Unrelated Business Income Tax

nonprofit tax services Northern VANot-for-profit organizations are generally exempt from income tax for their activities related to their exempt purposes.  However, some activities conducted by not-for-profit organizations may be subject to unrelated business income tax even if the income is used to further the organization’s exempt purposes.

What is and is not subject unrelated business income tax?

An exempt organization that has income of $1,000 or more from an unrelated trade or business that is regularly carried on must file an exempt organization business income tax return (IRS Form 990-T, Exempt Organization Business Income Tax Return).  Any unrelated business income may be offset by any allowable deductions which are directly associated with the unrelated business income.

All of the following three requirements must be met for income from an activity to be subject to unrelated income tax:

  1. The activity is a trade or business.
  2. The activity is regularly carried on.
  3. The activity is not substantially related to the organization’s exempt purpose.

If any of the above three requirements are not met, the income generated from the activity by an exempt organization is not unrelated taxable income.  Furthermore, the Internal Revenue Code provides specific exceptions that the certain trade or business conducted by an exempt organization is not an unrelated trade or business even if the three requirements are met.  Those exceptions include, but are not limited to, the following:

    1. Any trade or business in which substantially all the work is performed without compensation, such as an activity where substantially all staffing is provided by volunteers (“substantially all” is generally considered as 85 percent of all the work).
    2. Any trade or business which is primarily for the convenience of its members, students, patients, officers, or employees, such as parking fees charged for the use of a parking garage adjacent to a hospital or university for the convenience of its patients, students, or visitors or selling work-related clothes and items through vending machines for the convenience of its members or employees.
    3. Any trade or business which is selling of merchandise, substantially all of which has been received by the organization as gifts or contributions (“substantially all” is generally considered as 85 percent of the merchandise).

 

  • Qualified sponsorship payments received by an exempt organization from a business entity are non-taxable.  Qualified sponsorship payments are defined in IRC Section 513(i)(2) as those payments “made by any person engaged in a trade or business with respect to which there is no arrangement or expectation that such person will receive any substantial return benefit other than the use or acknowledgement of the name or logo (or product line) of such person’s trade or business in connection with the activities.”  Therefore, if an exempt organization receives sponsorship payments from a business entity by merely listing its business logo or its product line in an annual conference is not subject to unrelated business income tax.

 

  1. Interest, dividends, and similar passive investment income.  The exclusion also applies to business interest charged on overdue open account receivables.  However, all income from debt-financed property is subject to unrelated business income.
  2. Gains or losses from disposition of property or from investment activities are generally excluded from unrelated business tax, unless the property is a debt-financed property or is S Corporation stock.  This exception does not apply to any inventory held by an exempt organization.
  3. Royalties are generally excluded from unrelated business taxable income unless they are derived from debt-financed property (see Rental Income below), they are mineral royalties, or if there are services performed in exchange for the royalty payment.  As always, some exceptions apply.
  4. Rent derived from lease of a real property normally is non-taxable to an exempt organization with some common exceptions (see below).
  5. Generally, research income is excluded from unrelated business income if it is “derived from research for (A) the United States or any of its agencies or instrumentalities, (B) or a state or political subdivision thereof . . . .  In the case of a college, university, or hospital . . . .  In the case of an organization operated primarily for the purposes of carrying on fundamental research, the results of which are freely available to the general public.” (IRC Sections 512(b)(7)-512(b)(9)).

What are common types of unrelated business income?

Advertising Income

Generally, advertising published in its journals or periodicals is a recognized form of commercial advertising services, and the income derived from advertising is normally taxable.  However, Rev. Rul. 76-93 clarified that unrelated business income tax does not apply to advertising where the advertiser does not expect more than a negligible commercial benefit.  Therefore, income derived from mere listing of names of business entities without direct purposes of selling any product or services is not subject to unrelated business income tax.

Rental Income from Debt-Financed Property

Rent derived from debt-financed property is taxable.  Debt-financed property defined under Internal Revenue Code section 514(b)(1) as any property “held to produce income and with respect to which there is an acquisition indebtedness at any time during the taxable year” unless substantially all the use of the property is substantially related to the exempt purpose.  Therefore, if an exempt organization receives rent income and the leased property is subject to mortgage, the rent is subject to unrelated business income tax.

Rental Income from Personal Property

Rent derived from personal property is normally taxable.  However, if the personal property is leased in conjunction with real property, and rent received is incidental compared to the total rents received or accrued under the lease, the rent is excluded from unrelated business tax.  Generally, if more than 50 percent of the total rent received or accrued under the lease is attributable to personal property, the rent is subject to tax under Internal Revenue Code section 512(b)(3)(B).

Rent Calculated as the Percentage of Income or Profits of Lessee.

If an exempt organization receives rent payments which are calculated based on income or profits of lessee, the rent is subject to unrelated business income tax.

The correct interpretation of tax laws with regard to unrelated business income tax could result in a big difference to your tax situation.  If you believe you may have unrelated business income or have questions regarding unrelated business income tax, please contact us for details.