(a) Disadvantages of §501(c)(3) Status

An instrumentality or an affiliate that receives recognition of §501(c)(3) status has a dual status. It may retain its governmental status as well as its new public charity status. The most serious disadvantage can be that, as a public charity, the entity becomes subject to the intermediate sanctions that allow the IRS to impose penalties if it finds that compensation paid for services or other financial transactions provide excess benefits to organizational insiders.²² A government-controlled hospital that in the past sought and received qualification as a tax-exempt §501(c)(3) entity considered abandoning that status when it became subject to the enhanced standards imposed by §501(r). A 1991 IRS ruling found that there was no procedure, short of dissolution or violation of the tax law, to abandon tax exemption.²³ In response to a request from the East Alabama Healthcare Authority,²⁴ the IRS noted that it had provided for issuance of a (un)determination letter to recognize a government entity's voluntary termination of its tax-exempt status “where it can document that status other than under § 501(a).”

A dual-status organization is required to file Form 990 annually unless it meets the specific exceptions outlined in the “Affiliates” discussion later in this section. The filing of Form 990 brings public scrutiny that may not be desirable.²⁵ Forms 990 are available on the Internet at www.guidestar.org within months of their submission to the IRS. Three years of returns, plus Form 1023, must also be shown to anyone who asks to see them, and copies must be provided to anyone willing to pay modest copying charges.²⁶ In many states, an exempt organization satisfies its annual filing requirement by furnishing a copy of Form 990 to the appropriate state authority. Many grant-making foundations request a copy of Form 990 in addition to or in lieu of audited financial statements, to verify an organization's activity. Open-records standards may also require that financial reports and records be open to the public.

Form 990, since its expansion in 2008, provides a wealth of information. An organization's basic financial information—revenues, expenses, assets, and liabilities—is classified into meaningful categories to allow the IRS to evaluate the nonprofit's ongoing qualification for federal tax exemption under §501(c). Extensive details about compensation for services, sales of assets, loans to or from persons who run and control the organization, names of related entities, and much more are reported. The returns are also used by funders, states, and other persons to evaluate the scope and type of a nonprofit's activity. Information pertaining to the accomplishment of the organization's mission is presented: how many persons are served, papers researched, reports completed, students enrolled, and the like. Details are reported for grants paid to support other organizations or disbursed directly as aid to the poor, sick, students, and for other charitable purposes. The return also includes lists of questions that fish for failures to comply with the federal (and, to some extent, state) requirements for donor and member disclosures, governance policies and practices, political and lobbying activity, transactions with nonexempt organizations, insider transactions, and more.

For this reason alone, some organizations may be hesitant to come under the §501(c)(3) filing requirements. In sum, the returns are designed to show that a nonprofit organization is entitled to maintain its tax-exempt status and provide a wealth of other information that may interest funders, constituents, and regulators. The advantages (shown as YES) and disadvantages (shown as NO) are illustrated in the following chart:

(b) Why Aren't Governments Exempt?

The income of certain governmental entities is excluded, or exempt, from federal income tax by virtue of implied statutory immunity,²⁷ rather than due to recognition of tax-exempt status under §501(c)(3). In two 1971 rulings, the IRS observed in summary form that the tax code does not tax states in the absence of specific statutory authorization for taxing such income.²⁸ A statutory exception to this general rule taxes the unrelated business income of any college and university that is an agency or instrumentality of any government or any political subdivision thereof, or its wholly owned corporation.²⁹ The word government for this purpose includes any foreign government and all domestic governments (the United States and any of its territories or possessions, any state, and the District of Columbia).³⁰ Note that the word instrumentality is not defined by this regulation, but in the IRS guidance discussed later.

To answer the questions posed by this section's title, one must first understand the meaning of the term governmental entities. For tax purposes and for purposes of this supplement, governmental entities may be broken down into the following categories:

• Entities that never qualify as public charities:
  • Governmental units
  • Political subdivisions
  • Integral parts of government
• Entities that may also qualify as public charities:
  • Instrumentalities
  • Organizations affiliated with governmental units, political subdivisions, or their integral parts

Other designations that can cause confusion exist within the overall “governmental” framework, such as governmental instrumentalities, governmental entities, possessions of the United States, state agency, and municipality, but the preceding terms constitute the main ones.

