Editor: Mary Van Leuven, J.D., LL.M.
How an organization that is exempt for federal income tax purposes under Sec. 501(a) reports unrelated business taxable income (UBTI) may appear to be straightforward at first glance, especially in light of detailed federal statutory, regulatory, and administrative guidance. However, how an exempt organization computes UBTI for state income tax purposes varies from state to state. This item discusses various state tax treatments, focusing on whether a separate state filing is required, how the tax base is computed, and how UBTI is apportioned among states by multistate entities.
Most states conform to the federal classification of an entity as an exempt organization. However, some states require the entity to qualify for an exemption for state purposes. For example, Connecticut requires entities that have UBTI to register for state taxes by filing Form REG-1, Business Taxes Registration Application, and obtaining a tax registration number. In California, if an entity is exempt under Sec. 501(c)(3), it must submit Form 3500A, Submission of Exemption Request, and a copy of the IRS determination letter or ruling recognizing the organization’s exempt status under Sec. 501(c)(3) to the Franchise Tax Board (FTB). If the entity does not have a determination letter, it must file Form 3500, Exemption Application, and pay a $25 filing fee.
A few states, such as Kentucky, New Jersey, and Texas, do not impose tax on exempt organizations even if they have UBTI. However, most states impose tax on UBTI but vary in how they calculate its base.
Most states conform in whole or in part to the federal definition of UBTI. Federal UBTI generally is defined under Sec. 512(a)(1) as gross income derived by any organization from any unrelated trade or business, less the deductions connected with that unrelated trade or business. The gross income and deductions are subject to modifications under Sec. 512(b) that exclude certain income from UBTI, such as dividends, interest, royalties, and rents from real property. Notwithstanding these exclusions, Sec. 514 includes in UBTI a portion of unrelated business income from debt-financed property.
Some states, such as Georgia, Florida, and Virginia, adopt the federal definition of UBTI without modifications. However, taxpayers should be aware of a state’s conformity date. For example, California follows the federal definition of UBTI but follows the Internal Revenue Code as it existed on Jan. 1, 2009. Therefore, even though California generally conforms to the federal definition of UBTI with few modifications, any changes in the Code adopted after that date are not taken into account in determining California UBTI.
Many states use federal UBTI as a starting point and then require state-specific modifications. For example, Illinois requires addback of Illinois income taxes. New York also requires addback of New York income taxes as well as other modifications, such as (1) addback of expenses deducted under Sec. 199 and (2) addback of royalty payments made to a related person, corporation, or entity that owns or controls, or is owned or controlled by, the exempt entity.
Many states allow an exempt organization to carry over a net operating loss but may impose additional restrictions or modifications. For example, New York and Massachusetts do not allow an exempt entity to carry over losses sustained during a year when the entity was not subject to UBTI tax in that state. In many states, such as Massachusetts, an exempt organization may not carry losses back to a prior year. New York allows only $10,000 of loss to be carried back but otherwise conforms to the federal carryback and carryforward provisions.
The next question is how to determine the amount of UBTI attributable to states in which the exempt organization operates. Many states require exempt entities to follow the apportionment rules applicable to taxable entities (e.g., Georgia and Kansas). Other states specifically provide a formula for UBTI that is different from the generally applicable formula. Connecticut, for example, generally requires taxable entities to use either a double-weighted three-factor formula (for net income derived from the manufacture, sale, or use of tangible personal property or real property) or a single-sales-factor formula (for other income). However, an exempt entity that has a regular place of business outside Connecticut where it conducts unrelated business activities is required to apportion UBTI using an equally weighted, three-factor formula based on in-state property, payroll, and sales relative to their out-of-state amounts. Likewise, New York generally uses a single-sales-factor formula for taxable entities, but it requires an exempt entity to use an equally weighted, three-factor formula to apportion UBTI.
The topics discussed in this item represent only a few of the important issues relating to the calculation and taxation of state UBTI. Thus, it is critical to understand each state’s rules and nuances in the area of exempt organizations and the authority related to UBTI.
Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with KPMG LLP. This article represents the views of the author or authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.