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Do Gift Planners Need to Worry About Unrelated Business Income Tax?

January 13, 2021
Do Gift Planners Need to Worry About Unrelated Business Income Tax?

Maybe, but just a little.

Exempt organizations, of which charities are a large subclass, do not pay federal income tax. The most notable exception to the exemption is the tax imposed on unrelated business income (UBI) generated by, in our case, charities.  That income is subject to the unrelated business income tax (UBIT).

Few subjects in nonprofit law are as arcane as UBI.  The topic is, therefore, sorely in need of a “cheat sheet.”

Here is what gift planners need to know:

  1. UBI is not a marker of charitable mismanagement. Many charities, especially larger organizations, generate UBI and pay UBIT.  There is even a special schedule for this item on the 990.  It is called 990-T.  Unless a charity’s UBI becomes a significant part of its overall income (say, more than 10% or 15%), the chances of the IRS raising an issue are quite slim.
  2. The underlying logic of UBIT rests on two related pillars: (1) charities should be devoting their time and resources to raising funds for, and implementing, charitable programs, not to running businesses; and (2) charities should also not be running businesses because they would have an unfair competitive advantage over taxpaying businesses.
  3. Even if the charity uses the UBI for charitable purposes it is still subject to UBIT. The law was not always that way.  It used to be that the “destination” (i.e., the use of the income) was the determinative factor.  Now it is the source of the money.  Revenue from an unrelated business is subject to taxation.  End of story.
  4. Many common sources of revenue for charities – donations, investment income, royalties (from mailing lists and the like) – present no UBIT risk.
  5. One area where charities sometimes create UBI is in corporate relationships (such as cause marketing) that raise revenue. If a charity provides “too much” in the way of services or advertising to a corporate partner, some of the income from the partnership may be taxable to the charity.  Good nonprofit tax counsel can go a long way toward mitigating or even eliminating this risk.  This obviously has little or nothing to do with bequest cultivation or bequest management.
  6. Certain noncash donations can sometimes be a source of UBI. The primary gift types would be business interests (like partnerships or private stock), commercial real estate (including agricultural land) and certain mineral interests, especially those that pay “operating income” as opposed to pure royalties.  The UBI risk applies both to inter vivos gifts and to bequests.  Sometimes, careful consultation with the donor/testator in the planning stages can address these issues.  Even when that is not possible, good after-the-fact tax counsel can often find ways to minimize tax-related consequences.
  7. While a taxed gift is not as valuable as a tax-exempt donation of the same item, it is sometimes in the charity’s best interest to accept an asset that will produce UBI. Deductions can often reduce UBIT, and at the end of the day, it is sometimes better to accept a gift with tax baggage than to reject it entirely.
  8. It is rare for a charity to initiate a business activity that produces UBI. When a charity voluntarily gets into a “business,” it is often an activity that is intertwined with its exempt purpose and therefore not subject to UBI.  Here are examples:
    1. A nonprofit halfway house operated a furniture store to provide transitional employment to recovering addicts. INCOME NOT SUBJECT TO UBIT.
    2. A museum gift shop sells books and cards containing reproductions of, and scholarship about, items in its collection.  INCOME NOT SUBJECT TO UBIT.
    3. The same gift shop also sells tourist guides for the city, phone chargers and raincoats. INCOME FROM THOSE ITEMS PROBABLY SUBJECT TO UBIT. (Yes, revenue streams within the same business may have different tax consequences.)
    4. A nonprofit art school sells items created by its students. INCOME NOT SUBJECT TO UBIT.
    5. A nonprofit senior citizens’ center sells large appliances and installation services to its clientele. INCOME LIKELY SUBJECT TO UBIT.

The bottom line is that while all charities need to be aware of the possibility of UBI, it is not a matter of such pervasive concern as to hamper a gift cultivation program.  Beyond the general concepts elaborated in this article, there is a substantial body of law relating to exemptions from UBIT.  Any fundraiser or bequest manager facing a substantial UBI question should consider retaining expert tax counsel to achieve the best outcome.