Downloaded From OutlineDepot.com TAX EXEMPT ORGANIZATIONS I. Calculating the Charitable Deduction a. Tax exempt charity – Possible charitable deduction; Other exempt organization – No charitable deduction b. 50%/30% Calculation c. C corp deduction (not S corp) d. Process – 11 steps i. Treas. Reg. § 1.170A-1(c) 1. Start with the FMV of the property donated. ii. § 170(e)(1)(A) 1. Subtract any potential non-long-term capital gain iii. § 170(e)(1)(B)(i)(I) 1. Subtract 100% of any potential long-term capital gain if the transfer is a gift of unrelated tangible personal property given to a public charity or to a § 170(b)(1)(F) private foundation iv. § 170(e)(1)(B)(i)(II) 1. Subtract 100% of any potential long-term capital gain if the transfer is a gift of tangible personal property but (1) is sold, exchanged, or disposed of by the done before the last day of the taxable year and (2) the done has not made a 170(e)(7)(D) certification with respect to the property. v. § 170(e)(1)(B)(ii) 1. Subtract 100% of any potential long-term capital gain if the transfer is a gift to a private foundation other than one described in § 170(b)(1)(F) vi. § 170(e)(1)(B)(iii) 1. Subtract 100% of any potential long-term capital gain if the transfer is a gift of a patent, copyright, trademark, trade name, trade secret, know-how, software, or similar property, or applications or registrations of such property vii. § 170(e)(1)(B)(iv) 1. Subtract 100% of any potential long-term capital gain if the transfer is a gift off taxidermy property by the person who prepared, stuffed, or mounted the property or by a person who paid for preparation, stuffing, or mounting viii. § 170(b)(1)(A) 1. Limit the amount of contributions to 50% of the taxpayer’s contribution base if they are either to a public charity or to a § 1 Downloaded From OutlineDepot.com 170(b)(1)(F) private foundation. Carryover the remainder of such contributions for five years per §170(d) ix. §170(b)(1)(B) 1. Limit any contributions to private foundations other than those described in §170(b)(1)(F) to the lesser of: a. 30% of the contribution base b. 50% of the contribution base minus the amount from step 8 2. Carry over remainder for five years x. §170(b)(1)(C) 1. Limit the contributions from step 8 to 30% of the contribution base if they involve capital gain property and Steps 3 through 7 did not cause a reduction. Carry over the remainder for five years. Do not change Step 9, or 2. Elect §170(b)(1)(C)(iii) to apply all capital gain property. If you elect, do not apply the 30% limitation in this Step 10, but go back to steps 4 through 7. xi. §170(b)(1)(D) 1. Limit the contributions from Step 9 to the lesser of: a. 20% of the contribution base, or b. 30% of the contribution base minus the Step 10 amount (if no § 170(b)(1)(C)(iii) election was made). xii. Carry over the remainder for 5 years e. Reduction versus limitation II. Qualifying as a Public Charity a. Four methods i. Public safety ii. One third public support 1. Listed 2. One third public support 3. Ten percent plus facts and circumstances a. Continuous and bona fide government or public fundraising program b. How much over ten percent? c. Diverse sources of support d. Representative governing body e. Services continuously available to general public iii. Section 509 one third public support 1. More than one third may NOT come from: a. Passive investment income 2 Downloaded From OutlineDepot.com b. After tax unrelated business taxable income iv. Supporting organization 1. Organized and operated exclusively for the benefit of, or to perform the functions, or to carry out the purposes of one or more publicly supported organization, §509(a)(3)(A) 2. And is either a. Operated, supervised or controlled in connection with one or more publicly supported organizations §509(a)(3)(B)(I), or b. Supervised or controlled in connection with one or more publicly supported organization §509(a)(3)(B)(II), or c. Is controlled in connection with one or more publicly supported organization §509(a)(3)(B)(III), 3. And not directly or indirectly controlled by a disqualified person, other than a foundation manager or a publically supported organization 4. The organization documents must state that the entity’s purpose is to support one or more specifically identified publically supported organizations. Treas. Regs. § 1.509(a)-4(h)(1)(i) b. Test i. Public support/All support ii. 4-year look-back; status is for current and following years iii. Public support 1. Total support – Gifts, grants, membership fees, net income from unrelated business even if the business is not regularly carried on, Taxes collected for the benefit of the organization, Free government services provided to organization (but not fees for performing exempt purpose) 2. 2% Rule 3. Unusual gift rule – Rev. Proc. 81-7 a. Not from related person b. Cash, marketable stock, or related to exempt purpose c. Unrestricted 4. Governmental contract rules a. No more than $5,000/1% (see below) iv. Permitted persons 1. Not disqualified person (§4946) 2. Government unites described in §170(c)(1) 3. Listed organizations 3 Downloaded From OutlineDepot.com 4. Donation is not included in public support to the extent that it exceeds 1% of total support III. Excise Taxes a. Private charity – Good public policy/Potential evasion conduit i. 2 types of exempt organizations 1. Tax-exempt charities – 2 types (difference is oversight) a. Private foundations b. Public charities 2. Other exempt organizations b. Disqualified persons – Relationships, Draw a chart c. Private operating foundation i. Status 1. Spend directly for its exempt purpose substantially all of the lesser of: a. Its adjusted net income, or b. Its minimum investment return 2. And must fit into one of the following categories: a. devote substantially more than half of its assets to its