eligible small employers and to 35 percent from 25 percent for tax-exempt eligible small employers. A tax-exempt eligible small employer may claim the credit by filing Form 990-T, Exempt Organization Business Income Tax Return and attaching Form 8941, Credit for Small Employer Health Insurance Premiums. The regulations provide guidance on determining eligibility for the credit and calculating and claiming the credit. See Treas. Reg. 1.45R-1 through -5.

(1) Section 512(a)(3) provides special rules for certain exempt organizations to

calculate their unrelated business taxable income (UBTI).

(1) The following organizations must calculate their UBTI under Section 512(a)(3)

rather than Section 512(a)(1):

a. Social clubs (described in Section 501(c)(7)),

b. Voluntary employees’ beneficiary associations (VEBAs) (described in

Section 501(c)(9)), and

c. Supplemental unemployment compensation benefit trusts (SUB trusts)

(described in Section 501(c)(17)).

(2) Organizations that must calculate their unrelated business income under

Section 512(a)(3) are taxed on all income that isn’t "exempt function income." Thus, such organizations are taxed on income from outside their membership and on investment income. Congress explained the special UBTI rule as follows (H.R. Rep. No. 91-413 Pt. 1 p. 48 (Aug. 2, 1969)):

a. “Since the tax exemption for social clubs, for example, is designed to allow

individuals to join together to provide recreational or social facilities on a mutual basis, without tax consequences, the tax exemption operates properly only when the sources of income of the organization are limited to receipts from the membership. Under such circumstances, the individual is in substantially the same position as if he had spent his income on pleasure or recreation without the intervening separate organization. However, where the organization receives income from sources outside the membership, such as income from investments, upon which no tax is paid, the membership receives a benefit not contemplated by the

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exemption in that untaxed dollars can be used by the organization to provide pleasure or recreation to its membership.”

(3) In general, Section 512(a)(3) provides rules for determining the UBIT of social

clubs, voluntary employees' beneficiary associations and SUB trusts. Under Section 512(a)(3)(A), UBTI of a social club, VEBA, or SUB trusts means all income except exempt function income, less the deductions allowed by Chapter 1 of the Code which are directly connected with the production of the gross income.

(4) In general, under Section 512(a)(3)(B), gross income from members is

considered exempt function income if it is paid by members as consideration for providing such members, their dependents (as defined in Section 152), or guests with goods, facilities or services in furtherance of the exempt purposes of the organization. Exempt function income also includes income that is set aside for purpose specified in Section 170(c)(4) or in the case of an organization described in Section 501(c)(9) or 501(c)(17) to provide for the payment of life, sick, accident or other benefits, subject to certain limitations on the amounts set-aside.

(1) Generally, UBTI under Section 512(a)(3)(A) is calculated in the following

manner:

a. All gross income, (excluding exempt function income),

b. Less deductions allowed by Chapter 1 of the Code which are directly

connected with the production of gross income (excluding exempt function income), both computed with

c. Modifications for net operating losses as described in Section 512(b)(6),

charitable contributions under Section 512(b)(10) or Section 512(b)(11), and the standard $1,000 deduction under Section 512(b)(12).

(1) In calculating unrelated business income under Section 512(a)(3)(A), gross

income needs to be determined initially. Gross income is all income to the organization.

(2) Rev. Rul. 76-337, 1976-2 C.B. 177 holds that interest on obligations of a state

received by a social club exempt under Section 501(c)(7) isn’t included in its gross income for the purpose of computing UBTI under Section 512(a)(3), based on the exclusion from gross income provided under Section 103(a).

(1) Exempt function income includes:

a. Amounts derived from dues, fees, charges, or similar amounts of gross

income from members, and

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b. Set-aside income.

(2) Treas. Reg. 1.512(a)-5 provides special rules for the computation of UBTI of

VEBAs and SUB trusts (referred to in the regulations as a “Covered Entity”). Treas. Reg. 1.512(a)-5(b)(2) provides that the exempt function income of a Covered Entity is the sum of:

a. Amounts referred to in the first sentence of Section 512(a)(3)(B) that are

paid by members of the Covered Entity and employer contributions to the Covered Entity (collectively “member contributions”),

b. Other income of the Covered Entity (including earnings on member

contributions) that is set aside for a purpose specified in Section 170(c)(4) and reasonable costs of administration directly connected with such purpose, and

c. Other income of the Covered Entity (including earnings on member

contributions) that, subject to the limitation of Section 512(a)(3)(E) (as described in Treas. Reg. 1.512(a)-5(c)), is set aside for the payment of life, sick, accident, or other benefits and reasonable costs of administration directly connected with such purpose. See Treas. Reg. 1.512(a)-5(b)(1).

(1) Gross income from members is considered exempt function income if it is paid

by members as consideration for providing such members, their dependents (as defined in Section 152), or guests with goods, facilities, or services in furtherance of the exempt purposes of the organization. See Section 512(a)(3)(B). These items of gross income include:

a. Dues,

b. Fees,

c. Charges, or

d. Similar amounts paid by members.

(2) Examples of gross income from members (exempt function income) include:

a. Income derived by a social club from members of the club for use of the

club’s golf course. See H.R. Rep. No. 91-413 (Part 2), 91st Cong., 1st Sess. 23 (1969), 1969-3 C.B. 353.

b. Amounts paid by a social club member’s spouse or by a member for his or

her dependent. See Rev. Proc. 71-17, Section 2.01.

c. Amounts paid for the benefit of a social club member by the member’s

employer for a use that serves a direct business objective of the employee-member solely for purposes of section 3.03(1) and 3.03(2). See Rev. Proc. 71-17, Section 3.03(3).

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(1) Set-aside income is classified as exempt function income. See Section

512(a)(3)(B). It is income derived by an organization which is set aside for either of the following purposes (including the reasonable administration costs directly connected with such purpose):

a. for a purpose specified in Section 170(c)(4) (religious, charitable,

scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals); or

b. in the case of Section 501(c)(9) or (17) organizations, to provide for the

payment of life, sick, accident, or other benefits.

(2) If in any year an amount attributable to income set aside is used for any other

purpose than those described in Section 512(a)(3)(B)(i) or (ii), then this amount is subject to the UBIT. See Section 512(a)(3)(B).

(3) Gross income from an unrelated trade or business described in Section

512(a)(1) can’t be set aside as exempt-function income. See Section 512(a)(3)(B).

(4) National organizations of college fraternities and sororities often set aside

income for various activities such as:

a. Scholarships,

b. Student loans, and

c. Leadership and citizenship schools and services.

(5) Prop. Reg. 1.512(a)-3 (36 FR 8808, May 13, 1971), later withdrawn (52 FR

2724, Jan. 26, 1987), provided that set-aside income may be temporarily invested or accumulated (as long as the amount and duration aren’t unreasonable), provided that it’s earmarked or placed in a separate account. This provision has long appeared in the Form 990-T instructions. Phi Delta Theta Fraternity v. Commissioner, 887 F.2d 1302 (6th Cir. 1989), applying the provisions of Treas. Regs. 1.512(a)-4 and 1.642(c)–2 to define a proper setaside, held that funds used to pay the costs of the fraternity’s publication (even if it had been educational) from an endowment fund weren’t properly set aside because the fund could be used for non-charitable purposes of the fraternity. See also Confrerie de la Chaine des Rotisseurs v. Commissioner, T.C. Memo. 1993-637.

(6) The above-referenced withdrawn proposed regulation also provided that set aside income may be excluded from gross income only in the taxable year in which it’s includible in gross income, except that a taxpayer may set aside amounts of gross income from a prior taxable year to the extent that such amounts could have been set aside and are actually set aside on or before the date prescribed for filing the Exempt Organization Business Income Tax Return (Form 990–T). This provision has also long appeared in the Form 990-T instructions and in Pub. 598.

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(7) Example: Assume that X, a social club described in Section 501(c)(7), received

$5,000 in dividend income which is includible in gross income in X’s taxable year ending December 31, 2017, on account of Section 512(a)(3). Also, assume that X must file its Form 990-T for taxable year 2017 by May 15, 2018. In this case, X may elect to treat the $5,000 as a set-aside on its 2017 Form 990-T if it sets aside such amount no later than May 15, 2018.

(8) Section 512(a)(3)(E) provides an amount won’t be considered set aside for

purposes of Section 512(a)(3)(B)(ii) to the extent it exceeds the account limit of Section 419A(c) for life, medical, supplemental unemployment, severance, or disability benefits, except that under Section 512(a)(3)(E)(ii)(I), the limitation doesn’t apply to existing reserves for post-retirement medical benefits or postretirement life insurance benefits. The effect of this provision is to tax Section 501(c)(9) and (17) organizations on their investment income to the extent their asset accounts under Section 419A are overfunded. See Treas. Reg. 1.512(a)5(c)(1).

(9) A VEBA may not avoid the limitation on exempt function income in Section

512(a)(3)(E)(i) merely by allocating, or purporting to allocate, investment income toward the payment of welfare benefits during the course of the tax year. See Treas. Reg. 1.512(a)-3(c)(2)(i) and Northrop Corp. Employee Ins. Benefit Plans Master Trust v. U.S., 99 Fed.Cl. 1 (2011).

(10) In Sherwin-Williams Co. Employee Health Plan Trust v. Comm'r, 330 F.3d 449

(6th Cir. 2003), the Court of Appeals for the Sixth Circuit concluded Section 512(a)(3)(E) limits how much the VEBA may accumulate, not how much may be set aside. The court held that Section 512(a)(3)(E)(i)'s limit on accumulating setaside income doesn’t apply to income that was set aside and spent on the reasonable costs of administering health care benefits under Section 512(a)(3)(B), and that such spent income is exempt function income, not subject to tax under Section 512(a)(3)(A). This was contrary to the interpretation the IRS and Treasury maintained. Sherwin-Williams remained precedent for taxpayers in the 6 ^th Circuit until IRS and Treasury issued final regulations. The IRS issued final regulations on this issue that were effective December 10, 2019. See Treas. Reg. 1.512(a)-5. Based on the final regulations, IRS will continue to interpret Section 512(a)(3)(E)(i) to mean that whether a Section 501(c)(9) organization or Section 501(c)(17) organization allocated its investment income (rather than other funds) to current year expenditures is irrelevant to the application of the set aside limitation.

(1) A deduction allowable under Chapter 1 of the Code will only be taken into

account in computing UBTI under Section 512(a)(3) if it is directly connected with the production of gross income (excluding exempt function income). Personnel expenses used both for an exempt purpose and for the production of

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gross income (excluding exempt function income) shall be allocated between the two uses on a reasonable basis. See Treas. Reg. 1.512(a)-1(c).

(2) Example: Assume that X, an exempt organization subject to the provisions of

Section 511, pays its manager a salary of $10,000 a year and that it derives gross income from the conduct of unrelated trade or business activities. If the manager devotes 10 percent of his/her time during the year the unrelated business activity), a deduction of $1,000 (10 percent of $10,000) would be allowable for purposes of computing X’s UBTI.

(3) In Chicago Metropolitan Ski Council v. Commissioner, 104 T.C. 341 (1995), the

Tax Court held that the special rules for the computation of UBTI from periodical advertising under Treas. Reg. 1.512(a)-1(f) apply to social clubs. Thus, a deduction from advertising income is allowed for excess readership costs (expenses related to the editorial content of a publication), as discussed in Part III.D of this document.

(4) In Rolling Rock Club v. United States, 785 F.2d 93 (3rd Cir. 1986), the court

held that a Section 501(c)(7) social club wasn’t entitled to claim the dividends received deduction under Section 243 against its investment income. The court observed that Section 512(a)(3)(A) was amended in 1976 to provide that, for purposes of determining the UBTI and the allowable deductions therefrom, the deductions provided by Sections 243 and 245 (relating to dividends received by corporations) shall be treated as not directly connected with the production of income.

(5) In South End Italian Independent Club, Inc. v. Commissioner, 87 T.C. 168

(1986), acq. in result,1987-2 C.B. 1, AOD-1987-15 (June 15, 1987), the court held that a Section 501(c)(7) social club, which distributed its net proceeds from the operation of beano (bingo) games in accordance with state law requirements, wasn’t subject to the charitable contribution deduction limitations imposed by Section 512(b)(10), because the proceeds were deductible as ordinary and necessary business expenses under Section 162, rather than as charitable contributions under Section 170.

(6) In Ye Mystic Krewe of Gasparilla v. Commissioner, 80 T.C. 755 (1983), a

Section 501(c)(7) social club staged a "mock invasion" of a city which was followed by a parade. The club owned the concession rights along the parade route and negotiated contracts with others to provide seats and refreshments. The club received a percentage of the net receipts from these concessions, as well as amounts derived from the sale of logbooks and from the sale of advertising contained in them. The court held that the club’s gross income from the concessions and the sales of logbooks was UBTI under Section 512(a)(3)(A), and that the expenses of staging the invasion and parade weren’t directly connected with the production of income from the concessions and logbooks.

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(1) Rev. Rul. 81-69, 1981-1 C.B. 351 discusses a Section 501(c)(7) social club that

has UBTI from investments made for profit. The club also sells food and beverages to nonmembers at prices insufficient to recover the costs of such sales. Sales of food and beverages to nonmembers have consistently over a number of years resulted only in losses, which are expected to continue. Applying Section 512(a)(3)(A), the revenue ruling holds that because the club’s sales of food and beverages to nonmembers aren’t profit motivated, the club may not deduct losses from sales to nonmembers from its net investment income.

(2) In Portland Golf Club v. Commissioner, 497 U.S. 154 (1990), the Court held that

a Section 501(c)(7) social club was required to demonstrate an intent to earn gross receipts in excess of both variable and fixed costs to show an intent to profit. The case required the Court to determine whether the club, in calculating its liability for Federal income tax, may offset losses incurred in selling food and drink to nonmembers against the income realized from its investments. The club had sustained losses on sales to nonmembers for ten years. The Court held that the club was allowed to offset investment income by losses incurred in sales to nonmembers only if those sales were motivated by an intent to profit. The Court further held that an intent to profit is determined by using the same method to allocate fixed costs to nonmember sales as that used to compute the club's actual profit or loss. In applying this standard, the Court determined that Portland failed to show that it had intended to earn gross income from nonmember sales in excess of its total cost. Therefore, the club lacked the requisite profit motive with regard to nonmember sales. The Court analyzed Section 512(a)(3)(A) and viewed the inclusion of the phrase "allowed by this chapter" as limiting deductions of expenses to those described in Chapter 1. Thus, only deductions that meet the criteria of Section 162(a) are permitted. Under Section 162(a), expenses must be incurred in connection with a "trade or business." The Court noted that to disregard the profit-motive requirement would run counter to the principle of tax neutrality underlying the statutory scheme (discussed in Part IV.A(2) of this document). See also the discussion in Part II.A of this document.

(3) See also Losantiville Country Club v. Commissioner, T.C. Memo. 2017-158,

aff’d by 906 F.3d 468 (6th Cir. 2018).

(4) Note that post-2017, Section 512(a)(6) requires siloing of unrelated businesses

for purposes of offsetting losses from one unrelated business (including an investment activity) against net income from another, as discussed in Part III.G of this document. Section 512(a)(6) applies to Section 501(c)(7), (9), and (17) organizations as well as other exempt organizations, subject to certain special rules for the treatment of investment activities in Treas. Reg. 1.512(a)-6, as discussed in Part III.G.2(4) of this document.

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(1) Section 512(a)(3)(C) provides that when the income of an exempt holding

company (described in Section 501(c)(2)) is payable to an exempt organization which is described in Section 501(c)(7), (9), or (17), the holding company is to be treated as if it were the organization to which its income is payable. Thus, if the income of a holding company is payable to a social club or a VEBA, the holding company will be subject to tax as if it were a social club or a voluntary employees’ beneficiary association. However, the holding company won’t be treated as having exempt function income unless it files a consolidated return with the payee organization.

(1) The sale of property is taxable under Section 512(a)(3)(A) unless the sale

satisfies the nonrecognition requirements of Section 512(a)(3)(D). If the requirements of Section 512(a)(3)(D) are satisfied, then an organization may exclude all or a portion of the gain from the sale of property.

(2) Requirements for an organization to exclude gain under Section 512(a)(3)(D):

a. A sale of property.

b. The property is used directly in the performance of an organization’s

exempt function.

c. New property is purchased by the organization.

d. The new property is used directly in the performance of an organization’s

exempt function.

e. The new property is purchased within a four-year period, beginning one

year before the date of the sale of the old property and ending three years after the sale.

f. The new property purchased need not be similar in nature or in use to the

property sold. See Tamarisk Country Club v. Commissioner, 84 T.C. 756, 758 n. 2. (1985).

g. Gain (if any) from the sale is recognized only to the extent that the sales

price of the old property exceeds the cost of the new property. The recognized gain is includible in the organization’s gross income in the year in which the gain is realized. Rules similar to subsections (b), (c), (e), and (j) of Section 1034 (relating to rollover of gain on sale of principal residence, immediately before its repeal in 1997) apply. See former Section 1034(j) and former Treas. Reg. 1.1034-1(i)(1) (1997) for an extended limitations period for the assessment of any tax deficiency on such gain.

h. The recognized gain is includible in the organization’s gross income in the

year in which the gain is realized.

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i. Example : A social club sells its clubhouse. The gain on the sale won’t be

taxed if the entire proceeds are reinvested in a new clubhouse within three years. See S. Rep. No. 91-552, 91st Cong., 1st Sess. 72 (1969), 1969-3 C.B. 470.

(1) There is no definition of what is considered "used directly" in the performance of

an organization’s exempt function for purposes of Section 512(a)(3)(D). Examples of property that are directly used, include but aren’t limited to:

a. Golf course (see PLR 200826038 (Apr. 4, 2008)

b. Club house (see id.)

c. Timber cut on a hunting or fishing club’s property (see TAM 9541002

(Feb. 3, 1995))

(2) Atlanta Athletic Club v. Commissioner, 980 F.2d 1409 (11th Cir. 1993)

addressed the issue of whether property is used directly in performance of its exempt function.

a. Facts: The club owned a piece of property which has a slag road for

members and guest parking. A pine jogging track was built on the property but later abandoned. Club members testified that the property was the site of a number of member activities such as pasture parties, Easter egg hunts, fishing tournaments, kite flying contests, hot air balloon rides and organized foot races. Members jogged on the property, used it for archery practice and flew model airplanes.

b. Holding: The court looked at the record and saw nothing to contradict the

club’s evidence that the property was used for recreational purposes. Direct use isn’t to be equated with dominant use or requiring that direct use have either continuity or regularity. Direct use is to be determined by looking at the activities that took place on the property and determining whether these activities constitute recreational uses by the club. Organizations need to keep records that provide details concerning the use of the property to prove that the property sold furthered their exempt purposes.

(3) The Tax Court in Deer Park Country Club v. Commissioner, T.C. Memo. 1995–

567, stated that land subject to Section 512(a)(3)(D) must actually be used for exempt functions prior to the sale.

a. Facts: A country club purchased two tracts of land, one used for fishing

and one as a golf course. It subsequently transferred the fishing property to the state of Illinois for cash and a 63.8-acre tract of farmland. The farmland was rented from 1981 to 1986, and during that time, the club engaged a designer to develop plans for constructing an additional golf course, a swimming pool, and tennis courts. After consulting with banks

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regarding financing, the club decided to devote 59 acres for recreational purposes and to subdivide and sell the remaining 4.8 acres.

b. Holding: Section 512(a)(3)(D) requires a use of assets or property that is

both actual and direct in relation to the performance of its exempt function. The intention of using property in furtherance of exempt purposes is irrelevant. Although the club may have originally intended to use all of the land for recreational purposes, the fact that the club never used the 4.8 for exempt purposes was dispositive. The club’s gain on the 4.8 acres was therefore subject to UBIT.

(4) In Framingham Country Club v. United States, 659 F. Supp. 650 (D. Mass.

1987), the court held a Section 501(c)(7) social club couldn’t use the nonrecognition of gain provision under Section 512(a)(3)(D) with respect to income received from an option on the sale of property. In the court’s view, the lapse of an option is to be treated as ordinary income to the grantor and not as short-term capital gain resulting from a "sale." An alternative adverse holding made by the court was that the club hadn’t sufficiently demonstrated that the property was used directly in the performance of the club’s exempt function as required by Section 512(a)(3)(D). The court noted that although the property may have been originally purchased with the intention of providing golfing facilities, it was never used for that purpose. The use of a home for a greenskeeper and the storage of large equipment on the property didn’t directly facilitate the club’s exempt function.

