In the fifth article in our 990-T blog series, our advisors examine how income from partnerships, LLCs taxed as partnerships, and S corporations can trigger unrelated business income tax (UBIT). Learn how to identify taxable pass-through income, determine whether Form 990-T is required, and apply the silo rules to unrelated business income.
Read our fourth article to learn more about debt-financed income.
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Organizations with interests in partnerships, LLCs taxed as partnerships, or S corporations receive Schedule K-1s each year. These investments are a common reason an organization that otherwise files only Form 990 may need to file Form 990-T.
A K-1 does not identify income as taxable or nontaxable. Some pass-through income remains excluded from UBIT, while other income may be taxable. Since 2018, taxable income must also be separated into specific activity “silos.”
When K-1 Income Becomes UBI
Under IRC §512(c), an exempt organization that is a partner in a partnership is generally treated as directly conducting the partnership’s activities. If the partnership operates a trade or business unrelated to the organization’s exempt purpose, the organization’s share of income is generally unrelated business income (UBI), whether or not it is distributed.
Income generally retains its character as it passes through. Dividends, interest, royalties, and real-property rents may remain excluded under §512(b), as they would if the organization held the investments directly.
However, income may become taxable in several situations:
- Ordinary business income: Income from an operating business is generally UBI unless it is related to the organization’s exempt purpose.
- Debt-financed income: Under §514, income from property acquired or improved with borrowed funds may be taxable, even when the income would otherwise be excluded.
- Payments from controlled entities: Rent, interest, royalties, and annuities paid by an entity controlled by the organization may be UBI under §512(b)(13).
- Certain rental income: Rent may lose its exclusion when significant services are provided to tenants or when too much rent relates to personal property.
The S Corporation Rule
S corporation stock is treated differently. Under §512(e), all income flowing through to a 501(c)(3) organization from an S corporation is UBI, including dividends, interest, and capital gains. Gain on the sale of S corporation stock is also UBI.
When Form 990-T Is Required
An organization must file Form 990-T if its gross income from unrelated activities is $1,000 or more for the year, even if deductions reduce taxable income to zero.
Income is generally taxed at the 21% corporate rate or at trust rates, if applicable. Estimated tax payments may be required, and some states, including Pennsylvania, require separate state filings. Because fund K-1s often arrive after the original Form 990-T due date, organizations with pass-through holdings should plan to file an extension.
The UBIT Silo Rules
Before 2018, losses from one unrelated activity could offset income from another. Under §512(a)(6), UBI must now be calculated separately for each unrelated trade or business. Losses from one silo generally cannot offset income from another.
Each activity is generally identified using the first two digits of its NAICS code, and each silo is reported on a separate Schedule A attached to Form 990-T.
The Investment Activities Silo
Certain investment activities may be grouped into one silo, including:
- Qualifying partnership interests
- Qualifying S corporation interests
- Debt-financed property
When investments qualify, income and losses from those investments may be combined within the investment activities silo. If they do not qualify, the organization may need to review each partnership and report each unrelated business activity separately.
Qualifying Partnership Interests
A partnership interest qualifies under either of these tests:
- De minimis test: The organization holds no more than 2% of both profits and capital interests.
- Participation test: The organization holds no more than 20% of the capital interest and does not significantly participate in the partnership.
Significant participation may include the ability to direct or block operations, management rights held by officers or employees, or the authority to appoint or remove officers or a majority of directors.
Interests held by supporting organizations or controlled entities are included for purposes of the 20% test. A general partner interest cannot qualify. S corporation stock follows the same 2% and 20% framework, although a nonqualifying S corporation is treated as its own silo rather than being looked through.
Net Operating Losses and Other Deductions
Net operating losses (NOLs) generated in 2018 or later remain with the silo that produced them and may only offset future income from that same silo, subject to the 80% limitation. Pre-2018 NOLs may still offset total UBI and must be used before any other NOLs.
The $1,000 specific deduction and charitable contribution deduction are applied once at the total UBI level after silo calculations are complete.
Practical Steps
- Review the entire K-1, including ordinary income, rental income, capital gains, debt information, and footnotes.
- Track ownership percentages to determine whether investments qualify for the investment activities silo.
- Consider whether a blocker corporation is available and appropriate.
- Evaluate S corporation stock carefully before accepting it, including as a gift.
- Maintain silo-level records beginning with the first year UBI is generated.
Key Takeaways
K-1 income requires a line-by-line review. Ordinary business income, debt-financed income, and S corporation stock are common sources of UBI. Once income is taxable, the silo rules determine whether investment income and losses can be combined or must be reported separately.
