Exempt Organization Future LeadersTaxProgram:unrelated ...

Exempt Organization Future LeadersTax Program: unrelated business income 22 February 2018 Disclaimer EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. This presentation is 2018 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party. Views expressed in this presentation are those of the speakers and do not necessarily represent the views of Ernst & Young LLP.

This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayers facts and circumstances. These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice. Page 2 Exempt Organization Future Leader Tax Program: unrelated business income Presenters Nicole Sokolowski Senior Manager Ernst & Young LLP New York, NY Olatunji Barlatt

Manager Ernst & Young LLP New York, NY Emily Seelye Manager Ernst & Young LLP Boston, MA Page 3 Exempt Organization Future Leader Tax Program: unrelated business income Agenda Compliance for estimates and extensions

Unrelated business income (UBI) Effect of tax reform on UBI Exclusions and modifications to Unrelated Business Taxable Income (UBTI) 2016 Form 990-T changes Computing UBTI Common scenarios that can give rise to UBTI IRS examinations Page 4 Exempt Organization Future Leader Tax Program: unrelated business income Compliance for estimates and extensions Page 5 Exempt Organization Future Leader Tax Program: unrelated business income Compliance for estimates and extensions Requirements to file Form 990-T

Page 6 Any domestic or foreign organization under Section 501(a) or Section 529(a) if it has gross income of $1,000 or more from a regularly conducted unrelated trade or business Organizations liable for the proxy tax on lobbying and political expenditures Colleges and universities of states and other governmental units and subsidiary corporations wholly owned by such colleges and universities Applicable reinsurance entities under the Affordable Care Act of 2010 Organizations that are liable for other taxes, such as Section 1291 tax or recapture taxes Qualified tuition programs described under Section 529 that have $1,000 or more of unrelated trade or business gross income Trustees for the following trusts that have $1,000 or more of unrelated business gross income (IRSs, SEP IRAs, SIMPLE IRAs, Roth IRAs under Section 408A, ESAs, Archer MSAs and HSAs) Exempt Organization Future Leader Tax Program: unrelated business income Compliance for estimates and extensions

When to file An employees trust defined in Section 401(a), an IRA, a Roth IRA, a Coverdell ESA or an Archer MSA must file Form 990-T by the 15th day of the fourth month after the end of its tax year. All other organizations must file Form 990-T by the 15th day of the fifth month after the end of their tax years. Extension Page 7 An organization may request an automatic six-month extension of time to file; however, this does not grant the organization additional time to pay any tax liabilities. Exempt Organization Future Leader Tax Program: unrelated business income Compliance for estimates and extensions

Estimated tax payments An organization filing Form 990-T must make installment payments of estimated tax if its estimated tax liability is expected to be $500 or more. Estimated payments must amount to the smaller of the organizations tax liability for the tax year or 100% of the prior years tax. Failure to make estimated tax payments may be subject to an underpayment penalty. Interest and penalties Page 8

Interest is charged on taxes not paid by the original due date for the return even if the organization requested an extension of time to file. Late filing is subject to a penalty of 5% up to 25% of the unpaid tax. Late payment of tax is usually one-half of 1% of the unpaid tax for each month the tax is unpaid. Other penalties may be imposed for negligence, substantial understatement of tax, reportable transaction understatements and fraud. Exempt Organization Future Leader Tax Program: unrelated business income Compliance for estimates and extensions Consideration of tax reform for 2018 Except in the case of exempt trusts, the corporate tax rate decrease should decrease organizations income tax owed; however, limits on net operating losses (NOLs) need to be considered. NOLs generated in years ending after 31 December 2017 will be allowed to be carried forward indefinitely, but NOLs generated in years beginning after 31 December 2017 will be capped at 80% of taxable income.

There are new streams of (UBTI) to consider, i.e., qualified transportation fringe. Page 9 Exempt Organization Future Leader Tax Program: unrelated business income UBI basics Page 10 Exempt Organization Future Leader Tax Program: unrelated business income UBI basics background and definitions Section 511 imposes a tax on UBTI of organizations described in Sections 401(a) and 501(c), as well as state colleges and universities Section 512 UBTI is composed of: Gross income from unrelated trade or business, reduced by: Page 11

Allowable deductions directly connected to such trade or business Exempt Organization Future Leader Tax Program: unrelated business income Determining UBI in three steps 3. Compute $ 2. Exclusion or modification? 1. Unrelated? Page 12 Exempt Organization Future Leader Tax Program: unrelated business income Step 1: Is it unrelated? 1. Unrelated? Is the activity: A trade or business?

Regularly carried on? Not substantially related to the organizations exempt purposes? Page 13 Exempt Organization Future Leader Tax Program: unrelated business income UBI basics background and definitions Section 513 defines an unrelated trade or business as: Any trade or business that is regularly carried on and the conduct of which is not substantially related to the exercise of performance by such organization of its charitable, educational or other purpose or function constituting the basis for its exemption under Section 501 Three components of UBI:

1. Trade or business 2. Regularly carried on 3. Not substantially related to exempt purpose Page 14 Exempt Organization Future Leader Tax Program: unrelated business income Trade or business requirement Section 162 definition used Regularly carried on for the production of income (profit motive) Competition/commerciality: Activity must be of a type that presents sufficient likelihood of unfair competition with non-exempt business endeavors.

