Before one determines how to report unrelated business taxable income (UBTI) on a Schedule K-1, a quick review of the basics of UBTI is in order. It is worth noting that most tax-exempt organizations are subject to the UBTI rules. Sec. 511 details the organizations subject to tax on unrelated business income, which include:
- Trusts, corporations, and any other organization exempt from taxation under Sec. 501(c), excluding U.S. instrumentalities exempt under Sec. 501(c)(1);
- State colleges and universities;
- Qualified pension, profit sharing, and stock bonus plans under Sec. 401;
- Individual retirement accounts (IRAs), including Roth and SEP IRAs; and
- Charitable remainder trusts.
UBTI is "the gross income derived by any organization from any unrelated trade or business (as defined in section 513) regularly carried on by it, less the deductions allowed by this chapter which are directly connected with the carrying on of such trade or business" (Sec. 512(a)(1)). This definition can be broken down into three components: (1) income from a trade or business that is (2) regularly carried on and (3) unrelated to an exempt purpose.
In determining whether the UBTI rules apply, a tax-exempt organization must first determine whether the income is from a trade or business. Any activity that is carried on for production of income and possesses the characteristics required to constitute a trade or business within the meaning of Sec. 162 will generally be considered a trade or business under the UBTI rules (Regs. Sec. 1.513-1(b)). The phrase "production of income" is important, as the regulations note that activities entered into with the intention to produce income will still be classified as a trade or business even if they generate a loss (Regs. Sec. 1.513-1(b)). Numerous classes of income (generally including most items typically associated with portfolio investment income) are specifically excluded from UBTI, including dividends; interest; royalties; rental income from real property; and gains or losses from the sale, exchange, or other disposition of property (Sec. 512(b)).
Second, any activity generating business income must be regularly carried on for its income to be considered UBTI. The regulations consider an activity to be regularly carried on if it has frequency and continuity, and is pursued in a manner, similar to comparable activities of nonexempt organizations (Regs. Sec. 1.513-1(c)(1)). The IRS is not seeking to curb the occasional fundraiser but rather focuses on activities that are carried on frequently, such as operating a commercial parking lot one day a week (Regs. Sec. 1.513-1(c)(2)(i)).
Lastly, to avoid classification as UBTI, the conduct of the trade or business that produces the income must be substantially related (other than the production of funds) to the purposes for which the exemption is granted (Regs. Sec. 1.513-1(d)(1)). An activity is related to the organization's exempt purpose if it contributes importantly and bears a substantial causal relationship to the achievement of the exempt purpose (Regs. Sec. 1.513-1(d)(2)). Activity income that does not meet this definition will be considered unrelated for UBTI purposes. It is important to note the "other than production of funds" language, as it is the source of the funds and not the destination that drives the determination of whether an activity is related. An investment in a private-equity fund that is important to an exempt organization's long-term funding needs would generally not be considered related to the organization's exempt purpose, unless the underlying activities of the fund are substantially related and contribute importantly to the organization's exempt purpose.
All three components of the definition must be present for the UBTI rules to apply. While a detailed discussion of all of the rules and exceptions to UBTI is beyond the scope of this item, generally, most passthrough trade or business income is UBTI in the hands of its tax-exempt investors. To the extent an exempt organization has gross income (defined as gross receipts less cost of goods sold) of more than $1,000 from a regularly conducted unrelated trade or business, it must file Form 990-T, Exempt Organization Business Income Tax Return, to report and pay income tax on its UBTI. The $1,000 specific exemption reduces taxable UBTI by up to that amount.
Unrelated Debt-Financed Income
Even if an exception to the UBTI rules noted above applies (such as the exception for investment income), the income may still be subject to UBTI if it is classified as income from "debt-financed property." Debt-financed property is any property held to produce income and with respect to which there is acquisition indebtedness at any time during the tax year or preceding 12-month period, if the property was disposed of during the tax year (Sec. 514(b)(1)). These rules are particularly important to be aware of in the context of exempt organizations investing in partnerships. If partnership property has been debt-financed, as is often the case with real estate or alternative investment funds, then otherwise exempt rental income or investment income could be subject to UBTI (Sec. 512(b)(4)). Additionally, debt financing could trigger the UBTI rules when an exempt organization disposes of its interest in a partnership.
UBTI and Passthrough Entities
Essentially, any unrelated trade or business income flowing through to a tax-exempt organization from a passthrough entity can generate UBTI. For investments in partnerships, the organization must look through to the underlying partnership activity and apply the UBTI rules as if the organization had conducted the activity directly. Exempt organizations that are partners in a partnership that regularly carries on a trade or business unrelated to the organization's exempt purpose must include their share of the unrelated trade or business's gross income as well as their share of partnership deductions directly connected with that gross income when computing UBTI (Sec. 512(c)(1)). However, allocable partnership income that otherwise would be excluded from the calculation of UBTI under Sec. 512(b) is still excluded. For example, if an exempt organization invested in a partnership that generated gross income by operating a factory and the partnership also received dividend income from a corporate investment, the exempt organization would report only the factory income as UBTI (Regs. Sec. 1.512(c)-1)).