(5) In Tamarisk Country Club v. Commissioner, 84 T.C. 756 (1985), the court held

that the gain realized by a Section 501(c)(7) social club from the sale of real property was fully recognized as UBTI because the club’s sales price less selling expenses exceeded the cost of the new property by more than the amount of gain realized on the sale. The court rejected the club’s argument that it was entitled to nonrecognition of gain to the extent its equity or profit was reinvested in other qualifying property.

(1) This section discusses the rules expanding the definition of unrelated business

income to include unrelated debt-financed income from investment property in proportion to the degree of indebtedness on the property (measured as a percentage of the property’s average adjusted basis). Property purchased with borrowed money (acquisition indebtedness) and held to produce investment income is referred to as debt-financed property. Various types of passive income constitute unrelated business taxable income if:

a. The income arises from property acquired or improved with borrowed

funds, and

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b. The production of income is unrelated to the purpose constituting the

basis of the organization’s tax exemption.

(1) Rents from real property traditionally have been excluded from the statutory

definition of UBTI. See Section 512(b)(3). To avoid an abuse of this exclusion, the Revenue Act of 1950 included “business lease” provisions which provided, in general, that long-term rentals from real property would be taxed to the extent of the indebtedness on the property.

(2) The necessity for Section 514 arose because a large number of tax-exempt

organizations bought businesses and investments on credit, frequently at greater than the market price, while contributing little or nothing to the transaction other than their tax exemption. In a typical transaction, a corporate business was sold to a Section 501(c)(3) organization, which paid little or no money down, and agreed to pay the balance of the purchase price out of profits from the property. The exempt organization next liquidated the corporation and leased the business assets back to the seller. The seller then formed a new corporation to operate the business. The newly formed corporation paid a large portion of its business profits as rent to the exempt organization, which then paid most of these profits back to the original owner as installment payments on the original purchase price. In the well-known Clay Brown case (Commissioner v. Brown, 380 U.S. 513 (1965)), a business was able to realize increased aftertax income, and the exempt organization acquired the ownership of a business valued at $1.3 million without the investment of its own funds. The tax results of this transaction under pre-1969 law provided a capital gain to the seller, a rent deduction for the operator, and no tax on the tax-exempt organization, similar to the arrangement described above. See H.R. Rep. 91-413, 91st Cong., 1st Sess., reprinted at 1969-3 C.B. 200, 229 and S. Rep. 91-552, 91st Cong., 1st Sess., reprinted at 1969-3 C.B. 423, 464.

(3) Congress remedied this situation by including in the Tax Reform Act of 1969 a

provision which imposes the unrelated business income tax on all types of passive unrelated income from income-producing debt-financed property. This differs from the "business lease" provisions that only taxed "rentals from real property." To further strengthen this measure, Congress expanded the categories of exempt organizations subject to UBIT to include all organizations exempt under Section 501(a) other than organizations described in Section 501(c)(1).

(4) The Supreme Court has stated that the undisputed purpose of UBIT is to

prevent tax-exempt organizations from competing unfairly with businesses whose earnings were taxed. See U.S. v. American Bar Endowment, 477 U.S. 105, 114 (1986) and United States v. American College of Physicians, 475 U.S. 834, 838 (1986). The House Report on Section 514 also indicated a purpose to eliminate the incentive for owners desiring to sell a business to exploit the tax exemption of nonprofit organizations, with its damaging consequences to the

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Federal revenues. H.R. Rep. No 413 (Pt. 1), 91st Cong., 1st Sess. 46 (Aug. 2, 1969).

(5) Under Section 514(a), unrelated debt-financed income that would otherwise be

excluded from an exempt organization's UBTI must be included to the extent it is derived from debt-financed property. See Debt-financed Income Lead Sheet (Exhibit X.G of this document).

(6) Under Section 514(b), the term "debt-financed property" generally means any

property held to produce income (including gain from its disposition) and with respect to which there is an acquisition indebtedness at any time during the tax year (or during the 12-month period before the date of the property's disposal if it was disposed of during the tax year). It includes rental real estate, tangible personal property, and corporate stock. The calculation of debt-financed taxable income is made on a property-by-property basis. See Treas. Reg. 1.514(b)1(a).

(7) Under Section 512(b)(4), in the case of debt-financed property, an exempt

organization must include, as an item of gross income from an unrelated trade or business, any unrelated debt-financed income determined under Section 514 with respect to such debt-financed property, even if an amount received with respect to the debt-financed property would ordinarily be excluded from the calculation of UBTI under Section 512(b)(1), (2), (3), or (5). The amount of income included is proportionate to the debt on the property.

(8) Under Section 512(b)(1), (2), (3), and (5), the amounts that are included in UBTI

if subject to acquisition indebtedness include dividends, interest, annuities, royalties, rents, and capital gains. These generally are income from investment activities. Moreover, Section 514 generally doesn’t apply to any property to the extent that the income from such property is taken into account in computing the gross income of any unrelated trade or business (except in the case of capital gains from such property that would be excluded under Section 512(b)(5)). See Section 514(b)(1)(B).

(9) In some circumstances, rental of real property is an unrelated trade or business

that must be identified using NAICS 2-digit codes which were discussed earlier in this document in Part III.G.1. For example, Section 512(b)(3)(B) provides that rents from real and personal property are included in UBTI if more than 50 percent of the total rent received or accrued under a lease is attributable to personal property. Section 512(b)(4) and Section 514 don’t apply where such real or personal property is purchased with debt financing because the rents from these properties will have already been included in UBTI. See Section 514(b)(1)(B) and Treas. Reg. 1.514(b)-1(b)(2)(i). Accordingly, because rent from such real and personal property is included in UBTI, the exempt organization must identify such unrelated trade or business using the NAICS 2digit code for real estate rental and leasing (NAICS code 53) Note: The NAICS business activity codes are updated every 5 years. See www.cenus.gov. By contrast, if the rents were included in UBTI solely as unrelated debt-financed

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income, then the debt-financed property would be treated (together with other investment activities) as a single trade or business, except in the case of Section 501(c)(7) social clubs. See Treas. Reg. 1.512(a)-6(c)(1) and (7) and Part III.G of this document.

(1) The primary components for figuring unrelated debt-financed gross income

under the formula announced in Treas. Reg. 1.514(a)-1(a)(1)(ii) are:

a. Average acquisition indebtedness,

b. Average adjusted basis, and

c. Gross income derived during the taxable year from or on account of the

debt-financed property.

(2) The formula for deriving "unrelated debt-financed income" is:

(3) The initial fraction in the formula is the debt/basis percentage. See Treas. Reg.

1.514-1(a)(1)(iii). The percentage of income treated as income from an unrelated trade or business decreases as the indebtedness on the debtfinanced property decreases.

a. Example: X, an exempt trade association, owns an office building which is

debt-financed property. The building in 1971 produces $10,000 of gross rental income. The average adjusted basis of the building for 1971 is $100,000, and the average acquisition indebtedness with respect to the building in 1971 is $50,000. Accordingly, the debt/basis percentage for 1971 is 50% (the ratio of $50,000 to $100,000). Therefore, the unrelated debt-financed income with respect to the building for 1971 is $5,000 (50% of $10,000). See Treas. Reg. 1.514(a)-1(a)(iv).

(1) Section 514(e) provides that where only a portion of property is debt-financed

property, proper allocation of the basis, indebtedness, income, and deductions with respect to such property must be made to determine the amount of income or gain derived from such property that will receive treatment as unrelated debtfinanced income. See Treas. Reg. 1.514(b)-1(b)(1)(iii), Treas. Reg, 1.514(b)1(b)(3) and Part V.J.1(7) of this document.

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(1) Under Treas. Reg. 1.514(a)-1(a)(1)(v), if an organization sells or otherwise

disposes of debt-financed property, it must include in computing unrelated business taxable income an amount with respect to any gain (or loss) which is the same percentage (not over 100%) of the total gain (or loss) derived from the sale as:

a. The highest acquisition indebtedness with respect to such property during

the 12-month period preceding the date of disposition, is of

b. The average adjusted basis of such property.

(2) Treas. Reg. 1.514(a)-1(a)(1)(v) provides that the tax on this amount is

determined in accordance with the rules regarding capital gains and losses in Subchapter P, chapter 1 of the Code.

(3) However, Rev. Rul. 77-71, 1977-1 C.B. 155, provides that the transfer, subject

to an existing mortgage, of an appreciated building by a tax-exempt organization to its wholly-owned taxable subsidiary, in a manner that satisfies the nonrecognition provisions of Section 351(a), doesn’t result in a gain for which the exempt organization making the transfer will be taxed under Section 511.

(1) Under Section 514(a)(2), the deductions allowed with respect to each debt financed property are determined by applying the debt/basis percentage to the sum of the deductions allowable.

(2) The deductions allowable are those items allowed as deductions by chapter 1

of the Code which are directly connected with the debt-financed property or income therefrom (including the dividends received deductions allowed by Sections 243 and 245), except that:

a. The allowable deductions are subject to the modifications provided by

Section 512(b) on computation of UBTI, and

b. The depreciation deduction under Section 167 is computed only by use of

the straight-line method. See Treas. Reg. 1.514(a)-1(b)(2).

(3) To be "directly connected with" debt-financed property or the income therefrom,

an item of deduction must have a proximate or primary relationship to such property or income. Expenses, depreciation, and similar items attributable solely to such property qualify for deduction to the extent they meet the above requirements. See Treas. Reg. 1.514(a)-1(b)(3).

(4) Example: If the straight-line depreciation allowance for an office building is

$10,000 a year, an organization would be allowed a deduction for depreciation of $10,000 if the entire building were debt-financed property. However, if only half of the building were treated as debt-financed property, the depreciation allowed as a deduction would be $5,000. See Treas. Reg. 1.514(a)-1(b)(3).

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(1) If the sale or exchange of debt-financed property results in a capital loss, the

amount of such loss taken into account in the taxable year in which the loss arises is computed in determining the gain (or loss) from the sale or other disposition of the property. If any part of a loss may be carried back, or forward to another taxable year, it is taken as a deduction for that year without further application of the debt/basis percentage for such year. See Treas. Reg. 1.514(a)-1(b)(4)(i).

(2) Example : X, an exempt educational organization, owns securities which are

capital assets and which it has held for more than 6 months. In 1972 X sells the securities at a loss of $20,000. The debt/basis percentage with respect to computing the gain (or loss) derived from the sale of the securities is 40 percent. Thus, X has sustained a capital loss of $8,000 (40 percent of $20,000) with respect to the sale of the securities. For 1972 and the preceding three taxable years X has no other capital transactions. Under these circumstances, the $8,000 of capital loss may be carried over to the succeeding 5 taxable years without further application of the debt/basis percentage.

(1) Under prior law, organizations could carry back and carry forward net operating

losses from activities generating unrelated business taxable income under Section 511. In enacting Section 512(a)(6), Congress drastically changed how unrelated business taxable income is computed and how losses from unrelated business taxable activities may be utilized. Congress also provided transition rules for losses generated prior to December 31, 2017. The critical concept to remember in implementing Section 512(a)(6) is the idea of “siloing.” That is, in computing unrelated business taxable income, each unrelated trade or business is computed separately based on the applicable NAICS code, and the gains or losses from each trade or business aren’t aggregated. This prevents losses from certain unrelated trade or business activities from offsetting income from other unrelated trade or business activities. See Treas. Reg. 1.512(a)-6(a), (b), and (h). If income from debt-financed properties is included in UBTI solely as unrelated debt-financed income, then the debt-financed properties would be treated together, along with other investment activities, as a single trade or business for purposes of Section 512(a)(6). See Treas. Reg. 1.512(a)-6(c)(1) and (7) and Part III.G of this document.

(2) If, after applying the debt/basis percentage to the income and deductions from

debt-financed property, the deductions exceed such income, and there is no other source of income within the same trade or business, an organization has a net operating loss for the taxable year. This amount may be carried forward with its investment activities trade or business NOL to other taxable years in accordance with Section 512(b)(6). However, the debt/basis percentage isn’t applied in such other taxable years to determine the amounts that may be taken as deductions in those years. See Treas. Reg. 1.514(a)-1(b)(5).

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(3) Example: A property is debt-financed. During the taxable year, Y, an exempt

organization, receives $20,000 of rent from a building which it owns. Y has no other unrelated business taxable income for the year. The deductions directly connected with this building are property taxes of $5,000, interest of $5,000 on the acquisition indebtedness, and salary of $15,000 to the manager of the building. The debt/basis percentage of the taxable year with respect to the building is 50%. Under these circumstances, Y must take into account in computing its unrelated business taxable income for the taxable year, $10,000 of income (50% of $20,000) and $12,500 (50% of $25,000) of the deductions directly connected with such income. Thus, for the year, Y has sustained a net operating loss of $2,500 ($10,000 of income less $12,500 of deductions) which may be carried forward to other taxable years without further application of the debt/basis percentage. Remember, as mentioned earlier the loss would be siloed based on the unrelated trade or business activity and applicable NAICS code or if it was from an investment the appropriate code for those activities. See Treas. Reg. 1.514(a)-1(b)(5)(ii) and Treas. Reg. 1.512(a)-6(a), (b), and (h) and the Instructions to the Form 990-T.

(1) The "average adjusted basis" of debt-financed property is the average amount

of the adjusted basis of such property during that portion of the taxable year in which it is held by an organization. It is computed by averaging the adjusted basis as of the first day and as of the last day during the taxable year in which the organization holds the property. (Refer to Section 1011 and the Regulations thereunder for determination of the adjusted basis of property.) See Treas. Reg. 1.514(a)-1(a)(2)(i).

(2) The average adjusted basis of debt-financed property isn’t affected by the fact

that an organization was exempt from tax for prior taxable years. Adjustment must be made under Section 1011 for the entire period beginning with the acquisition of the property. See Treas. Reg. 1.514(a)-1(a)(2)(ii).

(3) For example, adjustment must be made for depreciation for all prior taxable

years whether or not the organization was exempt from tax. See Section 1016(a)(3)(B). The fact that only a portion of the depreciation allowance may be taken into account in computing the percentage of deductions allowable under Section 514(a)(2) doesn’t affect the amount of the adjustment for depreciation which is used in determining average adjusted basis. See Treas. Reg. 1.514(a)1(a)(2)(ii).

(1) Under Section 514(d), if debt-financed property is acquired by an exempt

organization in a complete or partial liquidation of a corporation in exchange for its stock, the organization’s basis in such property is the same as it would be in the hands of the transferor corporation. This basis is increased by the amount of gain recognized to the transferor corporation upon such distribution (see

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Section 337(d) and Treas. Reg. 1.337(d)-4) and by the amount of any gain to the organization, which is includible, on account of such distribution, as UBTI pursuant to Section 514(a).

(1) Section 514(c) defines acquisition indebtedness as the outstanding amount of

indebtedness incurred before, during or after the acquisition or improvement. In the case of indebtedness incurred before or after, acquisition indebtedness exists only if the indebtedness wouldn’t have been incurred but for such acquisition or improvement. See Section 514(c)(1)(B) and (C).

(2) In the case of indebtedness incurred after the acquisition or improvement,

acquisition indebtedness exists only if such indebtedness was also reasonably foreseeable at the time of such acquisition or improvement. See Section 514(c)(1)(C).

(3) The facts and circumstances of each situation determine whether incurring a

debt was reasonably foreseeable. That an organization may not have foreseen the need to incur a debt before acquiring or improving the property doesn’t necessarily mean that incurring the debt later wasn’t reasonably foreseeable. See Treas. Reg. 1.514(c)-1(a)(1).

(4) Example: Y, an exempt scientific organization, mortgages its laboratory to

replace working capital used in remodeling an office building that Y rents to an insurance company for nonexempt purposes. The debt is acquisition indebtedness since the debt, though incurred after the improvement of the office building, wouldn’t have been incurred without the improvement, and the debt was reasonably foreseeable when, to make the improvement, Y reduced its working capital below the amount necessary to continue current operations. See Example 2, Treas. Reg. 1.514(c)-1(a)(2).

(5) There are also several factors that need to be considered before determining

the amount of debt-financed income, including the income from the property, the cost of the property, and the amount of the liability.

(6) The amount of income subject to UBIT is the unrelated debt-financed income.

As discussed in (A), above, this value is derived from calculating the “average acquisition indebtedness,” the “average adjusted basis” and the gross income from the debt-financed property. See Section 514(a)(1).

(1) The term "average acquisition indebtedness" means the average amount of

outstanding principal indebtedness for the portion of the taxable year during which the property is held by an organization. See Treas. Reg. 1.514(a)1(a)(3)(i).

(2) Compute average acquisition indebtedness by determining principal

indebtedness on the first day in each calendar month during the taxable year,

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adding them together, and then dividing the sum by the total number of months in the year during which the organization held the property. A fractional part of a month is treated as a full month in computing average acquisition indebtedness. See Treas. Reg. 1.514(a)–1(a)(3)(ii). To computing the percentage of any gain or loss to be taken into account on a sale or other disposition of debt-financed property, use the highest amount of the acquisition indebtedness with respect to such property during the 12-month period ending with the date of the sale or other disposition instead of the average acquisition indebtedness for the taxable year. See Treas. Reg. 1.514(a)-1(a)(1)(v).

(3) In Marprowear Profit-Sharing Trust v. Commissioner, 74 T.C. 1086 (1980), a

qualified trust under Section 401(a) negotiated a reduction in the purchase price of a shopping center, which was debt-financed property, two years after the trust purchased the property. Since this reduced the amount owing on the property, the trust argued that it should be allowed to retroactively reduce the acquisition indebtedness on the property back to the time of the purchase. The Tax Court disagreed. The Court noted that to hold otherwise would mean that a property’s acquisition indebtedness could never be fixed because any mortgage payments, prepayments, or negotiated reductions of any sort in any subsequent taxable year would reduce the property’s acquisition indebtedness.

(1) In the event an organization purchases property in a transaction where neither

the price nor debt is clearly stated, the unadjusted basis of property acquired (or improved) is the fair market value of the property (or improvement) on the date of acquisition (or completion of improvement). The initial acquisition indebtedness is the fair market value of the property (or improvement) on the date of acquisition (or completion of improvement) less any down payment or other initial payment applied to the principal indebtedness. See Treas. Reg. 1.514(a)-1(a)(4)(ii)-(iii) and the example in Treas. Reg. 1.514(a)-1(a)(4)(iv)

(2) The average acquisition indebtedness of such property is computed in the usual

manner as set forth in Treas. Reg. 1.514(a)-1(a)(3). See Treas. Reg. 1.514(a)– 1(a)(4)(iii). The average adjusted basis of such property is computed as set forth in Treas. Reg. 1.514(a)-1(a)(2). See Treas. Reg. 1.514(a)-1(a)(4)(ii).

(1) The following sections discuss the special rules relating to acquisition

indebtedness.

(1) Indebtedness incurred in performing exempt functions doesn’t constitute

"acquisition indebtedness." Therefore, "acquisition indebtedness" doesn’t include the indebtedness incurred by an exempt credit union in accepting deposits from its members. See Treas. Reg. 1.514(c)-1(d).

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(2) In Alabama Central Credit Union v. United States, 646 F. Supp. 1199 (N.D. Ala.

1986), the court held that purchasing securities on margin and with borrowed funds isn’t inherent in the performance or exercise of a credit union’s exempt purpose or function. Accordingly, the use of borrowed funds to purchase bonds and loans constituted acquisition indebtedness under Section 514(c) and any income derived therefrom would constitute unrelated debt-financed income under Section 514(a).

(3) In Southwest Texas Electrical Cooperative, Inc. v. Commissioner, 67 F.3d 87

(5th Cir. 1995), affirming 1994–363 T.C.M. (1994), a nonprofit rural electric cooperative borrowed funds to replace its own funds it had spent in its exempt activities. Immediately after receiving the borrowed funds, it invested them in U.S. Treasury Notes. The Fifth Circuit held that the interest income from the Treasury Notes was unrelated debt-financed income.