charitable activities or to a functionally related business; or b. derives substantially all of its support (other than gross investment income) from at least five independent exempt organizations or from the general public, with not more than 25 percent of its support being received from any one such exempt organization and not more than half of its support from gross investment income; or c. make qualifying distributions directly, for the active conduct of its exempt activities, of at least two-thirds of its minimum investment return (5% of FMV of noncharitable assets, less acquisition indebtedness) 3. Note: Substantially more than half is defined as at least 65 percent, under Reg. §53.4942(b)-2(a) 4. Note: “Substantially all” is defined as at least 85 percent, Treas. Reg. §53.4942(b)-1 ii. Exempt operating foundation status 1. Operating foundation status 2. Ten years of meeting either: a. the §170 public support test (one third) b. the §509 public support test (more than one third, less than one third) 4 Downloaded From OutlineDepot.com 3. A representative governing board a. With no more than 25% disqualified persons (§4940(d)(2)) 4. No disqualified people as officers of the private foundation d. Excise taxes – If a private foundations runs afoul of the qualifications i. Audit fee tax – §4940 (2% of the private foundation’s “net investment income”) 1. Gross investment income, plus a. Interest, dividends, rents, royalties 2. Capital gain net income, a. Gains from sale of property used for the production of unrelated income and interest, dividends, rents, royalties b. Objective/Subjective standard for determining capital gain (class of property/this specific property) i. Case law 3. Less ordinary and necessary expenses related to gross investment income and property held for production of income 4. Increase in net investment income Increase in audit tax 5. Net investment income = Gross investment income + Capital gain net income – Related expenses 6. Unrelated business income is not investment income 7. Proceeds from the sale of an asset that is utilized exclusively in the furtherance of the purposes of the organization are not included in income ii. Self-dealing excise tax – §4941 (sale, exchange, or leasing of property between a private foundation and a disqualified person) 1. Disqualified persons (watch out for attributions) a. Substantial contributor b. Member/Owner of substantial contributor c. Partner of member/owner/substantial contributor d. First degree of consanguinity of member/owner/substantial contributor e. First degree of consanguinity of partner of member/owner/substantial contributor 2. Indirect disqualification a. A transaction between a disqualified person and an organization “controlled” by a private foundation i. A private foundation controls an organization when a disqualified person and other individuals who are 5 Downloaded From OutlineDepot.com also disqualified persons by reason of their relationship to the first disqualified person ii. Can only by joining their voting power with that of the foundation, iii. Cause the organization to engage in a self-dealing transaction with a disqualified person iii. Mandatory distributions – §4942 1. Tax is 30% on undistributed income a. Undistributed income = Distributable amount – Qualifying distribution i. Distributable amount = Minimum investment return (i.e. 5% of the value of noncharitable assets less acquisition indebtedness) + any repayments of previous qualifying distributions + amounts received from the sale or disposition of charitable assets + set aside any amounts that are no longer necessary to achieve the purpose for which the amount was set aside – any taxes imposed ii. Non-charitable asset = Not directly used or held for the use of the exempt purpose 1. Do not include: a. Investments that help the charity achieve its exempt purpose (program-related investments) b. Investments in functionally-related businesses iii. Qualifying distribution = Amounts paid for charitable purposes iv. Suitability test (Rev. Rul. 74-450) = Set aside involving relatively long term grants or expenditures that must be make in order to assure the continuity of particular charitable projects (e.g. a plan to erect a building) v. Cash distribution test 1. Foundation must have made: Aggregate cash or “equivalent” distributions in amounts equal to the sum of 20% of its distributable amount for the first taxable of its “start up” period + Successive annual 6 Downloaded From OutlineDepot.com distributions increasing by 20% per year until the fourth year of its start up period of 53.4942(a)-3(b)(3) vi. Foundation would have to establish to the satisfaction of the Commissioner that: 1. Its immediate use of the funds for the exempt purpose of building its new headquarters is not practical (based on the facts and circumstances of the particular case), and 2. That definite plans exist to commence such use within a reasonable time. Treas. Reg. §53.492(a)-2(c)(3)(i) a. Property “to be used” for an exempt purpose will be deemed “used” for an exempt purpose even though it is being leased for a reasonable period of time pending its actual conversion to exempt uses. b. 1 year is acceptable; more than that requires proof iv. Excess business holdings – §4943 1. Two-tier tax – Imposed if the foundation does not divest itself of the excess business holdings by the end of the taxable period 2. §4942(c)(1) excess business holdings = Percentage of a “business enterprise” owned by a private foundation and its disqualified persons 3. Dependent on type of business enterprise a. Corporation = 20% of voting stock (combined ownership) b. If the corporation is controlled by a person who is NOT a disqualified person, then the limit for how much disqualified persons plus the foundation can own is raised to 35% of the voting stock 