Mitigate Your Risk from Unrelated Business Taxable Income
By Joseph Giso
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.
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.
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.
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.