(1) If an organization converts property that is used in a manner described in

Section 514(b)(1)(A), (B), (C), or (D) (excepted from debt-financed property) to a use that results in its treatment as debt-financed property, the outstanding principal debt on the property is thereafter treated as acquisition indebtedness. See Treas. Reg. 1.514(c)-1(a)(3).

(2) Example: Four years ago, a university borrowed funds to acquire an apartment

building as housing for married students. Last year, the university rented the apartment building to the public for nonexempt purposes. The outstanding principal debt becomes acquisition indebtedness as of the time the building was first rented to the public.

(1) If an organization sells property and, without paying off debt that would be

acquisition indebtedness if the property were debt-financed property, buys property that is otherwise debt-financed property, the unpaid debt is acquisition indebtedness for the new property. This is true even if the original property wasn’t debt-financed property. See Treas. Reg. 1.514(c)-1(a)(4).

(2) Example: To house its administration offices, an exempt organization bought a

building using $600,000 of its own funds and $400,000 of borrowed funds secured by a pledge of its securities. The office building wasn’t debt-financed property. The organization later sold the building for $1 million without repaying the $400,000 loan. It used the sale proceeds to buy an apartment building it rents to the general public. The unpaid debt of $400,000 is acquisition indebtedness with respect to the apartment building. See Treas. Reg. 1.514(c)1(a)(4).

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(1) If property (other than certain gifts, bequests, and devises) is acquired subject

to a mortgage, the outstanding principal debt secured by that mortgage is treated as acquisition indebtedness even if the organization didn’t assume or agree to pay the debt. See Section 514(c)(2) and Treas. Reg. 1.514(c)-1(b)(1).

(2) Example: An exempt organization paid $50,000 for real property valued at

$150,000 and subject to a $100,000 mortgage. The $100,000 of outstanding principal debt is acquisition indebtedness, as though the organization had borrowed $100,000 to buy the property. See Treas. Reg. 1.514(c)-1(b)(1).

(1) In determining acquisition indebtedness, a lien similar to a mortgage is treated

as a mortgage. A lien is similar to a mortgage if title to property is encumbered by the lien for a creditor's benefit. However, when state law provides that a lien for taxes or assessments attaches to property before the taxes or assessments become due and payable, the lien isn’t treated as a mortgage until after the taxes or assessments have become due and payable and the organization has had an opportunity to eliminate the lien by paying the amount it secured in accordance with state law. Pursuant to Treas. Reg. 1.514(c)-1(b)(2), liens similar to mortgages include (but aren’t limited to):

a. Deeds of trust,

b. Conditional sales contracts,

c. Chattel mortgages,

d. Security interests under the Uniform Commercial Code,

e. Pledges,

f. Agreements to hold title in escrow, and

g. Liens for taxes or assessments (other than those discussed earlier in this

paragraph).

(1) If property subject to a mortgage is acquired by gift, bequest, or devise, the

outstanding principal debt secured by the mortgage isn’t treated as acquisition indebtedness during the 10-year period following the date the organization receives the property. See Section 514(c)(2)(B) and Treas. Reg. 1.514(c)1(b)(3)(ii). However, this applies to a gift of property only if:

a. The mortgage was placed on the property more than 5 years before the

date the organization received it, and

b. The donor held the property for more than 5 years before the date the

organization received it.

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(2) This exception doesn't apply if an organization assumes and agrees to pay all,

or part of the debt secured by the mortgage or makes any payment for the equity in the property owned by the donor or decedent. See Section 514(c)(2)(B).

(3) Whether an organization has assumed and agreed to pay all or part of a debt in

order to acquire the property is determined by the facts and circumstances of each situation. See Treas. Reg. 1.514(c)-1(b)(3).

(1) Extending, renewing, or refinancing an existing debt is considered a

continuation of that debt to the extent its outstanding principal doesn’t increase. When the principal of the modified debt is more than the outstanding principal of the old debt, the excess is treated as a separate debt. See Section 514(c)(3).

(2) Pursuant to Treas. Reg. 1.514(c)-1(c)(2), the following are examples of acts

resulting in the extension or renewal of a debt:

a. Substituting liens to secure the debt,

b. Substituting obligees whether or not with the organization's consent,

c. Renewing, extending, or accelerating the payment terms of the debt, and

d. Adding, deleting, or substituting sureties or other primary or secondary

obligors.

(3) Debt increase. If the outstanding principal of a modified debt is more than that

of the unmodified debt, and only part of the refinanced debt is acquisition indebtedness, the payments on the refinanced debt must be allocated pro rata between the old debt and the excess. See Treas. Reg. 1.514(c)-1(c)(3).

a. Example. An organization has an outstanding principal debt of $500,000

that is treated as acquisition indebtedness. The organization borrows another $100,000, which isn’t acquisition indebtedness, from the same lender, resulting in a $600,000 note for the total obligation. A payment of $60,000 on the total obligation would reduce the acquisition indebtedness by $50,000 ($60,000 x $500,000/$600,000) and the excess debt by $10,000. See Treas. Reg. 1.514(c)-1(c)(3).

(1) The term acquisition indebtedness doesn’t include an obligation to pay an

annuity which meets the following three requirements:

a. Is the sole consideration (other than a mortgage to which Section

514(c)(2)(B) applies) issued in exchange for property if, at the time of the exchange, the value of the annuity is less than 90 percent of the value of the property received in the exchange. See Section 514(c)(5)(A).

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b. Is payable over the life of one individual in being at the time the annuity is

issued, or over the lives of two individuals in being at such time. See Section 514(c)(5)(B).

c. Is payable under a contract which doesn’t guarantee a minimum amount

of payments or specify a maximum amount of payments and doesn’t provide for any adjustment of the amount of the annuity payments by reference to the income received from the transferred property or other property. See Section 514(c)(5)(C).

(1) Under Section 514(c)(6)(A)(i), "acquisition indebtedness" doesn’t include an

obligation/debt to finance the purchase, rehabilitation, or construction of housing for low- and moderate-income persons to the extent that it is insured by the Federal Housing Administration.

a. Example: To the extent that an obligation is insured by the Federal

Housing Administration under Section 221(d)(3) (12 U.S.C. 1715(l)(d)(3) or Section 236 (12 U.S.C. 1715z-1) of Title II of the National Housing Act, as amended, the obligation isn’t “acquisition indebtedness.” See Treas. Reg. 1.514(c)-1(f).

(2) Under Section 514(c)(6)(A)(ii), the term “acquisition indebtedness” doesn’t

include indebtedness incurred by a small business investment company licensed after the date of the enactment of the American Jobs Creation Act of 2004 under the Small Business Investment Act of 1958 if the indebtedness is evidenced by a debenture—

a. Issued by such company under section 303(a) of such Act, and

b. Held or guaranteed by the Small Business Administration.

(1) It is common practice for an owner of securities to lend the securities to a

broker who uses them to make timely deliveries of securities to purchasers. In the usual transaction, the broker is required to return identical securities to the lender, and the loan of securities is fully collateralized by cash or marketable securities having a fair market value of not less than the fair market value of the securities loaned. The lender receives from the borrower amounts equal to the dividends paid on the stock during the period of the loan and additional compensation for the stock.

(2) If an exempt organization enters into a securities loan (as defined in Section

512(a)(5)) as the owner/lender, there is no adverse consequence under Section 514. An obligation to return collateral isn’t treated as acquisition indebtedness. All payments with respect to securities loans are deemed to be derived from the securities loaned and not from the collateral security or the investment of collateral security from such loans. Any deductions that are directly connected

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with the collateral security for the loan or with the investment of the collateral security are deemed to be deductions directly connected with the securities loaned. See Section 514(c)(8).

(3) By contrast, if an exempt organization incurs indebtedness to purchase

securities that it loans to others, any income from such securities, including any income from the loan of the securities, would be treated as debt-financed income and would be subject to tax to the extent provided in Section 512(b)(4) and Section 514. See Alabama Central Credit Union v. United States, 646 F. Supp. 1199 (N.D. Ala. 1986).

(4) In Kern County Electrical Pension Fund v. Commissioner, 96 T.C. 845 (1991),

the pension fund owned certificates of deposit at a savings and loan that could be withdrawn prior to maturity but only with a substantial reduction of the interest earned. At a time when interest rates were rising, the pension fund obtained a loan from the savings and loan using the certificates as collateral and invested the loan proceeds in new certificates at higher interest rates. The court rejected the pension fund’s argument that the interest constituted “payments with respect to securities loans” under Section 512(a)(5). The pension fund didn’t lend the old certificates to the savings and loan association but rather pledged the old certificates as collateral for a loan to itself. The court held that the interest received on the new certificates was income from debtfinanced property and wasn’t excludable from UBTI because it didn’t represent, in substance, additional interest on the old certificates.

(1) Section 514(c)(9)(A) provides that, with certain exceptions, the term "acquisition

indebtedness" doesn’t include indebtedness incurred by a qualified organization in acquiring or improving any real property.

(2) Pursuant to Section 514(c)(9)(C), a qualified organization includes:

a. A qualified trust under Section 401,

b. An educational organization described in Section 170(b)(1)(A)(ii) and its

supporting organizations described in Section 509(a)(3),

c. A multiple-parent title holding company as described in Section

501(c)(25). A shareholder of a Section 501(c)(25) organization may be taxable on its pro rata share of income received from debt-financed property held by the Section 501(c)(25) organization if the shareholder itself isn’t a "qualified organization," (see Section 514(c)(9)(F)) and

d. A retirement income account described in Section 403(b)(9).

(3) Under Section 514(c)(9)(B), this exception doesn’t apply if:

a. The price for the acquisition or improvement isn’t a fixed amount

determined as of the date of the acquisition or the completion of the improvement,

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b. The amount of any indebtedness or any other amount payable with

respect to such indebtedness, or the time for making any payment of any such amount is dependent, in whole or in part, upon any revenue, income or profits derived from the real property,

c. After the acquisition the real property is leased to the seller or to a person

related to the seller as described in Section 267(b) or Section 707(b),

d. In the case of a qualified trust the real property is acquired from or leased

to certain disqualified persons under Section 4975(e)(2),

e. Any person described in (c) or (d) provides the qualified organization with

financing in connection with the acquisition or improvement, or

f. The real property is held by a partnership, unless the partnership meets

the requirements of clauses (a) through (e) above, and unless (I) all of the partners of the partnership are qualified organizations, (II) each allocation to a partner of the partnership which is a qualifying organization is a qualified allocation under Section 168(h)(6) or, (III) the partnership meets the "disproportionate allocation rule of Section 514(c)(9)(E)."

(4) In order for a partnership to meet the " disproportionate allocation rule," both of

the following requirements must be met:

a. The allocation of items to any partner which is a qualified organization

can’t result in such partner having a share of the overall partnership income for any taxable year greater than such partner’s “fractions rule percentage” (in other words, such partner’s share of the overall partnership loss for the taxable year for which such partner’s loss share will be the smallest). See Section 514(c)(9)(E)(i)(I) and Treas. Reg. 1.514(c)-2(c)(2).

b. Each partnership allocation must have "substantial economic effect" within

the meaning of Section 704(b)(2). See Section 514(c)(9)(E)(i)(II) and Treas. Reg. 1.514(c)-2(b)(1)(ii). Allocations that can’t have economic effect must be deemed to be in accordance with the partners’ interests in the partnership. See Treas. Reg. 1.514(c)-2(c)(4) for examples of how these rules operate.

(5) Overall partnership income is the amount by which the aggregate items of

partnership income and gain for the taxable year exceed the aggregate items of partnership loss and deduction for the year. Overall partnership loss is the amount by which the aggregate items of partnership loss and deduction for the taxable year exceed the aggregate items of partnership income and gain for the year. See Treas. Reg. 1.514(c)-2(c)(1).

(6) Generally, the partnership items that are included in computing overall

partnership income or loss are those items of income, gain, loss, and deduction that increase or decrease the partners’ capital accounts. Treas. Reg. 1.514(c)2(c)(1)(i).

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(7) Generally, a guaranteed payment to a qualified organization (QO) isn’t treated

as an item of partnership loss or deduction in computing overall partnership income or loss. See Treas. Reg. 1.514(c)-2(c)(1)(ii)(A) but also see Treas. Reg. 1.514(c)-2(d) (exclusion of reasonable preferred returns and guaranteed payments).”

(8) A partnership typically doesn’t qualify for the UBIT exception provided by

Section 514(c)(9)(A) for any taxable year of its existence unless it satisfies the fractions rule for every year to which the fractions rule applies. A partnership must satisfy the fractions rule both on a prospective basis and on an actual basis for each partnership taxable year, beginning with the first taxable year of the partnership in which the partnership holds debt-financed real property and has a qualified organization as a partner. Treas. Reg. 1.514(c)-2(b)(2)(i).

(9) A subsequent change to a partnership agreement that causes the partnership

to violate the fractions rule ordinarily causes the partnership’s income to fail the UBIT exception provided by Section 514(c)(9)(A) only for the taxable year of the change and subsequent taxable years. See Treas. Reg. 1.514(c)-2(b)(2)(ii).

(10) A qualified organization’s fractions rule percentage is that partner’s percentage

share of overall partnership loss for the partnership taxable year for which that partner’s percentage share of overall partnership loss will be the smallest. See Treas. Reg. 1.514(c)- 2(c)(2).

(11) Except to the extent provided in Treas. Reg. 1.514(c)-2(d), income that a

qualified organization may receive or accrue with respect to a guaranteed payment is treated as an allocable share of overall partnership income or loss for purposes of the fractions rule. See Treas. Reg. 1.514(c)-2(c)(1)(ii)(B).

(12) The IRS has issued proposed regulations (REG-136978-12) under Treas. Reg.

514(c)(9)(E) regarding the application of the fractions rule to partnerships that hold debt-financed real property and have one or more qualified tax-exempt organization partners. Issues relating to these proposed regulations should be coordinated with the appropriate Knowledge Management group.

(1) There are several exceptions to the debt-financed property rules, including the

following types of property.

(1) Section 514(b)(1)(A) provides that if substantially all the use of any property is

substantially related to the exercise or performance of an organization’s exempt purpose, such property isn’t treated as "debt-financed property." The term "substantially all" is defined as 85 percent or more. Treas. Reg. 1.514(b)1(b)(1)(ii). See Treas. Reg. 1.513-1 for principles applicable in determining whether the particular use of property is substantially related to the exempt purpose of the organization. See Treas. Reg. 1.514(b)-1(b)(1)(i).

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(2) The extent a property is used for a particular purpose is determined based on

all the facts and circumstances. Pursuant to Treas. Reg. 1.514(b)-1(b)(1)(ii), this determination may include, where appropriate:

a. A comparison of the portion of time such property is used for exempt

purposes with the total time such property is used.

b. A comparison of the portion of such property that’s used for exempt

purposes with the portion of such property that is used for all purposes.

c. Both of these comparisons.

(3) Rev. Rul. 77-47, 1977-1 C.B. 157 provides that buildings, acquired through

assumption of outstanding mortgages by an exempt organization that restores, preserves, and exhibits buildings of historical and/or architectural significance, constitute debt-financed property when they are leased at fair rental value for uses that neither bear any relationship to the buildings’ historical or architectural significance nor accommodate viewing by the general public.

(4) An organization exempt under Section 501(c)(6) subjected a shell building it

owned to a mortgage so it could finance its completion to suit the needs of its tenant. Notwithstanding that the organization had to borrow money and mortgage its property to finance the alterations, the building wasn’t debtfinanced under Section 514, because the organization was furthering its stated purpose of promoting the commercial development of its metropolitan area by encouraging new industries to move to the area. Therefore, the leasing activity was substantially related within the meaning of Section 514(b)(1)(A)(i) to the organization’s accomplishment of its exempt purpose. See Rev. Rul. 81-138, 1981-1 C.B. 358.

(5) In Elliot Knitwear Profit Sharing Plan. v. Commissioner 71 T.C. 65 (1979), aff’d,

614 F.2d 347 (3rd Cir, 1980), an employee profit-sharing plan that was exempt from tax under Section 501(a) because it qualified under Section 401(a) purchased securities on margin. The court held the securities purchased on margin (in other words, with funds borrowed from a broker) constituted debtfinanced property and that the profits derived from their sale are taxable as unrelated business income since the purchase of securities on margin isn’t inherent to the purpose of a tax-exempt profit-sharing plan and that such purchases aren’t substantially related to the purpose of such an organization so as to be excepted from the definition of debt-financed property.

(6) In Alabama Central Credit Union v. United States, 646 F. Supp. 1199 (N.D. Ala.

1986), the court considered whether income from securities purchased on margin or with borrowed funds was income from debt-financed property. There, a credit union exempt under Section 501(a) as an organization described in Section 501(c)(14) received income from the sale of Government of Israel bonds and construction loan certificates guaranteed by the Government National Mortgage Association. The court held the securities are debt-financed property, and that purchasing securities on margin and with borrowed funds

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isn’t inherent in the performance or exercise of a credit union’s purpose or function.

(7) If less than 85 percent of the use of any property is devoted to an organization’s

exempt purposes, only that portion of the property used in furtherance of the organization’s exempt purposes isn’t treated as debt-financed property. See Treas. Reg. 1.514(b)-1(b)(1).

a. Example: X, an exempt college, owns a four-story office building

purchased with borrowed funds. In 20xx, the lower two stories of the building are used to house computers which are used by X for administrative purposes. The top two stories are rented to the public for purposes not described in Section 514(b)(1)(A), (B), (C), or (D). The gross income derived by X from the building is $6,000, all attributable to the rents paid by tenants. There are $2,000 of expenses, allocable equally to each use of the building. The average adjusted basis of the building for 20xx is $100,000, and the outstanding principal indebtedness throughout 20xx is $60,000. Thus, the average acquisition indebtedness for 20xx is $60,000. Since the two lower stories are used for exempt purposes, only the upper half of the building is debt-financed property. Consequently, only the rental income and the deductions directly connected with such income are to be taken into account in computing unrelated business taxable income. The portion of such amounts to be taken into account is determined by multiplying the $6,000 of rental income and $1,000 of deductions directly connected with such rental income by the debt/basis percentage. The debt/basis percentage is the ratio which the allocable part of the average acquisition indebtedness is of the allocable part of the average adjusted basis of the property, that is, the ratio which $30,000 (one-half of $60,000) bears to $50,000 (one-half of $100,000). Thus, the debt/basis percentage for 20xx is 60 percent (the ratio of $30,000 to $50,000). Under these circumstances, X shall include net rental income of $3,000 in its unrelated business taxable income for 20xx, computed as follows:

X’s Net Rental Income

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(1) Property, to the extent that the income from such property is taken into account

in computing the gross income of any unrelated trade or business, isn’t treated as "debt-financed property." See Section 514(b)(1)(B).

(2) However, any gain on the disposition of such property which isn’t included in

income from an unrelated trade or business by reason of Section 512(b)(5) is includible as gross income derived from, or on account of, debt-financed property. See Treas. Reg. 1.514(b)-1(b)(2)(i).

(3) Section 514 doesn’t apply to amounts otherwise included in the computation of

unrelated business taxable income, such as rents from personal property included under Section 512(b)(3), or rents and interest from controlled organizations includible under Section 512(b)(13). See Treas. Reg. 1.514(b)1(b)(2)(ii).

(1) Section 514(b)(1)(C) provides that property, to the extent it produces gross

income derived from research activities otherwise excluded from the unrelated trade or business tax by Section 512(b)(7), (8), or (9), isn’t treated as "debtfinanced property.” See Treas. Reg. 1.514(b)-1(b)(4).

(1) Under Section 514(b)(1)(D), debt-financed property doesn’t include any

property to the extent it produces income from a trade or business excepted from the definition of an "unrelated trade or business" by Section 513(a)(1), (2), or (3). Thus, property used in connection with the donated merchandise, volunteer labor, or convenience exceptions doesn’t constitute debt-financed property. See Treas. Reg. 1.514(b)-1(b)(5).

(1) Property owned by an exempt organization and used by a related exempt

organization or by an exempt organization related to such related exempt organization isn’t treated as "debt-financed property" to the extent such property is used by either of such related exempt organizations in furtherance of their exempt purposes. Furthermore, property isn’t treated as debt-financed property to the extent such property is used by a related exempt organization for a purpose described in Section 514(b)(1)(A), (C), or (D). See Section 514(b)(2) and Treas. Reg. 1.514(b)-1(c)(2)(i).

