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Amending Taxes

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Amending Taxes

Amending taxes 4. Amending taxes   Unrelated Business Taxable Income Table of Contents IncomeExclusions Dues of Agricultural Organizations and Business Leagues DeductionsDirectly Connected Exploitation of Exempt Activity—Advertising Sales Modifications Partnership Income or Loss S Corporation Income or Loss Special Rules for Foreign Organizations Special Rules for Social Clubs, VEBAs, SUBs, and GLSOsIncome that is set aside. Amending taxes Special Rules for Veterans' Organizations Income From Controlled OrganizationsAddition to tax for valuation misstatements. Amending taxes Net unrelated income. Amending taxes Net unrelated loss. Amending taxes Control. Amending taxes Income from property financed with qualified 501(c)(3) bonds. Amending taxes Disposition of property received from taxable subsidiary and used in unrelated business. Amending taxes Income From Debt-Financed Property Debt-Financed PropertyAcquisition Indebtedness Computation of Debt-Financed Income Deductions for Debt-Financed Property Allocation Rules How to Get Tax Help The term “unrelated business taxable income” generally means the gross income derived from any unrelated trade or business regularly conducted by the exempt organization, less the deductions directly connected with carrying on the trade or business. Amending taxes If an organization regularly carries on two or more unrelated business activities, its unrelated business taxable income is the total of gross income from all such activities less the total allowable deductions attributable to all the activities. Amending taxes In computing unrelated business taxable income, gross income and deductions are subject to the modifications and special rules explained in this chapter. Amending taxes Whether a particular item of income or expense falls within any of these modifications or special rules must be determined by all the facts and circumstances in each specific case. Amending taxes For example, if the organization received a payment termed rent that is in fact a return of profits by a person operating the property for the benefit of the organization, or that is a share of the profits retained by the organization as a partner or joint venturer, the payment is not within the income exclusion for rents, discussed later under Exclusions. Amending taxes Income Generally, unrelated business income is taxable, but there are exclusions and special rules that must be considered when figuring the income. Amending taxes Exclusions The following types of income (and deductions directly connected with the income) are generally excluded when figuring unrelated business taxable income. Amending taxes Dividends, interest, annuities and other investment income. Amending taxes   All dividends, interest, annuities, payments with respect to securities loans, income from notional principal contracts, and other income from an exempt organization's ordinary and routine investments that the IRS determines are substantially similar to these types of income are excluded in computing unrelated business taxable income. Amending taxes Exception for insurance activity income of a controlled foreign corporation. Amending taxes   This exclusion does not apply to income from certain insurance activities of an exempt organization's controlled foreign corporation. Amending taxes The income is not excludable dividend income, but instead is unrelated business taxable income to the extent it would be so treated if the exempt organization had earned it directly. Amending taxes Certain exceptions to this rule apply. Amending taxes For more information, see section 512(b)(17). Amending taxes Other exceptions. Amending taxes   This exclusion does not apply to unrelated debt-financed income (discussed under Income From Debt-Financed Property, later), to interest or annuities received from a controlled corporation (discussed under Income From Controlled Organizations, later). Amending taxes Income from lending securities. Amending taxes   Payments received with respect to a security loan are excluded in computing unrelated business taxable income only if the loan is made under an agreement that:    Provides for the return to the exempt organization of securities identical to the securities loaned, Requires payments to the organization of amounts equivalent to all interest, dividends, and other distributions that the owner of the securities is entitled to receive during the period of the loan, Does not reduce the organization's risk of loss or opportunity for gain on the securities, Contains reasonable procedures to implement the obligation of the borrower to furnish collateral to the organization with a fair market value each business day during the period of the loan in an amount not less than the fair market value of the securities at the close of the preceding business day, and Permits the organization to terminate the loan upon notice of not more than 5 business days. Amending taxes   Payments with respect to securities loans include: Amounts in respect of dividends, interest, and other distributions, Fees based on the period of time the loan is in effect and the fair market value of the security during that period, Income from collateral security for the loan, and Income from the investment of collateral security. Amending taxes The payments are considered to be from the securities loaned and not from collateral security or the investment of collateral security from the loans. Amending taxes Any deductions that are directly connected with collateral security for the loan, or with the investment of collateral security, are considered deductions that are directly connected with the securities loaned. Amending taxes Royalties. Amending taxes   Royalties, including overriding royalties, are excluded in computing unrelated business taxable income. Amending taxes   To be considered a royalty, a payment must relate to the use of a valuable right. Amending taxes Payments for trademarks, trade names, or copyrights are ordinarily considered royalties. Amending taxes Similarly, payments for the use of a professional athlete's name, photograph, likeness, or facsimile signature are ordinarily considered royalties. Amending taxes However, royalties do not include payments for personal services. Amending taxes Therefore, payments for personal appearances and interviews are not excluded as royalties and must be included in figuring unrelated business taxable income. Amending taxes   Unrelated business taxable income does not include royalty income received from licensees by an exempt organization that is the legal and beneficial owner of patents assigned to it by inventors for specified percentages of future royalties. Amending taxes   Mineral royalties are excluded whether measured by production or by gross or taxable income from the mineral property. Amending taxes However, the exclusion does not apply to royalties that stem from an arrangement whereby the organization owns a working interest in a mineral property and is liable for its share of the development and operating costs under the terms of its agreement with the operator of the property. Amending taxes To the extent they are not treated as loans under section 636 (relating to income tax treatment of mineral production payments), payments for mineral production are treated in the same manner as royalty payments for the purpose of computing unrelated business taxable income. Amending taxes To the extent they are treated as loans, any payments for production that are the equivalent of interest are treated as interest and are excluded. Amending taxes Exceptions. Amending taxes   This exclusion does not apply to debt-financed income (discussed under Income From Debt-Financed Property, later) or to royalties received from a controlled corporation (discussed under Income From Controlled Organizations, later). Amending taxes Rents. Amending taxes   Rents from real property, including elevators and escalators, are excluded in computing unrelated business taxable income. Amending taxes Rents from personal property are not excluded. Amending taxes However, special rules apply to “mixed leases” of both real and personal property. Amending taxes Mixed leases. Amending taxes   In a mixed lease, all of the rents are excluded if the rents attributable to the personal property are not more than 10% of the total rents under the lease, as determined when the personal property is first placed in service by the lessee. Amending taxes If the rents attributable to personal property are more than 10% but not more than 50% of the total rents, only the rents attributable to the real property are excluded. Amending taxes If the rents attributable to the personal property are more than 50% of the total rents, none of the rents are excludable. Amending taxes   Property is placed in service when the lessee first may use it under the terms of a lease. Amending taxes For example, property subject to a lease entered into on November 1, for a term starting on January 1 of the next year, is considered placed in service on January 1, regardless of when the lessee first actually uses it. Amending taxes   If separate leases are entered into for real and personal property and the properties have an integrated use (for example, one or more leases for real property and another lease or leases for personal property to be used on the real property), all the leases will be considered as one lease. Amending taxes   The rent attributable to the personal property must be recomputed, and the treatment of the rents must be redetermined, if: The rent attributable to all the leased personal property increases by 100% or more because additional or substitute personal property is placed in service, or The lease is modified to change the rent charged (whether or not the amount of rented personal property changes). Amending taxes Any change in the treatment of rents resulting from the recomputation is effective only for the period beginning with the event that caused the recomputation. Amending taxes Exception for rents based on net profit. Amending taxes   The exclusion for rents does not apply if the amount of the rent depends on the income or profits derived by any person from the leased property, other than an amount based on a fixed percentage of the gross receipts or sales. Amending taxes Exception for income from personal services. Amending taxes   Payment for occupying space when personal services are also rendered to the occupant does not constitute rent from real property. Amending taxes Therefore, the exclusion does not apply to transactions such as renting hotel rooms, rooms in boarding houses or tourist homes, and space in parking lots or warehouses. Amending taxes Other exceptions. Amending taxes   This exclusion does not apply to unrelated debt-financed income (discussed under Income From Debt-Financed Property, later), or to interest, annuities, royalties and rents received from a controlled corporation (discussed under Income From Controlled Organizations, later), investment income (dividends, interest, rents, etc. Amending taxes ) received by organizations described in sections 501(c)(7), 501(c)(9), 501(c)(17), and 501(c)(20). Amending taxes See Special Rules for Social Clubs, VEBAs, SUBs, and GLSOs, discussed later for more information. Amending taxes Income from research. Amending taxes   A tax-exempt organization may exclude income from research grants or contracts from unrelated business taxable income. Amending taxes However, the extent of the exclusion depends on the nature of the organization and the type of research. Amending taxes   Income from research for the United States, any of its agencies or instrumentalities, or a state or any of its political subdivisions is excluded when computing unrelated business taxable income. Amending taxes   For a college, university, or hospital, all income from research, whether fundamental or applied, is excluded in computing unrelated business taxable income. Amending taxes   When an organization is operated primarily to conduct fundamental research (as distinguished from applied research) and the results are freely available to the general public, all income from research performed for any person is excluded in computing unrelated business taxable income. Amending taxes   The term research, for this purpose, does not include activities of a type normally conducted as an incident to commercial or industrial operations, such as testing or inspecting materials or products, or designing or constructing equipment, buildings, etc. Amending taxes In addition, the term fundamental research does not include research conducted for the primary purpose of commercial or industrial application. Amending taxes Gains and losses from disposition of property. Amending taxes   Also excluded from unrelated business taxable income are gains or losses from the sale, exchange, or other disposition of property other than: Stock in trade or other property of a kind that would properly be includable in inventory if on hand at the close of the tax year, Property held primarily for sale to customers in the ordinary course of a trade or business, or Cutting of timber that an organization has elected to consider as a sale or exchange of the timber. Amending taxes   It should be noted that the last exception relates only to cut timber. Amending taxes The sale, exchange, or other disposition of standing timber is excluded from the computation of unrelated business income, unless it constitutes property held for sale to customers in the ordinary course of business. Amending taxes Lapse or termination of options. Amending taxes   Any gain from the lapse or termination of options to buy or sell securities is excluded from unrelated business taxable income. Amending taxes The exclusion applies only if the option is written in connection with the exempt organization's investment activities. Amending taxes Therefore, this exclusion is not available if the organization is engaged in the trade or business of writing options or the options are held by the organization as inventory or for sale to customers in the ordinary course of a trade or business. Amending taxes Exception. Amending taxes   This exclusion does not apply to unrelated debt-financed income, discussed later under Income From Debt-Financed Property. Amending taxes Gain or loss on disposition of certain brownfield property. Amending taxes   Gain or loss from the qualifying sale, exchange, or other disposition of a qualifying brownfield property (as defined in section 512(b)(19)(C)), which was acquired by the organization after December 31, 2005 and before January 1, 2011, is excluded from unrelated business taxable income and is excepted from the debt-financed rules for such property. Amending taxes See sections 512(b)(19) and 514(b)(1)(E). Amending taxes Income from services provided under federal license. Amending taxes   There is a further exclusion from unrelated business taxable income of income from a trade or business conducted by a religious order or by an educational organization maintained by the order. Amending taxes   This exclusion applies only if the following requirements are met. Amending taxes The trade or business must have been operated by the order or by the institution before May 27, 1959. Amending taxes The trade or business must provide services under a license issued by a federal regulatory agency. Amending taxes More than 90% of the net income from the business for the tax year must be devoted to religious, charitable, or educational purposes that constitute the basis for the religious order's exemption. Amending taxes The rates or other charges for these services must be fully competitive with the rates or other charges of similar taxable businesses. Amending taxes Rates or other charges for these services will be considered as fully competitive if they are neither materially higher nor materially lower than the rates charged by similar businesses operating in the same general area. Amending taxes Exception. Amending taxes    This exclusion does not apply to unrelated debt-financed income (discussed under Income From Debt-Financed Property, later). Amending taxes Member income of mutual or cooperative electric companies. Amending taxes   Income of a mutual or cooperative electric company described in section 501(c)(12) which is treated as member income under subparagraph (H) of that section is excluded from unrelated business taxable income. Amending taxes Dues of Agricultural Organizations and Business Leagues Dues received from associate members by organizations exempt under section 501(c)(5) or section 501(c)(6) may be treated as gross income from an unrelated trade or business if the associate member category exists for the principal purpose of producing unrelated business income. Amending taxes For example, if an organization creates an associate member category solely to allow associate members to purchase insurance through the organization, the associate member dues may be unrelated business income. Amending taxes Exception. Amending taxes   Associate member dues received by an agricultural or horticultural organization are not treated as gross income from an unrelated trade or business, regardless of their purpose, if they are not more than the annual limit. Amending taxes The limit on dues paid by an associate member is $148 for 2011. Amending taxes   If the required annual dues are more than the limit, the entire amount is treated as income from an unrelated business unless the associate member category was formed or availed of for the principal purpose of furthering the organization's exempt purposes. Amending taxes Deductions To qualify as allowable deductions in computing unrelated business taxable