Not-for-profit organizations have a long-standing debate with regulators about whether revenue generated by certain organizational activities should be taxable. In the 1940s and the 1950s, the IRS noticed that more and more not-for-profits were reporting non-charitable business income alongside their charitable revenues. These organizations were applying their tax exemption to revenues that would otherwise be taxable as corporate business income. There were growing concerns that this created a competitive disadvantage for their for-profit counterparts that were required to pay tax on identical revenue streams.
To solve this problem, Congress introduced the Unrelated Business Income Tax. The Unrelated Business Income Tax rules remained mostly unchanged over the years until Congress passed the tax reform law known as the Tax Cuts and Jobs Act (TCJA) at the end of 2017. The changes under the TCJA make it especially important for not-for-profits to do a review of their sources of income to determine whether they would potentially owe tax on those activities.
Applying the Three-Part Test
To figure out if your not-for-profit’s activity’s revenues should be classified as unrelated business taxable income (UBTI), answer the following three questions:
- Is your activity a true trade or business?
The IRS defines 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.” At the root of this definition is whether the activity is carried on with the intention of making a profit. Internal Revenue Code (IRC) Section 162 can provide some additional guidance. Look at the facts and circumstances holistically to answer the question.
- Is your activity regularly carried on?
There is no bright-line test, but consider the frequency and continuity with which you are conducting the activity. If you only perform the activity once per year or engage in something for less than two weeks at a time, chances are you won’t be subject to Unrelated Business Income Tax.
- Is your activity related to your exempt purpose?
Remind yourself what your charitable goals are. A college that has an on-campus restaurant could be required to classify its restaurant revenues as UBTI because the restaurant does not align with its exempt purpose of education. However, if the college uses that restaurant as a course of study for its students, the income may be exempt. Activities should be taken on a case-by-case basis. What could be considered “unrelated business” for one not-for-profit may be an exempt activity for another.
Unexpected Ways Not-For-Profits Can Incur UBTI Liabilities
Providing unrelated services can become UBTI. For example, a not-for-profit that provides housing to community members may see the merit in also offering home cleaning services. Because the cleaning services are not part of the organization’s exempt purpose, revenue from the cleaning services will be considered UBTI. This rule applies even if your not-for-profit uses 100% of the unrelated business revenues to further its charitable goals. The IRS will look to the activity itself rather than how the resulting funds are expended.
Advertising income has always been an area of concern for not-for-profits because there can be such a fine line between advertising and sponsorships. The good news is that the IRS has explicit rules to help you keep sponsorship revenues exempt. The bad news is that those rules are easy to overlook. You can do something as innocuous as verbally endorsing your sponsor’s services or displaying their menu board at your event to turn those sponsorship dollars into UBTI.
Income Excluded from UBTI
Passive income, like interest, dividends, royalties, and capital gains, are almost always free from taxation. A few other common exemptions from UBTI are:
- Rental income from real property that you own outright
There are different rules if you have a mortgage on the property.
- Revenues from thrift shops
Thrift shop sales will not be considered UBTI as long as substantially all (generally defined as 85%) of what you sell was donated.
- Revenues that are generated from volunteer labor
This is colloquially known as the “Girl Scout Cookie Rule.” As long as substantially all of your sales are generated from volunteers, the revenues are not taxable as UBTI.
- Revenues that are generated from an activity created for member convenience
Churches that sell coffee before and after church services will be exempt from tax, as will elementary schools that run school cafeterias for their students and faculty.
Not-for-profits are taxed on their unrelated business income as if they were corporations, so when the TCJA changed the corporate tax rate, the Unrelated Business Income Tax rate changed along with it. The corporate tax rate dropped from a maximum of 35% down to a flat rate of 21%. This change will be good for a select few, but many not-for-profits will be worse off. Those that made less than $50,000 of UBTI in 2017 would have paid only 15% tax, and today they would pay 21%.
The TCJA introduced two other key changes to UBTI:
One of the more controversial components of the TCJA was classifying qualified transportation benefits as UBTI. If you have a parking lot that your employees park in, you may have to file a new tax return and pay some tax. In the past, these fringe benefits were deductible, but going forward, they will be classified as UBTI. In effect, this new rule transformed deductible expenses into taxable income. This is another effort by the IRS to put not-for-profits on an even playing field; the TCJA also made parking costs non-deductible for for-profit companies.
Parking lot expenses pose a unique challenge. How can you calculate which expenses are allotted to your employees? Does the answer change if you share your lot with other businesses, or if you allow visitors to park there? The IRS released a four-step method in Notice 2018-99 that can help. If you pay a third party, such as a city lot owner, for employee parking, the amount paid up to $260/month is UBTI. Amounts over $260 must be included on employee W-2s and is deductible as compensation. If you own or rent your lot, the IRS suggests the following approach:
STEP 1: Determine employee-designated spaces
Calculate the percentage of parking spaces reserved for employees. These are spots reserved by signage, segregated by a barrier or with limited access. This percentage of the parking expenses will be nondeductible and UBTI.
STEP 2: Determine the primary use of the remaining spaces
Of the spaces that are left, see if at least 50% are used by the general public. If so, all of the remaining expenses are deductible. If not, move to the next step.
STEP 3: Determine non-employee-designated spaces
How many of the remaining spaces are designated for non-employees like visitors, delivery vehicles, or clients? This percentage is fully deductible.
STEP 4: Determine use of remaining spaces
From here, you can estimate employee use of the remaining spaces and allocate nondeductible expenses accordingly.
Determining your total parking costs can be a difficult exercise. If you own your lot, carefully consider all sources of expense – snow removal, repair/maintenance costs, security fees, utilities, trash and leaf removal, insurance, property taxes, interest, etc. (depreciation is not included). If you rent office space, you will need to allocate a portion of your rent expense to your parking lot using a “reasonable method.”
This new “parking tax” is expected to push many nonprofits over the $1,000 UBTI reporting threshold, which will leave them with less cash and more reporting burdens.
As in years past, you will report your UBTI on Form 990-T. However, this year you will need to separate your unrelated business activities. This requirement, sometimes called “siloing” or “basketing,” lets the IRS see each activity on its own. This also means that you cannot offset the income from one activity with the losses from another. In addition, going forward net operating losses can only be applied against the activity that generated the original loss and can only offset 80% of future income.
The Form 990-T will generally look the same, with Parts I and II of the form reporting your unrelated business income and expenses. Your first activity will be reported here. All subsequent activities will go on their own Schedule M. The parking tax is reported on Part III, line 34.
Review Early and Often
The disaggregation rules and changes to the parking benefits make now an especially good time to review your organization’s UBTI and potential for the tax on that income. There are several bills in Congress that include a repeal of the parking rules, but until something passes, not-for-profits are stuck with them. For questions about your UBTI, please contact us.-------------------------------------------------------------------------------------------------------------
Lisa Burke is a Senior Manager in the Not-For-Profit & Education Tax Practice. She can be reached at 816.945.5500 or firstname.lastname@example.org.
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