- 7.27.4 Taxation of Unrelated Business Income
- 220.127.116.11 Introduction
- 18.104.22.168 Organizations Subject to Tax-Years Beginning With 1970
- 22.214.171.124.1 Taxation of Churches
- 126.96.36.199.2 State and Municipal Colleges
- 188.8.131.52.3 Special Rules for Title Holding Companies
- 184.108.40.206 Tax Rates
- 220.127.116.11 Tax Preferences
- 18.104.22.168 Returns Forms and Due Dates
- 22.214.171.124 Digest of Published Rulings and Procedures for Taxation of Unrelated Business Income
Part 7. Rulings and Agreements
Chapter 27. Exempt Organizations Tax Manual
Section 4. Taxation of Unrelated Business Income
This Section provides information on IRC 511, which imposes a tax on the unrelated business income of certain otherwise tax exempt organizations. Also, a brief history of the unrelated business income tax provisions is provided.
The determination of what constitutes unrelated trade or business under IRC 513 is covered in IRM 7.27.5.
The computation of unrelated business taxable income under IRC 512 is discussed in IRM 7.27.6 and IRM 7.27.7.
Income from "debt-financed property" , includible in the computation, is discussed in IRM 7.27.8, IRM 7.27.9, and 7.27.10.
The Tax Reform Act of 1969 made significant changes in the categories of organizations subject to tax and in the determination and computation of unrelated taxable income. These Sections include the changes made by the Tax Reform Act of 1969, as well as more recent statutory amendments.
An organization is exempt only if it falls within one of the specific classes of organizations described in IRC 501 and 521. Thus, an organization may be held exempt only if its primary purpose is to engage in the type of activity prescribed in the Code section under which it claims exemption. If it is found that an organization’s primary purpose is the conduct of a business of a type ordinarily carried on for profit, and not the furtherance of an exempt purpose, exemption cannot be established. But if the business activity is subservient or secondary to the organization’s exempt purpose and functions, exemption may or may not be established, depending upon whether the specific statutory provision under which exemption is sought precludes operation of a trade or business.
Many exempt organizations operate trades or businesses which further their exempt purposes. Others operate trades or businesses which have little or no relationship to their exempt purposes aside from the need for the profits from the business to carry out such purposes. It is at this latter situation that IRC 511 through 515 are directed. Certain organizations are exempted from these provisions, however, as discussed in this Section.
Prior to enactment in the Revenue Act of 1950 of what are now IRC 511 through 515, the Service made numerous attempts to deny exemption to organizations which engaged in transparently profit-making activities on the ground that these organizations were not organized and operated exclusively for their stated exempt purpose. The courts almost always ruled against the Government in these proceedings, however. See 6 Mertens Law of Federal Income Taxation, Par. 34.14. The principal stumbling block was the "destination of income" test laid down by the United States Supreme Court in Trinidad v. Sagrada Orden de Predicadores, 263 US 578, T.D. 3548, III–1 C.B. 270 (1924), holding that the destination and not the source of the income was the ultimate test of the right of exemption. The problem was further complicated by the fact that many of the organizations exempt under the 1939 Code were not required to file information returns, so the Service was often unaware of the business activities in which such organizations participated.
By 1950 many exempt organizations were engaged in profitable business activities in competition with taxable entities.
The following extract from the Congressional Record illustrates the extent of this practice and the concern in Congress about it (Congressional Record, Vol. 96, Part 7, pp. 9273–9274): "Mr. Sabath. *** A year ago one of the South’s profitable textile operations was turned into a tax-exempt foundation, involving its $34,000,000 holdings. The community gets about $400,000 in tax-exempt moneys — about equal to the taxes the company formerly paid locally. All of its other huge profit total is tax exempt to the Federal Treasury. "Our universities and colleges have gone into business in grand style under this strangely overlooked weakness in our laws. Union College recently purchased all of the properties of Allied Stores Corp., one of the largest national department-store chains. The same college recently acquired the Abraham & Straus property in Brooklyn for $9,000,000 and immediately leased it back to Abraham & Straus at low rentals under an 80-year lease." " Meanwhile, the involvement of educational institutions in the field of banking, real estate, commerce, and industry goes merrily on. Universities own haberdasheries, citrus groves, movies, cattle ranches, the Encyclopedia Britannica (owned by the University of Chicago), and a large variety of other enterprises. The University of Wisconsin controls patent pools and collects royalties. Universities and colleges, together with foundations, have an annual income from their business activities of well over a half billion dollars annually. Were this income not tax-exempt, they would pay $173,000,000 in Federal Taxes annually.
These problems were for the most part resolved by the Revenue Act of 1950, which, among other things, imposed a tax on the "unrelated business taxable income" of certain otherwise exempt organizations. In addition, the present law and regulations require most exempt organizations to file annual information returns, making it easier to scrutinize their operations to determine whether they continue to be entitled to exemption, and, if so, whether they are subject to the tax on unrelated business income.
