Copyright © 2002, United States Conference of Catholic Bishops, Inc. All rights reserved.
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Income Tax Issues
The accounting treatment for income taxes is specified in Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. Adherence to the guidance in SFAS No. 109 is required by generally accepted accounting principles (GAAP). The following is intended to provide general information about income tax issues (other than accounting treatment) that are relevant to dioceses in the United States.
USCCB Group Tax Exemption RulingAnnually since 1946, the Internal Revenue Service (IRS) has issued to the United States Conference of Catholic Bishops (or, before the 2001 name change, the United States Catholic Conference) a group tax exemption ruling with respect to the Catholic organizations listed in The Official Catholic Directory (OCD) for a particular year ("Group Ruling"). The Group Ruling establishes (1) that organizations included in the OCD are exempt from federal income tax under section 501(c)(3) of the Code and from federal unemployment tax; and (2) that contributions to such organizations are deductible for federal income, gift, and estate tax purposes. The current Group Ruling is available on the USCCB website at www.usccb.org/ogc. Inclusion in the Group Ruling has no effect on an organization's liability for any federal excise taxes, nor does it automatically establish an organization's exemption from state or local income, sales, or property taxes. For more information on the Group Ruling, see the annual Group Ruling explanatory memo issued by OGC, as well as further discussion in the second section of this "Income Taxes" chapter.
Deductibility/Substantiation of ContributionsOne of the primary benefits of section 501(c)(3) exemption is deductibility of contributions for federal income (§ 170), estate (§ 2055), and gift (§ 2522) tax purposes. Cash contributions by individuals to organizations listed in the OCD generally are deductible up to 50% of the donor's adjusted gross income (IRC § 170[b][A]), with a five-year carryover for any excess (IRC § 170[d]). Noncash contributions can have different limitations. Corporate gifts are deductible up to 10% of taxable income (IRC § 170[b]), with a five-year carryover (IRC 170[d]).
In order to be deductible, a payment must first qualify as a gift, which is defined as a voluntary transfer of money or property without receipt of or expectation of a commensurate return benefit. Thus, for example, the payment of tuition, whether made directly to a school or to a church operating the school, is not deductible. In addition, payments made in various fundraising contexts may or may not be deductible, depending on whether goods or services are received in return. For example, payment for a purchase at a charity auction will be deductible only to the extent the payment exceeds the fair market value (FMV) of goods or services received in return. Payments for charity raffle tickets are not deductible, since the amount paid is not a gift, but rather payment for the chance to win whatever prize is being offered.
In response to abuses with respect to charitable contributions, in 1993 Congress enacted enhanced substantiation rules applicable to contributions of $250 or more. Section 170(f)(8) provides that no contribution of $250 or more will be deductible unless the donor obtains, prior to filing his or her tax return, written acknowledgment from the donee charity verifying the amount of the contribution and whether any goods or services were received in return. If so, such goods or services must be identified and must be valued by the donee charity. If the benefits received consist solely of intangible religious benefits, a statement to that effect must be included. Although the burden of requesting appropriate acknowledgment is placed on the donor and not imposed on the donee charity, charities that knowingly provide false written substantiation statements may be subject to penalties for aiding and abetting an understatement of tax liability under section 6701.
Certain payments are considered quid pro quo contributions—namely, they are made partly as a gift and partly in consideration for goods or services furnished to the donor. An exception is provided for payments made to an exclusively religious organization in return for which the donor receives solely intangible religious benefits. Under section 6115, charitable organizations must inform donors in writing that quid pro quo contributions in excess of $75 are deductible only to the extent that they exceed the value of any goods or services provided by the charitable organization in return, and the organizations must provide a good-faith estimate of the value of such goods or services. This disclosure must be made either at the time of solicitation or upon receipt of the quid pro quo contribution. Penalties are imposed on any charity that fails to make appropriate disclosure under section 6115 at $10 per contribution, capped at $5,000 per particular fundraising event or mailing. Typical quid pro quo contribution situations include charity golf tournaments, auctions, dinner dances, and so forth, where part of the payment constitutes a contribution. In such situations, the disclosure statement may be placed in solicitation materials, in event programs or brochures, or on the face of event tickets—i.e., in any reasonable manner likely to come to the attention of the donor.
Additional substantiation requirements are imposed with respect to certain contributions. Contributors of noncash gifts valued at $500 or more must complete Form 8283 and attach it to Form 1040. Contributors of noncash gifts valued at $5,000 or more (other than gifts of publicly traded securities) must
The donee charity is required to report to the IRS on Form 8282 if such contributions are subsequently sold or otherwise disposed of within two years of receipt.
- Obtain a qualified appraisal and submit an appraisal summary with the Form 8283 attached to Form 1040, and
- Have the donee charity complete and return to the donor the "Donee Acknowledgment Section" (in doing so, the donee charity is not vouching for the appraised value)
Lobbying ActivitiesSection 501(c)(3) organizations may not engage in more than insubstantial lobbying activities. Lobbying includes contacting, or urging the public to contact, members of a legislative body for the purposed of proposing, supporting, or opposing legislation or advocating adoption or rejection of legislation (Treas. Reg. § 1.501[c]–1[c][ii]). Legislation includes any action by Congress, by a state or local legislative body, or by the public in a referendum, initiative, constitutional amendment, or similar procedure (Treas. Reg. § 1.501[c]–1[c][ii]). No distinction is made between "good" and "bad" legislative activity. (See Rev. Rul. 67-293, 1967-2 C.B. 185.)