4. Grace periods a. When the private foundation does not know of the conflict before purchasing shares i. Within 90 days of the knowledge ii. One way to obtain knowledge is through an annual survey of the disqualified person’s holdings 7 Downloaded From OutlineDepot.com b. When a foundation receives business holdings other than by purchase by the foundation or its disqualified persons i. 5-year grace period with possible extension ii. Extension is based on constraints of the market c. In any case in which all disqualified persons together do not own more than 20 percent of the voting stock of an incorporated business enterprise, nonvoting stock held by the private foundation shall also be treated as permitted holdings. IRC § 4943(c)(2)(A) [flush language] d. Had the foundation's holdings exceeded its permitted holdings, it would have to sell the stock to a person who was not a disqualified person. IRC § 4943(c)(1); Treas. Reg. § 53.4943-2(a)(1)(ii). v. Jeopardizing investments – §4944 1. Standard: Foundations and their managers must exercise ordinary business prudence under the facts and circumstances prevailing at the time of making the investment, in providing for the long and short term financial needs of the foundation to carry out its exempt purposes 2. Examples of investments that do not meet this standard of ordinary business prudence: Treas. Reg. §53.4944-1(b)(2)(i) a. Exception: Program related investments are never jeopardizing investments no matter how risky §4944(c) 3. Two tier tax a. 1st tier on the foundation = 10% of Jeopardizing investment i. Foundation manager is also subject to 10% tax 1. With a maximum of $10,000 per investment §4944(a)(2) ii. But only for knowing and willful actions 1. Knowing = actual knowledge of facts that would make the investment a jeopardizing investment and is aware that the investment might violate §4944. Treas. Regs. § 53.4944-1(b)(2)(i) 2. Willful = voluntary, conscious, or intentional b. 2nd tier tax = 25% of jeopardizing investment vi. Taxable expenditures – §4945 8 Downloaded From OutlineDepot.com 1. Harm to be avoided = Political and legislative activities 2. 2-tier tax system 3. Taxable expenditure = a. Amounts spent for lobbying and political campaign activities b. Grants to individuals for travel and study (some exceptions) c. Grants to non-public charities d. Grants for non-charitable purposes vii. Termination tax – §507 1. Private foundations are terminated for: a. A single flagrant violation leading to an excise tax b. Two or more willful violations leading to an excise tax 2. Ways to avoid termination tax a. Service may abate the termination tax if, after assessment, the foundation’s net assets are distributed to one or more charities, each of which has been in existence for at least 60 months IV. Unrelated Business Income Tax (UBIT) – UBIT is a tax on a trade or business regularly carried on by an exempt organization that is not substantially related to the organization’s exempt purpose. i. “Substantially” 1. Test is whether the business is substantially related to the exempt purpose of the organization, aside from the need for funds. a. The activity which generates income must "contribute importantly" to the accomplishment of the exempt purposes for which the organization was formed, b. Sale of products resulting from the performance of exempt functions is not an unrelated trade or business if: i. The product is sold in substantially the same state as on completion of the exempt function. c. Thus, the sale of milk by a scientific organization that maintains an experimental dairy herd would not constitute an unrelated trade or business, i. but the sale of ice cream would constitute an unrelated trade or business 2. “Fragmentation rule” - §513(c)(unrelated income embedded in activity) 9 Downloaded From OutlineDepot.com a. For purposes of this section, the term "trade or business" includes any activity which is carried on for the production of income from the sale of goods or the performance of services. For purposes of the preceding sentence, an activity does not lose identity as a trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of the organization. Where an activity carried on for profit constitutes an unrelated trade or business, no part of such trade or business shall be excluded from such classification merely because it does not result in profit. b. Does not includes those sales carried on primarily for the convenience of its members 3. Corporate sponsorship exception (“Qualified sponsorship payments”) a. any payment made by any person engaged in a trade or business with respect to which there is no arrangement or expectation that such person will receive any substantial return benefit other than the use or acknowledgement of the name or logo (or product lines) of such person's trade or business in connection with the activities of the organization that receives such payment. b. There is no substantial return benefit (and so no unrelated business taxable income from among other things): i. Exclusive sponsorship arrangements ii. The use of the sponsor's logo or slogans if they do not contain qualitative or comparative descriptions, iii. Value neutral descriptions, displays or visual depictions of the sponsor's products or services. c. A sponsor does receive substantial return benefits from: i. Advertising ii. Exclusive provider arrangements iii. The use of the exempt organization's goods, facilities, services or other privileges, or iv. The exclusive or nonexclusive right to use the exempt organization's trademark, patent, logo or designation. 10 Downloaded From OutlineDepot.com 4. Treas. Regs. §1. 513-1(b) any activity that is carried on for the production of income and otherwise possesses the characteristics required to constitute a trade or business under IRC § 162 is a trade or business for purposes of IRC § 511 and so is also potentially an unrelated trade or business. 