Section Library
UBIT
Unrelated Business Income Tax
The primary objective of the unrelated business income tax is to eliminate a source of unfair competition by placing the unrelated business activities of exempt organizations on the same tax basis as that of for-profit enterprise. Therefore, the primary purpose of the unrelated business income tax provision is not to prevent competition for revenues between nonprofit and for-profit organizations, but to place such competition on equal footing from a tax standpoint.
Many organizations engage in some type of activity which is, to a degree, unrelated to the accomplishment of its exempt purposes. In some instances, the net income of such activities is subject to income tax. Basically, the unrelated business income tax provisions create two issues for tax-exempt organizations:
- Potential taxation of the net income of certain activities.
- In some instances, it is important to note that loss of exempt status due to more than an insignificant amount of unrelated activities is a function of the exemption statutes and not of the unrelated business income tax provisions.
The net taxable unrelated business income of an exempt organization is subject to regular corporate income tax rates.
Current corporate tax rates are:
- 15% of the first $50,000 of taxable income;
- 25% of the next $25,000 of taxable income;
- 34% of taxable income in excess of $75,000; and
- income in excess of $100,000 is subject to a surtax of 5% until the tax benefit of the lower rate structure is recovered ($11,750 in tax).
Unrelated business taxable income may generally be defined as:
- gross unrelated business income;
- less those deductions that are directly connected with the carrying on of the trade or business; and
- computed subject to certain modifications.
The definition of unrelated business income for most organizations such as the Association and sections may generally be stated as:
The gross income from a trade or business that is regularly carried on and which is substantially unrelated to the carrying out of the exempt purpose for which the organization exists. All three parts of the definition must be met. In other words, if an activity fails any one of the three tests, the activity is not considered an unrelated business income activity.
Determination of whether or not a trade or business is regularly carried on is dependent upon the frequency and continuity of the activities. Activities which are conducted in a somewhat random, intermittent basis usually avoid being classified as "regularly carried on." Key characteristics to consider in the "trade or business" test include:
- conducted in a manner to be commercial and competitive;
- profit motive; and
- control of financial results and activities sharing.
The substantially related test creates the most problems and "grey area" in determining if an activity should be considered an unrelated business activity. The regulations state "to be substantially related to purposes for which exemption is granted the production or distribution of the goods or the performance of the services from which the gross income is derived must contribute importantly to the accomplishment of those purposes . . . ."
Deductions may be applied to unrelated business income. Once the gross unrelated business income has been determined, the income is offset against deductions attributable to the activity to arrive at "net unrelated business income before modification."
The Internal Revenue Code (IRC) and the regulations provide little specific guidance on the allocation of expenses to unrelated business income activities.
Expenses, depreciation, and other costs not only must qualify as deductions allowed by other IRC provisions, but also must be directly connected with the carrying on of the unrelated trade or business activity. To be directly connected, an expense or cost must have a "proximate and primary" relationship to carrying on that business.
Directly connected expenses include expenses attributable solely to the unrelated trade or business activity and allocable dual use cost. Where personnel, facilities, etc., are used both for exempt activities and unrelated activities, such costs are allocated on a "reasonable" basis.
General and administrative expenses of an organization cannot be allocated to an unrelated activity on the basis of a percentage of unrelated gross receipts to total gross receipts or by other methods which do not involve a direct link between the cost and the unrelated activity.
A tax-exempt organization will be denied business expense deductions in computing its unrelated business taxable income if it cannot adequately substantiate that the expenses were incurred or that they were directly connected with the activity. Frequently, the internal accounting systems of exempt organizations do not have proper procedures for substantiation of costs, (i.e., time reporting by activity, advertising and readership cost by periodical, general ledger segregation of cost by activity, etc.).
Any trade or business in which substantially all of the work in carrying on such trade or business is performed for the organization without compensation is not considered an unrelated business activity. It is important to note that the Internal Revenue Service has consistently taken the position that even a minimal amount of compensation or the receipt of any items or services of value may cause forfeiture of this exception. If a section conducts a trade or business activity, (i.e., sale of publications, an entertainment event, etc.) and a substantial portion of the labor (85% or more) involved in conducting the activity is volunteer, the activity may be excluded from application of unrelated business income tax provisions.
Following are some common areas of unrelated business income activity:
- affinity credit card programs;
- insurance programs;
- advertising income; and
- mail list rental income.
Are corporate sponsorships considered UBIT? When a corporation makes a "qualified sponsorship payment", that is, a payment for which there is no expectation that the sponsor will receive a "substantial return benefit," the income received by the sponsored organization is not subject to tax as unrelated business income.
A "substantial return benefit" is any benefit other than:
- 1) The use or acknowledgment of the sponsor's name, logo or product lines. (this must be "Value Neutral" meaning no qualitative or comparative descriptions and no endorsement by the sponsored organization)
- 2) Certain "disregarded benefits." (benefits such as complimentary tickets, receptions for donors, etc. are allowed if they have a fair market value of not more than 2 percent of the sponsorship payment)