Facing increased competition for donor dollars and a growing charitable base, many tax-exempt organizations have set their sights on income diversification.
As part of this quest for alternative revenue streams, non-profits are expanding into businesses traditionally dominated by taxable entities. While this can be a boon to an organization’s resources, it can potentially subject tax-exempt entities to reporting and paying taxes, the most common of which is the tax on unrelated business income.
Congress added the Unrelated Business Income Tax (UBIT) provisions to the IRC in 1950 in an attempt to eliminate “unfair competition” between for-profit businesses and tax-exempt organizations conducting similar activities. Under UBIT, an organization could no longer qualify for exemption from taxation merely because its profits were destined for charitable purposes. This served to effectively level the playing field, as otherwise tax0exempt organizations would have had a built in market advantage (tax free net income).
What is UBIT?
To explain it (not so) simply, UBIT is the tax paid on Unrelated Business Taxable Income (UBTI), which results when Unrelated Business Income (UBI) exceeds Unrelated Business Losses (UBL).
In order to qualify as UBIT, an activity must be
- a trade or business
- that Is regularly carried on
- and is not substantially related to exempt purpose.
While these seem simple enough, each of these individual components have specific nuances that need to be considered when making a determination as to whether the income from an activity is taxable.
Trade or Business:
IRC section 513(c) defines a trade or business as “any activity which is carried on for the production of income from the sale of goods or the performance of services.”
One of the key factors to consider when determining if an activity is a trade or business is the presence of a “profit motive.” In order to fall into this category, the activity must be undertaken to produce a profit. That said, an activity will not automatically be excluded from being classified as an unrelated trade or business because it ultimately doesn’t produce a profit, but the intention to make one must be present.
Regularly Carried On:
Treasury Regulations section 1-513-1 (c) indicates that in order to determine if an activity is “regularly carried in,” one must consider the frequency and continuity with which the activities producing the income are conducted and the manner in which they are pursued.
In applying this, the IRS generally compares the time span of comparable commercial activity to the time span of activity conducted by the exempt organization.
It’s important to note that activities engaged in only discontinuously or periodically will not be considered regularly carried on if they are conducted without the same level of effort typical of a similar commercial endeavor. Income-producing or fundraising activities lasting only a short period of time on an annual basis would also not be considered regularly carried on. For example, an organization’s annual gala dinner would not be considered regularly carried on, and therefore any income received from this event would not be taxable.
Not Substantially Related:
IRC section 513(a) states that “not substantially related” activities include any trade or business, the conduct of which is not substantially related to the performance of the organization’s charitable, educational, or other purpose that constitutes the basis for tax exemption under IRC section 501 (c)(3).
Generally, whether a trade or business is substantially related to an organization’s purpose depends on the facts and circumstances of each organization’s mission and activity; however, in order to be considered “related,” an activity must contribute importantly to the accomplishment of the exempt purpose.
It’s important to note that the destination of the income from the activity does not factor into this determination. Even if 100% of all income goes to directly support the organization’s charitable mission, it can still be considered unrelated business income.
Common Unrelated Business Income Sources
Although exempt organizations can generally enter into the same business ventures as for-profit entities, certain activities maybe prove more easily accessible than others. Some of the following are the common types of unrelated business income streams that we see among nonprofit organizations:
Advertising/Corporate Sponsorship Payment:
Payments received for advertising are generally characterized as UBI.
“Advertising” is defined by the IRC as any language that is an inducement to purchase a product or service. Some of the variables that would be used to make this determination include whether the advertisement contains qualitative or comparative language, price information, or any endorsements or call to action.
In direct contrast to advertising are “Qualified Sponsorship Payments,” which are specifically excluded from the definition of UBI. These are payments to the organization in exchange for which the corporate sponsor neither gets nor expects any substantial return benefit other than:
- goods or services, or other benefits, the total value of which does not exceed 2% of the sponsorship payment (safe harbor) or
- recognition (i.e., use or acknowledgment of the sponsor’s name, logo, or product lines in connection with the nonprofit’s activities).
As such, an organization can acknowledge the sponsor’s payment, as long as it is not considered “advertising” income, which would be considered UBI.
Sales of Merchandise:
In general, sales of merchandise directly related to the nonprofit’s charitable mission, such as educational items sold at a university bookstore, would not be taxable, while all other sales would be considered unrelated business income.
There are a few key exceptions to this rule, which—if met—will preclude sales from being unrelated business income:
Volunteer Labor: Any trade or business in which 85% or more of the work is performed for the organization without compensation. Some fundraising activities, such as a bake sale run by volunteers, might meet this exception.
Convenience of Members: Any trade or business of a IRC section 501(c)(3) organization for the convenience of its members, students, patients, officers, or employees. A typical example of this is a school cafeteria. Sales to the general public do not fall within the “convenience exception” and would still be taxable.
Selling Donated Merchandise: Any trade or business is excluded that consists of selling merchandise, 85% or more of which the organization received as gifts or contributions. Many thrift shop operations of exempt organizations meet this exception.