The IRS has never defined "insubstantial" in this context or identified a percentage safe harbor for legislative activities. Court cases suggest a 5 to 15% range, but the IRS comfort zone is at the lower end. See Murray Seasongood v. Commissioner (227 F.2d 907 [6th Cir. 1955]), which ruled that less than 5% time and effort is not substantial; and Haswell v. U.S. (500 F.2d 1133 [Ct. Cl. 1974], cert. denied, 419 U.S. 1107 ), which ruled that 16 to 17% of a budget was substantial. A more specific elective lobbying standard was enacted in 1976 as section 501(h) of the Code. Churches, conventions of churches, and integrated auxiliaries at their own request were made ineligible (IRC §§ 501[h] and 4911[f]).
Political ActivitiesA section 501(c)(3) organization may not engage in any political campaign activity. Unlike the lobbying limitation, this is an absolute prohibition. The statute states that 501(c)(3) organizations may not "participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office." The prohibition applies only to candidates for elective public office. Although very little additional interpretation is provided in the regulations, the penalties for violating the prohibition are severe. In addition to loss of tax-exempt status and deductibility of contributions, two-tiered excise taxes may be imposed on the exempt organization (10% and 100%) and on the organization manager (2-1/2% and 50%) for political expenditures (IRC § 4955). In flagrant cases, the IRS may seek an injunction against further political expenditures (IRC § 7409[a]) and immediate determination and assessment of income and excise taxes (IRC § 6852). For more information, check the OGC website, www.usccb.org/ogc.
Intermediate SanctionsIn 1996, Congress enacted section 4958 of the Internal Revenue Code, the so-called "intermediate sanctions" provisions, which were designed to provide the IRS with a sanction other than revocation of exemption for non-fair market value transactions with insiders, defined in section 4958 as "excess benefit" transactions. Section 4958 applies to transactions occurring on or after September 14, 1995 (with the exception of transactions pursuant to certain binding written contracts in effect before that date). In 1998, proposed regulations were issued to provide interpretive guidance under section 4958. Public hearings were held in March 1999. In January 2001, the IRS issued temporary regulations; and in January 2002, the IRS issued final regulations. Some of the major provisions of the final regulations are summarized below.
Applicable Tax-Exempt Organizations
Section 4958 applies to any organization that, without regard to any excess benefit, would be described in section 501(c)(3) or (c)(4) and exempt from tax under section 501(a) (EO, or "exempt organization"), at any time during a five-year period ending on the date of the excess benefit transaction ("lookback period"). An organization is described in section 501(c)(3) for purposes of section 4958 only if it provides notice under section 508 (filing Form 1023), unless it is otherwise described in section 501(c)(3) and is specifically excluded from application of section 508. Accordingly, churches, their integrated auxiliaries, and conventions and associations of churches—which are statutorily excepted from section 508—are nonetheless subject to section 4958.
Excise Taxes Imposed
Section 4958 imposes excise taxes on any excess benefit resulting from an excess benefit transaction between the EO and a disqualified person (DP). Significantly, these taxes are not imposed on the organization. Rather, the DP is liable for a 25% first-tier tax, and for a 200% second-tier tax, if the excess benefit transaction is not corrected within the correction period. In addition, a tax equal to 10% of the excess benefit (up to a maximum tax of $10,000) is imposed on an organization manager (OM) who knowingly participates in an excess benefit transaction, unless participation was not willful and was due to reasonable cause. An OM will not be liable for tax if he or she opposed the transaction. If more than one person is liable for tax under section 4958, all such persons are jointly and severally liable.
"Disqualified Person" Defined
Section 4958 defines a "disqualified person" as any person who was in a position to exercise substantial influence over the affairs of the organization at any time during a five-year lookback period ending with the date of the transaction. The term also encompasses certain members of the DP's family and certain 35%-controlled entities.
Persons Having Substantial Influence. The final regulations state that individuals holding any of the following powers, responsibilities, or interests are in a position to exercise substantial influence over the affairs of an EO: (1) voting members of the governing body; (2) individuals who, regardless of title, have ultimate responsibility for implementing the decisions of the governing body or for supervising the management, administration, or operation of an EO (persons serving as president, chief executive officer, or chief operating officer have such responsibility unless they demonstrate otherwise); and (3) individuals who, regardless of title, have ultimate responsibility for managing the finances of an EO (persons serving as treasurer or chief financial officer have such responsibility unless they demonstrate otherwise).
Persons Deemed Not to Have Substantial Influence. The final regulations state that the following are deemed not to have substantial influence over the affairs of an EO: (1) organizations exempt under section 501(c)(3); (2) certain section 501(c)(4) organizations; and (3) employees receiving direct or indirect economic benefits of less than the "highly compensated employee" amount in section 414(q)(1)(B)(i) ($90,000 for 2003), who are not otherwise classified as DPs by virtue of position, family relationship, or substantial contribution.
