In computing unrelated business taxable income, gross income and deductions are subject to certain modifications and special rules. Whether a particular item of income or expense falls within any of these modifications or special rules must be determined by all the facts and circumstances in each specific case.
For example, if the organization received a payment termed rent that is in fact a return of profits by a person operating the property for the benefit of the organization, or that is a share of the profits retained by the organization as a partner or joint venturer, the payment is not within the modification for rents.
The modifications (to gross income and deductions) and special rules are as follows.
Dividends, interest, and annuities. All dividends, interest, payments with respect to securities loans, annuities, income from notional principal contracts, and other income from an exempt organization's ordinary and routine investments that the IRS determines are substantially similar to these types of income, and deductions directly connected with these types of income, are excluded in computing unrelated business taxable income.
Exception for insurance activity income of a controlled foreign corporation. For tax years beginning after 1995, this exclusion does not apply to income from certain insurance activities of an exempt organization's controlled foreign corporation. The income is not excludable dividend income, but instead is unrelated business taxable income to the extent it would be so treated if the exempt organization had earned it directly. Certain exceptions to this rule apply. For more information, see section 512(b)(17).
Other exceptions. This exclusion does not apply to unrelated debt-financed income (discussed in chapter 7) or to interest or annuities received from a controlled corporation (discussed under Special Rules for Income or Losses From Partnerships and Certain Other Sources, later).
Income from lending securities. Payments received with respect to a security loan are excluded in computing unrelated business taxable income if certain requirements are met.
The transfer must be under an agreement that provides for:
Payments with respect to securities loans include:
Royalties. Royalties, including overriding royalties, and deductions directly connected with these royalties are excluded in computing unrelated business taxable income.
To be considered a royalty, a payment must relate to the use of a valuable right. Payments for trademarks, trade names, or copyrights are ordinarily considered royalties. Therefore, payments for the use of a professional athlete's name, photograph, likeness, or facsimile signature are ordinarily considered royalties. However, royalties do not include payments for personal services. Therefore, payments for personal appearances and interviews are not excluded as royalties and must be included as income from an unrelated trade or business.
Unrelated business taxable income does not include royalty income received from licensees by an exempt organization that is the legal and beneficial owner of patents assigned to it by inventors for specified percentages of future royalties.
Mineral royalties are excluded whether measured by production or by gross or taxable income from the mineral property. However, the exclusion does not apply to royalties that stem from an arrangement whereby the organization owns a working interest in a mineral property and is liable for its share of the development and operating costs under the terms of its agreement with the operator of the property. To the extent they are not treated as loans under section 636 (relating to income tax treatment of mineral production payments), payments for mineral production are treated in the same manner as royalty payments for the purpose of computing unrelated business taxable income. To the extent they are treated as loans, any payments for production that are the equivalent of interest are treated as interest and are excluded.
Exceptions. This exclusion does not apply to debt-financed income (discussed in chapter 7) or to royalties received from a controlled corporation (discussed under Special Rules for Income or Losses From Partnerships and Certain Other Sources, later).
Rents. Rents from real property, including elevators and escalators, are excluded in computing unrelated business taxable income. Rents from personal property are not excluded. However, special rules apply to "mixed leases" of both real and personal property.
Deductions directly connected with excluded rents are also excluded in computing unrelated business taxable income.
Mixed leases. In a mixed lease, all of the rents are excluded if the rents attributable to the personal property are not more than 10% of the total rents under the lease, as determined when the personal property is first placed in service by the lessee. If the rents attributable to personal property are more than 10% but not more than 50% of the total rents, only the rents attributable to the real property are excluded. If the rents attributable to the personal property are more than 50% of the total rents, none of the rents are excludable.
Property is placed in service when the lessee first may use it under the terms of a lease. For example, property subject to a lease entered into on November 1, for a term starting on January 1 of the next year, is considered placed in service on January 1, regardless of when the lessee first actually uses it.
If separate leases are entered into for real and personal property and the properties have an integrated use (for example, one or more leases for real property and another lease or leases for personal property to be used on the real property), all the leases will be considered as one lease.
The rent attributable to the personal property must be recomputed, and the treatment of the rents must be redetermined, if:
Exception for rents based on net profit. The exclusion for rents does not apply if the amount of the rent depends on the income or profits derived by any person from the leased property, other than an amount based on a fixed percentage of the gross receipts or sales.
Exception for income from personal services. Payment for occupying space when personal services are also rendered to the occupant does not constitute rent from real property. Therefore, the exclusion does not apply to such transactions as renting hotel rooms, rooms in boarding houses or tourist homes, and space in parking lots or warehouses.
