The Law Offices of Erika E. Cole, LLC

Transcription

1 The Law Offices of Erika E. Cole, LLC 9433 Common Brook Road, Suite 208 Owings Mills, MD National Plaza, Suite 300 Oxon Hill, MD From: The Law Offices of Erika E. Cole, LLC; Erika E. Cole, Esq.; Candie C. Deming, Esq. Date: April 28, 2014 Re: Potential Tax Issues Related to Facility Rentals by Tax-Exempt Organizations Churches and other nonprofit entities have a long standing history of being good neighbors and good stewards with their facilities. It is common for a church to extend goodwill by letting neighborhood and community groups use church meeting rooms for a nominal fee. In today s economy, depending solely on Sunday contributions may not provide enough income for a church to pay its bills. A church may seek to increase its income by renting its facilities on days and times such facilities are not in use for church purposes. While rental income may provide financial benefits to a tax-exempt organization, there are some important tax pitfalls that must be considered. Organizations that enjoy federal 501(c)(3) income tax-exemption need to be sure that income from facilities rentals will not jeopardize that critical tax benefit. Tax-exempt organizations that have state real property tax exemption must also have clear understanding of what rental actions could negatively impact that state exemption. The purpose of this memo is to provide you with a general overview of both of these tax considerations. A. Federal Income Tax-exemption. In order for a nonprofit entity to maintain its federal 501(c)(3) tax-exempt status, it must, of course, comply with all IRS regulations. The issue raised by the rental of facilities is whether the rental income will be characterized as unrelated business income or UBIT and thus be taxable income pursuant to U.S. Code 511. While a tax-exempt organization is not prohibited from earning UBIT, all 1

2 such income must be properly and timely reported and any associated taxes on such income paid. Unfortunately, many tax-exempt organizations are not in compliance with this IRS regulation due either to the lack of any knowledge of UBIT or the failure to properly characterize business income as UBIT. The Internal Revenue Service ( IRS ) defines UBIT in Publication 598, Section 3 as the income from a trade or business regularly conducted by an exempt organization and not substantially related to the performance by the organization of its exempt purpose or function, except that the organization used the profits derived from this activity. Though income earned by the organization substantially related to its exempt purposes enjoys an exemption from income tax, UBIT must be reported using Form 990-T and income taxes must usually be paid on such income at the appropriate corporate rate. However, not all unrelated business income is considered by the IRS to be UBIT, and thus reportable and taxable. And, like many IRS regulations, the IRS does not lay out a clear path for the taxpayer to easily determine which income constitutes UBIT. I. Income Characteristics. There is no straight forward method to determine which business income is considered UBIT by the IRS. However, the IRS will look at the follows characteristics to determine whether income may be UBIT: a. Not substantially related An activity is not substantially related if such activity does not contribute importantly to accomplishing that purpose of the organization other than through the production of funds. The less related the activity is to the purpose for which the exempt organization was formed, the more likely that income from the activity will be considered UBIT. b. Regularly conducted If the income comes from an activity that is frequent and/or continuous, it is more likely to be considered unrelated. For example, an occasional church supper is not likely to be considered unrelated and thus not reportable business income because even though it may be competing with local restaurants, it is only conducted occasionally. c. Convenience of the Members If the trade or business activity is not substantially related 2