Fragmentation: It does not matter if actual competition with taxable entities takes place. You cannot cleanse unrelated activity because you do a similar related activity. The activity retains its own identity, even if it is carried on as an integral part of a larger aggregate of similar activities. Activities consistently producing losses: May be evidence of a lack of profit motive: Page 15 Can prevent use of losses to offset income from other activities Exempt Organization Future Leader Tax Program: unrelated business income Regularly carried on requirement Concept:

Normal time span: If the exempt organization (EO) is acting in a manner similar to a taxpaying entity, then the business would be considered regularly carried on. Where income-producing activities are of a kind normally conducted by commercial entities on a year-round basis, the conduct by an EO of such activities over a period of a few weeks is not regularly carried on. Conduct of year-round activities of commercial enterprise for one day each week by an EO would constitute being regularly carried on. Seasonal activity:

There must be a frequency and continuity similar to the activities of a comparable non-exempt commercial enterprise. If conducted during time of year that commercial entities would operate then regularly carried on (sale of Christmas trees) Intermittent activities can be considered regularly carried on Page 16 Exempt Organization Future Leader Tax Program: unrelated business income Not substantially related requirement In order for an activity to be related (as opposed to an unrelated activity), there must be a substantial causal relationship to the achievement of tax-exempt purposes: Activity examined (not how income from the activity will be used)

Facts and circumstances determination Type of relationship required: The activity must contribute importantly to the accomplishment of the organizations exempt purposes. Size and extent of activities must be appropriate: If activities are conducted on a basis larger than necessary to accomplish exempt mission, the excess is taxable. Dual use concept. Page 17 Exempt Organization Future Leader Tax Program: unrelated business income Effect of tax reform on UBI Page 18 Exempt Organization Future Leader Tax Program: unrelated business income UBTI increased by amount of certain fringe expenses Provision summary: New Section 512(a)(7) provides that, effective for amounts paid

after 31 December 2017, organizations subject to the UBI tax rules must increase their UBTI by their expenses of providing certain fringe benefits that would be nondeductible for a taxable entity. Fringe benefits subject to the rule: Expenses for commuter highway vehicle transportation, transit passes and qualified parking increase UBTI if the benefits are excludable from employee income under Section 132(f). On-premises athletic facility expenses increase UBTI if the facility is primarily for benefit of highly compensated employees. Expense considerations: Employee pretax salary reduction (excludable under Section 132(f)) is likely to be treated as UBTI.

Post-tax reimbursements of commuting expenses that do not qualify for exclusion under 132(f) should not generate UBTI. Other considerations: Page 19 Many organizations may be subject to state or local laws requiring employers to provide some form of transportation subsidy. Exempt Organization Future Leader Tax Program: unrelated business income UBTI to be separately computed for each trade of business Prior law: UBTI is calculated by aggregating the gross income from all unrelated trades and businesses and then subtracting the aggregate deductions directly connected with producing that income. New provision: Section 512(b)(12), effective for tax years starting after

31 December 2017, requires determining UBTI separately for each business. Thus, an unrelated trade or businesss income can only be offset using deductions directly connected with that particular trade or business. NOLs of a particular business could offset future income from that business but not from other businesses. However, NOLs arising in a tax year beginning before 1 January 2018 that are carried forward to a tax year beginning after such date are not subject to provision and can be applied to UBTI generally. Key takeaway: Overall UBIT burden of organizations may increase due to inability to offset losses from one unrelated trade or business against the gains of another. Page 20 Exempt Organization Future Leader Tax Program: unrelated business income UBTI to be separately computed for each trade of business

Considerations: The key question for regulatory guidance will be What constitutes a separate business? Will all investment income of an EO be treated as a single business, or is each investment separate? There will be an increased emphasis on tracking and allocating expenses to each business. If the separate computation would significantly increase UBTI, consider transferring the unrelated business activities to a taxable corporation that would be able to net the gains and losses on an aggregate basis. Page 21 Exempt Organization Future Leader Tax Program: unrelated business income Exclusions and modifications to UBTI Page 22

Exempt Organization Future Leader Tax Program: unrelated business income Step 2: Excluded? 2. Exclusion? Section 513 provides specific UBTI exclusions. Page 23 Exempt Organization Future Leader Tax Program: unrelated business income UBTI exclusions Principal exclusions: Same state rule Convenience exception

Volunteer labor exception Donated goods exception Certain hospital services Section 513(e) Page 24 Exempt Organization Future Leader Tax Program: unrelated business income Same state exception Treas. Reg. Section 1.513-1(d)(4)(ii) General rule: Gross income resulting from the sale of products that result from the performance of exempt functions will not be considered UBTI if the

products are sold in substantially the same state that existed at the completion of exempt functions. Example: Page 25 Consider an experimental dairy herd maintained for scientific purposes by a Section 501(c)(3) research organization. Income from the sale of milk and cream produced in the ordinary course of operations would not be UBTI. If the milk and cream were later used to manufacture ice cream and pastries, the gross income from the sale of such products would be UBTI, unless this also contributed importantly to the organizations exempt purposes. Exempt Organization Future Leader Tax Program: unrelated business income Convenience exception Section 513(a)(2) General rule:

UBTI does not include income from a trade or business carried on by the organization primarily for the convenience of its members, students, patients, officers or employees. Applies only to: Section 501(c)(3) organizations, and colleges and universities subject to UBTI Certain sales by local association of employees under Section 501(c)(4) Page 26 Exempt Organization Future Leader Tax Program: unrelated business income Volunteer labor and donated goods exceptions Volunteer labor exception Section 513(a)(1): provides that any trade or business in which substantially all the work in carrying on the trade or business is performed for the

organization without compensation is not an unrelated trade or business: Substantially all 85% or more see PLR 8433010 Without compensation Tips can be considered compensation. Noncash fringe benefits, such as meals, can be considered compensation. Donated goods exception Section 513(a)(3): provides that UBTI does not include income from a trade or business that involves the selling of merchandise, substantially all of which was donated

