UBIT update: the non-profit guide to unrelated business income

22nd Annual Health Sciences Tax Conference

UBI update: the nonprofit guide to unrelated business income December 3, 2012

UBI update: the nonprofit guide to unrelated business income Page 2

Disclaimer

► Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.


Disclaimer

Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. For more information about our organization, please visit www.ey.com. This presentation is © 2012 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party. Views expressed in this presentation are not necessarily those of Ernst & Young LLP.


Presenters

► Justin Anderson Allegiance Health Jackson, MI

► Diane Bean Ernst & Young LLP

Columbus, OH +1 614 232 7136 [email protected]

► Tery Kennedy Ernst & Young LLP Cleveland, OH +1 216 583 1504 [email protected]

► Michael Vecchioni Ernst & Young LLP Detroit, MI +1 313 628 7455 [email protected]

Legislative and regulatory activity and unrelated business income (UBI)


Legislative and regulatory activity and UBI — IRS focus

FY12 Internal Revenue Service (IRS) Exempt Organizations (EO) Work Plan:

“In FY 2012, EO will be looking at organizations that report unrelated business activities on Form 990 but have not filed a 990-T. In addition, we will analyze Form 990-T data to develop risk models that will help us identify organizations that consistently report significant gross receipts from unrelated business activities but declare no tax due. EO will use this work in connection with a coming UBIT project.”


Legislative and regulatory activity and UBI

► The Subcommittee on Oversight of the Committee on Ways and Means has been holding a series of hearings on tax-exempt organizations.

► In announcing the July hearing, Chairman Boustany said, “Given the size and scale of the operations of public charities, which in

2008 had over $2.5 trillion in assets, it is critical that the Subcommittee continue its review of the tax-exempt sector. Indeed, over the last two decades, the organizational structures of public charities have become increasingly complex, creating compliance and transparency issues. This hearing is an excellent opportunity for the Subcommittee to hear from the IRS and experts in the tax-exempt community. Their insight will allow the Subcommittee to better understand what is driving organizational complexity, and to learn about the new compliance efforts by the IRS and the UBIT rules.”


Legislative and regulatory activity and UBI (cont.)

► Steven T. Miller, IRS Deputy Commissioner for Services and Enforcement, stated that “the third, or ‘relatedness,’ prong of the definition of unrelated business income — that the activity is not ‘substantially related’ to the organization’s charitable mission — has proved the most challenging to regulate.”

► He noted that there is difficulty in identifying what types of expenses could offset unrelated income because the IRS lacks clear guidance in that area.

► When asked if Congress could help the IRS clarify these areas, his response was “not really.”


Legislative and regulatory activity and UBI (cont.)

► Mr. Miller also noted that further guidance or initiatives in these areas is not impending due to limited resources.

► Ranking member Rep. John Lewis (D-GA) said as Congress moves toward tax reform, it should consider whether the rules for charities are working as intended.

► Several witnesses provided insight into whether the rules should be revamped for determining UBI, including suggesting a move toward a “commerciality” test.


Legislative and regulatory activity and UBI — increased state scrutiny

► Currently, 45 states have some form of state income taxation of unrelated business income ► Separate filing requirements ► Estimated payment considerations

► Nexus provisions being applied ► Economic nexus ► Online sales tax compact


Legislative and regulatory activity and UBI — increased state scrutiny (cont.)

► Referral programs ► The IRS is increasing disclosures to state agencies

► Exemption revocations and denials ► Excise tax exam results ► Terminations

► Referrals go both ways ► States referring their findings to the IRS

► Change in nonprofit status

Update on recent court and/or IRS decisions involving unrelated business taxable income (UBTI)

PLR 201128028


Update on recent court and/or IRS decisions involving UBTI

► The parent of a large US health care system created a US nonprofit membership corporation (“A”) for the purpose of performing certain health care-related services in several foreign countries.

► “A” stated that it “will enter into affiliation agreements to provide consulting services, materials and limited licenses to health care facilities ... throughout the world.”

► “A” claimed that its consulting services provided expedient step-by-step processes to create a foundation for efficient, quality-driven health care.”


Update on recent court and/or IRS decisions involving UBTI (cont.)

