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Foreign. Hello and welcome to the 48th episode of How Tax Works. I'm Matt Foreman. In this episode, I'm going to talk about unrelated business taxable income, or as it's known by its acronym, ubti. How Tax Works is meant for informational and entertainment purposes only. This may be advertising and it is certainly not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law. Regulations, case law and guidance demystify how taxes shape the financial and business decisions we all make before we get started. New episodes every two weeks. In two weeks, I'm going to talk about what is a hobby and what is a business under the hobby loss rules under section 183. If you have any questions, comments or constructive criticism can email me my FRB email address you can find via your favorite search engine. Upcoming webinars you can honestly, if you just connect me on LinkedIn, I post every, I probably post once a week, maybe more. I don't know about things. I write podcast webinars, stuff like that. And I often have free passes to the webinars. So if you like, you know, need cle, cpe, CE, or cfpce, we can, you know, I can hook that up. I'll give you free passes. I tend to have them, so ask me. Anyway, so we're talking about ubti. So what is ubti, right? What is unrelated business taxable income? And what it is, is income from conducting an active business that is unrelated to the basis for the exemption from tax. So I think for a UBTI purposes, it's important to give a little bit of history, perhaps in conjecture, perhaps some speculation involved, but history, right? So there's a big case involving NYU Law, which owned a pasta factory, Mueller Pasta. And what it was, was basically look like at the time a nonprofit could just own an active business and paid no income tax, right? On its profit. And it was viewed as an unfair advantage to businesses to that business, right? Because there's no income tax. So if you need, you know, 20% post tax profit margin, but you're not paying taxes, right? Give a 30% tax rate, you need 20% net profit, you need to make about 30%. If you don't, you need to make 20 so you can undercut your competitors, right? So there were complaints, there were, there was lobbying. The story goes, if you, if you go to NYU Law, as I did for my LLM, they will say that it was the alumni base of Columbia Law that complained. Throw in Allegedly. There you decide if it's true or not. And the result was the passing of sections 511, 512, 513 and 514, which created a tax schema to tax unrelated business taxable income. What they look for in the definition of it is in 513, this section. I've always found it kind of goes backward a lot of times, but it is what it is. The definition of UBTI is an unrelated trader business, I.e. any trader business that meets two specific requirements. One, regularly carried on by the exempt organization and two, not substantially related to other than the need for money to the organization's exercise the performance of his exempt purpose or function. Okay, that's really important. And I've always sort of found that one kind of important is it's important to think about what that means. Okay, and what does it mean? Right? So there's two things that go into it. Regularly carried on and regularly carried on. It looks at the frequency and continuity of the exempt organization's activities with similar activities of businesses, tactical entities. Right? An activity conducted intermittently or sporadically will generally not be considered regularly carried on. So frequency is really, really, really, really, really important. And then the second requirement is not substantially related. So that test, it looks at whether the activity contributes, I don't say significantly, substantially. I don't know. Sometimes you hear word importantly to accomplishing the organization's exempt purpose. The fact that it just generates money is not enough. It's not really relevant, not terribly helpful. But there's ones, you know, the regularly carried on. There's actually some really good examples and I think they also talk about the substantially related too, to some extent. So, you know, the most common one is used at university college, right? Selling athletic merchandise. Look, they have a bookstore, they have whatever. They're selling sweatshirts, selling hoodies, selling T shirts, selling socks, whatever. Look, the operation is active only in a couple months, a year. But they have a staff even. Look, it could be open part of the year, going all the year, whatever. You know, the commercial, this is the commercial business owned by a school, right? Has staffing, has advertising, etc. It, you know, it's regularly carried on, you know, but it's substantially related. It is substantially related, right? Maybe so that one's interesting. A lot of, a lot of companies actually just, and I'll get to this in a second, they just totally outsource it. They take royalties. Royalties are generally exempt. Talk about that later. But I think that's really important to know how to do it, right. Structuring is really important. Museum gift shop, right? Special exemption versus like Museum of Natural History, the Met, whatever. It's regularly carried on. This could be, you know, this could be problematic. But also it supports the exempt purpose. Right? So I think that you would have an issue with regularly carried on for a lot of these. But it is substantially related to the purpose. So depending on certain factors, I think you're fine. Charity auction with a professional auctioneer is a really interesting one. You know that one looked like it is not regularly carried on, right? Unless you're doing weekly auctions. I think that's an important one. There's also stuff about like, you know, bingo, right? Bingo is generally exempted. I'll talk about stuff like that in a little bit later. I think that's a really interesting one. How is UBTI computed? Basically it's whatever taxable income is or would be for a for profit business. There's a $1,000 standard deduction, 512B12. And you know there's a number