CAP Taxation & Legal Compliance 2 — Questions and Answers
Question 1: Which type of income earned by a tax-exempt organization is subject to Unrelated Business Income Tax (UBIT)?
- Investment income from a permanent endowment
- Income from a trade or business regularly carried on that is not substantially related to the exempt purpose (Correct answer)
- Passive rental income from real property without debt financing
- Dividends from a minority stock holding in a public company
Correct answer: Income from a trade or business regularly carried on that is not substantially related to the exempt purpose
UBIT applies to income from a trade or business that is regularly carried on and not substantially related to the organization's exempt purpose, regardless of how the proceeds are used.
Under IRC 511-514, UBIT is taxed at corporate rates on net income from qualifying unrelated activities. Common examples include advertising in publications and certain rental income. Excluded are passive activities like dividends, interest, royalties, and most rental income. The policy rationale is competitive fairness with for-profit businesses.
Question 2: Under IRC 170(e)(1), which type of contribution requires a donor to reduce the deduction by the amount of ordinary income that would have been recognized if the property were sold?
- Long-term appreciated publicly traded stock
- Short-term capital gain property and ordinary income property (Correct answer)
- Real estate held more than one year
- Cash contributions to donor-advised funds
Correct answer: Short-term capital gain property and ordinary income property
For short-term capital gain property or ordinary income property such as inventory or property held one year or less, the deduction equals fair market value minus the gain that would have been ordinary income, effectively limiting the deduction to cost basis.
This ordinary income reduction rule ensures that donations of property where gain would be ordinary income are deductible only at cost basis. For example, a business donating inventory worth $10,000 with a basis of $4,000 would deduct $4,000, not $10,000. There is a special exception under 170(e)(3) for inventory donated to needy individuals allowing a partial appreciation deduction.
Question 3: A private foundation that fails to distribute at least 5% of its non-charitable use assets annually is subject to which excise tax under IRC 4942?
- 1.39% of undistributed income
- 30% of undistributed income (Correct answer)
- 10% of undistributed income
- Revocation of tax-exempt status
Correct answer: 30% of undistributed income
Under IRC 4942, private foundations that fail to meet the 5% minimum distribution requirement are subject to a 30% initial excise tax on undistributed income.
The excise tax under IRC 4942 for failure to distribute is 30% of the undistributed income (first-tier tax), with an additional 100% corrective tax if not remedied in the correction period. The 5% minimum distribution must be made by the end of the tax year following the year in which the income was earned, creating significant pressure on foundation boards to maintain distribution discipline.
Question 4: Which of the following correctly describes the tax treatment of a quid pro quo contribution to a charity?
- The full amount paid is deductible as a charitable contribution
- Only the amount exceeding the fair market value of goods or services received is deductible (Correct answer)
- Quid pro quo contributions are never tax-deductible
- The IRS requires a separate appraisal for all quid pro quo gifts
Correct answer: Only the amount exceeding the fair market value of goods or services received is deductible
In a quid pro quo contribution, the deductible amount equals the amount paid minus the fair market value of any goods or services received in return. For payments over $75, the charity must provide written disclosure.
Under IRC 6115, charities receiving quid pro quo contributions exceeding $75 must provide written disclosure stating the amount constituting a deductible contribution and a good-faith estimate of the value of goods or services provided. Failure subjects the charity to a $10 per contribution penalty. Common examples include charity galas (ticket price minus dinner value) and charity auctions.
Question 5: For estate planning purposes, what is the primary tax advantage of making a charitable bequest from a traditional IRA rather than from taxable estate assets?
- The bequest qualifies for a stepped-up cost basis
- The IRA bequest avoids income in respect of a decedent, eliminating both income tax and estate tax on those funds (Correct answer)
- The charity receives a larger gift because IRAs grow tax-free
- Bequests from IRAs qualify for an additional estate tax charitable deduction
Correct answer: The IRA bequest avoids income in respect of a decedent, eliminating both income tax and estate tax on those funds
IRA assets left to charity escape both the income tax that heirs would owe as income in respect of a decedent and estate tax, making them the most tax-efficient bequest vehicle.
IRD assets such as IRAs and 401(k)s do not receive a stepped-up basis at death—heirs pay income tax on distributions. If left to charity, the charity pays no income tax, achieving 100% charitable efficiency. Advisors should recommend leaving IRA assets to charity and taxable stepped-up assets to heirs as an optimal asset allocation strategy for clients with charitable intent.
Question 6: A nonprofit that engages in private benefit transactions for the benefit of a non-charitable class risks which IRS consequence?
- Imposition of UBIT on all future investment income
- Revocation of tax-exempt status under IRC 501(c)(3) (Correct answer)
- Reclassification as a private foundation
- Required distribution of all assets to government
Correct answer: Revocation of tax-exempt status under IRC 501(c)(3)
Under IRC 501(c)(3), an organization must operate exclusively for exempt purposes; serving private interests beyond incidental benefit is grounds for revocation of tax-exempt status.
The private benefit doctrine is broader than the self-dealing rules applicable to private foundations. Even public charities may not operate for the substantial benefit of private interests. Courts apply an inurement test for insiders and a private benefit test for non-insiders. Examples of violations include operating a for-profit business primarily for a private party's benefit or using charitable resources to benefit the founder's family business.
CAP Taxation & Legal Compliance 2
Which type of income earned by a tax-exempt organization is subject to Unrelated Business Income Tax (UBIT)?