Unrelated Business Income

An overview of the rules
Gregory B. Capin, CPA 
This article provided by the Engstrom Institute

Most managers of not-for-profit organizations have heard of "unrelated business income" (UBI). Some organizations take great care to avoid UBI, while others, looking for more resources, are more ready to consider new income sources and UBI. The management of an exempt organization must be alert to situations in which there is a possibility of unrelated business income. If UBI is present, care must be taken to comply with laws and reporting requirements and, when applicable, to remit taxes due on a timely basis.

Not-for-profit organizations are supported primarily from contributions and earned revenue from activities directly related to their exempt purposes. Sales of religious books, tuition at schools, and campers' fees at a camp are examples of exempt purpose revenue. This income is not subject to federal or state tax on UBI.

On the other hand, income from activities that are not directly related to fulfilling an organization's exempt purposes may be considered unrelated and subject to taxation as unrelated business income. It is important to understand the rules, evaluate operations on a continual basis, and plan for reporting and tax compliance.

UBI can exist in a charitable trust. A charitable remainder trust that has any UBI loses its exempt status entirely for the year during which UBI is present. For exempt organizations, there are significant penalties for failure to report UBI and to remit taxes when due. In extreme situations, the tax exemption of the organization may be at risk.

There are two broad categories of unrelated business income. One is, as the name implies, income from an unrelated business activity. The other is debt-financed income.

Unrelated Business Activity

Activities that result in unrelated business income have three characteristics: (1) there is a trade or business; (2) it is regularly carried on; and (3) it is not related to the exempt purposes of the organization.

Trade or Business

The trade or business characteristic provides that the activity must be carried on similarly to, or in the manner and style which is typically associated with, a trade or business. An important element of a business enterprise is the expectation of income or profit. When a charity is engaged in selling goods or services which are comparable to goods or services provided by commercial businesses, then the activity could be considered a trade or business.

Regularly Carried On

An activity is regularly carried on if performed with the frequency and continuity that similar activities are performed by commercial businesses. If a particular activity is performed by a commercial business on a year-round basis, it is not regularly carried on by an exempt organization only doing it two or three times a year. However, if an activity is commercially performed one month out of the year, it would be regularly carried on by an exempt organization doing it for that month. Comparison with for-profit businesses conducting such activity is critical.

Not Related to Exempt Purposes

An activity which is substantially related to the performance of a charity's exempt purposes is not an unrelated business activity. Thus, the sale of religious books, tapes or magazine subscriptions are typically considered to further the exempt purpose of a religious organization. However, a sub-component may not be related. For example, the selling of advertising in a magazine may not be related to the exempt purpose, though the selling of subscriptions to the magazine would be.

Safe Havens > Exceptions to the Rule

Tax law provides two major areas where business activity will not result in unrelated business income. These are the (1) traditionally charitable businesses and (2) passive income items.

Charitable Businesses

Three specific exemptions from UBI are provided for traditionally charitable businesses:

• A business selling merchandise received through gifts or contributions [Example: a thrift shop.]
• A business existing primarily for the convenience of the members, students, patients, officers, and employees of the organization [Example: a college book store.]
• A business in which most of the work is performed by volunteers [Example: some community theater concession stands.]

Passive Income

Charitable organizations have traditionally held temporary investments, as well as long-term investments for endowment and other funds. The Internal Revenue Code specifically recognizes exemptions for many passive investment items including:

• Interest and dividends
• Royalties from licenses of literary or other artistic efforts, patents, trademarks, and some kinds of mineral rights [But not royalties from debt-financed property or from a controlled organization.]
• Rents from real property [But not real property that is debt-financed where there are significant services provided with the use of the property, such as would be true with the rental of a hotel room or full services conference service. This exemption also does not include rents from personal property, such as equipment and vehicles.]
• Income from the sale of property (includes both real property and personal property), but the exemption does not include property considered inventory or otherwise held for sale in an unrelated business activity or for debt-financed property.

Controlled Organizations > Exceptions to the Exceptions

The specific exemption of interest, royalties, and rents, as previously discussed, does not apply when an exempt organization receives them from a controlled entity. When a tax-exempt organization controls another, the interest, royalties, and rents received from the controlled entity are subject to tax to the extent activities in the controlled entity would be unrelated businesses if done in the parent. The definition of control and the calculation of the tax can be difficult to apply to some situations. Dividends from a controlled corporation are still exempt.

Debt-Financed Income

Congress imposed a tax on debt-financed income for tax exempt organizations that borrow money to purchase passive income items. An organization may have debt-financed income if:

• Debt is incurred because of the purchase, or in order to purchase, an income-producing asset, whether or not the asset secures the debt and even if the debt was incurred before or after the actual purchase; and
• Some of that debt remains within the twelve months prior to the income being received from the asset, whether through sale, rent, dividend, interest, etc.

An organization may also have debt-financed income if it accepts gifts or bequests of mortgaged property. The two most common circumstances are:

• It accepts responsibility to pay off the debt or mortgage; or
• The mortgage was put on the property within five years of being given to the organization, or the donor owned the property for less than five years.