Alternative investment vehicles such as partnerships, private equity funds, real estate investment trusts, and hedge funds can afford an organization a significantly larger return on its investment than traditional stocks, bonds, or money market funds.
For these types of alternative investments, the character of any item of income or loss of a partner’s share of partnership income is generally determined as if the partner realized or incurred the item from its source. IRC section 512(c) (1) provides that the income derived by a tax-exempt organization from a partnership’s trade or business is included in the calculation of the organization’s UBTI if the trade or business is unrelated to its exempt purpose.
Exclusions from Unrelated Business Income
Although this provision appears all encompassing, the IRC excludes many categories of income from UBTI, including most types of passive income. IRC section 512 excludes from taxation interest, dividends, rental income from real property, and gains or losses from the sale, exchange, or disposition of property other than inventory. As often is the case when dealing with the tax code, however, there is a very significant exception to the exception.
Under IRC section 512(b), investment income from stocks, bonds, and real estate is not generally subject to UBTI. Thus, to the extent that a tax-exempt organization or trust acquires real estate in a straight cash transaction, the income derived from the property is not subject to UBTI.
Such income, however, can be taxable if derived from debt-financed property. Debt-financed property is property that is acquired with borrowed funds. Thus, if an exempt organization purchases corporate securities or commercial or rental real estate with borrowed funds, all or part of the dividends or rental income from the property might be subject to the unrelated business income tax. This distinction applies whether the organization uses debt financing directly or indirectly through a partnership.
The UBIT rules generally impose an income tax at corporate rates (or at trust rates for exempt organizations that are created as trusts) on an exempt organization’s net income derived from an unrelated business.
The information needed to file and pay the UBIT is reported annually to the investor on Schedule K-1, which is required to contain certain disclosures of UBTI for exempt organizations. The organization files a Form 990-T to report and pay any UBIT that might be owed at the federal level and must also make quarterly estimated tax deposits if it incurs UBIT in excess of $500 during its tax year.
Generally, any unrelated business income is taxable in the state where it originated—simple enough if the organization merely operates an unrelated business in its state of residency.
Pass-through income, however, can be attributable to many different jurisdictions, and it requires the filing and payment of state taxes. For example, partnership investments might generate unrelated business income from activities in many states through its underlying holdings. In this case, organizations need to be especially careful not to simply report all of its income in its state of residence.
Presently, most states have provisions for the taxation of UBI, and each has its own method for the taxation of UBI including tax forms, minimum UBI subject to taxation, and estimated tax requirements, which can add additional complexity to the organization’s tax reporting.
Tax Cuts and Jobs Act:
The recently passed Tax Cuts and Jobs Act (TCJA) include a number of provisions that would directly and indirectly affect tax-exempt organizations. One of the most impactful of these changes affects the calculation of net UBTI.
Prior to the passage of the TCJA, in determining UBTI, an organization that operates multiple unrelated trades or businesses aggregates income from all those activities and subtracts the aggregate of deductions from the aggregate gross income. As a result, an organization was able to use a deduction from one unrelated trade or business to offset income from another, thereby reducing total UBTI.
As a result of the TCJA, taxpayers are required to compute UBTI separately with respect to each trade or business. Specifically, the Act amends the UBTI provisions by adding a new IRC section 512(a)(6), which requires organizations operating one or more unrelated trades or businesses to compute UBTI separately for each trade or business (without regard to IRC section 512(b)(12), which provides a specific deduction equal to the lower of $1,000 or the gross UBTI).
The result is that a deduction or loss from one unrelated trade or business may not be used to offset the income from a different unrelated trade or business. Net losses from a specific unrelated business activity may be used to offset income from the same trade or business in another taxable year. Under a special transition rule, net operating losses arising in a taxable year before Jan. 1, 2018 that are being carried forward are not subject to this new provision.
How Much Is Too Much?
Exempt organizations are set up with a mission, and that mission should always be its primary focus. The presence of too much unrelated business income has, in the past, been used to disqualify organizations from tax-exempt status—and as such, it’s critical that organizations limit their unrelated business activities. But what is the limit?
Unfortunately, the limit does not exist, and there is no specific guidance as to what percentage of unrelated business activity is acceptable. The IRC states that a non-profit organization must “operate exclusively for” charitable purposes, while the regulations expand upon this to instruct that an organization should have not more “than an insubstantial part of activities (that) are not in furtherance of an exempt purpose.”
Ultimately, there is no magic number, and the facts and circumstances of each specific activity would need to be considered in making this determination. In fact, some private letter rulings have allowed more than 50% of an organizations activity to be an unrelated business. Lacking any other guidance, the generally accepted “safe zone” has been no more than 10%-20% of an organization’s activity.
Although organizations should always be mindful that they are utilizing their assets first and foremost to advance their organizational objectives and that they are not generating an excessive amount of UBIT, unrelated business income can be an extremely valuable revenue source for non-profits to the extent there is a well thought-out and vetted strategy behind it.
This article originally appeared in the March 2018 TaxStringer and is reprinted with permission from the New York State Society of Certified Public Accountants. Click here to view original article.