of exemptions and there's that go into it that are in 513exemptions and modifications that I think are really in discussion. The exemptions. There's a number of types of income that are exempt from ubti. What UBTI is looking for is an active business. So dividends, interest, annuities, royalties, rents from real property and capital gains are generally speaking exempt from ubti. There there's no tax imposed and I think that that's really important because I think those really carve out what you're trying to, what you're trying to do. Other exemptions and modifications, volunteer labor, donated goods, bingo, trade shows, conventions, stuff like that. Those are generally income from. Those are generally exempted as well. A lot of that's in 513. And I think that's really important. Look, what they're looking for is a business, right? They're not looking for a gift shop in a hospital or a museum. They're looking for someone who is operating a business with a nonprofit. And you're like, well, you know, it's interrupting with, with the idea. I think that's really important. I'm going to come back in just a moment and I'm going to talk about joint venture stuff like that and debt financed income, which is probably the biggest situation where something goes from not EBTI back into ubti. So I'll be back in just a moment. Hopefully you enjoy. Foreign. Hope you enjoyed the music. So let's talk about debt finance income, which is basically the entirety of section 514. Right. So tax exempt entities are taxed on income from assets that are acquired with debt financing. Basic rule and, and I thought about going through the mechanics, I'll talk about it later a little bit. But basically the debt financed percent is the percent that's taxed even if it's otherwise exempt income. This prevents tax exempty from creating a real estate empire although and throwing shade here but Columbia University is the largest private landowner in New York City even with ubti. Right. So my assumption is low leverage gifts over time it's existed forever. Right. Columbia University predates, you know, different name but predates the revolution. If you saw Hamilton, you know, you know that's, that's where Alexander Hamilton went. Aaron Burr went to Princeton. So you know, which was at the time Kings and Queens College. Right. So you know they've just been around for a while. So they're, they're going to have that, they're going to have real estate. It's going to be really important and I think that's an important kind of point. However, there's kind of an exemption that exists. It's in revenue ruling 7,695 if I know if my handwriting can be read where that deals with joint ventures and debt. So fund borrows 30%, investors contribute 40%, tax exempt entity contributes 30%. Right. And that's how the money goes into buy. It's not ubti. The idea is that basically in the agreement you're going to include two things. One, you're going to allocate the interest expense to the taxable, the non tax exempt partners interest income interest expense to them. And two, upon sale the tax exempt entity gets money as if there were no debt. So you just sort of close your eyes and you blink. But it's about how you do it. The tax examine entity which take on debt to put money in. That's different fact pattern not what's going on there. Also if there's a guarantor, it's recourse debt. That one's plantation patterns. 462 Fed 2nd 712 which was a 5th Circuit case. So basically like you put in money or it's debt financed both but the taxable entity is a guarantor that is recourse to them that will actually take it out of the debt financing rules. So what they're really looking for is the idea that yes, it's a joint venture, yes there's a business element to it but all they're getting is dividends. Well maybe not dividends, but all they're getting is royalty, all they're getting is rents and therefore that's not an issue. Debt finance percent I really thought about how actually have it in my notes to some extent, the idea of going into detail on how determining the debt finance percentage. But I made the decision to keep this one as a slightly shorter episode because I think it's important and I don't think it needs that much detail. But the debt finance rules are in 514C7 and Treasury Reg. 1.514A1. Those are really important. It's really important. They're very mechanical, specific rules that go through it, how it's done, how it's computed, etc. I always tell people that this is one of the ones where the devil's really in the details and it's not that bad. But again, the debt finance percentage is the percentage of UBTI is the percentage is taxable. So I think it's really important to think through it and say, all right, this isn't that much, right? UBTI and Real Property 512B3. Generally speaking, you know, rents from real property or sale of real property is not your ubti. However, I have seen it where nonprofits own a fair amount of real estate and they create a service entity to deal with their real estate. That's fine, that's fine. But then they also start managing other people's real estate in the area because they're good at it and brings in money that could be UBTI. That's the 512A3B A3 cap B. And I think that's really important one. People talk about what about fees, service fees and things like that. So, you know, it depends. There's a lot of examples in this fees for being on a board, right? So, so somewhat like a non. You know, there's fees that are paid to a nonprofit for giving advice to another nonprofit or to a profit or whatever. That's generally UBTI at the service management fee for something likely service. So. So watch out for stuff like that, right? Think about the structuring there, what you're doing. Sometimes it's worth it. Look, you know, at the end of the day, tax is not a 100. You know, they do exist, but there's very few taxes that are 100% or sufficiently punitive to say don't take the income. And I think that's a sample. I also want to talk about reporting requirements. All of this goes on to IRS form 990T there may be a state corollary. It's due the 15th day of the fifth