Unrelated Business Income
1st in a Series
Organizations that are recognized as tax-exempt under Internal Revenue Code (“IRC”) §501(c)(3) are generally exempt from Federal income tax unless they participate in certain activities that generate unrelated business income (“UBI”). Tax-exempt organizations need to be aware of any activity in which it is engaging to ensure whether or not it is generating UBI and, if so, not to participate in these types of activities to an extent that may jeopardize the tax-exempt status of the organization.
As mentioned in previous WithumSmith+Brown tax tips, (1) the Exempt Organization Annual Report and Workplan (February 20, 2013) and (2) Internal Revenue Service (“IRS”) Colleges and Universities Compliance Project (May 22, 2013), the IRS is devoting additional resources to examinations related to those tax-exempt organizations that are reporting UBI on their Form 990, Return of Organization Exempt from Income Tax, and not paying any Federal income tax on the UBI. This tax tip will serve as the first in a series related to UBI.
WHAT IS UNRELATED BUSINESS INCOME?
In general, UBI is income that is not substantially related to the purpose for which tax-exempt status is granted to the organization. Income will be considered to be UBI if it is:
- Derived from a “trade or business”;
- “Regularly carried on” and;
- “Not substantially related” to the tax-exempt organization’s primary purpose and operations.
An activity deemed to be a “trade or business” generally includes any activity carried on for the production of income from selling goods or performing services. It is irrelevant whether the activity generates a profit for purposes of determining whether the gross revenue derived from the activity is subject to UBI.
A tax-exempt organization is required to report UBI on an activity by activity basis. In doing so, all expenses associated with each activity are netted, again on an activity by activity basis, against the gross UBI to determine unrelated business taxable income (“UBTI”). The IRS generally takes the position that a taxpayer cannot offset net unrelated business income generated from an unrelated business activity with unrelated business losses incurred by a different unrelated business activity.
Offsetting expense categories include (1) “directly connected” and (2) “dual use” expenses. Directly connected expenses are those that are incurred solely as a result of the unrelated business activity. 100% of these costs are able to be allocated against the UBI. Dual use expenses are those expenses that are incurred to both carry on the exempt functions and conduct an unrelated business (e.g. overhead costs). These expenses must be apportioned based upon the respective use of either the related or unrelated business activity. It is important to note that when allocating dual use expenses an organization should maintain a clear and concise accounting trail of how the allocation was determined.
EXCLUSIONS FROM UBI
As long as the three criteria listed above with respect to UBI are present, a tax-exempt organization should carefully consider whether or not the activity may potentially be considered to be UBI. However, it is important to note, that the IRS has determined that certain sources of income which are not generated in furtherance of a tax-exempt program service of the tax-exempt organization, are generally exempt from classification as UBI. These exclusions include, but are not limited to, passive income such as interest and dividends, royalties, certain research activities, volunteer activities, parking, gift shop, cafeteria, sales of contributed properties and other low cost items. IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations, provides the following example for clarity – “The hospital operates a gift shop patronized by patients, visitors making purchases for patients, and employees; a cafeteria and coffee shop primarily for employees and medical staff; and a parking lot for patients and visitors only. These activities are also substantially related to the hospital’s exempt purpose and do not constitute unrelated trades or businesses”. The reason for the exclusion is that these services are provided for the convenience of the hospital’s patients, visitors and employees.
UBI TAX RATE AND REPORTING
All activities that generate UBI are required to be reported, on an activity by activity basis, on Form 990-T, Exempt Organization Business Income Tax Return. Any tax-exempt organization with gross income of $1,000 or more for any year from the conduct of an unrelated trade or business must prepare and file a Form 990-T. Any net UBI, or UBTI, reported on a Form 990-T is subject to Federal income tax at regular corporation rates as prescribed by the IRS.
CONCLUSION
Continued IRS interest and scrutiny in this area will continue to subject organizations to questions and examinations with respect to their UBI reporting and activities. All organizations should carefully consider reviewing their existing business activities to determine if any may constitute UBI and any new business ventures for UBI reporting.
A complete copy of the 2012 IRS Form 990-T and associated instructions and IRS Publication 598 can be accessed on our IRS Resource Center.
For more information on the topics discussed or services we can provide, please contact:
Scott Mariani, JD, Partner
Practice Leader
973.898.9494 ? [email protected]
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To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
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