In all other cases, whether an individual is a DP depends on all relevant facts and circumstances. The final regulations clarify that an organization can be a DP.
"Organization Manager" Defined
An "organization manager" is defined as any officer, director, or trustee of an EO, or any individual having similar powers with respect to the EO, regardless of title. An officer includes an individual who (1) is so designated in organizational documents, or (2) "regularly exercises general authority to make administrative or policy decisions on behalf of the organization." The final regulations provide that independent contractors, acting solely in their capacity as attorneys, accountants, or investment managers/advisors, are not officers. In addition, individuals who are not officers, directors, or trustees, but who serve on a committee of an EO's governing body that is attempting to invoke the rebuttable presumption of reasonableness (discussed below) based on the committee's actions, are considered OMs for purposes of section 4958.
"Excess Benefit Transaction" Defined
The final regulations define an "excess benefit" as the amount by which the value of the economic benefit provided by an EO directly or indirectly to or for the use of any DP exceeds the value of the consideration (including the performance of services) received by the EO for providing such benefit. With certain exceptions explained below, all consideration and benefits exchanged between a DP and an EO (including any controlled entities) must be taken into account in order to determine whether an excess benefit transaction has occurred. The final regulations provide that, in determining the reasonableness of compensation that is paid (or vests, etc.) in one year, services performed in prior years may be taken into account.
Rebuttable Presumption of Reasonableness. Consistent with the legislative history of section 4958, the final regulations establish a rebuttable presumption whereby compensation paid by an EO to a DP, or the transfer of property or other benefit between the EO and a DP, will be presumed to be at FMV, provided three conditions are satisfied: (1) the compensation or terms of transfer are approved in advance by the organization's governing body (or a committee of the governing body) composed entirely of individuals who do not have a conflict of interest with respect to the arrangement or transaction; (2) the governing body or committee obtained and relied upon appropriate data as to comparability prior to making its determination; and (3) the governing body or committee adequately and concurrently documented the basis for its determination. The IRS may rebut the presumption only if it develops sufficient contrary evidence to rebut the probative value of the comparability data relied upon by the governing body or committee.
Certain Economic Benefits Disregarded. All fringe benefits that are excluded from income under section 132 (except certain liability insurance premiums, payments, or reimbursements) are disregarded for purposes of section 4958. The final regulations also disregard expense reimbursements paid under an accountable reimbursement plan that meets the requirements of section 1.62-1(c). Thus, as is the case with section 132(d) on working condition fringe benefits, the existing standards under section 162 and 274 will apply to determine whether employee expense reimbursements are disregarded or should be treated as part of a DP's compensation for purposes of determining reasonableness under section 4958.
Written Contemporaneous Substantiation. An EO must provide written substantiation that is contemporaneous with the transfer of benefits at issue in order to provide clear and convincing evidence of its intent to treat benefits provided to a DP as compensation for services. To satisfy this requirement, either (1) the EO must report the economic benefit as compensation on an original or amended federal tax return with respect to the payment, e.g., Form W-2 or 1099, filed prior to commencement of an IRS examination; or (2) the DP must report the benefit on his or her original or amended federal tax return, e.g., Form 1040, also filed prior to commencement of an IRS examination.
If a benefit is not reported on a return filed with the IRS, other written contemporaneous evidence, e.g., employment contract, may be used to demonstrate that the appropriate decision-making body or an authorized officer approved a transfer as compensation for services in accord with established procedures. The final regulations clarify that the term "established procedures" refers to the EO's usual practice for approving compensation and does not require that an EO have a formal written procedure for approving compensation.
Correction. An excess benefit transaction is corrected by undoing the excess benefit to the extent possible and by taking any additional measures necessary to place the EO in a financial position not worse than that in which it would be if the DP were dealing under the highest fiduciary standards. The correction amount equals the sum of the excess benefit and the interest thereon. Generally, a DP corrects an excess benefit by making a payment in cash or cash equivalents (not a promissory note) to the EO equal to the correction amount. However, with the agreement of the EO, the DP may make correction by returning specific property previously transferred in the excess benefit transaction. The DP will be treated as making a payment equal to the lesser of the following: either the property's FMV determined on the date the property is returned or the FMV determined on the date the excess benefit transaction occurred. If such payment is not equal to the correction amount, the DP must make additional cash payment to the EO in the amount of the difference. If the DP makes payment of less than the full correction amount, the 200% tax is imposed only on the unpaid portion.
The final regulations clarify the rules governing correction when an EO no longer exists or is no longer tax-exempt by requiring that another section 501(c)(3) organization receiving the correction amount be a publicly supported charity that has been in existence as such for a continuous period of at least sixty calendar months ending on the correction date. This time-in-existence requirement is designed to prevent a DP from creating a new EO to receive the correction amount. The final regulations also require that the organization receiving the correction amount not allow the DP to make or recommend any grants or distributions by the organization. Finally, the DP may not also be a DP with respect to the organization receiving the correction amount.