(c) Governmental Units

States, their municipalities, and other divisions thereof, interestingly, are not named in any part of §501(c)(3), though, by definition, one might think they should qualify under §501(c)(3) because relieving the burdens of government is considered a charitable purpose.³¹ But not so.

A governmental unit is not entitled to exemption because of its sovereign powers to tax and to exercise eminent domain and police powers. As noted tax-exempt organization lawyer Bruce Hopkins has observed:

The test set by the IRS is based on the scope of the organization's purposes and powers, that is, whether the purposes and powers are beyond those of a charitable organization. For example, a state or municipality itself cannot qualify as a charitable organization, inasmuch as its purposes are not exclusively those inherent in charities, nor can an integral component of the state or municipality.³²

In other words, a state or municipality itself would not qualify as a §501(c)(3) organization, as its purposes are clearly not exclusively those described in that section of the code.

Furthermore, where the particular branch or department under whose jurisdiction the activity in question is being conducted is an integral part³³ of a state or municipal government, the provisions of §501(c)(3) would not be applicable. For example, a public school or hospital that is an integral part of a local government could not meet the requirements for exemption as a publicly supported charity. Just as the purposes of a state or municipality are clearly not exclusively those described in §501(c)(3), the powers of an integral part of government likewise would exceed those public charity purposes.³⁴ However, a state or municipal instrumentality that is a counterpart of a public charity, such as a separately organized school or hospital, may qualify for exemption under §501(c)(3).³⁵

IRC §170(b)(1)(A)(v) provides for a charitable contribution deduction for amounts given to a governmental unit, defined in §170(c)(1) as:

A State, a possession of the United States, or any political subdivision of any of the foregoing, or the United States or the District of Columbia, but only if the contribution or gift is made for exclusively public purposes.

Intending to clarify the §6033(a)(2)(C)(vi) exception that excludes certain §501(c)(1) organizations³⁶ from filing Form 990 each year, the IRS in 1995 expanded the definition of governmental unit for filing requirement purposes to include the following:³⁷

• It is a state or local governmental unit as defined in Reg. §1.103-1(b). (As shown in the next subsection, the term political subdivision also appears in the last sentence of this definition.)
• It is entitled to receive deductible charitable contributions as an organization described in IRC §170(c)(1).
• It is an Indian tribal government or a political subdivision thereof, under §7701(a)(40) and §7871.

(d) Political Subdivisions

The regulations under IRC §170 do not define what is meant by a political subdivision. On February 23, 2016, the IRS/Treasury Department issued proposed regulations intended to provide a definition for this important type of municipal entity. The 2017-18 IRS Priority Guidance Plan announced withdrawal of the proposal on October 20, 2017.

Beginning in 2013, the IRS attempted to limit the definition of community development districts and other units created to develop land outside city limits.³⁸ The rationale for allowing such entities to be classified as municipal districts (referred to as “mud districts”) stems from the expectation that taxes can be imposed on buildings developed from bond proceeds.

The question is whether such entities are actually political subdivisions.³⁹The IRS asserted in 1983, and has continued to assert, that to qualify, in addition to the three sovereign powers, an entity must be operated for a governmental purpose and must be governmentally controlled.⁴⁰ Then the U.S. Treasury proposed regulations to incorporate this requirement. Stay tuned: this proposal is expected to be controversial. Withdrawal of proposed regulations under §103 regarding the definition of political subdivision was announced in 2017-18 Priority Guidance Plan.One must look to §103, “Interest on State and Local Bonds,” to find out what the term denotes:

Any division of any State or local governmental unit which is a municipal corporation or which has been delegated the right to exercise part of the sovereign power of the unit. As thus defined, a political subdivision of any State or local governmental unit may or may not include special assessment districts so created, such as road, water, sewer, and similar districts.⁴¹

The term most simply means a jurisdictional or geographical component of a state, such as a county or city. The 1944 court decision in Shamberg complicated the meaning by saying it must be broad and comprehensive and denotes any division of the state made by the proper authorities thereof, acting within their constitutional powers, for the purpose of carrying out a portion of those functions of the state that by long usage and the inherent necessities of government have always been regarded as public.⁴²