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a. Example: M, an exempt trade association described in Section 501(c)(6),

leases 70 percent of the space of an office building for furtherance of its exempt purpose. The title to such building is held by N, an exempt title holding company described in Section 501(c)(2), which acquired title to the building with borrowed funds. The other 30 percent of the space of this office building is leased to L, a nonstock exempt trade association described in Section 501(c)(6). L uses such office space in furtherance of its exempt purpose. The members of L’s Board of Trustees serve for fixed terms and M’s Board of Directors has the power to select all such members. N pays over to M all the profits it derives from the leasing of space in this building to M and L. Accordingly, M is "related" to N and L is "related" to M. Under these circumstances, since all the available space in the building is leased to either an exempt organization related to the exempt organization holding title to the building or an exempt organization related to such related exempt organization, no portion of the building is treated as debt-financed property.

(2) Under Section 514(b)(2), use of property by a "related exempt organization" is

taken into account in determining the extent property is used for a purpose described in Section 514(b)(1)(A), (C), or (D).

(3) Pursuant to Treas. Reg. 1.514(b)-1(c)(2)(ii), an exempt organization is related

to another exempt organization only if:

a. One organization is an exempt title holding company described in Section

501(c)(2) and the other receives profits derived from such exempt title holding company,

b. One organization has control of the other within the meaning of Treas.

Reg. 1.512(b)-1(l)(4),

c. More than 50 percent of the members of one organization are members of

the other, or

d. Each organization is a local organization directly affiliated with a common

state, national, or international organization which is also exempt.

(1) Real property isn’t debt-financed property if it is leased to a medical clinic, and

the lease is entered into primarily for purposes that are substantially related to the exempt purposes of the lessor. See Section 514(b)(1) and Treas. Reg. 1.514(b)-1(c)(1).

(2) Example: Assume an exempt-hospital leases all of its clinic space to an

unincorporated association of physicians and surgeons who, by the provisions of the lease, agree to provide all of the hospital’s out-patient medical and surgical services and to train all of the hospital’s residents and interns. In this situation, the rents received aren’t unrelated debt-financed income.

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(1) Under Treas. Reg. 1.514(b)-1(c)(3), a life income contract isn’t treated as debt financed property if the following circumstances are present:

a. An individual transfers property to a trust or a fund subject to a contract

providing that the income is to be paid to him/her or other individuals or both for a period of time not to exceed the life of such individual or individuals in a transaction in which the payments to the individual or individuals don’t constitute the proceeds of a sale or exchange of the property so transferred, and

b. The remainder interest is payable to an exempt organization described in

Section 501(c)(3).

(2) Example: On January 1, 1967, A transfers property to X, an exempt

organization described in Section 501(c)(3), which immediately places the property in a fund. On January 1, 1971, A transfers additional property to X, which property is also placed in the fund. In exchange for each transfer, A receives income participation fund certificates which entitle him/her to a proportionate part of the fund’s income for his/her life and for the life of another individual. None of the payments made by X is treated by the recipients as the proceeds of a sale or exchange of the property transferred. In this situation, none of the property received by X is treated as debt- financed property.

(1) If an organization acquires real property for the principal purpose of using the

land in the performance of its exempt purpose (within 10 years), it won’t be treated as debt-financed property if it is in the neighborhood of other property used by the organization for exempt purposes and the intent to use the property for exempt purposes (within 10 years) isn’t abandoned. This provision is referred to as the "neighborhood land rule." See Section 514(b)(3)(A).

(2) Property is considered in the "neighborhood" of property owned and used by an

organization for its exempt purposes if the acquired property is contiguous with the exempt purpose property or would be contiguous but for a road, street, railroad, stream, or similar property. If the acquired property isn’t contiguous with the exempt purpose property, it may still be in the "neighborhood" of such property if it is within one mile of such property and the facts and circumstances of the particular situation make the acquisition of contiguous property unreasonable. See Treas. Reg. 1.514(b)-1(d)(1)(ii).

(3) Some criteria to consider in determining whether noncontiguous property is still

in the "neighborhood" of exempt purpose property include the availability of land and the intended future use of the land. For example, a university attempts to purchase land contiguous to its present campus but can’t do so because the owners either refuse to sell or ask unreasonable prices. The nearest land of sufficient size and utility is a block away from the campus. The university

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purchases such land. Under these circumstances, the contiguity requirement is unreasonable, and the land purchased would be considered "neighborhood land." See Treas. Reg. 1.514(b)-1(d)(1)(ii).

(1) The neighborhood land rule doesn’t apply to property 10 years after it is

purchased. Further, the rule applies after the first five years only if the organization satisfies the IRS that future use of the land for exempt purposes before the expiration of the 10-year period is reasonably certain. The organization doesn’t need to show binding contracts in satisfying this requirement but must have a definite plan detailing a specific improvement and a completion date and show some affirmative action toward the fulfillment of such plan. At least 90 days prior to the end of the fifth year after acquisition of the land, the organization must forward the necessary information to the IRS for a letter ruling request under Rev. Proc. 2023-1 (updated annually), 2023-1 IRB

1. See Treas. Reg. 1.514(b)-1(d)(1)(iii).

(2) If the neighborhood land rule is inapplicable because the acquired land isn’t in

the neighborhood of other land used for exempt purposes or because the organization fails to establish after the first five years that the property will be used for exempt purposes, but the land is eventually used for exempt purposes within the 10-year period, such property isn’t treated as debt-financed property for any period prior to such conversion. See Section 514(b)(3)(B) and Treas. Reg. 1.514(b)-1(d)(2). Where the neighborhood land rule is initially inapplicable, but the land is eventually used for exempt purposes, a refund of taxes shall be allowed in accordance with Section 514(b)(3)(D) and Treas. Reg. 1.514(b)1(d)(4).

(1) The neighborhood land rule applies with respect to any structure on the land

when acquired, or to the land occupied by the structure, only so long as the intended future use of the land requires that the structure be demolished or removed in order to use the land for exempt purposes. See Section 514(b)(3)(C)(i). Thus, during the first five years after acquisition (and for subsequent years if there is a favorable ruling in accordance with Section 514(b)(3), improved property isn’t debt-financed so long as the organization doesn’t abandon its intent to demolish the existing structures and use the land in furtherance of its exempt purpose. Treas. Reg. 1.514(b)-1(d)(3)(i) provides that if there is an actual demolition of such structures, the use made of the land need not be the one originally intended as long as it is any use which furthers the exempt purposes of the organization.

(2) In addition to the above limitation, the neighborhood land rule and exceptions

don’t apply to either structures erected on the land after its acquisition or to property subject to a business lease (as defined in Section 514(f) immediately before the enactment of the Tax Reform Act of 1976) whether the organization

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acquired the property subject to the lease or whether it executed the lease subsequent to acquisition. See Section 514(b)(3)(C)(ii) and (iii) and Treas. Reg. 1.514(b)-1(d)(3)(iii).

(1) The neighborhood land rule also applies to churches as well as conventions or

associations of churches, but with two differences.

a. First, instead of the 10-year period during which an organization must

demonstrate intent to use acquired property for exempt purposes, a 15year period applies.

b. Second, there is no requirement that the acquired land be in the

neighborhood of other property used by the organization for exempt purposes. See Section 514(b)(3)(E) and Treas. Reg. 1.514(b)-1(e).

(1) Section 512(b) excludes certain items of income, and any deductions directly

connected with them, from unrelated business taxable income. Whether a particular item of income falls within any of these modifications depends on the substantive nature of the item rather than its form so that all the facts and circumstances in each case must be fully considered. The following sections discuss such modifications.

(2) Several Section 512(b) provisions also include in the computation of UBTI

certain kinds of passive income (and associated deductions) that would otherwise be excluded under Section 512(b), including Section 512(b)(4) (which cross-references Section 514 unrelated debt-financed income, discussed in Part V of this document), Section 512(b)(13) (interest, annuities, royalties, and rents from controlled entities), and Section 512(b)(17) (certain amounts received from foreign corporations attributable to insurance income).

(1) Under Section 512(b)(1), dividends, interest, and annuities, as well as the

deductions directly connected with these types of income, are excluded in computing unrelated business taxable income. Section 512(b)(1) also excludes payments with respect to securities loans (separately discussed in Parts V.I.10 and VI.A.1 of this document), and consideration for agreeing to make a loan. However, if such income is derived from debt-financed property (Section 514, which largely excludes annuities under Section 514(c)(5)) or, in the case of interest and annuities is derived from a controlled organization (Section 512(b)(13)), it is included in computing unrelated business taxable income to the extent provided in those sections.

(2) Treas. Reg. 1.512(b)-1(a)(1) expands the modification contained in Section

512(b)(1) to exclude income from notional principal contracts and directly

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connected deductions. The regulation also excludes other substantially similar income from ordinary and routine investments to the extent determined by the IRS. See Treas. Reg. 1.512(b)-1(a)(2) and (3) for limitations and effective dates.

(3) Rev. Rul. 79-349, 1979–2 C.B. 233, describes an exempt employees’ trust

engaged in the unrelated trade or business of making mortgage loans in a commercial manner. The ruling holds that the interest earned on the loans is excluded from the computation of the organization’s unrelated business taxable income under Section 512(b)(1). The service fees charged on the loans such as for investigating the prospective borrower and his security, closing costs, and fees paid to a third party for servicing and collecting the loan are included.

(4) Treas. Reg. 1.512(b)-1(a)(1) provides that an inclusion of subpart F income

under Section 951(a)(1)(A), or an inclusion of global intangible low-taxed income under Section 951A(a), is treated as a dividend for purposes of Section 512(b)(1). However, Section 512(b)(17) requires any amount included in gross income under Section 951(a)(1)(A) to be included as an item of gross income from an unrelated trade or business to the extent that the amount is attributable to insurance income (as defined in Section 953) and would be treated as gross income from an unrelated traded or business if derived directly by the organization.

(1) Payments received by an exempt organization for loans of securities in its

investment portfolio to brokers aren’t treated as unrelated business income. See Sections 512(b)(1) and 512(a)(5). In order for the payments to qualify under Section 512(b)(1), however, the securities must be loaned pursuant to an agreement which:

a. Provides for the return to the exempt organization of identical securities

loaned;

b. Requires that payments be made to the exempt organization in amounts

equivalent to the interest, dividends, and other distributions that the owner of the securities is entitled to receive because of its ownership during the period of the loan;

c. Doesn’t reduce the exempt organization’s risk of loss or opportunity for

gain as to the transferred securities;

d. Contains reasonable procedures to implement the obligation of the

borrower to furnish collateral to the exempt organization with a fair market value on each business day the loan is outstanding in an amount at least equal to the fair market value of the securities at the close of business on the preceding day; and

e. Permits the exempt organization to terminate the loan at any time upon

notice of no more than five business days. See Sections 512(b)(1) and

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512(a)(5) (discussed in Part V.I.10 of this document). See also Section 1058 regarding nonrecognition of gain or loss on transfer of securities under certain agreements.

(2) This treatment isn’t available if the securities which are loaned constitute

inventory or are being held for sale to customers in the ordinary course of the organization’s trade or business. See Rev. Rul. 78-88, 1978-1 C.B. 163 (holding that income derived by an exempt organization from the temporary transfer of securities to a brokerage house isn’t unrelated business income where the securities transferred were neither inventory nor held for sale to customers in the ordinary course of a trade or business

(1) Royalties, including overriding royalties, are excluded under Section 512(b)(2),

whether measured by production or by gross or taxable income from the property. All deductions directly connected with excludable royalties must also be excluded. However, if royalty income is derived from debt-financed property (Section 514) or controlled organizations (Section 512(b)(13)), it is included in computing unrelated business income to the extent provided in those sections.

(2) To be a royalty, a payment must relate to the use of a valuable right. Payments

for the use of trademarks, trade names, service marks, or copyrights, whether or not payment is based on the use of such property, are ordinarily classified as royalties for federal tax purposes. See Commissioner v. Affiliated Enterprises, Inc., 123 F.2d 665 (10th Cir. 1941), cert. denied 315 U.S. 812 (1942).

(3) Similarly, payments for the use of a professional athlete’s name, photograph,

likeness, or facsimile signature are ordinarily characterized as royalties. See generally, Cepeda v. Swift & Co., 415 F.2d 1205 (8th Cir. 1969) and Rev. Rul. 81-178, 1981-2 C.B. 135. Situation 1 of Rev. Rul. 81-178 relies on the rationale of the cases cited therein in reaching the conclusion that income from licensing agreements involving the use of certain athletes’ names, photographs, etc. is royalty income and thus excludable under Section 512(b)(2).

(4) Royalties don’t include payments for personal services. Situation 2 of Rev. Rul.

81–178 presents an example in which, an exempt organization entered into a licensing agreement for the endorsement of certain products and services that require personal appearances by, and interviews with, members of the organization. Income from such agreements is gross income from unrelated trade or business and because the payments received by the organization are compensation for personal services, they aren’t excluded as royalties under Section 512(b)(2).

(5) In Sierra Club, Inc. v. Commissioner, 86 F.3d 1526 (9th Cir. 1996), aff’g T.C.

Memo. 1993–199, aff’g in part and rev’g in part and remanding 103 T.C. 307 (1994), the court confirmed that there is a distinction between payments for services and payments for the right to use an intangible property right. The court held that royalties under Section 512(b)(2) are defined as payments

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received for the right to use intangible property rights, and that royalties don’t include payments for services.

(6) Other derivations of this concept include:

a. Mailing Lists — Based on the above definition, the Court of Appeals

affirmed the decision of the Tax Court in Sierra Club, Inc. v. Commissioner, T.C. Memo. 1993–199 and found that income from mailing list rentals constituted royalty income the organization was described in Section 501(c)(4) and thus couldn’t use the Section 513(h) exception discussed in Part VII.I of this document. The Court of Appeals concluded that Sierra Club received royalty income. In so concluding, the court noted that Sierra Club neither performed services relating to the mailing list rental nor marketed the mailing lists. Sierra Club merely collected a fee for the mailing list rental. The court, rejecting the argument that any active marketing activity would convert a royalty into a non-royalty, specifically noted that Sierra Club activity in connection with the rental of its mailing list was substantially less than the amount of activity which other courts had found to preclude a finding of royalty income. The Ninth Circuit’s decision left unanswered the question of what services an exempt organization can perform in connection with mailing list rentals and still treat the income from them as royalty income. Although the court rejected the Tax Court’s all-inclusive definition of royalties as including "active" and "passive" income, it didn’t state what activities will cause an organization to have unrelated business taxable income. The Ninth Circuit’s decision in Sierra Club, Inc. is inconsistent with the IRS’s administrative position that income from the regular sale of membership mailing lists by an exempt organization is subject to the unrelated business income tax and isn’t a royalty under Section 512(b)(2).

b. Disabled American Veterans v. United States, 650 F.2d 1178, 227 Ct. Cl.

474 (1981), where the Court of Claims found that because the organization performed substantial business activity in preparing and mailing the lists, royalty treatment was precluded.

c. Affinity Credit Cards — In Sierra Club, Inc. v. Commissioner, T.C. Memo.

1999-86, the Tax Court also held that the revenue from an affinity credit card program didn’t constitute unrelated business income because it constituted income from royalties under Section 512(b)(2). See also, Oregon State University Alumni Association, Inc. v. Commissioner, T.C. Memo. 1996-34, Alumni Association of the University of Oregon, Inc. v. Commissioner, T.C. Memo. 1996-63, and Mississippi State University Alumni, Inc. v. Commissioner, T.C. Memo. 1997-397. The Tax Court concluded that revenues received as part of the affinity card program weren’t received as compensation for services, but as payment for an intangible property right. Such compensation therefore constituted royalty income under Section 512(b)(2). Generally, The IRS’s administrative approach in the area of mailing lists and affinity credit cards is that such

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cases should be resolved in a manner consistent with existing court cases. In the cases decided in favor of the taxpayer, the facts showed that the involvement of the exempt organization was relatively minimal, and the organizations generally hired outside contractors to perform most services associated with exploitation of the use of intangible property. Thus, courts concluded that the payment was for the intangible property rather than for services of the organization's members or employees.

d. In December 1999, the Director, Exempt Organizations Division, issued a

memorandum on mailing lists and affinity credit cards advising that “it is now clear that courts will continue to find [income from mailing list rentals and affinity credit card arrangements] to be excluded royalty income unless the factual record clearly reflects more than insubstantial services being provided.” These cases should be resolved in a manner consistent with existing court cases.

(7) The royalty exclusion doesn’t apply to royalties which stem from an

arrangement whereby the organization owns a working interest in a mineral property and is liable for its share of the development costs under the terms of its agreement with the operator of the property. See Treas. Reg. 1.512(b)-1(b). An exempt organization’s income from a mineral interest isn’t a royalty excluded from the computation of unrelated business taxable income by Section 512(b)(2), where the organization is liable for the operating expenses associated with its interest. Rev. Rul. 69-179, 1969-1 C.B. 158.

(8) Patent development and management service fees deducted from royalties

collected from licensees by an exempt charitable organization for distribution to the beneficial owners of the patents aren’t within the exception for royalties provided by Section 512(b)(2). The fees, although derived from royalties, constituted compensation for services provided by the organization. See Rev. Rul. 73-193, 1973-1 C.B. 262. However, Rev. Rul. 76-297, 1976-2 C.B. 178, provides that amounts received from licensees by an exempt organization, the legal and beneficial owner of patents assigned to it by inventors for specified percentages of future royalties, is royalty income that is excludable in computing unrelated business taxable income.

(9) In several cases involving income from advertising, exempt organizations have

unsuccessfully sought to treat the income as royalties from the license of their publication to a contractor. The courts look to the substance of the transaction, not merely the parties’ label on the agreement, and the contractor may be operating as the exempt organization’s agent in conducting the advertising, on behalf of and under the control of the exempt organization.

a. In Fraternal Order of Police Illinois State Troopers Lodge No. 41 v.

Commissioner, 87 T.C. 747 (1986), aff’d, 833 F.2d 717 (7th Cir. 1987), the court held, in part, that income from advertising appearing in an organization’s magazine, The Trooper, was subject to tax on unrelated business income. The organization took an active role in publication of the

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magazine and therefore its advertising income didn’t constitute royalties under Section 512(b)(2).

b. NCAA v. Commissioner, 92 T.C. 456 (1989), rev'd on other grounds, 914

F.2d 1417 (10th Cir. 1990), held that income received by NCAA for publishing commercial advertisements in its game programs for the basketball tournament was UBTI and not royalties. NCAA made a written agreement for a Publisher to produce and sell the programs, and to sell advertising to be placed in the programs. The Tax Court held that Publisher's activities should be attributed to NCAA as NCAA's agent, since the contract called for Publisher to perform services (1) on behalf of, and (2) under the control of, NCAA. Therefore, NCAA's advertising business was regularly carried on by it. The court noted that the contract designated Publisher as NCAA's "agent" (although contract designation isn’t controlling); that the contract expressly called for Publisher to "provide services" to NCAA "in an efficient and workmanlike manner"; and that the contract contemplated that Publisher would "represent" NCAA in soliciting advertising. The court also noted that NCAA could control Publisher's activities, particularly by reserving the right to approve all advertising (the court accorded little weight to the fact that NCAA devoted little time to actual oversight). The court found an agency relationship existed despite the compensation structure (which shifted the risk of loss to Publisher) and the indemnification clause in favor of NCAA. Regarding the royalty issue, the court noted that licensors may reserve quality control rights (see Rev. Rul. 81-178, 1981-2 C.B. 135), but that the contract at issue wasn’t a mere license to Publisher to use a valuable right of NCAA; it rather set forth an agency relationship, imposing a duty on Publisher to perform services on NCAA's behalf and under its control.

c. Arkansas State Police Ass'n v. Commissioner, TCM 2001-38, involved an

EO that entered into a "Royalties and Licensing Agreement" with a publisher to publish EO's official magazine containing articles and advertising. Publisher solicited the ads in EO's name. EO approved the sales pitches, ads, and editorial content. Publisher bore all production costs, paid EO an annual fee, and received 73 percent of the proceeds. The court rejected EO's royalty argument, reasoning that EO substantially participated in and maintained control over significant aspects of the publication. The court distinguished the mailing list and affinity credit card cases as involving minimal activity on the EO's part.