Other exceptions. This exclusion does not apply to unrelated debt-financed income (discussed in chapter 7) or to rents received from a controlled corporation (discussed under Special Rules for Income or Losses From Partnerships and Certain Other Sources, later).
Income from research. A tax-exempt organization may exclude income from research grants or contracts from unrelated business taxable income. However, the extent of the exclusion depends on the nature of the organization and the type of research.
Income from research for the United States, any of its agencies or instrumentalities, a state, or any of its political subdivisions, and all deductions connected with this income, are excluded when computing unrelated business taxable income.
For a college, university, or hospital, all income from research, whether fundamental or applied, and all directly connected deductions are excluded in computing unrelated business taxable income.
When an organization is operated primarily to conduct fundamental research (as distinguished from applied research) and the results are freely available to the general public, all income from research performed for any person and all deductions directly connected with the income are excluded in computing unrelated business taxable income.
The term research, for this purpose, does not include activities of a type normally carried on as an incident to commercial or industrial operations, such as testing or inspecting materials or products, or designing or constructing equipment, buildings, etc. In addition, the term fundamental research does not include research carried on for the primary purpose of commercial or industrial application.
Gains and losses from disposition of property. Also excluded from unrelated business taxable income are gains or losses from the sale, exchange, or other disposition of property other than:
It should be noted that the last exception relates only to cut timber. The sale, exchange, or other disposition of standing timber is excluded from the computation of unrelated business income, unless it constitutes property held for sale to customers in the ordinary course of business.
Exception. This exclusion does not apply to unrelated debt-financed income. (See chapter 7.)
Lapse or termination of options. Any gain from the lapse or termination of options to buy or sell securities is excluded from unrelated business taxable income. The exclusion applies only if the option is written in connection with the exempt organization's investment activities. Therefore, this exclusion is not available if the organization is engaged in the trade or business of writing options or the options are held by the organization as inventory or for sale to customers in the ordinary course of a trade or business.
Income from services provided under federal license. There is a further exclusion from unrelated business taxable income together with all deductions connected with this income when the trade or business is carried on by a religious order or by an educational organization maintained by the order.
To qualify for this exclusion, it must be shown that:
Net operating loss deduction. The net operating loss deduction (as provided in section 172) is allowed in computing unrelated business taxable income. However, the net operating loss carryback or carryover (from a tax year for which the organization is subject to tax on unrelated business income) is determined without taking into account any amount of income or deduction that has been excluded specifically in computing unrelated business taxable income. For example, a loss from an unrelated trade or business is not diminished because dividend income was received.
If this were not done, organizations would, in effect, be taxed on their exempt income, since unrelated business losses then would be offset by income from dividends, interest, and other excluded sources of income. This would reduce the loss that could be applied against unrelated business income of prior or future tax years. Therefore, to preserve the immunity of exempt income, all computations of net operating losses are limited to those items of income and deductions that affect the unrelated business taxable income.
In line with this concept, a net operating loss carryback or carryover is allowed only from a tax year for which the organization is subject to tax on unrelated business income.
For example, if an organization just became subject to the tax last year, its net operating loss for that year is not a carryback to a prior year when it had no unrelated business taxable income, nor is its net operating loss carryover to succeeding years reduced by the related income of those prior years.
However, in determining the span of years for which a net operating loss may be carried back or forward, the tax years for which the organization is not subject to the tax on unrelated business income are counted. For example, if an organization is subject to the tax for 1996 and has a net operating loss for that year, the last tax year to which any part of that loss may be carried over is the year 2011, regardless of whether the organization is subject to the unrelated business income tax in any of the intervening years.
Charitable contributions deduction. An organization taxable at corporate rates is allowed a deduction for charitable contributions up to 10% of its unrelated business taxable income computed without regard to the deduction for contributions. Contributions in excess of the 10% limit may be carried over to the next 5 taxable years. A contribution carryover is not allowed, however, to the extent that it increases a net operating loss carryover.
A trust generally is allowed a deduction for charitable contributions in the same amounts as allowed for individuals. However, the limit on the deduction is determined in relation to unrelated business taxable income computed without regard to the deduction, rather than in relation to adjusted gross income.
For purposes of the deduction, a distribution by a trust made under the trust instrument to a beneficiary, which itself is a qualified organization, is treated the same as a contribution.
The deduction, whether made by a trust or other exempt organization, is allowed whether or not the contributions are directly connected with the unrelated business.