income, the expenses, depreciation, and similar items generally must be allowable income tax deductions that are directly connected with carrying on an unrelated trade or business. Amending taxes They cannot be directly connected with excluded income. Amending taxes For an exception to the “directly connected” requirement, see Charitable contributions deduction, under Modifications, later. Amending taxes Directly Connected To be directly connected with the conduct of an unrelated business, deductions must have a proximate and primary relationship to carrying on that business. Amending taxes For an exception, see Expenses attributable to exploitation of exempt activities, later. Amending taxes Expenses attributable solely to unrelated business. Amending taxes   Expenses, depreciation, and similar items attributable solely to the conduct of an unrelated business are proximately and primarily related to that business and qualify for deduction to the extent that they are otherwise allowable income tax deductions. Amending taxes   For example, salaries of personnel employed full-time to conduct the unrelated business and depreciation of a building used entirely in the conduct of that business are deductible to the extent otherwise allowable. Amending taxes Expenses attributable to dual use of facilities or personnel. Amending taxes   When facilities or personnel are used both to conduct exempt functions and to conduct an unrelated trade or business, expenses, depreciation, and similar items attributable to the facilities or personnel must be allocated between the two uses on a reasonable basis. Amending taxes The part of an item allocated to the unrelated trade or business is proximately and primarily related to that business and is allowable as a deduction in computing unrelated business taxable income if the expense is otherwise an allowable income tax deduction. Amending taxes Example 1. Amending taxes A school recognized as a tax-exempt organization contracts with an individual to conduct a summer tennis camp. Amending taxes The school provides the tennis courts, housing, and dining facilities. Amending taxes The contracted individual hires the instructors, recruits campers, and provides supervision. Amending taxes The income the school receives from this activity is from a dual use of the facilities and personnel. Amending taxes The school, in computing its unrelated business taxable income, may deduct an allocable part of the expenses attributable to the facilities and personnel. Amending taxes Example 2. Amending taxes An exempt organization with gross income from an unrelated trade or business pays its president $90,000 a year. Amending taxes The president devotes approximately 10% of his time to the unrelated business. Amending taxes To figure the organization's unrelated business taxable income, a deduction of $9,000 ($90,000 × 10%) is allowed for the salary paid to its president. Amending taxes Expenses attributable to exploitation of exempt activities. Amending taxes   Generally, expenses, depreciation, and similar items attributable to the conduct of an exempt activity are not deductible in computing unrelated business taxable income from an unrelated trade or business that exploits the exempt activity. Amending taxes (See Exploitation of exempt functions under Not substantially related in chapter 3. Amending taxes ) This is because they do not have a proximate and primary relationship to the unrelated trade or business, and therefore, they do not qualify as directly connected with that business. Amending taxes Exception. Amending taxes   Expenses, depreciation, and similar items may be treated as directly connected with the conduct of the unrelated business if all the following statements are true. Amending taxes The unrelated business exploits the exempt activity. Amending taxes The unrelated business is a type normally conducted for profit by taxable organizations. Amending taxes The exempt activity is a type normally conducted by taxable organizations in carrying on that type of business. Amending taxes The amount treated as directly connected is the smaller of: The excess of these expenses, depreciation, and similar items over the income from, or attributable to, the exempt activity; or The gross unrelated business income reduced by all other expenses, depreciation, and other items that are actually directly connected. Amending taxes   The application of these rules to an advertising activity that exploits an exempt publishing activity is explained next. Amending taxes Exploitation of Exempt Activity—Advertising Sales The sale of advertising in a periodical of an exempt organization that contains editorial material related to the accomplishment of the organization's exempt purpose is an unrelated business that exploits an exempt activity, the circulation and readership of the periodical. Amending taxes Therefore, in addition to direct advertising costs, exempt activity costs (expenses, depreciation, and similar expenses attributable to the production and distribution of the editorial or readership content) can be treated as directly connected with the conduct of the advertising activity. Amending taxes (See Expenses attributable to exploitation of exempt activities under Directly Connected, earlier. Amending taxes ) Figuring unrelated business taxable income (UBTI). Amending taxes   The UBTI of an advertising activity is the amount shown in the following chart. Amending taxes IF gross advertising income is . Amending taxes . Amending taxes . Amending taxes THEN UBTI is . Amending taxes . Amending taxes . Amending taxes More than direct advertising costs The excess advertising income, reduced (but not below zero) by the excess, if any, of readership costs over circulation income. Amending taxes Equal to or less than direct advertising costs Zero. Amending taxes   • Circulation income and readership costs are not taken into account. Amending taxes   • Any excess advertising costs reduce (but not below zero) UBTI from any other unrelated business activity. Amending taxes   The terms used in the chart are explained in the following discussions. Amending taxes Periodical Income Gross advertising income. Amending taxes   This is all the income from the unrelated advertising activities of an exempt organization periodical. Amending taxes Circulation income. Amending taxes   This is all the income from the production, distribution, or circulation of an exempt organization's periodical (other than gross advertising income). Amending taxes It includes all amounts from the sale or distribution of the readership content of the periodical, such as income from subscriptions. Amending taxes It also includes allocable membership receipts if the right to receive the periodical is associated with a membership or similar status in the organization. Amending taxes Allocable membership receipts. Amending taxes   This is the part of membership receipts (dues, fees, or other charges associated with membership) equal to the amount that would have been charged and paid for the periodical if: The periodical was published by a taxable organization, The periodical was published for profit, and The member was an unrelated party dealing with the taxable organization at arm's length. Amending taxes   The amount used to allocate membership receipts is the amount shown in the following chart. Amending taxes   For this purpose, the total periodical costs are the sum of the direct advertising costs and the readership costs, explained under Periodical Costs, later. Amending taxes The cost of other exempt activities means the total expenses incurred by the organization in connection with its other exempt activities, not offset by any income earned by the organization from those activities. Amending taxes IF . Amending taxes . Amending taxes . Amending taxes THEN the amount used to allocate membership receipts is . Amending taxes . Amending taxes . Amending taxes 20% or more of the total circulation consists of sales to nonmembers The subscription price charged nonmembers. Amending taxes The above condition does not apply, and 20% or more of the members pay reduced dues because they do not receive the periodical The reduction in dues for a member not receiving the periodical. Amending taxes Neither of the above conditions applies The membership receipts multiplied by this fraction:   Total periodical costs Total periodical costs Plus Cost of other exempt activities Example 1. Amending taxes U is an exempt scientific organization with 10,000 members who pay annual dues of $15. Amending taxes One of U's activities is publishing a monthly periodical distributed to all of its members. Amending taxes U also distributes 5,000 additional copies of its periodical to nonmembers, who subscribe for $10 a year. Amending taxes Since the nonmember circulation of U's periodical represents one-third (more than 20%) of its total circulation, the subscription price charged to nonmembers is used to determine the part of U's membership receipts allocable to the periodical. Amending taxes Thus, U's allocable membership receipts are $100,000 ($10 times 10,000 members), and U's total circulation income for the periodical is $150,000 ($100,000 from members plus $50,000 from sales to nonmembers). Amending taxes Example 2. Amending taxes Assume the same facts except that U sells only 500 copies of its periodical to nonmembers, at a price of $10 a year. Amending taxes Assume also that U's members may elect not to receive the periodical, in which case their dues are reduced from $15 a year to $6 a year, and that only 3,000 members elect to receive the periodical and pay the full dues of $15 a year. Amending taxes U's stated subscription price of $9 to members consistently results in an excess of total income (including gross advertising income) attributable to the periodical over total costs of the periodical. Amending taxes Since the 500 copies of the periodical distributed to nonmembers represent only 14% of the 3,500 copies distributed, the $10 subscription price charged to nonmembers is not used to determine the part of membership receipts allocable to the periodical. Amending taxes Instead, since 70% of the members elect not to receive the periodical and pay $9 less per year in dues, the $9 price is used to determine the subscription price charged to members. Amending taxes Thus, the allocable membership receipts will be $9 a member, or $27,000 ($9 times 3,000 copies). Amending taxes U's total circulation income is $32,000 ($27,000 plus the $5,000 from nonmember subscriptions). Amending taxes Periodical Costs Direct advertising costs. Amending taxes   These are expenses, depreciation, and similar items of deduction directly connected with selling and publishing advertising in the periodical. Amending taxes   Examples of allowable deductions under this classification include agency commissions and other direct selling costs, such as transportation and travel expenses, office salaries, promotion and research expenses, and office overhead directly connected with the sale of advertising lineage in the periodical. Amending taxes Also included are other deductions commonly classified as advertising costs under standard account classifications, such as artwork and copy preparation, telephone, telegraph, postage, and similar costs directly connected with advertising. Amending taxes   In addition, direct advertising costs include the part of mechanical and distribution costs attributable to advertising lineage. Amending taxes For this purpose, the general account classifications of items includable in mechanical and distribution costs ordinarily employed in business-paper and consumer-publication accounting provide a guide for the computation. Amending taxes Accordingly, the mechanical and distribution costs include the part of the costs and other expenses of composition, press work, binding, mailing (including paper and wrappers used for mailing), and bulk postage attributable to the advertising lineage of the publication. Amending taxes   In the absence of specific and detailed records, the part of mechanical and distribution costs attributable to the periodical's advertising lineage can be based on the ratio of advertising lineage to total lineage in the periodical, if this allocation is reasonable. Amending taxes Readership costs. Amending taxes   These are all expenses, depreciation, and similar items that are directly connected with the production and distribution of the readership content of the periodical. Amending taxes Costs partly attributable to other activities. Amending taxes   Deductions properly attributable to exempt activities other than publishing the periodical may not be allocated to the periodical. Amending taxes When expenses are attributable both to the periodical and to the organization's other activities, an allocation must be made on a reasonable basis. Amending taxes The method of allocation will vary with the nature of the item, but once adopted, should be used consistently. Amending taxes Allocations based on dollar receipts from various exempt activities generally are not reasonable since receipts usually do not accurately reflect the costs associated with specific activities that an exempt organization conducts. Amending taxes Consolidated Periodicals If an exempt organization publishes more than one periodical to produce income, it may treat all of them (but not less than all) as one in determining unrelated business taxable income from selling advertising. Amending taxes It treats the gross income from all the periodicals, and the deductions directly connected with them, on a consolidated basis. Amending taxes Consolidated treatment, once adopted, must be followed consistently and is binding. Amending taxes This treatment can be changed only with the consent of the Internal Revenue Service. Amending taxes An exempt organization's periodical is published to produce income if: The periodical generates gross advertising income to the organization equal to at least 25% of its readership costs, and Publishing the periodical is an activity engaged in for profit. Amending taxes Whether the publication of a periodical is an activity engaged in for profit can be determined only by all the facts and circumstances in each case. Amending taxes The facts and circumstances must show that the organization carries on the activity for economic profit, although there may not be a profit in a particular year. Amending taxes For example, if an organization begins publishing a new periodical whose total costs exceed total income in the start-up years because of lack of advertising sales, that does not mean that the organization did not have as its objective an economic profit. Amending taxes The organization may establish that it had this objective by showing it can reasonably expect advertising sales to increase, so that total income will exceed costs within a reasonable time. Amending taxes Example. Amending taxes Y, an exempt trade association, publishes three periodicals that it distributes to its members: a weekly newsletter, a monthly magazine, and a quarterly journal. Amending taxes Both the monthly magazine and the quarterly journal contain advertising that accounts for gross advertising income equal to more than 25% of their respective readership costs. Amending taxes Similarly, the total income attributable to each periodical has exceeded the total deductions attributable to each periodical for substantially all the years they have been published. Amending taxes The newsletter carries no advertising and its annual subscription price is not intended to cover the cost of publication. Amending taxes The newsletter is a service that Y distributes to all of its members in an effort to keep them informed of changes occurring in the business world. Amending taxes It is not engaged in for profit. Amending taxes Under these circumstances, Y may consolidate the income and deductions from the monthly and quarterly journals in computing its unrelated business taxable income. Amending taxes It may not consolidate the income and deductions from the newsletter with the income and deductions of its other periodicals, since the newsletter is not published for the production of income. Amending taxes Modifications Net operating loss deduction. Amending taxes   The net operating loss (NOL) deduction (as provided in section 172) is allowed in computing unrelated business taxable income. Amending taxes However, the NOL for any tax year, the carrybacks and carryovers of NOLs, and the NOL deduction are determined without taking into account any amount of income or deduction that has been specifically excluded in computing unrelated business taxable income. Amending taxes For example, a loss from an unrelated trade or business is not diminished because dividend income was received. Amending taxes   If this were not done, organizations would, in effect, be taxed on their exempt income, since unrelated business losses then would be offset by dividends, interest, and other excluded income. Amending taxes This would reduce the loss that could be applied against unrelated business income of prior or future tax years. Amending taxes Therefore, to preserve the immunity of exempt income, all NOL computations are limited to those items of income and deductions that affect the unrelated business taxable income. Amending taxes   In line with this concept, an NOL carryback or carryover is allowed only from a tax year for which the organization is subject to tax on unrelated business income. Amending taxes   For example, if an organization just became subject to the tax last year, its NOL for that year is not a carryback to a prior year when it had no unrelated business taxable income, nor is its NOL carryover to succeeding years reduced by the related income of those prior years. Amending taxes   However, in determining