Unrelated business income (UBI) can involve significant labor in accounting and documentation efforts, but the payoffs can be rewarding. The route to the payoffs must be followed carefully to keep on the right side of the IRS, whose scrutiny of UBI continues to intensify.
Nonprofit organizations that are tax-exempt under §501(c) of the Internal Revenue Code (the Code) are not liable for income tax on revenue generated from activities related to the exempt purpose. But they are still liable for tax due from UBI at regular corporate (or trust, if applicable) income tax rates.
As you pursue UBI, ready your organization for an IRS audit by preparing a revenue analysis, following these framework recommendations:
Become familiar with the three-part test
Generally, a revenue stream will constitute taxable UBI if these three factors are all present:
Understand what the IRS is looking at
The income is earned from a trade or business.
The trade or business is regularly carried on by the organization.
The conduct of the trade or business is not substantially related to the organization’s performance of its tax-exempt function.
Over the past 18 months, the IRS has become very active with audit activity at not-for-profits, something not unexpected in the current economic and political environment. A primary focus has been UBI. Based on studies, examinations and sample returns, the IRS and Congress have publicly expressed concern that tax-exempt organizations are not properly identifying income that meets the three-part UBI test; when they do report the UBI, organizations aren’t properly allocating the expenses to offset it.
UBI can present in many ways, but the streams we see most frequently scrutinized by the IRS are:
Keep documentation up-to-date
Rental activities (e.g., personal property requiring services or utilizing debt-financed space)
Limited partnership investments
Sales of unrelated items (e.g., logo items or certain museum gift shop items)
Service agreements characterized as royalties or licenses, but requiring a certain level of active involvement of the organization
Special events that occur too frequently
For associations, the provision of particular services to members (more akin to a fee-for-service transaction) or multilevel membership classifications
When the IRS initiates an audit, the agent mails a request for specific information about your organization’s activities. The requests begin innocuously with trial balance accounts, detail of underlying amounts reported on Form 990 and the like. Then the requests become more focused, asking for contracts generating particular revenue, documentation supporting the reasons behind undertaking an activity, and details of the expenses offsetting each revenue stream.
From a practical perspective, it is often difficult to gather this information because the audit occurs years after the fact. Because of this, it is prudent to document your support as you prepare your returns.
Examples: If you are renting out conference space, you should document the identity of lessors and how the lease furthers your organization’s exempt purposes. If the lessor has a different tax-exempt purpose (or is a taxable person/entity), you might document that it was a space-only rental agreement with no debt, thereby meeting one of the exceptions to UBI.
If you are selling items in a gift shop, document the relationship between the items and a particular exhibit or your mission in general. If the shop is run by volunteers, document that their level of effort exceeds 85% of the overall effort.
Parse your revenue streams
When evaluating a revenue stream, proceed methodically. In addition to the three-part test, the Code contains specific modifications and exclusions for activities such as passive investment income, royalties, sale of donated goods and activities conducted primarily by volunteers. Verify and document the exceptions.
When allocating expenses to unrelated business activities, identify only those expenses directly related to carrying on the trade or business. Take these two steps:
Identify the truly direct expenses. These are expenses such as salaries paid to staff that conduct an unrelated activity and all out-of-pocket expenses incurred for that activity (e.g., meal cost for an event).
Determine if there are indirect expenses related to the UBI activity. Indirect expenses are not as easily identified and almost always involve an allocation. The process of determining the value of indirect expenses is not as simple or arbitrary as determining the percentage of UBI over total revenue and multiplying that by your overhead. This is a common mistake. Make the allocation based on employee time incurred, space used, etc. The denominator in the ratio is usually of particular concern. For example, if an expense such as utilities is incurred in carrying on an unrelated activity, be careful to allocate it based on unrelated time over available time, e.g., if a room is used for UBI for 30 days and related for 170 days, the allocation is 30 over 365, not 30 over 200. The IRS often finds issue with this common error.
An organization cannot offset UBI by deducting expenses incurred from a related-purpose activity partially funded by the unrelated business activity. For example, if providing services at a conference generates UBI and those services help fund athletic programs, you cannot deduct athletic expenses against the conference services revenue. In addition, expenses incurred regardless of whether the organization conducted the unrelated activity are often disallowed as a deduction against UBI.
Watch out for UBI loss activities
Supported by past court rulings, the IRS has adopted a facts and circumstances test to determine if an activity constitutes a trade or business. Some facts the IRS will consider in this determination are:
Three successive years of activity without a profit
Variable and fixed expenses routinely exceeding income from the activity
Continuing losses without adjusting the price or discontinuing the activity
Activity directed toward a single recipient with no effort to solicit additional sales or customers
Informal operations, e.g., no business plan, no contract, temporary or intermittent provision of services
If these factors are present and the activities generate a net operating loss deduction for future years, the organization may have to justify the stream as UBI to be able to take advantage of those losses. Keep the Code’s exploitation rules in mind for UBI activities that incur losses. The IRS has asserted, and courts have agreed, that an activity that continually loses money is not considered a “trade or business” because there is no “profit motive.” The IRS disallows the losses to offset other profitable UBI activities of the organization.
UBI can be a good thing
Although some organizations are averse to having “taxable” income, we think it should be embraced as a source of additional income activities that, though taxable, can still create funds to further mission. To find these potential business activities, review current activities to see if any can be expanded or modified, even if they serve a slightly unrelated purpose. Look at facilities to see if you can rent any that are not already fully utilized. Remember to report the income, and carefully determine and document the expenses directly and indirectly related to the activity so you can file a Form 990-T and pay tax on the net income.
Be creative and make a profit. There is nothing wrong with some UBI — just pursue it with caution.
Our how-to guide
can help you.
See the full report: The State of the Not-for-Profit Sector in 2015