(1) Rents from real property generally are excluded in computing unrelated

business taxable income. Some rents from personal property are also excluded. Special rules apply when rents are received from personal property leased with real property (mixed lease). See Section 512(b)(3).

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(2) Under law in effect prior to the Tax Reform Act of 1969, Section 512(b)(3)

excluded all rents from real property (including personal property leased with the real property) and all deductions directly connected therewith in computing unrelated business taxable income. The intention was to exclude passive income from tax and not exclude an active business. However, exempt organizations began leasing business assets of an operating business to an independent management company and claiming the rent exclusion. The exempt organizations received most of the profits from the business in the form of "passive" rents and in one case the Tax Court held that such rental activity came under the rental exclusion for real property and personal property leased with real property. See University Hill Foundation v. Commissioner, 51 T.C. 548 (1969), rev’d, 446 F.2d 701 (9th Cir. 1971), cert. denied, 405 U.S. 965 (1972). If the exempt organization had conducted the business itself, the profits from the business would be unrelated business taxable income. Although University Hill Foundation was reversed on appeal, Section 512(b)(3) was amended to correct this abuse.

(3) Consistent with the passive income concept, the Tax Reform Act of 1969

provided for the taxation of rent derived from the leasing of either real or personal property where the determination of the amount of such rent depends on the net income from the property. See S. Rep. No. 91-552, 91st Cong., 1st Sess. 69 (1969), 1969–3 C.B. 468, 1969 U.S.C.C.A.N. 2027, 2091 and Treas. Reg. 1.512(b)-1(c)(2)(iii)(b).

(4) If rents are derived from debt-financed property (Section 514) or controlled

organizations (Section 512(b)(13)), they are included in computing unrelated business taxable income.

(1) Real property is all real property including any property described in Section

1245(a)(3)(C) and Section 1250(c). See Section 512(b)(3)(A)(i) and Treas. Reg. 1.512(b)-1(c)(3)(i). Also, income derived from a lease of a pipeline system, consisting of right-of-way interests in land, pipelines buried in the ground, pumping stations, plants, equipment, and other appurtenant property, constitutes rent from real property. See Rev. Rul. 67-218, 1967-2 C.B. 213. An appurtenance, which can be defined as being immovable or fixed to the land, is real property.

(2) Personal property is all personal property including any property described in

Section 1245(a)(3)(B). See Treas. Reg. 1.512(b)-1(c)(3)(ii). Also, income derived from railroad cars leased to an industrial company that had the responsibility for operation and maintenance of the cars constitutes rent from personal property. See Rev. Rul. 60–206, 1960–1 C.B. 201. Also, see Cooper Tire & Rubber Company Employees’ Retirement Fund v. Commissioner, 36 T.C. 96 (1961), aff’d, 306 F.2d 20 (6th Cir. 1962).

(3) Property is placed in service when it is first subject to use by the lessee under

the terms of the lease. For example, property subject to a lease entered into on

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November 1, 1971, for a term commencing on January 1, 1972, shall be considered as placed in service on January 1, 1972, regardless of when the property is first actually used by the lessee. See Treas. Reg. 1.512(b)1(c)(3)(iv).

(1) Rents from personal property leased with real property (mixed lease) are

excluded where the rent from the personal property is an incidental amount of the total rent as determined at the time the personal property is first placed in service. See Section 512(b)(3)(A)(ii).

(2) Rent from personal property will generally be considered incidental if the rent

attributable to it doesn’t exceed 10 percent of the total rents from all the leased property. See Treas. Reg. 1.512(b)-1(c)(2)(ii).

a. Example 1: If the rents attributable to the personal property leased are

determined to be $3,000 per year, and the total rents from all property leased are $10,000 per year, then the $3,000 isn’t to be excluded from the computation of unrelated business taxable income, since such amount isn’t an incidental portion of the total rents. Deductions directly connected with excluded rents aren’t allowable.

(3) Where the rent attributable to the personal property is more than 10 percent but

doesn’t exceed 50 percent of the total rent, determined at the time the personal property is first placed in service by the lessee, the rental income attributable to the real property is excluded from the computation of unrelated business taxable income. See Section 512(b)(3)(B)(i) and Treas. Reg. 1.512(b)1(c)(2)(iii)(a).

(4) Where the rent attributable to the personal property is more than 50 percent of

the total rent, determined at the time the personal property is first placed in service by the lessee, none of the rent (including the rent from real property) is excluded.

(5) Separate leases for real and personal property which have an integrated use

(one or more leases for real property and another lease or leases for personal property to be used upon such real property) will be considered as one lease. See Treas. Reg. 1.512(b)-1(c)(3)(iii).

a. Example 2: On January 1, 1971, A, an exempt organization, executes two

leases with B. One is for the rental of a computer, with a stated annual rental of $750. The other is for the rental of office space in which to use the computer, at a stated annual rental of $7,250. The total annual rent under both leases for 1971 is $8,000. At the time the computer is first placed in service, however, taking both leases into consideration, it is determined that notwithstanding the terms of the leases, $3,000, or 37.5 percent ($3,000/$8,000), of the rent is actually attributable to the computer. Therefore, for 1971, only the $5,000 ($8,000 less $3,000) attributable to the rental of the office space is excluded from the

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computation of A’s unrelated business taxable income. See Treas. Reg. 1.512(b)–1(c)(4) Example (1).

(6) If a change in the amount of personal property in service results in an increase

of 100 percent or more in the rent attributable to all the personal property leased, or there is a modification of the lease by which there is a change in the rent charged (whether or not there is a change in the amount of personal property rented), the rent attributable to personal property will be recomputed to determine whether the above mentioned 10 percent exclusion or 50 percent exception applies. Any change in the treatment of rents resulting from such recomputation is effective only for the period beginning with the event which occasioned the recomputation. See Treas. Reg. 1.512(b)-1(c)(3)(v). The following examples illustrate this principle.

a. Example 3: Assume the facts as stated in example 2 set forth above in

(5)a, except that on January 1, 1973, B rents a second computer from A, which is placed in service on that date. The total rent is increased to $2,000 for the computer lease and to $10,000 for the office space lease. It is determined at the time the second computer is first placed in service that notwithstanding the terms of the leases $7,000 of the rent is actually attributable to the computers. Since the rent attributable to personal property has increased by more than 100 percent ($4,000/$3,000 equals 133 percent), a redetermination must be made. As a result, 58.3 percent ($7,000/$12,000) of the total rent is determined to be attributable to personal property. Accordingly, since more than 50 percent of the total rent A receives is attributable to the personal property leased, none of the rents is excluded from the computation of A’s unrelated business taxable income by operation of Section 512(b)(3).

b. Example 4: Assume the facts as example 3 above, except that on June

30, 1975, the lease between B and A is modified. The total rent for the computer lease is reduced to $1,500 and the total rent for the office space lease is reduced to $7,500. Pursuant to this lease modification by which there is a change in the rent charged a redetermination is made as of June 30, 1975. As of the modification date, it is determined that notwithstanding the terms of the leases, the rent actually attributable to the computers is $4,000 or 44.4 percent ($4,000/$9,000), of the total rent. Since less than 50 percent of the total rent is now attributable to personal property, the rent attributable to real property ($5,000), for periods after June 30, 1975, is excluded from the computation of A’s unrelated business taxable income by operation of Section 512(b)(3). However, the rent attributable to personal property, $4,000, isn’t excluded from unrelated business taxable income for such periods by operation of Section 512(b)(3) since it represents more than an incidental portion of the total rents.

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(1) Where the real or personal property rentals are measured in whole or in part on

the income or profits derived by any person from the property leased, the total rent from real and personal property is taxed. However, a lease based on a fixed percentage of the gross receipts or sales won’t be taxed solely by reason of such lease. See Section 512(b)(3)(B)(ii) and Treas. Reg. 1.512(b)1(c)(2)(iii)(b).

(2) In Ohio County & Independent Agriculture Societies, Delaware County Fair v.

Commissioner, T.C. Memo. 1982–210, an agricultural society described in Section 501(c)(3) conducted an annual fair and also rented its fairgrounds to a horse sales company. Under a lease agreement, the exempt organization was paid 10 percent of the first $10,000 of the lessee organization’s yearly net profits from sales conducted on the premises, 20 percent of the next $10,000, and 25 percent of all net profits in excess of $20,000. The court held that the rents are based on a percentage of the lessee’s net profits and, therefore, in accordance with Section 512(b)(3)(B)(ii), aren’t excluded in computing the tax on unrelated business income.

(1) Payment for the use or occupancy of rooms or other space where services are

also rendered to the occupant doesn’t constitute rent from real property. Therefore, the exclusion doesn’t include transactions such as the use of hotel rooms, boarding house rooms or apartments furnishing hotel services. Other examples of uses involving services include tourist camps or homes, motels, use of space in parking lots, warehouses, or storage garages. See Treas. Reg. 1.512(b)-1(c)(5).

(2) Generally, services are considered rendered to the occupant if they are

primarily for his/her convenience and are different from those usually or customarily rendered in connection with the rental of rooms or space for occupancy only.

a. The supplying of maid service constitutes one example of a service

rendered to the occupant primarily for his/her convenience and not usually or customarily rendered in connection with the rental of rooms or space for occupancy only. See Treas. Reg. 1.512(b)-1(c)(5). Furnishing of meals is another. See Rev. Rul. 69-69, 1969-1 C.B. 159.

b. The furnishing of heat and light, the cleaning of public entrances, exits,

stairways and lobbies, and the collection of trash aren’t considered as services rendered to the occupant. See Treas. Reg. 1.512(b)-1(c)(5). Also, security services, parking, an unstaffed exercise room, swimming pools, tennis courts and other recreational facilities, depending on the facts and circumstances, may be considered, as services customarily rendered in connection with the rental of rooms or space for occupancy only. See PLR 200241050 which addresses maintenance services, including security

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guard services, not considered rendered to the occupant, Rev. Rul. 80297, 1980-2 C.B. 196, Rev. Rul. 2004-24, 2004-1 C.B. 550 and Madden v. Comm'r, T.C. Memo. 1997-395. Note: PLRs cannot be cited as precedent but do offer an analysis of tax law used in certain circumstances.

(3) Further examples applying the modification in Section 512(b)(3), excluding

rents from real property from unrelated business income include:

a. Income derived by an exempt organization from the occasional use by

outside individuals and groups of its meeting hall for a fee, where only utilities and janitorial services are provided, does constitute rent from real property within the meaning of Section 512(b)(3). See Rev. Rul. 69-178, 1969-1 C.B. 158.

b. Rev. Rul. 80-297, 1980-2 C.B. 196, considers two situations, both of which

describe an exempt school that furnished the use of its tennis facilities for ten weeks during the summer. In the first situation, for ten weeks during the summer the school operates a tennis club. For a fee, the general public is invited to join the club and thereby use the school's tennis courts and dressing rooms during designated periods. The employees collected fees, scheduled courts, and administered club affairs. The revenue ruling holds that income to the school from this activity isn’t excludable as rent from real property under Section 512(b)(3) because of the substantial services provided by the school. In the second situation, the school rented its tennis courts to an unrelated individual at a fixed fee which didn’t depend, in whole or in part, on the income or profits derived from the leased property. The individual formed a tennis club and hired employees to operate the club. Since the school provided only the facilities and no services, the revenue ruling holds that the school’s income under these circumstances is excludable rental income under Section 512(b)(3).

c. Rev. Rul. 80-298, 1980-2 C.B. 197, holds that a university’s leasing of its

stadium to a professional football team and provision of utilities, grounds maintenance, and dressing room, linen, and stadium security services is an unrelated trade or business under Section 513, and that income from this activity isn’t excludable as rent from real property under Section 512(b)(3). Linen services, extensive ground maintenance, and stadium security provided by the university pursuant to a lease is furnishing substantial services for the convenience of the lessee that go beyond those usually rendered in connection with the rental of space for occupancy only and preclude the income from being classified as rent under Section 512(b)(3).

(1) Section 512(b)(5) provides an exclusion from the computation of unrelated

business taxable income for gains and losses from the sale, exchange, or other disposition of property which isn’t:

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a. Stock in trade or other property of a kind which would properly be

includable in inventory if on hand at the close of the taxable year, or

b. Property held primarily for sale to customers in the ordinary course of the

trade or business. In Parklane Residential School, Inc. v. Commissioner, T.C. Memo. 1983-139, a Section 501(c)(3) educational organization entered into 22 transactions over a two-year period involving the simultaneous purchase and sale of real property. The court held that these transactions constitute a regularly carried on trade or business that wasn’t substantially related to the organization’s exempt purpose or function. Amounts derived from these transactions were subject to tax on unrelated business income.

(2) In addition, if an organization has made an election under Section 631 to treat

the cutting of timber as a sale or exchange, any gains or losses resulting from such treatment shall not be excluded by reason of Section 512(b)(5).

(3) If a gain or loss is derived from the sale or other disposition of debt-financed

property (Section 514), it is included in computing unrelated business income to the extent provided in that Section. See Treas. Reg. 1.512(b)-1(d)(1).and Part V.D. of this document.

(1) The term "unrelated business taxable income" doesn’t include gains realized on

the lapse or termination of options to buy or sell securities when the options have been written in connection with the exempt organization’s investment activities. See Section 512(b)(5). This applies whether or not the option is covered (in other words, whether or not the exempt organization owns the securities). Thus, all premiums received by an exempt organization on an option which it writes under these circumstances, regardless of whether the option lapses or is terminated, aren’t unrelated business taxable income. See Treas. Reg. 1.512(b)-1(d)(2).

(2) This treatment doesn’t apply if an exempt organization writing the options takes

such an active role in such activity that its options can be regarded an inventory or as being held for sale to customers in the ordinary course of its trade or business, or if the underlying securities on which the options are written constitute inventory or are being held for sale. See Treas. Reg. 1.512(b)1(d)(2).

(3) Similarly, if an organization is engaged in the trade or business of writing

options, the exclusion won’t be available.

(1) One of the exempt purposes listed in Section 501(c)(3) is scientific. Income

from research that is substantially related to an organization’s exempt scientific purposes doesn’t constitute unrelated business taxable income.

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a. The term "scientific" includes the carrying on of scientific research in the

public interest.

b. The term "research" has a variety of meanings and isn’t synonymous with

"scientific." The nature of particular research depends upon the purpose which it serves. For research to be scientific within the meaning of Section 501(c)(3), it must be carried on in furtherance of a scientific purpose. The determination of whether research is scientific doesn’t depend on whether such research is classified as "fundamental" or "basic," in contrast to "applied" or "practical." See Treas. Reg. 1.501(c)(3)-1(d)(5) and TG 3-4 Exempt Purpose, Scientific Organizations 501(c)(3).

(2) If an organization’s research activities don’t meet the requirements for scientific

research under Treas. Reg. 1.501(c)(3)-1(d)(5), amounts derived from such research might still be excluded from unrelated business taxable income, if the provisions of Section 512(b)(7), (8), or (9) are applicable.

(3) Section 512(b)(7) excludes from unrelated business taxable income all income

derived from research performed for the United States, or any of its agencies or instrumentalities, or any State or political subdivision thereof. All deductions directly connected with such research are also excluded. Under this provision, an exempt organization that conducts research for the government won’t be subject to the tax on unrelated business income regardless of whether the research activities further an exempt purpose. The key consideration with respect to this modification is that the research is being performed for a government entity.

(4) Section 512(b)(8) excludes from unrelated business taxable income all income

derived from research performed "for any person" by a college, university, or hospital. All deductions directly connected with such research are also excluded. Under this provision, income from research conducted by a college, university, or hospital won’t be subject to tax on unrelated business income, regardless of whether the research activities further an exempt purpose of such organization. The key consideration with respect to this modification is that a college, university, or hospital is performing the research.

(5) Section 512(b)(9) excludes from unrelated business taxable income all income

derived from research performed "for any person" by an organization operated primarily for the purpose of carrying on fundamental research. Such research may be performed "for any person," but the results of such research must be freely available to the general public. See Rev. Rul. 76-296, 1976-2 C.B. 142. The key considerations with respect to this modification are that the nature of the research is "fundamental" rather than "applied" and that the results are freely available to the general public.

a. The term “fundamental research” doesn’t include research carried on for

the primary purpose of commercial or industrial application. See Treas. Reg. 1.512(b)-1(f)(4). Whether an organization is operated primarily for the purpose of carrying on fundamental, as opposed to applied, research

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is a question of fact to be determined based on all the facts and circumstances.

b. Rev. Rul. 76-296, 1976-2 C.B. 141, holds that research isn’t in the public

interest and constitutes unrelated business if publication is withheld or delayed significantly beyond the time reasonably necessary to establish ownership rights. But research may constitute scientific research in the public interest even if commercially sponsored by private industries that will own any patents arising from the research if the results, including all relevant information, are timely published in such form as to be available to the interested public (delayed pending reasonable opportunity to establish the sponsor’s patent ownership rights).

(6) The term “research” doesn’t include activities of a type ordinarily carried on as

an incident to commercial or industrial operations, for example, the ordinary testing or inspection of materials or products or the designing or construction of equipment or buildings. Therefore, any income from such sources would constitute unrelated business income to an organization subject to tax under Section 511, if regularly carried on and not related to its exempt purposes. See Treas. Reg. 1.512(b)-1(f)(4).

(7) In Midwest Research Institute v. United States, 554 F. Supp. 1379 (W.D. Mo.

1983. aff’d, 744 F.2d 635 (8 ^th Cir. 1984), a Section 501(c)(3) scientific organization conducted research projects for independent sponsors on a contract basis. The lower court held that income from such research wasn’t subject to tax on unrelated business income because the research business was substantially related to the accomplishment of scientific purposes (and thus didn’t need to meet a Section 512(b) exception). The court stated that the application of scientific research results through private intermediaries produced public benefit which outweighed private benefit, that most of the income received was from scientific research, and that the research encouraged the development of industry within a particular area. Income received from marketing results of research and rental of computer time was unrelated business taxable income.

(8) In IIT Research Institute v. United States, 9 Cl. Ct. 13 (1985), a Section

501(c)(3) scientific organization carried on numerous research assignments of various types pursuant to contracts. The organization generally priced its research services to cover its direct costs, overhead costs, and a profit of six percent. Of 650 contracts, 58 were selected as being representative of the organization’s research endeavors. Of the 58 representative contracts, 34 were conceded to be substantially related. The remaining 24 were the subject of the court opinion. The Claims Court found that the research contracts were substantially related to scientific purposes because they either:

a. Involved the use of observation or experimentation to formulate or verify

facts or natural laws,

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b. Could only have been performed by an individual possessing scientific or

technical expertise,

c. Added to knowledge within a particular scientific field,

d. Involved the application of scientific or mathematical reasoning, or

e. Were attempts to systematize or classify a body of scientific knowledge by

collecting information and presenting it in a useful form.

(9) The court held that the research activities weren’t commercial in nature, and

that research results need not be published in every instance in order to serve a public purpose. See Treas. Reg. 1.501(c)(3)-1(d)(5)(iii). The court concluded by noting that in any event, income from nine of the 24 challenged contracts was excluded from unrelated business taxable income by Section 512(b)(7). The organization performed research for the United States or a political subdivision of a state in these nine contracts.

(1) Under Section 512(b)(10), an organization described in Section 511(a)(2) (an

organization other than a trust) is allowed a Section 170 deduction for charitable contributions up to 10 percent of its unrelated business taxable income (computed without regard to the Section 170 deduction for contributions). The deduction is allowed whether or not the contributions are directly connected with the carrying on of the trade or business. The provisions of Section 170(b)(2) aren’t applicable to contributions by organizations described in Section 511(a)(2). See Treas. Reg. 1.512(b)-1(g)(1).

