Mid-Atlantic Health Law TOPICS
Unrelated Business Taxable Income
Every Maryland hospital, except one, is a not-for-profit, tax-exempt, charitable organization. That does not necessarily mean that all of the income earned by these hospitals is free from income tax, however.
Income earned by a tax-exempt organization in an activity not substantially related to its exempt purpose is subject to income tax. Income that is subject to tax is referred to as unrelated business taxable income, or - not because it sounds pretty - UBTI.
Besides being hard to say, the boundaries governing when income is UBTI, and, therefore, taxable, are also somewhat awkward, but understandable upon exposition.
A. What's Unrelated to a Hospital's Charitable Purpose?
UBTI consists of, not surprisingly, income derived from an unrelated trade or business. An unrelated trade or business is any regularly conducted trade or business not substantially related to the exempt organization's charitable purpose.
Although healing the sick may be a noble pursuit, it is not a charitable purpose. Otherwise, every doctor would be exempt from the payment of taxes.
In fact, the tax exempt purposes of hospitals have historically been either education or providing care to the indigent. More recently, the Internal Revenue Service has recognized a third potential charitable purpose, namely, providing adequate health care services to communities in need of such services.
The variable in determining whether the UBTI rules apply is not the nature of the activity, but rather whether the activity can be tied into the hospital's exempt mission. For example, an in-house pharmacy is related to a hospital's exempt purpose if it is targeted to hospital patients, but is unrelated if marketed with an eye to maximizing revenue. Similarly, a health club operated for the convenience of patients is related to the hospital's exempt mission, while a health club primarily marketed to the public is not. A similar analysis would apply to the leasing of debt-financed medical office building suites to non-employee doctors.
The issue, in essence, is whether the activity bears a synergistic relationship to an exempt purpose. If the hospital appears to be "in it for the money," whether operating a pharmacy, a health club or renting office space, the income will be taxed as UBTI.
B. What About Investment Income?
Recognizing that charitable organizations often fund their charitable efforts from earnings on their investments, applicable regulations provide that dividends, interest, annuities and other investment related income are not UBTI, and, therefore, are not taxable. Royalties, as well as income derived from research by colleges, universities, or hospitals, are also excluded from the definition of UBTI.
Gains and losses recognized in connection with the organization's investment activities and from sales of real property are also not UBTI, and, therefore, not taxable. In addition, certain rental income, including certain rent from real property, is not UBTI.
The exclusion for real property rent has a "too good to be true" feel about it, in that it sounds like an invitation for charitable organizations to go into the real estate development business. However, this blanket invitation is severely narrowed because income derived from debt-financed property is taxable as UBTI.
Also, if an exempt organization owns an interest in a partnership that regularly carries on an unrelated trade or business, the exempt partner's allocable share of partnership income is considered UBTI, and, therefore, taxable. Even though partnership income accrued by a limited partner that is considered UBTI is not much different than dividend income which is not UBTI, courts have, nevertheless, held that partnership income from an unrelated trade or business is taxable.
June 22, 2004