Is endowment investment income subject to UBIT?

• Author: Ruvelson, Richard L.
• Position: Unrelated business income tax

This item focuses on the applicability of the unrelated business income tax (UBIT) basics to endowment investments. Tax advisers should consider the UBIT rules when structuring investment opportunities.

The endowment portfolios of tax-exempt charitable organizations have risen, declined and risen again in value over the last decade, with increased diversity in both the types and forms of investments held. Ten years ago, only the larger endowments held investments that are now common (e.g., interests in hedge funds, private equity and offshore funds). Tax advisers should work more closely with their clients to inform them of both the tax consequences and opportunities that these options present. If the basics are kept in mind, delivering this advice is much less complicated than it might otherwise seem.

UBIT Modifications

Sec. 512 sets forth a definition of unrelated business taxable income (UBTI) that generally includes gross income from activities unrelated to an organization's exempt function. Such activities constitute a trade or business regularly carried on by the organization. The income is subject to directly connected deductions and modifications as provided in Sec. 512(b), as well as to exceptions found in Sec. 513.

Certain unrelated income streams are excluded from UBTI. For instance, Sec. 512(b)(1) excludes all dividends, interest, annuities and payments for securities loans (as defined in Sec. 512(a)(5)) from UBTI. Kegs. Sec. 1.512(b)-1(a)(1) excludes substantially similar income from ordinary and routine investments to the extent determined by the IRS. For example, distributions out of the earnings and profits of a real estate investment trust were dividends exempt in computing UBTI (Rev. Rul. 66-106).

Sec. 512(b)(2) excludes royalties, whether measured by production or by gross or taxable income from the underlying property. Sec. 512(b)(3) excludes, generally, rents from real property and certain rents from personal property. Sec. 512(b)(5) excludes all gains or losses from the sale, exchange or other disposition of property not stock in trade, inventory or held for sale to customers in the ordinary course of trade or business. Also, Sec. 512(b)(5) excludes all gains or losses recognized from investment activities or from the lapse or termination of options to buy or sell securities or real property; see Letter Ruling 200041038 for a discussion of a related trade or business and Sec. 512(b)(5)'s applicability to timber...