the span of years for which an NOL may be carried back or forward, the tax years for which the organization is not subject to the tax on unrelated business income are counted. Amending taxes For example, if an organization was subject to the tax for 2009 and had an NOL for that year, the last tax year to which any part of that loss may be carried over is 2029, regardless of whether the organization was subject to the unrelated business income tax in any of the intervening years. Amending taxes   For more details on the NOL deduction, including property eligible for an extended carryback period, see sections 172 and 1400N, Publication 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts, and Publication 4492-B, Information for Affected Taxpayers in the Midwestern Disaster Areas. Amending taxes Charitable contributions deduction. Amending taxes   An exempt organization is allowed to deduct its charitable contributions in computing its unrelated business taxable income whether or not the contributions are directly connected with the unrelated business. Amending taxes   To be deductible, the contribution must be paid to another qualified organization. Amending taxes For example, an exempt university that operates an unrelated business may deduct a contribution made to another university for educational work, but may not claim a deduction for contributions of amounts spent for carrying out its own educational program. Amending taxes   For purposes of the deduction, a distribution by a trust made under the trust instrument to a beneficiary, which itself is a qualified organization, is treated the same as a contribution. Amending taxes Deduction limits. Amending taxes   An exempt organization that is subject to the unrelated business income tax at corporate rates is allowed a deduction for charitable contributions up to 10% of its unrelated business taxable income computed without regard to the deduction for contributions. Amending taxes See the Instructions for Form 990-T for more information. Amending taxes    An exempt trust that is subject to the unrelated business income tax at trust rates generally is allowed a deduction for charitable contributions in the same amounts as allowed for individuals. Amending taxes However, the limit on the deduction is determined in relation to the trust's unrelated business taxable income computed without regard to the deduction, rather than in relation to adjusted gross income. Amending taxes   Contributions in excess of the limits just described may be carried over to the next 5 tax years. Amending taxes A contribution carryover is not allowed, however, to the extent that it increases an NOL carryover. Amending taxes Suspension of deduction limits for farmers and ranchers. Amending taxes   The limitations discussed above are temporarily suspended for certain qualified conservation contributions of property used in agriculture or livestock production. Amending taxes See the Instructions for Form 990-T for details. Amending taxes Specific deduction. Amending taxes   In computing unrelated business taxable income, a specific deduction of $1,000 is allowed. Amending taxes However, the specific deduction is not allowed in computing an NOL or the NOL deduction. Amending taxes   Generally, the deduction is limited to $1,000 regardless of the number of unrelated businesses in which the organization is engaged. Amending taxes Exception. Amending taxes   An exception is provided in the case of a diocese, province of a religious order, or a convention or association of churches that may claim a specific deduction for each parish, individual church, district, or other local unit. Amending taxes In these cases, the specific deduction for each local unit is limited to the lower of: $1,000, or Gross income derived from an unrelated trade or business regularly conducted by the local unit. Amending taxes   This exception applies only to parishes, districts, or other local units that are not separate legal entities, but are components of a larger entity (diocese, province, convention, or association) filing Form 990-T. Amending taxes The parent organization must file a return reporting the unrelated business gross income and related deductions of all units that are not separate legal entities. Amending taxes The local units cannot file separate returns. Amending taxes However, each local unit that is separately incorporated must file its own return and cannot include, or be included with, any other entity. Amending taxes See Title-holding corporations in chapter 1 for a discussion of the only situation in which more than one legal entity may be included on the same Form 990-T. Amending taxes Example. Amending taxes X is an association of churches and is divided into local units A, B, C, and D. Amending taxes Last year, A, B, C, and D derived gross income of, respectively, $1,200, $800, $1,500, and $700 from unrelated businesses that they regularly conduct. Amending taxes X may claim a specific deduction of $1,000 with respect to A, $800 with respect to B, $1,000 with respect to C, and $700 with respect to D. Amending taxes Partnership Income or Loss An organization may have unrelated business income or loss as a member of a partnership, rather than through direct business dealings with the public. Amending taxes If so, it must treat its share of the partnership income or loss as if it had conducted the business activity in its own capacity as a corporation or trust. Amending taxes No distinction is made between limited and general partners. Amending taxes The organization is required to notify the partnership of its tax-exempt status. Amending taxes Thus, if an organization is a member of a partnership regularly engaged in a trade or business that is an unrelated trade or business with respect to the organization, the organization must include in its unrelated business taxable income its share of the partnership's gross income from the unrelated trade or business (whether or not distributed), and the deductions attributable to it. Amending taxes The partnership income and deductions to be included in the organization's unrelated business taxable income are figured the same way as any income and deductions from an unrelated trade or business conducted directly by the organization. Amending taxes The partnership is required to provide the organization this information on Schedule K-1. Amending taxes Example. Amending taxes An exempt educational organization is a partner in a partnership that operates a factory. Amending taxes The partnership also holds stock in a corporation. Amending taxes The exempt organization must include its share of the gross income from operating the factory in its unrelated business taxable income but may exclude its share of any dividends the partnership received from the corporation. Amending taxes Different tax years. Amending taxes   If the exempt organization and the partnership of which it is a member have different tax years, the partnership items that enter into the computation of the organization's unrelated business taxable income must be based on the income and deductions of the partnership for the partnership's tax year that ends within or with the organization's tax year. Amending taxes S Corporation Income or Loss An organization that owns S corporation stock must take into account its share of the S corporation's income, deductions, or losses in figuring unrelated business taxable income, regardless of the actual source or nature of the income, deductions, and losses. Amending taxes For example, the organization's share of the S corporation's interest and dividend income will be taxable, even though interest and dividends are normally excluded from unrelated business taxable income. Amending taxes The organization must also take into account its gain or loss on the sale or other disposition of the S corporation stock in figuring unrelated business taxable income. Amending taxes Special Rules for Foreign Organizations The unrelated business taxable income of a foreign organization exempt from tax under section 501(a) consists of the organization's: Unrelated business taxable income derived from sources within the United States but not effectively connected with the conduct of a trade or business within the United States, and Unrelated business taxable income effectively connected with the conduct of a trade or business within the United States, whether or not this income is derived from sources within the United States. Amending taxes To determine whether income realized by a foreign organization is derived from sources within the United States or is effectively connected with the conduct of a trade or business within the United States, see sections 861 through 865 and the related regulations. Amending taxes Special Rules for Social Clubs, VEBAs, SUBs, and GLSOs The following discussion applies to: Social clubs described in section 501(c)(7), Voluntary employees' beneficiary associations (VEBAs) described in section 501(c)(9), Supplemental unemployment compensation benefit trusts (SUBs) described in section 501(c)(17), and Group legal services organizations (GLSOs) described in section 501(c)(20). Amending taxes These organizations must figure unrelated business taxable income under special rules. Amending taxes Unlike other exempt organizations, they cannot exclude their investment income (dividends, interest, rents, etc. Amending taxes ). Amending taxes (See Exclusions under Income, earlier. Amending taxes ) Therefore, they are generally subject to unrelated business income tax on this income. Amending taxes The unrelated business taxable income of these organizations includes all gross income, less deductions directly connected with the production of that income, except that gross income for this purpose does not include exempt function income. Amending taxes The dividends received by a corporation are not allowed in computing unrelated business taxable income because it is not an expense incurred in the production of income. Amending taxes Losses from nonexempt activities. Amending taxes   Losses from nonexempt activities of these organizations cannot be used to offset investment income unless the activities were undertaken with the intent to make a profit. Amending taxes Example. Amending taxes A private golf and country club that is a qualified tax-exempt social club has nonexempt function income from interest and from the sale of food and beverages to nonmembers. Amending taxes The club sells food and beverages as a service to members and their guests rather than for the purpose of making a profit. Amending taxes Therefore, any loss resulting from sales to nonmembers cannot be used to offset the club's interest income. Amending taxes Modifications. Amending taxes   The unrelated business taxable income is modified by any NOL or charitable contributions deduction and by the specific deduction (described earlier under Deductions). Amending taxes Exempt function income. Amending taxes   This is gross income from dues, fees, charges or similar items paid by members for goods, facilities, or services to the members or their dependents or guests, to further the organization's exempt purposes. Amending taxes Exempt function income also includes income set aside for qualified purposes. Amending taxes Income that is set aside. Amending taxes   This is income set aside to be used for religious, charitable, scientific, literary, or educational purposes or for the prevention of cruelty to children or animals. Amending taxes In addition, for a VEBA, SUB, or GLSO, it is income set aside to provide for the payment of life, sick, accident, or other benefits. Amending taxes   However, any amounts set aside by a VEBA or SUB that exceed the organization's qualified asset account limit (determined under section 419A) are unrelated business income. Amending taxes Special rules apply to the treatment of existing reserves for post-retirement medical or life insurance benefits. Amending taxes These rules are explained in section 512(a)(3)(E)(ii). Amending taxes   Income derived from an unrelated trade or business may not be set aside and therefore cannot be exempt function income. Amending taxes In addition, any income set aside and later spent for other purposes must be included in unrelated business taxable income. Amending taxes   Set-aside income is generally excluded from gross income only if it is set aside in the tax year in which it is otherwise includible in gross income. Amending taxes However, income set aside on or before the date for filing Form 990-T, including extensions of time, may, at the election of the organization, be treated as having been set aside in the tax year for which the return was filed. Amending taxes The income set aside must have been includible in gross income for that earlier year. Amending taxes Nonrecognition of gain. Amending taxes   If the organization sells property used directly in performing an exempt function and purchases other property used directly in performing an exempt function, any gain on the sale is recognized only to the extent that the sales price of the old property exceeds the cost of the new property. Amending taxes The purchase of the new property must be made within 1 year before the date of sale of the old property or within 3 years after the date of sale. Amending taxes   This rule also applies to gain from an involuntary conversion of the property resulting from its destruction in whole or in part, theft, seizure, requisition, or condemnation. Amending taxes Special Rules for Veterans' Organizations Unrelated business taxable income of a veterans' organization that is exempt under section 501(c)(19) does not include the net income from insurance business that is properly set aside. Amending taxes The organization may set aside income from payments received for life, sick, accident, or health insurance for the organization's members or their dependents for the payment of insurance benefits or reasonable costs of insurance administration, or for use exclusively for religious, charitable, scientific, literary, or educational purposes, or the prevention of cruelty to children or animals. Amending taxes For details, see section 512(a)(4) and the regulations under that section. Amending taxes Income From Controlled Organizations The exclusions for interest, annuities, royalties, and rents, explained earlier in this chapter under Income, may not apply to a payment of these items received by a controlling organization from its controlled organization. Amending taxes The payment is included in the controlling organization's unrelated business taxable income to the extent it reduced the net unrelated income (or increased the net unrelated loss) of the controlled organization. Amending taxes All deductions of the controlling organization directly connected with the amount included in its unrelated business taxable income are allowed. Amending taxes Excess qualifying specified payments. Amending taxes   Excess qualifying specified payments received or accrued from a controlled entity are included in a controlling exempt organization's unrelated business taxable income only on the amount that exceeds that which would have been paid or accrued if the payments had been determined under section 482. Amending taxes Qualifying specified payments means any payments of interest, annuities, royalties, or rents received or accrued from the controlled organization pursuant to a binding written contract in effect on August 17, 2006, or to a contract which is a renewal, under substantially similar terms of a binding written contract in effect on August 17, 2006, and the payments are received or accrued before January 1, 2012. Amending taxes   If a controlled participant is not required to file a U. Amending taxes S. Amending taxes income tax return, the participant must ensure that the copy or copies of the Regulations section 1. Amending taxes 482-7 Cost Sharing Arrangement Statement and any updates are attached to Schedule M of any Form 5471, Information Return of U. Amending taxes S. Amending taxes Persons With Respect To Certain Foreign Corporations, any Form 5472, Information Return of a 25% Foreign-Owned U. Amending taxes S. Amending taxes Corporation or a Foreign Corporation Engaged in a U. Amending taxes S. Amending taxes Trade or Business, or any Form 8865, Return of U. Amending taxes S. Amending taxes Persons With Respect to Certain Foreign Partnerships, filed for that participant. Amending taxes Addition to tax for valuation misstatements. Amending taxes   Under section 512(b)(13)(E)(ii), the tax imposed on a controlling organization will be increased by 20 percent of the excess qualifying specified payments that are determined with or without any amendments or supplements, whichever is larger. Amending taxes See section 512(b)(13)(E)(ii) for more information. Amending taxes Net unrelated income. Amending taxes   This is: For an exempt organization, its unrelated business taxable income, or For a nonexempt organization, the part of its taxable income that would be unrelated business taxable income if it were exempt and had the same exempt purposes as the controlling organization. Amending taxes Net unrelated loss. Amending taxes   This is: For an exempt organization, its NOL, or For a nonexempt organization, the part of its NOL that would be its NOL if it were exempt and had the same exempt purposes as the controlling organization. Amending taxes Control. Amending taxes   An organization is controlled if: For a corporation, the controlling organization owns (by vote or value) more than 50% of the stock, For a partnership, the controlling organization owns more than 50% of the profits or capital interests, or For any other organization, the controlling organization owns more than 50% of the beneficial interest. Amending taxes For this purpose, constructive