By Meredith N. Pratt, CPA
Often, when people think of a nonprofit organization they automatically assume it is tax exempt; however, that is not always the case. Certain exempt nonprofit organizations are liable for tax if they have unrelated business taxable income, which is discussed in detail below. The tax that organizations must pay on this income is called the unrelated business income tax (UBIT). UBIT is designed to prevent exempt entities from avoiding a tax liability on a business activity that a regular nonexempt entity would have to pay during the ordinary course of business.
What is unrelated business income?
Code §512(a)(1) defines unrelated business taxable income as "gross income derived by any organization from any unrelated trade or business regularly carried on by it, less the deductions allowed." Code §513(a) defines an unrelated business as "any trade or business the conduct of which is not substantially related to the exercise or performance by such organization of its charitable. . . . or other purpose."
In simpler terms, unrelated business income is the profit derived from any trade or business activity that is performed on a regular basis by an exempt entity that is not substantially related to the exempt purpose of the organization. For example, if an exempt organization engages in a one-time profitable, unrelated activity, it will not be liable for the UBIT because the activity is not conducted on a frequent and continuous basis in a comparable manner to a nonexempt entity as required by Reg. §1.513-1. This is true even though the activity is unrelated to the exempt purpose of the organization. If, however, the activity is performed on a recurring basis and is unrelated, the exempt organization will be subject to UBIT.
Reg. §1.513-1 states that in order for a trade or business activity to be related to the exempt purpose of the nonprofit, it must have a causal relationship, and it also must "contribute importantly" to the exempt purpose of the entity. This can only be determined on a case-by-case basis and is therefore very subjective. You must consider the size of the business activity in relation to the size of the exempt function and whether or not the size of the business activity is larger than what would be considered necessary to achieve the desired goal of the activity.
There are also many activities that are specifically excluded from the definition of an unrelated trade or business by the IRS. These include activities performed by unpaid volunteers, activities that are principally for the convenience of members or employees, and activities involving the sale of donated merchandise. The types of income that are excluded include dividend and interest income, royalties, and rents from real property.
If an organization does conduct an unrelated trade or business, they are allowed to take certain deductions that are directly connected to the activity when computing unrelated business taxable income. These include normal income tax deductions, such as depreciation, salaries, and other similar items. Dual-purpose expenses that are related to the exempt function of the organization and to the unrelated business must be allocated between the two functions.
How do you calculate UBIT?
Organizations with unrelated business income (after applicable deductions) of $1,000 or more are required to file a Form 990-T, along with supporting schedules. According to Code §511(a), UBIT is calculated using corporate tax rates provided in §11 of the Internal Revenue Code. Organizations subject to the UBIT are also allowed to take many of the same tax credits as for-profit entities, including the General Business Credit and the Foreign Tax Credit. If an exempt organization is expected to owe $500 or more in UBIT, it is required to make estimated tax payments using Form 990-W.
There is a special rule regarding advertising revenue received by an exempt entity. Revenue derived from advertising in a printed publication produced by an exempt organization is generally taxable and reported on Schedule J of Form 990-T. However, there are exceptions to this general rule. In order to be exempt from taxation, the advertising activity generating the revenue must be regularly carried on, significantly related to the organization's exempt purpose, and conducted mainly by volunteers. If it does not meet any of the above requirements, then the advertising revenue is unrelated business income under §513(a) and it is subject to the UBIT.
Taxable gross advertising revenue is reduced by direct advertising costs and any readership costs that are in excess of circulation income. Gross advertising revenue is simply any amount received from the advertising activities that are unrelated to the exempt purpose of the organization. Reg. § 1.512(a)-1 describes circulation income as "the income attributable to the production, distribution, or circulation of a periodical (other than gross advertising income), including all amounts realized from or attributable to the sale or distribution of the readership content of the periodical." Circulation income also includes an allocable portion of dues or fees received by the organization from its members.
Reg. §1.512(a)-1(f)(6) defines direct advertising costs as "all expenses, depreciation, and similar items of deduction which are directly connected with the sale and publication of advertising" of the exempt organization. Readership costs are any expenses related to the publication that are not allocated to direct advertising costs. If the advertising activity of the publication produces a net loss (direct advertising costs in excess of advertising income), then the organization is allowed to use this to offset other unrelated business income.
There is also a special rule that requires income generated from debt-financed property to be included in an exempt organization's unrelated business income. Code §514(b)(1) defines debt-financed property as "any property which is held to produce income. and with respect to which there is an acquisition indebtedness at any time during the taxable year." However, if "substantially all" of the property is used to support the exempt purpose of the organization, then the income is not required to be included in unrelated business income. Reg. §1.514(b)-1 states that property will be substantially related if "85 percent or more of the use of such property is devoted to the organization's exempt purpose." If the property is used less than 85 percent of the time for exempt purposes, then only that specific percentage of income can be excluded from unrelated business income, as opposed to the entire amount if the "substantially all" requirement is met.
As mentioned above, Reg. §1.6012-2 requires nonprofit organizations with gross unrelated business income (before any deductions) greater than or equal to $1,000, to file a form 990-T with the IRS. Organizations with unrelated business income greater than $1,000 but less than $10,000 are only required to complete a portion of the form. The filing of Form 990-T does not preclude an entity from filing Form 990 or any other required returns. It is also important to note that organizations that are generally exempt from filing a Form 990 (e.g., churches) are required to file a Form 990-T if they have unrelated business income in excess of the $1,000 threshold.
Even though nonprofits do not typically operate with the objective of generating profits, there may be a time when income is generated that is unrelated to the organization's exempt purpose. Organizations need to be proactive when it comes to planning activities that could possibly generate unrelated business income and should always consider the tax implications that could come from these activities. Therefore, it is extremely important for tax-exempt organizations be aware of UBIT and when it is required.
About the author:
Meredith N. Pratt, CPA, is a staff accountant in the Tax Services practice of Lattimore Black Morgan & Cain, PC (LBMC).