Unrelated Business Income

Posted on Wednesday, July 03, 2013

Charitable nonprofit organizations are eligible for tax exemption under the Internal Revenue Code section 501(c)(3).  For profit corporations are currently taxed at a federal rate of up to 35 percent.  In 1950 Congress enacted the unrelated business income tax (UBIT) to prevent unfair competition between tax exempt organizations and for profit corporations engaging in similar activities.  If both an exempt and a non exempt organization are carrying on a similar activity that creates income, why should the exempt organization be excluded from paying income tax on the net income? 

Nonprofit organizations often supplement their income with other sources of revenue, of which some may be unrelated.  The UBIT is a tax on a nonprofit’s unrelated income.  The IRS defines an activity as unrelated if all three of the following are met for the activity.

1. It is a trade or business,
2. It is regularly carried on, and
3. It is not substantially related to furthering the exempt purpose of the organization.

Excluded Activities

The IRS has specifically excluded certain activities from unrelated business income tax, even though all three of the above conditions are met.

• Activities in which substantially all of the work is performed by volunteers (example: bake sale)
• Activities carried on for the convenience of members, students, patients, officers or employees (example: school cafeteria)
• The sale of donated merchandise (example: thrift store)
• Bingo, which meets the specific definition of “a game of chance played with cards that are typically printed with five rows of five squares each. Participants place markers over randomly called numbers on the cards in an attempt to form a pre-selected pattern such as a horizontal, vertical, or diagonal line or all four corners.  The first participant to form the pre-selected pattern wins the game.  In addition, for a game to meet the legal definition of bingo, wagers must be placed, winners must be determined and prizes or other property must be distributed in the presence of all persons placing wagers in that game.”

Excluded Income

In addition to the exclusions above, other income is specifically excluded from being treated as unrelated business income.

• Dividends, interest and other investment income
• Gains and losses from the disposal/sale of property
• Rents from real property (rents from personal property are not excludable)
• Research income

Two of the most common types of unrelated business income are debt-financed property and advertising.

Debt-Financed Property

In general, income received from the rental of real property is exempt from UBIT.  However, if the organization carried any debt on the real property at any time during the year, the rent income received for the property is subject to UBIT.    A debt/basis percentage, calculated using the average acquisition indebtedness and average adjusted basis, is used to determine the portion of rent income received that is subject to UBIT.  

There is a special rule that allows the rent income received for debt-financed property to be exempt from UBIT if substantially all (85% or more) of the property’s use is directly related to the organization’s exempt purpose.  For example, organization A leases a portion of its office building, which it has a mortgage on, to organization B.  Organization B leases 900 of the total 10,000 square feet and organization A uses the remaining space for its exempt purpose.  Since organization A uses substantially all (91%) of the property for its exempt purpose, the rent income received is not subject to UBIT.

Advertising

Payments received for advertising are normally considered unrelated business income.  Not only is the income taxable, it is also not considered public support for the purpose of qualifying as a public charity.  The IRS has stated, however, that qualified sponsorships are not unrelated business income.  Unlike advertising, sponsors making a qualified sponsorship do not receive a substantial return benefit in exchange for the payment.  The use or acknowledgement of the sponsor’s name or logo is allowable and is not considered a substantial return benefit.

It is important to remember that a nonprofit using its income to further its exempt purpose does not automatically mean that the income is related and exempt from UBIT.  Whether income is taxable or not is dependent on the manner in which it was earned, not the way it was used.

Posted by: Carrie Minnich, CPA
 

Posted in Mission Minded Nonprofits

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