Understanding UBIT

A Comprehensive Overview
Understanding the complex unrelated busi-ness income tax (UBIT) requirements is a necessity for running your organization. Mis-interpretation of UBIT rules can affect not only your payment of taxes but also your public charity status — this income does not count as public support — and even your exempt status.

UBIT Basics
First, let’s understand why the law exists and how it operates. The Internal Revenue Code grants exemption from income tax to several types of nonprofit organizations. Exemptions exist because these organizations serve a public purpose and take the place of the gov-ernment 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.

UBIT laws developed like most tax laws, starting with the adoption of legislation cov-ering what is taxed. But the legislation needed to be interpreted because every set of circum-stances is different — consider the unique-ness of any unrelated activities you conduct. So, the Internal Revenue Service (IRS) issued interpretations, or regulations. The laws were further interpreted by tax courts that settled disputes.

Surprisingly, for all of the possibilities these rules must cover, neither the tax code nor the regulations are extensive. So when seeking guidance, many organizations had to look at how past cases were settled. Considering these circumstances, the IRS found massive misunderstanding of the rules when it per-formed a statistical sample audit of UBIT in the early 1990s.

The Rules
An exempt organization must be operated primarily for its exempt purpose, but it is permitted to carry on certain unrelated busi-ness activities without jeopardizing its exempt status. The exempt organization is subject to income tax on the net income from these activities if the activities:

• Are not substantially related to its exempt purpose,

• Are regularly carried on, and

• Do not meet one of the other specific exemptions listed below.

The income tax due is calculated almost iden-tically to that of for-profit sector organiza-tions — such as corporations or trusts — and the tax rates are the same.

Excluded Activities
Let’s take a closer look at the two major types of excluded activities.

Substantially related. If an activity signifi-cantly contributes to accomplishing the pur-pose and the scope of activities for which the exemption was granted to the organization, then the activity is substantially related. But note that your need for money to carry on your activities is not enough to relate an activity to its exempt purpose.

Not regularly carried on. The regulations give examples of activities that are carried on regularly (one or two days a week throughout the year or for a period of a few months each year), and therefore subject to UBIT. The regulations also give examples of activities that are not regularly carried on, such as sin-gle annual events and events carried on annu-ally for a two-week period.

In addition to income from related and occa-sional activities, specifically excluded from the definition of unrelated trade or business is income from:

•  Activities that are performed solely by volunteers without any 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 organiza-tions,

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

• Research conducted for gov-ernmental agencies, by a college or uni-versity 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.

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

Cost Allocation
Expenses deductible against an organization’s unrelated business income must be directly connected with and have a proximate and primary relationship to the revenue. Indirect costs can be allocated on a basis that is rea-sonable and consistent.

Corporate Sponsorships
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, unrelated business income will not result unless the sponsor’s product is compared with its competition.

Also, most passive income is excluded from the computation of unrelated business income,  including:

• Dividends,

• Interest,

• Royalties,

• Gains from the sale of property, and

• Real property rental income.

Note: Social clubs exempt under Section 501(c)(7) do not exclude passive income from unrelated business income.

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 prop-erty, 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.

Play It Safe
Do not risk tax penalties, your public charity status or possibly even your exempt status by unintentionally misinterpreting these complicated laws. If you are unsure about the tax laws affecting your unrelated business income or have any other questions, please call us. We will be happy to help.