Specified Payments from Controlled Entities
Author: Krystal Creach
An exception to rules for specified payments and their treatment as unrelated business taxable income (UBTI) expired this year, which could affect financial decisions for many tax-exempt organizations.
Certain specified payments, including interest, annuities, royalties and rent, usually are excluded from a tax-exempt organization’s UBTI. Under Internal Revenue Code (IRC) Section 512(b)(13), however, these specified payments from controlled entities can be considered UBTI.
The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extended an exception for payments after December 31, 2005, and before January 1, 2012, that required as UBTI only the portion of payments received or accrued in a tax year exceeding the amount that would have been paid or accrued if the amount of the payment had been determined under the principles of IRC Sec. 482, i.e., at arm’s length. With the expiration of this exception as of January 1, 2012, controlling organizations need to look more closely at payments from controlled entities.
A controlled entity is one in which the organization has:
- The power to remove and replace a majority of the directors or trustees or the power to remove and replace a majority of the subsidiary’s directors or trustees as trustees, directors, officers, employees or agents of the parent (in the case of a tax-exempt organization)
- Ownership by vote or value of more than 50 percent of the stock in a corporation (in the case of a corporation)
- Ownership of more than 50 percent of the profits interests or capital interests in a partnership (in the case of a partnership)
- Ownership of more than 50 percent of the beneficial interests in the entity in all other cases
In addition to the above, the constructive ownership rules under IRC Sec. 318 apply, meaning these rules may be applied between brother/sister organizations in addition to parent/subsidiary organizations.
Payments from the controlled entity will be considered UBTI to the controlling organization if the payments reduce net unrelated income or increase net unrelated loss of the controlled entity. For a taxable controlled entity, the controlled entity’s payments would be UBTI if, when looking at the nature of the income, the income would be UBTI if the organization were tax-exempt and had the same tax-exempt purpose as the controlling organization. For any tax-exempt controlled entity, the payments would be UBTI if the controlled entity itself has UBTI and reduces its UBTI by the payments made.
Payments should be included in UBTI in the year the payment obligation accrues whether or not actually received in that year. A controlling organization should consider loans to controlled entities, where imputed interest may need to be calculated. Use of building space to controlled entities that may fit the above conditions also could meet these UBTI rules.
Those with tax years ending after December 31, 2011, should take these rules into consideration to begin properly reporting specified payments from controlled entities. If you have questions or would like to discuss how these rules apply to your organization, contact your BKD advisor or Brian Todd.