PRIMER ON SET ASIDE PROCEDURES

Barbara Schwartz Bromberg, Esq., Dinsmore & Shohl LLP

INTRODUCTION

It has been some time since we reviewed the rules surrounding set asides in this column and with many fraternal organizations’ fiscal year ends and tax seasons approaching, this seems like a good time to do so.  This article will focus on the procedural aspects of set asides and a future article will deal with the substantive aspects of set asides.  First, we will explore the basic underpinnings of the set aside procedure and what is required for a timely and effective set aside to be made, and then we will explore some of the finer points of the set aside rules.

THE BASICS OF SET ASIDES

Under the Internal Revenue Code, college fraternities and sororities exempt under Code Section 501(c)(7) (including local chapters and most house corporations) must pay federal income tax on their investment income of over $1,000 per year as unrelated business income.  Investment income includes dividends on stock, interest on bank accounts, rents, royalties, net capital gains and similar investment income.  Expenses directly incurred in the production of the investment income, such as investment advisory fees, may be deducted from gross income to produce the correct net investment income amount.  The set aside procedure is one that allows such funds to escape taxation if they are properly set aside to be used for charitable and educational purposes.  In such cases and if the funds are used in a proper manner, then no federal income tax is payable.  Therefore, any fraternal organization exempt under Code Section 501(c)(7) should consider using the set aside procedure if it has over $1,000 of investment income of the type described above.  Many fraternal organizations routinely use the set aside procedure for all investment income every year, while others choose to set aside a part of their investment income and pay federal income tax on the remainder (this option will be further explained in question 8 below).

The set aside procedure should be instituted by first determining the amount of net investment income that would otherwise be subject to tax.  The organization should then adopt a resolution like that below, setting aside the amount of such net investment income (or the desired amount, if less) in a separate bank account, which is identified as a “set aside fund”.  It is very important that this exact procedure be followed.

SUGGESTED RESOLUTION

At a meeting of the (governing body) of ______________ Fraternity, on the _____ day of ___________, 200__, after discussion of the net investment income for the organization’s fiscal year ending __________________, 200__, the following motion was duly made, seconded, and unanimously resolved as follows:

RESOLVED, that the amount of $__________ be set aside from the general assets of the __________________ Fraternity in a separate bank account to be known as set aside account no. ______ of ________________ Fraternity.

RESOLVED, FURTHER, that said amount of $______________ may be used only for the following purposes:  Religious, charitable, scientific, literary or educational purposes, loans on local chapter housing, or for the prevention of cruelty to children or animals; and for scholarships, student loans, leadership and citizenship schools and services, and similar purposes. _____________________________

President

This Resolution should be signed and one signed copy should be placed in the organization’s corporate minutebook.

This procedure must be followed every year to avoid such taxation for any year that the organization has a total of over $1,000 in investment income and wishes to avoid taxation thereon.  All amounts set aside must first be deposited in a set aside account before being disbursed for qualifying purposes.  The account should clearly be labeled as set aside funds and preferably each year’s set aside should also be separately designated–e.g., set aside 1-2005; set aside 2-2006, etc.  It must not be commingled with an organization’s general funds.  If the amount is large, it may also be invested in other ways–for example, money market or mutual fund–as long as it is properly segregated and labeled as a set aside fund.  However, long term investments that are not readily available should be avoided as set aside funds are supposed to be used within a “reasonable” time.  Thus, while set aside funds need not be used in the same year set aside, in general, money in a set aside account should not accumulate for more than two or three years after it was set aside.  Therefore, when an organization needs funds for any qualifying purpose, the amount should first be taken from set aside funds and earlier years’ set aside funds should be depleted before later years.

It should also be noted that set aside accounts cannot be loaned for general fraternal purposes.  In addition, an organization may not pledge the set aside monies or otherwise use them as collateral for a third party loan.  If such a transaction occurs, the set aside funds immediately become taxable.

THE FINER POINTS OF SET ASIDE PROCEDURE

Once a fraternal organization and its advisors have become familiar with the basics of the set aside procedure, there are many pitfalls that need to be avoided in order to manage the organization’s set aside procedures effectively.  Some of the most commonly asked questions about these finer points of set aside procedure are discussed below in question and answer form.

1. Q. What is the set aside procedure available for investment income that has been debt-financed–for example, rent received on real estate that has a mortgage on it?

A.It has been the IRS’ position since the set aside procedure first came into the Internal Revenue Code in 1969 that debt-financed income, such as is described in this question, would not qualify for the set aside procedure and that unrelated business income tax is due thereon under the rules of Code Section 514 relating to debt-financed income of exempt organizations generally.

2. Q. What should a fraternity do if it has a large amount of set aside funds and cannot use all of them in two to three years as indicated above?

A.While the Internal Revenue Service has been quite reasonable in its interpretation of this rule, it is nevertheless important that an organization that cannot use all of its set aside funds in a reasonable period of time show that it is using some of the funds as quickly as it can, and that it has definite plans to use the rest as soon as possible. For example, if the plan is to use all of the set aside funds in a large project which will begin in, say, five years, then it is important for the organization to document carefully in its records detailed plans for the use of the funds and when that project will begin, why it cannot be done earlier, etc.