The interpretation of what constitutes a political subdivision for purposes of §103 has been frequently used for defining that term for purposes of other tax code sections. The key phrase to focus on is “sovereign powers.” The three generally acknowledged sovereign powers are:

1. Power to tax
2. Power of eminent domain
3. Police power⁴³

Various published revenue rulings indicate that it is not necessary that all the powers enumerated be delegated to the entity; the delegation of just one sovereign power will be sufficient for political subdivision status if the delegation is substantial. However, possession of merely an insubstantial amount of any or all of those powers is not sufficient for the entity to achieve political subdivision status. All of the facts and circumstances must be taken into consideration, including the public purposes of the entity and the extent to which it is subject to control by a government.⁴⁴

The IRS held in one ruling that soil conservation districts created under the laws of Colorado constituted political subdivisions of that state. The IRS stated that for purposes of §103, divisions of a state that are formed to achieve a recognized public purpose and whose revenue and assets inure only to the benefit of the state constitute political subdivisions of the state even though the sovereign powers delegated to the subdivision are limited in degree. In the facts of the ruling, some measure of sovereign powers, including the power to levy taxes and to enact land use ordinances, were delegated to the conservation districts.⁴⁵ An authority established by the state to provide health-care services and promote general health within specified county was deemed a political subdivision.⁴⁶

A Community Development District formed by a developer of a retirement community was found not to qualify as a political subdivision because it was organized and operated in a manner intended to perpetuate private control and to avoid indefinitely responsibility to a public electorate.⁴⁷

(e) Integral Parts

The IRS provides the following guidance in regard to integral parts:

A state or municipal instrumentality may qualify under §501(c)(3) if it is organized as a separate entity from the governmental unit that created it and if it otherwise meets the organizational and operational tests of §501(c)(3). Examples of a qualifying instrumentality might include state schools, universities, or hospitals. However, if an organization is an integral part of the local government or possesses governmental powers, it does not qualify for exemption. A state or municipality itself does not qualify for exemption.⁴⁸

The list of criteria in Rev. Rul. 57-128 provides that in determining whether an organization is an instrumentality of one or more states or political subdivisions, the following factors are taken into consideration:

• Whether it is used for a governmental purpose and performs a governmental function.
• Whether performance of its function is on behalf of one or more states or political subdivisions.
• Whether there are any private interests involved, or whether the states or political subdivisions involved have the powers and interests of an owner.
• Whether control and supervision of the organization is vested in a public authority or authorities.
• If express or implied statutory or other authority is necessary for the creation and/or use of the instrumentality, and whether that authority exists; and the degree of financial autonomy and the source of its operating expenses.

The subject of the ruling was a charter school providing education for children in kindergarten through grade eight as an independently-run nonprofit corporation. None of the governing board's members were appointed by a governmental entity. Though the state legislature had authorized the creation of state charter schools, this school remained independent. The school applied for FICA tax refund claims, which were denied because it didn't qualify as a wholly owned instrumentality of the state or of a political subdivision of the state. Although it was publicly funded and performed the governmental function of providing public education in the state, it didn't perform this function on behalf of the state, because the state exercised no meaningful control over either its day-to-day operations or its budget. Further, the laws of the state allowed the charter school to operate independently from the local school district. No governmental entity had the power to appoint the charter school's governing board, and the organization's bylaws allowed management to be delegated to a private management company.

In some separate legal entity situations, the IRS has ruled that in spite of the separate status, the entity in question was an integral part of a state or political subdivision.⁴⁹

One of the generally required facts of being classified as an integral part of government is the existence of regulatory or enforcement powers. Even though a wholly owned state or municipal instrumentality may be a separately organized entity, it is not entitled to §501(c)(3) exemption if it is “clothed with powers other than those described in §501(c)(3).”⁵⁰ For example, where an instrumentality exercises substantial regulatory or enforcement powers in the public interest, it will not qualify.

