The healthcare and educational sectors brought renewed scrutiny to nonprofits’ unrelated business income activity in recent years. High rates of noncompliance in the IRS College and University Compliance Project Final Report and renewed focus on spending in the healthcare sector have regulators taking an especially close look at the issue of unrelated business income tax (UBIT).
Not-for-profits should monitor for unrelated business income, defined as revenues from trade or business that is regularly carried on and not substantially related to their mission. UBI is not necessarily bad and can be a source of additional revenue. But income that reaches a certain level—it’ll depend on the facts and circumstances as to what that level would be for your organization—can cost an organization its tax-exempt status.
The changing not-for-profit operating environment is making UBIT compliance risk greater than ever before. To prepare, you should consider how the following could have an impact on your organization.
Digitized Form 990s
In its 2016 Tax-Exempt/Government Entities Priorities, the IRS stated plans to digitize Form 990s and use more data-driven decision-making. Though the digital filing requirement may make it easier for nonprofits to file their Form 990, it also comes with implications for IRS oversight.
With digital forms, the IRS can more easily use statistical sampling to test for compliance. The ease with which the IRS will be able to test for key risks and the attention brought to unrelated business income by recent IRS studies mean that your organization should be particularly careful with its Form 990 preparation. Reexamine your revenue-generating activities in comparison with your organization’s mission statement as recorded on your Form 990. Organizations and their programs evolve, and your mission statement should reflect any changes to your key focus areas, particularly those that have revenue associated with them.
Another key source of the UBIT risk the IRS will be looking for comes from your online presence. The IRS treats an organization’s website as it would a brick and mortar location. The agency looks for revenue-generating activity to see if it aligns with the organization’s mission or if the activity constitutes unrelated business income. Some common sources of activity online include banners and links to sponsors or corporate donors, merchandise sales and merchandise affiliate programs.
Just as if the banner were at an in-person event, an online sponsorship banner can acknowledge the existence of the sponsorship in any of the following six ways:
- List the name and the logo of the sponsor
- Acknowledge an exclusive sponsorship award
- Showcase logos and slogans of the sponsor, so long as those slogans do not contain qualitative language
- List the sponsor’s locations, address, phone number and website
- Provide value-neutral descriptions of the sponsor’s products
- List the sponsor’s brands or other trade names
Not-for-profits must be careful that their online acknowledgment does not become advertising, which is subject to UBIT. Or, that their URL takes you to the sponsor's online store rather than the company information page, which could also subject your organization to UBIT.
Many 501(c)(3) including colleges, universities and museums offer online bookstores, gift shops, catalogs or other merchandising through their websites. Organizations should keep in mind that the same level of IRS scrutiny will be applied to products sold online as would be in their physical location. Without having to leave their offices, regulators can look to see if the materials have a direct relationship to your organization’s exempt purpose and consider any of those items that do not to be generating unrelated business income. Though time-consuming, it is recommended that your organization go item-by-item in your online stores to determine which might trigger unrelated business income.
Merchant Affiliate Programs
Not-for-profits may enter into arrangements where they receive royalties on items purchased through a sponsor. If that’s the case, organizations should acknowledge this on their website. They should also keep in mind that the IRS will look at the affiliated merchant sales with the same lens it would if the organization sold the items itself. If, for example, organizations offer a link to Amazon to purchase certain items, they should consider the risk that might bring of UBIT. If visitors to the website use that link to purchase other items beside the ones with a direct affinity to the organization, those sales could trigger UBIT considerations.
The IRS looks at merchant affiliate programs similarly to affinity programs. They can carry similar risks, and agreements should be looked at to make sure they stay within the boundaries of royalties and not become a service contract.
Another focal point for the IRS with nonprofits is the Schedule K-1. An interest in an S Corporation, even if it has a related purpose, is subject to UBI. An organization may have UBI as a member of a partnership if the partnership is regularly engaged in a trade of business that is unrelated with respect to the organization or if the partnership has debt-financed property.
Organizations must also consider whether there is debt financing within the partnership. The determination is similar to the one used for debt-financed buildings rented out by the nonprofit. Debt-financed investments may also trigger UBI when the investment is disposed of.
Partnerships are required to furnish their partners the information necessary to compute their distributive share of partnership income and deductions from any unrelated trade or business. Box 20, Code V on the Schedule K-1 should indicate the amount of unrelated business income. But be cautious, sometimes this information is buried in the statements and sometimes you will find that the issue is totally ignored. If there is income on Line 1, "Ordinary Business Income (Loss)," on a partnership K-1 you should investigate whether it is generating UBI for the organization.
State and local tax agencies also look at nonprofits' unrelated business income from Schedule K-1s to determine if the nonprofit has created nexus in their state. So an organization that only operates in one state may open itself to multi-state filing with an investment in a multi-state partnership.
UBIT Takes Monitoring
Scrutiny on UBIT is only increasing. To avoid penalties and other compliance risks with UBIT, nonprofits need to consistently revisit their sources of revenue and their reporting functions of those revenues. Consider carefully how each source of revenue contributes to your organization’s mission, and whether that activity still fits into the long-term strategic plan of your organization. Again, UBI is not always bad, but your organization needs to be aware when it exists and must properly report it.
For more information about how you can manage your UBIT considerations, please contact us here.
Betty Isler is a Managing Director in the Tax Group of CBIZ MHM in the Tampa Bay office. She can be reached at 727.451.7923 or BIsler@cbiz.com.