5. 3 requirements a. The exempt organization derives income from a trade or business, and b. That trade or business is regularly carried on by the exempt organization, and c. The exempt organization's conduct of its trade or business is not substantially related to the organization's exempt function b. §501(c)(3) i. Tax-exempt charity is organized exclusively for: 1. religious, 2. charitable, 3. scientific, 4. testing for public safety, 5. literary, or educational purposes, 6. foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), 7. for the prevention of cruelty to children or animals ii. no part of the net earnings of which inures to the benefit of any private shareholder or individual, iii. no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h)), and iv. which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office. c. Definition: i. the gross income derived from any unrelated trade or business less deductions directly connected with the carrying on of such trade or business, ii. subject to certain modifications the gross receipts from an unrelated trade or business less the associated costs d. UBIT is imposed on: 11 Downloaded From OutlineDepot.com i. the unrelated business taxable income ("UBTI") of otherwise exempt organizations ii. Rate is the corporate tax rate (except for trusts) V. Unrelated Business Income Tax Modifications a. All dividends, interest, payments with respect to loans of securities, and annuities are excluded. b. Royalties (including overriding royalties), whether measured by production or by gross or taxable income, are excluded. i. Sierra Club standard 1. royalties are "payments received for the right to use intangible property rights and that such definition does not include payments for services.". ii. Arkansas State Police Ass’n standard 1. A royalty exists when A uses B's name to promote A's products. 2. The affinity credit card cases involved royalties because the credit card company used the tax-exempt organization's name to promote the credit card company's product. 3. But the magazine publisher used the exempt organization's name to promote the exempt organization not the magazine publisher 4. The fact that the parties labeled their agreement a "Royalties and Licensing Agreement" is of no consequence because the agreement was really an agency relationship. c. Rent from real property, and rents from personal property leased with real property if the rents attributable to the personal property are only an incidental amount of the total rents received or accrued under the lease, i. EXCEPTION If more than 50 percent of the rent under a lease is attributable to personal property, then none of the rent, whether attributable to the real property or the personal property, qualifies for the modification exclusion. . . . d. All gains or losses from the sale, exchange or other disposition of property other than the sale of property of a kind properly includable in inventory and property held primarily for sale to customers in the ordinary course of a trade or business are excluded e. Also excluded are all gains on the lapse or termination of options to buy or sell securities written by the organization in connection with its investments activities. f. Income from various research activities. i. All income from research performed for the United States, a State, or a political subdivision of a State is excluded. 12 Downloaded From OutlineDepot.com ii. In the case of a college, university, or hospital and in the case of an organization operating primarily for the purpose of carrying on fundamental research that makes the results of its research freely available to the public, all income derived from research is excluded, regardless of for whom performed. g. Expenses directly connected to the conduct of unrelated business are fungible and may be deducted against any other unrelated activity. Treas. Reg. 1.512(a)– 1(f)(2)(i). i. However, if the unrelated activity produces a net gain, and the exploited exempt activity produces a net loss, then the loss is deductible against any net gain from that specific unrelated business ii. Any loss in excess of the net gain is not fungible and may not be deducted against any unrelated activity that does not exploit the exempt activity. Treas. Reg. 1.512(a)–1(f)(2)(ii). VI. Controlled Entities a. Potential income paid as tax-free rent results in wiping out all taxable income to company and no income for the tax exempt b. §512(b)(13) i. Include in unrelated trade or business income 1. any interest, annuity, royalty, or rent 2. that is paid by a controlled organization, 3. to the extent that payment of such income to the charitable organization 4. Reduces the controlled organization's income otherwise subject to tax. ii. A charity controls the subsidiary if: 1. It owns more than 50% of the sub's voting stock, or 2. If the controlled organization is a corporations a. More than 50% of the total value of the sub's stock. 3. If the controlled organization is a partnership, control means: a. Ownership of more than 50% profit or capital interest iii. To determine which specified payments reduce the controlled entity’s taxable income: 1. The portion of any specified payment that reduces the payor's taxable income (and therefore must be included in the payee's taxable income) is derived by: a. Multiplying the amount of the specified payment by an inclusion ratio. 