In a 1974 ruling, advice was requested as to whether a nonprofit county library itself was exempt under §501(c)(3). The public library was organized as a separate entity under a state statute, without power to impose taxes for its operations, although it did have a limited power to determine the tax rate necessary to support its operations. The IRS determined that the organization qualified for exemption under §501(c)(3), stating:

Although the library is wholly-owned by a political subdivision of a State, it is a separate entity and is otherwise a counterpart of an organization exempt from Federal income tax under §501(c)(3) of the Code. The power regarding the tax rate described above is not a regulatory or enforcement power within the meaning of Rev. Rul. 60-384, since it merely involves the determination, subject to specified limits, of a tax rate necessary to support the library's operations. A limited power to determine a tax rate necessary to support another public library's operations did not constitute a regulatory or enforcement power.⁵¹

Thus, the fact that an organization has one of the sovereign powers listed earlier does not automatically preclude the organization from qualifying under §501(c)(3). For example, many nongovernmental organizations, such as colleges and hospitals, have been authorized to exercise a limited power of eminent domain. The IRS has held that a public hospital that has the power to acquire, through eminent domain, property essential to its purposes qualifies for public charity status under §501(c)(3). Thus, the power of eminent domain or other sovereign power, if limited to furthering an organization's charitable purpose, does not constitute an enforcement or regulatory power within the meaning of Rev. Rul. 60-384.⁵²

Conversely, in another ruling, the IRS held that a public housing authority formed to investigate the existence of unsanitary or unsafe housing conditions did not qualify for public charity status. The housing authority had the power to conduct investigations by entering property and issuing subpoenas. A subpoena power involves the power to compel testimony under threat of imprisonment if the testimony is not forthcoming. The IRS indicated that the power to punish is a power of the state alone; therefore, the organization possessed powers more related to governance than to the furtherance of a charitable purpose. Those powers were considered enforcement or regulatory powers within the meaning of Rev. Rul. 60-384, substantial enough to disqualify the housing authority from obtaining §501(c)(3) status.⁵³

The Michigan Education Trust fought an interesting battle to qualify for tax exemption. It was created as a state agency to collect and receive advanced state college tuition; its board members were appointed by the governor, and its investments were managed by employees of the state treasury. Its assets, however, were not available to state creditors and were returnable to the “investors” upon dissolution. The IRS and a district court agreed that the trust was neither an instrumentality of the state nor a governmental unit and instead benefited the individual students who were to earn tax-free interest on their college savings. The Sixth Circuit Court disagreed and found the trust to be an integral part of the state of Michigan.⁵⁴ This decision appears to stretch its conclusion in determining that the education trust was an integral part of the state of Michigan. In reaching its decision, the majority of the court looked to the criteria contained in the revenue ruling, which listed factors of an instrumentality, not an integral part.⁵⁵

The IRS points out the discrepancy in letter rulings, noting that the court's reliance on the factors cited in reaching its conclusion is “misplaced.” The IRS indicated that other factors should be used and said, “In determining whether an enterprise is an integral part of a state, it is necessary to consider all of the facts and circumstances, including the state's degree of control over the enterprise and the state's financial commitment to the enterprise.”⁵⁶

In a revenue ruling in which §501(c)(3) status was not an issue, the IRS considered the excludability of income of a Lawyer Trust Account Fund created, supervised, and controlled by a state supreme court. In determining that the fund's income is not subject to federal income tax, the ruling states, in part,

In this case the Supreme Court's creation of the Fund and its ability to select and remove the Fund's governing body, to control the Fund's investments and expenditures, to monitor the Fund's daily operation, and to abolish the Fund indicate that the Fund is not an independent entity, but rather is an integral part of the state.⁵⁷

Other recognized facts and circumstances that tend to indicate an integral part of government are when the government exercises control over the separate entity, where the government makes a financial contribution to the separate organization, or where the government has a present interest in the income of the separate organization.⁵⁸ Over the years, the IRS has come to emphasize a financial commitment by government as evidence that a structure is an integral part of a state or political subdivision.⁵⁹

In its 1996 exempt organization (EO) Continuing Professional Education (CPE) text, the IRS listed factors it would consider in determining whether an organization is an integral part of a state or municipal government. If a state is substantially involved in the activities of an organization, that organization will be considered an integral part of the state or municipal government. Factors that indicate state involvement include:

• Creation of the organization by executive order of the governor of a state.
• Creation of the organization by executive order of the governor of a state as an official state agency.
• A state or a state agency having the power to appoint and remove the organization's board.
• A state or a state agency having the power to abolish the organization.
• A state or a state agency monitoring the organization's activities.
• The organization using government employees to conduct its activities.⁶⁰

(f) Instrumentalities

The IRS has adopted the use of the term instrumentalities for public entities that also qualify for exempt status as §501(c)(3) organizations. Although the term is used in the Internal Revenue Code itself only with respect to payroll taxes, the IRS has chosen to use the term in the exemption context as a “shorthand” description method.⁶¹ Webster's International Dictionary defines an instrumentality as a subbranch of a department or agency.