► The consulting services covered a range of vital areas: ► Organization and leadership ► Patient care and quality measures ► Nursing staff ► Support services ► Finance and accounting ► Medical staff organization ► Information technology



► The IRS considered three representative agreements ► Short-Term Consulting Services Agreement ► Two-Year Consulting Services Agreement ► Ten-Year Management and Development Agreement



► The IRS characterized the services provided by “A” as “providing management, advisory and consulting services.”

► Based on this characterization, the IRS concluded that the organization did not qualify for exemption under Internal Revenue Code (IRC) § 501(c)(3) because these services, although they involved health care and education, did not promote health for charitable purposes or further education within the meaning of IRC § 501(c)(3).



► The IRS also concluded that: ► These activities were not inherently charitable or educational, but

instead constituted activities that further a substantial non-exempt purpose.

► Although the educational activities may incidentally benefit the community, this was insufficient to enable the organization to qualify for exemption under IRC §501(c)(3).



► While this letter ruling dealt with an exemption issue, the ruling also stands for the IRS’ position on the relatedness of the particular type of consulting activities as conducted by a tax-exempt health care organization.

► It is possible that by properly arranging and structuring the provision of health care-related services and educational services for foreign hospitals, governments or health care entities, similar services should not be treated as an unrelated trade or business.

PLR 201222040



► The IRS ruled that contributions or sharing of assets, personnel, facilities and services between a supporting organization (“B”) and its supported organizations did not give rise to unrelated business income because the transactions are related to the organizations’ exempt purpose of meeting the special needs of the elderly.

► This ruling is consistent with earlier rulings issued by the IRS on system-based intercompany transactions. ► See: e.g., PLR 9817034 and PLR 9819046.



► “B” is the sole member/parent of a system of retirement communities providing oversight, supervision, management and strategic planning for the system.

► “B” is exempt under IRC § 501(c)(3) and is classified as an IRC § 509(a)(3) supporting organization.

► The supported organizations each operate a retirement community that provides housing, health care and other services to serve the special needs of the aged within the meaning of IRC § 501(c)(3).

► The supported organizations are exempt under IRC § 501(c)(3) and their non-private foundation classification is under IRC § 509(a)(1).



► “B” developed policies for standards of care and operation for the supported organizations.

► “B” carries out various executive, administrative, financial, policy-setting, planning and other functions of the supported organizations; coordinates activities by or among them and supervises overall policy and planning.

► “B” stated that each supported organization benefited by its performance of the functions that each supported organization would otherwise be required to perform.



► Each of the supported organizations transferred a pro rata amount of funds to “B” to fund its start-up and initial working capital requirements. They will continue to regularly make contributions to support the operations of “B.”

► Additional sharing of funds, assets, services and personnel throughout the system will likely be needed in the future on a case-by-case basis to support the exempt purposes of any supported organization or the system.

► This may be done through formal contracts or other less formal arrangements, gratuitous transfers, sales, leases or charges for services, to ensure that each entity is fully capable of fulfilling its respective exempt purpose.



► The IRS ruled that “B” and its supported organizations collectively function to meet the housing, health and financial needs of elderly persons, a charitable purpose within the meaning of IRC § 501(c)(3).

► Citing Rev. Rul. 78-41, reflecting the “integral part” test, the IRS said that “B” was enhancing the supported organizations’ ability to serve the special needs of the aged in the community by providing overall policy and planning guidance, coordinating activities among the communities and assuming various functions that they would otherwise conduct.

► The activities of “B” relieved each entity of administrative and other burdens, allowing them to focus on providing housing, health care and services for their residents.



► The IRS ruled the activities were related to “B”’s and the supported organizations’ exempt purposes because the transfers of cash, assets and personnel, and the sharing of personnel, services, facilities and expenses permit all of the entities to more efficiently carry out their respective tax-exempt operations. ► Transfers that are related to an exempt purpose do not result in

unrelated business activity. ► Citing Rev. Rul. 77-72, the IRS said that transfers

between closely related exempt organizations for their exempt purposes are regarded as matters of accounting. ► Such transfers are generally not trades or businesses regularly

carried on for the production of income and do not give rise to unrelated business taxable income.

PLR 201215019



► The IRS denied exempt status under IRC § 501(c)(4) to an organization (“C”) that was formed to provide fertility medication to individuals, because the organization’s activities were the same as the activities of a commercial pharmacy.

► This ruling, while dealing with an exemption request under IRC § 501(c)(4), reflects the IRS’ view of how the commercialism of an activity affects its “relatedness.”