Exceptions to the Debt-Financed Income rule:

Substantially all (85% or more) of any property is used for an organization's exempt purposes. Thus, if an organization leases out more than 15% of any property on which it has debt, it may be subject to tax unless another exception applies.

• The rented property is used by a related exempt organization to further its exempt purposes.
• The lease of property is to a medical clinic entered into primarily for exempt purposes of the lessor.
• Life income contracts—if the remainder is payable to an exempt charitable organization.
• Neighborhood land rule—if an organization acquires real property in its neighborhood (the neighborhood limitation does not apply to churches) mainly to use it for exempt purposes within ten years (fifteen years for churches). In such cases, rental income may not be treated as debt-financed income.
• Charitable gift annuities, if the value of the annuity is less than 90% of the value of the property given to the organization, there are no more than two annuitants, and there is no minimum or maximum number of payments.

Common Sources of Unrelated Business Income

Common sources of unrelated business income include the following:

• The sale of products or services which are available because of excess capacity, such as the sale of unused computer time or the services of a technician, photographer, or engineer who has extra time.
• Rentals or sales of encumbered property.
• Rentals of property such as audio-visual equipment, vehicles, and computers.
• Sales of candy, cards, and grocery coupon book sales which are regularly carried on.
• Sales of unrelated advertising in publications.
• Revenue from operation of a business given to the organization or charitable trust.
• Income from a partnership interest (including a limited partnership, a general partnership, or a master limited partnership) which has been given to the organization or charitable trust.
• Revenue from charitable gift annuities for a term certain or with a minimum guaranteed period.

Handling Unrelated Business Income

When an exempt organization has unrelated business income, wise planning includes:

• Keeping records which separately identify income from the unrelated business activities.
• Maintaining records to identify and allocate allowable UBI expenses. This requires three things:
• A written method for identifying and allocating all expenses directly connected with generating unrelated business income.
• A comprehensive chart of accounts that segregates specific income and expenses associated with unrelated business activity; and,
• Record keeping forms and accounting procedures that capture necessary data.

Capturing expenses directly is best, but the use of formulas to allocate expenses which are hard to quantify or distinguish may be acceptable in some circumstances. Documentation should include the rationale for using a formula and the reasons for believing it accurately reflects allocable expenses. Employee expenses, allocation of rental income and expense for space utilized (including depreciation) for the unrelated business activity and appropriate allocation of overhead (including management time) all need particular attention and careful documentation.

• Paying estimated federal and state tax on anticipated unrelated business income quarterly.
• Filing Form 990-T reporting the UBI if the gross income is $1,000 or greater. Net UBI in excess of $1,000 is taxed at the normal corporate rates. For charitable remainder trusts, Form 1041 is filed and net income, not just UBI, is taxed at taxable trust rates.
• Filing appropriate state tax returns.
• Evaluating whether the organization's involvement in producing the unrelated business income to determine that in respect to all operations it is not substantial, and therefore, will not endanger an organization's tax exemption. No precise measure of substantial exists. The involvement of personnel, assets, finances, and time would all be considered.

Special Concerns

How much is too much?

The IRS has revoked the tax-exempt status of nonprofits that engage in too much unrelated business activities. The IRS says that if up to 5% of your organization's gross revenues comes from unrelated sources, you're probably safe. It has accepted, however, instances where nonprofits receive 17%, 25%, or even more—of their gross revenue from unrelated business sources. But these approvals were based on the specific facts and circumstances in each case.

If you or your legal and financial advisers feel your organization's unrelated business activities may jeopardize its tax-exemption, you may want to consider setting up a separate, for-profit subsidiary to handle all of your organization's unrelated business activities. If implemented properly, this setup can effectively shield your non-profit's tax-exempt status from revocation due to too much UBI.

Check for Volunteer Exclusion

UBI tax on any income-producing activity can be eliminated by using volunteers to run the activity. If at least 85% of an otherwise taxable activity is conducted by volunteers who receive no compensation, the income is automatically tax-free. Cookie sales, for instance, though otherwise unrelated, might be exempt if all sales are done by unpaid parents or young girls.

Donor Lists

The Tax Court ruled that income a nonprofit earns from renting its donor mailing lists to a for-profit is not taxable as UBI [Sierra Club, Inc. T.C. Memo 1993-199]. The long-standing position of the IRS was that such income was taxable as UBI. (Note: For most nonprofits, income they earn when they rent donor lists to other non-profits is not UBI taxable.)

Sponsorships

Regarding income nonprofits earn from corporate sponsorships, the law now says sponsorship income is tax-free so long as there's no active promotion of the sponsor's product and the sponsor's payments aren't keyed to some kind of audience variable (e.g., attendance at the sponsored event). Therefore, all acknowledgments in print or media should be carefully evaluated. Exempt sponsorship income, to avoid unrelated advertising income, should only provide name recognition and not information about the business or its operations.

Gregg Capin serves as partner in charge of Marketing and Practice Development for Capin Crouse LLP, a CPA firm devoted to serving not-for-profit organizations nationally and internationally. The firms regional offices include: Atlanta, Chicago, Colorado Springs, Denver, Indianapolis, Grand Rapids, and Los Angeles. www.capincrouse.com