Special Rule for Churches
The final regulations provide that the church audit procedures under section 7611 of the Internal Revenue Code will be used in initiating and conducting any IRS inquiry or examination into whether an excess benefit transaction has occurred between a church and a DP. The reasonable belief required to initiate a church tax inquiry will be satisfied if there is a reasonable belief that taxes under section 4958 are due from a DP with respect to a transaction involving a church.
Any economic benefit received by a DP (who by definition has substantial influence) from the assets of an EO is considered to be provided by the EO, even if the transfer of the benefit was not authorized under the regular procedures of the organization. The practical result of this rule is that funds embezzled by a DP generally constitute excess benefit transactions. The final regulations clarify that in no event will an economic benefit that a DP obtains by theft or fraud be treated as consideration for the performance of services.
Substantive Exemption Requirements Still Apply
The final regulations verify that section 4958 does not affect the substantive requirements for exemption under sections 501(c)(3) or (4), including the requirements that the EO be organized and operated exclusively for exempt purposes and that no part of the net earnings inure to the benefit of any private shareholder or individual. Thus, regardless of whether a transaction is subject to excise taxes under section 4958, existing exemption principles and rules apply (e.g., a transaction that is not subject to section 4958 because of the initial contract exception may still jeopardize the EO's exempt status). The preamble to the temporary regulations indicated that the IRS would exercise its administrative discretion in enforcing sections 4958, 501(c)(3), and 501(c)(4) in accordance with the direction provided in the legislative history, and would publish guidance concerning factors it will consider with respect to revocation of exemption in excess benefit transaction situations. Until such time, the IRS will consider all facts and circumstances in the administration of section 4958. (See Final Regulations on Excise Taxes on Excess Benefit Transactions, 67 Fed. Reg. 3076 [January 23, 2002].)
Filing Requirements for Form 990Under section 6033 of the Code, organizations exempt from tax under section 501(c)(3) are required to file Form 990 annually, unless they qualify either for a mandatory (in statute) or discretionary (by authority of IRS commissioner) exception under section 6033(a)(2). Organizations included in the Group Ruling are not automatically relieved of the Form 990 filing requirement. Organizations required to file Form 990 must do so by the fifteenth day of the fifth month following the close of the fiscal year. There are, however, numerous exceptions to the Form 990 filing requirement available to churches and their affiliated organizations, including the following:
Penalties. The penalty for failure to file Form 990, or for failure to include all required information, is $20 per day for each day the failure continues, up to a maximum penalty per return of either $10,000 or 5% of the organization's gross receipts, whichever is less. Organizations with annual gross receipts in excess of $1 million are subject to penalties of $100 per day, up to a maximum of $50,000 per return (IRC § 6652[c][A]). In addition, penalties of $10 per day may be imposed on managers who fail to comply with an IRS demand to file Form 990 (IRC § 6651[c][B]).
- Churches (IRC § 6033[a][A][i])
- Conventions or associations of churches (IRC § 6033[a][A][i])
- Integrated auxiliaries of churches (IRC § 6033[a][A][I]; Treas. Reg. § 1.6033-2[h]). To qualify as an integrated auxiliary of a church, an organization must be described in section 501(c)(3), be other than a private foundation under section 509(a), and be considered "internally supported" by a church. An organization will be considered internally supported unless it both
- Offers admissions, goods, services, or facilities for sale, other than on an incidental basis, to the general public (except goods, services, or facilities sold at a nominal charge or substantially below cost), and
- Normally receives more than 50% of its support from a combination of governmental sources; public solicitation of contributions (such as through a community fund drive); and receipts from the sale of admissions, goods, performance of services, or furnishing of facilities in activities that are not unrelated trades or businesses.
- Exclusively religious activities of religious orders (IRC § 6033[a][A][iii]). The Code does not define the term "religious order." However, Rev. Proc. 91-20, 1991-1 C.B. 524, sets forth the characteristics used by the IRS to determine whether an organization qualifies as a religious order.
- Public charities with annual gross receipts normally less than $25,000.
- Organizations that finance, fund, or manage church assets or maintain church retirement insurance programs, as well as organizations controlled by religious orders that finance, fund, or manage assets used for exclusively religious activities (Rev. Proc. 96-10, 1996-1 C.B. 577)
- Interchurch organizations of local units of a church (Treas. Regs. § 1.60332[g][i])
- Mission societies sponsored by or affiliated with one or more churches or church denominations, more than half of whose activities are conducted in or directed at persons in foreign countries (Treas Regs. § 1.6033-2[g][iv])
- Schools below college level affiliated with church or operated by religious order (Treas. Regs. § 1.6033-2[g][vii])
Disclosure RequirementsSince 1987, section 6104(d) of the Internal Revenue Code has required tax-exempt organizations—including section 501(c)(3) organizations to which the Form 990 filing requirements apply—to allow public inspection of their three most recent Form 990s, as well as their applications for recognition of tax exemption, Form 1023, during normal business hours at their main offices as well as regional offices having three or more employees. The impact on churches and their affiliated organizations has been limited, since organizations covered under a Group Ruling do not file their own Form 1023, and since many are exempt from the Form 990 filing requirement.