► “C” was formed to operate a pharmacy on a nonprofit basis to serve the economically disadvantaged and their families. It intended to: ► Purchase medicine directly from manufacturers and sell at slightly

above cost to those individuals who are needy and cannot afford to pay market costs of medications and are unqualified to obtain either private or governmental insurance for drugs

► Solicit donations for the purpose of dispensing medications at no cost to the uninsured recipient individual who cannot afford to pay for such medications



► “C” sold the drugs at cost to uninsured customers. ► For insured customers, “C” sold the drugs at the amount

the applicable insurer would reimburse and it waived the co-payment for the customer.

► For needy clients, “C” waived all charges for fertility drugs. ► “C” did not collect actual financial information from individuals to

verify their financial situation, nor did it define “poor.”



► The IRS focused on the considerable overlap between IRC § 501(c)(4) and § 501(c)(3), stating that many organizations could qualify for exempt status under either IRC section.

► Unlike IRC § 501(c)(3), which includes both an organizational test and operational test, IRC § 501(c)(4) has only an operational test.



► Under Section 501(c)(4), the promotion of social welfare includes being primarily engaged in promoting the common good and general welfare of the people of the community.

► Social welfare organizations are not precluded from engaging in business activities as a means of financing their social welfare programs; however: ► The Treasury Regulations state that an organization is not

operated primarily for the promotion of social welfare if its primary activity is carrying on a business with the general public in a manner similar to organizations which are operated for profit.



► The IRS ruled that the primary activity of “C” is the provision of fertility medication in a commercial manner. This type of pharmaceutical business activity is commonly conducted to produce a profit. ► Citing several Tax Court decisions, the IRS further stated that even

though there was some consideration given to a client’s ability to pay, charging a sufficient fee which would enable “C” to recover its costs plus a small profit is akin to being engaged in a business normally pursued by commercial enterprises and appeared to be in competition with them, which is “strong evidence of the predominance of nonexempt commercial purposes.”



► Other than giving away a certain percentage of its medication, “C” did not sell the medication below cost.

► Although “C” waived the co-pay, it charged the individual’s insurance the amount they were willing to pay for the fertility medication, which is above cost.

► The distribution of free drugs to a few customers was financed by selling drugs to other customers at above “C”’s cost.



► Citing the Tax Court decision in B.S.W. Group, Inc. v. Commissioner, one of the factors in determining whether an organization is operated for a non-exempt purpose is the existence and amount of annual or accumulated profits.

► “C” continually operated with excess revenues over expenses, which is typical of a commercial business.



► The Tax Court has stated that it does not believe that the law requires any organization whose purpose is to benefit health, however remotely, is automatically entitled, without more, to the desired exemption.

► Sales of prescription drugs to the elderly and the handicapped even at a discount is not, without more, in furtherance of a charitable purpose. In the same manner, the provision of fertility medication is a commercial business. Although it is beneficial to some individuals, and often at a discount, it is not an exempt function.



► In refuting the argument of “C” that the IRS was imposing a more stringent exemption requirement on it than applied to hospitals, the IRS said: ► “Unlike the hospitals described in Rev. Rul. 69-545, you are not

providing a benefit to the community that promotes the general health and welfare of the public. Although exempt hospitals are only required to provide a “minimal amount” of charity care, they also promote community health.”

► “C”’s only activity is the operation of a commercial pharmacy, not a hospital. Since its primary activity is carrying on a business by operating a pharmacy in a manner similar to organizations operated for profit, “C” was not operated primarily for promotion of social welfare.

PLR 201206018



► Debt-financed land purchased by a church for the construction of a new campus will be exempt from debt-financed property unrelated business income provisions because it is reasonably certain the property will be used for an exempt purpose within 15 years of its acquisition.



► Slightly more than half of the site was to be developed. ► The remainder of the acreage was to be maintained in its

undeveloped state as a part of the church campus. ► The undeveloped land was being leased at no cost for

livestock grazing, which retains the pastoral setting. ► The leases weren’t structured to produce income, but to exempt

unimproved portions of the campus from real property taxes. ► This is a common practice in the state because local property tax

laws do not exempt from property taxes any portion of a church campus that has not been physically improved.



► In general, any income derived from rents or royalties from debt-financed property, as defined by IRC § 514, would be treated as unrelated business taxable income.