Example: thrift store Page 27 Exempt Organization Future Leader Tax Program: unrelated business income Hospital services under Section 513(e) The term unrelated trade or business does not include the furnishing of one or more support services described in Section 501(e)(1)(A) to other unrelated exempt hospitals described in Section 170(b)(1)(A)(iii) if such services: Are furnished solely to such hospitals that have no more than 100 inpatient beds Would, if performed on its own behalf by the recipient hospital, constitute an activity consistent with that hospitals exempt purposes

Are provided at a fee or cost that does not exceed the actual cost of providing such services The list of excludible support services is specific. It includes many common services (e.g., data processing, billing, personnel), but not laundry. Page 28 Exempt Organization Future Leader Tax Program: unrelated business income UBTI modifications 2. Modification? Section 512(b) specifies modifications that carve out certain types of income from UBTI. Page 29 Exempt Organization Future Leader Tax Program: unrelated business income UBTI modifications

Principal modifications: Interest and dividends Royalties Rents Gains and losses from the sale, exchange or other disposition of property Income from research activities Income from S corporations Page 30

Exempt Organization Future Leader Tax Program: unrelated business income Passive income Generally, passive income is not considered UBTI. This rule applies to interest, dividends, annuities, royalties or rents received (Sections 512(b)(1)-(3)). There are several exceptions with respect to passive income: Income from controlled organizations (Section 512(b)(13)) Page 31 This exception does not apply to dividends. Income from debt-financed property (Section 512(b)(4)) Exempt Organization Future Leader Tax Program: unrelated business income

Royalties Royalties are generally excluded under Section 512(b)(2). To be a royalty, a payment must relate to the use of a valuable intellectual property right (e.g., copyright, trademark, trade name). Royalties do not include payments for personal services. A royalty is, by definition, passive, and thus cannot include compensation for services rendered by the owner of the property. Key question: Are services being performed in conjunction with the use of a valuable right? An EO is permitted to perform certain types of services to protect/safeguard its licensed property rights without jeopardizing the royalty exclusion.

Page 32 Example: quality control rights (i.e., retaining the right to approve the quality or style of the licensed product) Exempt Organization Future Leader Tax Program: unrelated business income Rental income Generally, rents of real property are excluded from UBTI under Section 512(b)(3); rents of personal property are not excluded. Special rules apply when rents are received from personal property leased with real property (mixed lease). See next slides. Exceptions to rental exclusion (see next slides for detail): Page 33 Rents based on net income or profit

Substantial services If rents are derived from controlled organizations (Section 512(b)(13)) or debtfinanced property (Section 514), included in computing UBTI to the extent provided in those sections Exempt Organization Future Leader Tax Program: unrelated business income Rents from real property mixed leases with personal property Rents from personal property leased with real property (mixed leases) are excluded where the rent from personal property is an incidental amount of the total rent. Rent from personal property is considered incidental, if the rent

attributable to it does not exceed 10% of the total rents from all the leased property. Where the rent attributable to the personal property is more than 10% but does not exceed 50% of the total rent, only the rental income attributable to the real property is excluded from UBTI. Where the rent attributable to the personal property is more than 50% of the total rent, none of the rent (including the rent from real property) is excluded. Summary of mixed leases: Page 34 Personal property 10% = all rents excluded Personal property > 10% but 50% = only real property rents excluded Personal property > 50% = no rents excluded Exempt Organization Future Leader Tax Program: unrelated business income Rents from real property based on net profits Rental income exclusion does not apply if real or personal property rentals are measured by reference to the net income or profits from the property.

Page 35 However, a lease based on a fixed percentage of the gross receipts or sales will not be taxed solely by reason of such lease (Section 512(b)(3) (B)(ii)). Exempt Organization Future Leader Tax Program: unrelated business income Rents from real property rendering of personal services General rule: Payments for the use or occupancy of rooms or other space where services are also rendered to the occupant do not constitute rent from real property. Services are considered rendered to the occupant if they are primarily for his/her convenience and are different from those usually or customarily rendered in connection with the rental of rooms or space for occupancy only.

Example: supplying maid services The furnishing of heat and light, the cleaning of public entrances, exits, stairways and lobbies, and the collection of trash are not considered as services rendered to the occupant. Page 36 Exempt Organization Future Leader Tax Program: unrelated business income Income from controlled organizations Generally, passive income (interest, annuities, royalties and rents) is excluded from UBTI. Exception under Section 512(b)(13) for qualified specified payments (if met, then the income is UBI): Interest, annuities, royalties and rents (net of any directly connected deductions) received or accrued by a controlling entity from a controlled entity

To the extent the payment reduces the net unrelated income of the controlled entity (or increases net unrelated loss): Page 37 Net unrelated income for an EO is its UBTI. For a non-EO entity, the portion of its taxable income that would be UBTI if the taxable entity were exempt and had the same purposes as the controlling organization. Exception to this exception: payments made at arms length pursuant to a written binding contract in effect on 17 August 2006 Exempt Organization Future Leader Tax Program: unrelated business income Income from controlled organizations Control defined

