| Summer 2007 |
Nonprofit Advisor
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The Promise (and Peril) of Unrelated Business Income
Because of dwindling government support and reduced charitable
contributions (or donor-imposed restrictions on those funds), many
nonprofits are seeking additional sources of revenue. Examples range
from hospitals that package software for commercial sale to art
museums selling special reproductions.
The concern: Unrelated business activities of an otherwise exempt
organization are subject to income tax liability. In addition, too much
involvement in unrelated commercial activities can cause an organization to lose
its tax-exempt status.
The Basics
Tax-exempt organizations are subject to income tax liability in the same
manner as taxable organizations if they engage in certain activities unrelated
to their exempt purposes. An activity is subject to the unrelated business
income tax (UBIT) if it meets three requirements:
- It is a trade or business. This generally includes any activity
performed for production of income from the sale of goods or the performance
of services.
- It is regularly carried on. Activities are considered "regularly
carried on" if they can be shown to be frequent and continuous, and are
pursued in a manner similar to comparable commercial activities of nonexempt
organizations.
- It is not substantially related to the furtherance of the exempt
purpose of the organization. The fact that profits from an unrelated
business are later used by an exempt organization to perform its charitable
functions has no bearing upon whether an unrelated business activity is taxed.
Exempt … Or Not Exempt?
Determining whether activities are "substantially related" to your
organization's exempt purposes can get complex. It requires an examination of
the relationship between business activities generating income and
accomplishment of exempt purposes.
Example: A hospital operates a pharmacy at which its patients can fill
their prescriptions. In this case, the "business" of operating the pharmacy is
"related" to the hospital's charitable mission. But if the same hospital
operates a pharmacy at which it also fills prescriptions for people not patients
of the hospital, that portion of the "business" is considered unrelated.
Example: A college sponsors appearances of a professional theater
company that presents drama performances for students and faculty members. Such
activities are related to the exempt purposes of the school. Even though members
of the general public are admitted, presentations are deemed to contribute
importantly to the overall educational and cultural function of a college or
university; thus, income from such functions would not be taxed.
Should income be realized from activities that are in part related to the
performance of exempt functions, but that are conducted on a larger scale than
is reasonably necessary for performance of those functions, income attributable
to the excessive portion of activities is considered income from conduct of an
unrelated trade or business.
Likewise, business activities that fall under a "split" or dual-use category
can trigger UBIT.
Example: A museum has a theater auditorium specially designed and
equipped for showing educational films in connection with its program of public
education in the arts and sciences. The theater is used in evenings as an
ordinary motion picture theater for public entertainment. Income from operation
of the theater in the evenings is considered to be from an unrelated trade or
business.
In cases such as this, where facilities are used for both tax-exempt purposes
and production of unrelated business taxable income, expenses are allocated
between the two activities on some reasonable basis. Generally, expenses are
apportioned according to hours devoted to exempt and to nonexempt uses.
What Is Excluded?
The following activities are specifically excluded from the definition of
unrelated trade or business:
- Volunteer labor - Any trade or business is excluded in which
substantially all the work is performed for the organization without
compensation.
- Convenience of members - Any trade or business is excluded that is
carried on primarily for the convenience of an exempt organization's members,
students, patients, officers or employees (sales of things like work-related
clothes and equipment, and items normally sold through vending machines, food
dispensing facilities, or snack bars). Example: A school cafeteria.
- Selling donated merchandise - Any trade or business is excluded
that consists of selling merchandise, substantially all of which the
organization received as gifts or contributions. Example: An exempt
organization's thrift shop.
What About Fundraising?
Fundraising activities are exempted from unrelated business activities
because they generally are not regularly carried on, are usually conducted by
volunteers, and often involve the sale of donated merchandise. Distribution of
low-cost articles is not unrelated business income if distribution is
"incidental" to solicitation of charitable contributions.
Your Responsibilities
If your organization has unrelated business gross income in excess of $1,000,
you'll need to file Form 990-T by the 15th day of the fifth month following the
close of your taxable year and pay tax on that income. Tax liability on
unrelated business income is computed in the same manner as for the
corresponding taxable entity. In other words, a tax-exempt corporation is
subject to corporate rates, and a trust is taxed in the same manner as a taxable
trust.
Note also that public charities must make available for public inspection a
copy of any annual return related to UBIT for returns filed after Aug. 17, 2006.
Editor's Note: Bober, Markey, Fedorovich
& Company frequently works with clients on matters such as
this. Please call your partner / manager contact if you would like assistance in this area.
The Nonprofit Advisor is produced quarterly by Bober, Markey, Fedorovich
& Company's Nonprofit Services Team. If you would like additional information about the services that we can provide to nonprofit organizations, please call or email our team leader, Lori A. Sheets, CPA at 330.762.9785 or
lsheets@bobermarkey.com.
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