The tax on unrelated business income was designed to achieve the following results, according to the report of the Senate Finance Committee (S. Rep. No. 2375, 81st Cong., 2d Sess. 27 (1950), 1950–2 C.B. 483, 504):
The problem at which the tax on unrelated business income is directed is primarily that of unfair competition. The tax-free status of section (501) organizations enables them to use their profits tax-free to expand operations, while their competitors can expand only with the profits remaining after taxes. Also, a number of examples have arisen where these organizations have, in effect, used their tax exemptions to buy an ordinary business. That is, they have acquired the business with little or no investment on their own part and paid for it in installments out of subsequent earnings — a procedure which usually could not be followed if the business were taxable. In neither the House bill nor your committee’s bill does this provision deny the exemption where the organizations are carrying on unrelated active business enterprises, nor require that they dispose of such businesses. Both provisions merely impose the same tax on income derived from an unrelated trade or business as is borne by their competitors. In fact it is not intended that the tax imposed on unrelated business income will have any effect on the tax-exempt status of any organization. An organization which is exempt prior to the enactment of this bill, if continuing the same activities, will still be exempt after this bill becomes law. In a similar manner any reasons for denying exemption prior to enactment of this bill would continue to justify denial of exemption after the bill ‘s passage.
The Revenue Act of 1950 excepted certain organizations from the unrelated business income tax provisions. However, it became apparent that many of the excepted organizations were engaging, or were apt to engage, in unrelated business. Congress responded in the Tax Reform Act of 1969 by subjecting almost all exempt organizations to the tax on unrelated business income. In addition, there were changes expanding or redefining the types of income subject to the unrelated provisions in order to eliminate tax avoidance abuses. These changes include:
the unrelated debt-financed income provisions;
a more restrictive definition of the rent exclusion (IRC 512(b)(3));
conditions under which interest, rents, annuities, and royalties from a controlled corporation are subject to tax (IRC 512(b)(13)).
All of these changes will be discussed either in this Section or in one of the following Sections.
Under law in effect prior to the Tax Reform Act of 1969, the tax on unrelated business income applied only to certain tax-exempt organizations. The Tax Reform Act extended this tax to virtually all tax-exempt organizations in order to end, according to the Report of the Committee on Ways and Means, the inequity in taxing certain exempt organizations and not taxing others equally apt to engage in unrelated business. H.R. Rep. No. 91–413 (Part 1), 91st Cong., 1st Sess. 46 (1969), 1969–3 C.B. 230.
For years beginning with January 1, 1970, the tax on unrelated business income applies to all organizations exempt from taxation under IRC 501(a) (except United States instrumentalities described in IRC 501(c)(1)) and State and municipal colleges and universities. In addition, there are special rules for taxing the unrelated business income of title-holding corporations described in IRC 501(c)(2).
Prior to the Tax Reform Act of 1969 churches were not subject to the unrelated business income tax provisions. However, as cited by the Committee on Finance, churches were involved in various types of commercial activities, such as operating publishing houses, hotels, factories, radio and TV stations, parking lots, newspapers, bakeries, and restaurants. The Tax Reform Act of 1969 made income derived by churches from unrelated trade or business subject to tax.
However, in general, any business carried on by a church or a convention or association of churches was not subject to tax under IRC 511 until 1976 if the business was carried on before May 27, 1969. See IRM 7.27.6 and Regs. 1.511–2(a)(3)(iii) for details. As to what specific organizations constitute a church or a convention or association of churches for IRC 511 purposes, Regs. 1.511–2(a)(3)(ii) supply the following answer:
The term " church" includes a religious order or a religious organization if such order or organization (a) is an integral part of a church, and (b) is engaged in carrying out the functions of a church, whether as a civil law corporation or otherwise. In determining whether a religious order or organization is an integral part of a church, consideration will be given to the degree to which it is connected with, and controlled by, such church. A religious order or organization shall be considered to be engaged in carrying out the functions of a church if its duties include the ministration of sacerdotal functions and the conduct of religious worship. If a religious order or organization is not an integral part of a church, or if such an order or organization is not authorized to carry out the functions of a church (ministration of sacerdotal functions and conduct of religious worship) then it is subject to the tax imposed by section 511 whether or not it engages in religious, educational, or charitable activities approved by a church. What constitutes the conduct of religious worship or the ministration of sacerdotal functions depends on the tenets and practices of a particular religious body constituting a church * * *.
A religious order has been held subject to tax on the profit from its operation of a winery and distillery. The court concluded that the order did not come within the definition of the term "church," set forth in the regulations, so as to be exempt from tax. De La Salle Institute v. United States, 195 Fed. Supp. 891 (1961). Also, Rev. Rul. 77–290, 1977–2 C.B. 26, holds, in part, that where a member of a religious order receives income as an agent of the order and, pursuant to a vow of poverty, remits the income to the order, such income is the income of the order and not of the member. In such cases the tax imposed by IRC 511 may be applicable to the income of the order.