An entity is a controlled organization if the controlling organization owns: By vote or value more than 50% of the corporations stock More than 50% of a partnerships profits or capital interests More than 50% of the beneficial interests in an organization (other than a corporation or partnership) An exempt parent organization is treated as controlling any subsidiary in which it holds more than 50% of the voting power or value, whether directly (as in first-tier sub) or indirectly (as in second-tier sub). To determine the ownership of a corporation, a partnership or any other organization, apply the principles of Section 318 (constructive ownership). Page 38

Exempt Organization Future Leader Tax Program: unrelated business income Gains or losses from dispositions of property Section 512(b)(5) General rule: Gains or losses from the sale, exchange or other disposition of property do not constitute UBTI. Exceptions: Stock in trade or other property of a kind that would properly be includible in inventory if on hand at the end of the tax year Property held primarily for sale to customers in the ordinary course of the trade or business If gain/loss is derived from the sale or other disposition of debt-financed property, it is included in UBTI to the extent provided in

Section 514. Depreciation recapture provisions of Sections 1245 and 1250 may apply and treat certain recapture amounts as UBTI. Page 39 Exempt Organization Future Leader Tax Program: unrelated business income Research activities General rule income from research activities is excluded in computing UBTI if the research is performed: For the United States, or any of its agencies or instrumentalities, or any state or political subdivision thereof (Section 512(b)(7)) For any person by a college, university or hospital (Section 512(b)(8)) For any person by an organization operated primarily for the purpose of carrying on fundamental research; the results of such research must be freely available to the general public; the key consideration with respect to this modification is that the nature of the research is fundamental rather than applied (Section 512(b)(9))

The term research is not defined in the Internal Revenue Code (IRC). However, the Treasury regulations indicate that research does not include activities of a type ordinarily carried on as an incident to commercial or industrial operations, for example, the ordinary testing or inspection of materials or products, or the designing or construction of equipment or buildings. Page 40 Exempt Organization Future Leader Tax Program: unrelated business income Section 512(e) special rule applicable to S corporations General rule if a Section 501(c)(3) organization (or trust which is part of a Section 401(a) qualified plan) holds stock in an S corporation: Such interest shall be treated as an interest in an unrelated trade or business. All items of income, loss or deduction, as well as any gain or loss on the

disposition of the stock in the S corporation, are treated as UBTI. Page 41 Exempt Organization Future Leader Tax Program: unrelated business income Sections 512(b)(4) and 514 debt-financed property Income from debt-financed property is taxable in proportion to which the property is debt financed. Debt-financed property: Usually associated with real property and improvements to real property Definition: all property held to produce income with respect to which there is an acquisition indebtedness at any time during the tax year

Examples: rental real estate, tangible personal property and corporate stock Deductions directly connected with the property or its income are allowed in the same proportion. Depreciation must be computed on the straight-line method. Page 42 Exempt Organization Future Leader Tax Program: unrelated business income Exceptions to debt-financed property Property with a substantially related use: the term debt-financed property does not include: Any property in which substantially all (at least 85%) of its use is substantially related to the organizations tax-exempt purpose

Thus, up to 15% of the use of the property can be unrelated and avoid UBI treatment. If the foregoing provision does not apply, any property to the extent that the use of the property is substantially related. Examples: A hospital constructs a 10-story building with borrowed funds and leases out one floor to an unrelated tenant. Since at least 85% of the building (9 of 10 floors, or 90%) is used by the hospital in carrying out its exempt functions, the rental income will not be subject to the debt-financed property rules. If less than 85% of the building is used by the hospital, a portion of the rental income would be UBTI (portion attributable to use which is not substantially related to the hospitals exempt purpose). Page 43 Exempt Organization Future Leader Tax Program: unrelated business income Other exceptions to debt-financed property

Medical clinics Use by related organizations Income exempt from UBTI Research activities Neighborhood land exclusion Page 44 Exempt Organization Future Leader Tax Program: unrelated business income 2016 Form 990-T changes Page 45 Exempt Organization Future Leader Tax Program: unrelated business income 2016 Form 990-T changes New tax on the income of any 501(r) noncompliant hospital facility operated by the organization

There is a new line 39 for the income tax on a hospital organizations noncompliant facility income. Section 179D deductions Page 46 The deduction under Section 179D for the cost of energy-efficient commercial building property has been extended and is allowable for property placed in service on or before 31 December 2016. You can claim a deduction for energy-efficient buildings in Part II, line 28. Exempt Organization Future Leader Tax Program: unrelated business income 2016 Form 990-T changes Qualified specified payments Exclusion from UBTI for qualified specified payments under Section 512(b)(13)(E) has been made permanent.

You need written a contract as of 17 August 2006 or a renewal on similar terms. Page 47 Exempt Organization Future Leader Tax Program: unrelated business income Computing UBTI Page 48 Exempt Organization Future Leader Tax Program: unrelated business income Step 3: Computing UBTI 3. Compute $ Gross income (after modifications) Less: Directly connected deductions Specific deduction (generally, $1,000) = UBTI Three baskets of expenses: Directly connected to UBTI activity proximate and primary deduct in full Exempt/related expenses do not deduct

Dual use allocate on a reasonable basis Page 49 Exempt Organization Future Leader Tax Program: unrelated business income UBTI deductions allocation methodology Treas. Reg. Section 1.512(a)-1(a) imposes two criteria for deduction against UBTI: Only deductions allowed under the IRC (e.g., Section 162, Section 167) may be taken against UBTI. Deductions must be directly connected with activity that produced the UBTI. Page 50 Direct connection: Costs have proximate and primary relationship to the carrying on of the business that generated the UBTI.

