What not-for-profits need to know about UBIT

Many not-for-profit organizations dread the unrelated business income tax (UBIT) because it can be a challenge to sort out when a not-for-profit’s activities are subject to the tax and when they are not.  However, it’s important that organizations that qualify as tax-exempt get their arms around UBIT’s uncertainties.

More than 80,000 exempt organizations filed a 2017 Form 990-T, Exempt Organization Business Income Tax Return, reporting $15.4 billion in taxable income and $871.4 million in tax, according to the most recent IRS statistics.  And while more than half of those organizations did not have unrelated business taxable income (UBTI) after subtracting deductions from gross unrelated business income (UBI) and thus did not have a UBIT liability, it is not unusual for Sec.  501(c) tax-exempt organizations, especially charities, to have a UBIT liability, which can sometimes be an unexpected major expense.

CPAs working in or with tax-exempt entities can provide valuable assistance in helping those organizations recognize when they have UBI and manage their UBTI.

UNDERSTANDING UBI

According to the Internal Revenue Code, UBI is the income generated by activities of tax-exempt organizations that meet all of the following criteria:

• They are a trade or business, defined in Sec. 513(c) as any activity that is carried on for the production of income from the sale of goods or the performance of services.
• They are regularly carried on.  According to Regs. Sec.  1.513-1(c)(1), business activities might be taxable “if they manifest a frequency and continuity, and are pursued in a manner, generally similar to comparable commercial activities of nonexempt organizations.”
• They are not substantially related to the organization’s exempt purposes.  A key point here is that under Regs.  Sec.  1.513-1(d)(2), an activity may be deemed to generate unrelated income even if the tax-exempt organization uses that income to support its mission.  While the profits from these activities may benefit the organization’s purpose, the profits would still probably be subject to UBIT because the activities don’t contribute importantly to achieving the organization’s exempt purpose.  Examples cited by the IRS in Publication 598, Tax on Unrelated Business Income of Exempt Organizations, include an educational organization that sells its membership mailing list to vendors and a youth welfare organization that operates a miniature golf course that is open to the general public, with the course, its admission fees, and management substantially similar to commercial courses (see the sidebar,”IRS Examples of Unrelated Businesses”).

Not-for-profits can take several steps to effectively manage UBI concerns:

GET THE BIG PICTURE

To identify potential UBI, Irvine, Calif.-based Brian Yacker, CPA, partner at Baker Tilly, recommended that not-for-profits think of their revenue streams as falling into three buckets:

• Contributions, which clearly are not UBI.
• Program service revenue derived from the not-for-profit charging fees from the furthering of its mission, such as patient revenue paid to a hospital or ticket admission revenue to a museum.
• Unrelated revenue (everything else).  Not-for-profits should analyze all their unrelated revenue to determine whether it satisfies an applicable UBI exception/exclusion.  For example, while advertising revenues may be taxable, qualified sponsorship payments are not (see Sec.  513(i)).  Additionally, activities performed by the not-for-profit primarily for the convenience of its members, clients, patients, students, etc. (Sec.  513(a)(2)) are a potential exception.  Also note that Sec.  513, in defining gunrelated trade or business, exempts bingo games (Sec.  513(f)) and some utility pole rentals (Sec.  513(g)).

CONSIDER THE DETAILS

Key details can help not-for-profits decide if an activity’s revenues are subject to UBIT, according to David Moja, CPA, of Moja & Co., in Reidsville, Ga.  For example, a church coffee shop that is open daily to the public, uses paid labor, engages in advertising, and aims to compete with other local shops will likely be subject to UBIT. In this case, in addition to the tax considerations, the organization may want to consider potential damage to its reputation if it was perceived to be positioned to compete with other for-profit endeavors and/or was perceived by the public to endanger the business of a local mom-and-pop coffee shop, Moja said, noting the value of being seen as a good citizen.  “Take a holistic view of the benefit of the activity, and don’t get stuck in the numbers,” he advised.

If the same shop is staffed by volunteers and only open around Sunday services, it likely will not be subject to UBIT because the use of unpaid labor and services provided for member convenience are common factors for activities that are considered exceptions.  A church with a storefront coffee shop that is open all week and has paid workers but is only open to church members and does not advertise may be able to take the position that the income in this case is generated by sales to members, thereby also escaping UBIT.

CONSIDER THE MEANING OF ‘REGULARLY CARRIED ON’

Of the three elements of the definition of an unrelated business activity, the most controversial is determining whether an activity is regularly carried on.

For example, in a number of recent IRS audits, Yacker has seen the Service assert that gaming activities — such as raffles — should be considered “regularly carried on” if they happen more than once a year.  Yacker has even been involved in an IRS audit where the Service asserted that conducting one raffle annually constituted a regularly carried on activity.

CPAs can help clients make their cases by pointing to legal precedent.  In one seminal case, National Collegiate Athletic Association, 914 F.2d 1417 (10th Cir.  1990), the Tenth Circuit decided that advertising revenues related to the NCAA’s Final Four basketball program should not be taxable as UBI because the advertising activity only occurred over a few weeks’ time and not throughout the year and, hence, was not regularly carried on.  The IRS objected to this ruling, putting out an Action on Decision (AOD 1991-015) that stated the IRS would not follow the Tenth Circuit holding outside of that jurisdiction.

DOCUMENT YOUR REASONABLE POSITION

“With anything you do, you should have a defendable position,” Moja said.  That includes documentation of the evidence behind the not-for-profit’s reasoning. In addition, key people throughout the organization should be aware of the position.  “We share our documentation not only with the finance department but also with the organization’s leadership and the finance or audit committee,” he said.  “That way, if the IRS takes exception, they aren’t blindsided.”

