Does unrelated business income tax (UBIT) apply to private foundations?
Yes, unrelated business income tax (UBIT) applies to private foundations in the same way it applies to the vast majority of other tax-exempt entities. The rules governing UBIT are complex and confusing but below we will try to shed some light on how the rules affect private foundations.
The IRS generally defines unrelated business income (UBI) as “income from a trade or business, regularly carried on, that is not substantially related to the charitable, educational, or other purpose that is the basis of the organization's exemption.” UBI is generated when tax-exempt organizations are connected to ordinary business operations like those of restaurants and retailers. For private foundations the most common source of UBI is from alternative investments such as hedge funds, private equity funds, and venture capital funds. Private foundations can also pick up UBI when they have direct ownership in a for-profit operating business or when the foundation engages directly in commercial activities (The most common direct commercial activity is advertising income from websites, social media, and publications).
Passive income, including interest, dividends, capital gains and royalties, is generally excluded from UBI. As such, common off the shelf investments such as stocks, bonds, and mutual funds do not get entangled in the UBIT rules. Private foundations should ordinarily avoid UBI because it has two direct negative impacts:
(1) UBI is taxed at much higher rates than regular investment income. For private foundations UBI is taxed at the relatively high rate of 21% in contrast to the standard investment income tax rate of just 1.39%. Furthermore, depending on the physical location where the UBI is generated, the foundation may need to file state tax returns and pay state income tax on the UBI. The federal and state taxes on UBI can negatively alter investment returns changing what might be an otherwise good investment into a mediocre or bad investment.
(2) If UBI accounts for a “substantial” portion of a private foundation’s income, the IRS has the power to revoke the foundation’s tax-exempt status. The reasoning here is that private foundations are nonprofit entities—receiving substantial amounts of UBI contradicts the idea of being a nonprofit. There is no fixed percentage or mechanical test to help determine how much UBI is too much. Many private foundations consistently receive a small amount of UBI each year from their investment portfolio—no one, including the IRS, would bat an eye if UBI is 5% of gross income or less. Ultimately, the IRS is final arbiter of how much UBI is too much and it considers all facts and circumstances in making determinations. In the absence of a definitive threshold level, private foundations should carefully evaluate their situation if UBI reaches 10 to 20% of gross income or higher.
In general, private foundations should endeavor to avoid UBI due to the higher tax rates and the potential consequence of losing tax-exempt status. Foundations should be particularly vigilant when conducting due diligence on alternative investments because they oftentimes can generate UBI. Before buying into an exotic financial instrument, foundation investment managers should verify whether the investment has potential exposure to UBI. If yes, the higher tax rates should definitely be considered on the front end. It is not wise to let tax laws be the tail that wags the dog—but having a solid understanding of the UBIT rules can help private foundations with investment planning and help assure their future as a tax-exempt entity.
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