13 Downloaded From OutlineDepot.com i. When the controlled organization is another charity, the ratio is the controlled organization's unrelated income divided by the controlled organization's taxable income or unrelated income (whichever amount is greater). ii. When the controlled organization is a taxable entity, the ratio is the amount of the controlled organization's income that would be unrelated if earned directly by the charitable parent (what we refer to as "the deemed unrelated amount") divided by the controlled entity's taxable income or the deemed unrelated amount, whichever is greatest. b. The denominators are determined without reduction for amounts paid to the controlling organization. c. §511(a)(1) – Tax on UBTI (unrelated business taxable income) i. IRC § 512(b)(2) and (3) 1. unrelated business taxable income does not include income from rents and royalties. ii. IRC § 512(b)(13)(A) 1. provides an exception to the rule that rents and royalties are not unrelated business taxable income. a. The exception applies when the exempt organization receives the rents or royalties from a "controlled entity." 2. Treas. Regs. § 1.512(b)-1(1)(1)(iii) provides that rents and royalties received by an exempt organization from its controlled entity are included in computing the exempt organization's unrelated business taxable income to the extent that the rents or royalties reduce the controlled entity's "net unrelated income." iii. IRC § 512(b)(13)(D) defines a controlled entity as: 1. a corporation, partnership or other organization a. that the exempt organization has an ownership interest in of more than 50%. 2. Under IRC § 512(b)(13)(D)(ii) the constructive ownership rules of IRC § 318 apply in determining the exempt organization's stock ownership in a corporation by attribution from other owners. 3. IRC § 318(a)(2)(C) and (a)(3)(c) a. if 50% or more in value of the stock in a corporation is owned, directly or indirectly, by or for any person, then that person is considered as owning the stock owned, directly or 14 Downloaded From OutlineDepot.com indirectly, by or for the corporation in the proportion that the value of the stock the person owns bears to the value of all the stock in the corporation. iv. TR §1.512(b)-(1)(3) 1. When the controlled organization is a taxable entity a. Ratio derived from the amount of the controlled organization's income that would be unrelated if earned directly by the charitable parent, b. Divided by the controlled entity's: i. Taxable income, or ii. The deemed unrelated amount, iii. Whichever is greatest. iv. The denominators are determined without reduction for amounts paid to the controlling organization. 2. §512(b)(13) a. Includes in the controlling tax exempt organization's unrelated business income: b. Interest, rent, annuity, or royalty payments made by a controlled entity to the controlling tax-exempt organization to the extent that: c. The payment from the controlled entity to the controlling tax exempt organization reduces the controlled entity's net unrelated income (or increases any net unrelated loss). v. IRC §512(b)(13)(E)(i) limits 1. The amounts included in the controlling tax exempt organization's unrelated business income by IRC § 512(b)(13) is limited to the portion of payments received or accrued in a taxable year that exceeds the amount of the specified payment that would have been paid or accrued if such payment had been determined under the principles of section 482. a. Thus, if a payment of rent by a controlled subsidiary to its tax-exempt parent organization exceeds fair market value, then the excess amount of the rents paid over the fair market value (as determined in accordance with section 482) is included in the parent organization's unrelated business income, to the extent that the excess over fair market value reduced by the net unrelated income (or increased any net unrelated loss) of the controlled entity (determined as if the entity were tax exempt). 15 Downloaded From OutlineDepot.com 2. In addition, IRC§ 512(b)(13)(E)(ii) provides a 20 percent penalty tax on the amount of the excess over what IRC § 482 would allow. a. IRC § 512(b)(13)(E)(iii) defines "qualified specified payment" as a payment made pursuant to a biding written contract or renewal entered into after adoption of new section 512(b)(13)(E). d. Non-exempt subsidiary calculation i. Subsidiary l's taxable income (disregarding rent and royalties paid to National Geographic), less ii. Subsidiary l's taxable income from the 5 Discovery Channel episodes [because this income is related to National Geographic's exempt purpose] iii. $5,000,000 minus $3,500,000 = $1,500,000 iv. Excess taxable income = (Subsidiary l's taxable income that is not related to National Geographic's exempt purpose) v. Ratio of Subsidiary l's excess taxable income to all of Subsidiary l's income vi. 1,500,000/5,000,000 = 30% vii. Total rents and royalties paid by Subsidiary 1 to National Geographic – $1,000,000 viii. National Geographic's deductible expenses associated with the rents and royalties – None Given ix. Portion of $1,000,000 rents and royalties treated as National Geographic's gross income from an unrelated trade or business x. (30% x 1,000,000) = $300,000 xi. less directly connected deductions – None Given xii. Net rent and royalty income treated as National Geographic's unrelated business taxable income $300,000 xiii. Limitation — Only the amount of the payment in excess of what would be allowed under IRC § 482 is subject to tax. Thus, only the amount of the rents that exceed fair market value are subject to the 20 percent tax. xiv. Subsidiary l's taxable income (disregarding rent and royalties paid to National Geographic) $5,000,000 1. Less Subsidiary l's taxable income from the 5 Discovery Channel episodes [because this income is related to National Geographic's exempt purpose] $3,500,000] 2. Excess taxable income (Subsidiary l's taxable income that is not related to National Geographic's exempt purpose) =$1,500,000 3. Ratio of Subsidiary l's excess taxable income to all of Subsidiary l's income 1,500,000/5,000,000 30% 16 Downloaded From OutlineDepot.com 4. Total rents and royalties