The Taxpayer Bill of Rights 2 of 1996 amended section 6104(d) of the Code to require tax-exempt organizations to comply with requests made in writing or in person for copies of their applications for exemption, Form 1023, and for their three most recent Forms 990. An exempt organization may not make any charge other than a reasonable fee for reproduction and actual postage costs, no more than the per-page copying charges applied by the IRS: currently $1 for the first page and $0.15 per page thereafter. Response must be made the same day to requests made in person, and within thirty days for written requests. There are special anti-harassment rules and provisions for making documents available through posting on the Internet.
The USCCB did not file an application for exemption (Form 1023), so there is no application that the USCCB or any organization covered under the Group Ruling must make available for inspection or copying. Each organization covered under the Group Ruling is required to provide for inspection or copying only the page(s) on which it appears in the current OCD. If a covered organization does not have a copy of the current edition of the OCD, it has two weeks in which to obtain a copy of the appropriate page(s) in order to comply with the provisions of section 6104(d). Organizations covered under the Group Ruling that file Form 990 are subject to the general rules regarding disclosure of annual information returns. For more information, contact the OGC.
Penalties. The penalty for failure to provide public inspection or copying of Form 990 is $20 per day up to $10,000 per return (IRC § 6652[c][C]); and the penalty for failure to provide public inspection or copying of Form 1023 is $20 per day (IRC § 6651[c][D]). In addition, the penalty for willful failure to provide inspection or copies of documents under section 6104(d) is $5,000 with respect to each Form 990 or Form 1023 (IRC § 6685).
Filing Requirements for Form 5578Rev. Proc. 75-50, 1975-2 C.B. 587, sets forth notice, publication, and record keeping requirements regarding racially nondiscriminatory policies that must be complied with by private schools, including church-related schools, as a condition of establishing and maintaining exempt status under section 501(c)(3) of the Code. Under Rev. Proc. 75-50, private schools are required to file an annual certification of racial nondiscrimination with the IRS. For private schools not required to file Form 990, the annual certification must be filed on Form 5578, Annual Certification of Racial Nondiscrimination for a Private School Exempt from Federal Income Tax. Form 5578 must be filed by the fifteenth day of the fifth month following the close of the fiscal year. Form 5578 may be filed individually by school or by the diocese on behalf of all its diocesan schools.
Unrelated Business Income Tax (UBIT)Although organizations included in the Group Ruling are exempt from federal income tax, they are subject to tax on the income from any unrelated trade of business in which they regularly engage. Unrelated business income is governed by sections 511-514 of the Internal Revenue Code. UBIT is imposed at the normal corporate rates. A Form 990-T must be filed if an organization has gross income from unrelated trade or business of $1,000 or more, regardless of whether tax is due or whether the organization is required to file Form 990. The Form 990-T must be filed no later than the fifteenth day of the fifth month after the close of the organization's tax year (IRC § 6072[e]). If taxes are owed, organizations are expected to file quarterly estimated income tax returns.
An "unrelated trade or business" is as follows: (1) a trade or business as defined under section 162 of the Code (generally, any activity carried on for the production of income from the sale of goods or the performance of services); (2) one that is regularly carried on; and (3) one that is not substantially related to an organization's exempt purposes. The IRS applies a "fragmentation rule" to classify different aspects of what might otherwise appear to be a unitary business endeavor as being either related or unrelated. For example, the sale of advertising in an otherwise exempt educational periodical is considered a trade or business, which will generally be unrelated to its exempt purposes.
To be considered "regularly carried on," a trade or business must exhibit "frequency and continuity" and be carried on in a manner similar to its commercial counterpart (Treas. Reg. § 1.513-1[c]). In order to qualify as "related," IRS requires a substantial causal relationship between the activity and an organization's exempt purposes (Treas. Reg. § 1.513-1[d]). The fact that an organization uses funds derived from its unrelated business activity in order to further its exempt programs does not convert an unrelated activity into a related one. Further, even if an activity relates to exempt purposes, it may be carried on to an extent greater than necessary to achieve those purposes. In such situations, income derived from excess activity will be subject to unrelated business income tax.
There are a number of exceptions to the UBIT rules, including the following:
In addition to the above exceptions to the definition of unrelated trade or business, the Code provides certain modifications to the computation of UBI, primarily for passive income sources. Thus, although unrelated, income from certain sources will be excluded from the computation of unrelated business income. The major modification categories under section 512(b) include dividends, interest, annuities, rents, and royalties.
- Volunteer Exception. This exception applies when substantially all of the work in a particular activity is performed by volunteers (IRC § 513[a]). The IRS's unofficial standard for "substantially all" is 85%. This exception typically applies to activities like church raffle, bingo games, and other fundraisers, although many such activities could also avoid being characterized as subject to UBIT because they are not regularly carried on.
- Convenience Exception. This exception applies to any trade or business carried on primarily for the convenience of its members, students, patients, officers, or employees (IRC § 513[a]). Classic examples of this exception include the hospital pharmacy sales made to patients, the sale of books by a university bookstore to students, sales in hospital gift shops, and laundry and vending operations provided for student use.