The IRS has argued that for an expense to be directly connected with an activity, it must be one that would not have been incurred in the absence of the activity. The Tax Court has placed the burden on the taxpayer to prove direct connection to deductions. CORE Special Purpose Fund v. Commr, TC Memo 1985-48 (Tax Court disallowed deductions taxpayer did not prove actual incurrence of expenses, or that the expenses were directly connected with an unrelated trade or business activity that generated UBTI). Exempt Organization Future Leader Tax Program: unrelated business income UBTI deductions related expenses Identify those expenses that are strictly for exempt purposes and do not use those expenses to offset UBTI. Also, do not use those expenses in management and general and administrative that are program- or fundraising-related. Examples:

Development officer and fundraising expenses Government relations Community benefit studies Page 51 Exempt Organization Future Leader Tax Program: unrelated business income UBTI deductions dual-use property Dual use of facilities or personnel Where facilities or personnel are used for both exempt functions and the conduct of unrelated trade or business, the expenses, depreciation and similar items attributable to such facilities or personnel must be allocated between the two uses on a reasonable basis. See Reg. Section 1.512(a)-1(c). Page 52 Exempt Organization Future Leader Tax Program: unrelated business income

UBTI deductions allocation methodology Examples of categories of expenses that may be allocated on a reasonable basis Depreciation Personnel costs Rent for dual-use space Utilities Maintenance

Examples of what may constitute reasonable allocation Hours spent: to allocate payroll taxes, employee benefits and pensions related to persons performing both related and unrelated activities Square footage: to allocate depreciation, maintenance, utilities and other fixed expenses of a facility in which unrelated functions are conducted continually in designated areas Gross receipts: variable expenses, such as cost of goods sold Page 53 Exempt Organization Future Leader Tax Program: unrelated business income UBTI deductions use of Medicare cost reports GCM 39843 held that an organization cannot use Medicare costs in computing UBTI.

Medicare costs and income tax deductions differ in purpose, definition, allocation and timing. Consequently, deducting Medicare costs in computing UBTI generally fails to accurately reflect UBTI. In deducting Medicare costs, a hospital must prove that all Medicare costs: Page 54 Are allowable deductions under the IRC Are directly connected to unrelated trade or business (i.e., bear a proximate and primary relationship)

Clearly reflect income Exempt Organization Future Leader Tax Program: unrelated business income American Institute of Certified Public Accounts (AICPA) recommendations Expense allocations on 990-T Page 55 AICPA provided comment letter to IRS on 27 February 2017 Deductible expenses must bear a proximate and primary relationship to the conduct of the activity. Deductible expenses include both direct costs and indirect costs. Indirect costs include fixed expenses (those which do not change when the

unrelated activity is conducted or not conducted) and variable expenses (those which increase or decrease when the unrelated activity is conducted or not conducted). The methodology for allocating expenses relating to dual-use facilities/personnel is reasonable and consistently followed from year to year and should not cause the double-counting of any expense. The methodology for allocating expenses relating to dual-use facilities/personnel is based on the character of the expense involved. Exempt Organization Future Leader Tax Program: unrelated business income AICPA recommendations Facility costs (rent, mortgage interest, insurance, taxes, security and utilities) apportioned based on portion of facility used (square footage and time) for each activity Personnel costs (salary, benefits and taxes) apportioned based on time spent

on each activity Information technology costs (software, computer services and internet) apportioned based on allocation of personnel to activity Office expenses (supplies, printing, postage and subscriptions) apportioned based on allocation of personnel to activity AICPA recommends IRS permit use of gross revenue, from each respective activity, to allocate direct and/or indirect expenses if there is no difference in prices charged to earn unrelated versus related revenue AICPA recommends that IRS provide simplified method for small businesses to determine expenses that are deductible against UBI Page 56 Exempt Organization Future Leader Tax Program: unrelated business income

Common scenarios that can give rise to UBTI Page 57 Exempt Organization Future Leader Tax Program: unrelated business income Specific categories of UBTI Laboratory services Pharmacy sales Cafeteria Parking facilities Fitness facilities/health clubs Gift shops Sale of durable medical equipment (DME)

Management and other administrative services Medical office buildings (MOB) Alternative investments Joint ventures Telemedicine and accountable care organizations Page 58 Exempt Organization Future Leader Tax Program: unrelated business income General question Who is receiving the service? Patients Employees

General public The IRS has adopted a patient/non-patient approach to determining the taxation of many services (e.g., lab, pharmacy): Services to patients generally will not generate UBTI Services to non-patients generally will generate UBTI Private patients of hospital staff physicians are not patients. Exception: Services to employees of the exempt entity or related exempt entity and related to their employment generally will not generate UBTI (convenience exception). Six examples of a patient are provided in Rev. Rul. 68-376. Page 59 Exempt Organization Future Leader Tax Program: unrelated business income

Who is a patient? Examples of a patient (Rev. Rul. 68-376): A person admitted to the hospital as an inpatient A person receiving general or emergency diagnostic, therapeutic or preventive health services from outpatient facilities of the hospital A person directly referred to the hospitals outpatient facilities by his or her private physician for specific diagnostic or treatment procedures A person refilling a prescription written during the course of his or her treatment as a patient of the hospital A person receiving medical services as part of a hospital-administered

home care program A person receiving medical care and services in a hospital-affiliated extended care facility Page 60 Exempt Organization Future Leader Tax Program: unrelated business income Laboratory services Provision of lab services to patients of affiliated entities in a health system generally will not result in UBTI. PLR 9102035; 9837031; 9102034 Exceptions to non-patient rules: Training/education testing contributes importantly to nurses, medical students, interns, residents or physicians