(2) Under Section 512(b)(11), a trust described in Section 511(b)(2) is allowed a

deduction for charitable contributions within the limitations prescribed by Section 170(b)(1)(A) and (B). However, the limitation on the deduction is determined by reference to unrelated business taxable income computed without regard to the deduction, rather than by reference to adjusted gross income. The deduction is allowed whether or not the contributions are directly connected with the unrelated business. For the purposes of this deduction, a distribution by the trust made pursuant to the trust instrument to a beneficiary described in Section 170 is treated in the same manner as a contribution. See Treas. Reg. 1.512(b)-1(g)(2).

(3) Contributions, in order to be deductible, must be paid to another organization

that qualifies under Section 170(c). For example, an exempt university that operates an unrelated business may deduct a contribution made to another university but may not claim a deduction for contributions with respect to amounts spent for administering its own educational program. See Treas. Reg. 1.512(b)-1(g)(3).

(4) The term “unrelated business taxable income” as used in Section 512(b)(10)

and (11) refers to unrelated business taxable income after application of

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Section 512(a)(6) (UBIT siloing) for taxable years beginning on or after December 2, 2020. See Treas. Reg. 1.512(b)-1(g)(4), (5).

(5) In Crosby Valve & Gage Company v. Commissioner, 380 F.2d 146 (1st Cir.

1967), cert. denied, 389 U.S. 976 (1967), the court considered whether a business corporation, wholly owned by a charitable foundation, was entitled to claim a deduction for property transferred to its parent without consideration. The court concluded that the transfer of property from subsidiary to parent wasn’t a gift that was deductible under Section 170. Citing Section 512(b)(10), the court stated that a charitable organization is barred from making contributions to itself, and there is no reason for a difference in tax treatment merely because the income was earned by a wholly owned subsidiary, rather than directly by the tax-exempt organization.

(6) In South End Italian Independent Club, Inc. v. Commissioner, 87 T.C. 168

(1986), acq. in result, 1987–2 C.B. 1 (IRS AOD-1987-15 (June 15, 1987)), the court held that a Section 501(c)(7) social club that distributed to charities its net proceeds from the operation of beano games in accordance with state law wasn’t subject to the limitations imposed by Section 512(b)(10), since the distributions were deductible as ordinary and necessary business expenses under Section 162, rather than as charitable contributions under Section 170. The distribution of the proceeds for charitable purposes was a condition of the state license to operate such games. However, the transfer of bingo proceeds to an organization’s general fund is no more deductible than a contribution to a reserve for future liabilities. See Women of the Motion Picture Industry v. Commissioner, T.C. Memo. 1997-518.

(1) Section 512(b)(12) provides for a $1,000 deduction from gross income in

computing unrelated business taxable income, except for purposes of computing the net operating loss under Section 172. The deduction is limited to $1,000 regardless of the number of unrelated businesses in which the organization is engaged. See Rev. Rul. 68-536, 1968-2 C.B. 244.

(2) An exception is provided in the case of a diocese, province of a religious order,

or a convention or association of churches which may claim for each parish, individual church, district, or other local unit, a specific deduction limited to the lower of $1,000 or the gross income derived from an unrelated trade or business regularly carried on by such local unit. If a local unit files its own Form 990-T, it claims the specific deduction limited to the lower of $1,000 or the gross income derived from the unrelated trade or business. In such case, the diocese, province of a religious order, or convention or association of churches may not also claim that deduction. See Treas. Reg. 1.512(b)-1(h)(2)(i).

(1) Before 1969, rent, interest, royalty and annuity expenses were deductible in

computing the income of a business, and receipt of such income by tax-exempt

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organizations was generally excluded from unrelated business taxable income. Some exempt organizations would, therefore, "rent" their physical plant to a wholly owned taxable corporation for 80 percent or 90 percent of all the net profits (before taxes and before the rent deduction). This arrangement enabled the taxable corporation to escape nearly all of its income taxes because of the large "rent" deduction. See S. Rep. No. 91-552, 91st Cong., 1st Sess. 73 (1969), 1969-3 C.B. 471.

(2) The Internal Revenue Service challenged but had not always been successful

in its attempt to treat such rents as unrelated business taxable income and to characterize the payments according to the substance of the transaction.

a. In one case, an exempt foundation transferred its working interests in oil

and gas properties to two corporations of which it was the controlling shareholder under agreements giving it "net profits overriding royalties" and requiring the company to look only to the income from production for reimbursement of expenses. The District Court held that the foundation wasn’t engaged in a trade or business and that the contracts under which the foundation received income were in the form of overriding royalties. The Court of Appeals stated the district court determined that the contracts "...did in truth and in fact create income from overriding royalties and not income from working interests." It rejected the Government’s argument that the contracts, though framed as to create an appearance of overriding royalties, were in substance working interests. The Court stated, “To agree with these views would call for a departure from the concepts of the terms, ‘overriding royalties' and ‘working interests.’". The court concluded that the amounts involved were royalties. See Robert A. Welch Foundation v. United States, 228 F. Supp. 881 (D.C. Tex. 1963), aff’d 334 F.2d 774 (5th Cir. 1964).

b. In Rev. Rul. 69-162, 1969-1 C.B. 158, the IRS announced that it wouldn’t

follow the decision in Robert A. Welch Foundation (above) but would continue to review exempt organizations’ transfers of mineral properties to controlled corporations.

(3) In Section 512(b)(13), special rules for certain amounts received from controlled

entities, were added by the Tax Reform Act of 1969. This addition was part of an ongoing attempt to deal with the recharacterization issue.

(4) In J. E. and L. E. Mabee Foundation v. United States, 533 F.2d 521 (10th Cir.

1976), a taxable corporation engaged in the production and sale of oil and gas through ownership of oil and gas leases. The corporation was a wholly owned subsidiary of a tax-exempt foundation, which received payments directly from oil purchasers rather than indirectly through its subsidiary. The foundation argued that the provisions of Section 512(b)(13) shouldn’t be applicable because the income wasn’t "derived from" the subsidiary. The court rejected this argument and held that Congress intended to tax a charitable organization’s receipt of "royalties" from a controlled organization. In the court’s

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view, taxation doesn’t depend upon the mechanical formality of whether the overriding royalty income was paid through the controlled organization generating the income, or directly to the charitable recipient.

(5) Under Section 512(b)(13), the exclusions of interest, annuities, royalties, and

rents provided by Section 512(b)(1), (2), and (3) don’t apply where those amounts are derived from controlled organizations.

(6) Section 512(b)(13) provides that, if an organization (referred to as the

"controlling organization") receives or accrues (directly or indirectly) a "specified payment" from another entity which it controls (referred to as the "controlled entity"), the controlling organization must include the payment as an item of gross income derived from an unrelated trade or business to the extent the payment reduces the net unrelated income of the controlled entity (or increases any net unrelated loss of the controlled entity) notwithstanding Section 512(b)(1)-(3).

a. All deductions of the controlling organization directly connected with

amounts treated as derived from an unrelated trade or business under the preceding sentence are allowed.

b. For purposes of Section 512(b)(13), the term "net unrelated income"

means, in the case of a controlled entity which isn’t exempt from tax under Section 501(a), the portion of the entity’s taxable income which would be unrelated business taxable income if the entity were exempt from tax under Section 501(a) and had the same exempt purposes as the controlling organization, or in the case of a controlled entity which is exempt from tax under Section 501(a), the amount of the unrelated business taxable income of the controlled entity.

c. For purposes of Section 512(b)(13), the term "specified payment" means

any interest, annuity, royalty, or rent.

d. For purposes of Section 512(b)(13), the term "control" means, in the case

of a corporation, ownership (by vote or value) of more than 50 percent of the stock in such corporation; (in the case of a nonstock organization, Treas. Reg. 1.512(b)-1(l)(4)(i)(b) measures control not by the controlling organization’s percentage of ownership but its percentage of control over the directors and trustees) in the case of a partnership, ownership of more than 50 percent of the profits interests or capital interests in such partnership, or in any other case, ownership of more than 50 percent of the beneficial interests in the entity.

e. Under Section 512(b)(13)(D)(ii), the constructive ownership rules of

Section 318 (relating to constructive ownership of stock) apply for purposes of determining ownership of stock in a corporation. Similar principles shall apply for purposes of determining ownership of interests in any other entity.

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f. Under Section 512(b)(13)(E), special rules apply to a specified payment

under a binding written contract in effect on August 17, 2006 (or a renewal of such a contract under substantially similar terms). Section 512(b)(13) applies only to the excess portion of such payment (the amount that exceeds fair market value, using Section 482 standards). Thus, a specified payment at fair market value isn’t taxable under Section 512(b)(13). But if the payment is taxable under Section 512(b)(13)(E) (on the excess portion of the payment), the tax otherwise imposed is increased by 20 percent of the excess. Under Section 512(b)(13)(E)(ii), a taxpayer can’t reduce the excess by filing an amended return but can increase it.

(1) Section 512(b)(15) provides an exclusion from unrelated business taxable

income from a business carried on by a religious order or by an educational institution maintained by such order. This special exception is intended to cover a trade or business which has been operated since before May 27, 1959, and which consists of providing services under a license issued by a federal regulatory agency. Less than 10 percent of the net income for each taxable year from the business can’t be used for activities that aren’t related to the purpose constituting the basis for the religious order’s exemption. The organization must also establish that the rates or other charges for such services are competitive with the rates or other charges of similar taxable businesses. See Treas. Reg. 1.512(b)-1(j) and S. Rep. No. 91-552, 91st Cong., 1st Sess. 70 (1969), 1969–3 C.B. 469.

(1) Section 512(b)(16) - (19) contain other, more rarely cited modifications.

a. Section 512(b)(16) - Exclusion of gains or losses from the sale, exchange,

or other disposition of certain real property acquired from financial institutions in conservatorship or receivership.

b. Section 512(b)(17) - Inclusion of certain amounts derived from foreign

corporations attributable to insurance income. See Part VI.A.(4) of this document.

c. Section 512(b)(18) - Treatment of mutual or cooperative electric

companies under Section 501(c)(12)(H).

d. Section 512(b)(19) - Exclusion of gain or loss on sale or exchange of

certain brownfield sites.

(2) As these are unusual and if they arise, please contact one of the UBIT

Knowledge Management core team members as needed for assistance.

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(1) Section 513(a) specifically states that the term unrelated trade or business

doesn’t include:

a. Any trade or business in which substantially all the work in carrying on

such trade or business is performed for the organization without compensation, or

b. Any trade or business carried on by an organization described in Section

501(c)(3) or by a governmental college or university described in Section 511(a)(2)(B), primarily for the convenience of its members, students, patients, officers, or employees, or

c. Any trade or business carried on by a local association of employees

described in Section 501(c)(4) organized before May 27, 1969, which consists of the selling by the organization of items of work-related clothes and equipment and items normally sold through vending machines, through food dispensing facilities, or by snack bars, for the convenience of its members at their usual places of employment, or

d. Any trade or business which consists of selling merchandise, substantially

all of which has been received by the organization as gifts or contributions.

(1) The term” unrelated trade or business” doesn’t include any trade or business in

which substantially all the work is performed for the organization without compensation. See Section 513(a)(1) and Treas. Reg. 1.513-1(e)(1). For example, an exempt orphanage operating a retail store and selling to the general public, where substantially all the work in carrying on the business is performed for the organization by unpaid volunteers, wouldn’t be carrying on unrelated trade or business. See Treas. Reg. 1.513-1(e).

(2) In St. Joseph Farms of Indiana Brothers of Congregation of Holy Cross,

Southwest Province, Inc. v. Commissioner, 85 T.C. 9 (1985), a Section 501(c)(3) religious order operated a farm that produced livestock and crops that were marketed commercially. The farm was operated by the organization’s Brothers, who took a vow of poverty and received no actual salaries. However, the Brothers residing on the farm received food, clothing, shelter, and medical care, regardless of whether they were involved in farm operations. The Tax Court held that although the organization’s farming operations constituted unrelated trade or business, the exception for volunteer labor under Section 513(a)(1) applied. The court reasoned that the support provided to the Brothers wasn’t compensation for purposes of Section 513(a)(1), because such support would be provided regardless of whether the Brothers were operating the farm. The IRS didn’t acquiesce in this decision. See IRS AOD-1986-45 (July 28, 1986).

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(3) A similar case considered by the Tax Court is Shiloh Youth Revival Centers v.

Commissioner, 88 T.C. 565 (1987). There, the members of a Section 501(c)(3) religious organization engaged in forestry, cleaning and maintenance, painting, and so-called "donated labor " activities. The organization provided its members with food, clothing, shelter, medical care, and other benefits. The court applied St. Joseph Farms of Indiana in concluding that the organization’s activities constituted unrelated trade or business. However, the court distinguished St. Joseph Farms of Indiana for the applicability of the volunteer labor exception under Section 513(a)(1). In Shiloh, the court deemed this exception inapplicable because the organization’s members wouldn’t have received food, clothing, shelter, medical care, and other benefits if they didn’t work. In contrast, the Brothers in St. Joseph Farms of Indiana would be cared for even if they were no longer involved in the farming operations.

(4) In Waco Lodge No. 166, Benevolent & Protective Order of Elks v.

Commissioner, 696 F. 2d 372 (5th Cir. 1983), a Section 501(c)(8) organization conducted bingo games where approximately 21 percent of the work was performed for cash compensation and the balance of the work was performed by volunteers who received free drinks for their services. The court held that although free drinks didn’t constitute compensation, the approximately 21 percent of the work performed for cash compensation was substantial enough to prevent the bingo game operation from meeting the exception for volunteer labor under Section 513(a)(1).

(1) Section 513(a)(2) and Treas. Reg. 1.513-1(e)(2) state that any trade or

business carried on by a Section 501(c)(3) organization or by a governmental college or university described in Section 511(a)(2)(B) primarily for the convenience of its members, students, patients, officers, or employees isn’t unrelated trade or business. For example, a laundry operated by a college for the purpose of laundering dormitory linens and students’ clothing wouldn’t be considered unrelated trade or business. See Treas. Reg. 1.513-1(e).

(2) Any trade or business carried on by a local association of employees described

in Section 501(c)(4) organized before May 27, 1969, which consists of the selling of items of work-related clothes and equipment and items normally sold through vending machines, through food-dispensing facilities, or by snack bars, for the convenience of its members at their usual place of employment isn’t considered unrelated trade or business. See Section 513(a)(2) and Treas. Reg. 1.513-1(e)(2).

(3) The following are several authorities illustrating the "convenience exception":

a. The leasing of studio apartments and the operation of a dining hall by a

Section 501(c)(3) organization constitute unrelated trade or business where occupancy in the apartments isn’t primarily for the convenience of its members. See Rev. Rul. 69-69, 1969-1 C.B. 159.

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b. A gift shop operated by the hospital for the convenience of its patients,

visitors, and employees, isn’t unrelated trade or business. Rev. Rul. 69267, 1969-1 C.B. 160.

c. The operation of a cafeteria and coffee shop by a hospital, for the

convenience of its employees and medical staff, isn’t unrelated trade or business. Rev. Rul. 69-268, 1969-1 C.B. 160.

d. The operation of a parking lot for patients and visitors by an exempt

hospital for the convenience of such patients and visitors isn’t unrelated trade or business. Rev. Rul. 69-269, 1969-1 C.B. 160.

e. The operation of a dining room, cafeteria, and snack bar by an exempt art

museum for the convenience of its staff, employees, and members of the public visiting the museum doesn’t constitute an unrelated trade or business activity. See Rev. Rul. 74-399, 1974-2 C.B. 172.

f. In St. Luke’s Hospital of Kansas City v. United States, 494 F. Supp. 85

(W.D. Mo. 1980), the court held, in part, that the hospital’s performance of diagnostic laboratory testing upon specimens of patients of the hospital’s staff physicians wasn’t unrelated trade or business because the testing was performed primarily for the convenience of the hospital’s staff physicians, who were "members " for purposes of Section 513(a)(2). Note: Rev. Rul. 85–109, 1985–2 C.B. 165, states that the IRS won’t follow that portion of the St. Luke’s Hospital of Kansas City holding that private patient specimen testing is for the convenience of the hospital’s members and therefore not an unrelated trade or business. The IRS position is that hospital staff physicians are neither "members " nor "employees" of the hospital in their capacities as private practitioners of medicine. Therefore, by providing laboratory testing services on tissue specimens referred by its staff physicians in their private capacities, the hospital isn’t carrying on an activity primarily for the convenience of its members, officers, or employees within the meaning of Section 513(a)(2).

g. In New Jersey Council of Teaching Hospitals v. Commissioner, 149 T.C.

No. 22 (2017), the taxpayer contracted with third-party vendors to provide its members (hospitals and a medical school) access to debt-collection services and group purchasing programs. The taxpayer received fees from the vendors in exchange for administering these programs and promoting the programs to its members. In addition to holding that these fees weren’t royalties, the court held that the taxpayer’s activities of providing members access to lower cost services, or high-quality vendors weren’t carried on primarily for the convenience of its members and therefore constituted unrelated business taxable income.

h. See also the discussion in Part II.B.3 of this document regarding non casual sales to persons other than members resulting in a business’s failure to qualify for the convenience exception.

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(1) Section 513(a)(3) and Treas. Reg. 1.513-1(e)(3) exclude from the definition of

unrelated trade or business any trade or business that consists of selling merchandise, substantially all of which has been received by the organization as gifts or contributions. For example, the operation of a thrift shop by a Section 501(c) organization, which sells donated clothes and books to the general public, wouldn’t be considered unrelated trade or business. See Treas. Reg. 1.513-1(e) and Rev. Rul. 71-581, 1971-2 C.B. 236.

(1) Section 513(d) states that income from qualified public entertainment activities

engaged in by qualified organizations isn’t treated as unrelated trade or business.

(2) As per Section 513(d)(2)(A), a public entertainment activity is any entertainment

or recreational activity traditionally conducted at fairs or expositions promoting agricultural and educational purposes. These activities include, but aren’t limited to, any activity, one of the purposes of which is to attract the public to fairs or expositions or to promote the breeding of animals or the development of products or equipment.

(3) As per Section 513(d)(2)(B), qualified public entertainment activities are

excluded from unrelated trade or business only when they are conducted by a qualifying organization in:

a. Conjunction with an international, national, state, regional, or local fair or

exposition,

b. Accordance with the provisions of state law which permit the activity to be

operated or conducted solely by such an organization, or by an agency, instrumentality, or political subdivision of such state, or

c. Accordance with the provisions of state law which permit such an

organization to be granted a license to conduct not more than 20 days of such activity on payment to the state of a lower percentage of the revenue from such licensed activity than the state requires from organizations not described in Section 501(c)(3), (4), or (5).

(4) A qualifying organization is defined in Section 513(d)(2)(C) as an organization

described in Section 501(c)(3), (4) or (5) that regularly conducts, as one of its substantial exempt purposes, an agricultural or educational fair or exposition.

For example, activities such as horse racing with pari-mutuel betting as described in Rev. Rul. 68-505 wouldn’t be considered unrelated trade or business under this Section provided the above requirements are met.

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(1) Section 513(d)(3) and Treas. Reg. 1.513-3(b) provide that certain traditional

convention and trade show activities carried on by a qualifying organization in connection with a qualified convention or trade show aren’t treated as unrelated trade or business and income from such activities isn’t subject to the tax imposed by Section 511.

(2) Section 513(d)(3)(C) defines a qualifying organization as one described in

Section 501(c)(3), (4), (5) or (6) that regularly conducts, as one of its substantial exempt purposes, a qualified convention or trade show activity, as described in that Section. The Tax Reform Act of 1986 extended the definition of qualifying organization to organizations described in Section 501(c)(3) and 501(c)(4). The effective date of this provision is October 22, 1986.

(3) According to Section 513(d)(3)(B), a qualified convention or trade show activity

is an activity that meets the following requirements:

a. It is conducted by a qualifying organization,

b. At least one purpose of the qualifying organization in sponsoring the

activity is the promotion and stimulation of interest in, and demand for, the products and services of the qualifying organization’s members’ industry in general or to educate persons in attendance regarding new developments or products and services related to the exempt activities of the organization, and

c. The show is designed to achieve that purpose through the character of the

exhibits and the extent of the industry products displayed.

(4) Per Treas. Reg. 1.513-3(c)(4), for the purposes of this section, convention and

trade show activity means any activity of a kind traditionally carried on at shows. The regulations indicate that this includes, but isn’t limited to:

a. Activities designed to attract to the show members of the sponsoring

organization, members of an industry in general, and members of the public, to view industry products or services and to stimulate interest in, and demand for, such products and services,

b. Activities designed to educate persons in the industry about new products

and services or new rules and regulations affecting the industry, and

c. Incidental activities, such as furnishing refreshments, of a kind traditionally

carried on at such shows.

