Transfers Between Controlled Entities Can Provide Surprises Under Sec. 512(b)(13)

By David Lowenthal, CPA, LL.M., Washington, DC

Editor: Mindy Cozewith, CPA, M. Tax.

Many tax-exempt organizations are growing into complex multi-entity groups including both nonprofit corporations that are tax exempt under Sec. 501(c) and for-profit entities, which are taxed accordingly. Typically, members of a multi-entity structure enter into contracts with one another regarding matters such as management agreements, real property leases, lending facilities, and licenses of intellectual property. Sometimes these relationships can create undesired tax consequences caused by Sec. 512(b)(13), which can lead to unrelated business taxable income (UBTI) for tax-exempt members of a group.


In a standard application of Sec. 512(b)(13), a subsidiary entity will make a deductible payment of interest, rent, royalty, or annuity to a parent exempt organization. Under Secs. 512(b)(1), (2), and (3), receipt by (tax-exempt) Sec. 501(c) entities of interest, rents, royalties, and annuities is generally excluded from UBTI. However, under Sec. 512(b)(13), the parent exempt organization is subject to UBTI. (The subsidiary is not affected by Sec. 512(b)(13).) Thus, Sec. 512(b) (13) treats a parent exempt organization more harshly in its contractual relationships within its related group than in similar relationships with unrelated third parties.

Sec. 512(b)(13)(A) provides that if a tax-exempt organization (controlling organization) receives or accrues a “specified payment” from a “controlled entity,” the resulting income will be UBTI to the controlling organization to the extent it would reduce the net unrelated income or increase the net unrelated loss of the controlled entity.

Under Sec. 512(b)(13)(D), a controlling organization is deemed to control a taxable controlled entity if it owns:

  • More than 50% of a corporation’s stock;
  • More than 50% of the profits or capital interest in a partnership; or
  • More than 50% of the beneficial interest in any entity

Sec. 318 constructive ownership rules apply, including the rules regarding attribution of indirect ownership.

A specified payment is defined under Sec. 512(b)(13)(C) to include “interest, annuity, royalty, or rent.”

Sec. 512(b)(13)(B) defines “net unrelated income or loss” differently depending on whether the controlled entity is tax exempt or taxable. For a tax-exempt controlled entity, net unrelated income is equal to the controlled entity’s UBTI before deducting the specified payment. For a taxable controlled entity, net unrelated income is equal to the amount of its taxable income, which would be UBTI (before deducting the specified payment) if the controlled entity had the same exempt purpose as the controlling organization.

Regs. Sec. 1.512(b)-1(l)(3) adds that the taxable income of a taxable controlled entity equals the greater of taxable income or taxable income less any income that would not be unrelated business income of the controlling organization (excess taxable income). Thus, if the controlled entity operated an activity that would be considered an exempt activity, any loss generated by the activity would increase taxable income for these purposes to an amount in excess of the actual taxable income. This regulation keeps the related loss from knocking the calculation of net unrelated income out of parity.

Applying the Rules

The following examples show the application of these rules. E is a philanthropy group consisting of H, a Sec. 501(c)(3) public charity; F, a type I Sec. 509(a)(3) supporting organization of H, which does not carry out any unrelated activities; and G, a wholly owned C corporation of H. G’s activities would be unrelated business income if carried on by H.

Since F is a type I supporting organization (i.e., it is operated, supervised, and controlled by H), H is deemed to control 100% of F, which in turn is considered akin to 100% ownership of the beneficial interest of F under Sec. 512(b)(13) (D). Therefore, F is a controlled entity. G is a controlled entity because H owns 100% of its stock, which is more than the 50% stock ownership required under Sec. 512(b)(13)(D).

Example 1: H owns the building in which the group is housed. H entered into separate written leases on January 1, 2008, with F and G for use of the building.

Rent payments are considered specified payments under Sec. 512(b)(13)(C). G’s activities would all be unrelated business income if carried out by H. Therefore, payments of rent from G to H would reduce G’s “net unrelated income or loss” under Sec. 512(b)(13)(B). Hence, rents received from G will be considered UBTI to H. However, F does not conduct unrelated activities. Thus, when F pays rent to H, the payment does not reduce F’s “net unrelated income or loss” (which remains $0). As such, rent received from F will not be considered UBTI to H.