When originally imposed by the Revenue Act of 1950, the tax on unrelated business income did not apply to State and municipally owned institutions of higher learning. However, the Revenue Act of 1951 remedied this omission and subjected these schools to the same treatment with respect to unrelated business income as applied to other colleges and universities which are exempt under IRC 501(c)(3). The following excerpt from the Senate Finance Committee Report states the reason (S. Rep. No. 781, 82d Cong., 1st Sess. 29 (1951), 1951–2 C.B. 458, 478):
*** It has been called to the attention of your committee that some State schools are engaging in unrelated activities and "lease-backs" which would be taxable if they were not a State or its instrumentality. It is clear that the same opportunities for unfair competitive advantage exist in connection with these activities of State universities as with respect to similar activities of other educational institutions. Therefore, section 338 of your Committee’s bill extends the present tax to the unrelated business income of universities and colleges of States and of other governmental units * * *.
The tax is imposed on the unrelated business income not only of the universities and colleges themselves, but also upon their wholly owned subsidiary organizations. Consequently, it is immaterial whether the business activity is conducted by the university or by a separately incorporated, wholly owned subsidiary. If the business activity is unrelated, the income in both instances will be subject to the tax. Of course, if the wholly owned subsidiary is operated for the primary purpose of carrying on any trade or business other than holding title to property and collecting income therefrom, it is not exempt, and IRC 511 is not applicable. IRC 511(a)(2)(B) and Regs. 1.511–2(a)(2).
IRC 7871(a)(5), which was added by P.L. 97–473 on January 14, 1983 and made permanent by the Deficit Reduction Act of 1984, provides that an Indian tribal government shall be treated as a state for purposes of IRC 511(a)(2)(B). Consequently, any college or university owned by an Indian tribal government is now subject to the same treatment with respect to unrelated business income as applies to state and municipally owned colleges and universities. IRC 7871(a)(5) is effective for taxable years beginning after December 31, 1982.
IRC 511(c) provides that when an exempt title holding company (described in IRC 501(c)(2)) pays any amount of its net income to an organization exempt from taxation under IRC 501(a) (or would pay such an amount but for the fact that the expenses of collecting its income exceed its income), and files a consolidated return with that organization, the title holding company is to be treated as organized and operated for the same purposes as the exempt payee organization. Thus, if the source of income of a title holding company is related to the exempt functions of the exempt payee organization, such income will not be subject to tax provided the holding company and the payee organization file a consolidated return.
For example, assume that the income of X, an IRC 501(c)(2) corporation, is required to be distributed to exempt organization A. During the taxable year X realizes net income of $900,000 from source M and $100,000 from source N. Source M is related to A’s exempt function, while source N is not so related. X and A file a consolidated return for such taxable year. X has net unrelated business income of $100,000 subject to the modifications in IRC 512(b).
All organizations subject to these provisions, except trusts described below, are taxable at corporate rates under section 11 on unrelated business taxable income. IRC 511(a)(1) and Regs. 1.511–1.
All trusts subject to these provisions, 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. IRC 511(b)(1) and Regs. 1.511–2(b). However, a trust may not claim the deductions for personal exemption provided in IRC 642(b). Regs. 1.511–1.
The foreign tax credit is available to organizations filing Form 990–T to the extent provided in IRC 901. If an exempt organization is eligible for such a credit, it must compute the limitations upon the credit on the basis of its unrelated business taxable income, which is considered to be synonymous with the term "taxable income" for the purposes of IRC 901 and 904. IRC 515.
An investment credit under IRC 38 is available for property used predominantly in an unrelated trade or business, the income of which is subject to tax under IRC 511. Rev. Rul. 82–218, 1982–2 C.B. 30, discusses the availability of such credit for a state college or university. In general the investment credit was greatly affected by the Tax Reform Act of 1986. However, an organization still may be eligible for such credit if it meets the transitional rules under IRC 49(e).
The Tax Reform Act of 1986 amended the alternative minimum tax provision applicable to organizations subject to the tax under IRC 511. Under IRC 511(d), as previously enacted, for taxable years prior to January 1, 1987, and beginning after December 31, 1982, the tax imposed by IRC 55 was applicable to organizations taxable as trusts, while the tax imposed by IRC 56 was applicable to organizations taxable at corporate tax rates. The alternative minimum tax was initially enacted by P.L. 91–172, section 301(b)(8) for tax years beginning after 1–1–1970, amended by P.L. 95–600, section 421(e)(3), further amended by P.L. 97–248, section 201(d)(5), and finally amended by P.L. 97–448, section 306(a)(1)(A). No reference was made to IRC 511(d) in P.L. 99–514 (Tax Reform Act of 1986).
