There are a myriad of ways an otherwise tax-exempt entity might earn income that becomes taxable as unrelated business taxable income or “UBTI”. Investments in partnerships that produce income that is unrelated to the tax-exempt entity’s primary purpose is one of those ways.
While the burden of reporting UBTI to the IRS rests on the tax-exempt entity, they still rely on the partnerships in which they are invested to provide the proper information so they can accurately report and pay their unrelated business income tax (“UBIT”).
Therefore, it is important for a partnership to understand what information they need to track and analyze in order to provide helpful footnotes to their tax-exempt partners. Certain accounting methods may apply at the partnership level, and footnote requirements may be extensive.
What is UBTI/UBIT?
For a partnership to determine what information must be provided to a tax-exempt partner, it is important to understand what most tax-exempt partners need to pay tax on. Unrelated Business Taxable Income or Unrelated Business Income Tax are often used interchangeably. In general, under IRC 512 (a)(3)(A), it is the gross income, less deductions allowed, that are received or earned from a business that is unrelated to the primary purpose of the tax-exempt entity, and the tax on that unrelated income. These amounts are taxed at a flat 21% (beginning after 1/1/2018). Certain items considered passive in nature are excluded from the definition above under IRC 512(b): “dividends, interest, payments with respect to securities loans, amounts received or accrued as consideration for entering into agreements to make loans, …royalties, …rents from real property [subject to limitations described below], gains or losses from the sale, exchange, or other disposition of property other than stock in trade…which would be includible in inventory…or property held primarily for sale…in the ordinary course of the trade or business, …and all deductions directly connected with such income.”
Income Producing Property and Tax-Exempt Partners
In addition to dividends and interest noted above, rental real estate investments are generally a great way for tax-exempt entities to earn money that is outside of their primary purpose without triggering UBTI. With efficient ways of earning income for non-tax-paying entities comes tax laws created to narrow those opportunities. Real estate investments are often held in partnerships, so it makes sense that these rules often go hand in hand.
ADS Recovery Periods
Internal Revenue Code (“IRC”) Section 168(g)(1) requires that any tax-exempt use property’s depreciation deduction amount is determined using the Alternative Depreciation System, or ADS, which uses generally longer class lives and the straight line method for determining the annual depreciation deduction. Section 168(h) defines the meaning of tax-exempt use property as is either leased or owned, directly or indirectly, by a tax-exempt entity through a partnership or tiered structure. So, although this rule applies to tax-exempt partners, it is the partnerships responsibility to calculate and report depreciation expense using ADS lives. It should be noted, that generally, to the extent there are both tax-exempt and non-tax-exempt owners of a partnership, each asset can be depreciated using both the ADS and GDS lives in the same proportionate percentage of tax-exempt ownership to non-tax-exempt ownership. A partnership can also elect on behalf of all of its owners to use the ADS system for ease of administrative burden by completing line 20 in Part III of Form 4562. There are several sections of the code that allow for additional accelerated depreciation, such as 179 expensing, but these sections generally do not apply to assets (or portions of assets) using ADS. The rules regarding IRC 168 are complex and should be reviewed with your tax advisor.
Debt-Financed Income and Debt-Financed Property
As noted above, rents from real property are usually a source of income that is an exception to UBTI. However, if it is considered debt-financed property, or a portion thereof, it no longer falls under this exception. Debt-financed property is defined as any property that is held to produce income and there is acquisition indebtedness on the property at any time during the previous 12 months. Acquisition indebtedness is defined as the indebtedness incurred by the organization either before, after, or during the acquisition of the property, or to improve the property, if that indebtedness would not have been incurred were it not for the acquisition or improvement of the property (with exceptions to property received via bequest).
Average acquisition indebtedness is the average amount of indebtedness taken on the first of the month throughout the taxable year, or the previous 12 months if disposed of. The ratio of average acquisition indebtedness (or highest acquisition indebtedness in the 12 months prior to disposition) to the tax adjusted basis (using ADS) of such property at the end of the taxable year is the percentage of net rental income to total taxable income that is subject to UBIT for most tax exempt partners.
Reg. 1.514(c)-1(a)(2) describes an example where a tax-exempt partner invested its own funds as well as borrowed funds in a partnership. The partnership purchased a building and used a mortgage to leverage the purchase. The tax-exempt partner must calculate its acquisition indebtedness taking into consideration both the borrowed funds used to invest in the partnership as well as the borrowed funds used to purchase the income-producing building.