- Donated Merchandise and Low Cost Item Exceptions. The donated merchandise exception applies to the sale of merchandise that has been received as a contribution or gift (IRC § 513[a]). This exception applies to thrift stores operated by churches and other charitable organizations. The Code also contains an exception for the distribution of low-cost items incident to charitable solicitations. If a church mails unrequested, low-cost items as part of a fundraising effort, the church is not liable for UBIT on the income received (IRC § 513[h][B]). The dollar amount is indexed for inflation and changes each year.
- Mailing List Exception. Section 513(h)(1)(B) of the Code provides that income from the rental or exchange of mailing lists between or among section 501(c)(3) organizations is not subject to UBIT. The IRS has taken the position that rentals or exchanges with non-501(c)(3) organizations is subject to UBIT. However, after a string of litigation losses, the IRS will agree that properly structured licensing agreements for the use of mailing lists can generate non-taxable royalty income (see below).
- Bingo and Gambling Activities Exception. An important UBIT exception for many churches and related entities is the bingo exception, which applies to bingo games where participants place wagers, winners are determined, and prizes are distributed in the presence of all persons placing wagers in the game (IRS § 513[f]). The bingo exception does not apply to scratch-off bingo cards or to other forms of "walk-away" games. Since 1986, non-bingo gambling activities have been subject to UBIT, except in North Dakota (IRS Announcement 89-138, 1989-45 I.R.B. 41 [November 6, 1989]). Thus, except in North Dakota, income from charitable gambling like keno, pull tabs, lotteries, and "pickle jars" are subject to UBIT unless one of the other UBIT exceptions applies—e.g., for activities not regularly carried on or for the volunteer exception.
- Miscellaneous Exceptions. There are also UBIT exceptions for qualified convention and trade show activities conducted by section 501(c)(3), (c)(4), (c)(5), and (c)(6) organizations, and for certain services, including data processing, food services, and laboratory services provided at cost to hospitals with one hundred or fewer beds (IRC §§ 513[d], [e]).
There are two major exceptions to the exclusions from UBIT under section 512(b) outlined above that render income taxable despite the section 512(b) modifications:
- Royalties. A "royalty" is a payment for the use of a valuable intangible property right, e.g., use of an exempt organization's name and logo. Payments for services provided by the organization are not considered royalties (Rev. Rul. 81-178, 1981 C.B. 135). Royalties are not included in the computation of unrelated business income (IRC § 512[b]). The scope of the royalty exception has been unclear for the past several years, particularly in the context of affinity credit card and similar arrangements. However, after a string of litigation losses, IRS determined in late 1999 to stop litigating affinity card and mailing list rental cases except where the factual record clearly established that the exempt organization was providing more than incidental services in exchange for payments received. Thus, income from an exempt organization's licensing of the use of its name, logo, mailing lists, or other valuable intangible property rights will generally be treated as nontaxable royalty income, provided that no more than incidental services—i.e., those inherent in and necessary to the nature of the arrangement—are provided in return.
- Rents from Real Property. Rents from real property are not subject to UBIT under section 512(b)(3) of the Code. Rents from personal property rented with real property may also be exempt provided that the rent attributable to personal property is no more than 10% of the total. If 10 to 50% of the rent is attributable to the rental of personal property, then a pro rata share of the rental income will be subject to UBIT. However, if more than 50% of the rent is attributable to personal property, then the modification is lost and the entire rental amount will be taxed.
Further, an exempt organization may not provide services in connection with the rental of real property, with the exception of services customary in connection with the rental of space: such as light, heat, trash collection, and cleaning of common areas. This issue of services often arises in the context of retreat houses and parking lots. For example, if an exempt organization rents its parking lot to a third party, which is responsible for all aspects of its operation, the income is considered the rental of real property not subject to UBIT. If, on the other hand, a church rents certain spaces in its parking lot during the week for use by nearby business people, these rents will generally be subject to UBIT. They do not qualify for the rental of real property exception because the church remains responsible for lot maintenance, snow removal, signs, barriers, security, line painting, etc. (See, e.g., PLR 9301024 [October 15, 1992].) In the retreat house situation, frequently church organizations rent excess capacity in their facilities for business retreats, wedding receptions, and the like. Because a full range of services is typically provided in such situations, including maid service, food service, etc., it is not considered the rental of real property, but rather is more analogous to hotel operations.
- Sales or Exchanges. Under section 512(b)(5), all gains or losses from the sale, exchange, or other disposition of property is excluded from the computation of UBIT, with the exception of stock in trade or other property that would be classified as inventory, and property held primarily for sale to customers in the ordinary course of trade or business.
- Debt-Financed Income. Under the provisions of section 514 of the Code, income that would otherwise be excluded from taxation under section 512(b)(1), (2), (3), and (5) (i.e., dividends, interest, royalties, rents and certain gains and losses from the sale of property) may nonetheless be subject to UBIT if it is subject to acquisition indebtedness—i.e., was acquired or improved with borrowed funds. Unrelated debt-financed income from such property is taxable in proportion to its acquisition indebtedness.