To be deductible, the contribution must be paid to another qualified organization. For example, an exempt university that operates an unrelated business may deduct a contribution made to another university for educational work, but may not claim a deduction for contributions of amounts spent for carrying out its own educational program.
An organization (whether a corporation or a trust) may deduct contributions only in the year paid or in the 5 succeeding taxable years. However, an organization on the accrual basis may elect to deduct contributions authorized, but not paid, during the tax year if payment is made within 2 1/2 months after the close of the tax year.
Specific deduction. In computing unrelated business taxable income, a specific deduction of $1,000 is allowed. However, the specific deduction is not allowed in computing a net operating loss or the net operating loss deduction.
Generally, the deduction is limited to $1,000 regardless of the number of unrelated businesses in which the organization is engaged.
Exception. An exception is provided in the case of a diocese, province of a religious order, or a convention or association of churches that may claim a specific deduction for each parish, individual church, district, or other local unit. In these cases, the specific deduction for each local unit is limited to the lower of:
This exception applies only to parishes, districts, or other local units that are not separate legal entities, but are components of a larger entity (diocese, province, convention, or association) filing Form 990-T. The parent organization must file a return reporting the unrelated business gross income and related deductions of all units that are not separate legal entities. The local units cannot file separate returns. However, each local unit that is separately incorporated must file its own return and cannot include, or be included with, any other entity. See Title-holding corporations in chapter 1 for a discussion of the only situation in which more than one legal entity may be included on the same Form 990-T.
Example. X is an association of churches and is divided into local units A, B, C, and D. Last year, A, B, C, and D derived gross income of, respectively, $1,200, $800, $1,500, and $700 from unrelated businesses that they regularly conduct. X may claim a specific deduction of $1,000 with respect to A, $800 with respect to B, $1,000 with respect to C, and $700 with respect to D.
Partnership income or loss. An organization may have unrelated business income or loss as a member of a partnership, rather than through direct dealings with a business. If so, it must treat its share of the partnership income or loss as if it had conducted the business activity in its own capacity as a corporation or trust. No distinction is made between limited and general partners.
Thus, if an organization is a member of a partnership regularly engaged in a trade or business, that is an unrelated trade or business with respect to the organization the organization must include in its unrelated business taxable income its share of the partnership's gross income (whether or not distributed), and the deductions attributable to it, that come from the unrelated trade or business.
The partnership gross income and deductions are figured the same way as any unrelated trade or business income the organization earns directly. For example, an exempt educational organization is a partner in a partnership that operates a factory, and the partnership also holds stock in a corporation. The exempt organization must include its share of the gross income from operating the factory in its unrelated business taxable income, but may exclude its share of any dividends the partnership received from the corporation.
If the exempt organization and the partnership of which it is a member have different tax years, the partnership items that 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 partnership's tax year that ends within or with the organization's tax year.
S corporation income or loss. Beginning in 1998, exempt section 501(c)(3) organizations and qualified retirement plan trusts (other than employee stock ownership plans (ESOPs)) may own stock in an S corporation without causing the corporation to lose its subchapter S status. An organization that owns S corporation stock must take into account its share of the S corporation's income, deductions, or losses in figuring unrelated business taxable income, regardless of the actual source or nature of the income, deductions, and losses. For example, the organization's share of the S corporation's interest and dividend income will be taxable, even though interest and dividends are normally excluded from unrelated business taxable income. The organization must also take into account its gain or loss on the sale or other disposition of the S corporation stock in figuring unrelated business taxable income.
Income from controlled organizations (for tax years beginning before August 6, 1997). The following rules apply to tax years beginning before August 6, 1997. They also apply to certain payments made in later tax years under a contract in effect on June 8, 1997, as explained under Income from controlled organizations (for tax years beginning after August 5, 1997), later.
The exclusion of interest, annuities, royalties, and rents, as previously discussed, does not apply when an exempt controlling organization receives them from a controlled organization (whether or not the activities producing this income represent a trade or business or are regularly carried on). The interest, annuities, royalties, and rents from the controlled organization are taxable to the controlling organization at a specific ratio depending on whether the controlled organization is exempt or nonexempt. All deductions directly connected with amounts included in an organization's gross income under this provision are allowed.
If control is gained or lost during the tax year, amounts of interest, annuities, royalties, and rents are includible in the controlling organization's unrelated business taxable income only for the part of the tax year it has control.
Control. If the organization from which the interest, annuities, royalties, and rents are received is a stock corporation, control generally means stock ownership of at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock in the corporation.
In the case of a nonstock organization, control means that at least 80% of the directors or trustees of the organization are either representatives of, or directly or indirectly controlled by, the controlling organization.
