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

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.

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

Disclaimer

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Views expressed in this presentation are not necessarily those of Ernst & Young LLP.


Presenters

► Justin Anderson ► Tery Kennedy
Allegiance Health Ernst & Young LLP
Jackson, MI Cleveland, OH
+1 216 583 1504
► Diane Bean tery.kennedy@ey.com
Ernst & Young LLP
Columbus, OH ► Michael Vecchioni
+1 614 232 7136 Ernst & Young LLP
diane.bean@ey.com Detroit, MI
+1 313 628 7455
michael.vecchioni@ey.com


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.”


(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.”


(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.


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


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)

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.”


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.


involving UBTI

► 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.


involving UBTI

► 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.


involving UBTI

► 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

involving UBTI

► 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.

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.


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

within the industry

► Alternative investments
► UBI sourced from private equity, fund of funds, multi-tiered
partnerships, foreign activity, etc.
► Pension plans
► Separate reporting requirements


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


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


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.


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.


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?


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


within the industry — expense allocations

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


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


within the industry — loss activities

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


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


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