paid by Subsidiary 1 to National Geographic $1,000,000 5. National Geographic's deductible expenses associated with rents and royalties= $50,000 6. Portion of National Geographic's $1,000,000 rents and royalties gross income from unrelated trade or business (30% x 1,000,000) = $300,000 7. less directly connected deductions (30% x $50,000) = [$15,000] 8. Net rent and royalty income treated as National Geographic's unrelated business taxable income = $285,000 e. Exempt subsidiary calculation i. Subsidiary l's unrelated taxable income (disregarding rent and royalties paid to National Geographic) $1,000,000 ii. Subsidiary l's total taxable income computed as if Subsidiary 1 were not an exempt organization and disregarding any rents or royalties paid to National Geographic $4,000,000 iii. Ratio of Subsidiary l's unrelated business taxable income to Subsidiary l's total taxable income 1,000,000/4,000,000 = 25% iv. Total rents and royalties paid by Subsidiary 1 to National Geographic $1,000,000 v. National Geographic's total deductions in relation to the rents and royalties National Geographic receives from Subsidiary 1 [$50,000] vi. Total rents and royalties treated as National Geographic's unrelated business taxable income [25% x 1,000,000] $250,000 vii. Less directly connected deductions [25% x 50,000] = [12,500] viii. Net rent and royalty income included in National Geographic's unrelated business income $237,500 VII. Debt-Financed Property a. Definition i. All property held to produce income and with respect to which there is “acquisition indebtedness” at any time during the taxable year (or during the preceding 12 months, if the property is disposed of during the year) ii. Exception 1. Property whose use is substantially related to the exercise or performance of the organization's exempt function; property where all of its income is already subject to tax as income from the conduct of an unrelated trade or business, 2. Property whose income is exclusively derived from research activities excepted from UBIT 17 Downloaded From OutlineDepot.com 3. Property used in a trade or business that is exempted from tax because: a. substantially all the work is performed without compensation, b. the business is carried on primarily for the convenience of members, students, patients, etc., c. or the business is the selling of merchandise, substantially all of which was received as gifts (sec. 513(a)(1), (2), (3)). 4. Income from a debt-financed building that is owned by an exempt organization and used by any related exempt organization, a. is not classified as debt-financed property to the extent it is used by the related exempt organization in the performance of its exempt functions. 5. income from real property, located in the neighborhood of the exempt organization, which it plans to devote to exempt uses within 10 years of the time of acquisition. A more liberal 15–year rule is established for churches and it is not required that the property be in the neighborhood of the church. iii. Acquisition indebtedness 1. IRC § 514(c) defines acquisition indebtedness as indebtedness a. Incurred in acquiring or improving debt financed property IRC § 514(c)(1)(A) b. Incurred before the acquisition or improvement of debt financed property IRC § 514(c)(1)(B), or c. Incurred after the acquisition or improvement of the debt financed property if i. The debt would not have been incurred but for the acquisition or improvement of the debt financed property and the incurrence of the debt was reasonably foreseeable at the time of the acquisition or improvement. IRC § 514(c)(1)(C) 2. Exists whenever the indebtedness was incurred in acquiring or improving the property, 3. Or the indebtedness would not have been incurred "but for" the acquisition or improvement of the property. 4. If debt is incurred after the property is acquired or improved, it is not "acquisition indebtedness" unless its incurrence was reasonably foreseeable at the time of the acquisition or improvement. 18 Downloaded From OutlineDepot.com 5. If property is acquired subject to a mortgage, the mortgage is acquisition indebtedness incurred when the property is acquired. 6. Exception a. Property subject to indebtedness which an exempt organization receives by devise, by bequest, or, under certain conditions, by gift. b. Indebtedness which was necessarily incurred in the performance or exercise of the purpose or function constituting the basis of the organization's exemption c. Property acquired under a life income contract is not debt- financed property if none of the payments received by any life beneficiary are treated for tax purposes as the proceeds of a sale or exchange of part or all of the property transferred to the exempt organization. b. Computation of unrelated debt-financed income i. Apply the fraction below to the total gross income and deductions attributable to debt-financed property : ii. average acquisition indebtedness for the taxable year/ average adjusted basis of the property during the taxable year iii. When debt-financed property is disposed of during the year, "average acquisition indebtedness" is the highest acquisition indebtedness during the preceding 12 months. 1. Without this rule, an exempt organization could avoid tax by using other resources to discharge indebtedness before the end of one taxable year and dispose of property after the beginning of the next taxable year. c. Planning exercise (pg. 839) i. IRC § 511(a) taxes most exempt organizations on their unrelated business taxable income. ii. IRC § 512(b)(3) excludes rents from the definition of unrelated business taxable income. iii. IRC § 514(a) will force an exempt organization to include some rents (or other items of gross income) into the exempt organization's unrelated business taxable income if those rents (or other items of gross income) are derived from debt financed property. iv. IRC § 514(b) defines debt-financed property as "any property which is held to produce income and with respect to which there is an acquisition indebtedness." 