Tip-Toeing Through a Mine Field

How To Identify Unrelated Business Income
Unrelated business income (UBI) can cause your nonprofit substantial problems if you don’t know how to recognize it. In short, nonprofits must pay unrelated business income tax (UBIT) on income generated by activities not substantially related to its tax-exempt purposes, not regularly performed or not specifically exempt. Failure to abide by UBIT rules cannot only trigger tax penalties; it can actually jeopardize your tax-exempt status. Let’s take a look specifically at perilous situations that museums might face.

UBIT Basics
First, let’s understand why the law exists and how it operates.  As you know, The Internal Revenue Code grants exemption from income tax to several types of nonprofit organizations because these organizations serve a public purpose and take the place of the government in providing certain services.  UBIT rules are intended to avoid exemptions in business areas that would promote “unfair competition” by nonprofit organizations.  Taxes are imposed on the profits that result from unrelated business activities at the same rate that businesses pay.

The Rules
Much of the rules governing UBIT are derived not from direct legislation but rather by IRS interpretations or regulations.  This occurs because no piece of legislation can possibly address every unique situation.  Therefore, in seeking guidance for UBIT you need to understand past cases, IRS regulations and interpretations in addition to the UBIT laws.  Not surprisingly, the IRS found massive misunderstanding of the rules.

What are the rules?  An exempt organization is subject to income tax on the net income from activities if these activities:

• Are not substantially related to its exempt purpose;

• Are regularly carried on, and

• Do not meet one of these other specific exemptions:

• Activities that are performed solely by volunteers without compensation.

• Activities that are carried on primarily for the convenience of an organization’s members, students, patients, officers or employees,

• Activities that consist of selling items that have been contributed to the organization,

• Distribution of low-cost articles by a charity (items with a cost not in excess of $7.10 – this amount is indexed for inflation),

• Conventions or trade shows,

• Bingo carried on by nonprofit organizations,

• Renting mailing lists or donor lists to another 501(c)(3),

• Research conducted for governmental agencies, by a college or university or by an organization that does primary fundamental research and makes its findings available to the general public, and

• Finally, there is a $1,000 specific exclusion.

Recognize UBI
So what qualifies as UBI? That question can be answered only by examining your specific circumstances. However, to give you a general idea of what activities may result in UBIT, here are a few examples. (Please note that even if your circumstances are similar, your tax treatment may differ from the examples.)

Membership list sales. A tax-exempt educational organization regularly sells membership mailing lists to business firms. This activity doesn’t contribute significantly to a nonprofit’s tax-exempt purpose and therefore is an unrelated trade or business.

The IRS uses this as an example, but the Sierra Club is just one of many organizations that have continued to sell their member lists to commercial businesses. Because this income was treated as royalty earnings, it was exempt from UBIT, and the Sierra Club has prevailed over the IRS in tax court. Sales or rentals to other nonprofit organizations are exempt from UBI as well.

Museum greeting card sales. A museum that exhibits modern art sells greeting cards displaying printed reproductions of selected works. Each card is imprinted with the artist’s name, descriptions of the work and the museum’s name. The museum sells the cards at quantity discounts to retail stores and through a mail-order catalog that is advertised in magazines and other publications. As a result, the museum sells a large number of cards at a significant profit.

The museum is exempt as an educational organization based on its ownership, maintenance and public exhibition of works of art. The card sales help the museum achieve its exempt educational purposes by enhancing public awareness, interest in and appreciation of art. The cards may encourage more people to visit the museum to share in its programs. Yes, the cards are promoted and sold in a commercial manner at a profit and in competition with commercial greeting card publishers; but that doesn’t alter the fact that the activity is related to the museum’s exempt purpose. Therefore, the sales activities aren’t an unrelated trade or business.

Museum shop general sales. An art museum maintained and operated for the exhibition of American folk art operates an on-premises shop that sells:

1.  Reproductions of works in the museum’s own collection and reproductions from other art museums (prints, postcards, greeting cards and slides),

2.  Metal, wood and ceramic copies of American folk art from its own collection and similar copies of objects from other artwork collections,

3.  Instructional literature and scientific books and souvenir items concerning the history and development of art and, in particular, of American folk art, and

4.  Scientific books and souvenirs of the museum’s home city.

The shop also rents originals and reproductions of its paintings. All such reproductions are imprinted with the name of the artist, a description of the work and the museum’s name.

To determine if sales are related to the exempt purpose, you must examine each line of merchandise separately. Selling or renting reproductions and copies from the museum’s own collection and other sources contributes to the museum’s purpose. How? By making art familiar to a broader public audience and enhancing an understanding and appreciation of art. The same is true for the sale of art-related literature. Therefore, these activities aren’t an unrelated trade or business.

On the other hand, the sale of scientific books and city souvenirs has no causal relationship to art or to artistic endeavor and, therefore, doesn’t contribute importantly to furthering the museum’s exempt educational purpose. Granted, selling some of these items could, under different circumstances, be considered related to the exempt educational mission of another exempt educational organization; but that fact doesn’t change this conclusion. In addition, selling these items doesn’t change the museum’s identity as a trade or business merely because it also sells trinkets that don’t help it accomplish its exempt function. Therefore, these sales are an unrelated trade or business.

Museum cafeteria sales. An exempt art museum operates a cafeteria, dining room or snack bar the museum’s staff, employees and visitors can use. These facilities help attract visitors and encourage them to spend more time viewing the museum’s exhibits without leaving the premises. These concessions also allow the museum staff and employees to remain in the museum longer. Thus, the eating facilities contribute to the museums exempt purposes and aren’t unrelated trade or business.

Advertising Revenue. Most advertising revenue is taxable as unrelated business income unless it is not regularly conducted. Advertising will be subject to tax even when related products or services are advertised.

Corporate Sponsorship. Corporate sponsorships, which are in fact advertising, result in unrelated business income. Regulations make it clear that when a corporate sponsor’s product is displayed at a sponsored event, UBI will not result unless the sponsor’s product is compared with its competition.

Debt-Financed Real Property. Internal Revenue Code Section 514 imposes tax on debt-financed real property. Rentals of personal property are also subject to UBIT. The debt-financed portion is based on the relationship of average debt to average basis. In the case of sales of debt-financed property, the highest debt during the previous year is compared with basis to determine the taxable portion. The debt-financed income rules also apply to other assets, such as securities, that are acquired with debt.

Is Extra Income a Bad Thing?
Extra income from UBI can benefit your nonprofit because the unrestricted cash flow will help it perform its mission. But beware of the potential tax liabilities that accompany such revenue. Also, realize that concerns about public support status arise when a nonprofit lets its UBI exceed one-third of its total income. Take heart, though. An alternative exists when you find you have too much of a good thing. You can always form a taxable subsidiary. Taxes don’t go away, but the threat to your public charity status will. Call us for specifics or to devise other strategies to help you avoid UBI.