Section 170(c)(1) does not refer to instrumentalities of a state or instrumentalities of a political subdivision of a state. However, the longstanding position of the IRS is that contributions or gifts to an instrumentality of a state or to an instrumentality of a political subdivision of a state are considered to be “for the use of” a state rather than gifts “to” a state or political subdivision. Though this position lends a definition, the significance of this distinction is that a gift “for the use of” a state or political subdivision is subject to the 30 percent of adjusted gross income deduction limitation of §170(b)(1)(B).⁶²

The language contained in IRS Publication 557,⁶³ as noted earlier, indicates that an instrumentality may qualify under §501(c)(3) if it is organized as a separate entity from the governmental unit that created it and if it otherwise meets the organizational and operational tests of §501(c)(3). However, if the entity is an integral part of the government or possesses governmental powers, it does not qualify as a public charity.

A 1957 ruling defined the term instrumentality by providing the following guidance. In cases involving the status of an organization as an instrumentality of one or more states or political subdivisions, the following factors are taken into consideration:⁶⁴

• Whether it is used for a governmental purpose and performs a governmental function.
• Whether performance of its function is on behalf of one or more states or political subdivisions.
• Whether there are any private interests involved, or whether the states or political subdivisions involved have the powers and interests of an owner.
• Whether control and supervision of the organization is vested in public authority or authorities.
• Whether express or implied statutory or other authority is necessary for the creation and/or use of such an instrumentality, and whether such authority exists.
• The degree of financial autonomy and the source of its operating expenses.

Not all of the elements must be present in testing each entity to see if it is an instrumentality within the purview of this ruling. However, an entity must have a separate existence from the related political subdivision or governmental unit and have a preponderance of the factors in its favor to be treated as an instrumentality.⁶⁵ A wholly owned state instrumentality has, under certain circumstances, been allowed to qualify for exemption as a public charity, particularly if it is a separate entity and a clear counterpart of an organization described in §501(c)(3). The instrumentality must be organized and operated exclusively for §501(c)(3) purposes.⁶⁶

(g) Affiliates

An affiliate of a state or political subdivision may also qualify as a §501(c)(3) organization if it meets the criteria outlined earlier for instrumentalities, though the author finds no formal citation for this understanding. The term affiliate also is not contained in the code or regulations under §501(c)(3), but was introduced into the tax lexicon by the 1995 revenue procedure intended to clarify Form 990 filing requirements. The procedure expanded the definition of a governmental unit and provided attributes for identifying an affiliate of a governmental unit. The procedure is tiered and first lists an affiliate that need not file Form 990 as an organization that has a ruling from the IRS that provides any of the following:⁶⁷

• Its income, derived from activities constituting the basis for its exemption under IRC §501(c)(3) of the Code, is excluded from gross income under IRC §115.
• It is entitled to receive deductible charitable contributions under IRC §170(c)(1) on the basis that contributions to it are “for the use of” governmental units.
• It is a wholly owned instrumentality of a state or a political subdivision thereof, for employment tax purposes.

An affiliate of a governmental unit that does not have a ruling or determination from the IRS that it meets these criteria may also be excused from filing Form 990 if it possesses any of the following criteria:

• It is either “operated, supervised, or controlled by” governmental units, or by organizations that are affiliates of governmental units, or the members of the organization's governing body are elected by the public at large, pursuant to local statute or ordinance.
• Its filing of Form 990 is not otherwise necessary to the efficient administration of internal revenue laws.
• It possesses two or more of the affiliation factors in the following list.