ownership of stock (determined under section 318) or other interests is taken into account. Amending taxes   As a result, an exempt parent organization is treated as controlling any subsidiary in which it holds more than 50% of the voting power or value, whether directly (as in the case of a first-tier subsidiary) or indirectly (as in the case of a second-tier subsidiary). Amending taxes Income from property financed with qualified 501(c)(3) bonds. Amending taxes If any part of a 501(c)(3) organization's property financed with qualified 501(c)(3) bonds is used in a trade or business of any person other than a section 501(c)(3) organization or a governmental unit, and such use is not consistent with the requirements for qualified 501(c)(3) bonds under section 145, the section 501(c)(3) organization is considered to have received unrelated business income in the amount of the greater of the actual rental income or the fair rental value of the property for the period it is used. Amending taxes No deduction is allowed for interest on the private activity bond. Amending taxes See sections 150(b)(3) and (c) for more information. Amending taxes Disposition of property received from taxable subsidiary and used in unrelated business. Amending taxes A taxable 80%-owned subsidiary corporation of one or more tax-exempt entities is generally subject to tax on a distribution in liquidation of its assets to its exempt parent (or parents). Amending taxes The assets are treated as if sold at fair market value. Amending taxes Tax-exempt entities include organizations described in sections 501(a), 529, and 115, charitable remainder trusts, U. Amending taxes S. Amending taxes and foreign governments, Indian tribal governments, international organizations, and similar non-taxable organizations. Amending taxes A taxable corporation that transfers substantially all of its assets to a tax-exempt entity in a transaction that otherwise qualifies for nonrecognition treatment must recognize gain on the transaction as if it sold the assets at fair market value. Amending taxes However, such a transfer is not taxable if it qualifies as a like-kind exchange under section 1031 or an involuntary conversion under section 1033. Amending taxes In such a case the built-in appreciation is preserved in the replacement property received in the transaction. Amending taxes A corporation that changes status from taxable to tax-exempt is treated generally as if it transferred all of its assets to a tax-exempt entity immediately before the change in status (thus subjecting it to the tax on a deemed sale for fair market value). Amending taxes This rule does not apply where the taxable corporation becomes exempt within 3 years of formation, or had previously been exempt and within several years (generally a period of 3 years) regains exemption, unless the principal purpose of the transactions is to avoid the tax on the change in status. Amending taxes In the transactions described above, the taxable event is deferred for property that the tax-exempt entity immediately uses in an unrelated business. Amending taxes If the parent later disposes of the property, then any gain (not in excess of the amount not recognized) is included in the parent's unrelated business taxable income. Amending taxes If there is partial use of the assets in unrelated business, then there is partial recognition of gain or loss. Amending taxes Property is treated as disposed if the tax-exempt entity no longer uses it in an unrelated business. Amending taxes Losses on the transfer of assets to a tax-exempt entity are disallowed if part of a plan with a principal purpose of recognizing losses. Amending taxes Income From Debt-Financed Property Investment income that would otherwise be excluded from an exempt organization's unrelated business taxable income (see Exclusions under Income earlier) must be included to the extent it is derived from debt-financed property. Amending taxes The amount of income included is proportionate to the debt on the property. Amending taxes Debt-Financed Property In general, the term “debt-financed property” means any property held to produce income (including gain from its disposition) for which there is an acquisition indebtedness at any time during the tax year (or during the 12-month period before the date of the property's disposal, if it was disposed of during the tax year). Amending taxes It includes rental real estate, tangible personal property, and corporate stock. Amending taxes Acquisition Indebtedness For any debt-financed property, acquisition indebtedness is the unpaid amount of debt incurred by an organization: When acquiring or improving the property, Before acquiring or improving the property if the debt would not have been incurred except for the acquisition or improvement, and After acquiring or improving the property if: The debt would not have been incurred except for the acquisition or improvement, and Incurring the debt was reasonably foreseeable when the property was acquired or improved. Amending taxes The facts and circumstances of each situation determine whether incurring a debt was reasonably foreseeable. Amending taxes That an organization may not have foreseen the need to incur a debt before acquiring or improving the property does not necessarily mean that incurring the debt later was not reasonably foreseeable. Amending taxes Example 1. Amending taxes Y, an exempt scientific organization, mortgages its laboratory to replace working capital used in remodeling an office building that Y rents to an insurance company for nonexempt purposes. Amending taxes The debt is acquisition indebtedness since the debt, though incurred after the improvement of the office building, would not have been incurred without the improvement, and the debt was reasonably foreseeable when, to make the improvement, Y reduced its working capital below the amount necessary to continue current operations. Amending taxes Example 2. Amending taxes X, an exempt organization, forms a partnership with A and B. Amending taxes The partnership agreement provides that all three partners will share equally in the profits of the partnership, each will invest $3 million, and X will be a limited partner. Amending taxes X invests $1 million of its own funds in the partnership and $2 million of borrowed funds. Amending taxes The partnership buys as its sole asset an office building that it leases to the public for nonexempt purposes. Amending taxes The office building costs the partnership $24 million, of which $15 million is borrowed from Y bank. Amending taxes The loan is secured by a mortgage on the entire office building. Amending taxes By agreement with Y bank, X is not personally liable for payment of the mortgage. Amending taxes X has acquisition indebtedness of $7 million. Amending taxes This amount is the $2 million debt X incurred in acquiring the partnership interest, plus the $5 million that is X's allocable part of the partnership's debt incurred to buy the office building (one-third of $15 million). Amending taxes Example 3. Amending taxes A labor union advanced funds, from existing resources and without any borrowing, to its tax-exempt subsidiary title-holding company. Amending taxes The subsidiary used the funds to pay a debt owed to a third party that was previously incurred in acquiring two income-producing office buildings. Amending taxes Neither the union nor the subsidiary has incurred any further debt in acquiring or improving the property. Amending taxes The union has no outstanding debt on the property. Amending taxes The subsidiary's debt to the union is represented by a demand note on which the subsidiary makes payments whenever it has the available cash. Amending taxes The books of the union and the subsidiary list the outstanding debt as interorganizational indebtedness. Amending taxes Although the subsidiary's books show a debt to the union, it is not the type subject to the debt-financed property rules. Amending taxes In this situation, the very nature of the title-holding company and the parent-subsidiary relationship shows this debt to be merely a matter of accounting between the two organizations. Amending taxes Accordingly, the debt is not acquisition indebtedness. Amending taxes Change in use of property. Amending taxes   If an organization converts property that is not debt-financed property to a use that results in its treatment as debt-financed property, the outstanding principal debt on the property is thereafter treated as acquisition indebtedness. Amending taxes Example. Amending taxes Four years ago a university borrowed funds to acquire an apartment building as housing for married students. Amending taxes Last year, the university rented the apartment building to the public for nonexempt purposes. Amending taxes The outstanding principal debt becomes acquisition indebtedness as of the time the building was first rented to the public. Amending taxes Continued debt. Amending taxes   If an organization sells property and, without paying off debt that would be acquisition indebtedness if the property were debt-financed property, buys property that is otherwise debt-financed property, the unpaid debt is acquisition indebtedness for the new property. Amending taxes This is true even if the original property was not debt-financed property. Amending taxes Example. Amending taxes To house its administration offices, an exempt organization bought a building using $600,000 of its own funds and $400,000 of borrowed funds secured by a pledge of its securities. Amending taxes The office building was not debt-financed property. Amending taxes The organization later sold the building for $1 million without repaying the $400,000 loan. Amending taxes It used the sale proceeds to buy an apartment building it rents to the general public. Amending taxes The unpaid debt of $400,000 is acquisition indebtedness with respect to the apartment building. Amending taxes Property acquired subject to mortgage or lien. Amending taxes   If property (other than certain gifts, bequests, and devises) is acquired subject to a mortgage, the outstanding principal debt secured by that mortgage is treated as acquisition indebtedness even if the organization did not assume or agree to pay the debt. Amending taxes Example. Amending taxes An exempt organization paid $50,000 for real property valued at $150,000 and subject to a $100,000 mortgage. Amending taxes The $100,000 of outstanding principal debt is acquisition indebtedness, as though the organization had borrowed $100,000 to buy the property. Amending taxes Liens similar to a mortgage. Amending taxes   In determining acquisition indebtedness, a lien similar to a mortgage is treated as a mortgage. Amending taxes A lien is similar to a mortgage if title to property is encumbered by the lien for a creditor's benefit. Amending taxes However, when state law provides that a lien for taxes or assessments attaches to property before the taxes or assessments become due and payable, the lien is not treated as a mortgage until after the taxes or assessments have become due and payable and the organization has had an opportunity to pay the lien in accordance with state law. Amending taxes Liens similar to mortgages include (but are not limited to): Deeds of trust, Conditional sales contracts, Chattel mortgages, Security interests under the Uniform Commercial Code, Pledges, Agreements to hold title in escrow, and Liens for taxes or assessments (other than those discussed earlier in this paragraph). Amending taxes Exception for property acquired by gift, bequest, or devise. Amending taxes   If property subject to a mortgage is acquired by gift, bequest, or devise, the outstanding principal debt secured by the mortgage is not treated as acquisition indebtedness during the 10-year period following the date the organization receives the property. Amending taxes However, this applies to a gift of property only if:    The mortgage was placed on the property more than 5 years before the date the organization received it, and The donor held the property for more than 5 years before the date the organization received it. Amending taxes   This exception does not apply if an organization assumes and agrees to pay all or part of the debt secured by the mortgage or makes any payment for the equity in the property owned by the donor or decedent (other than a payment under an annuity obligation excluded from the definition of acquisition indebtedness, discussed under Debt That Is Not Acquisition Indebtedness, later). Amending taxes   Whether an organization has assumed and agreed to pay all or part of a debt in order to acquire the property is determined by the facts and circumstances of each situation. Amending taxes Modifying existing debt. Amending taxes   Extending, renewing, or refinancing an existing debt is considered a continuation of that debt to the extent its outstanding principal does not increase. Amending taxes When the principal of the modified debt is more than the outstanding principal of the old debt, the excess is treated as a separate debt. Amending taxes Extension or renewal. Amending taxes   In general, any modification or substitution of the terms of a debt by an organization is considered an extension or renewal of the original debt, rather than the start of a new one, to the extent that the outstanding principal of the debt does not increase. Amending taxes   The following are examples of acts resulting in the extension or renewal of a debt: Substituting liens to secure the debt, Substituting obligees whether or not with the organization's consent, Renewing, extending, or accelerating the payment terms of the debt, and Adding, deleting, or substituting sureties or other primary or secondary obligors. Amending taxes Debt increase. Amending taxes   If the outstanding principal of a modified debt is more than that of the unmodified debt, and only part of the refinanced debt is acquisition indebtedness, the payments on the refinanced debt must be allocated between the old debt and the excess. Amending taxes Example. Amending taxes An organization has an outstanding principal debt of $500,000 that is treated as acquisition indebtedness. Amending taxes The organization borrows another $100,000, which is not acquisition indebtedness, from the same lender, resulting in a $600,000 note for the total obligation. Amending taxes A payment of $60,000 on the total obligation would reduce the acquisition indebtedness by $50,000 ($60,000 x $500,000/$600,000) and the excess debt by $10,000. Amending taxes Debt That Is Not Acquisition Indebtedness Certain debt and obligations are not acquisition indebtedness. Amending taxes These include the following. Amending taxes Debts incurred in performing an exempt purpose. Amending taxes Annuity obligations. Amending taxes Securities loans. Amending taxes Real property debts of qualified organizations. Amending taxes Certain Federal financing. Amending taxes Debt incurred in performing exempt purpose. Amending taxes   A debt incurred in performing an exempt purpose is not acquisition indebtedness. Amending taxes For example, acquisition indebtedness does not include the debt an exempt credit union incurs in accepting deposits from its members or the debt an exempt organization incurs in accepting payments from its members to provide them with insurance, retirement, or other benefits. Amending taxes Annuity obligation. Amending taxes   The organization's obligation to pay an annuity is not acquisition indebtedness if the annuity meets all the following requirements. Amending taxes It must be the sole consideration (other than a mortgage on property acquired by gift, bequest, or devise that meets the exception discussed under Property acquired subject to mortgage or lien, earlier in this chapter) issued in exchange for the property received. Amending taxes Its present value, at the time of exchange, must be less than 90% of the value of the prior owner's equity in the property received. Amending taxes It must be payable over the lives of either one or two individuals living when issued. Amending taxes It must be payable under a contract that: Does not guarantee a minimum nor specify a maximum number of payments, and Does not provide for any adjustment of the amount of the annuity payments based on the income received from the transferred property or any other property. Amending taxes Example. Amending taxes X, an exempt organization, receives property valued at $100,000 from donor A, a male age 60. Amending taxes In return X promises to pay A $6,000 a year for the rest of A's life, with neither a minimum nor maximum number of payments specified. Amending taxes The amounts paid under the annuity are not dependent on the income derived from the property transferred to X. Amending taxes The present value of this annuity is $81,156, determined from IRS valuation tables. Amending taxes Since the value of the annuity is less than 90 percent of A's $100,000 equity in the property transferred and the annuity meets all the other requirements just discussed, the obligation to make annuity payments is not acquisition indebtedness. Amending taxes Securities loans. Amending taxes   Acquisition indebtedness does not include an obligation of the exempt organization to return collateral security provided by the borrower of the exempt organization's securities under a securities loan agreement (discussed under Exclusions earlier in this chapter). Amending taxes This transaction is not treated as the borrowing by the exempt organization of the collateral furnished by the borrower (usually a broker) of the securities. Amending taxes   However, if the exempt organization incurred debt to buy the loaned securities, any income from the securities (including income from
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Historical Highlights of the IRS

