Understanding How Income Affects Qualification for Exemption as a IRC Section 501(c)(2) Corporation

Understanding how an organization’s income is generated is an essential part of determining whether the organization qualifies for exemption under IRC Section 501(c)(2).

IRC Section and Treasury Regulation

Internal Revenue Code

Section 501(a) Exemption from taxation

Section 501(c)(2) Single parent title holding corporations

Section 512 Unrelated business taxable income

Treasury Regulation:

Treas. Reg. Section 1.501(c)(2)-1(a) Corporations organized to hold title to property for exempt organizations

Treas. Reg. Section 1.512(b)-1 Modifications to unrelated business taxable income

Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources)

Omnibus Budget Reconciliation Act of 1993, P.L. 103-66, Section 13146, amended Section 501(c)(2) to indicate that the receipt of disqualifying income which is incidentally derived from the holding of real property will not cause the organization to fail at being described in Section 501(c)(2). The regulations do not address this amendment, which is reflected in Section 501(c)(2) via a cross reference to Section 501(c)(25).

Stanford University Bookstore v. Commissioner, 29 B.T.A. 1280, aff’d, 83 F.2d 710, denied recognition under Section 501(c)(2) to a student bookstore because its activities constituted business beyond merely holding title to property. It did not matter that income was turned over to an exempt organization.

Sand Springs Railway Co. v. Commissioner, 31 B.T.A. 392, denied recognition under Section 501(c)(2) to a public utility because its activities constituted business beyond merely holding title to property. It did not matter that income was turned over to an exempt organization.

Revenue Ruling 69–278, 1969-1 C.B. 148, found that a title holding corporation renting a building and trucks under separate unrelated leases to exempt fraternal beneficiary societies is engaged in the business of renting personal property independent of real property and is not exempt as a Section 501(c)(2) organization.

Rev. Rul. 69-381, 1969-2 C.B. 113, held that a title holding corporation that leases a building to the general public and turns over the rents less expenses incident to the operation and maintenance of the building to its parent, an exempt charitable organization, is not precluded from exemption as a Section 501(c)(2) organization.

Rev. Rul. 69-528, 1969-2 C.B. 127, held that an organization regularly carrying on an investment service business that would be unrelated trade or business if carried on by any of the exempt organizations on whose behalf it operates, is not exempt as a Section 501(c)(2) organization.

IRM 7.25.2, Exempt Organizations Determinations Manual, Single Parent Title Holding Corporations

IRS 2001 EO CPE Text, Title Holding Companies

Analysis

The Code limits the activities of Section 501(c)(2) organizations to holding title to property, collecting the income there from, and turning over the entire amount, less expenses, to an exempt organization. By doing so, it automatically limits the sources from which Section 501(c)(2) organizations may receive income. See Treas. Reg. Section 1.501(c)(2)-1(a).

Section 501(c)(2) organizations may hold title to passive investments and collect the income they yield. Generally, a Section 501(c)(2) organization may not hold title to properties which generate unrelated business income.

For example, an organization exempt under Section 501(c)(2) may invest in stocks and bonds and passively collect the income from these investments. However, permissible passive investment activities should be distinguished from the active "business" of securities trading. An organization regularly carrying on an investment service that would have been unrelated trade or business if carried on by any of the exempt organizations on whose behalf it operates is not exempt as an organization described in Section 501(c)(2) or Section 501(c)(3). Rev. Rul. 69-528, 1969-2 C.B. 127.

Additionally, nothing in Section 501(c)(2) prevents organizations from renting their realty to the general public. See Rev. Rul. 69-381, 1969-2 C.B. 113. However, when a corporation moves beyond merely holding title to a property and uses the property to operate a trade or business, the income derives from the active conduct of a trade or business and is not permissible. See Stanford University Bookstore v. Commissioner, 29 B.T.A. 1280 (1934) and Sand Springs Railway Co. v. Commissioner, 21 B.T.A. 1291 (1931).

As illustrated by the examples above, ordinarily an exempt title holding corporation may not have unrelated business taxable income (UBTI) and would be revoked if it engaged in an unrelated trade or business. However, the Code and Regulations provide several exceptions to this general rule.