► However, IRC § 514(b)(3) provides certain exceptions to the general rule: ► When land is acquired for exempt use within 10 years (extended to

15 years for churches), it is not treated as unrelated business taxable income.

► This exception is commonly referred to as the “neighborhood land rule.”



► IRS — while the property allows room for future growth, the church campus was substantially complete and converted to exempt-use within 15 years of the land acquisition.

► Thus, the property is not treated as debt-financed land because it qualifies for the exception under the neighborhood land special rule for churches. ► Any rents or royalties received during the 15-year time period

would not be treated as unrelated business taxable income.

PLR 201208038 and PLR 201223021



► In two similar rulings, the IRS ruled that the issuance of units in an exempt organization’s endowment fund to a charitable remainder unitrust, making endowment fund payments to the trust, receiving endowment fund payments by the trust, and holding or redeeming units in the endowment fund by the trust, will not generate unrelated business taxable income to either the trust or trustee.



► A tax-exempt organization owned a widely diversified endowment fund that invested in broad classes of assets.

► Most of the income earned by the endowment fund consists of passive income such as interest, dividend and capital gains income, but some income may be debt-financed or otherwise treated as unrelated business taxable income.



► The tax-exempt organization (Trustee) unitized the endowment fund so that the value of a unit could be determined at any given time equal to the net value of the endowment fund divided by the number of units outstanding at such time.

► The trust contracted with the Trustee and was assigned units in the endowment fund in exchange for its assets.

► The number of units assigned was based upon the value of a unit at the time the assets are conveyed.

► The endowment fund was valued, and the trust was permitted to acquire units in the endowment fund, monthly.



► The Trustee did not charge a fee for the investment services, and therefore did not generate UBI.

► The investment units are an investment activity, and the income is income from ordinary and routine investments of the type that is excludable from unrelated business taxable income.

► Neither the payments nor the holding or redemption of the units are unrelated business taxable income to the trust.

► Even though some of the endowment’s other investments might generate unrelated business taxable income, none of that would be attributed to the Trust.



► The endowment fund would pay any tax owed on the UBI earned by the endowment.

► The commingling of assets in the endowment for investment purposes is not characterized as a partnership for federal income tax purposes.

► The unit is a capital asset and IRC § 1234A applies to treat gain or loss from the cancellation, lapse, expiration or other termination of a unit as short-term or long-term capital gain or loss to the trust, depending on the holding period of the unit.

Florida Independent Colleges and Universities Risk Management Association, Inc. v. IRS et al.


Update on recent court and/or IRS decisions involving UBTI — court rulings

► The case dealt with IRC § 501(m), which denies exempt status to organizations if a substantial part of their activities consists of providing commercial-type insurance.

► Under IRC § 501(m)(2)(A), the activity of providing commercial-type insurance is treated as an unrelated trade or business.


Update on recent court and/or IRS decisions involving UBTI — court rulings (cont.)

► The organization was formed by a group of tax-exempt secondary schools and universities in Florida to purchase group insurance policies for their benefit and self-insured a certain amount of risk.

► Member contributions were set in accordance with each member’s specific risk profile, and contributions exactly covered the costs of the policies, the self-insured retainer and administration.



► Of the funds solicited from members, 81% went to the purchase of group policies from commercial insurance companies, and 19% was retained for the self-insured portion.

► The court upheld the IRS position that a risk pool was substantially engaged in providing commercial-type insurance and was precluded from exempt status.



► The court applied the logic of the Tax Court in Paratransit Ins. Corp. v. Commissioner, holding that: ► The risk of potential tort liability was shifted from each of the

individual insured organizations to the pool. ► This was a type of insurance offered by commercial carriers. ► The term “commercial-type insurance” in IRC § 501(m)

“encompasses every type of insurance that can be purchased in the commercial market.” ► It is irrelevant that it is not provided to the general public.

► By self-insuring to a certain extent and arranging for group policies for excess risk, the organization was “providing” insurance to its members.

► IRC § 501(n) provides the sole method through which a risk pool such as the organizations in question can gain tax-exempt status.

Income and expense classification trends within the industry


Income and expense classification trends within the industry

► Alternative investments ► UBI sourced from private equity, fund of funds, multi-tiered

partnerships, foreign activity, etc.