Example 2: On January 1, 2008, H enters into a license agreement with G for use of its trade names, trademarks, and related intellectual property. G agrees to pay H a royalty equal to 4% of G’s gross revenue. G’s 2008 gross revenue is $12,500,000, resulting in a royalty of $500,000. Separately, H transfers to G one of its exempt activities. In 2008, G has $750,000 of taxable income (before deducting the royalty), consisting of $375,000 each from unrelated and exempt activities.

H will recognize $250,000 of the $500,000 royalty payment as UBTI. Since 50% of G’s taxable income would be earned in activities in furtherance of H’s exempt purpose, the other 50% of G’s revenue would be considered net unrelated income. H would have UBTI of $250,000 (50% of $500,000). See Regs. Sec. 1.512(b)-1(l)(3) (iii), Example (1).

Arm’s-Length Transfer

The Pension Protection Act of 2006, P.L. 109-280, added an important exception (which applies to the concepts provided above) in reference to Sec. 512(b)(13). Under Sec. 512(b)(13)(E), a qualifying specified payment that meets the Sec. 482 arm’slength transfer standards will be excluded from the application of Sec. 512(b)(13). A qualifying specified payment is any specified payment made under a contract in force as of August 16, 2006, or a contract that is a renewal under terms substantially similar to those entered into under a prior contract in force as of August 16, 2006. There is a penalty for valuation misstatement equal to 20% of the excess of the appropriate fair value. This provision was originally to sunset on December 31, 2007, but has been extended until December 31, 2009.

In the Pension Protection Act, Congress also enacted Sec. 6033(h)(1), which requires taxpayers to report on payments between controlling organizations and controlled entities (see 2007 Form 990, Part XI). After assessing information provided by taxpayers in Part XI, Treasury is required to report to Congress in 2009 about the provision.

Example 3: The facts are the same as in Example 1, except now the lease agreements are entered into on January 1, 2006. Since the leases were entered into prior to August 16, 2006, assuming H meets the Sec. 482 fair value standard, the rental payments from G will be considered qualifying specified payments and as such are excluded from UBTI.

This exception is valued and welcomed by exempt organizations and practitioners. Hopefully, following the submission of the Treasury report, Congress will amend Sec. 512(b)(13) as a whole to allow exempt organizations arm’s-length receipts from their subsidiaries in all instances without being subject to UBTI.

It is important to note that, notwithstanding Sec. 512(b)(13)(E), there is no fair value standard for specified payments between controlled entities. However, payments made at below-market value from taxable or noncharitable entities to charitable entities are inherently instances of private inurement and can subject organizations to the risk of sanction, including loss of exemption for the charitable organization.

Circumventing Sec. 512(b)(13

In some instances, the provisions of Sec. 512(b)(13) can be circumvented. Sometimes organizations work with unrelated for-profit enterprises on for-profit activities. In these instances, it can be possible for the for-profit enterprise to own 50% or more of an entity and the taxexempt organization less than 50% of the entity. Thus, the for-profit enterprise is not a controlled entity. Since the receipt of interest is otherwise excluded from UBTI under Sec. 512(b)(1), the organization can provide financing to the entity and lock in a steady return without paying any tax because the level of ownership is not more than 50%.

In other instances, Sec. 512(b)(13) can be a tool in expending tax attributes. A tax-exempt organization with a controlled entity may have significant net operating loss carryovers or tax credits that it cannot otherwise utilize. By structuring an arrangement whereby the controlled entity makes specified payments to a parent exempt organization and generates UBTI, the controlled entity will be able to generate a tax deduction while the exempt organization will offset its UBTI with net operating losses or tax credits.


Sec. 512(b)(13) is an important Code section for practitioners involved in multi-entity tax-exempt groups—especially groups with both taxable and nontaxable entities. These rules pose a significant roadblock to contractual relationships among the group members. However, in some instances these roadblocks can be overcome by careful planning.


Mindy Cozewith is director, National Tax, at RSM McGladrey, Inc., in New York City.

Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.

For additional information about these items, contact Ms. Cozewith at (908) 233-2577 or

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