1862 - President Lincoln signed into law a revenue-raising measure to help pay for Civil War expenses. The measure created a Commissioner of Internal Revenue and the nation's first income tax. It levied a 3 percent tax on incomes between $600 and $10,000 and a 5 percent tax on incomes of more than $10,000.

1867 - Heeding public opposition to the income tax, Congress cut the tax rate. From 1868 until 1913, 90 percent of all revenue came from taxes on liquor, beer, wine and tobacco.

1872 - Income tax repealed.

1894 - The Wilson Tariff Act revived the income tax and an income tax division within the Bureau of Internal Revenue was created.

1895 - Supreme Court ruled the new income tax unconstitutional on the grounds that it was a direct tax and not apportioned among the states on the basis of population. The income tax division was disbanded.

1909 - President Taft recommended Congress propose a constitutional amendment that would give the government the power to tax incomes without apportioning the burden among the states in line with population. Congress also levied a 1 percent tax on net corporate incomes of more than $5,000.

1913 - As the threat of war loomed, Wyoming became the 36th and last state needed to ratify the 16th Amendment. The amendment stated, "Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration." Later, Congress adopted a 1 percent tax on net personal income of more than $3,000 with a surtax of 6 percent on incomes of more than $500,000. It also repealed the 1909 corporate income tax. The first Form 1040 was introduced.

1918 - The Revenue Act of 1918 raised even greater sums for the World War I effort. It codified all existing tax laws and imposed a progressive income-tax rate structure of up to 77 percent.

1919 - The states ratified the 18th Amendment, barring the manufacture, sale or transport of intoxicating beverages. Congress passed the Volstead Act, which gave the Commissioner of Internal Revenue the primary responsibility for enforcement of Prohibition. Eleven years later, the Department of Justice assumed primary prohibition enforcement duties.

1931 - The IRS Intelligence Unit used an undercover agent to gather evidence against gangster Al Capone. Capone was convicted of tax evasion and sentenced to 11 years.

1933 - Prohibition repealed. IRS again assumed responsibility for alcohol taxation the following year and for administering the National Firearms Act. Later, tobacco tax enforcement was added.

1942 - The Revenue Act of 1942, hailed by President Roosevelt as "the greatest tax bill in American history," passed Congress. It increased taxes and the number of Americans subject to the income tax. It also created deductions for medical and investment expenses.

1943 - Congress passed the Current Tax Payment Act, which required employers to withhold taxes from employees' wages and remit them quarterly.

1944 - Congress passed the Individual Income Tax Act, which created the standard deductions on Form 1040.

1952 - President Truman proposed his Reorganization Plan No. 1, which replaced the patronage system at the IRS with a career civil service system. It also decentralized service to taxpayers and sought to restore public confidence in the agency.

1953 - President Eisenhower endorsed Truman's reorganization plan and changed the name of the agency from the Bureau of Internal Revenue to the Internal Revenue Service.

1954 - The filing deadline for individual tax returns changed from March 15 to April 15.

1961 - The Computer Age began at IRS with the dedication of the National Computer Center at Martinsburg, W.Va.

1965 - IRS instituted its first toll-free telephone site.

1972 - The Alcohol, Tobacco and Firearms Division separated from the IRS to become the independent Bureau of Alcohol, Tobacco and Firearms.

1974 - Congress passed the Employee Retirement and Income Security Act, which gave regulatory responsibilities for employee benefit plans to the IRS.

1986 - Limited electronic filing began. President Reagan signed the Tax Reform Act, the most significant piece of tax legislation in 30 years. It contained 300 provisions and took three years to implement. The Act codified the federal tax laws for the third time since the Revenue Act of 1918.

1992 - Taxpayers who owed money were allowed to file returns electronically.

1998 - Congress passed the IRS Restructuring and Reform Act, which expanded taxpayer rights and called for reorganizing the agency into four operating divisions aligned according to taxpayer needs.

2000 - IRS enacted reforms, ending its geographic-based structure and instituting four major operating divisions: Wage and Investment, Small Business/Self-Employed, Large and Mid-Size Business and Tax Exempt and Government Entities. It was the most sweeping change at the IRS since the 1953 reorganization.

2001 - IRS administered a mid-year tax refund program to provide advance payments of a tax rate reduction.

2003 - IRS administered another mid-year refund program, this time providing an advance payment of an increase in the Child Tax Credit. Electronic filing reached a new high - 52.9 million tax returns, more than 40 percent of all individual returns.