514(c) (9) Exemption—Qualified vs. Non-Qualified Organizations and The Fractions Rule
Tax exempt partners can be further broken down into qualified or non-qualified organizations under IRC Section 514(c)(9)(C). This section references several other code sections, but the list generally describes tax-exempt organizations that are educational organizations (and certain affiliates), pension trusts, tax-exempt title-holding corporations, and retirement income accounts as being “qualified organizations” or “QOs”. These QOs may be exempt from the inclusion of UBTI from debt-financed property if they adhere to the various exceptions listed Section 514(c)(9)(B). Within this section is what is known as the “partnership limitation”, which precludes QOs from being exempt from recognizing UBTI on debt-financed income from property held in partnerships.
If a QO holds debt-financed property through a partnership, and that partnership does not meet any of the other exceptions in 514(c)(9)(B), they must then fall into one of three categories, before they can finally claim non-recognition. Either all of the partners in the partnership must be QOs (unlikely), each allocation to a partner must be a fixed and unchanging share of every item in the partnership within the meaning on 168(h)(6) (also unlikely), or they must comply with the “Fractions Rule”. Since the first two categories are often hard to achieve, most partnerships and QO partners attempt to satisfy the last category.
Yes, partners and partnerships alike have to jump through that many hoops before they can even get to the fractions rule. The fractions rule under Section 514(c)(9)(E)(i) applies to the QO partners, however, it is satisfied at the partnership level, so every partnership must understand how to adhere to these rules on behalf of their investors. The fractions rule says qualified organizations do not have to recognize UBTI on debt financed property, if the partnership can follow two rules: “1) the allocation of items to any partner which is a qualifying organization cannot result in such partner having a share of the overall partnership income for any taxable year greater than such partner’s share of the overall partnership loss for the taxable year...and 2) each allocation with respect to the partnership has substantial economic effect within the meaning of Section 704(b)(2).” The intention is to make sure taxable income isn’t improperly allocated to tax-exempt entities and tax losses allocated to tax-paying entities, and that all allocations are consistent with the underlying economic arrangements of the partnership. I know that all sounded so simple in theory, but it is actually quite complex in application.
The IRS issued proposed regulations and actually slightly relaxed the fractions rule in November of 2016. The proposed regs cover eight aspects of the of the fractions rule that are now generally allowed and will no longer jeopardize the partnership’s compliance with the fractions rule: 1) preferred returns; 2) partner-specific expenditures and management fees; 3) unlikely losses; 4) chargebacks of partner-specific expenditures and unlikely losses; 5) acquisitions of partnership interests after initial formation of the partnership; 6) capital commitment defaults or reductions; 7) applying the fractions rule to tiered partnerships; and 8) de minimus exceptions to the fractions rule.
Reporting UBTI to Tax-Exempt Investors
Unrelated business taxable income is required to be reported on Line 20 code V of the Schedule K-1. However, there is little guidance on how to present this information to partners. UBTI is often reported as either a percentage of total taxable income reported by the partnership, or as an actual allocable amount in the footnotes to the Schedule K-1. Schedule K-1 line by line UBTI percentages or amounts are preferable in a tiered structure, as UBTI may be generated at each level from debt financing. If the partnership does not know if their tax-exempt partner is a qualified or a non-qualified tax exempt entity as described by IRC 514(c)(9)(C), it may be easier to track and provide both amounts for their investors in a matrix format assuming they are in compliance with the fractions rule. Tax-exempt partners will also need to layer in their own UBTI if they used borrowed funds to acquire their interest in the partnership.
The Best Interests of Everyone
A partnership is required to understand its investor base as it may govern how they depreciate property or how they allocate income. The partnership agreement may require the partnership remain fractions rule compliant and that all allocations have substantial economic effect.
However, understanding these rules and being able to provide meaningful footnotes to tax exempt entities can substantially widen the base of investors a partnership can attract. As tax-exempt entities continue to seek out ways to raise their own funds for their not-for-profit purposes, partnerships can use their knowledge on UBTI requirements to attract tax-exempts such as educational institutions and pension funds to raise capital for themselves. Everyone wins.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.