Recognizing unrelated business income in nonprofit organizations

Written on Jul 18, 2017

Tax
By Rod MacLachlan, CPA and Karen Gries, CPA

As nonprofits continue to look for ways to enhance or diversify revenue streams, the possibility of generating unrelated business income (UBI) increases. UBI rules are complex, and in some cases tax must be paid on income that is not substantially related to an organization’s exempt purpose. But knowing the basic framework of the regulations can help organizations avoid hidden snares.

Defining UBI

There are three ways to define UBI in nonprofit organizations.

Trade or business — Any activity for the production of income from the sale of goods or performance of services.

Regularly carried on — Frequently and consistently pursued in a manner similar to commercial activities.

Unrelated to exempt purpose — The purpose on which the organization's exempt status is based.

All UBI is not considered equal
While receiving revenue classified as UBI is not in itself detrimental to a tax-exempt organization, there are potential consequences of these funding sources. UBI might result in the assessment of federal and state income tax and might impact whether the organization pays property or other taxes to a local jurisdiction.

Many exempt organizations are fearful of generating any UBI, believing that its mere existence jeopardizes the organization’s tax-exempt status. In reality, income usually does not threaten an organization’s status, and in many cases provides a more stable and predictable source of funding than contributions, grants or other forms of exempt income. However, there might be consequences if the income from the activity is significant and it is determined that the organization is no longer organized and operated exclusively for an exempt purpose.

In recent years, the IRS has been more active in scrutinizing UBI activities. During the fiscal year ending June 30, 2016, the IRS completed about 5,000 exempt organization examinations, with many of these audits uncovering noncompliance with unrelated business income tax (UBIT) regulations. This effort of regulatory scrutiny, along with the potential tax liability and revocation of exempt status, are solid reasons to actively monitor all sources of revenue.

To help monitor activities and determine whether Form 990T must be filed with the IRS, here are some common revenue sources that might be classified as unrelated.

Services provided to other entities It is not uncommon for exempt organizations to enter into arrangements to provide services to other entities. For example, a nonprofit entity might provide marketing services for a strategic partner that is looking to expand service offerings to its members. While some services might fall within the mission of the organization or be rendered in a manner in which the entity lacks a profit motive, many organizations cannot rely on these exceptions. When an organization receives revenue from the rendering of services, and the performance of those services does not further the tax-exempt mission of the organization, the income might be classified as UBI.

Conventional and online advertising
Since advertisements promote the business of the advertiser and not the tax-exempt entity, the sale of advertising in an exempt publication, such as a trade journal or newsletter, or on an organization’s website is typically considered UBI. It is often argued that this activity is not UBI because it is not “regularly carried on” or lacks a profit motive. Even so, advertising contracts should be analyzed to make sure the income is properly classified.

Tax-free corporate sponsorship or advertising
Nonprofit organizations that receive corporate sponsorship payments need to determine whether the revenue is a tax free sponsorship (charitable contribution) or if it should be classified differently when other benefits are provided to the sponsor. Although not all benefits provided to a sponsor would be deemed to generate UBI, a benefit such as advertising might be classified as such. And while it might be the intent that a sponsorship payment be treated as tax free, advertising could be an unintended consequence to the nonprofit. A best practice when developing and implementing a sponsorship program is to craft the agreement language to ensure that the intended outcome is obtained.

Passive royalties from licensing agreements
The licensing of an organization’s intangible property, such as its name or logo, is deemed to be a passive royalty and is excluded from UBI. However, it is not uncommon for royalty agreements to contain provisions that require the exempt organization to perform services for or promote the organization licensing the intangible asset. When this type of structure occurs, the income might be considered unrelated.

Any organization choosing to enter into a royalty agreement should address the specifics of the arrangement to ensure a complete understanding of potential consequences.

Income from controlled organizations
Certain payments from controlled organizations are subject to regulations under IRC Section 512(b)(13). This generally includes interest, rent, royalty, or annuity payments from the controlled entity. An arrangement where a nonprofit owns a building and rents space to a for-profit subsidiary would generate payments that might be considered UBI from a controlled organization. That income could create a tax liability. While the definition of control, for this purpose, is dependent on the structure of the organization, these payments should still be reviewed to determine how they should be classified.

Income from S corporations
With the transfer of wealth that is occurring in today’s society, many exempt organizations are receiving interests in S corporations through donations or bequests. Oftentimes, an organization will accept this type of contribution without realizing the full tax implications. All items of income, deductions and other amounts reported on a shareholder’s Schedule K1 are subject to UBIT. In addition, the gain or loss from the sale of S corporation stock is also considered UBI. Commonly, a donor will make a contribution of S corporation stock with unrealized gain. However, the transfer results in the tax liability being paid by the tax-exempt organization. Again, the tax-exempt organization must be aware of the potential tax consequences before accepting such contribution.

Income from partnerships
Investment portfolios of exempt organizations continue to become more diversified and complex, and UBI might be generated when an exempt organization is in a partnership that undertakes activities unrelated to its exempt purpose. The flow through nature of a partnership requires that the parties characterize income the same as the underlying entity. Therefore, even the tax-exempt partner must include the income or loss from unrelated trade or business activities conducted within a partnership in its computation of UBI.

Debt-financed income
IRC Section 514 requires certain items of income to be included in the computation of UBI when the income is derived from debt financed property. To be classified as debt financed property, the property must be held for the production of income and subject to acquisition or improvement indebtedness. Acquisition indebtedness is any debt that would not have been incurred were it not for the acquisition — so the debt does not have to be secured on the property to be treated as acquisition indebtedness. Most commonly, the debt financed property rules apply to rental real estate. However, the rules might apply to royalties or other investment income that has outstanding acquisition indebtedness.

Navigating UBI in the future
Tax-exempt organizations should not fear UBI, but it is important to recognize when it might arise so the appropriate IRS (and state, if applicable) filings are made. By planning for UBI, and recognizing under which circumstances it might appear, organizations can effectively manage it in accordance with regulations.

The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, investment or tax advice or opinion provided by CliftonLarsonAllen LLP (CliftonLarsonAllen) to the reader. The reader also is cautioned that this material might not be applicable to, or suitable for, the reader’s specific circumstances or needs, and might require consideration of nontax and other tax factors if any action is to be contemplated. The reader should contact his or her CliftonLarsonAllen or other tax professional prior to taking any action based upon this information. CliftonLarsonAllen assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

Rod MacLachlan, CPA and Karen Gries, CPA are principals at CliftonLarsonAllen LLP.

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