Page Last Reviewed or Updated: 12-Feb-2014

The Amending Taxes

Amending taxes 9. Amending taxes   Depletion Table of Contents Introduction Topics - This chapter discusses: Who Can Claim Depletion? Mineral PropertyCost Depletion Percentage Depletion Oil and Gas Wells Mines and Geothermal Deposits Lessor's Gross Income TimberTimber units. Amending taxes Depletion unit. Amending taxes Introduction Depletion is the using up of natural resources by mining, drilling, quarrying stone, or cutting timber. Amending taxes The depletion deduction allows an owner or operator to account for the reduction of a product's reserves. Amending taxes There are two ways of figuring depletion: cost depletion and percentage depletion. Amending taxes For mineral property, you generally must use the method that gives you the larger deduction. Amending taxes For standing timber, you must use cost depletion. Amending taxes Topics - This chapter discusses: Who can claim depletion Mineral property Timber Who Can Claim Depletion? If you have an economic interest in mineral property or standing timber, you can take a deduction for depletion. Amending taxes More than one person can have an economic interest in the same mineral deposit or timber. Amending taxes In the case of leased property, the depletion deduction is divided between the lessor and the lessee. Amending taxes You have an economic interest if both the following apply. Amending taxes You have acquired by investment any interest in mineral deposits or standing timber. Amending taxes You have a legal right to income from the extraction of the mineral or cutting of the timber to which you must look for a return of your capital investment. Amending taxes A contractual relationship that allows you an economic or monetary advantage from products of the mineral deposit or standing timber is not, in itself, an economic interest. Amending taxes A production payment carved out of, or retained on the sale of, mineral property is not an economic interest. Amending taxes Individuals, corporations, estates, and trusts who claim depletion deductions may be liable for alternative minimum tax. Amending taxes Basis adjustment for depletion. Amending taxes   You must reduce the basis of your property by the depletion allowed or allowable, whichever is greater. Amending taxes Mineral Property Mineral property includes oil and gas wells, mines, and other natural deposits (including geothermal deposits). Amending taxes For this purpose, the term “property” means each separate interest you own in each mineral deposit in each separate tract or parcel of land. Amending taxes You can treat two or more separate interests as one property or as separate properties. Amending taxes See section 614 of the Internal Revenue Code and the related regulations for rules on how to treat separate mineral interests. Amending taxes There are two ways of figuring depletion on mineral property. Amending taxes Cost depletion. Amending taxes Percentage depletion. Amending taxes Generally, you must use the method that gives you the larger deduction. Amending taxes However, unless you are an independent producer or royalty owner, you generally cannot use percentage depletion for oil and gas wells. Amending taxes See Oil and Gas Wells , later. Amending taxes Cost Depletion To figure cost depletion you must first determine the following. Amending taxes The property's basis for depletion. Amending taxes The total recoverable units of mineral in the property's natural deposit. Amending taxes The number of units of mineral sold during the tax year. Amending taxes Basis for depletion. Amending taxes   To figure the property's basis for depletion, subtract all the following from the property's adjusted basis. Amending taxes Amounts recoverable through: Depreciation deductions, Deferred expenses (including deferred exploration and development costs), and Deductions other than depletion. Amending taxes The residual value of land and improvements at the end of operations. Amending taxes The cost or value of land acquired for purposes other than mineral production. Amending taxes Adjusted basis. Amending taxes   The adjusted basis of your property is your original cost or other basis, plus certain additions and improvements, and minus certain deductions such as depletion allowed or allowable and casualty losses. Amending taxes Your adjusted basis can never be less than zero. Amending taxes See Publication 551, Basis of Assets, for more information on adjusted basis. Amending taxes Total recoverable units. Amending taxes   The total recoverable units is the sum of the following. Amending taxes The number of units of mineral remaining at the end of the year (including units recovered but not sold). Amending taxes The number of units of mineral sold during the tax year (determined under your method of accounting, as explained next). Amending taxes   You must estimate or determine recoverable units (tons, pounds, ounces, barrels, thousands of cubic feet, or other measure) of mineral products using the current industry method and the most accurate and reliable information you can obtain. Amending taxes You must include ores and minerals that are developed, in sight, blocked out, or assured. Amending taxes You must also include probable or prospective ores or minerals that are believed to exist based on good evidence. Amending taxes But see Elective safe harbor for owners of oil and gas property , later. Amending taxes Number of units sold. Amending taxes   You determine the number of units sold during the tax year based on your method of accounting. Amending taxes Use the following table to make this determination. Amending taxes    IF you  use . Amending taxes . Amending taxes . Amending taxes THEN the units sold during the year are . Amending taxes . Amending taxes . Amending taxes The cash method of accounting The units sold for which you receive payment during the tax year (regardless of the year of sale). Amending taxes An accrual method of accounting The units sold based on your inventories and method of accounting for inventory. Amending taxes   The number of units sold during the tax year does not include any for which depletion deductions were allowed or allowable in earlier years. Amending taxes Figuring the cost depletion deduction. Amending taxes   Once you have figured your property's basis for depletion, the total recoverable units, and the number of units sold during the tax year, you can figure your cost depletion deduction by taking the following steps. Amending taxes Step Action Result 1 Divide your property's basis for depletion by total recoverable units. Amending taxes Rate per unit. Amending taxes 2 Multiply the rate per unit by units sold during the tax year. Amending taxes Cost depletion deduction. Amending taxes You must keep accounts for the depletion of each property and adjust these accounts each year for units sold and depletion claimed. Amending taxes Elective safe harbor for owners of oil and gas property. Amending taxes   Instead of using the method described earlier to determine the total recoverable units, you can use an elective safe harbor. Amending taxes If you choose the elective safe harbor, the total recoverable units equal 105% of a property's proven reserves (both developed and undeveloped). Amending taxes For details, see Revenue Procedure 2004-19 on page 563 of Internal Revenue Bulletin 2004-10, available at www. Amending taxes irs. Amending taxes gov/pub/irs-irbs/irb04-10. Amending taxes pdf. Amending taxes   To make the election, attach a statement to your timely filed (including extensions) original return for the first tax year for which the safe harbor is elected. Amending taxes The statement must indicate that you are electing the safe harbor provided by Revenue Procedure 2004-19. Amending taxes The election, if made, is effective for the tax year in which it is made and all later years. Amending taxes It cannot be revoked for the tax year in which it is elected, but may be revoked in a later year. Amending taxes Once revoked, it cannot be re-elected for the next 5 years. Amending taxes Percentage Depletion To figure percentage depletion, you multiply a certain percentage, specified for each mineral, by your gross income from the property during the tax year. Amending taxes The rates to be used and other rules for oil and gas wells are discussed later under Independent Producers and Royalty Owners and under Natural Gas Wells . Amending taxes Rates and other rules for percentage depletion of other specific minerals are found later in Mines and Geothermal Deposits . Amending taxes Gross income. Amending taxes   When figuring percentage depletion, subtract from your gross income from the property the following amounts. Amending taxes Any rents or royalties you paid or incurred for the property. Amending taxes The part of any bonus you paid for a lease on the property allocable to the product sold (or that otherwise gives rise to gross income) for the tax year. Amending taxes A bonus payment includes amounts you paid as a lessee to satisfy a production payment retained by the lessor. Amending taxes   Use the following fraction to figure the part of the bonus you must subtract. Amending taxes No. Amending taxes of units sold in the tax year Recoverable units from the property × Bonus Payments For oil and gas wells and geothermal deposits, more information about the definition of gross income from the property is under Oil and Gas Wells , later. Amending taxes For other property, more information about the definition of gross income from the property is under Mines and Geothermal Deposits , later. Amending taxes Taxable income limit. Amending taxes   The percentage depletion deduction generally cannot be more than 50% (100% for oil and gas property) of your taxable income from the property figured without the depletion deduction and the domestic production activities deduction. Amending taxes   Taxable income from the property means gross income from the property minus all allowable deductions (except any deduction for depletion or domestic production activities) attributable to mining processes, including mining transportation. Amending taxes These deductible items include, but are not limited to, the following. Amending taxes Operating expenses. Amending taxes Certain selling expenses. Amending taxes Administrative and financial overhead. Amending taxes Depreciation. Amending taxes Intangible drilling and development costs. Amending taxes Exploration and development expenditures. Amending taxes Deductible taxes (see chapter 5), but not taxes that you capitalize or take as a credit. Amending taxes Losses sustained. Amending taxes   The following rules apply when figuring your taxable income from the property for purposes of the taxable income limit. Amending taxes Do not deduct any net operating loss deduction from the gross income from the property. Amending taxes Corporations do not deduct charitable contributions from the gross income from the property. Amending taxes If, during the year, you dispose of an item of section 1245 property that was used in connection with mineral property, reduce any allowable deduction for mining expenses by the part of any gain you must report as ordinary income that is allocable to the mineral property. Amending taxes See section 1. Amending taxes 613-5(b)(1) of the regulations for information on how to figure the ordinary gain allocable to the property. Amending taxes Oil and Gas Wells You cannot claim percentage depletion for an oil or gas well unless at least one of the following applies. Amending taxes You are either an independent producer or a royalty owner. Amending taxes The well produces natural gas that is either sold under a fixed contract or produced from geopressured brine. Amending taxes If you are an independent producer or royalty owner, see Independent Producers and Royalty Owners , next. Amending taxes For information on the depletion deduction for wells that produce natural gas that is either sold under a fixed contract or produced from geopressured brine, see Natural Gas Wells , later. Amending taxes Independent Producers and Royalty Owners If you are an independent producer or royalty owner, you figure percentage depletion using a rate of 15% of the gross income from the property based on your average daily production of domestic crude oil or domestic natural gas up to your depletable oil or natural gas quantity. Amending taxes However, certain refiners, as explained next, and certain retailers and transferees of proven oil and gas properties, as explained next, cannot claim percentage depletion. Amending taxes For information on figuring the deduction, see Figuring percentage depletion , later. Amending taxes Refiners who cannot claim percentage depletion. Amending taxes   You cannot claim percentage depletion if you or a related person refine crude oil and you and the related person refined more than 75,000 barrels on any day during the tax year based on average (rather than actual) daily refinery runs for the tax year. Amending taxes The average daily refinery run is computed by dividing total refinery runs for the tax year by the total number of days in the tax year. Amending taxes Related person. Amending taxes   You and another person are related persons if either of you holds a significant ownership interest in the other person or if a third person holds a significant ownership interest in both of you. Amending taxes For example, a corporation, partnership, estate, or trust and anyone who holds a significant ownership interest in it are related persons. Amending taxes A partnership and a trust are related persons if one person holds a significant ownership interest in each of them. Amending taxes For purposes of the related person rules, significant ownership interest means direct or indirect ownership of 5% or more in any one of the following. Amending taxes The value of the outstanding stock of a corporation. Amending taxes The interest in the profits or capital of a partnership. Amending taxes The beneficial interests in an estate or trust. Amending taxes Any interest owned by or for a corporation, partnership, trust, or estate is considered to be owned directly both by itself and proportionately by its shareholders, partners, or beneficiaries. Amending taxes Retailers who cannot claim percentage depletion. Amending taxes   You cannot claim percentage depletion if both the following apply. Amending taxes You sell oil or natural gas or their by-products directly or through a related person in any of the following situations. Amending taxes Through a retail outlet operated by you or a related person. Amending taxes To any person who is required under an agreement with you or a related person to use a trademark, trade name, or service mark or name owned by you or a related person in marketing or distributing oil, natural gas, or their by-products. Amending taxes To any person given authority under an agreement with you or a related