Mitigate Your Risk from Unrelated Business Taxable Income
By Joseph Giso
As nonprofit organizations increasingly look to supplement regular funding with income from activities unrelated to their core mission, its important to understand how the IRS will treat that income in order to minimize taxes while maintaining their nonprofit status.
A recent report from the Internal Revenue Service (IRS) suggests unrelated business taxable income (UBTI) for tax-exempt organizations will be a key focus of IRS scrutiny as it pursues new government revenues.
Nonprofits earn UBTI from a regularly carried on trade or business that is not substantially related to their purpose. Activities qualify as substantially related (and therefore tax-exempt) if a causal relationship exists between the activities generating income and the accomplishment of the entitys defined mission but the line between income that the IRS considers taxable and tax-exempt is tricky.
What follows are some simple ways your organization can lower its UBTI and minimize associated taxes.
Qualified sponsorship payments, in which a nonprofit receives a payment from a corporate sponsor and the sponsor neither receives nor expects substantial favors in return, are considered exempt from UBTI considerations. Any time a nonprofit uses qualitative or endorsement-type language in regards to its corporate sponsor, the messaging becomes advertising and subject to unrelated business income tax.
To avoid turning a tax-exempt sponsorship into advertising, nonprofits need to carefully consider their sponsorship arrangement. The following actions represent tax-exempt options nonprofits can use with their sponsorships:
- Listing the name or logo of sponsor
- Awarding exclusive sponsorship award
- Providing logos or slogans that do not contain any qualitative language or comparative description of the products
- Listing of sponsors locations, addresses, phone numbers, and Internet addresses
- Providing value-neutral descriptions of the sponsors product displays
- Listing sponsors brands or trade names
Many facilities have conference rooms or other event spaces that they rent, for a fee, to the public or for-profit groups. The fees for the rental can be excluded from UBTI considerations if the event being held is substantially related to the nonprofits purpose. For example, a hospital rents a conference room to an organization (for profit or nonprofit) that conducts a continuing education course for nursing credit. Any rental income generated from this venture would be tax-exempt.
Rents from debt-financed property do not qualify for tax exemption if the activity falls outside of the exempt purpose. The necessity arose because a large number of tax-exempt organizations bought businesses and investments on credit, frequently at a price that was more than the market price, while contributing little or nothing to the transaction other than their tax exemption. The IRS reasoned that purchases made with debt and used for unrelated business put the nonprofit at a significant financial advantage compared to their for-profit counterparts. Income from debt-financed buildings falls subject to the unrelated debt-financed income (UDFI) calculation.
To minimize or avoid the debt-financed income calculation, nonprofits should consider asking donors to pay off the debt on buildings being used for non-exempt purposes as part of their donor contribution. When possible, try to eliminate or pay off the loan on the building that could or would be used for generating UBTI.
Nonprofits need to pay close attention to partnership investments, as the IRS is developing risk models to extrapolate and target specific activities. One of the activities of particular interest is net operating losses (NOLs) of three years or more. Partnerships typically will have losses in the earlier years and then start to generate income in later years. Capturing these earlier losses will benefit your organization by offsetting income in later years, but it will also pique the IRSs interest. The IRS has indicated that they will review returns for large NOLs.
To protect your nonprofit from scrutiny, know your activities and investments before undertaking new ventures. Take an inventory of your investments and prepare an investment summary work paper. The summary should include your nonprofits investments as of yearend and state filing requirements in the areas where your nonprofit has nexus.
The IRS is also considering whether your investments are in foreign partnerships or foreign corporations. Both require additional filing requirements, and there are substantial penalties involved if nonprofits neglect to file required forms.
Work closely with investment managers and try to obtain periodic updates on investments. The information needed to calculate the organizations share of partnership income must be provided by the investment manager.
Make a Plan
The IRSs Advisory Committee on Tax Exempt and Government entities recently proposed that the IRS adopt a new Form 990-T to address UBTI confusion. The committee also asked for a listing of categories of activities the IRS considers related and unrelated and a comprehensive revenue ruling on a range of unrelated business income issues.
In the absence of any notable regulatory changes surrounding UBTI, your nonprofit should monitor and review its sources of unrelated business income. Take inventory of all activities, especially the newly created, that carry the potential of being unrelated to your exempt purpose. Evaluate each with the IRS criteria for what constitutes UBTI to verify that the activities are classified correctly.
For the income-generating activities related to your exempt purpose, be sure to include appropriate documentation that demonstrates why the activity is related. This includes references to the relevant sections of the Internal Revenue Code or IRS rulings.
Joseph Giso, CPA, MST, is a managing director at CBIZ Tofias and a member of the companys Not-for-Profit & Education Practice. Email him at email@example.com or call 617-761-0623.