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Nonprofit Unrelated Business Income Tax (UBIT) Tips and Insights

January 13, 2021
Nonprofit Unrelated Business Income Tax (UBIT) Tips and Insights

Nonprofit executives often brood when the UBIT acronym surfaces.  Unrelated business income tax is a bugaboo and some professionals – lawyers and accountants – are only too willing to err on the side of caution, finding UBI when such a conclusion may not be entirely necessary.  What’s an executive to do?  Breathe deeply, relax and self-administer a little Unrelated Business Income Taxtherapy.

In a nutshell, the Unrelated Business Income Tax (UBIT) conclusion may often be avoidable and, even if it’s not, it is not the end of the world.  Read on.  By the way, “UBIT” refers to the tax, and “UBI” refers to the income that is taxed.

Tips and Insights for Nonprofit Unrelated Business Income Tax (UBIT)

Unrelated Business Income (UBI) is not fatal

Unlike the dreaded “private inurement” where even an errant dollar could theoretically lead to revocation of exemption, UBI is not evidence of any kind of misconduct.  In fact, in larger charities, especially those with multiple funding sources, one might expect to find some unrelated business income.

There is no hard-and-fast limit on Unrelated Business Income (UBI)

To be sure, excessive amounts of UBI can be an indication that a charity is no longer functioning as a charity.  What’s excessive?  As is almost always the case with IRS, no bright line exists.

A high percentage of UBI can be an indicator of excessive non-exempt activities.  Charities are only allowed an “insubstantial” amount of such activities.  Of course, it is often difficult to quantify activities, and quite easy to quantify UBI.  The IRS uses percentage-of-UBI as a proxy to detect non-charitable activity.  If a charity’s UBI is less than 10% of its revenue, IRS will likely not be interested.  If it’s 50%, IRS will be very interested.  In between those numbers, it’s anyone’s guess.

UBI is frequently created by careless paperwork

Unrelated Business Incomei s sometimes the unintended consequence of careless contracting.  Here’s how.   One of the prime sources of taxable income in the nonprofit world is the provision of advertising to corporate sponsors.  What counts as advertising is a complicated question, a good topic for a forthcoming posting.

Charities often blindly sign agreements requiring advertising-in-return-for-sponsorship.  Careful reading of proposed terms and conditions could eliminate that risk.   Many, if not most, sponsors will accept simple “acknowledgements” (which generally don’t create tax) in lieu of advertising.  It is simply a matter of good negotiation and a read-before-you-sign mindset.

UBI almost always starts with the lawyers or the accountants: Push Back!

UBI comes to a head at T-time.  Not “tee” time and certainly not “tea” time.  As part of the annual 990 filing, exempt organizations must disclose Nonprofit Unrelated Business Income Tax on the 990-T supplement to the main form.  The determination of whether income is UBI or not is often made by lawyers, accountants, or both.

In case you haven’t noticed, those who ply those trades are frequently . . . risk-averse.  No accountant or lawyer ever got in trouble for advising a charity to pay UBI.  No charity ever got in trouble for paying it, but many have gotten poorer!  Force your professionals to justify their positions, particularly with reference to the issues raised in the next three sections.

Not every business is an unrelated business

Some commercial-type activities carried on by charities actually relate to their exempt purpose.  In those cases, the “unrelated” business income question becomes moot.  The relationship analysis is an important one, and it is a big mistake to overlook this possible “escape” from UBIT.

The IRS has been willing to recognize the relatedness of profitable commercial undertakings that make an indirect but important contribution to the accomplishment of an organization’s exempt purpose.  For example, there are rulings finding that gift shops and cafeterias operated by nonprofit hospitals are “related” businesses because they contribute in an important way to realization of the exempt purpose of patient care.

The key appears to be the degree to which the commercial activity is integrated with clearly exempt functions.  The less integration, the more chance of unrelated business income.  A good example of this is the case where an exempt veterinary school ran an affiliated dog-boarding service.  The overnight guests were not doubling as “practice patients” for the students.   Revenue from the boarders was counted as UBI.  The reason?  Little connection between the (exempt) educational purpose and the kennel.

There is no Unrelated Business Income unless the business is “regularly” carried on

An important policy goal at the heart of the UBI rules is to keep exempt organizations from competing with for-profit companies.  Consistent with that, unrelated commercial activities that are “regularly” pursued are more likely to yield taxable income.  In many cases, IRS has found “intermittent” or “seasonal” activities, even though substantial, are not sufficiently regular.  Frankly,  the regularity rulings are perplexingly inconsistent.   The inconsistency is an opportunity:  it is often possible to find authority to support a position that a given undertaking is not pursued on the regular basis.  Absent regularity, there is no unrelated business income.

The list of exemptions for Unrelated Business Income Tax is long

There are numerous statutory exemptions from unrelated business income tax.  These all relate to certain income-producing activities that might facially appear to be “commercial” but are significant enough in the charitable world to be granted a pass from taxation.  Not surprisingly, these exemptions tend to be carefully defined and subject to limitations.  Nonetheless, no major UBI-or-not decision should ever be made without a glance at the exemptions.  A few of the most frequently used are those relating to:

  1. undertakings relying on volunteer labor for significant income production;
  2. facilities operated for the convenience of members, employees, etc. of a charity;
  3. businesses involving the sale of donated merchandise (e.g., thrift stores); and
  4. income generated from “qualified” sponsorship payments.

The bottom line is that there are numerous “escape” hatches from the characterization of an income stream as unrelated business income.  Every charity manager will want to explore the options before writing an unnecessary check to Uncle Sam.