19 Downloaded From OutlineDepot.com v. IRC § 514(c)(1)(A) defines acquisition indebtedness as "the indebtedness incurred by the organization in acquiring or improving" debt financed property. d. Neighborhood land rule (§514(b)(3)(A)) i. Real property ii. acquired for the principal purpose of using the land iii. Within 10 years of the date of the exempt organization's acquisition of the land iv. Substantially in the exercise of the organization's exempt purpose v. So long as, at the time of the acquisition of the property by the exempt organization, 1. The acquired property is in the neighborhood of other property already owned by the exempt organization, 2. The other property that is already owned by the exempt organization is used to further the exempt organization's exempt purpose, and 3. The exempt organization does not abandon its intent to use the acquired property in furthering the exempt organization's exempt purpose within a 10-year period vi. Facts needed to make the determination: 1. Is the acquired land is contiguous to other land owned by the tax- exempt organization that is used in the exempt organization's exempt function? 2. That the acquisition of contiguous land was not reasonable under the circumstances and that the acquired land is within a mile of land that the exempt organization uses to further its exempt purpose, or 3. The land is actually used in an exempt purpose within 10 years of the original acquisition. 4. Any structures on the land? Treas. Regs. § 1.514(b)-1(d)(3)(i) VIII. Lobbying a. §501(c)(3): Organized, operated, exclusively, for an exempt purpose, No: Private inurement, substantial lobbying, or intervening in a political campaign b. Definition i. Influence legislation 1. An organization will lose its exemption if it engages in substantial attempts to influence legislation. Treas. Reg. §1.501(c)(3)-1(c)(3) 2. “influence legislation” means either: 20 Downloaded From OutlineDepot.com a. Direct or indirect contacts with legislative officials in order to support or oppose legislation, OR b. Advocating the adoption or rejection of legislation. ii. Exceptions 1. Nonpartisan analysis, study or research; 2. Technical advice or assistance; 3. Self-defense communications; and examinations 4. Discussions of broad social or economic problems do not generally constitute attempts to “influence legislation.” See §4945(e) and Treas. Reg. 53.4945-2(d). iii. §501(h) safe harbor 1. The ultimate consequence of IRC §§ 501(h) and 4911 is that an electing organization will not be subject to the prohibition against substantial lobbying under IRC § 501(c)(3). IRC § 501(h)((1). 2. Instead, an electing organization will be subject to a 25% excise on its "excess lobbying expenditures." IRC § 4911(a)(1). 3. More importantly, an organization's tax exemption may be revoked if: a. its lobbying expenditures normally exceed its lobbying ceiling amount, or b. if its grass roots expenditures normally exceed its grass roots ceiling amount. IRC § 501(h)(1). 4. Basics: a. Under IRC § 501(h) an electing organization is not subject to the prohibition against substantial lobbying contained in IRC § 501(c)(3). b. Instead, an electing organization is subject to a 25% excise tax on its "excess lobbying expenditures" and its exemption will only be revoked if i. its "lobbying expenditures" normally exceed its "lobbying ceiling amount", or if ii. its "grass roots expenditures" normally exceed its "grass roots ceiling amount." c. The 25% excise tax on "excess lobbying expenditures" is imposed by IRC § 4911(a)(1). i. If an electing public charity's lobbying expenditures are within the dollar limits determined by IRC § 4911(c), then the electing charity will not owe any 21 Downloaded From OutlineDepot.com tax under IRC § 4911(a) nor will it lose its tax exempt status as a charity. ii. The potential loss of the tax exemption for normally exceeding the "lobbying ceiling amount" or the "grass roots ceiling amount," is contained in IRC § 501(h). d. The IRC § 501(h) election may only be made by "eligible organizations," which include all public charities except religious organizations and public safety testing organizations, IRC § 501(h)(4). i. Treasury regulation § 1.501(h)-2 lists those public charities that may elect to have their lobbying expenses judged under IRC § 501(h). c. Vocabulary i. Lobbying expenditures – 501(h)(2)(A), 4911(d) Treas. Reg. 56.4911– 2(a)(1) 1. "lobbying expenditure" means "expenditures for the purpose of influencing legislation (as defined in subsection (d)).“ IRC § 4911(c)(1) 2. Under IRC § 4911(d)(1) the term "influencing legislation" is one of either two activities: a. Under IRC § 4911(d)(1)(A) "any attempt to influence legislation through an attempt to affect the opinions of the general public or any segment thereof' is "influencing legislation." i. These are called "grass roots expenditures" under Treas. Reg. § 56.4911-2(a). b. OR Under IRC § 4911(d)(1)(B) "any attempt to influence any legislation through communication with any member or employee of a legislative body, or with any government official or employee who may participate in the formulation of the legislation," is also "influencing legislation." i. These are called "direct lobbying expenditures" under Treas. Reg. § 56.4911-2(a). 