Certain exceptions to the debt-financed income rules are relevant to church property. First, where substantially all (at least 85%) of the property's use is substantially related (aside from the need for funds) to the organization's exempt purposes, it is not treated as debt-financed property (IRC § 514[b][A]). Second, where property is owned by one exempt organization and is used by certain related organizations, it is not treated as debt-financed property to the extent that the property is used by either organization in furtherance of its exempt purposes (IRC § 514[b]).
Third, under the "neighborhood land rule" exception, if an organization acquires real property and intends to convert it to use for exempt purposes within ten years, the property will not be treated as debt-financed property if it is in the neighborhood of other property used by the organization for exempt purposes and if the intent to use the property for exempt purposes within ten years is not abandoned (IRC § 514[b][A]). Note, however, that section 514(b)(3)(C)(i) vitiates the neighborhood land rule exception with respect to any structure on the land, when it is acquired, that is not required to be removed or demolished as part of the conversion. Special consideration is given to churches and conventions or associations of churches. Among other things, a fifteen-year period applies instead of the regular ten-year period, and the requirement that the acquired land be in the neighborhood of other property used for exempt purposes is eliminated (IRC § 514[b][E]).
- Controlled Subsidiary Exception. Section 512(b)(13), which was significantly revised in 1997, provides that rent, royalty, annuity, and interest income, which is generally excluded from unrelated business taxable income, is not so excluded if it is received from a controlled subsidiary of a tax-exempt organization. Under section 512(b)(13) prior to 1997, a controlled subsidiary was defined as 80% controlled by the tax-exempt parent organization. The control test did not incorporate any indirect ownership rules, so that rents, royalties, annuities, and interest from second-tier subsidiaries generally did not constitute unrelated business taxable income to the tax-exempt parent organization.
In an attempt to thwart tax-exempt organizations' attempts to elude UBIT on amounts received from subsidiary organizations, Congress lowered the threshold for "control" from 80% to the current 50%. With respect to stock subsidiaries, "control" means ownership by vote or value of more than 50% of the stock. For partnerships or other entities, "control" means ownership of more than 50% of the profits, capital, or beneficial interests. In addition, the constructive ownership rules of section 318 of the Code were made applicable to section 512(b)(13). As a result, a tax-exempt parent organization will be considered to control a subsidiary in which it holds, directly or indirectly, more than 50% of the voting power or value. Any rent, royalty, annuity, or interest received by an exempt organization from its controlled entity will be unrelated business taxable income to the extent that the payment reduces the net unrelated income or increases the net unrelated loss of the controlled entity.
Corporate Sponsorship RegulationsThe Taxpayer Relief Act of 1997 amended the Internal Revenue Code to add section 513(i), which provides that the receipt of qualified sponsorship payments by an exempt organization subject to tax imposed under section 511 of the Code does not constitute receipt of income from an unrelated trade or business. Section 513(i) applies to payments solicited or received after December 31, 1997. In March 2000, the IRS issued proposed regulations interpreting section 513(i). The IRS has issued final regulations under section 513(i), which are effective as of April 25, 2002, and are applicable for payments solicited or received after December 31, 1997.
The final qualified sponsorship payment regulations apply to the following: single events conducted by an exempt organization (e.g., a bowl game, TV show, or walkathon); a series of events (e.g., an athletic tournament or concert series); or an activity conducted over a period of time (e.g., an art exhibit). It is irrelevant whether the sponsored event is substantially related to the exempt organization's tax-exempt purpose. The qualified sponsorship provisions do not apply to payments made in connection with exempt organization trade shows (governed by section 1.513-3 of the regulations) or to income derived from the sale of advertising or acknowledgements in exempt organization periodicals (governed by section 1.512[a]-1[f]). A "periodical" is defined as "regularly scheduled and printed material published by or on behalf of the exempt organization that is not related to and primarily distributed in connection with a specific event conducted by the exempt organization." The final regulations clarify that printed material includes material that is published electronically.
Qualified Sponsorship Payments
The final regulations define a "qualified sponsorship payment" as a payment made by any person engaged in a trade or business for which there is no expectation or arrangement that the payer (or persons designated by the payer) will receive any substantial return benefit from the exempt organization. "Payment" means the payment of money, transfer of property, or performance of services.
Substantial Return Benefit
Substantial return benefit is defined as any benefit other than (1) a use or acknowledgment or (2) certain disregarded benefits. With respect to the latter, the final regulations delete the $79 cap (the 2002 inflation-adjusted figure) found in the proposed regulations, so that benefits may be disregarded if the aggregate fair market value of all benefits provided to the payer (or persons designated by the payer) is not more than 2% of the payment. If the aggregate fair market value of the benefits exceeds 2%, then (except to the extent that the benefit constitutes an acknowledgment) the entire fair market value of such benefits, not merely the excess amount, is a substantial return benefit. Benefits to the payer (or persons designated by the payer) may include the following: advertising; exclusive provider arrangements; goods, facilities, services, or other privileges; and exclusive or non-exclusive rights to use an intangible asset (trademark, patent, logo, etc.) of the exempt organization.
