THE INS AND OUTS OF UNRELATED BUSINESS INCOME Nancy Kirchner, CPA Tax Manager Blue & Co. LLC
Agenda Background and basics of UBI Exclusions from UBI Potential UBI generating activities How much is too much? Reporting UBI
Reasons for UBI Rules Activities that are unrelated to an exempt organization s primary purposes should be segregated from related activities. Net income from unrelated activities is taxed in the same way that net income earned from forprofit corporations is taxed. IRS requires that entity be operated exclusively for charitable purposes
Identification of Unrelated Trade or Business (Activity must meet all three) 1. Activity is considered a trade or business for the production of income from selling goods or performed services 2. Activity is regularly carried on, and 3. Activity is not substantially related to exempt purpose
Trade or Business Commerciality Test Operated in a competitive and commercial manner Similar to a for-profit commercial business Profit Motive Was the activity entered into with the dominant hope and intent of realizing a profit? Fragmentation Rule Activity is carried on within a larger group of similar activities
Regularly Carried On Frequency and Continuity of Activities May be regularly carried on even though it is conducted a short period of time Seasonal activity can be regularly carried on Carried on in a similar manner to a for-profit organization
Not Substantially Related Must contribute importantly and bear a substantial relationship to the achievement of exempt purpose to be substantially related Doesn t qualify solely because its income is needed or used to fund the exempt organization
Activities Excluded (EVEN IF ALL THREE COMPONENTS ARE MET) Activities staffed with volunteers providing substantially all the work Activities of 501(c)(3) entities, primarily for the convenience of Members Students Patients Officers Employees
Activities Excluded Sale of merchandise all of which substantially was donated or gifted Conventions and Trade Shows Distribution of low cost articles
Income Specifically Excluded Dividends, interest, annuities and other investment income Royalties Rental income from real property Gains/losses from disposition of property Income from Research Qualified sponsorship payments Watch out for exceptions!
Income Excluded Royalties: Payment relates to use of a valuable right Affinity Card Income IRS requires entity to separate payments for intangible assets and for services Agreement should state it is not a JV NFP should avoid providing anything other than inconsequential services Party paying royalty should maintain books and records
Income Excluded Qualified Sponsorship Payments: If deemed to be a Qualified Sponsorship Payment, the contributions are not considered UBI. A Qualified Sponsorship Payment is one in which the sponsor does not receive any arrangement or expectation of a substantial benefit.
Qualified Sponsorships Substantial return benefit includes: Advertising An exclusive provider arrangement Providing facilities, services, or other privileges to payor or persons designated by the payor
Qualified Sponsorship Permissible Activities: Acknowledge the corporation s name, logo, and general contact information Value-neutral displays of the sponsor s products/services
Exceptions to Income Exclusions Investment income interest, dividends, capital gains Not excluded from UBI if: Income from debt financed property Interest or annuities from a controlled organization Income earned by social clubs Investment income on margin
Exceptions to Income Exclusions Rental of real estate Not excluded from UBI: Providing services other than customary rental Providing space and tables, chairs, decorations, etc. Parking rental is generally taxable Rental income from controlled organizations is taxable Debt-financed rental is generally taxable Unless 85% or more used in exempt purpose
Potential UBI-Generating Activities Advertising Corporate Sponsorships Trade Shows Sales of Merchandise and Publications Royalty/Affinity Income Investments in Partnerships and LLCs Pharmacy Catering
Advertising Any language which is an inducement to purchase a product or service Qualitative or comparative language Price information Indication of savings Endorsements
Advertising Nontaxable Advertising: No code or regulations to define it for UBI Negligible commercial benefit Produced by activity not regularly carried on Substantially related to exempt purpose Conducted substantially by volunteers
Advertising & Internet Activities Link/banner exchanges with other online organizations may result in taxable advertising income Based on facts and circumstances Advertising or simply providing additional information about organization s exempt purposes Exempt organization should monitor content of linked websites
Trade Shows Qualified Trade Show income excluded from UBI: Annual conventions and meetings Trade shows to display member products Education seminars & conferences Qualifying organization 501 (c)(3), (4), (5), or (6)