An affiliate that possesses two or more of the following factors is also excluded from filing Form 990:

• The organization was created by one or more governmental units or a government affiliate, or by public officials acting in their official capacity.
• The organization's support is received principally from taxes, tolls, fines, government appropriations, or fees collected pursuant to statutory authority. Amounts received as government grants for other contract payments are not qualifying support for this purpose.
• The organization is financially accountable to one or more government units or affiliates thereof.
• One or more governmental units or affiliates exercises control over, or oversees, some or all of the organization's expenditures.
• Upon dissolution, its assets will be distributed to one or more governmental units or affiliates thereof.

In three private letter rulings, the IRS indicated that in each case a §501(c)(3) publicly supported organization was also an affiliate of a governmental unit. Therefore, the organizations were not required to file Form 990.⁶⁸

(a) Organizational and Operational Requirements

As its name implies, a qualifying IRC §501(c)(2) title-holding corporation cannot be a trust, joint venture, or other unincorporated form of organization. It must be a corporation or an association classified as a corporation.⁷³ The exclusive purpose clause of the statute is strictly applied. The THC's purpose is reflected by its charter, its activities, and the facts and circumstances under which it was created. All of these factors are taken into account by the IRS in evaluating evidence that a THC's purposes are strictly limited to those provided in the statute. A THC will not be granted exemption if it engages in any business other than that of holding title to property and collecting income therefrom.⁷⁴ The income can be generated by investment sources, such as interest income on bonds held or rental income received from commercial tenants.⁷⁵ A charter containing language that empowers the organization to engage in broader activities is not acceptable. When the charter language contains the appropriate constraints, but the organization's proposed or actual activity goes beyond the limits, exemption may be denied. The (c)(25) THC must also comply with the specific requirements regarding beneficiary organizations and activities.

Connection to Beneficiary Organization. The amount of control and the relationship that must exist between the title-holding corporation and the exempt organization it benefits are not specified in the statute or in the regulation (which is only two paragraphs long). However, the IRS Exempt Organizations Internal Revenue Manual provides some guidelines.⁷⁶

A parent–subsidiary relationship is the most common form for a THC. As a rule, the THC must be controlled by and be responsive to the exempt organization for which it holds property, despite the lack of specific requirements in the statute or regulations. In the IRS's view, the elements of control necessary include owning the voting stock of the THC, possessing the power to select nominees to hold the voting stock, or having the ability to appoint the directors.⁷⁷ A group of philanthropists was not allowed to establish a THC that would have essentially circumvented the private foundation rules.

A single controlling beneficiary organization is ostensibly required for §501(c)(2) entities. The longstanding policy of the IRS was to consider multiple parents as evidence of asset pooling, not mere holding of title.⁷⁸ However, for some years the IRS debated the possibility that a title-holding company might hold title for more than one kind of exempt. Fortunately, in 1986 Congress created §501(c)(25), allowing pooled ownership in real estate by a group of tax-exempt organizations.

The method of a title-holding company's formation may be influenced by state or local rules. In one example, a title-holding company was approved despite its being controlled by a broad individual base of members (a college fraternity), when the stock conferred no rights to dividends or distributions to members. All of the income from the property was payable to the §501(c)(7) organization.⁷⁹ A THC controlled by and created to benefit a private foundation is subject to the additional constraints explained in Chapters.

Restrictions on Activity. The operating powers of a THC must be limited to those required to hold title to its property—to conserve and maintain the property and to remit income to the beneficiary organization. The property held by a (c)(2) THC can include real and personal property, investments, and exempt function assets.⁸⁰ A (c)(25) THC, however, can hold only real estate. The THC can lease the property to commercial tenants unrelated to its exempt parent.⁸¹ The THC cannot, however, operate a commercial manufacturing, service, or sales enterprise.⁸² The property held by a THC can also be a leasehold interest that it sublets. Traditionally, the THC holds assets that need protection from exposure to operational liability, but it can also hold property that would expose the benefited organization to unacceptable risks.

There is no express reason why operational or exempt function assets, real or personal, cannot be kept in a (c)(2) holding company. However, active operation of exempt functions by the THC is not permissible because it goes beyond “title-holding.” A subsidiary of a veterans organization that held title to a building and operated the social facilities located in the building was not permitted THC status.⁸³ Any activity that is actively conducted, whether it is considered to be related or unrelated to exempt purposes, is generally not appropriate to be carried on by a THC.

