News Flash! Exempt Organizations may actually have to pay income tax

UBIT. Pronounced “you-bit.” It’s one of seemingly millions of acronyms that not-for-profit organizations (let’s add another one, NFP’s) have probably heard of, but don’t know much about. It stands for unrelated business income tax, and it’s an area of the Internal Revenue Code (IRC) that is overlooked all too often. NFP’s may assume that, being tax-exempt entities, they are truly exempt from ever having to pay income taxes. Chances are that most of these assuming NFP’s are correct, but those that aren’t may be subjecting themselves to Internal Revenue Service (IRS) audits, income tax liabilities, interest, and penalties that they are completely unaware of. The worst-case scenario is that an NFP loses its exempt status by focusing too much of its efforts and energies on unrelated business activities. “Too much” in this case is not well-defined, but best practice seems to point at 20% as the threshold for having an excessive level of unrelated business. In recent years, the IRS has ramped up scrutiny of NFP’s in efforts to generate additional revenue for itself and the federal government. UBIT audits are thus becoming more commonplace and adversarial.

The goal of this article is to shed some much-needed light on UBIT, what it is, why it’s important to your NFP, how it practically comes into play, and what to be on the lookout for to ensure compliance and to avoid IRS scrutiny (or worse). There are countless situations, court cases, and exceptions that are enmeshed with this subject, so please realize the confines of this newsletter prohibit us from being completely comprehensive. As with any NFP issue, if you are facing a unique and/or complicated situation involving UBIT, we’d be glad to advise you on how to approach it.

What is UBIT?

UBIT is determined by the level of unrelated business income (UBI) that an NFP generates. The textbook definition of UBI is: “income from a trade or business which is regularly carried on and is not substantially related to the charitable, educational, or other purpose that is the basis of the organization’s exemption.” There are three major elements in that definition – the activity is (1) a trade or business, (2) is regularly carried on, and (3) is not substantially related to the exempt purpose of the NFP. We’ll provide more clarity later for each of these elements.

Why is there UBIT?

There are multiple reasons why UBIT exists. In short, it’s meant to provide a level playing field for NFP’s competing with for-profit enterprises. For-profit entities, who presumably have to pay income taxes, cannot fairly compete with NFP’s who are performing services or selling goods without the added burden of income taxes built into its pricing structure. The NFP, in this case, is operating with an unfair competitive advantage. UBIT helps reduce or eliminate that advantage. One may argue that the use of the funds from the sales in question still furthers the mission of the NFP, but unfortunately, when it concerns UBIT, the IRS is mainly interested in the operations generating the income, not the use of the funds (which are normally still charitable).

What is a “Trade of Business?”

An activity is a trade or business if it is carried on to sell goods, perform services, or includes some other activity with the purpose of producing income. Generally speaking, if the activity is designed solely to generate profits to supplement the NFP’s income, it likely is considered to be carried on for the production of income. The fact that an activity may also be in direct competition with commercial for-profit entities further cements its classification here.

Thankfully there are some exceptions to these general rules. For instance, if the activity is conducted principally (85% or more) by unpaid volunteers, it is not considered a trade or business subject to UBIT. If activities involve sales of donated items, they too are exempted from UBIT, as are activities carried out for the convenience of constituents or members of the NFP (the classic examples here are gift shops in NFP hospitals or cafeterias in NFP schools). There are other factors involved, so please seek pointed advice for your unique situation.

What is Considered “Regularly Carried On?”

Of course there is ambiguity in this definition, and specific circumstances require specific insights. In this case the frequency and ongoing nature of activities will play a role. Minor, one-time activities likely are excluded. Those that are conducted either seasonally or in a routine fashion, and require a relatively significant level of ongoing or scheduled efforts, likely are considered regularly carried on. Following the NFP food pantry example above, if sales of excess food occurred once over a short duration of time, it’s likely no considered regularly carried on, and would not be subjected to UBIT. If, however, it’s a part of normal operations, has staff dedicated to it, and is ongoing or occurring more periodically, it would fall under the auspices of UBIT rules.

When is an Activity Considered not Substantially Related to the NFP’s Exempt Purpose?

If an activity has no bearing on or contributes no meaningful advancement towards the NFP’s exempt purpose/mission, then it is not related, and it would be subject to UBIT. The most common rebuttal from NFP’s is that they “use the profits to pay for our mission and carry out our exempt purpose.” The IRS has specifically rejected this argument. The disposition of the funds generate from the activity in question has no bearing on the labeling of the activity as subject to UBIT or not.

My Activity Seems to be Subject to UBIT. Now what?

Don’t panic yet. The IRS has specifically identified certain transactions and activities as being statutorily exempt from UBIT. They are generally passive activities, and include interest, dividends, capital gains, royalties, and real estate rentals (though special rules exist for rentals of debt-financed property, which we will discuss later).

If your unrelated business activities do not seem to be excluded, then you’ll have to work on filing annual UBIT returns with the IRS (Form 990-T) and related states in which those activities are carried out. Like with any for-profit business enterprise though, you’re able to deduct expenses related to the activity to arrive at your unrelated business taxable income (UBTI, which is not the same as UBIT). Allocations can be tricky, but remember that whatever costs you claim as deductions against your unrelated business income (UBI) must be directly associated with those activities and must be supported by reasonable and appropriate allocation methodologies. Ultimately after deductions and credits, your UBTI will be taxed at a rate of 21%. For NFP’s with projected liabilities, you should consider the need for making quarterly estimated payments throughout the year to avoid late-filing penalties and interest.

What About Debt-Financed Property?

The most common questions that we face about UBIT come about with debt-financed real property. There are no simple answers, so if this applies to you, please let us know and we’ll help you closely analyze your particular set of circumstances.

Consider an NFP that purchased a building through debt financing. The NFP occupies a portion of the building, but rents the rest. If the NFP occupies substantially all of the property (measured in square feet, over 90%), it can probably stop there. The rental income is usually not subject to UBIT. If, however, a more significant portion of the space is rented, an amount subject to UBIT must be calculated based on the average level of acquisition indebtedness for the year in question (average debt balance associated with the property purchase) as compared to the average cost basis in the building during that same year (net of accumulated depreciation). That percentage is applied to the rental income to arrive at the portion subject to UBIT. It sounds complicated because it is. Again, seek professional advice if this applies to your NFP. Just know that if you’re renting space that you bought with debt financing, you definitely need to carefully assess the taxability of your rental income.

In Summary

Almost 1,300 words in, we’re only scratching the surface of the beast that is UBIT. The main takeaways should be that (1) NFP’s are not always exempt from paying income taxes, (2) activities that NFP’s carry out that are not related to their missions may subject them to UBIT, and (3) there are complexities, exceptions, and calculations that will likely come into play. If you think UBIT applies to your organization, we can help you determine to what extent it does or doesn’t.

This article was also featured in our newsletter NFP Advisor Vol. 23