Sales of Merchandise Unrelated, Excluded or Related? Unrelated Examples: University book store items sold to Alumni University or Hospital cafeteria providing catering services to other businesses Hospital s pharmacy sales to non-patients, nonemployees
Sales of Merchandise Excluded Examples: Non-educational items from University bookstore sold to students at a University (convenience) University catering to University departmental meetings (convenience) Hospital s pharmacy sales to employees (convenience) Sales where volunteer labor is a material factor (volunteer) Sales of merchandise that was donated
Related Examples: Sales of Merchandise Educational materials from a University s book store sold to students at a University Hospital pharmacy sales to patients Church s sale of religious CDs, Videos, Books
Investments in Partnerships and LLCs General Rule: income from partnerships & LLCs carrying on an unrelated trade or business is taxable. If activity is related to exempt purpose of organization, not UBI If taxable if the exempt organization conducted the activity directly, it is UBI
Controlled Entities General Rule: interest, annuities, royalties and rents received from or accrued by a controlled organization is UBI. Control Defined: Corporation: Ownership of more than 50% of the stock Partnership: Own more than 50% of profits, interests, or capital interest Other Entity: Own more than 50% of beneficial interest
Controlled Corporation Controlled entity is tax-exempt Net unrelated income or loss is amount of controlled entity s unrelated business taxable income or loss Controlled entity is taxable Calculate UBI as if it were tax-exempt
How Much UBI is Too Much? No bright line test Facts and circumstances Internal Revenue Code operate exclusively for charitable purposes IRS Regs not more than an insubstantial part of activities are not in furtherance of an exempt purpose General comfort level is no more than 10 20%
Preparing for UBI Scrutiny Have all sources of UBI been identified? Has your organization acquired interest in alternative investments, such as partnerships or LLCs? How reasonable is your organization s allocation of expenses to unrelated business activities? If your organization is in a taxpaying position, does it calculate and make timely quarterly deposits of estimated UBI tax?
Reporting UBI Required to file 990-T in addition to regular Form 990, 990-EZ, or 990-PF Filed if organization has more than $1,000 of gross income from unrelated trade or business Quarterly estimated tax payments required if tax owed is expected to be $500 or greater 990-T is open for public inspection
Reporting UBI - Deductions Consider three categories when applying expenses as deductions to UBI. Expenses incurred solely from the conduct of an unrelated business generally qualify for deduction Salaries of full-time personnel employed to carry on an unrelated business qualify for deduction The depreciation of a building used entirely in the conduct of that business
Reporting UBI Dual Use Use a reasonable allocation between shared costs The portion of total expenses that are allocated is the amount directly connected and is deductible Expenses incurred in the conduct of an exempt purpose activity have no direct connection to unrelated trade or business so they aren t deductible
Allocable Expenses Depreciation Personnel costs Rent of dual-use space Utilities Maintenance
Reasonable Allocation Hours spent: to allocate payroll taxes, employee benefits and pensions Square footage: to allocate depreciation, maintenance, utilities and other fixed expenses Gross receipts: variable expenses, such as cost of goods sold
Allocation Do s and Don ts Do: Use a consistent method. Charge as direct costs all expenses that can possibly be identified with specific activities. Use floor plans and leases for square footage allocations. Keep all worksheets and records used to develop cost allocations. Review and revisit your allocation method and its supporting rationale every 3 to 5 years and document.
Allocation Do s and Don ts Don t: Allocate on a ratio of gross income under most circumstances. Allocate membership, development and fund-raising costs. These should be direct costs. Allocate legislative or lobbying costs. These should be direct costs. Use the same allocation percentages year after year.
General IRS Assistance IRS Web Site Federal Tax Questions Forms & Publications www.irs.gov 800-829-4933 800-829-3676
Resources Pub 526 Charitable Contribution Pub 557 Tax-Exempt Status for Your Organization Pub 1771 Charitable Contributions-Substantiation and Disclosure Requirements Pub 3079 Gaming Publication for Tax-Exempt Organizations Pub 4220 Applying for 501(c)(3) Tax-Exempt Status FASB 958-720 Accounting for Costs of Activities of Not-for Profit Organizations and State and Local Governmental Entities That Include Fund Raising
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