month. So generally May 15th for a calendar year. Taxpayer or exempt or organization, two things. One, people somehow are like, well, it's a tax exempt organization, so I just didn't file a tax return. That seems to be a common problem fact, pattern, which has always sort of fascinated me. I run into that at least once a year. And it's really important to make sure to file your returns. If you don't file your returns, you lose your exempt status. And then the whole UBTI thing is kind of pointless because then you're a for profit business. The default people are like, oh, well, I've held it out as a nonprofit, therefore it should be a nonprofit. And the answer is no. You have to actually meet the requirements and file and be a nonprofit legally. Right? So if the IRS and states have requirements and registration, most states just say, oh, well, you know, IRS said yes, so we're fine. So I think it's really important to know and to think through this and make sure that you meet the requirements and that you do it. You know, ubti, I know this is sort of pigeonholed here, but UBTI is kind of a pointless conversation if you're not a nonprofit. Gonna have some more music. Like I said, it's a short one. Then we're gonna bring it home with some structuring and we're gonna close, close it out. So not, not the longest one I've had, but I think it's an important. Hey, we're back. So let's talk about structuring. Okay, this, this is kind of an important one that. One of the things that I get in terms of questions is nonprofits are like, you know, one of the people we have, they want to give us a business, they want to give us a cash producing asset, you know, whatever. Sometimes business nonprofits will do scientific research and they'll end up with a patent. And they're like, well, we kind of want to do more research and we want to start exploiting it. And like, royalties are not a problem, but if it becomes a for profit business, right? People are like, well, what do you do? Right? And, and if, if, you know, if the only income that's going to be generated is excluded from ubti, so we're going back dividends, interest, annuities, royalties, rents from real property, right? Not rents from tangible property and capital gains, then you can hold it directly. You can, you know, you probably want to pass through just for liability. Protection purposes, obviously, you know, follow the rules, don't get the corporate Vale Pierce, et cetera, et cetera. But what if it's an active business, right? This is, this is Mueller Pasta or maybe it's Mueller Pasta. I don't know. What you do is you just put the business into a C corp. That's it. Look, it just segregated the dividends, tax free. The C Corp gets taxed, passes it back up a little less efficient than you'd like, but that's the deal. And I think it's really important, you know, people say, oh, it's ubti, so what? And you know, because the UBI UBTI tax rate, I have not mentioned this yet, but the UBTI tax rate is actually right at the corporate tax rate. That's what it is, statutorily, definitionally. So it's not a huge deal from a tax perspective, right? 21% federal plus whatever state rate would be. So it's not like a huge issue from like, oh, you're adding so much tax because it's just adding the corporate. Or you get a C corp and you do it where it adds in tax is when you don't need an entity, right? You're just getting, you know, you're exploiting a royalty or whatever. It's not that bad. But the, the thing that I always point out is to be a NonProfit under section 501C1 of the 501Cs, you have to have, you know, nonprofit purpose, et cetera, et cetera. But also if you make too much money not from your members, not from your purpose, et cetera, then what happens is you actually lose your exemption. And exemptions are more than just income tax, they're sales tax too. And I think that that's a really important point that you could just. And then, then the money from your, your members becomes taxable. It's not deductible for 501c3. Remember, there are five ones before sevens is a 30, 40, 50 of them. There's a lot of them. I never remember exactly how many. I rarely get out of the single digits. Most people don't because they're really specific. So, you know, it's important to sort of watch UBTI as a proxy for are we running into other problems elsewhere? And I think that that's really important. It's just a C corp, right? Don't mess it up, don't do anything stupid. And the biggest area where people mess this up and this, this will be my final thought on, on ubti is really a very direct one, which is that a lot of times you have these private clubs, university clubs, vfw, whatever. And what happens is they, they make money by hosting events, Halloween party, wedding, whatever. And in doing that, if they have too much income, A, that can be UBTI and B, that also can be, you know, especially if it's considered regular. Right. We're going back to the beginning thing, my beginning point about, you know, the regularity which is carried on and it's not substantially related. And in doing that, do it too much, make too much money, you can blow your, your, your nonprofit status and you're going to hit by taxes, uti and then you lose it and really go sideways from there. So watch out for that. That's an important thing to do and that's where if you're going to do it, look, have a C corp, really focus on it, do what you're doing, make sure this whole thing works. And I think that that's really important. All right, well, that was the 48th episode episode of How Tax Works. I hope you enjoyed it. Hope you learned something. I'll be back in two weeks with a little more technical one. With the 49th episode, we're going to talk about the Hobby Loss Rules. It's a pretty good one. I think it's a little more, definitely more detailed than this one, but there's a lot more going on here. Although the UBTI rules can be really, really detailed if you're digging into it. But I thought sort of the, as opposed to doing like a six credit class, I thought the two credit survey made more sense. So hope you enjoyed it and have a nice day.