3. Q. What is the relationship between the set aside rules and the 35% test under which a fraternal organization may lose its exempt status if it receives more than 35% of its gross receipts from non-member income?

A.This is an area of frequent misunderstanding. Since investment income is by far the most common type of non-member receipts for Code Section 501(c)(7) organizations, the investment income which is set aside counts toward the 35% requirement, even though it is set aside and no tax is paid thereon. It is important to note, however, that if the 35% level is exceeded, then even though tax is paid on the non-member investment income, the organization still has exposure with regard to the possible loss of its exemption–in other words, paying tax does not resolve the 35% test issue.

4. Q. Can capital loss carryover deductions be applied against an organization’s current year’s investment income in determining the amount of net investment income to be set aside?

A.It should be remembered that the calculation of the set aside amount is directly tied to the amount of income on which the organization would otherwise pay federal income tax. Therefore, for questions of this type, one must always refer back to the calculation of unrelated business income tax of a Code Section 501(c)(7) organization. Since Code Section 165 allows deductions for capital losses to the extent not limited by Section 1211 and 1212, and Section 1212 allows capital losses in excess of capital gains for a year to be carried back three years and forward five years, it seems reasonable to conclude that capital loss carryovers are allowed as deductions from capital gains for purposes of the set aside calculation.

5. Q. Can set asides created in a given fiscal year of the organization be absorbed by qualifying expenses which were incurred in prior years–in other words, can the set aside funds themselves be carried back to prior qualifying expenses?

A.The proposed set aside regulations under Code Section 512 (which were withdrawn but are still often used as a source of guidance on these issues) are drafted in a manner that presupposes the use of set aside funds to pay future qualifying expenses and we have always interpreted these rules in this manner. Further, IRS Publication 598 describes set aside income as “income set aside to be used for religious, charitable, scientific, literary or educational purposes, or for the prevention of cruelty to children or animals” (emphasis added). The use of the future tense indicates an IRS position that set aside amounts must be used for expenses incurred in the current or future tax years.  Therefore, amounts treated as set aside and used to pay expenses incurred in prior years likely would not qualify as set aside amounts and would be subject to unrelated business income tax.

6. Q. In computing the amount of set asides, is it permissible to offset ordinary investment income by capital losses?

A.This question is similar to number 4 above, in that it is answered by reference to the Code Sections wherein a corporation’s unrelated business income tax is calculated. Code Section 165(f) provides that capital losses from sales or exchanges of capital assets shall be allowed only to the extent allowed in Code Sections 1211 and 1212.  Code Section 1211(a) provides that “[i]n the case of a corporation, losses from sales or exchanges of capital assets shall be allowed only to the extent of gains from such sales or exchanges.”  As a result, for purposes of determining the amount of net investment income that can be set aside in a year, capital losses should not be deducted against ordinary investment income.

7. Q. At one time there was some question about the ability to set aside royalties received by a fraternal organization for the use of its logo, Greek letters, etc. on merchandise–is this still the case?

A.Happily this issue has been resolved in favor of the taxpayer organizations. The IRS had been contending that this type of royalty income, which is known as affinity royalty income, was not really royalty income but resulted from the sale of the organization’s membership list. If such income was not deemed royalty income, then it would follow that it could not be set aside. After the IRS lost a series of court cases on this issue, it decided not to pursue the issue further and consequently, true affinity royalties may now be set aside by a fraternal organization in the same manner as other investment income.

8. Q. Is the set aside procedure a one time election or can it be made every year? Also, does the set aside procedure have to be used in its entirety or can a partial election be made?

A.There is considerable flexibility for fraternal organizations in the use of the set aside procedure. An organization can use the set aside procedure one year and elect not to use it in the next year and so on, and vice versa. Also, the set aside procedure can be used for a specific amount of investment income and the organization can elect to pay tax on the remainder, thus freeing up such funds for general fraternal uses.

9. Q. What can a fraternal organization do if its governing body is ready to approve the set aside resolution and the amount of investment income has not yet been computed?

A.This is a scenario that is encountered quite frequently. The set aside election, in order to be effective, must be made by the date that the organization’s Forms 990 and 990-T are due to be filed, including any extensions. The amount of set aside income must be computed with accuracy and should be identical on the organization’s audited financial statements, tax returns and set aside resolution.  Therefore, the proper method is to wait to file the election on the organization’s tax return until this amount has been computed with accuracy, even if that means that an extension must be secured to file the return.  In other words, filing the organization’s tax return too soon with the wrong amount leaves any excess investment income subject to tax, so it is much better to postpone adoption of the resolution and the filing of the tax return until the organization is certain that the set aside amount is accurately computed.

CONCLUSION

Use of the set aside procedure by Code Section 501(c)(7) fraternal organizations is perhaps the most important tool in tax planning for these organizations.  Correct use of the set aside procedure can save the organization literally thousands of dollars in tax dollars and, by creating a pool of resources to fund educational programs, free up other dollars that can be used for general fraternal purposes.  Thus, all Code Section 501(c)(7) fraternal organizations and their advisors, even those that do not use the set aside procedure regularly, should be extremely familiar with these rules.