For activities that might be questioned, not-for-profits should be prepared to demonstrate why those activities fulfill their exempt purpose, according to New York City-based Daniel Romano, CPA, principal and Not-for-Profit & Higher Education Tax leader at Grant Thornton Advisors LLC. For example, a college or school that rents out its theater to a for-profit production might argue for an exception to the imposition of UBIT by pointing out that its students are involved in the production and the activity thus supports its educational mission.  Renting space to another educational organization might also be considered part of its educational purpose.

In some cases, Romano has seen IRS auditors question a not-for-profit’s allocation of expenses to unrelated income from a partnership investment.  In that situation, it’s important to be able to present a reasonable methodology for the allocation percentage, he said.  The organization should have emails or time sheets documenting time spent if the expenses are based on hours, for example.

These steps are necessary because there are few bright lines in the UBI area.  Organizations exempt under Sec.  501(c)(3) must be organized and operated exclusively for one or more specified exempt purposes (Regs.  Sec.  1.501(c)(3)-1(a)). They fail the operational test if “more than an insubstantial” part of their activities does not further such an exempt purpose (Regs.  Sec.  1.501(c)(3)-1(c)(1)). Thus, substantial unrelated business activities might jeopardize the organization’s tax-exempt status. There is no objective definition of “substantial”; as such, the “substantiality” determination, as well as other UBI determinations, is often very facts-and-circumstances sensitive, Yacker noted.  Fortunately, loss of tax-exempt status rarely occurs, he said.

REMEMBER THE UPSIDE

Rather than to be avoided, in most instances, the generation of UBI could be beneficial to many not-for-profits.  “Nonprofits should not be turning away opportunities to earn UBI,” Yacker said. They should see the UBIT as an inevitable part of succeeding at an activity that is not related to the furthering of their mission.

The federal UBI tax rate for not-for-profits organized as corporations is 21%, and numerous states impose UBI tax rates that can be as high as 9% or 10%.  Even with a roughly 30% combined tax rate, however, the not-for-profit is still putting 70 cents on the dollar in its pockets, Yacker noted. “Just understand that if you are lucky enough to have developed a profitable unrelated revenue stream, you will be subject to tax.”

CPAs can help not-for-profits engage in planning that can protect their exempt status and mitigate the tax burden.  At the very least, clients should understand that the required UBIT should be factored into their budgeting so that they are not caught by surprise when the taxes are due.While activities that generate UBI may create administrative burdens, “if you’re still making money on them, they’re worth doing,” Romano said.

IRS examples of unrelated businesses

Some examples of unrelated trades or businesses are straightforward: 

• An organization whose exempt purpose is to stimulate and foster public interest in the fine arts that leases studio apartments to artist tenants and operates a dining hall primarily for these tenants.
• A tax-exempt business league that publishes a consumer-oriented magazine four times a year and makes it available to members for purchase.
• An exempt youth welfare organization that operates a miniature golf course that is open to the general public.
• An exempt organization, organized and operated for the prevention of cruelty to animals, that provides pet boarding and grooming services to the general public.
• An exempt school that leases tennis facilities to an unrelated individual who runs a tennis club for the summer.
• An exempt scientific organization, which enjoys an excellent reputation in the field of biological research, that exploits this reputation regularly by selling endorsements of laboratory equipment to manufacturers.
• An exempt university that leases its football stadium to a professional football team for a fixed fee.
• An exempt organization that receives income from the sale of advertising in its annual yearbook.

Other examples are more nuanced: 

• An exempt charitable organization’s purpose is to provide for the welfare of young people. The organization organized a health club program that its members could join for an annual fee in addition to the annual dues. Operating this program is an unrelated trade or business if there is an intent to make a profit.
• An art museum maintained and operated for the exhibition of American folk art operates a shop in the museum. Each line of merchandise must be considered separately to determine if sales are related to the exempt purpose. The sale and rental of reproductions and copies of artistic works and the sale of literature relating to art aren’t an unrelated trade or business. The sale (if they intend to make a profit) of other books and souvenir items of the city where the museum is located has no causal relationship to art or to artistic endeavor and, therefore, produces unrelated business income.
• An exempt vocational school operates a handicraft shop that sells articles. The sale of articles made by students doesn’t constitute an unrelated trade or business, but the sale of products made by local residents is an unrelated trade or business.

Source: IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations.

About the author

Anita Dennis is a New Jersey-based freelance writer. To comment on this article or to suggest an idea for another article, contact Jeff Drew at Jeff.Drew@aicpa-cima.com.

Keeping up with UBIT

A number of resources are available to CPAs serving not-for-profits and to those organizations’ in-house financial teams.

• IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations, as well as related information and legislative or other updates are available at IRS.gov/Pub598.
• Educational tools: AICPA State Unrelated Business Income Tax (UBIT) Return Chart
• The AICPA & CIMA Not-for-Profit Industry Conference and the AICPA & CIMA Governmental and Not-for-Profit Training Program provide a deep dive into current and ongoing issues.
• Membership in the AICPA Not-for-Profit Section offers access to news and other resources.

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AICPA & CIMA RESOURCES

Articles

“Creating a Not-for-Profit Accounting Course,” JofA, April 10, 2024

“Compliance Issues for Fundraising Organizations,” AICPA & CIMA, March 6, 2024

“An Educational Lesson on UBIT,” JofA, March 30, 2023