Isolated rural area not adequately served by commercial laboratories Specialized facilities/capabilities technologically advanced facilities that perform tests that could not be adequately performed at other medical laboratories or, in an emergency, necessary tests performed faster than by other medical labs in area Page 61 Exempt Organization Future Leader Tax Program: unrelated business income Pharmacy sales Sale of pharmaceutical supplies by a tax-exempt hospitals pharmacy to patients is not UBTI. Same definition of patient from Rev. Rul. 68-376 applies.

Sales to general public (non-patients) will likely be UBTI: Example: if a hospital maintains a pharmacy on the ground level of the building, giving the general public access from the street, and such sales are frequent and continuous Page 62 However, hospital pharmacy sales to the general public where the sales are not promoted by the hospital, do not occur with frequency and represent only an insignificant portion of the pharmacys sales are likely to not be considered UBTI (Rev. Rul. 68-374). Exempt Organization Future Leader Tax Program: unrelated business income Pharmacy sales Additional exception for pharmacy sales is pharmacy sales to employees (convenience exception). Note: Sale of pharmacy services to patients of affiliated entities under common control should not generate UBTI. See PLR 9241055.

Page 63 Exempt Organization Future Leader Tax Program: unrelated business income Sale of DME Sale by a hospital of DME to patients will generally not constitute UBTI. Substantially related to a hospitals exempt purpose or primarily for the convenience of the hospitals patients or employees; see Rev. Rul. 78435; PLR 8736046 Sale by a hospital of DME to non-patients is generally UBTI. Page 64 Exception: The IRS has ruled that DME sales to non-patients do not create UBTI where related health care services (i.e., teaching, demonstrating and supervising patient use of equipment, performing physical assessments of purchaser and evaluating home needs of purchaser) are provided in conjunction with the DME sales. See PLR 9801058.

Exempt Organization Future Leader Tax Program: unrelated business income Cafeteria In Rev. Rul. 69-268, the IRS held that the operation of a cafeteria and coffee shop primarily for employees and medical staff by a taxexempt hospital does not constitute an unrelated trade or business. The IRS also held that permitting use of the cafeteria by visitors to the hospital does not constitute an unrelated trade or business, since such usage would enable visitors to spend more time with the patients and such support is a vital component of therapy. Promotion to general public: One of the premises of Rev. Rul. 69-268 was that the general public was not encouraged to use the cafeteria. Potential UBTI is catering services. Page 65 Exempt Organization Future Leader Tax Program: unrelated business income Parking facilities

Use by patients, visitors and staff does not constitute an unrelated trade or business. See Rev. Rul. 69-269. Use by the general public: operation of a parking lot or garage that is open to the public generally results in UBI, unless the activity satisfies one of the exceptions or exclusions from UBTI: Substantially related activity Not regularly carried on Convenience exception Volunteer services Page 66

Exempt Organization Future Leader Tax Program: unrelated business income Fitness facility/health club IRS rulings in this area indicate that operation of a health club in a manner similar to a commercial business (a fee structure that restricts membership to a small community segment) constitutes UBTI. In Rev. Rul. 79-360, the IRS stated that the operation of a health club would not be considered an unrelated trade or business if it is distinguishable from commercial health clubs. Page 67 Exempt Organization Future Leader Tax Program: unrelated business income Fitness facility/health club Factors that distinguish a fitness facility from a commercial health club:

Fitness center integrated into other health care-providing activities (rehab for patients of affiliated hospital) Fee structure that permits significant segment of the community to be able to afford Scholarship programs for individuals who cannot afford Accessible to and/or equipped for the handicapped Other mitigating factors: Proximity to primary health care providers Fees below comparable commercial fitness centers Page 68

Exempt Organization Future Leader Tax Program: unrelated business income Hospital gift shops Substantially related to exempt purposes Promotes welfare of patients Improves the physical comfort and mental well-being of patients by encouraging recovery Convenience exception Operates for the convenience of employees and visitors to the hospital Could be UBTI if competing with for-profit business

Gift shops located in MOBs Internet sales to the public Page 69 Exempt Organization Future Leader Tax Program: unrelated business income MOBs Rental of debt-financed space generally generates UBTI, unless an exception to the debt-financed rules applies. The IRS has ruled that leasing an adjacent office building to physicians was a substantially related activity of the hospital. Rev. Rul. 69-464 The IRS has also ruled that leasing of an adjacent office building,

along with furnishing certain office services (nursing, secretarial, billing, collections and record-keeping services) to a hospital-based medical group, was a substantially related activity of the hospital. Page 70 Rev. Rul. 69-463 Exempt Organization Future Leader Tax Program: unrelated business income Management and administrative services The IRS generally takes the position that management and administrative-type services provided by a charitable organization to an unrelated organization constitute an unrelated trade or business. See Rev. Rul. 72-369, where the IRS ruled that an organization formed to provide managerial and consulting services at cost to unrelated EOs did not qualify for tax-exempt status, because the provision of those services constituted a trade or business that would ordinarily be carried on for profit.

