Revenue generated by nonprofits is generally tax-exempt, but income generated from activities inconsistent with an organization's tax-exempt purpose may give rise to tax obligations. In a recent webinar, attorneys from Venable's Nonprofit Organizations Practice Group presented an overview on how various revenue-generating activities by nonprofits can trigger unrelated business income tax (UBIT) obligations. During the program, George Constantine and Anne Gerson offered ways to minimize that risk and outlined the typical sources of taxable income for nonprofits, along with common pitfalls and questions.
As long as the profits from revenue-generating activities are going to support the work of a nonprofit, why isn't that revenue automatically tax exempt?
Currently, there is a three-prong test for determining whether income is considered unrelated business taxable income (UBTI) and therefore taxable. Before addressing the UBTI test, organizations should confirm that their exempt status is still valid and that their overall activities are still appropriate for an exempt organization. Additionally, organizations should be aware that the regulations clearly articulate that a focus of the UBIT regime is eliminating unfair competition between nonprofits and other businesses. Taxable activities undertaken by tax-exempt organizations are therefore an area of focus in audits.
The three prongs of the UBIT Test are as follows:
- Determination of whether an organization is a trade or business and carries out activities for the production of income from the sale of goods or performance of services. This can be analyzed using profit motive – is the trade or business operated in a commercial manner? Even if the business is not making a profit but is operated in a commercial manner, it passes this test.
- Determination of whether activities are regularly carried on. The Internal Revenue Service (IRS) will examine the manner in which activities are pursued and undertake comparison to similar activities by for-profit business. Fundraising events are excluded from this test because they're considered occasional and sporadic, even if they're annual events.
- Determination of whether activities are substantially related to an organization's exempt purpose. This prong is the most difficult to analyze because it is a subjective analysis of particular activities, the application of which can be different for organizations with different exempt purposes. The IRS may fragment income into related and unrelated buckets to allow for an accurate imposition of tax only on income generated from unrelated activities.
How is advertising income treated in relation to UBIT?
Advertising income is almost always treated as taxable because most advertising, such as advertisements in periodicals or paid acknowledgments, is not substantially related to an organization's exempt purpose. There are detailed rules for determining net income from advertising for tax calculations; advertising costs can be deducted to reduce tax liability.
What are some other activities that are likely taxable?
- Consulting services. The IRS views tailored or focused advice particular to a recipient as inconsistent with a tax-exempt purpose. Broad educational activities are different from consulting, however, and the payment of management services among tax-exempt organizations (for example, through a shared services arrangement) is unlikely to present significant UBIT exposure.
- Job listing services. Income from the sale of job listings is generally viewed as unrelated to tax-exempt purposes.
- Retail, food service, job training, community improvement. When evaluating these types of activities, the IRS looks for meaningful evidence of public benefit to outweigh private benefit to a business or organization. Establishing an underlying purpose that is beneficial to the community and documenting it will maximize that public benefit and minimize unfair competition allegations.
- Member categories in associations that essentially trade dues for marketing benefits. Offering membership categories that induce members to pay their dues for specific benefits, like free advertising or other business perks, may be viewed as generating taxable income.
- Sale of clothing and logoed merchandise. This excludes clothing made in a manner consistent with an organization's mission and exempt purposes. In some discrete cases, logos can be considered substantially related to an organization's mission, but nonprofits should seek legal counsel before trying to exclude income from the sale of logo merchandise from UBIT.
What are the Tax Code exceptions for income related to UBIT?
- Section 512(b) of the Internal Revenue Code outlines types of income that are exceptions to UBIT and are therefore not taxable, even if they would otherwise be taxable under the UBIT test
- Investment income
- Capital gains
- Research-generated income
- Income from religious services
- Exceptions to this list include earned income from shares in an S-Corporation or from debt financing, and/or participation in a partnership.
- Section 513 of the IRC outlines certain activities that are not classified as a "trade or business" and therefore cannot generate taxable income under the UBIT test, including
- Income from activities where substantially all of the work is conducted by uncompensated volunteers
- Sale of donated merchandise
- Rental of mailing lists from one exempt organization to another
- Sending low-cost items with fundraising solicitations
- Bingo game revenue
Looking specifically at royalties, how can they impact UBIT?
There is no statutory or regulatory definition of a "royalty," although case law has established that it is generally considered to be payment for intangible property rights. A royalty cannot be considered a payment for services in any part beyond a small amount and still fit the exception from UBIT for royalty income. While an intangible property right may generate royalty income, it loses that status if it is coupled with any level of services beyond a "de minimis" level. Quality control of the use of its intellectual property by the nonprofit is allowable and is typically not considered the provision of a service.
- A nonprofit cannot help a for-profit deal with customers or engage in any promotional activities; the license of its name and logo to a for-profit cannot be coupled with the management of the sale of goods or services.
- A separation of payments or division between payment for services provided by the nonprofit and royalty revenue helps in tracking taxable income and protecting the tax-exempt nature of royalty income.
Can commercial co-venture arrangements have UBIT implications?
Commercial co-venture (CCV) arrangements (also known as cause-related marketing) are heavily regulated under state law because they straddle fundraising and advertising. CCVs are an arrangement between a charity and a commercial entity to raise money for the charity.
- If the charity has a passive role, income from CCV is considered public support and is exempt from taxation.
- If the charity takes an active role, UBIT may be triggered.
- Payments may be bifurcated, as with certain royalty arrangements. Alternatively, the organizations may choose to set up the arrangement under the statutory corporate sponsorship exception. Under this exception, qualified sponsorship payments are excluded from taxable income as long as no substantial return benefits are allowed to the sponsor. Use or acknowledgment of the sponsor's name or logo is allowed, and a small amount of disregarded benefit (under 2% of the value of the sponsorship payment) may be received by the sponsor.
What are considerations around conventions and trade shows?
The tax code allows for tax exemption for certain activities related to trade shows or conventions. Qualified convention and trade show activities include exhibit space rentals, with the result that income generated from these activities would not be taxable. For-profit companies are investing in trade shows, and some nonprofits involved with these ventures are receiving favorable rulings from the IRS – meaning that revenue that flows to the nonprofit from a properly structured joint venture with a for-profit company is not taxable.
What recent developments should nonprofits be following?
The Tax Cuts and Jobs Act introduced three changes to a nonprofit's calculation of its taxable income:
- Taxable income generated by parking and fringe benefits – this has been repealed by Congress
- Establishment of excise tax on compensation over $1 million
- A requirement that income be siloed into business activity classifications; income and deductions can no longer be aggregated across activities. Recent proposed regulations clarify that business categories for this purpose can be determined using the first two digits of NAICS codes. There are special rules for a variety of income categories, so nonprofits should follow these rules carefully and seek the advice of counsel if they have questions about implementing these new provisions. Additionally, net operating loss (NOL) guidance now overlaps with the CARES Act, which repealed limitations for NOLs
How can nonprofits account for and pay UBIT?
An obligation to pay is triggered for UBIT in excess of $1000 and is recorded on a Form 990-T. This document is available for public inspection for 501c3 organizations. If Forms 990 report Unrelated Business Income (UBI) but a Form 990T is not filed, that may result in an audit. Nonprofits should pay careful attention to their UBIT obligations. On audit, a nonprofit may lose its exempt status if the IRS finds it generates too much unrelated business income relative to its exempt activities.