2002 Tax Help Archives  

Publication 598 2002 Tax Year

Tax on Unrelated Business Income of Exempt Organizations
(Revised 3/2000)

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This is archived information that pertains only to the 2002 Tax Year. If you
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Modifications

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 for any tax year, the carrybacks and carryovers of net operating losses, and the net operating loss deduction are determined without taking into account any amount of income or deduction that has been specifically excluded 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 dividends, interest, and other excluded 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 net operating loss computations 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 was subject to the tax for 1996 and had a net operating loss for that year, the last tax year to which any part of that loss may be carried over is 2011, regardless of whether the organization was subject to the unrelated business income tax in any of the intervening years.

Charitable contributions deduction.    An exempt organization is allowed to deduct its charitable contributions in computing its unrelated business taxable income 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.

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.

Deduction limits.   An exempt organization that is subject to the unrelated business income tax 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.

An exempt trust that is subject to the unrelated business income tax at trust rates 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 the trust's unrelated business taxable income computed without regard to the deduction, rather than in relation to adjusted gross income.

Contributions in excess of the limits just described may be carried over to the next 5 tax years. A contribution carryover is not allowed, however, to the extent that it increases a net operating loss carryover.

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:

  • $1,000, or
  • Gross income derived from an unrelated trade or business regularly carried on by the local unit.

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 business dealings with the public. 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 from the unrelated trade or business (whether or not distributed), and the deductions attributable to it. The partnership income and deductions to be included in the organization's unrelated business taxable income are figured the same way as any income and deductions from an unrelated trade or business conducted directly by the organization.

Example.   An exempt educational organization is a partner in a partnership that operates a factory. 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.

Different tax years.   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

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.

Special Rules for Foreign Organizations

The unrelated business taxable income of a foreign organization exempt from tax under section 501(a) consists of the organization's:

  1. Unrelated business taxable income derived from sources within the United States, but not effectively connected with the conduct of a trade or business within the United States, plus
  2. Unrelated business taxable income effectively connected with the conduct of a trade or business within the United States, whether or not this income is derived from sources within the United States.

To determine whether income realized by a foreign organization is derived from sources within the United States or is effectively connected with the conduct of a trade or business within the United States, see sections 861 through 865 and the related regulations.

Special Rules for Social Clubs, VEBAs and SUBs

The following discussion applies to:

  • Social clubs described in section 501(c)(7),
  • Voluntary employees' beneficiary associations (VEBAs) described in section 501(c)(9), and
  • Supplemental unemployment compensation benefit trusts (SUBs) described in section 501(c)(17).

These organizations must figure unrelated business taxable income under special rules. Unlike other exempt organizations, they cannot exclude their investment income (dividends, interest, rents, etc.). (See Exclusions under Income, earlier.) Therefore, they are generally subject to unrelated business income tax on this income.

The unrelated business taxable income of these organizations includes all gross income, less deductions directly connected with the production of that income, except that gross income for this purpose does not include exempt function income. The dividends received deduction for corporations is not allowed in computing unrelated business taxable income because it is not an expense incurred in the production of income.

Losses from nonexempt activities.   Losses from nonexempt activities of these organizations cannot be used to offset investment income unless the activities were undertaken with the intent to make a profit.

Example.   A private golf and country club that is a qualified tax-exempt social club has nonexempt function income from interest and from the sale of food and beverages to nonmembers. The club sells food and beverages as a service to members and their guests rather than for the purpose of making a profit. Therefore, any loss resulting from sales to nonmembers cannot be used to offset the club's interest income.

Modifications.   The unrelated business taxable income is modified by any net operating loss or charitable contributions deduction and by the specific deduction (described earlier under Deductions.

Exempt function income.    This is gross income from dues, fees, charges or similar items paid by members for goods, facilities, or services to the members or their dependents or guests, to further the organization's exempt purposes. Exempt function income also includes income that is set aside for qualified purposes.

Income that is set aside.   This is income set aside to be used for religious, charitable, scientific, literary, or educational purposes or for the prevention of cruelty to children or animals.In addition, for a VEBA or SUB, it is income set aside to provide for the payment of life, sick, accident, or other benefits.

However, any amounts set aside by a VEBA or SUB that exceed the organization's qualified asset account limit (determined under section 419A) are unrelated business income. Special rules apply to the treatment of existing reserves for post-retirement medical or life insurance benefits. These rules are explained in section 512(a)(3)(E).

Income derived from an unrelated trade or business may not be set aside and therefore cannot be exempt function income. In addition, any income set aside and later spent for other purposes must be included in unrelated business taxable income.

Set-aside income is generally excluded from gross income only if it is set aside in the tax year in which it is otherwise includible in gross income. However, income set aside on or before the date for filing Form 990-T, including extensions of time, may, at the election of the organization, be treated as having been set aside in the tax year for which the return was filed. The income set aside must have been includible in gross income for that earlier year.

Nonrecognition of gain.    If the organization sells property used directly in performing an exempt function and purchases other property used directly in performing an exempt function, any gain on the sale is recognized only to the extent that the sales price of the old property exceeds the cost of the new property. The purchase of the new property must be made within 1 year before the date of sale of the old property or within 3 years after the date of sale.

This rule also applies to gain from an involuntary conversion of the property resulting from its destruction in whole or in part, theft, seizure, requisition, or condemnation.

Special Rules for Veterans' Organizations

Unrelated business taxable income of a veterans' organization that is exempt under section 501(c)(19) does not include the net income from insurance business that is properly set aside. The organization may set aside income from payments received for life, sick, accident, or health insurance for the organization's members or their dependents for the payment of insurance benefits or reasonable costs of insurance administration, or for use exclusively for religious, charitable, scientific, literary, or educational purposes, or the prevention of cruelty to children or animals. For details, see section 512(a)(4) and the regulations under that section.

Income From Controlled Organizations

The exclusions for interest, annuities, royalties, and rents, explained earlier in this chapter under Income, may not apply to a payment of these items received by a controlling organization from its controlled organization. The payment is included in the controlling organization's unrelated business taxable income to the extent it reduced the net unrelated income (or increased 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.

For a payment made under a contract in effect on June 8, 1997, and received during the first 2 tax years beginning after August 4, 1997, the definition of a controlled organization and the computation of the amount included in the controlling organization's unrelated business taxable income are different. See section 1.512(b)-1(l) of the regulations for details.

Net unrelated income.   This is:

  • For an exempt organization, its unrelated business taxable income, or
  • For a nonexempt organization, the part of its taxable income that would be unrelated business taxable income if it were exempt and had the same exempt purposes as the controlling organization.

Net unrelated loss.   This is:

  • For an exempt organization, its net operating loss, or
  • For a nonexempt organization, the part of its net operating loss that would be its net operating loss if it were exempt and had the same exempt purposes as the controlling organization.

Control.   An organization is controlled if:

  • For a corporation, the controlling organization owns (by vote or value) more than 50% of the stock,
  • For a partnership, the controlling organization owns more than 50% of the profits or capital interests, or
  • For any other organization, the controlling organization owns more than 50% of the beneficial interest.

For this purpose, constructive ownership of stock (determined under section 318) or other interests is taken into account.

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).

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