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By Abigail Rosen, Esq. Winstead PC Houston, Texas
At one point or another, almost every tax-exempt organization will question whether its trade or business activities trigger the imposition of unrelated business income tax (UBIT) under §511. What happens, however, when an exempt organization is the beneficiary of trade or business income, but the organization did not originally engage in the activity that created the income? Is the income subject to UBIT? What if the organization sells real property it receives as a bequest; is the income from the sale subject to UBIT? The IRS provided answers to all these questions in PLR 201630009.
Decedent's will left a bequest to a §501(c)(3) tax-exempt organization, Foundation. Foundation was classified as a private foundation under §509(a) and its exempt purpose was to administer investments, receive funds, and distribute funds to other qualified §501(c)(3) organizations. Decedent's will provided a bequest to Foundation of all of Decedent's commercial real estate properties, free of any debt. The real estate properties were primarily office rental properties and of the rent received, at least 95% of the rent was for use of the office rental properties. The remaining rent was attributable to personal property leased with the real property and was an incidental amount of the total rents received.
Foundation, funded solely by Decedent, intended to hold the bequeathed commercial real estate properties as part of its investment portfolio, which up to the point of Decedent's death contained only marketable securities and cash. Foundation intended to form a new single-member limited liability company, which would be a disregarded entity, to manage the commercial real estate properties. Foundation anticipated that it eventually would sell certain commercial real estate properties, but Foundation's Board of Directors would need to approve any sales first, and Foundation indicated that such sales would occur on a sporadic basis based on Foundation's needs from time to time and the Board's diversification duties. Foundation indicated that it might make capital improvements to the property as needed, but that the properties would not be held for the primary purpose of improving them for purpose of resale.
The IRS concluded that both the rental income from the commercial real estate properties and any income received from the sale of such properties are properly excludable from UBIT. Regarding rental income, Reg. §1.512(b)-1(c)(2)(ii)(b) excludes from UBIT rents from personal property that are leased with commercial property, if the rents attributable to the personal property are incidental to the total amounts of rent received. Generally, rents exceeding 10% of the total rent are not considered incidental. In addition, Reg. §1.512(b)-1(c)(5) notes that payments are for the use of space and are not considered rent payments for real property if services are rendered. Therefore, in the case of this taxpayer, rental income will be excluded from unrelated business taxable income if (1) Foundation does not provide any services to the lessees; (2) the rent that Foundation receives for personal property is incidental to the total amounts of rent received for the commercial real estate properties; and (3) the rent paid does not depend, in whole or part, on the income derived by any person from the property leased.
As it relates to the sale of the commercial real estate properties, §512(b)(5) excludes from the computation of UBIT gains from the sale or other disposition of property other than “property of a kind which would properly be includible in inventory if on hand at the close of the taxable year, or property held primarily for sale to customers in the ordinary course of the trade or business.” Following the Supreme Court's standard for what “primarily” means in the context of sales in the ordinary course of a trade or business, the IRS ruled that the sales would need to be one of the Foundation's primary purposes in order for the income from the commercial real estate sales to be subject to UBIT.
Because sales were not Foundation's primary purpose and Foundation held the commercial real estate properties as income-producing properties and not inventory used in a trade or business, the IRS ruled that the income from a sale of such property would not be subject to UBIT.
Similarly, in PLR 201626004, a decedent bequeathed his interest in all of his law firm's accounts receivable to a qualified §501(c)(3) private foundation. The question presented to the IRS in that PLR was whether the foundation's receipt of income in satisfaction of the receivables would constitute unrelated business income subject to UBIT. The IRS held that the income from the receivables would not be unrelated business income, because the foundation was not engaged in a trade or business involving receivables, and it did not itself conduct any activities related to the generation of the income from the receivable.
These rulings may provide some comfort to planners with clients holding business assets destined for private foundations. However, PLRs are only guidelines and cannot be cited as precedent; therefore, planners should use caution when creating estate plans that have a charitable bequest of business assets. If the property or income stream bequeathed is not substantially related to the exempt organization's purpose, then the income from that property (and the income from the sale of the property) could be subject to UBIT rules.
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