3. Expenditure test a. An organization will violate the expenditure test in any taxable year and thus forfeit its tax exemption, if: i. its lobbying/grass roots expenditures for the taxable year and the three immediately past years (the four 22 Downloaded From OutlineDepot.com years are collectively referred to as the "base period") ii. exceed 150% of the total lobbying/grass roots nontaxable amounts for the same time period. b. Thus, the organization must: i. sum up its nontaxable amounts for each year in the base period. ii. then sum up its lobbying and grass roots expenditures for each year of the base period. iii. If the sum of the lobbying or grass roots expenditures exceed 1.5 times the sum of the lobbying or grass roots nontaxable amounts, respectively, the organization will be in violation of the expenditure test. IRC § 501(h)(2); Treas. Reg. 1.501(h)–3(b). 4. Excess lobbying expenditures a. Excess of lobbying expenditures over lobbying nontaxable amount, or b. Excess of grass roots expenditures over grass roots nontaxable amount. IRC § 4911(b); c. The 25% tax is imposed on the greater of the two excesses. Treas. Reg. 56.4911–1. d. "Excess lobbying expenditures" are either: i. The amount by which the organization's "lobbying expenditures" exceed the organization's "lobbying nontaxable amount," Or ii. The amount by which the organization's "grass roots expenditures" exceed the organization's "grass roots non-taxable amount.“ e. “Lobbying nontaxable amount" is dependent on the amount that the organization spends on exempt purposes up to a maximum lobbying nontaxable amount of $1,000,000.00. IRC § 4911(c)(2) ii. Direct lobbying – Treas. Reg. 56.4911–2(b)(1). iii. Grass roots lobbying – IRC § 4911(d)(1)(A). 1. a "grass roots expenditure" is an expenditure for "grass roots lobbying communication" 2. grass roots lobbying communication" is "any attempt to influence any legislation through an attempt to affect the opinions of the 23 Downloaded From OutlineDepot.com general public or any segment thereof“ Treas. Reg. § 56.4911-2(a) and (b)(2), 3. There are 3 required elements to the definition of "grass roots expenditure“ Treas. Reg. § 56.4911- 2(b)(2)(ii) a. The communication: i. Refers to specific legislation as defined in Treas. Reg. § 56.4911-2(d)(1), ii. Reflects a view on such legislation, iii. Encourages the recipient of the communication to take action with respect to the legislation as "encouraging the recipient" is defined in Treas. Reg. § 56.4911-2(b)(2)(iii). iv. Indirect encouragement – Treas. Reg. 56.4911–2(b)(2)(iii)(D). 1. Encouraging a recipient to take action with respect to legislation: a. Include any one of four statements: Treas. Reg. § 56.4911- 2(b)(2)(iii) i. That the recipient should contact a legislator or an employee of a legislative body, or should contact any other government official or employee who may participate in the formulation of legislation; ii. Giving out the address, telephone number, or similar information of a legislator or an employee of a legislative body; iii. Providing a petition, tear-off postcard or similar material for the recipient to communicate with a legislator or an employee of a legislative body, or with any other government official or employee who may participate in the formulation of legislation; iv. Identifying one or more legislators who will vote on the legislation as: opposing the communication's view with respect to the legislation; being undecided with respect to the legislation; being the recipient's representative in the legislature; or being a member of the legislative committee or subcommittee that will consider the legislation. b. 6 Exceptions i. Treas. Reg. § 56.4911-2(b)(5) provides a special rule for certain mass media advertisements 24 Downloaded From OutlineDepot.com ii. Treas. Reg. § 56.4911-5 provides a special rule for communications to members iii. The non-partisan communication exception requires no direct encouragement to action. See Treas. Reg. § 56.4911-2(c)(1)(v). iv. The broad social, economic or "similar" problem exception requires no discussion of the merits of the proposal or encouragement to action. See Treas. Reg. § 56.4911-2(c)(2). v. The technical advice or assistance to a governmental body or committee exception. See Treas. Reg. § 56.4911-2(c)(3). vi. The self-defense exception IRC §4911(d)(2)(C). v. Lobbying nontaxable amount IRC § 4911(c)(2). 1. Example a. This $1,500,000 of annual "exempt purpose expenditures" gives the exempt organization a "lobbying nontaxable amount" of $225,000. i. The organization's annual exempt purposes expenditures are $1,500,000, computed as follows: ii. IRC § 4911 (e)(1)(A) "charitable“ expenditure amount $1,250,000 iii. IRC § 4911 (e)(1)(B)(ii) "influencing legislation" amount $250,000 iv. Total $1,500,000 b. The calculation is: $175,000 plus 10 % of the excess of the exempt purpose expenditures over $1,000,000 (that is 10% of $500,000) for a total of $225,000. IRC § 4911 (c)(2) vi. Grass roots nontaxable amount § 4911(c)(4). vii. Exempt purpose expenditures Treas. Reg. 56.4911–4(b) viii. Membership communications ix. Indirect lobbying expenditures, Treas. Reg. 56.4911–3(c)(3)(ii). x. Communications specifically excluded from the definition of lobbying 1. Nonpartisan analysis, study, or research 4911 (d)(2)(A); Treas. Reg. 56.4911–2(c)(1)(ii). 2. Discussion of broad social problems 56.4911–2(c)(2). 3. Technical advice Treas. Reg. 56.4911–2(c)(3). 4. Self-defense 4911(d)(2)(C). IX. Last Things 25 Downloaded From OutlineDepot.com a. Organized, operated, exclusively, for an exempt purpose, No: Private inurement, substantial lobbying, or intervening in a political campaign b. NOT: Illegality (drugs, homosexuality) c. Exempt purposes i. religious, ii. charitable, iii. scientific, iv. testing for public safety, v. literary, vi. educational, vii. national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), viii. the prevention of cruelty to children or animals, d. Other exempt organizations i. Social welfare 501(c)(4) ii. Labor, agricultural, or horticultural organizations 501(c)(5) iii. Business leagues 501(c)(6) iv. Social clubs 501(c)(7) 26
"Tax Exempt Organizations Outline"