What it means
Tax-exempt organisations, such as charities, foundations, endowments and pension funds, generally do not pay tax on income that supports their purpose. Lawmakers added UBTI rules to stop these organisations from gaining an unfair advantage over taxable businesses by running commercial operations tax-free.
If a university runs a hotel open to the public, for example, the profit from that activity may be treated as UBTI because it is not part of its educational mission. The organisation can still operate the business, but the net income is taxed.
Most passive investment income, such as dividends, interest, royalties and rent from real property, is generally excluded from UBTI. The key exceptions arise when the investment is financed with debt, or when the organisation owns an interest in a partnership that runs an active trade or business.
UBTI is calculated by taking the gross income from the unrelated business, subtracting the directly connected deductions, and then subtracting a small specific deduction set in the tax code. Organisations must file a special tax return if their gross unrelated business income passes a modest threshold.
Individual retirement accounts and other tax-advantaged plans are also affected. A person who invests their retirement account in a partnership that operates a business, or in a leveraged property, could trigger UBTI and a tax bill inside the account, so many advisers screen for it before buying.
The tax code is detailed and changes from time to time. Anyone dealing with UBTI should rely on a qualified tax adviser and confirm rates and thresholds with the tax authority.
In practice
Real-world examples.
Example
A community museum runs a gift shop selling mass-market goods that have no link to its exhibitions. The profit from that shop could be treated as UBTI. The museum's finance team tracks the shop's income and costs separately so it can file correctly.
Example
A retirement account holder buys an interest in a partnership that operates a small chain of restaurants. At year end, the partnership reports $12,000 of business income to the account. The investor learns that the account itself may owe tax on that income and engages a tax professional.
Example
A university endowment buys an office building using a $6,000,000 mortgage, and part of its rental income may be treated as debt-financed income, which can fall within the UBTI rules. The investment office calculates the debt-financed percentage before deciding whether the return still justifies the purchase.
Formula
Calculation
UBTI = gross unrelated business income - directly connected deductions - specific deduction
A charity's endowment owns an interest in a partnership that runs a chain of car washes. For the year, the charity's share of gross income from the partnership is $40,000, and its share of directly connected expenses is $15,000. Assume the specific deduction is $1,000.
Income after directly connected deductions = 40,000 - 15,000 = $25,000.
UBTI = 25,000 - 1,000 = $24,000.
The charity pays tax on the $24,000 at the rate that applies to it under the tax rules. If the applicable rate were 20%, an assumed figure used here purely for illustration, the tax would be 24,000 x 0.20 = $4,800.Case study
Seen in the real world.
Fairhaven Foundation is a fictional charity, and this is an illustrative case. It had $10,000,000 in its endowment and invested $500,000 in a private fund that owned an operating company through a partnership.
At year end, the fund's tax statement allocated $60,000 of operating income to the foundation, with $20,000 of related expenses. After the small specific deduction of $1,000, the foundation had UBTI of $39,000, which required a tax return it had not expected to file.
The foundation's treasurer realised that the investment's after-tax return was lower than the brochure suggested. She asked the fund manager whether a blocker corporation, a structure which stands between a tax-exempt investor and the operating business, was available. The illustrative case shows why tax-exempt investors check for UBTI before investing.
Watch out
Common mistakes.
- Assuming a tax-exempt investor never pays tax. UBTI can create a tax bill even for charities and retirement accounts.
- Ignoring borrowing inside the account. Debt-financed income can turn otherwise excluded income into taxable income.
- Overlooking filing duties. Organisations above the reporting threshold must file a specific return, even if the tax due is small.
Questions
People also ask.
Is dividend income UBTI?
Generally not. Dividends, interest and most royalties are excluded, unless they come from debt-financed property.
Do IRAs have to worry about UBTI?
Yes, they can, when they invest in partnerships running active businesses or in leveraged assets.
What is a blocker corporation?
It is a company placed between a tax-exempt investor and an operating business so that income reaches the investor as a dividend, which is generally not UBTI.
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