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When nonprofits make profits, what are the rules?
A COMMON PERCEPTION OF FEDERAL TAX LAW is that it is characterized by a confusing set of exceptions and exceptions to exceptions and exceptions to those exceptions. This view is justified with respect to the federal tax law governing investments by tax-exempt organizations ("TEOs"). This article will guide the practitioner through the maze of rules that apply to TEOs by examining choices of strategies for TEOs in some common fact patterns. Being familiar with these rules will aid not just the practitioner representing the TEO but also the practitioner negotiating with the TEO in bringing a deal to a successful conclusion. Focusing on three types of common real estate deals-(1) a hotel with various amenities, (2) an office park, and (3) a residential development with a period of rental followed by sales of condominium units-this article will review the issues and investment vehicles practitioners should consider.
Throughout this article "TEOs" will refer to qualified pension trusts exempt from taxation by virtue of section 401 of the Internal Revenue Code, or to nonprofit organizations, including charitable and educational organizations (collectively "charitable organizations"), exempt under section 501. (All section references are to the Code unless otherwise indicated.)
INTRODUCTION TO UBTI * Under the Code, the unrelated business income tax ("UBIT") imposes the section 11 corporate tax rates on the unrelated business taxable income ("UBTI") of TEOs. Short of outright disqualification as a TEO, imposition of the UBIT is the most important financial consequence a TEO can experience, resulting in the difference between a tax rate of zero percent and one of 35 percent.
Before 1950, the determination of the existence of a valid TEO, mainly for purposes of the predecessor to section 501, was based on a "destination-of-income" test: an organization that dedicated its income to charitable purposes could claim to be a tax-exempt charitable organization. In the most famous case, C.F. Mueller Co. v. Commissioner, 190 F.2d 120 (3d Cir. 1951), a promoter hatched a scheme in which C.F. Mueller Co., a New Jersey corporation that manufactured macaroni, was taken over by C.F. Mueller Co., a Delaware corporation, using borrowed funds. The Delaware corporation stated in its certificate of incorporation that it had been organized for...