In some situations, the income earned from the THC property is treated as unrelated business income (UBI). For the purposes of identifying UBI, the THC is treated as being organized for the same exempt purposes for which its parent is organized.⁸⁴ The UBI rules treat two types of real estate activity as unrelated despite the fact that the activity is essentially passive. The most common type is rental income earned from a property that is acquired, refurbished, and/or maintained with borrowed funds. What is referred to as “debt-financed income” is treated as UBI and is permissible for a THC.⁸⁵ The exempt-use exception for indebted property applies to exclude rental from UBI if the parent organization plans to use the property within the requisite time period.⁸⁶ Similarly, leasing of personal property in connection with rental of the real estate that the THC owns is permissible, although it may result in UBI. Both (c)(2) and (c)(25) title-holding companies are permitted to receive a de minimis amount of up to 10 percent of their gross income as unrelated income so long as the income is incidentally derived from ownership of real estate, such as parking lot fees. Such income is still subject to the unrelated business income tax, but will not cause the title-holding company to lose its exempt status.⁸⁷ Investment income earned by a title-holding entity that benefits a social club or voluntary employee benefits association (VEBA) is also taxable.⁸⁸

Passive investments, other than real estate, that are also suitable as (c)(2) THC holdings include stocks and bonds and oil and gas royalties or production payments. Operating a merchandise store, managing a hotel, providing investment management services,⁸⁹ holding a working interest in an oil well, and other active business pursuits are not permitted.⁹⁰ When business activity is anticipated, the property should instead be spun off or transferred to a taxable “feeder” subsidiary.⁹¹

The calculation of taxable income from unrelated activity is based on the tax rules applicable to for-profit businesses and investors. Choice of depreciation methods, the definition of ordinary and necessary expenses that are deductible, tax rates, and other income tax rules apply. The calculation of taxable income from debt-financed property is based on a formula that equates the tax basis of the property in relation to the indebtedness.⁹² When the THC receives unrelated business income, it is entitled to file a consolidated return with its parent organization under the rules applicable to normal for-profit corporations.⁹³ If separate returns are filed, the surtax exemptions must be shared, essentially reaching the same effective tax rate as if a common return was filed.

(b) Turning Over the Income

Accumulation of surplus income by a title-holding corporation generally is contrary to the statutory theme of turning over the income. As a rule, all net income must be paid over to the beneficiary organization. Deductions for depreciation⁹⁴ and reserves or sinking funds to make current or future mortgage payments⁹⁵ are allowed to be withheld from income required to be turned over. A reasonable provision for maintenance or restoration of the property can also be deducted from distributable income. Rents can also be used to repay an interest-free construction loan through an organization also controlled by the THC's parent.⁹⁶ Regarding the timing for distribution of funds, there is no specific requirement, but a delay with no justification, as evidenced by a substantial surplus, might be expected to bring IRS scrutiny.

Payment to the beneficiary is customarily made in the form of cash dividends, or grants in the case of a nonstock corporation. When the THC owns the building occupied by the parent and no rent is paid, there may be no income generated and available to be paid. In such cases, the rent-free use of the building fulfills the statutory scheme.

(c) Why Form a Title-Holding Corporation?

Several factors must be considered before deciding to form a title-holding corporation. Among the advantages of a THC are the opportunity it provides to shelter some assets from operating fund liabilities and the possibility of increasing the beneficiary organization's borrowing power. Setting up a THC can also facilitate separate management and administration of a corporation's physical plant. A THC might also be created to serve as a nonmember form of property ownership for a member-controlled organization.

There is, of course, a downside to the formation of a title-holding corporation. First, it increases paperwork burdens: Form 1024 must be filed to seek IRS recognition of its exemption and a separate Form 990 must be filed annually. Some relief of the compliance burden may be gained by filing a consolidated tax return, which is permitted by IRC §1504(e).

On the other hand, there are situations in which the formation of a THC is ill-advised. The tax exemption of the THC is dependent on the continued qualification of its beneficiary. If the parent company loses its exemption, the THC automatically loses its §501(c)(2) status.⁹⁷ Also, the THC cannot be used as a fund-raising vehicle, because donations to a THC generally do not qualify as charitable contributions under IRC §170. In a private ruling (later revoked), however, the IRS held that gifts to the parent dedicated expressly to a charitable project conducted by a THC were deductible.⁹⁸