January 2010 -- Generating new sources of revenue and enhancing current income sources are frequent topics during board meetings and internal staff meetings of tax-exempt organizations, particularly during these economic times. An important consideration during these discussions is whether or not these new income sources will generate unrelated business taxable income (UBTI).
Generally, UBTI is defined as “net income derived from any unrelated trade or business that is regularly carried on by the exempt organization.” To be “unrelated,” the business activity must not be substantially related to the organization’s mission. This is determined by looking at the exempt purpose of the organization, which is generally found in its exemption application or articles of incorporation.
Not all unrelated income is taxable. Some income is excluded by IRS regulations, including dividends, interest and other investment income. Royalty income and rents are typically excluded, as are gains and losses from the sale of property other than inventory. But, as with many other IRS regulations, there are loopholes and traps. If the excluded income is generated from debt-financed property, the income is generally considered UBTI. For example, if you borrowed money to purchase a building which was rented to an unrelated party (or even certain related parties), the rents could be taxable as UBTI.
Certain types of income always seem to trigger UBTI. If you sell advertising space in your organization’s membership magazine or periodical, or sell space in your program beyond what is considered sponsorship identification, or sell items in your gift shop that are not substantially related to the exempt purpose of your organization, the revenue from those items will be UBTI.
There are some sources of revenue that could be considered “hidden” UBTI. The ordinary income or debt-financed investment income generated by a partnership could be taxable to the tax exempt partners. Investors are required to notify the partnership of their exempt status. That way, the partnership can calculate the UBTI that is being generated within the partnership and disseminate the information to its tax exempt partners. Any income generated by an S corporation in which the exempt organization is invested will be deemed UBTI.
Starting January 1, 2010, the interest, rent, royalty, and annuity (or “specified payments”) received from a controlled entity are once again considered UBTI, to the extent the payment would have been deductible by the controlled entity against income that would be UBTI if earned directly by the exempt controlling organization. For the past few years, these payments were excluded from taxable income, as long as the payments were comparable in terms to similar payments between unrelated parties. At the time of this article, the House of Representatives has passed an extension of this exclusion for an additional year. A controlled entity is typically a for-profit organization in which an exempt organization directly or indirectly owns more than 50% of the voting power or value. So, if your non-profit owns a for-profit subsidiary that pays rent, royalties, annuities or interest to your organization, that revenue could now be subject to tax.
UBTI is reported on the 990-T, Exempt Organization Business Income Tax Return and is filed with the Form 990. It is open for public inspection. There is a specific deduction of $1,000 allowed, so you do not have to pay tax on small amounts of UBTI. Like any for-profit taxable entity, the UBTI can be offset by ordinary and necessary expenses that are directly connected to the generation of that income. Tax is calculated on net income at current corporate or trust rates, depending on the type of entity.
UBTI is not necessarily a bad problem to have. If you are paying tax, you must be making money; however, UBTI should always be an insubstantial part of your organization’s total revenue. If your unrelated business begins generating substantial revenue, you will need to consider some tax planning strategies in order to not jeopardize your organization’s tax-exempt status.
As with all tax advice, please consult your CBIZ MHM tax advisor for advice regarding your particular facts and circumstances. At best, you could pay tax on revenues without realizing you would owe the taxes; at worst you could jeopardize your exemption.
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