3 but is carried out for the convenience of the members, it is likely that the resulting income will not be characterized as UBIT. d. Amount of the income UBIT must be reported on form 990-T when the gross amount from unrelated business income is $1,000 or more in any given tax year. II. Exclusions. Include but are not limited to: a. Rent from real property: Income received from rent of real property is generally excluded as UBIT. However, there are some exceptions to this exclusion: 1) If the real property is debt financed, i.e, the property is held to produce income and the property has an outstanding acquisition indebtedness, rental income will be considered UBIT. However, if substantially all, that is, 85% or more of the property is used to further the tax-exempt purposes of a tax-exempt entity, rental income is excluded from classification as UBIT. 2) If the rental of the property includes services, the rental income will likely not be excluded from UBIT. 3) Note that rental income from personal property such as tables and chairs is not treated the same as rent from real property. Rental income from personal property (defined as anything that is not real property) will most likely be considered to be UBIT. 4) If rent is received from facilities that are used dually, that is, at least some of the time by the exempt organization in furtherance of its exempt purposes, the IRS will still look at how and to what extent the other activity contributes importantly to the accomplishment of the organization s exempt purposes. Additionally, when a facility is dually used, the expenses must be allocated accordingly: they cannot all be deducted from unrelated business income. b. Volunteer workforce: Income from any activity in which substantially all of the work is performed for a tax-exempt organization utilizing volunteer workers is not considered UBIT. 3

4 III. Wesleyan Entities. Every Wesleyan entity is unique and operates under differing circumstances. As such, there is no one answer to the question of whether income from the rental of facilities at Wesleyan entities will be considered to be UBIT. Each Wesleyan entity that rents out its facilities should consider the following: 1. What is the stated purpose (mission) of the entity? 2. Does rental of the entity s facilities further this stated purpose? E.g. If the sanctuary and hall are rented for the celebration of a wedding and the entity s purpose includes religious ceremonies, the facility use will be considered to be in fulfillment of the mission of the organization and, thus, not UBIT. 3. Is the rental conducted on a regular or only occasional basis? 4. Is the rental income from real property held for investment debt-financed? 5. Does the rental amount for real property include any services to be performed by the landlord? 6. Is the rental accomplished by all or mostly all volunteers? 7. Is the business income from an activity held for the convenience of the members? 8. Will the income from this unrelated business activity bring the organization s total of gross income from UBIT to $1,000 or more? B. State Property Tax-exemption As you know, state laws are unique to each state. Many states have laws that provide organizations with federal income tax-exemption 501(c)(3) the ability to apply for exemption from state real property taxes on real property owned by the organization and used in furtherance of that exempt organization s tax-exempt purpose. Most of these state statutes, however, also contain provisions that disqualify real property owned by a tax-exempt organization, that property not used to further the tax-exempt mission of organization. For example, if a church owns a residential property bequeathed to it, that property will only be included as exempt from real property taxes only if that property is used for church purposes, such as church offices, living quarters for a church minister 4

5 or some other church ministerial use. If, instead, the church does not make use the realty for church business, but rents it out, the church will most likely be required to pay real property taxes on that property. In fact, it does not matter whether the church has allowed a church member to use it rent-free - if it is not used for church purposes, it will not be exempt from real property taxation. The key to the determination on whether real property will be exempted from real property taxes is how the property is utilized, not on whether income is earned on the real property. If the real property is used to further the purposes of the tax-exempt organization, the property will be tax-exempt. In cases in which a property has mixed use, that is usage partly for tax-exempt purposes and partly for other non-exempt purposes, the specifics text of that state s statute should be consulted. Generally, however, if a property is utilized mainly in furtherance of the mission of the tax-exempt organization, it will likely be included as exempt from real property taxation with the church s other exempt properties. Conclusion: The rental of a church s facilities could provide a welcomed additional stream of revenue; however, there are significant tax consequences that must be considered. Prior to offering church facilities for outside rentals, a church should be mindful of whether such usage could disqualify the realty from real property tax exemption and whether UBIT might apply. The real property exemption is based on whether the property is used to further the tax-exempt purposes of the organization. The determination as to whether income is UBIT is based on correctly identifying income from unrelated activities and determining whether any exclusions apply. As a church s decision to lease its property could have significant financial and/or legal consequences, questions about whether rental income will trigger UBIT requirements or whether unrelated use will disqualify the property from real property tax exemption should be explored with a legal professional. The attorneys of The Law Offices of Erika E. Cole, LLC that prepared this legal information are licensed to practice law in Maryland and DC. Specific advice regarding the laws of other jurisdictions should be sought from counsel licensed in such jurisdiction. 5