person to occupy any retail outlet owned, leased, or controlled by you or a related person. Amending taxes The combined gross receipts from sales (not counting resales) of oil, natural gas, or their by-products by all retail outlets taken into account in (1) are more than $5 million for the tax year. Amending taxes   For the purpose of determining if this rule applies, do not count the following. Amending taxes Bulk sales (sales in very large quantities) of oil or natural gas to commercial or industrial users. Amending taxes Bulk sales of aviation fuels to the Department of Defense. Amending taxes Sales of oil or natural gas or their by-products outside the United States if none of your domestic production or that of a related person is exported during the tax year or the prior tax year. Amending taxes Related person. Amending taxes   To determine if you and another person are related persons, see Related person under Refiners who cannot claim percentage depletion, earlier. Amending taxes Sales through a related person. Amending taxes   You are considered to be selling through a related person if any sale by the related person produces gross income from which you may benefit because of your direct or indirect ownership interest in the person. Amending taxes   You are not considered to be selling through a related person who is a retailer if all the following apply. Amending taxes You do not have a significant ownership interest in the retailer. Amending taxes You sell your production to persons who are not related to either you or the retailer. Amending taxes The retailer does not buy oil or natural gas from your customers or persons related to your customers. Amending taxes There are no arrangements for the retailer to acquire oil or natural gas you produced for resale or made available for purchase by the retailer. Amending taxes Neither you nor the retailer knows of or controls the final disposition of the oil or natural gas you sold or the original source of the petroleum products the retailer acquired for resale. Amending taxes Transferees who cannot claim percentage depletion. Amending taxes   You cannot claim percentage depletion if you received your interest in a proven oil or gas property by transfer after 1974 and before October 12, 1990. Amending taxes For a definition of the term “transfer,” see section 1. Amending taxes 613A-7(n) of the regulations. Amending taxes For a definition of the term “interest in proven oil or gas property,” see section 1. Amending taxes 613A-7(p) of the regulations. Amending taxes Figuring percentage depletion. Amending taxes   Generally, as an independent producer or royalty owner, you figure your percentage depletion by computing your average daily production of domestic oil or gas and comparing it to your depletable oil or gas quantity. Amending taxes If your average daily production does not exceed your depletable oil or gas quantity, you figure your percentage depletion by multiplying the gross income from the oil or gas property (defined later) by 15%. Amending taxes If your average daily production of domestic oil or gas exceeds your depletable oil or gas quantity, you must make an allocation as explained later under Average daily production. Amending taxes   In addition, there is a limit on the percentage depletion deduction. Amending taxes See Taxable income limit , later. Amending taxes Average daily production. Amending taxes   Figure your average daily production by dividing your total domestic production of oil or gas for the tax year by the number of days in your tax year. Amending taxes Partial interest. Amending taxes   If you have a partial interest in the production from a property, figure your share of the production by multiplying total production from the property by your percentage of interest in the revenues from the property. Amending taxes   You have a partial interest in the production from a property if you have a net profits interest in the property. Amending taxes To figure the share of production for your net profits interest, you must first determine your percentage participation (as measured by the net profits) in the gross revenue from the property. Amending taxes To figure this percentage, you divide the income you receive for your net profits interest by the gross revenue from the property. Amending taxes Then multiply the total production from the property by your percentage participation to figure your share of the production. Amending taxes Example. Amending taxes Javier Robles owns oil property in which Pablo Olmos owns a 20% net profits interest. Amending taxes During the year, the property produced 10,000 barrels of oil, which Javier sold for $200,000. Amending taxes Javier had expenses of $90,000 attributable to the property. Amending taxes The property generated a net profit of $110,000 ($200,000 − $90,000). Amending taxes Pablo received income of $22,000 ($110,000 × . Amending taxes 20) for his net profits interest. Amending taxes Pablo determined his percentage participation to be 11% by dividing $22,000 (the income he received) by $200,000 (the gross revenue from the property). Amending taxes Pablo determined his share of the oil production to be 1,100 barrels (10,000 barrels × 11%). Amending taxes Depletable oil or natural gas quantity. Amending taxes   Generally, your depletable oil quantity is 1,000 barrels. Amending taxes Your depletable natural gas quantity is 6,000 cubic feet multiplied by the number of barrels of your depletable oil quantity that you choose to apply. Amending taxes If you claim depletion on both oil and natural gas, you must reduce your depletable oil quantity (1,000 barrels) by the number of barrels you use to figure your depletable natural gas quantity. Amending taxes Example. Amending taxes You have both oil and natural gas production. Amending taxes To figure your depletable natural gas quantity, you choose to apply 360 barrels of your 1000-barrel depletable oil quantity. Amending taxes Your depletable natural gas quantity is 2. Amending taxes 16 million cubic feet of gas (360 × 6000). Amending taxes You must reduce your depletable oil quantity to 640 barrels (1000 − 360). Amending taxes If you have production from marginal wells, see section 613A(c)(6) of the Internal Revenue Code to figure your depletable oil or natural gas quantity. Amending taxes Also, see Notice 2012-50, available at www. Amending taxes irs. Amending taxes gov/irb/2012–31_IRB/index. Amending taxes html. Amending taxes Business entities and family members. Amending taxes   You must allocate the depletable oil or gas quantity among the following related persons in proportion to each entity's or family member's production of domestic oil or gas for the year. Amending taxes Corporations, trusts, and estates if 50% or more of the beneficial interest is owned by the same or related persons (considering only persons that own at least 5% of the beneficial interest). Amending taxes You and your spouse and minor children. Amending taxes A related person is anyone mentioned in the related persons discussion under Nondeductible loss in chapter 2 of Publication 544, except that for purposes of this allocation, item (1) in that discussion includes only an individual, his or her spouse, and minor children. Amending taxes Controlled group of corporations. Amending taxes   Members of the same controlled group of corporations are treated as one taxpayer when figuring the depletable oil or natural gas quantity. Amending taxes They share the depletable quantity. Amending taxes A controlled group of corporations is defined in section 1563(a) of the Internal Revenue Code, except that, for this purpose, the stock ownership requirement in that definition is “more than 50%” rather than “at least 80%. Amending taxes ” Gross income from the property. Amending taxes   For purposes of percentage depletion, gross income from the property (in the case of oil and gas wells) is the amount you receive from the sale of the oil or gas in the immediate vicinity of the well. Amending taxes If you do not sell the oil or gas on the property, but manufacture or convert it into a refined product before sale or transport it before sale, the gross income from the property is the representative market or field price (RMFP) of the oil or gas, before conversion or transportation. Amending taxes   If you sold gas after you removed it from the premises for a price that is lower than the RMFP, determine gross income from the property for percentage depletion purposes without regard to the RMFP. Amending taxes   Gross income from the property does not include lease bonuses, advance royalties, or other amounts payable without regard to production from the property. Amending taxes Average daily production exceeds depletable quantities. Amending taxes   If your average daily production for the year is more than your depletable oil or natural gas quantity, figure your allowance for depletion for each domestic oil or natural gas property as follows. Amending taxes Figure your average daily production of oil or natural gas for the year. Amending taxes Figure your depletable oil or natural gas quantity for the year. Amending taxes Figure depletion for all oil or natural gas produced from the property using a percentage depletion rate of 15%. Amending taxes Multiply the result figured in (3) by a fraction, the numerator of which is the result figured in (2) and the denominator of which is the result figured in (1). Amending taxes This is your depletion allowance for that property for the year. Amending taxes Taxable income limit. Amending taxes   If you are an independent producer or royalty owner of oil and gas, your deduction for percentage depletion is limited to the smaller of the following. Amending taxes 100% of your taxable income from the property figured without the deduction for depletion and the deduction for domestic production activities under section 199 of the Internal Revenue Code. Amending taxes For a definition of taxable income from the property, see Taxable income limit , earlier, under Mineral Property. Amending taxes 65% of your taxable income from all sources, figured without the depletion allowance, the deduction for domestic production activities, any net operating loss carryback, and any capital loss carryback. Amending taxes You can carry over to the following year any amount you cannot deduct because of the 65%-of-taxable-income limit. Amending taxes Add it to your depletion allowance (before applying any limits) for the following year. Amending taxes Partnerships and S Corporations Generally, each partner or S corporation shareholder, and not the partnership or S corporation, figures the depletion allowance separately. Amending taxes (However, see Electing large partnerships must figure depletion allowance , later. Amending taxes ) Each partner or shareholder must decide whether to use cost or percentage depletion. Amending taxes If a partner or shareholder uses percentage depletion, he or she must apply the 65%-of-taxable-income limit using his or her taxable income from all sources. Amending taxes Partner's or shareholder's adjusted basis. Amending taxes   The partnership or S corporation must allocate to each partner or shareholder his or her share of the adjusted basis of each oil or gas property held by the partnership or S corporation. Amending taxes The partnership or S corporation makes the allocation as of the date it acquires the oil or gas property. Amending taxes   Each partner's share of the adjusted basis of the oil or gas property generally is figured according to that partner's interest in partnership capital. Amending taxes However, in some cases, it is figured according to the partner's interest in partnership income. Amending taxes   The partnership or S corporation adjusts the partner's or shareholder's share of the adjusted basis of the oil and gas property for any capital expenditures made for the property and for any change in partnership or S corporation interests. Amending taxes Recordkeeping. Amending taxes Each partner or shareholder must separately keep records of his or her share of the adjusted basis in each oil and gas property of the partnership or S corporation. Amending taxes The partner or shareholder must reduce his or her adjusted basis by the depletion allowed or allowable on the property each year. Amending taxes The partner or shareholder must use that reduced adjusted basis to figure cost depletion or his or her gain or loss if the partnership or S corporation disposes of the property. Amending taxes Reporting the deduction. Amending taxes   Information that you, as a partner or shareholder, use to figure your depletion deduction on oil and gas properties is reported by the partnership or S corporation on Schedule K-1 (Form 1065) or on Schedule K-1 (Form 1120S). Amending taxes Deduct oil and gas depletion for your partnership or S corporation interest on Schedule E (Form 1040). Amending taxes The depletion deducted on Schedule E is included in figuring income or loss from rental real estate or royalty properties. Amending taxes The instructions for Schedule E explain where to report this income or loss and whether you need to file either of the following forms. Amending taxes Form 6198, At-Risk Limitations. Amending taxes Form 8582, Passive Activity Loss Limitations. Amending taxes Electing large partnerships must figure depletion allowance. Amending taxes   An electing large partnership, rather than each partner, generally must figure the depletion allowance. Amending taxes The partnership figures the depletion allowance without taking into account the 65-percent-of-taxable-income limit and the depletable oil or natural gas quantity. Amending taxes Also, the adjusted basis of a partner's interest in the partnership is not affected by the depletion allowance. Amending taxes   An electing large partnership is one that meets both the following requirements. Amending taxes The partnership had 100 or more partners in the preceding year. Amending taxes The partnership chooses to be an electing large partnership. Amending taxes Disqualified persons. Amending taxes   An electing large partnership does not figure the depletion allowance of its partners that are disqualified persons. Amending taxes Disqualified persons must figure it themselves, as explained earlier. Amending taxes   All the following are disqualified persons. Amending taxes Refiners who cannot claim percentage depletion (discussed under Independent Producers and Royalty Owners , earlier). Amending taxes Retailers who cannot claim percentage depletion (discussed under Independent Producers and Royalty Owners , earlier). Amending taxes Any partner whose average daily production of domestic crude oil and natural gas is more than 500 barrels during the tax year in which the partnership tax year ends. Amending taxes Average daily production is discussed earlier. Amending taxes Natural Gas Wells You can use percentage depletion for a well that produces natural