Sales of partnership interests would generally be excluded from UBTI under the general exception of gains or losses on the disposition of property. However, debt financing either at the partnership level or used by the exempt organization to acquire the interest could cause UBTI income under the debt-financing rules of Sec. 514. The IRS's position is that an exempt organization's sale of an interest in a partnership that owned debt-financed property is treated as unrelated debt-financed income (UDFI), even if the organization did not finance its purchase of the partnership interest (Technical Advice Memorandum 9651001). The recapture rules can also create UBTI.
Exempt organizations with investments in S corporations are subject to a different set of rules when calculating their share of UBTI. While partnership income is subject to the standard UBTI modifications (i.e., investment income items such as interest, dividends, real property rents, and royalties are generally excluded), all items of income, loss, or deduction reported by the S corporation on Schedule K-1 (Form 1120S, U.S. Income Tax Return for an S Corporation) are subject to UBTI (Sec. 512(e)(1)(B)(i)). In addition, any gain or loss on the disposition of the S corporation stock is included in the calculation of UBTI (Sec. 512(e)(1)(B)(ii)). The only exception to the UBTI rules for exempt organizations holding S corporation stock applies to employee stock ownership plans holding employer securities (Sec. 512(e)(3)).
Identifying Tax-Exempt Investors
Before an entity can determine how it should report UBTI information to its tax-exempt investors, it must identify which investors are tax-exempt. While it is a partner's responsibility to inform the partnership of its tax-exempt status, it would be best practice for the partnership to independently verify this information. Partnerships should generally obtain Form W-9, Request for Taxpayer Identification Number and Certification, from all new partners. Tax-exempt investors should complete line 4 and use the appropriate exemption code to indicate they are exempt. Partnerships can use this information to ensure they understand who may be required to report UBTI.
While it may be obvious which of an organization's own direct investors are tax-exempt, many sophisticated fund structures have multiple tiers of partnerships that can mask the identity of the ultimate investors. Funds of funds and other lower-tier partnerships may be unaware that some of their investors require UBTI information. In these situations, it would be best practice for the lower-tier partnerships to pass through UBTI information to all investors, so that partnerships investing in the fund have the information needed to meet their reporting requirements. This would be particularly beneficial for taxable investors such as trusts subject to Sec. 681, whose need for UBTI information may not be obvious. Additionally, upper-tier partnerships that are aware that certain funds or underlying portfolio companies could have UBTI would be smart to contact lower-tier partnerships to request they disclose UBTI information on Schedule K-1.
Many IRA investors searching for higher returns and/or noncorrelated asset classes are turning to alternative investments. IRAs are subject to the UBTI rules and should be provided this information on a Schedule K-1. The partnership should ensure it has the correct information and taxpayer identification number reported on the Schedule K-1 issued to an IRA investor. The identifying number of the IRA custodian rather than the Social Security number of the IRA account owner should be used (see 2014 Instructions for Form 1065, U.S. Return of Partnership Income, p. 26).
S Corporation Reporting Requirements
The UBTI reporting for S corporations appears to be very simple. Given that all S corporation income is treated as UBTI, no special reporting is required by the Code or regulations for S corporations with respect to their tax-exempt investors. S corporation tax return preparers may want to consider including a generic UBTI footnote such as the one below on Schedules K-1 issued to exempt shareholders to make them aware of a possible filing requirement on their end:
Tax-exempt investors owning S corporation stock may be subject to tax on unrelated trade or business income (UBTI) from their share of allocable income or from the disposition of S corporation stock. Please consult your tax adviser to determine whether your organization has a Form 990-T filing requirement.
Partnership Reporting Requirements
Any partnership carrying on a trade or business must provide its partners the information necessary to enable each partner to compute its distributable share of partnership income or loss from such trade or business in accordance with the UBTI rules (Sec. 6031(d)). However, the modifications under Secs. 512(b)(8)–(15) do not need to be considered for this purpose. These modifications include exclusions for certain research income, specified payments from controlled entities, and the $1,000 specific exemption from UBTI. Even though an exempt organization may not owe UBTI tax because its income is below the $1,000 specific exemption, the partnership still has an obligation to report the information.
Partnerships should use Schedule K-1, box 20, code V, to report UBTI information. However, simply reporting the total gross income from UBTI activities does not satisfy the partnership's reporting obligations. The Code and the instructions to Form 1065 indicate that an attachment should be provided showing the organization's share of partnership gross income from the unrelated trade or business as well as its share of partnership deductions directly connected with the unrelated gross income. However, the IRS does not provide a format or discuss the information to be disclosed on this attachment. Any statement should include the total gross UBTI as well as the deductions attributable to that income, so that the exempt organization can determine whether it has a filing requirement based on gross income before deductions.
