A recent Tax Court case, Leila G. Newhall Unitrust v. Com., 104 TC No. 10 March 6, 1995, reveals a severe trap for the unwary in investing charitable remainder trust assets. The case concludes that when a charitable remainder annuity trust or a charitable remainder unitrust has unrelated business taxable income (UBTI) in any year, it is not exempt for such taxable year. Consequently, the trust is taxable on all of its income for that year as a complex trust. Of course, the annuity paid to the beneficiary is deductible against the trust's income.
In general, an exempt organization is subject to tax only on its unrelated business income, which is income from a trade or business regularly carried on by the organization, provided such activity is not substantially related to its exempt purpose or function aside from the organization's need for funds.
In computing unrelated business taxable income, gross income and deductions are subject to certain exclusions, specific deductions, and other special rules. Generally, UBTI does not include dividends, interest, and annuities. Also excluded are gains and losses from the sale, exchange, or other disposition of property, other than inventory-type property or property held primarily for sale to customers in the ordinary course of business. The exclusions under these categories, however, do not apply to debt. financed property nor to the disposition of such property (see IRC Sec. 514). Consequently, UBTI will be derived, for example, where securities are bought on margin.
The Lelia G. Newhall Unitrust is a charitable remainder unitrust created in 1975, pursuant to a testamentary bequest. In 1983 and 1995, the trust acquired limited partnership interests in three publicly traded limited partnerships.
IRC Sec. 512(c) requires that the distributive share of partnership income of an organization that is a partner be considered as UBTI if the conduct of the partnership's business activities directly by the partner would have resulted in UBTI. Therefore, this section prevents a taxpayer from avoiding UBTI by becoming a member of a partnership that carries on what would be, if conducted directly, an unrelated trade or business. In Newhall, the unitrust conceded that the businesses conducted by the partnerships would generate UBTI if conducted by the unitrust. Therefore, the Tax Court affirmed the IRS determination that the trust received unrelated business income under IRC Sec. 512 (c) on the income it earned from its partnership investments in the years in question.
The Court then considered the tax consequences resulting from the receipt of UBTI. The trust argued that the appropriate interpretation of IRC Sec. 512(c) results in the taxation of only that portion of income attributable to UBTI, as in the case of other types of exempt organizations. The Court, however, in citing IRC Sec. 664 (c) and related regulations, held that charitable remainder trusts are tax exempt, only if they do not receive UBTI. The Court relied upon the regulations which state that if any portion of the income constitutes UBTI, for that taxable year, "the trust is taxable on all of its income as a complex trust" [Regs. …