Transfers between controlled entities can provide surprises under Sec. 512(b) (13).

• Author: Lowenthal, David

Many tax-exempt organizations are growing into complex multi-entity groups including both nonprofit corporations that are tax exempt under Sec. 501(c) and for-profit entities, which are taxed accordingly. Typically, members of a multi-entity structure enter into contracts with one another regarding matters such as management agreements, real property leases, lending facilities, and licenses of intellectual property. Sometimes these relationships can create undesired tax consequences caused by Sec. 512(b)(13), which can lead to unrelated business taxable income (UBTI) for tax-exempt members of a group.

UBTI

In a standard application of Sec. 512(b)(13), a subsidiary entity will make a deductible payment of interest, rent, royalty, or annuity to a parent exempt organization. Under Secs. 512(b)(1), (2), and (3), receipt by (tax-exempt) Sec. 501(c) entities of interest, rents, royalties, and annuities is generally excluded from UBTI. However, under Sec. 512(b)(13), the parent exempt organization is subject to UBTI. (The subsidiary is not affected by Sec. 512(b)(13).) Thus, Sec. 512(b) (13) treats a parent exempt organization more harshly in its contractual relationships within its related group than in similar relationships with unrelated third parties.

Sec. 512(b)(13)(A) provides that if a tax-exempt organization (controlling organization) receives or accrues a "specified payment" from a "controlled entity," the resulting income will be UBTI to the controlling organization to the extent it would reduce the net unrelated income or increase the net unrelated loss of the controlled entity.

Under Sec. 512(b)(13)(D), a controlling organization is deemed to control a taxable controlled entity if it owns:

* More than 50% of a corporation's stock;

* More than 50% of the profits or capital interest in a partnership; or

* More than 50% of the beneficial interest in any entity.

Sec. 318 constructive ownership rules apply, including the rules regarding attribution of indirect ownership.

A specified payment is defined under Sec. 512(b)(13)(C) to include "interest, annuity, royalty, or rent."

Sec. 512(b)(13)(B) defines "net unrelated income or loss" differently depending on whether the controlled entity is tax exempt or taxable. For a tax-exempt controlled entity, net unrelated income is equal to the controlled entity's UBTI before deducting the specified payment. For a taxable controlled entity, net unrelated income is equal to the amount of its taxable...