► Pension plans ► Separate reporting requirements


Income and expense classification trends within the industry — transfer pricing

► Transfer pricing refers to the pricing of transactions between related parties for: ► Tangible property ► Services ► Intangible property ► Rents ► Loans

► It is important for the proper calculation of taxable income resulting from an unrelated trade or business activity with a related party.


Income and expense classification trends within the industry — what is transfer pricing?

► Types of inter-company transactions between tax-exempt and taxable affiliates: ► Tangible goods (examples):

► Tax-exempt parent hospital sells or leases equipment or real property to its taxable subsidiary

► Tax-exempt parent hospital purchases supplies from its taxable subsidiary

► Intangible assets (examples): ► Tax-exempt hospital licenses its trade name to its taxable subsidiary ► Tax-exempt hospital licenses technology, patents, trademarks and

routine know-how to its taxable subsidiary ► Transfer of intangible property from tax-exempt to new

taxable subsidiary


Income and expense classification trends within the industry — what is transfer pricing? (cont.)

► Types of inter-company transactions (cont.) ► Financial transactions (examples):

► Tax-exempt parent lends funds to its taxable subsidiary ► Terms of payment implicit in inter-company accounts

payable/receivable ► Tax-exempt parent provides guarantees to its taxable subsidiary ► Taxable subsidiary sells its receivables to its tax-exempt parent

► Services (examples): ► Tax-exempt parent provides support or services to, or receives such

support from, its taxable subsidiary, such as: ► Executive, managerial, IT, accounting, staffing, HR, payroll services, legal,

tax, insurance, training, marketing, sales, R&D and other support ► Corporate overhead allocations


Income and expense classification trends within the industry — what is transfer pricing? (cont.)

► Why is the government interested? ► The related-party aspect of the transactions suspends the normal

laws of supply and demand. ► Without IRC § 482 and similar statutes in states and other

countries, related parties could artificially shift income to achieve tax benefits.

► In a tax-exempt setting, this shift could result in transactions escaping taxation as unrelated business income or regular tax through unrecognized income or unwarranted deductions.


Income and expense classification trends within the industry — conceptual framework

► The arm’s-length standard encompasses the following: ► An inter-company transaction is arm’s length if the results are the

same as results realized by uncontrolled taxpayers engaged in the same transaction under the same circumstances.

► Identical uncontrolled transactions are generally not available — it is appropriate to consider comparable uncontrolled transactions.

► Analysis of independent, uncontrolled comparable transactions is at the center of all transfer pricing analysis.

► The arm’s-length standard is the fundamental basis of worldwide transfer pricing regulations.


Income and expense classification trends within the industry — acquisition indebtedness

► Scope of Section 514 tracing principles ► Debt is acquired at the same time as the property (mortgage) ► But-for tests

► Pre-acquisition indebtedness ► Post-acquisition indebtedness

► Funding operations ► Issue: cash borrowed for operations/grant-making while exempt

organization buys and sells endowment fund assets ► Cross-tracing?


Income and expense classification trends within the industry — accounting methods

► A change in accounting method may need to be communicated to and approved by the IRS. ► Automatic change procedures ► Advance consent request procedures ► Form 3115


Income and expense classification trends within the industry — expense allocations

► IRS exam activity ► Agents are requesting substantiation ► Allocation based on assets vs accounts ► Bonus depreciation


Income and expense classification trends within the industry — expense allocations

► Historical thinking ► Gross-to-gross method ► IRS — need something stronger

► Hybrid methods ► Allocation based on square footage ► Time studies

► 501(c)(7) organizations — weighted-average number of days


Income and expense classification trends within the industry — loss activities

► Unrelated activities that result in a loss offsetting profitable activities ► IRS exam risk ► Profit motive


Income and expense classification trends within the industry — best practices

► Best practices for managing UBIT reporting: ► Assign an individual with overall responsibility ► Create a communication plan with representatives from other

departments of the organization — legal, finance, treasury, sponsorships (who is in charge of that? Like soft drink exclusive- provider arrangements)

► Conduct an internal document search for potential new UBI activities — board minutes, website, alternative investments

► Coordinate with other reporting entities important matters such as tax-bracket allocations

Questions or comments?

UBIT update: the non-profit guide to unrelated business income

Economy & Finance

unrelated income

young llpcolumbus

disclaimerernst young

ubi increased state

us tax advice

tax reform

irs deputy commissioner

violation of us