Use or Acknowledgment
For purposes of section 513(i), a substantial return benefit does not include the use or acknowledgment of the name, logo, or product line of the payer's trade or business. Use or acknowledgment does not include advertising but may include the following: exclusive sponsorship arrangements; logos and slogans that do not contain qualitative or comparative descriptions of the payer's products, services, facilities, or company; a list of the payer's locations, telephone numbers, or Internet address; a value-neutral description, including displays or visual depictions, of the payer's product line or services; and the payer's brand or trade names and product or service listings. Logos or slogans that are an established part of the payer's identity are not considered to contain qualitative or comparative descriptions.
For purposes of section 513(i), "advertising" means any message or other programming material that is broadcast or otherwise transmitted, published, displayed, or distributed, and that promotes or markets any trade, business, service, facility, or product. Advertising includes messages containing the following: qualitative or comparative language; price information or other indications of savings or value; an endorsement; or an inducement to purchase, sell, or use any company, service, facility, or product. Mere display or distribution—whether for free or for a charge—of a payer's product to the general public at the sponsored activity is not considered an inducement to purchase, sell, or use the product. A single message with both advertising content and an acknowledgment is advertising. These provisions do not apply to activities a payer undertakes on its own (e.g., the purchase of broadcast time from a television station during commercial breaks in a sponsored program).
The final regulations adopt the distinction between an "exclusive sponsor" and an "exclusive provider" that was delineated in the proposed regulations. An arrangement that acknowledges a company as the exclusive sponsor (or the exclusive sponsor representing a particular business or industry) of an exempt organization activity does not, by itself, constitute a substantial return benefit. However, if the arrangement is an exclusive provider arrangement that limits the sale, distribution, availability, or use of competing products in connection with the sponsored activity, the payer has received a substantial return benefit.
Allocation of Payments
The final regulations adopt a reasonable allocation rule. If an arrangement provides that a payer will receive substantial return benefit, only the portion, if any, of the payment that exceeds the FMV of the return benefit is a qualified sponsorship payment. The burden of establishing valuation is on the exempt organization. The final regulations clarify that the fair market value of the substantial return benefit generally is to be determined when the benefit is provided. However, if the parties enter into a binding, written sponsorship contract, the fair market value of any substantial return benefit provided pursuant to that contract is to be determined on the date the parties enter into the sponsorship contract (except in the case of material changes).
The amount of a qualified sponsorship payment may not be contingent, by contract or otherwise, on attendance at the exempt organization's event, on broadcast ratings, or on other indications of public exposure that would be typical of advertising. A qualified sponsorship payment may, however, be contingent on the sponsored activity's actually taking place.
Public Support Determinations. Qualified corporate sponsorship payments in the form of money or property (but not services) will be considered as contributions for purposes of the public support tests of sections 170(b)(1)(A)(vi) and 509(a)(2) of the Code. However, this "contribution" classification with respect to the exempt organization does not determine whether the corporate sponsorship payment is deductible by the payer under section 162 as a business expense or under section 170 as a charitable contribution.
Written Agreements. The final regulations maintain that neither the existence nor the detail of a written sponsorship agreement, by itself, disqualifies payment from classification as a qualified sponsorship payment.
Sponsor Hyperlinks. For purposes of section 513(i), the final regulations address the issue of whether a hyperlink constitutes an acknowledgment or advertising in two new examples. In Example 11, a symphony orchestra maintains a website with information about its performance schedule. A music shop makes a payment to fund a concert series. The symphony posts a list of sponsors on its website, including the music shop's name and Internet address, which appears as a hyperlink from the symphony's website to the music shop's website. The symphony's website does not promote or advertise the music shop. The entire payment by the music shop is a qualified sponsorship payment. The posting of its Internet address as a hyperlink does not constitute advertising.
In Example 12, a health-based charity sponsors a year-long program to educate the public about a particular medical condition. A drug company that produces a drug used in treating the condition provides funding for the program to help the charity produce educational materials and post information on its website, which contains a hyperlink to the drug company's website. The drug company's website contains an endorsement by the charity of its drug, which was reviewed and approved in advance by the charity. The endorsement is advertising, the fair market value of which exceeds 2% of the total payment from the drug company to the charity. Thus, only the portion of the payment, if any, in excess of the fair market value of the advertising can be classified as a qualified sponsorship payment.
The preamble to the final regulations cautions that these two examples deal with hyperlinks in the section 513(i) context only and should not be relied upon with respect to the treatment of hyperlinks for purposes of other sections of the Code.
Safe Harbor Application. The final regulations reiterate that the UBIT treatment of any payment or portion thereof that does meet the requirements for the qualified sponsorship payment safe harbor will be determined by application of the ordinary UBIT rules under sections 512, 513, and 514.
See Final Regulations on Taxation of Tax-Exempt Organizations' Income from Corporate Sponsorship, 67 Fed. Reg. 20433 (April 25, 2002).
CaveatThe general information provided herein is not a substitute for specific legal advice. You should contact your (arch)diocesan legal counsel for advice concerning the application of the tax law to particular fact situations.