While the Code is vague regarding what should be included on the UBTI statement, the Code's minimum requirements are most likely insufficient to properly calculate UBTI. For instance, the passive activity rules under Sec. 469 and at-risk limitations under Sec. 465 may limit the deductibility of losses for UBTI purposes, so it probably makes sense to disclose in the statement sufficient information to allow the organization to calculate any limitations under those Code sections. The statement should allow an exempt organization to determine what amount of UBTI or loss is nonpassive versus passive. Additionally, gain from the disposition of property that is otherwise excluded from UBTI may be subject to depreciation recapture under Sec. 1250 or Sec. 1245 and thus be taxable as UBTI (Regs. Secs. 1.1245-6(b) and 1.1250-1(c)(2)). Partnerships should provide the portion of any gain potentially subject to depreciation recapture on their UBTI statement.
UDFI in the context of investing in partnerships can take two forms. The first is acquisition indebtedness by the exempt organization to finance its partnership interest. From a reporting standpoint, this should not concern the partnership. This is a partner-level determination that the partnership will not have the necessary information to calculate. However, the exempt organization should be aware that the UBTI information reported to it does not factor in any indebtedness it may have incurred to acquire its partnership interest. The sample UBTI statement on p. 571 includes language describing this limitation.
The second source of UDFI is debt incurred by the partnership to acquire property. Real estate and other leveraged investment funds may generate only investment income excluded under Sec. 512(b), but if this excluded income is debt-financed, it is taxable as UBTI under Sec. 512(b)(4). In this case, the partnership should be able to calculate UDFI at the partnership level and include this information in the taxable UBTI information provided to exempt investors. As for presentation on Schedule K-1, the UDFI could be included in the UBTI numbers or separately broken out via a footnote indicating the percentage of non-UBTI income subject to treatment as UDFI. Partnerships with debt-financed property need to consider whether additional disclosure is needed to inform exempt partners that a portion of their gain or loss on the disposition of their partnership interest could be subject to UDFI.
The exempt organization could have UDFI from both internal and external sources if, for example, it borrows to purchase its partnership interest and the partnership financed its purchases of property. In this case, the exempt organization must include both internal and external debt in calculating UBTI from debt-financed income (Regs. Sec. 1.514(c)-1(a)(2), Example (4)).
The UDFI relating to income on debt-financed partnership property is calculated and reported by the partnership as noted above. However, the exempt organization will need to calculate UDFI resulting from its financing of the acquisition of the partnership interest. To calculate the debt/basis percentage needed to determine the portion of income that is UDFI, the exempt organization needs to know its average acquisition indebtedness with respect to the property and the average adjusted basis of the property (Regs. Sec. 1.514(a)-1(a)(1)(ii)). If such property is sold, the exempt organization will need to know the highest acquisition indebtedness with respect to such property during the 12-month period preceding the date of disposition, in addition to the average adjusted basis of the property (Regs. Sec. 1.514(a)-1(a)(1)(v)). Partnerships reporting gain or loss from the disposition of property or issuing a final Schedule K-1 to an exempt partner that sold its partnership interest should consider whether to provide additional disclosure detailing partnership-level acquisition indebtedness and average adjusted basis.
Sample UBTI Reporting Requirements
A sample format for a UBTI footnote may look something like the one in the exhibit below, with supplemental information as needed regarding depreciation recapture, passive income limitations, and debt-financed reporting.
While exempt organizations investing in passthrough entities may owe income tax under the UBTI rules, these organizations need to consider how their after-tax rate of return compares between their UBTI- and non-UBTI-generating investments. Additionally, proper planning and structuring can help mitigate or eliminate the effects of UBTI and UDFI.
For example, many investment funds allow tax-exempt investors to invest through a foreign corporation, which can block UBTI from flowing out to the tax-exempt partner and eliminate a Form 990-T filing. However, this strategy could lead to effectively connected income, and a filing of Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, by the foreign "blocker" corporation, which may be equally as costly in terms of compliance and tax costs. Proper planning such as extinguishing debt more than 12 months before a disposition can also help mitigate the effects of UDFI.
It is important for the tax professionals of both the partnership and exempt organization to collaborate to ensure the various UBTI exceptions have been considered and the exempt organization has all the information needed to apply those exceptions and calculate its UBTI liability. For example, real estate partnerships using debt financing should be aware of the qualified-organization rules under Sec. 514(c)(9) and consider whether their tax-exempt investors (typically, educational organizations) may meet this exception to the UDFI rules and whether that affects their supplemental UBTI reporting. Particularly in the context of joint ventures, supplemental information such as whether any of the partnership's activities could be related to an exempt purpose could also produce valuable tax savings and ensure proper compliance.
Anthony Bakale is with Cohen & Company Ltd. in Cleveland. For additional information about these items, contact Mr. Bakale at 216-774-1147 or firstname.lastname@example.org. Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.