Unrelated business income tax

By Jeffrey G. Cohen, CPA
Stout, Causey, & Horning

More tax-exempt 501(c)(3) organizations are looking for ways to enhance their revenues and have more money to spend on charitable activities. It might come as a surprise to some, but tax-exempt 501(c)(3) organizations can be subject to corporate income taxes.

The purpose of this unrelated business income tax, or UBIT, is to protect for-profit businesses from unfair competition from nonprofits. Taxes paid by a nonprofit organization on unrelated business income are paid at corporate rates. Without such a tax, tax-exempt entities would have a substantial advantage in the marketplace when competing with for-profit organizations.

What is unrelated business income?

According to the IRS, three conditions determine whether or not nonprofit revenue is taxable:

The revenue comes from a trade or business which ...
... is regularly carried on, and
is not substantially related to the nonprofit's tax-exempt purpose.

If your nonprofit organization has revenue that meets these conditions, that income will be taxed at the corporate tax rate. Whether or not an organization engages in a trade or business and whether it is considered regularly carried on can be a nebulous area. While these statements appear to be straightforward, all tax rules are subject to interpretation by the IRS and the courts.

Section 513(c) of the Code provides that the term "trade or business" includes any activity which is carried on for the production of income from the sale of goods or the performance of services. An activity does not lose its identity as trade or business merely because it is carried on within a larger complex of other endeavors which might be related to the exempt purposes of the organization. For instance, a university bookstore selling trade books to students and the general public is engaged in a business activity.

If an activity's frequency, continuity and manner of conduct are comparable to the commercial operations of similar nonexempt entities, it is normally considered regularly carried on. Advertising revenue from the NCAA's Official Souvenir Program for the Final Four round of the NCAA basketball tournament was not taxable as unrelated business income. It was conceded that program advertising was a trade or business that was not substantially related to the NCAA's exempt purpose. The only question was whether the activity was "regularly carried on" for purposes of defining unrelated business income. Applying Reg. 1.513-1(c), the court concluded that the activity was not regularly carried on because it was not conducted on a year-round basis.

To determine whether an activity is unrelated, its relationship to the exempt purpose of the organization must be analyzed. IRS regulations provide that a trade or business is related to exempt purposes in the relevant sense, only where the conduct of the business activities has a causal relationship to the achievement of exempt purposes (other than through the production of income), and that it is "substantially related" for purposes of Section 513 of the Code, only if the causal relationship is a substantial one. Thus, for the conduct of trade or business to be substantially related to purposes for which the exemption is granted, the performance of the services from which the gross income is derived must contribute importantly to the accomplishment of those purposes.

For example, an art museum regularly charges an entry fee for admission to exhibits. In addition, the museum operates a restaurant which is open to the general public. The earnings from the restaurant are used to support museum activities. The admission fees are substantially related to the purpose of the organization and are not considered unrelated business income. However, the restaurant income is unrelated business income, even though it is used to support the general mission of the museum.

Rules and exemptions

As is the case with many tax laws, there are exceptions. Organizations engaged in conducting unrelated business activities are not subject to income taxation under the following conditions:

All work is performed by volunteers.
Substantially all of the merchandise being sold has been acquired by gift.
The activity is being conducted for the convenience of the organization's members, patients, employees, etc.
Dividends, interest, annuities, and royalties income.
Rental income from real property which is not debt-financed.
Gains or losses from the sale, exchange or other disposition of property, but not stock in trade (e.g., inventory); property held primarily for sale to customers in the ordinary course of a trade or business; or research grants.

There are several other special rules and exceptions relating to special types of unrelated business income:

Income from Bingo games is not considered unrelated business income if the game is legal under both state and local law and commercial Bingo games are not legal in the jurisdiction.
Tax-exempt organizations can exchange or rent donor or membership mailing lists without generating unrelated business income.
As part of an exempt organization's solicitation activities, it may distribute low cost items (e.g., stickers, stamps, etc., with an aggregate value of less than $5) without unrelated business income consequences.

There are certain types of common activities that will almost always be subject to the unrelated business income rules. For example:

Various IRS revenue and private letter rulings have stated that if a tax-exempt organization performs management and administrative services for another unrelated tax-exempt organization, the income is unrelated and subject to tax.
An organization that has a newsletter or magazine and sells unrelated advertising space will be subject to tax on the advertising income (Reg. 1.512(a)-1).
Corporate sponsorship payments are considered advertising if there is a benefit to the sponsor other than an acknowledgement received. The Treasury Office has indicated that a hyperlink to a sponsor's Web site would not change the acknowledgement into an advertisement.
In a recent Tax Court decision, the court ruled that securities an exempt trust purchased on margin with funds borrowed from its stockbroker constituted debt-financed property that produced income subject to the unrelated business income tax, regardless of whether investment activities qualify as the taxpayer's trade or business.
Operating a parking lot or garage that is open to the public will generally result in unrelated business income.
In a recent private letter ruling, the IRS ruled that rental income from the lease of space on an antenna tower is rent from personal property and taxable.

Some of these activities have exceptions as well, but they are examples of activities that are carried on by many organizations which could trigger a tax liability.

There are many complicated rules related to rental income. In general, rents from real property are not taxable, whereas rents from personal property would be subject to tax. Where the real and personal property are rented together or where services are provided in connection with the lease, the Internal Revenue Code provides a number of tests to determine the taxable portion. Careful planning of rental arrangements can help a tax-exempt organization minimize or avoid the tax on unrelated business income.

Even the raising of funds by a charitable organization is not in itself an exempt function. Therefore, fund-raising activities might be vulnerable to the claim that they are unrelated trades or businesses, particularly when the method of raising funds competes with commercial enterprises.

The commerciality doctrine

This leads us to an additional vague area, and one of the most important concepts for non-profits — the commerciality doctrine. The doctrine says that even related revenue cannot be exempt if it is conducted in a commercial manner. The doctrine is troublesome in that it lacks any substantial support in the Internal Revenue Code but has been developed by the courts, thus causing uncertainty in its application. Commerciality is based on competition with for-profit entities.

The two factors the courts have cited in determining whether operations are commercial or not are direct competition and price-setting comparable to for-profits, including profit motive. Some believe the IRS will continue to expand the use of this commerciality test.

Some nonprofit organizations are concerned that they might be in danger of losing their tax-exempt status if they have too much earned income. If you are charging fees for service related to your mission, the income is generally not taxable and there is no limit on what your organization can earn unless a significant portion is unrelated. If, on the other hand, your organization decided to earn money from an unrelated business source, the income would be subject to UBIT. If your gross unrelated business income is less than a $1,000 a year, your organization doesn't need to worry about UBIT.

Proactively reviewing your business activities and any new developments in the law could save time and money in reducing your exposure to unrelated business income reporting and taxation rules.

Jeffrey G. Cohen, CPA, is a member of the tax department at Stout, Causey, & Horning. He is responsible for the tax compliance and consulting needs of SC&H's tax exempt client base.