(5) To overcome Congress’ specific objection to the taxing of income received by

organizations conducting trade shows where selling by exhibitors was permitted, Treas. Reg. 1.513-3(d)(1) states that the rental of display space to exhibitors, including exhibitors who are suppliers, at a qualified trade show or at a qualified convention isn’t considered unrelated trade or business even though the exhibitors who rent the space are permitted to sell or solicit orders.

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(6) Treas. Reg. 1.513–3(d) and (e) make it clear that a supplier exhibit may be part

of a qualified trade show and, as such, isn’t treated as unrelated trade or business. A supplier exhibit is one in which the exhibitor displays goods or services that are supplied to, rather than by, the members of the qualifying organization in the conduct of such members’ own trades or businesses. Income from a supplier show not connected with a qualified trade show is treated as unrelated trade or business income. See examples from the regulations below:

a. X, an organization described in Section 501(c)(6), was formed to promote

the construction industry. Its membership is made up of manufacturers of heavy construction machinery many of whom own, rent, or lease one or more digital computers produced by various computer manufacturers. X is a qualifying organization under Section 513(d)(3)(C) that regularly holds an annual meeting. At this meeting a national industry sales campaign and methods of consumer financing for heavy construction machinery are discussed. In addition, new construction machinery developed for use in the industry is on display with representatives of the various manufacturers present to promote their machinery. Both members and nonmembers attend this portion of the conference. In addition, manufacturers of computers are present to educate X's members. While this aspect of the conference is a supplier exhibit (as defined in paragraph (d) of this Section), income earned from such activity by X won’t constitute unrelated business taxable income to X because the activity is conducted as part of a qualified trade show described in Treas. Reg. 1.513–3(c).

b. Assume the same facts as in Example a., but the only goods or services

displayed are those of suppliers, the computer manufacturers. Selling and order taking are permitted. No member exhibits are maintained. Standing alone, this supplier exhibit (as defined in Treas. Reg. 1.513-3(d)(2) would constitute a supplier show and not a qualified convention or trade show. In this situation, however, the rental of exhibition space to suppliers isn’t unrelated trade or business. It is conducted by a qualifying organization in conjunction with a qualified convention or trade show. The show (the annual meeting) is a qualified convention or trade show because one of its purposes is the promotion and stimulation of interest in, and demand for, the products or services of the industry through the character of the annual meeting.

c. Y is an organization described in Section 501(c)(6). The organization

conducts an annual show at which its members exhibit their products and services in order to promote public interest in the line of business. Potential customers are invited to the show, and sales and order taking are permitted. The organization secures the exhibition facility, undertakes the planning and direction of the show, and maintains exhibits designed to promote the line of business in general. The show is a qualified convention or trade show described in Treas. Reg. 1.513-3(c)(2). The

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provision of exhibition space to individual members is a qualified trade show activity and isn’t unrelated trade or business.

d. Z is an organization described in Section 501(c)(6) that sponsors an

annual show. As the sole activity at the show, suppliers to the members of Z exhibit their products and services for the purpose of stimulating the sale of their products. Selling and order taking are permitted. The show is a supplier show and doesn’t meet the definition of a qualified convention show as it doesn’t satisfy any of the three alternative bases for qualification. First, the show doesn’t stimulate interest in the members' products through the character of product exhibits as the only products exhibited are those of suppliers rather than members. Second, the show doesn’t stimulate interest in members' products through conferences or seminars as no such conferences are held at the show. Third, the show doesn’t meet the definition of a qualified show on the basis of educational activities as the exhibition of suppliers' products is designed primarily to stimulate interest in, and sale of, suppliers' products. Thus, the organization's provision of exhibition space isn’t a qualified convention or trade show activity. Income derived from rentals of exhibition space to suppliers will be unrelated business taxable income under Section 512.

(7) Rev. Rul. 2004-112, 2004-2 C.B. 985, provides that supplemental internet

activities of a Section 501(c)(6) trade association, extending 3 days before and after its in-person trade show at a physical facility, were qualified convention and trade show activity under Section 513(d)(3)(B). The revenue ruling also holds that internet activities that didn’t coincide with a physical trade show weren’t qualified convention and trade show activities and weren’t excepted from the definition of an unrelated trade or business. A convention or trade show activity which is conducted by a qualifying organization, but which otherwise isn’t so qualified under Section 513(d), is considered unrelated trade or business.

(1) Section 513(e), added by the Tax Reform Act of 1976, provides that the term

“unrelated trade or business” doesn’t include a tax-exempt hospital’s furnishing of the services listed in Section 501(e)(1)(A) to other tax-exempt hospitals. The provision applies if:

a. Such services are furnished solely to hospitals that have facilities to serve

not more than 100 inpatients,

b. Such services, if performed on its own behalf by the recipient hospital,

would constitute activities in exercising or performing the purpose or function constituting the basis for its exemption, and

c. such services are provided at a fee or cost which doesn’t exceed the

actual cost of providing such services, such cost including straight line

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depreciation and a reasonable amount for return on capital goods used to provide such services.

(1) Section 513(f), added by Public Law 95-502, effective for taxable years

beginning after December 31, 1969, provides that certain bingo games are excluded from the definition of unrelated trade or business. Before this law, exempt organizations were subject to the UBIT on the proceeds of bingo games regularly carried on, unless the bingo games were conducted by unpaid volunteers.

(2) Treas. Reg. 1.513-5(d) defines a bingo game as a game of chance played with

cards that are generally printed with five rows of five squares each. Participants place markers over randomly called numbers on the cards in an attempt to form a preselected pattern such as a horizontal, vertical, or diagonal line, or all four corners. The first participant to form the preselected pattern wins the game. As used in Treas. Reg. 1.513-5, bingo game means any game of bingo of the type described above in which wagers are placed, winners are determined, and prizes or other property is distributed in the presence of all persons placing wagers in that game. See also Section 513(f)(2).

(3) The regulations provide that, in order for a bingo game to come within

applicable provisions, it must be legal under state and local law, and it must not be in direct commercial competition with similar games conducted by for-profit organizations. See Treas. Reg. 1.513-5(c)(1) and (2) and Section 513(f)(2)(B) and (C). It should be noted that, if bingo is illegal under state law or local law, it is immaterial whether state or local officials enforce the law. See Treas. Reg. 1.513-5(c)(3), Example (2).

(4) In determining whether bingo games are conducted in competition with

commercial entities, Treas. Reg. 1.513-5(c)(2) provides that bingo games are "ordinarily carried out on a commercial basis" within a jurisdiction if they are regularly carried on (within the meaning of Treas. Reg. 1.513-1(c)) by for-profit organizations in any part of that jurisdiction. Ordinarily, the entire state would constitute the appropriate jurisdiction for making this determination. However, if state laws permit local jurisdictions to determine whether bingo games may be conducted by for-profit organizations, or if state law limits or confines the conduct of bingo games by for-profit organizations to specific local jurisdictions, then the local jurisdiction will constitute the appropriate jurisdiction for determining whether bingo games are ordinarily carried out on a commercial basis.

a. Example: Veterans’ organizations Y and X, both tax-exempt

organizations, are organized under the laws of State N. State N has a statutory provision that permits bingo games to be conducted by taxexempt organizations. In addition, State N permits bingo games to be conducted by for-profit organizations in city S, a resort community located in county R. Several for-profit organizations conduct nightly bingo games

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in city S. Y conducts weekly bingo games in city S. X conducts weekly bingo games in county R and its game operators are fully compensated for their labor. Because state law confines the conduct of bingo games by for-profit organizations to city S, and because bingo games are regularly carried on there by those organizations, Y’s bingo games conducted in city S constitute unrelated trade or business. However, X’s bingo games conducted in county R outside of city S do not constitute unrelated trade or business. See Treas. Reg. 1.513-5(c)(3), Example (3).

(5) A broader exemption from unrelated business applies to certain games of

chance conducted in North Dakota. Section 311 of the Deficit Reduction Act of 1984 (as amended by Section 1834 of the Tax Reform Act of 1986) provides that for purposes of Section 513, the term unrelated trade or business doesn’t include games of chance conducted by nonprofit organizations if the conduct of such games doesn’t violate any state or local law and, as of October 5, 1983, there was a state law (originally enacted on April 22, 1977) in effect which permitted only nonprofit organizations to conduct such games. This provision applied to games of chance conducted after June 30, 1981, in taxable years ending after that date. The amendment in the Tax Reform Act of 1986 limited the exception to games of chance conducted in the State of North Dakota.

(1) Section 513(g), added to the Code by P.L. 96-605, states that, in the case of

mutual or cooperative telephone or electric companies exempt under Section 501(c)(12), the term "unrelated trade or business " doesn’t include engaging in qualified pole rentals (as defined in Section 501(c)(12)(D)).

(2) The term "qualified pole rental " is defined in Section 501(c)(12)(D) as any

rental of a pole (or other structure used to support wires) if such pole (or other structure) is used:

a. By the telephone or electric company to support one or more wires that

are used in providing telephone or electric services to its members, and

b. Per the rental to support one or more wires (in addition to the wires

described above) for use in connection with the transmission by wire of electricity or of telephone or other communications.

(3) In this context, "rental" includes any sale of the right to use the pole (or other

structure).

(4) This provision is effective for all taxable years beginning after December 31,

(1) Treas. Reg. 1.513-1(b) states that where an activity doesn’t possess the

characteristics of a trade or business per Section 162, such as when an

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organization sends out low-cost articles incidental to the solicitation of charitable contributions, the UBIT doesn’t apply because the organization doesn’t compete with taxable organizations.

(2) Defining the term "low-cost article" presented difficulties for the IRS and the

courts. In Hope School v. United States, 612 F. 2d 298 (7th Cir. 1980), the court held that a tax-exempt school’s solicitation of contributions through the mailing of greeting cards to potential contributors didn’t constitute unrelated trade or business. In the court’s view, the organization wasn’t selling greeting cards but was, instead, distributing them incidental to the solicitation of charitable contributions. The court focused on the unfair competition question, holding that no unfair competition was involved. The court emphasized that the net proceeds were used for the benefit of the school rather than reinvestment in the greeting card business.

(3) A similar approach was taken by the court in Veterans of Foreign Wars of the

United States v. United States, 601 F. Supp. 7 (W.D. Mo. 1984). Citing Hope School, the court found that the greeting cards were distributed as low-cost articles incidental to the solicitation of contributions. In addition, the court noted that the organization didn’t reinvest proceeds into its greeting card program, thereby gaining no competitive advantage, which indicates that it wasn’t operating a trade or business for purposes of the tax on unrelated business income.

(4) In Disabled American Veterans v. United States, 650 F. 2d 1178 (Ct. Cl. 1981),

the court considered whether amounts received from the DAV’s merchandise premiums and mailing list rentals constituted unrelated business taxable income. Under DAV’s Special Solicitation program, requests for contributions were accompanied by books, maps and charts, or wrist calendars. The premiums were offered for contributions in stated amounts of $2.00, $3.00, $5.00 or more. The Court of Claims stated that what is necessary to constitute a trade or business for purposes of the tax on unrelated business income is that an activity be operated in a competitive commercial manner. Applying this test, the court found that the contributions required for both the $2.00 and $3.00 premiums were substantially in excess of their retail value and, therefore, no trade or business was present. However, the contributions required for the $5.00 premiums weren’t so greatly in excess of their retail value and, therefore, amounts attributable to the $5.00 premiums were derived from a trade or business. DAV also rented out its donor mailing list. Income from the exchanges and rentals of member lists was held to be unrelated business taxable income. In response to this court decision, Congress enacted Section 513(h)(1)(B), which provides that for exempt organizations that are eligible to receive deductible contributions under Section 170(c)(2) or (3), the term "unrelated trade or business” doesn’t include any trade or business which consists of exchanging or renting members’ or donors’ names and addresses with or to another such organization. In accordance with this provision, an exempt organization eligible to receive deductible contributions under Section

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170(c)(2) or (3) that exchanges its member lists with " another such organization," or that rents its member lists to "another such organization" doesn’t engage in unrelated trade or business. See also Common Cause v. Commissioner, 112 T.C. 332 (1999) (enactment of Section 513(h) doesn’t mean that mailing list rentals that do not fall within that provision are always unrelated business taxable income and not royalties) and Planned Parenthood Federation of America, Inc. v. Commissioner, T.C. Memo. 1999-206. See also the discussion of Royalties in Part VI.A.2 of this document for cases involving mailing list rentals.

(5) In order to clarify the definition of low-cost articles, Congress enacted Section

513(h) as part of the Tax Reform Act of 1986. Section 513(h)(1)(A) provides that, in the case of an organization which is described in Section 501 and contributions to which are deductible under Section 170(c)(2) or (3), the term "unrelated trade or business" doesn’t include activities relating to the distribution of low-cost articles, if the distribution of such articles is incidental to the solicitation of charitable contributions. A "low-cost article" is defined in Section 513(h)(2)(A) as any article with a cost of $5.00 or less to the organization distributing the item (or on whose behalf such item is distributed). Items are aggregated in a calendar year where more than one item is distributed to a single distributee. The aggregate of the items is treated as one article for purposes of the $5.00 limit. See Section 513(h)(2)(B). Section 513(h)(2)(C) indexes the $5.00 limit with a cost-of-living adjustment for years after 1987. For taxable years beginning in 2023, for purposes of defining the term ‘unrelated trade or business’ for certain exempt organizations under Section 513(h)(2), ‘low cost articles’ are articles costing $12.50 or less. See Rev. Proc. 2022-38, Section 3.34(1). An annual revenue procedure is published with updated inflation-adjusted amounts.

(6) A distribution of low-cost articles is treated as a distribution incidental to the

solicitation of charitable contributions only if:

a. The distribution isn’t made at the request of the distributee,

b. The distribution is made without the express consent of the distributee,

and

c. The distributed articles are accompanied by a request for a charitable

contribution by the distributee to the distributing organization and by a statement that the distributee may retain the low-cost article regardless of whether the distributee makes a charitable contribution to the distributing organization. See Section 513(h)(3).

(7) The Tax Court considered whether an organization’s Christmas card program

resulted in unrelated business taxable income in Veterans of Foreign Wars, Department of Michigan v. Commissioner, 89 T.C. 7 (1987). The Veterans of Foreign Wars (VFW) entered into a contract with a commercial organization, which agreed to prepare boxes of Christmas cards and send them to individuals appearing on a list provided by VFW. Each package sent to an individual

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appearing on the list included a cover letter, a box of 20 Christmas cards, a return envelope, and a remittance card. The cover letter asked the recipient to pay $2.00 in 1975 and $3.00 in 1976 and 1977 and stated that contributions were tax deductible. The commercial organization also sent out reminder notices to those who didn’t respond initially. VFW was involved in the Christmas card program for about one week per month from September through February of each year. Approximately 50,000 boxes of cards were shipped during each of the three years. The commercial organization provided similar services to other exempt organizations and, during the three years in question, its share of the Christmas card market was 1.52 percent, 1.84 percent, and 2.12 percent, respectively. On these facts, the Tax Court concluded that VFW conducted the Christmas card program:

a. With the predominant intent of producing income,

b. The Christmas card program was in substance the regularly carried on

sale of goods,

c. The program was in competition with Christmas cards marketed by

commercial entities,

d. The program wasn’t substantially related to VFW’s exempt purposes, and

e. Those paying more than the $2.00 or $3.00 amounts requested made a

gift to VFW.

(8) With regard to the trade or business issue, the court stated that it believed VFW

conducted the Christmas card program in order to produce income. All of the facts indicated that there was a trade or business under Section 513(a) and (c). The court also rejected the organization’s argument that the Christmas cards were low-cost articles sent incidental to the solicitation of charitable contributions as the amounts solicited by the organization were ‘within a reasonable range’ of the retail values of the Christmas cards. Therefore, the court found that the Christmas cards weren’t low-cost articles and held that the low-cost article exception didn’t apply. In a footnote, the court stated that the distribution of the Christmas cards wouldn’t qualify under Section 513(h) (see below), and, in any event, this provision applies only to distributions made after October 22, 1986. The distributions in this case occurred prior to this date.

(1) Section 513(i), added to the Code by P.L. 105–34 in 1997, provides that the

term "unrelated trade or business" doesn’t include the activity of soliciting and receiving "qualified sponsorship payments."

(2) A qualified sponsorship payment is any payment made by any person engaged

in trade or business (sponsor) to a tax-exempt organization in return for the organization’s use or acknowledgment of the sponsor’s name or logo (or product lines), where there is no arrangement or expectation that such person

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will receive any other substantial return benefit. See Section 513(i)(2)(A) and Treas. Reg. 1.513-4(c)(1).

(3) Use or acknowledgment doesn’t include advertising the sponsor’s products or

services, including endorsement or other inducements to buy, sell or use such products or services. See Section 513(i)(2)(A). A more detailed discussion of what a use or acknowledgment does and doesn’t include is set forth in Treas. Reg. 1.513-4(c)(2)(iv). Also, payments contingent on the level of attendance at one or more events, on broadcast ratings, or on other factors indicating the degree of public exposure to the sponsored activity aren’t qualified sponsorship payments. Treas. Reg. 1.513-4(e)(2).

(4) Section 513(i) doesn’t apply to payments made in connection with qualified

convention and trade show activities, nor to income derived from the sale of advertising or acknowledgments in exempt organization periodicals. See Treas. Reg. 1.513-4(b). In some cases, a mere listing of multiple donors in a periodical might not constitute unrelated business. See Rev. Rul. 76-93, 1976-1 C.B. 170, clarifying Rev. Rul. 74-38, 1974-1 C.B. 144.

(5) In some situations, a payment may be a qualified sponsorship payment in part.

If there is an arrangement or expectation that the sponsor will receive a substantial return benefit with respect to any payment, then only the portion, if any, of the payment that the exempt organization establishes is in excess of the fair market value of the substantial return benefit is a qualified sponsorship payment. Treatment of the remaining portion (and treatment of any other payment that doesn’t qualify as a qualified sponsorship payment) is determined by applying Sections 512-514. See Treas. Reg. 1.513-4(d).

(1) The term "unrelated trade or business" has a special meaning for a trust

computing its unrelated business taxable income under Section 512 for purposes of Section 681 (relating to the limitation on the charitable deduction by a trust), an exempt trust described in Section 401(a) or a Section 501(c)(17) trust. Any trade or business regularly carried on by one of these trusts, or by a partnership of which it is a member, is unrelated trade or business. See Section 513(b). The same rule applies to an individual retirement account (which is subject to UBIT under Section 408(e)). See Treas. Reg. 1.513-1(f). In addition, the exclusions of Section 513(a) aren’t applicable to these trusts. See Cooper Tire and Rubber Co. Employees’ Retirement Fund v. Commissioner, 36 T.C. 96 (1961), aff’d, 306 F. 2d. 20 (6th Cir. 1962).

(1) An exempt organization that has $1,000 or more of gross income from an

unrelated business must file Form 990-T. See Treas. Regs 1.511-3(b), 1.6012

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2(e) and 1.6012-3(a)(5). An organization must pay estimated tax if it expects its tax for the year to be $500 or more. See Section 6655(f).

(2) The obligation to file Form 990-T is in addition to the obligation to file the annual

information return, Form 990, 990-EZ or 990-PF. Each organization must file a separate Form 990-T, except title holding corporations and organizations receiving their earnings that file a consolidated return. See Treas. Regs 1.5113(b), 1.6012-2(e) and 1.6012-3(a)(5)(g)(3) and Part I.D.3 of this document.

(3) For most exempt organizations, Form 990-T is due annually by the 15 ^th day of

the 5 ^th month after the end of its tax year. See Section 6072(c) and Treas. Reg. 1.6072-2(c).

(4) As mentioned previously, an exempt organization claims the specific deduction

of $1,000 on the Form 990-T and only one specific deduction may be taken, regardless of the number of unrelated businesses conducted. Section 512(b)(12) provides for a $1,000 deduction from gross income in computing unrelated business taxable income, except for purposes of computing the net operating loss under Section 172.