gas that is either Sold under a fixed contract, or Produced from geopressured brine. Amending taxes Natural gas sold under a fixed contract. Amending taxes   Natural gas sold under a fixed contract qualifies for a percentage depletion rate of 22%. Amending taxes This is domestic natural gas sold by the producer under a contract that does not provide for a price increase to reflect any increase in the seller's tax liability because of the repeal of percentage depletion for gas. Amending taxes The contract must have been in effect from February 1, 1975, until the date of sale of the gas. Amending taxes Price increases after February 1, 1975, are presumed to take the increase in tax liability into account unless demonstrated otherwise by clear and convincing evidence. Amending taxes Natural gas from geopressured brine. Amending taxes   Qualified natural gas from geopressured brine is eligible for a percentage depletion rate of 10%. Amending taxes This is natural gas that is both the following. Amending taxes Produced from a well you began to drill after September 1978 and before 1984. Amending taxes Determined in accordance with section 503 of the Natural Gas Policy Act of 1978 to be produced from geopressured brine. Amending taxes Mines and Geothermal Deposits Certain mines, wells, and other natural deposits, including geothermal deposits, qualify for percentage depletion. Amending taxes Mines and other natural deposits. Amending taxes   For a natural deposit, the percentage of your gross income from the property that you can deduct as depletion depends on the type of deposit. Amending taxes   The following is a list of the percentage depletion rates for the more common minerals. Amending taxes DEPOSITS RATE Sulphur, uranium, and, if from deposits in the United States, asbestos, lead ore, zinc ore, nickel ore, and mica 22% Gold, silver, copper, iron ore, and certain oil shale, if from deposits in the United States 15% Borax, granite, limestone, marble, mollusk shells, potash, slate, soapstone, and carbon dioxide produced from a well 14% Coal, lignite, and sodium chloride 10% Clay and shale used or sold for use in making sewer pipe or bricks or used or sold for use as sintered or burned lightweight aggregates 7½% Clay used or sold for use in making drainage and roofing tile, flower pots, and kindred products, and gravel, sand, and stone (other than stone used or sold for use by a mine owner or operator as dimension or ornamental stone) 5%   You can find a complete list of minerals and their percentage depletion rates in section 613(b) of the Internal Revenue Code. Amending taxes Corporate deduction for iron ore and coal. Amending taxes   The percentage depletion deduction of a corporation for iron ore and coal (including lignite) is reduced by 20% of: The percentage depletion deduction for the tax year (figured without this reduction), minus The adjusted basis of the property at the close of the tax year (figured without the depletion deduction for the tax year). Amending taxes Gross income from the property. Amending taxes   For property other than a geothermal deposit or an oil or gas well, gross income from the property means the gross income from mining. Amending taxes Mining includes all the following. Amending taxes Extracting ores or minerals from the ground. Amending taxes Applying certain treatment processes described later. Amending taxes Transporting ores or minerals (generally, not more than 50 miles) from the point of extraction to the plants or mills in which the treatment processes are applied. Amending taxes Excise tax. Amending taxes   Gross income from mining includes the separately stated excise tax received by a mine operator from the sale of coal to compensate the operator for the excise tax the mine operator must pay to finance black lung benefits. Amending taxes Extraction. Amending taxes   Extracting ores or minerals from the ground includes extraction by mine owners or operators of ores or minerals from the waste or residue of prior mining. Amending taxes This does not apply to extraction from waste or residue of prior mining by the purchaser of the waste or residue or the purchaser of the rights to extract ores or minerals from the waste or residue. Amending taxes Treatment processes. Amending taxes   The processes included as mining depend on the ore or mineral mined. Amending taxes To qualify as mining, the treatment processes must be applied by the mine owner or operator. Amending taxes For a listing of treatment processes considered as mining, see section 613(c)(4) of the Internal Revenue Code and the related regulations. Amending taxes Transportation of more than 50 miles. Amending taxes   If the IRS finds that the ore or mineral must be transported more than 50 miles to plants or mills to be treated because of physical and other requirements, the additional authorized transportation is considered mining and included in the computation of gross income from mining. Amending taxes    If you wish to include transportation of more than 50 miles in the computation of gross income from mining, request an advance ruling from the IRS. Amending taxes Include in the request the facts about the physical and other requirements that prevented the construction and operation of the plant within 50 miles of the point of extraction. Amending taxes For more information about requesting an advance ruling, see Revenue Procedure 2013-1, available at www. Amending taxes irs. Amending taxes gov/irb/2013-01_IRB/ar11. Amending taxes html. Amending taxes Disposal of coal or iron ore. Amending taxes   You cannot take a depletion deduction for coal (including lignite) or iron ore mined in the United States if both the following apply. Amending taxes You disposed of it after holding it for more than 1 year. Amending taxes You disposed of it under a contract under which you retain an economic interest in the coal or iron ore. Amending taxes Treat any gain on the disposition as a capital gain. Amending taxes Disposal to related person. Amending taxes   This rule does not apply if you dispose of the coal or iron ore to one of the following persons. Amending taxes A related person (as listed in chapter 2 of Publication 544). Amending taxes A person owned or controlled by the same interests that own or control you. Amending taxes Geothermal deposits. Amending taxes   Geothermal deposits located in the United States or its possessions qualify for a percentage depletion rate of 15%. Amending taxes A geothermal deposit is a geothermal reservoir of natural heat stored in rocks or in a watery liquid or vapor. Amending taxes For percentage depletion purposes, a geothermal deposit is not considered a gas well. Amending taxes   Figure gross income from the property for a geothermal steam well in the same way as for oil and gas wells. Amending taxes See Gross income from the property , earlier, under Oil and Gas Wells. Amending taxes Percentage depletion on a geothermal deposit cannot be more than 50% of your taxable income from the property. Amending taxes Lessor's Gross Income In the case of leased property, the depletion deduction is divided between the lessor and the lessee. Amending taxes A lessor's gross income from the property that qualifies for percentage depletion usually is the total of the royalties received from the lease. Amending taxes Bonuses and advanced royalties. Amending taxes   Bonuses and advanced royalties are payments a lessee makes before production to a lessor for the grant of rights in a lease or for minerals, gas, or oil to be extracted from leased property. Amending taxes If you are the lessor, your income from bonuses and advanced royalties received is subject to an allowance for depletion, as explained in the next two paragraphs. Amending taxes Figuring cost depletion. Amending taxes   To figure cost depletion on a bonus, multiply your adjusted basis in the property by a fraction, the numerator of which is the bonus and the denominator of which is the total bonus and royalties expected to be received. Amending taxes To figure cost depletion on advanced royalties, use the computation explained earlier under Cost Depletion , treating the number of units for which the advanced royalty is received as the number of units sold. Amending taxes Figuring percentage depletion. Amending taxes   In the case of mines, wells, and other natural deposits other than gas, oil, or geothermal property, you may use the percentage rates discussed earlier under Mines and Geothermal Deposits . Amending taxes Any bonus or advanced royalty payments are generally part of the gross income from the property to which the rates are applied in making the calculation. Amending taxes However, for oil, gas, or geothermal property, gross income does not include lease bonuses, advanced royalties, or other amounts payable without regard to production from the property. Amending taxes Ending the lease. Amending taxes   If you receive a bonus on a lease that ends or is abandoned before you derive any income from mineral extraction, include in income the depletion deduction you took. Amending taxes Do this for the year the lease ends or is abandoned. Amending taxes Also increase your adjusted basis in the property to restore the depletion deduction you previously subtracted. Amending taxes   For advanced royalties, include in income the depletion claimed on minerals for which the advanced royalties were paid if the minerals were not produced before the lease ended. Amending taxes Include this amount in income for the year the lease ends. Amending taxes Increase your adjusted basis in the property by the amount you include in income. Amending taxes Delay rentals. Amending taxes   These are payments for deferring development of the property. Amending taxes Since delay rentals are ordinary rent, they are ordinary income that is not subject to depletion. Amending taxes These rentals can be avoided by either abandoning the lease, beginning development operations, or obtaining production. Amending taxes Timber You can figure timber depletion only by the cost method. Amending taxes Percentage depletion does not apply to timber. Amending taxes Base your depletion on your cost or other basis in the timber. Amending taxes Your cost does not include the cost of land or any amounts recoverable through depreciation. Amending taxes Depletion takes place when you cut standing timber. Amending taxes You can figure your depletion deduction when the quantity of cut timber is first accurately measured in the process of exploitation. Amending taxes Figuring cost depletion. Amending taxes   To figure your cost depletion allowance, you multiply the number of timber units cut by your depletion unit. Amending taxes Timber units. Amending taxes   When you acquire timber property, you must make an estimate of the quantity of marketable timber that exists on the property. Amending taxes You measure the timber using board feet, log scale, cords, or other units. Amending taxes If you later determine that you have more or less units of timber, you must adjust the original estimate. Amending taxes   The term “timber property” means your economic interest in standing timber in each tract or block representing a separate timber account. Amending taxes Depletion unit. Amending taxes   You figure your depletion unit each year by taking the following steps. Amending taxes Determine your cost or adjusted basis of the timber on hand at the beginning of the year. Amending taxes Adjusted basis is defined under Cost Depletion in the discussion on Mineral Property. Amending taxes Add to the amount determined in (1) the cost of any timber units acquired during the year and any additions to capital. Amending taxes Figure the number of timber units to take into account by adding the number of timber units acquired during the year to the number of timber units on hand in the account at the beginning of the year and then adding (or subtracting) any correction to the estimate of the number of timber units remaining in the account. Amending taxes Divide the result of (2) by the result of (3). Amending taxes This is your depletion unit. Amending taxes Example. Amending taxes You bought a timber tract for $160,000 and the land was worth as much as the timber. Amending taxes Your basis for the timber is $80,000. Amending taxes Based on an estimated one million board feet (1,000 MBF) of standing timber, you figure your depletion unit to be $80 per MBF ($80,000 ÷ 1,000). Amending taxes If you cut 500 MBF of timber, your depletion allowance would be $40,000 (500 MBF × $80). Amending taxes When to claim depletion. Amending taxes   Claim your depletion allowance as a deduction in the year of sale or other disposition of the products cut from the timber, unless you choose to treat the cutting of timber as a sale or exchange (explained below). Amending taxes Include allowable depletion for timber products not sold during the tax year the timber is cut as a cost item in the closing inventory of timber products for the year. Amending taxes The inventory is your basis for determining gain or loss in the tax year you sell the timber products. Amending taxes Example. Amending taxes The facts are the same as in the previous example except that you sold only half of the timber products in the cutting year. Amending taxes You would deduct $20,000 of the $40,000 depletion that year. Amending taxes You would add the remaining $20,000 depletion to your closing inventory of timber products. Amending taxes Electing to treat the cutting of timber as a sale or exchange. Amending taxes   You can elect, under certain circumstances, to treat the cutting of timber held for more than 1 year as a sale or exchange. Amending taxes You must make the election on your income tax return for the tax year to which it applies. Amending taxes If you make this election, subtract the adjusted basis for depletion from the fair market value of the timber on the first day of the tax year in which you cut it to figure the gain or loss on the cutting. Amending taxes You generally report the gain as long-term capital gain. Amending taxes The fair market value then becomes your basis for figuring your ordinary gain or loss on the sale or other disposition of the products cut from the timber. Amending taxes For more information, see Timber in chapter 2 of Publication 544, Sales and Other Dispositions of Assets. Amending taxes   You may revoke an election to treat the cutting of timber as a sale or exchange without IRS's consent. Amending taxes The prior election (and revocation) is disregarded for purposes of making a subsequent election. Amending taxes See Form T (Timber), Forest Activities Schedule, for more information. Amending taxes Form T. Amending taxes   Complete and attach Form T (Timber) to your income tax return if you claim a deduction for timber depletion, choose to treat the cutting of timber as a sale or exchange, or make an outright sale of timber. Amending taxes Prev  Up  Next   Home   More Online Publications