IRC 511(d) was stricken in its entirety, by the Technical and Miscellaneous Revenue Act of 1988, (P.L. 100–647, section 1007(g)(6)). Pursuant to section 1019(a) of that Act, this change took effect as if included in the provision of the Tax Reform Act of 1986 (P.L. 99–514) to which such amendment related. The change (deletion) of IRC 511(d) is therefore effective for taxable years beginning after 12–31–1986.
The alternative minimum tax remains applicable to exempt organizations. Only those items of tax preference which enter into the computation of unrelated business taxable income are taken into account in computing the alternative minimum tax.
Every domestic and foreign organization exempt under IRC 501(a) (except instrumentalities of the United States) must file a return on Form 990–T when its gross income from an unrelated trade or business is $1,000 or more. The obligation to file Form 990–T is in addition to the obligation to file information return Form 990. Regs. 1.6012–2(e) and 1.6012–3(a)(5).
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.
The filing of an information return on Form 990 (or any other return required by IRC 6033) by an organization exempt from income tax under IRC 501(a) does not 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 Service of the potential existence of unrelated business taxable income. (See Rev. Rul. 62–10, 1962–1 C.B. 305 and Rev. Rul. 69–247, 1969–1 C.B. 303.)
All organizations exempt under IRC 501(c) 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 P.L. 95–628, 1978–2 C.B. 435, effective for tax years that start after November 10, 1978.)
IRC 6154(h) provides, in part, that exempt organizations subject to the tax on unrelated business income must make estimated tax payments through deposits to the Federal Tax Deposit System. Form 990–W, Estimated Tax on Unrelated Business Income for Tax-Exempt Trusts, and Form 1120–W, Corporation Estimated Tax, are used in calculating estimated tax.
Assessment of unrelated business income tax; statute of limitations— The filing of an information return pursuant to the provisions of IRC 6033, by an exempt organization, starts the running of the statute of limitations on assessment of the unrelated business income tax which is imposed by IRC 511, and required to be reported on Form 990–T. The return must state the nature of the income-producing activity with sufficient specificity to enable the Service to determine whether the income is from an activity related to the organization’s exempt purpose, and the return must disclose the gross receipts from this activity. Rev. Rul. 69–247, 1969–1 C.B. 303, modifying Rev. Rul. 62–10, 1962–1 C.B. 305, amended by Rev. Rul. 64–132, 1964–1 (Part 1) C.B. 501. See California Thoroughbred Breeders Association, 47 T.C. 335 (1966).
Assessment of unrelated business income tax; statute of limitations— In order to facilitate compliance with Rev. Rul. 62–10, and the administration thereof the retroactive application of said ruling is hereby limited by authority of IRC 7805(b), to January 22, 1962. Accordingly, the holding in Rev. Rul. 62–10 will not be applied to any taxable year which would have been barred as of January 22, 1962, had the filing of an information return on Form 990, Form 990–A, or Form 990–P, in good faith, been regarded as the filing of a "return" for the purposes of starting the period of limitations on assessment and collection of the unrelated business income tax imposed by IRC 511. Rev. Rul. 62–10, 1962–1 C.B. 305 is amended accordingly. Rev. Rul. 64–132, 1964–1 (Part 1) C.B. 501.
Corporate taxpayer previously recognized as an exempt organization.— The unrelated business income tax shown on Form 990–T by a corporate taxpayer, with respect to which the period of limitations has already expired, can be used in determining the amount of a deficiency of the corporation when it is no longer recognized as an exempt organization where an extension of the period of limitations was obtained in connection with its Form 990. Rev. Rul. 73–577, 1973–2 C.B. 405.
Public inspection of documents— Documents submitted in connection with a question concerning unrelated business income of an otherwise tax-exempt organization are not subject to public inspection under the provisions of IRC 6104. Rev. Rul. 59–267, 1959–2 C.B. 382.
Parent subject to IRC 511— A title holding corporation subject to unrelated business tax if one of its parent organizations is subject to that tax. Rev. Rul. 68–490, 1968–2 C.B. 241.
Prospective revocation of exemption.— An organization whose exemption is revoked prospectively pursuant to IRC 7805(b) is subject to the unrelated business income tax for the period covered by IRC 7805(b) relief. Rev. Rul. 78–289, 1978–2 C.B. 180.
Investment credit.— An investment credit under IRC 38 is available to a state college or university where property is used predominantly in an unrelated trade or business and is not excluded from the definition of "section 38 property" by virtue of the exception for property used by a state instrumentality. A state college or university is not treated as an instrumentality of a state for purposes of IRC 48(a)(5) to the extent it engages in an unrelated trade or business, the income of which is subject to tax under IRC 511. Rev. Rul. 82–218, 1982–2 C.B. 30.