Managing Unrelated Business IncomeSeptember 01, 2010
By Reed W. Risteen, CPA
The recent IRS survey of 400 institutions of higher education regarding their identification and reporting of unrelated business income (UBI) causes us to reflect on what constitutes UBI for non-profit organizations.
The IRS defines UBI as income from a trade or business regularly carried on by a non-profit organization that is not substantially related to the performance by the organization of its exempt function. However, it is important to note that simply using unrelated income to support the organization's exempt function does not make that income exempt from taxation. Against this broad definition of taxable income are a number of specific income exclusions which include investment income, sales of donated items and gains on the sale of capital assets, among others.
The most common sources of UBI are:
- Rental income received on debt-financed property;
- Use of exempt property for nonexempt purposes;
- Advertising income;
- Pass-through of UBI generated by partnerships in which the non-profit is a partner; and
- Income from other nonexempt activities.
Below is a detailed look at each of these common UBI sources:
Rental income – If a non-profit organization owns real estate with a mortgage on it, and leases all or a portion of it to another party, the rental income is generally considered UBI. The non-profit organization is only taxed in proportion to the amount of debt on the building as compared with the building's book value. If the lessee is another non-profit organization whose mission is similar or complementary to the lessor's, the lessor may be able to demonstrate that the income is related to its exempt purpose and is not UBI. Leasing of real estate by non-profits where that is their exempt purpose is not UBI. Generally speaking, though, rental of personal property is usually considered to be UBI.
Use of exempt property for non-exempt purposes – For example: If a school operates a tennis club during the summer using tennis courts and dressing rooms that are used during the rest of the year for its exempt education purpose, that income is UBI if the club were operated by school employees. However, if the school were to rent the facilities to a commercial operator, the rental income would be subject to the rental income rules above and would not be considered UBI if the facility is not debt-financed.
Advertising income – Advertising sold by trade and professional associations that publish magazines or other periodicals is generally considered to be UBI. Advertising is defined as messages containing self-laudatory language, endorsements and inducements to purchase goods or services. Advertising does not include "sponsorships" in which businesses support an event and their name is recognized, but there is no inducement to purchase.
UBI incurred by pass-through entities – Although dividends, interest and investment gains are specifically excluded from UBI, some non-profit investments are in the form of ownership interests in partnerships. To the extent these partnerships engage in debt-financed rental or other UBI activities, the UBI retains its character when passed through for tax purposes to the partners. Partnerships report their tax attributes to their partners using Schedule K-1, which has a place for reporting UBI. It is important to retain all Forms K-1 received from partnerships so that UBI is properly identified and reported.
Income from non-exempt activities – Other non-exempt activities may include fees for providing administration services or maintaining accounting records for other non-profit organizations. The fact that the services are provided to a non-profit organization does not mean that the revenue received is exempt from UBI classification.
UBI is identified on Form 990, and is reported and computed on Form 990T. Expenses incurred to earn the revenue are deductible against the UBI, and there is a $1,000 exemption as well. Corporate tax rates are applied to the net taxable amount, and UBI earned in Connecticut is also subject to Connecticut tax and is reported on Form CT990T.
The above guidance is general in nature and does not cover all situations or potential sources of UBI. When working with a firm to prepare your organization's returns, make sure you identify for them any UBI or potential UBI.