Not-for-profits earn UBTI from a regularly carried on trade or business that is “not substantially related” to their purpose. Activities qualify as substantially related (and therefore tax-exempt) if a causal relationship exists between the activities generating income and the accomplishment of the entity’s defined mission.
For example, income derived from ticket charges for the performance of a play by a theatre company is exempt function revenue and is not subject to the unrelated business income tax.
The line between income that the IRS considers taxable and tax-exempt is tricky, as April 2013’s “College and University Compliance Project Final Report” revealed. The IRS reviewed 34 not-for-profit colleges and universities for its initiative. UBTI examinations resulted in more than 180 adjustments to the examined institutions' returns, resulting in an aggregate increase to UBTI of approximately $90 million spread among 90 percent of the examined institutions.
The source of the mistakes stemmed from three primary reasons: the improper reporting of certain losses as connected to unrelated business activities, errors in computation or substantiation, and misclassifying unrelated activities as exempt.
Though the report targeted educational facilities, it holds ramifications for all subsets of the not-for-profit sector. Below, we highlighted some simple ways your organization can lower its UBTI and minimize its tax burden in common areas where UBTI occurs.
Advertising/SponsorshipQualified sponsorship payments, in which a not-for-profit receives a payment from a corporate sponsor and the sponsor neither receives nor expects substantial favors in return, are considered exempt from UBTI considerations. Any time the not-for-profit uses qualitative or endorsement-type language in regards to its corporate sponsor, the messaging becomes advertising and subject to unrelated business income tax.
To avoid turning a tax-exempt sponsorship into advertising, we recommend not-for-profits carefully consider their sponsorship arrangement. The following actions represent tax-exempt options not-for-profits can use with their sponsorships:
- Listing the name or logo of sponsor;
- Awarding exclusive sponsorship award;
- Providing logos or slogans that do not contain any qualitative language or comparative description of the products;
- Listing of payor’s locations, addresses, phone numbers, and Internet addresses;
- Providing value-neutral descriptions of the sponsor’s product displays, and
- Listing sponsor’s brands or trade names.
Conference CentersMany facilities have conference rooms or other event spaces that they rent, for a fee, to the public or for-profit groups. The fees for the rental can be excluded from UBTI considerations if the event being held is substantially related to the not-for-profit’s purpose. For example, a hospital rents a conference room to an organization (for profit or not-for-profit) that conducts a continuing education course for nursing credit. Any rental income generated from this venture would be tax-exempt.
Debt-Financed PropertyRents from debt-financed property do not qualify for tax exemption if the activity falls outside of the exempt purpose. The necessity arose because a large number of tax-exempt organizations bought businesses and investments on credit, frequently at a price that was more than the market price, while contributing little or nothing to the transaction other than their tax exemption. The IRS reasoned that purchases made with debt and used for unrelated business put the not-for-profit at a significant financial advantage compared to their for-profit counterparts. Income from debt-financed buildings falls subject to the unrelated debt-financed income (UDFI) calculation.
For each debt-financed property, the unrelated debt-financed income is a calculation as detailed below:
The average acquisition indebtedness with respect to the property for the tax year of the property's average adjusted basis for the year (the debt/basis percentage):
Average acquisition indebtedness X Gross income from debt-finance property = UDFI
Average adjusted basis.
Unrelated trade or business decreases as indebtedness decreases. For example, X owns a debt-financed office building. The building produces $10,000 of gross rental income. The average adjusted basis is $100,000, and the average acquisition indebtedness is $50,000. The debt/basis percentage is 50% (the ratio of $50,000 to $100,000). The unrelated debt-financed income is $5,000 (50% of $10,000).
To minimize or avoid the debt-financed income calculation, not-for-profits should consider asking donors to pay off the debt on buildings being used for non-exempt purposes as part of their donor contribution. When possible, try to eliminate or pay off the loan on the building that could or would be used for generating UBTI.
Not-for-profits need to pay close attention to partnership investments, as the IRS is developing risk models to extrapolate and target specific activities. One of the activities of particular interest is net operating losses (NOLs) of three years or more. Partnerships typically will have losses in the earlier years and then start to generate income in later years. Capturing these earlier losses will benefit your organization by offsetting income in later years but it will also pique the IRS’s interest. The IRS has indicated that they will review returns for large NOLs.
To protect your not-for-profit from scrutiny, know your activities and investments before undertaking new ventures. Take an inventory of your investments and prepare an investment summary work paper. The summary should include your not-for-profit’s investments as of year end and state filing requirements in the areas where your not-for-profit has nexus.
The IRS is also considering whether your investments are in foreign partnerships or foreign corporations. Both require additional filing requirements, and there are substantial penalties involved if not-for-profits neglect to file required forms.
Work closely with investment managers and try to obtain periodic updates on investments. The information needed to calculate the organization’s share of partnership income must be provided by the investment manager.
Make a Plan
The IRS’s Advisory Committee on Tax Exempt and Government entities recently proposed that the IRS adopt a new Form 990-T to address UBTI confusion. The committee also asked for a listing of categories of activities the IRS considers related and unrelated and a comprehensive revenue ruling on a range of unrelated business income issues.
In the absence of any notable regulatory changes surrounding UBTI, your not-for-profit should monitor and review its sources of unrelated business income. Take inventory of all activities, especially the newly created, that carry the potential of being unrelated to your exempt purpose. Evaluate each with the IRS criteria for what constitutes UBTI to verify that the activities are classified correctly.
For the income-generating activities related to your exempt purpose, be sure to include appropriate documentation that demonstrates why the activity is related. This includes references to the relevant sections of the Internal Revenue Code or IRS rulings.
Where in doubt about your not-for-profit’s UBTI, consult a tax professional.