(1) All organizations subject to tax under Section 511, except trusts described

below, are taxable at corporate rates under Section 11 on unrelated business taxable income. See Section 511(a)(1) and Treas. Reg. 1.511-1.

a. For corporate (non-trust) organizations and state colleges and universities,

for tax years beginning after December 31, 2017, the tax rate on unrelated business taxable income is a flat 21%.

(2) Trusts exempt from taxation under Section 501(a) and which, if not exempt,

would be taxable as trusts under subchapter J, are taxable at trust rates under Section 1(e) on unrelated business taxable income. See Section 511(b)(1) and Treas. Reg. 1.511-2(b). The deduction for personal exemption provided in Section 642(b) in the case of a trust taxable under subchapter J, chapter 1 of the Code, isn’t allowed in computing unrelated business taxable income.

(3) The foreign tax credit is available to organizations filing Form 990-T to the

extent provided in Section 901. Section 515 provides that the term “unrelated business taxable income” is considered synonymous with “taxable income” for purposes of an exempt organization claiming the foreign tax credit under Section 901 and 904.

a. Other tax credits may also be available. For example, see Rev. Rul. 82 218, 1982-2 C.B. 30, and Rev. Rul. 2003-64, 2003-1 C.B. 1036. See also the discussion in Part III.N of this document.

(1) Trusts liable for tax on unrelated business taxable income may be liable for

alternative minimum tax (“AMT”) on certain adjustments and tax preference

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items under Section 55. Only those items of tax preference which enter into the computation of unrelated business taxable income are taken into account in computing the AMT. See Section 55(b)(2).

(2) For tax years beginning before 2018, the AMT applies to corporations, subject

to an exemption for small corporations under Section 55(e). Section 12001 of the TCJA eliminated the AMT on corporations under Section 55(a) for tax years beginning after January 1, 2018. For taxable years beginning after December 31, 2022, Section 10101 of the Inflation Reduction Act of 2022 established a new corporate AMT, which generally applies to corporations with more than $1 billion of income on their financial statements (which, for corporations subject to tax under Section 511, includes only income from an unrelated trade or business (including debt-financed property)). See Section 56A(c)(12) and Notice 2023-7, 2023-3 IRB 390.

(1) Every domestic and foreign organization exempt under Section 501(a) (except

instrumentalities of the United States) must file a return on Form 990–T, Exempt Organization Business Income Tax Return, when the sum of its gross income from an unrelated trade or business and unrelated business taxable income is $1,000 or more. An exempt organization files a single Form 990-T. The 990-T was revised in 2020, and among the revisions was the creation of Schedule A, Unrelated Business Taxable Income From an Unrelated Trade or Business. This schedule is where an organization reports the income and expenses for each of its unrelated businesses. A separate Schedule A would be attached to the 990-T for each unrelated business activity. See Treas. Reg. 1.512(a)-6 for information about how to identify separate unrelated trades or businesses, discussed in Part III.G of this document.

(2) Mandatory electronic filing of Form 990-T started in February 2021. Limited

exceptions apply. See the Instructions for Form 990-T for more information. The obligation to file Form 990–T is in addition to the obligation to file an information return (i.e., Form 990). See Treas. Reg. 1.6012–2(e) and 1.6012–3(a)(5).

(3) Each organization must file a separate Form 990-T, except Section 501(c)(2)

title-holding corporations and organizations receiving their earnings that file a consolidated return under Section 1501 as discussed in Part I.D.3 of this document.

(4) The various provisions of law relative to accounting periods, accounting

methods, assessment, and collection penalties, etc., which apply to tax returns generally are equally applicable to returns filed on Form 990-T. See Treas. Reg. 1.511-3(a) and (c).

(5) Any tax due with Form 990-T must be paid in full when the return is filed, but no

later than the date the return is due (determined without extensions). See Section 6151(a). Taxpayers must pay the tentative tax (an estimate) with a Form 8868 request for extension.

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(6) All organizations exempt under Section 501(c) (other than employees’ trusts

described in Section 401(a)) that are subject to unrelated business income tax must file Form 990-T by the fifteenth day of the fifth month after the close of their tax year. See Section 6072(e).

(7) The filing of an information return on Form 990 (or any other return required by

Section 6033 by an organization exempt from income tax under Section 501(a)) doesn’t start the running of the statute of limitations for purposes of assessment of the unrelated business income tax required to be reported on Form 990-T, unless the return discloses sufficient facts to apprise the IRS of the potential existence of unrelated business taxable income. When the Form 990, Return of

statute of limitations for purposes of assessment of unrelated business income tax starts running with the Form 990 filing and discloses the gross receipts from the activity. See Rev. Rul. 69-247, 1969-1 C.B. 303. modifying Rev. Rul. 62–10, 1962–1 C.B. 305.

(1) Section 6501(a) provides the general rule that the amount of any tax shall be

assessed within three years after the tax return is filed. Section 6501(b)(1) provides that a return is deemed filed on the due date if it is filed early but is deemed filed on the date filed if it is filed late.

(2) Section 6501(c) lists several exceptions that allow assessment to be made at

any time. These include a false or fraudulent return with the intent to evade tax; a willful attempt to evade tax; failure to file a return; and assessment of tax on termination of private foundation status. The statutory period may also be extended by written agreement (on Form 872, Consent to Extend the Time to Assess Tax or Form 872-A, Special Consent to Extend the Time to Assess Tax) between the taxpayer and the IRS If the period of limitations is extended by agreement, the tax may be assessed any time within the period agreed on, and the period may be extended by subsequent written agreements made within the period previously agreed on. See Treas. Reg. 301.6501(c)-1(d).

(3) Section 6501(g)(2) and Reg. 301.6501(g)-1(b) provide that the period of

limitations for assessing income tax starts when an organization, believing in good faith that it is an exempt organization, files a return as such, even if the organization is later held to be a taxable organization for the taxable year for which the return is filed. Rev. Rul. 60-144, 1960-1 C.B. 636, provides that Section 6501(g)(2) applies even though the organization has not been recognized as exempt when the return is filed, and Treas. Reg. 1.6033-2(c) requires an organization claiming exempt status prior to recognition to file a return required by Section 6033. Section 6501(g)(2) doesn’t, however, relieve an organization that has not established its exempt status from the requirement that it file income tax returns and pay any tax due.

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(4) The "failure to file" exception of Section 6501(c)(3) doesn’t apply to related

returns (Form 990-T, Form 1120-POL, etc.) required of an exempt organization if the organization filed in good faith a Form 990-series information return that discloses information sufficient to apprise the IRS of the nature and extent of the items that should have been reported on a related return. This has been the position of IRS since the publication of Rev. Rul. 69-247, 1969-1 C.B. 303, which announced that the IRS will follow the decision in California Thoroughbred Breeders Association v. Commissioner, 47 T.C. 335 (1966), if certain conditions are met.

(5) In California Thoroughbred Breeders, the IRS attempted to assess unrelated

business income tax on a Section 501(c)(5) organization's income from horse sales. The tax was assessed more than three years after the organization filed Form 990 for the year in issue. The organization didn’t file Form 990-T for the year but reported the income from the horse sales on its Form 990. The organization asserted the defense that the three-year period of limitations barred assessment. The IRS contended that the period of limitations didn’t apply because the organization didn’t file Form 990-T, and the filing of Form 990 didn’t start the period of limitations for assessment of unrelated business income tax. The court held that the period of limitations for assessment of unrelated business income tax on the horse sale income started when the organization filed Form 990, which reported the nature and amount of the income. The court found as fact that the organization determined in good faith that it was exempt and had no taxable income. Therefore, the organization determined in good faith that it wasn’t required to file any return other than Form 990.

(6) In Rev. Rul. 69-247, 1969-1 C.B. 303, the IRS set out the information an

organization's annual information return must disclose to bring the return under the holding of the court in California Thoroughbred Breeders. The return (filed in good faith) must state the nature of the income-producing activity with sufficient specificity to enable the IRS to determine whether the income is from a related activity and must disclose the gross receipts from the activity. If the information return doesn’t disclose facts sufficient to apprise the IRS of the nature and amount of the income, the IRS follows the position of Rev. Rul. 62-10, which is that the filing of the information return doesn’t start the period of limitations for purposes of assessment of unrelated business income tax.

(1) This section focuses on how to calculate and assess the tax once you have

determined that there is an unrelated business income tax issue. See Section 511(a)(1).

(1) All organizations subject to the tax on unrelated business income, except the

exempt trusts described in Section 511(b)(2), are taxable at corporate rates on

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that income. See Treas. Reg. 1.511-1 and see the discussion in Part VIII. A. of this document. All exempt trusts subject to the tax on unrelated business income that, if not exempt, would be taxable as trusts are taxable at trust rates on that income. However, an exempt trust may not claim the deduction for a personal exemption that is normally allowed to a trust.

(2) Under Section 512(a)(6), an organization that conducts more than one

unrelated trade or business calculates its UBTI as the sum of the UBTI calculated separately for each unrelated trade or business, and when calculating this sum, the UBTI from any of the separate trades or businesses can't be less than zero. The tax computed on the total UBTI can be reduced by any applicable tax credits, including the general business credits (such as the investment credit) and the foreign tax credit. See Schedule A (Form 990-T). The UBTI with respect to any such trade or business shall not be less than zero when computing total UBTI. See the discussion in Part III.G of this document.

(1) This section provides techniques to identify potential unrelated business

income. It also provides issue indicators and examination tips when reviewing an unrelated business income issue. See Sources of Unrelated Business Income (UBI) Lead Sheet (Exhibit X.D of this document).

(1) Identify each separate trade or business using the first two digits of the NAICS

2-digit code that most accurately describes the unrelated trade or business based on the more specific NAICS code for each year under exam.

(2) Calculate UBI by totaling the UBI for each separate trade or business using the

first two digits of the NAICS code that most accurately describes the unrelated trade or business and subtracting the total allowable deductions.

a. Investigate the source of all allocated expenses.

b. Identify the allocation method used to allocate the expenses between

related and unrelated use.

c. Determine if the activity is directly connected to the unrelated business

activity.

d. Determine the history behind UBI activities which resulted in losses. A

pattern of losses for five or more years indicates a lack of profit motive, justifying a disallowance of that activity from the return.

e. Check the calculations which led to net operating losses reported on

returns.

f. Substantiate the expenses the business incurred over the years resulting

in net operating losses. Look beyond the calculations.

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g. Examine each UBI activity to determine if each “unrelated” activity is

properly siloed.

(3) Identify UBI activities reported that involve dual use of facilities.

(4) Review the organization’s activities to ensure that it reported all unrelated

business activities producing income on Form 990-T.

(5) Identify possible sources of rental income from debt financed property.

(6) Review newsletters and other publications to check for taxable advertising.

Note that the qualified sponsorship exception under Section 513(i) doesn’t apply to advertising in a periodical unless related to, and primarily distributed in connection with, a specific event conducted by the exempt organization.

(7) Review organization’s website for advertising and other indications of unrelated

trade or business. See the Advertising Lead Sheet (Exhibit X.F of this document).

(8) Look for indications of other unrelated activities.

(1) Identify possible sources of rental income and winter storage fees.

(2) Look for provision of goods and services to others.

(3) Associate member dues are excluded from UBI for exempt agricultural or

horticultural organizations if they are $100 or less. See Section 512(d). Caution: See annual inflation adjustment revenue procedure (latest is Rev. Proc. 202238, 2022-45 I.R.B. 445) for inflation-adjusted limitation for annual dues under this paragraph.

(1) Review organization’s website and other publications which may name the

products or services of members only. See Rev. Rul. 79-370, 1979-2 C.B. 238 and Rev. Rul. 65-14, 1954-1 C.B. 236.

(2) Analyze income from members (other than dues) to identify any payments for

particular or individualized services.

(3) Review the dues account in the cash receipts journal for associate member

dues.

(4) Look for multiple listing and coupon redemption service.

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(1) Examine the cash receipts journal and related supporting documents to

determine the club income’s size, extent, and nature and whether it’s related to the organization's exempt purpose.

(2) Review the balance sheet assets to identify any that might produce investment

income. Investment income not set aside is generally taxable.

(3) Identify any income from nonmembers or the general public. Amounts a

member or spouse paid for dependents are considered exempt function income. Also, amounts the member's employer or gratuitous donor paid for the member’s benefit, typically would constitute exempt function income. See Rev. Proc. 71-17 and Part IV.B.3 above.

(4) Identify green fees paid for any golf rounds played by bona fide guests possibly

included in the total green fees. Even though green fees are usually only paid by, or for, nonmembers, the entire amount isn’t necessarily nonmember income as the member may have paid some of the green fees for bona fide guests.

(5) Analyze how the club treats nonmembers as guests. Ensure they have properly

treated them as guests and complied with the recordkeeping requirements of Rev. Proc. 71-17.

(6) Identify any income from nontraditional business activities. Usually, don’t

consider income from these activities exempt function income. This holds true even if the activity is conducted with members, for example, selling package liquor to members for use off-premises and selling advertising space in the organization's newsletter to members and nonmembers.

(7) Review comparative balance sheets and notes to the financial statement to

identify any sales of assets. Section 512(a)(3)(D) permits non-recognition of gains from certain sales when proceeds are reinvested in property used exclusively for exempt Section 501(c)(7) purposes. See Part IV.D of this document, Gain on Sale of Assets. When they must recognize gain, however, it is treated as UBI. See Tamarisk Country Club v. Commissioner, 84 T.C. 756 (1985).

(8) Determine whether the taxpayer and another social club merged and whether

any excess assets have been sold or whether the social club has sold its assets and ceased operations. In the latter case, in addition to determining whether the club has UBI from the sale of its assets and real property, review whether the club has made distributions to members. If so, determine whether the organization issued Forms 1099 to the members because these distributions may create taxable income under Section 301.

(9) Ensure all UBI is properly reported on Form 990-T and on Form 990. If there

are indications that the organization sold property, check the returns to make sure the organization has notified the IRS of the sale. Verify that the organization has properly determined the property’s adjusted basis, including

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adjusting the basis by depreciation for all earlier tax years, in computing its gain.

(1) Identify sales to the general public, which are typically from a bar or restaurant.

(2) Look for rental income from debt-financed properties rented to non-members.

(3) Analyze gaming activities to see if they are open to the public.

(1) Analyze each activity and all the facts and circumstances surrounding that

activity to figure out the activity’s relation to the organization’s exempt purpose.

(2) Generally, income from the marketing of insurance products as well as certain

ATM fees would be considered UBI:

a. Automobile warranties,

b. Dental insurance,

c. Cancer insurance,

d. Accidental death and dismemberment insurance,

e. Life insurance,

f. Health insurance,

g. ATM “per transaction” fees from nonmembers.

(3) Generally, credit life and disability insurance, and GAP auto insurance wouldn’t

be UBI if sold to members.

(1) Does the Form 990, Form 990-EZ, Short Form Return of Organization Exempt

From Income Tax or Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Trust Treated as Private Foundation show any rental income? If so, then check the balance sheet for debt that might be associated with that income.

(2) The purchase of common stocks or bonds with borrowed funds (stocks

purchased on margin) gives rise to debt-financed property. An examination of the brokerage statements for the year(s) of examination should reveal any margin accounts or pledges of securities. Expense analysis should disclose any interest payments. The Board of Directors Finance Committee (or a similar type of committee) minutes should disclose the investments and any encumbrances.

(3) Unrelated Business Income reported from gaming with minimal or no reported

Unrelated Business Taxable Income.

(4) Income from gaming reported on Form 990 or discovered during an

examination of the organization.

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(5) Expenses reported on Form 990-T for gaming licenses and/or prizes.

(6) Charitable contributions reported on Form 990-T in excess of 10% of the

reported Unrelated Business Income.

(7) Gaming advertised in publications or at facility.

(8) Evidence of gaming equipment found during tour of facility.

(1) Ask questions about how the activity is conducted to determine the

organization’s motive for conducting the activity. Is the activity profit-motivated and does it have characteristics of an activity conducted by a for-profit entity? The comparison is both operational and financial. Treas. Reg. 1.183-2 provides a good discussion of factors to consider when determining if an activity is profitmotivated.

a. The way the taxpayer carries on the activity.

b. The expertise of the taxpayer or his advisors.

c. The time and effort expended by the taxpayer in carrying on the

activity.

d. The expectation that assets used in the activity may appreciate.

e. The success of the taxpayer in carrying on other activities.

f. The taxpayer’s history of income or losses with respect to the

activity.

g. The amount of occasional profits, if any, from the activity.

h. The financial status of the taxpayer.

i. Elements of personal pleasure or recreation.

(2) Isolate the financial transactions of the activity to derive a profit or loss for the

activity. A good starting point is to analyze the activity budget or departmental schedules of the financial statements.

(3) Examine the financial statements, particularly the balance sheet accounts, for

income-producing assets and long-term liabilities. The income statement should be examined for passive forms of income that is generally produced by debtfinanced property. The assets should be closely examined even though the liability accounts do not show any encumbrances that could be attached to assets.

(4) Investments in partnerships as either a limited or general partner can create

debt-financed income or income from the operation of a business. See Parts II.A.2 and III.J. Any time there is an investment in a partnership, the partnership return (Form 1065) must be secured to determine if there is any UBI. Also, inspect the K-1 received by the organization from the partnership.

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(5) Most loans on property require insurance, so you should review the insurance

policies of the organization to see who the "loss payees" are.

(6) Public property records will contain information on lien holders and mortgagers.

These should be reviewable online.

(7) Secure a description of the duties of employees, contractors, and volunteers for

the year under examination.

(8) Secure any time records kept of workers’ time for the year under examination.

(9) Review minutes from board meetings.

(10) Review sources of income for possible unrelated business income.

(11) Interview organization officials regarding operations.

(12) Tour facilities looking for possible sources of unrelated business income. For

instance, bingo operation with a concession stand open to the public, veterans’ organization with a restaurant/bar area open to the public, etc.

(13) Check to see whether the unrelated business income source was possibly

disclosed on the Form 990, thereby starting the statute timeline (see Statute of Limitations discussion in Part VIII.D above).

(14) If the organization is conducting gaming activities or there is evidence of

potential gaming activities, then use the following tips:

a. Review the financial information reported on the organization’s application

for a gaming license.

b. Obtain a copy of the state’s (or local jurisdiction’s) laws and regulations

related to charitable gaming activities and licensure.

c. Obtain a copy of the organization’s charitable gaming license.

(1) This section provides exhibits on computations for UBI or UBTI.

(1) S, a social club, operates a restaurant and bar for members and their guests.

Nonmembers are admitted to the restaurant and bar only if accompanied by a member. S is supported by annual dues and amounts received in consideration for food and beverages. S doesn’t normally receive payment for food and beverages at the time they are furnished but, rather, bills its members monthly for such items. Because some members prefer not to be billed, S has facilities for receiving cash payments. Although most cash payments are made by the members and include all expenses incurred by themselves and their guests,

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some nonmembers insist on paying their own expenses directly to the club. S didn’t set aside any amounts under Section 512(a)(3)(B).

(2) During the year, S received the following amounts of gross income:

S’s Gross Income

(3) S incurred expenses during the year of $180,000 from the operation of the

restaurant and bar and $72,000 from the performance of other exempt activities. The portion of the expenses directly connected with the furnishing of food and beverages to nonmembers who pay their own bills was $4,500. No expenses were incurred with respect to the interest income. S computes its UBTI as follows:

S's Unrelated Business Taxable Income

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(1) An exempt social club described in Section 501(c)(7) derived income and

incurred expenses during the year in the following manner:

(2) This organization’s UBTI is computed as follows:

Exempt Social Club Unrelated Business Taxable Income

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(1) N, a social club, purchased a building and land for use as a golf course in 1996

for $100,000. On April 1, 2018, N sold the entire tract, in one transaction, for $250,000 and purchased another tract for $120,000. N then spent $105,000 constructing a golf course and club house on the new tract. Construction was completed in 2018. Between February 1, 2018, and April 1, 2018, N incurred $4,000 of expenses in negotiating the sale of its old property and $1,000 of noncapital expenses for work performed on the old property to assist in its sale. The club computes its recognizable gain from the sale of the property as follows:

N’s Recognizable Gain

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137

138

139

140

141

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