See also Rev. Rul. 69-633 and BSW Group v. Commissioner, 70 T.C. 352 (1978). Administrative services provided to closely affiliated EOs are generally not UBTI. Page 71 See PLRs 8626102, 8649081, 8909056 and 9016053. Exempt Organization Future Leader Tax Program: unrelated business income Alternative investments What is an alternative investment? Investments in nontraditional asset classes: Hedge funds

Private equity funds Venture capital funds Real estate partnerships and trusts Commodities Many may be structured as partnerships or similar pass-through entities. Page 72 Exempt Organization Future Leader Tax Program: unrelated business income UBTI from alternative investments Three ways that a fund organized as a pass-through entity may generate UBTI:

Operation of a trade or business Borrowing to make investments Example: a commodities fund that borrows 9X capital to make large investments in future contracts Flow-through from other investments Example: a timber partnership Example: a fund of funds that invests in other partnerships UBTI information by a partnership

Section 6031(d) of the IRC: The information required to be furnished to its partners shall include such information as is necessary to enable each partner to compute its distributive share of partnership income or loss in accordance with Section 512(a)(1). Page 73 Exempt Organization Future Leader Tax Program: unrelated business income Identification of federal UBTI Total UBTI should be disclosed on Form 1065, Schedule K-1 and marked with appropriate code 20V. Review footnotes for any UBTI disclosure. Typically, if nothing is indicated on line 20V, amount on line 1 (ordinary business income (loss)) is UBTI. Page 74

However, review any line 1 footnote disclosure to verify that none of it is portfolio income. Exempt Organization Future Leader Tax Program: unrelated business income Identification of federal UBTI on Form 1065, Schedule K-1 Page 75 Exempt Organization Future Leader Tax Program: unrelated business income Identification of federal UBTI Page 76 Exempt Organization Future Leader Tax Program: unrelated business income Joint ventures (generally treated as passthrough entities for tax purposes) The term joint venture has no precise legal definition.

For our purposes, this term refers to arrangements in which a tax-exempt health care organization and one or more taxable, for-profit parties have agreed to provide capital or services in a common undertaking and to share in some manner the income or losses from the venture. Two general categories: Whole hospital or whole entity joint ventures exist when a tax-exempt entity contributes all or substantially all of its assets to a joint venture entity in partnership with a for-profit entity that also contributes cash and/or assets. Ancillary joint ventures involve an insubstantial portion of the exempt entitys assets and activities. Joint venture entities Limited and general partnerships, or LLCs, treated as partnerships for tax purposes

Corporations (less common) Page 77 Exempt Organization Future Leader Tax Program: unrelated business income Overview of joint ventures A tax-exempt health care organization may permissibly engage in a joint venture with for-profit parties, including physicians, without putting its exemption at risk, as long as the joint venture meets certain parameters. Issues: Page 78 Tax-exempt status Participation in the joint venture should further the organizations exempt purposes, and the arrangement should permit the organization to act

exclusively in furtherance of its exempt purposes. Prohibited private benefit and private inurement UBI Exempt Organization Future Leader Tax Program: unrelated business income Whole hospital joint ventures Tax issues raised: Continued tax-exempt status of the nonprofit partner Analysis: (1) Participation in the venture must further the nonprofits exempt purposes, and (2) the arrangement must permit the nonprofit to act exclusively in furtherance of its exempt purposes.

If a tax-exempt entity cedes control of partnership activities to a for-profit entity, the IRS will consider the partnership to serve private interests (of the forprofit partner), not public interests. Main guidance: Rev. Rul. 98-15 Redlands Surgical Services v. Commissioner, 113 T.C. 47 (1999), affd 242 F.3rd 904 (9th Cir. 2001) St. Davids Health Care System Inc. v. United States, 2002-1 US Tax Cas. (CCH) P50452 (W.D. Tex. 2002), revd and remanded, 349 F.3rd 232 (5th Cir. 2003) Page 79 Exempt Organization Future Leader Tax Program: unrelated business income Rev. Rul. 98-15

The IRS set out its analysis of a whole hospital joint venture in Rev. Rul. 98-15 in the form of two fact patterns. Good fact: Exempt hospital controls the joint venture and is able to verify that the venture furthers its exempt purposes. The hospital had majority representation on the joint venture board. Governing documents required the board to satisfy the community benefit standard without regard to profit maximization. Joint venture was managed by an independent party. Bad fact: The hospital was not able to further its exempt purposes through participation in the venture. 50/50 representation on the joint ventures board

No charitable override in the governing documents Joint venture managed by an affiliate of the for-profit entity Page 80 Exempt Organization Future Leader Tax Program: unrelated business income Demonstrating control by the exempt partner Formal majority control/ownership Less than majority control, but partnership agreement states that exempt purposes are primary and exempt partner retains certain reserved powers and unilateral rights sufficient to verify that partnership substantially furthers tax-exempt purposes Rev. Rul. 2004-41 allowed the operation of a joint venture to further exempt purposes, even without majority control by the tax-exempt partner, due to exempt partners control over educational content and operations

Page 81 Exempt Organization Future Leader Tax Program: unrelated business income Demonstrating control: management agreements If the joint venture enters into a management agreement with a forprofit entity, particularly if it is the for-profit partner or related entity, the management agreement could result in the exempt partner losing the control needed to verify that the joint venture substantially furthers exempt purposes. Factors in analysis of whether a management agreement deprives the exempt partner of sufficient control include: Length of the agreement Termination and renewal provisions