Exempt controlled organization. When the controlled organization is an exempt organization, the interest, annuities, royalties, and rents received by the controlling organization are includible in its unrelated business taxable income in the same ratio as the ratio of the controlled organization's unrelated business taxable income to its taxable income determined as if the exempt controlled organization were not tax exempt. The controlled organization's taxable income determined for this purpose cannot be less than its unrelated business taxable income. Both amounts must be computed without regard to amounts paid directly or indirectly to the controlling organization. The controlling organization will be allowed all deductions directly connected with the amounts included in gross income.
Example. A, an exempt organization, owns all the stock of B, another exempt organization. During the year, A rents a laboratory to B for $15,000 a year. A's total deductions for the year with respect to the leased property are $3,000 ($1,000 for maintenance and $2,000 for depreciation). If B were not an exempt organization, its total taxable income would be $300,000, disregarding rent paid to A. B's unrelated business taxable income, disregarding rent paid to A, is $100,000. Under these circumstances, the amount of rent paid by B that will be included by A as net rental income in determining its unrelated business taxable income is $4,000, computed as follows:
B's unrelated business taxable income (disregarding rent paid to A)
$100,000
B's taxable income (computed as though B were not exempt and disregarding rent paid to A)
$300,000
Ratio ($100,000/$300,000)
1/3
Total rent
$ 15,000
Total deductions
$ 3,000
Rental income treated as gross income from an unrelated trade or business (1/3 of $15,000)
$ 5,000
Less deductions directly connected with that income (1/3 of $3,000)
1,000
Net rental income included by A in computing its unrelated business taxable income
$ 4,000
If B's taxable income, in this example, were less than its unrelated business taxable income, the total rent ($15,000) and deductions directly connected to that rent ($3,000) would be included by A in computing its unrelated business taxable income.
Nonexempt controlled organization. When a controlled organization is not exempt from tax, the amount of interest, annuities, royalties, and rents received by the controlling organization that is includible in its unrelated business taxable income is an amount that bears the same ratio to the interest, annuities, royalties, and rents that the controlling organization received from the controlled organization as the excess taxable income of the controlled organization bears to the greater of:
The controlling organization is allowed all deductions directly connected with the amounts included in gross income.
The controlled organization's excess taxable income is the excess of its taxable income over the taxable income that, if derived directly by the controlling organization, would not be unrelated business taxable income.
Example. A, an exempt university, owns all the stock of M, a nonexempt organization. During the year, M leases a factory and a dormitory from A for a total annual rental of $100,000. During the tax year, M has $500,000 of taxable income, disregarding the rent paid to A. M's taxable income consists of $150,000 from a dormitory for students of A university, and $350,000 from operating a factory that is a business unrelated to A's exempt purpose. A's deductions for the year with respect to the leased property are $4,000 for the dormitory and $16,000 for the factory. Under these circumstances, the amount of the rent paid by M that will be included by A as net rental income in determining its unrelated business taxable income is $56,000, computed as follows:
M's taxable income (disregarding rent paid to A)
$500,000
Less taxable income from dormitory
150,000
Excess taxable income
$350,000
Ratio (350,000/500,000)
7/10
Total rent paid to A
$100,000
Total deductions ($4,000 + $16,000)
$ 20,000
Rental income treated as gross income from an unrelated trade or business (7/10 of $100,000)
$ 70,000
Less deductions directly connected with that income (7/10 of $20,000)
14,000
Net rental income included by A in computing its unrelated business taxable income
$ 56,000
Income from controlled organizations (for tax years beginning after August 5, 1997). The following rules apply to tax years beginning after August 5, 1997. However, they do not apply to payments under a binding contract in effect on June 8, 1997, and at all times thereafter before the payment, if made during the first 2 tax years beginning after August 4, 1997. See Income from controlled organizations (for tax years beginning before August 6, 1997), earlier.
The exclusions for interest, annuities, royalties, and rents explained earlier in this chapter do not apply to a payment received by a controlling organization from its controlled organization, to the extent the payment reduces the net unrelated income (or increases the net unrelated loss) of the controlled organization. All deductions of the controlling organization directly connected with the amount included in its unrelated business taxable income are allowed.
Net unrelated income. This is:
Net unrelated loss. This is:
Control. An organization is controlled if:
Therefore, an exempt parent organization is treated as controlling any subsidiary in which it holds more than 50% of the voting power or value, whether directly (as in the case of a first-tier subsidiary) or indirectly (as in the case of a second-tier subsidiary).