Treas. Reg. Section 1.501(c)(2)-1 provides that a title-holding corporation may retain exemption if it has income that is treated as UBTI solely because of the applicability of:

  • Section 512(a)(3)(C), making the unrelated business income rules covering Section 501(c)(7), Section 501(c)(9), and Section 501(c)(17) organizations applicable to its title-holding corporation;
  • Section 514, making income from debt-financed property subject to unrelated business income tax (UBIT);
  • Section 512(b)(3)(B)(ii), removing rents from the Section 512(b)(3)(A) rental exclusion, the amount of which are, based on the income or profits derived by any person from the leased property, from the Section 512(b)(3) rental exclusion;
  • Section 512(b)(13), treating as UBTI dividends, interest, annuities, royalties, rents, and similar payments received from a controlled organization by a controlling organization;
  • Section 512(b)(3)(A)(ii), excluding from UBTI rents from personal property leased with real property, if the rents attributable to the personal property are an incidental amount of the total rents received under the lease; and
  • Section 512(b)(3)(B)(i), removing rents from the Section 512(b)(3)(A) rental exclusion, if more than 50 percent of the total rent received under a lease is attributable to personal property.

Two of these categories from the Regulation address income from a lease involving both personal and real property. The rental of personal property, unless leased with realty, has consistently been treated as the conduct of a trade or business. Thus, income from rental of personal property is subject to UBIT if received regularly by an exempt organization subject to UBIT under Section 511(a)(2). See Rev. Rul. 69-278, 1969-1 C.B. 148.

However, Section 512(b)(3)(A)(ii) excludes from UBTI rents from personal property leased with real property, if the rents attributable to the personal property are an incidental amount of the total rents received under the lease. Treas. Reg. Section 1.512(b)-1(c)(2)(ii) provides that rents attributable to personal property generally are not an incidental amount of the total rents if such rents exceed 10 percent of the total rents from all the property leased. Treas. Reg. Section 1.501(c)(2)-1 provides that exemption will not be affected solely because rent attributable to the personal property leased with real property is more than incidental when compared to the total rents received or accrued under the lease. However, the rental income from the personal property may be subject to UBIT.

Section 512(b)(3)(B)(i) provides that if more than 50 percent of the total rent received or accrued under the lease is attributable to personal property, all the rental income (not just the portion attributable to personal property) is subject to UBIT. However, Treas. Reg. Section 1.501(c)(2)-1 provides that the organization will retain its exemption.

Treas. Reg. Section 1.512(b)-1(c)(2)(iv) provides an example of UBIT application in a mixed lease. In the example, 40 percent of the rent is is attributal to the rental of printing equipment, which is personal property, and 60 percent of the income is attributable to the rental of the building, which is real property. Because the income from the personal property is more than incidental but less than 50 percent of the total income from the lease, only the income from the rental of the printing equipment is subject to UBIT.

The Omnibus Budget Reconciliation Act of 1993 provides an additional permissible source of income for Section 501(c)(2) organizations. The Act provides that rules similar to the rule of Section 501(c)(25)(G) shall apply for purposes of Section 501(c)(2). Section 501(c)(25)(G) provides that an organization will not qualify as a title holding company if disqualifying income derived incidentally from the holding of real property exceeds 10 percent of its gross income for the taxable year. However, this treatment will not apply if the organization establishes to the IRS' satisfaction that the receipt of excess disqualifying income was inadvertent, and reasonable steps are being taken to correct the circumstances giving rise to the income. Disqualifying income includes income from the leasing of parking spaces and vending machine revenue.

Issue Indicators or Audit Tips

Audit Tips

When analyzing Form 990, Form 1024, or composing the initial interview, consider the following questions:

  • What are the income sources?
  • Is the income derived from passive holdings or from an active business?
    • See Rev. Rul. 69-528, 1969-2 C.B. 127
  • Is personal property leased independent of real property?
    • See Rev. Rul. 69-278, 1969-1 C.B. 148
  • If personal property is leased in connection with real property, what percentage of the income is attributable to personal property?
    • See Section 512(b)(3)(A)(ii) and Section 512(b)(3)(B)(i).
  • If income is subject to UBIT, has the organization filed a 990-T?
  • See the Audit Technique Guide – Single Parent Title-Holding Corporations Exempt Under Section 501(c)(2) for additional information.