Avoiding unrelated business income on payments from a controlled entity.

• Author: Schnee, Edward J.

In general, organizations that are exempt from tax under Sec. 501(a) are subject to tax on their unrelated business income (UBI)by Sec. 511. Unrelated business income is generally defined by Sec. 519. as income from a trade or business that is not substantially related to the organization's tax-exempt function and that is regularly carried on by the organization. This tax was imposed to place tax-exempt organizations on an equal footing with taxable organizations in relation to their business operations.

Interest, annuities, royalties and rents from real and certain personal property are specifically excluded from the definition of UBI by Sec. 512(b), absent the application of the debt-financed property rules of Sec. 514. Standing alone, these exclusions provide an opportunity to avoid the tax. Before Sec. 512(b)(13) was added to the Code by the Tax Reform Act of 1969, it was relatively easy for an exempt organization to create a controlled entity to which it loaned money or leased property. The interest and rent received was nontaxable to the exempt organization while deductible by the controlled entity, thereby reducing its income. Congress enacted Sec. 512(b)(13) to prevent this simple planning technique.

Sec. 512(b)(13) provides that interest, annuities, royalties and rents received from a controlled organization (as defined in Sec. 368(c) for purposes of corporate organization and reorganization) will be included in the recipient's unrelated business income. (1) The section limits the amount of includible income to the percentage of the controlled entity's taxable income that would have been taxable to the exempt organization had it earned all of the controlled entity's income directly.(2)

Although Sec. 512(b)(13)was designed to prevent tax avoidance, the Treasury has issued a number of letter rulings that provide a road map for organizations wishing to avoid this tax. This article will discuss these surviving tax planning opportunities and potential IRS attacks.

Noncontrolled Entities

IRS Letter Ruling 8303019(3) illustrates the direct application of Sec. 5 12(b)(13). In this ruling a tax-exempt foundation created a wholly owned subsidiary to operate an hotel. The foundation owned the real estate, which it leased to its subsidiary. The ruling concluded that the creation of the subsidiary was nontaxable under Sec. 351. It also concluded that the rent received by the foundation was UBI under Sec. 512(b)(13).

The ruling stated that the dividends received by the foundation from the subsidiary were not taxable under Sec. 512(b)(13). Since this provision was designed to prevent transactions that reduce or eliminate a subsidiary's taxable income without normally creating UBI, the omission of dividends from Sec. 512(b)(13)is reasonable since they do not reduce taxable income at the subsidiary level.

To avoid the result in Letter Ruling 8303019, one apparently simple tax planning strategy would be to create a for-profit corporation that is economically "controlled" by the exempt organization, but which does not meet the requirements of a controlled corporation in Sec. 512(b)(13). This path was chosen by the entity in IRS Letter Ruling (TAM) 8414001.(4)

In that ruling, N, a tax-exempt entity under Sec. 501(c)(3), created 0, a for-profit corporation. 0 sold 20,000 shares 110% 1 of its common stock to N and issued approximately 51.5% of its senior notes to N. To prevent Sec. 512(b)(13) from converting the interest income on the senior notes into UBI, N had O sell 100% of a newly authorized issue of nonvoting, nonparticipating, nonconvertible, cumulative preferred stock to A, a member of the governing bodies of both N and O. The IRS stated that "[t]he sale of preferred stock to A had been agreed upon by the governing body of N specifically to assure that N would not meet the technical definition of control contained in section 512(b)(13)." (Emphasis added by the IRS.) The District Office challenged the nontaxability of the interest directly on the basis that N controlled O and indirectly on the basis that the transactions were purely tax motivated. The issues were referred to the IRS National Office for technical advice.

The National Office rejected the tax avoidance argument. The ruling stated that Sec. 512(b)(13) is concerned with the degree of control and that the relationships among the parties is not relevant. If Congress had wanted this issue addressed, the Service reasoned, it could have included a "disqualified person" exception, as it did in other provisions. The Service concluded that the omission of this requirement precluded consideration of the relationships among the parties directly and the underlying intent of the transaction indirectly. Further, the transaction was not without substance because the preferred stock owned by A represented valuable rights that would result in benefit to A, not to N.

The District Office also contended that the preferred stock should be classified as debt under Sec. 385. This would have resulted in a finding that N owned 100% of the only class of stock outstanding. After reviewing Sec. 385 and the factors normally considered by the courts, the ruling held that the preferred stock was in fact stock. Therefore, N did not control O.

Although the entity in this ruling survived the challenge, it can be expected that the Sec. 385 issue will be raised again in future cases. Any entity trying to duplicate the outcome in Letter Ruling 8414001 should make certain that the instrument held by the minority party will be considered stock. Since this is usually a facts and circumstances determination, any recently litigated cases should be considered...