Operation of facility in a charitable manner The management agreement should require the manager to operate the facility in conformance with the joint ventures charitable purposes, and failure to comply with this requirement should be included as a basis for termination. Page 82 Exempt Organization Future Leader Tax Program: unrelated business income Ancillary joint ventures Examples: Patient care (clinics, surgery centers, imaging centers) Laboratory

MOB Tax issues raised: Tax exemption generally not at issue, since the activities of the joint venture are insubstantial compared to the exempt entitys operations and activities as a whole Page 83 But watch out for prohibited private benefit and inurement (i.e., non-arms length and non-fair market value transactions) UBI will likely depend upon the extent to which the EO controls the activities and operations of the joint venture (see Rev. Rul. 2004-51) Exempt Organization Future Leader Tax Program: unrelated business income AICPA recommendations

Telemedicine AICPA provided a comment letter to IRS on 6 July 2017. The current definition of a patient is an individual who visits the hospitals facilities or is touched by a hospital employee or agent. Page 84 The current IRS definition of patient originated in 1968 in Rev. Rul. 68-376 and encompasses the following: Person admitted to the hospital as inpatient Person receiving services from outpatient facilities of a hospital Person directly referred to outpatient facilities by private physician for treatment

Person refilling prescription written during treatment as hospital patient Person receiving medical services as part of a hospital-administered home care program (as an extension of inpatient and outpatient care) Person receiving medical care and services in a hospital-affiliated extended care facility Exempt Organization Future Leader Tax Program: unrelated business income AICPA recommendations Recommendation: The IRS should issue guidance recognizing that the term patient encompasses individuals directly or indirectly receiving clinical diagnosis or treatment through telemedicine modalities.

Page 85 The IRS should update Rev. Rul. 68-376 to include examples reflective of the definition of a patient in the modern health care environment. A person receiving medical diagnosis/treatment through remote access to physicians A persons health care provider receiving assistance with the individuals medical diagnosis/treatment through remote access to medical specialist A persons health care provider receiving assistance with the individuals medical diagnosis/treatment through remote access to medical specialist, and including access to ancillary services of consulting hospital A person belonging to a population health management program receiving health care services from outside of the program Exempt Organization Future Leader Tax Program: unrelated business income Other telemedicine implications

Various state taxes could apply to telemedicine activities such as: Real-time interactive services and consultations Store and forward technologies Remote patient monitoring Sale of mobile applications, through which a number of health care services can be accessed The concepts of telemedicine and telehealth are integral parts of the Affordable Care Act and expand the historical notion of a patient. The inconsistency of outdated interpretations of the term patient with current health care trends is detrimental to tax-exempt hospitals because their use of telemedicine technologies may result in taxable

income. The unintended result is to discourage the use of and investment in this type of technology by tax-exempt hospitals, rather than encourage its use. Page 86 Exempt Organization Future Leader Tax Program: unrelated business income Clinical research IRS will utilize four-part test Exempt purpose of organization academic medical centers usually have a research purpose Solely clinical trials would not meet exemption requirements Whether the questioned activity is scientific

Requires project supervision and design by professionals A project designed to solve a problem through a search for demonstrable truth using the scientific method A research goal that furthers a scientific purpose Whether it is research Whether it is in the public interest PLR 8230002 For benefit testing (patients) = not UBTI Not for benefit testing (non-patients) = UBTI

Page 87 Exempt Organization Future Leader Tax Program: unrelated business income Clinical research Hospitals may exclude income from research grants or contracts. Extent of exclusion depends on the nature of the organization and the type of research, and if research is directed toward benefiting the public. Hospitals need proper structuring of contracts and sufficient documentation. Results of the research, including any patents, copyrights, processes or formula resulting from such research, generally need to be made available to the public on a nondiscriminatory basis. Least likely to be characterized as UBTI:

Drug studies undertaken before clinical trials Clinical trials relating to proposed new uses of existing drugs Trials involving a hospitals patients Page 88 Exempt Organization Future Leader Tax Program: unrelated business income IRS examinations Page 89 Exempt Organization Future Leader Tax Program: unrelated business income Reasons why organizations are chosen Request for refunds (e.g., NOL carrybacks)

Newspaper articles Random Mismatch answers Data points Section 501(r) compliance website review Page 90 Exempt Organization Future Leader Tax Program: unrelated business income What the IRS is looking for

Support for prior year NOLs Mapping from trial balance Request for directors individual tax returns Book-to-tax differences (Schedule M-1) Allocation methods Foreign filings Profit intention for unrelated business activities Page 91 Exempt Organization Future Leader Tax Program: unrelated business income Timing Strict response times to IDRs Information due prior to initial meeting and during meeting Statute extension requests Page 92 Exempt Organization Future Leader Tax Program: unrelated business income Common IRS focus issues

Compensation reporting on Form 990 compared to W-2 reporting Compliance with IRC Section 501(r) and its corresponding regulations UBI activity and expense allocations See sample IDR on next page Page 93 Exempt Organization Future Leader Tax Program: unrelated business income Redacted sample initial IDR: Form 990T Page 94 Exempt Organization Future Leader Tax Program: unrelated business income Redacted sample initial IDR: Form 990T Page 95 Exempt Organization Future Leader Tax Program: unrelated business income Questions?

Page 96 Exempt Organization Future Leader Tax Program: unrelated business income EY | Assurance | Tax | Transactions | Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. 2018 Ernst & Young LLP. All Rights Reserved. 1802-2586650 ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other

professional advice. Please refer to your advisors for specific advice. ey.com

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