6 Ways Not-for-Profits Could Generate Unrelated Business Income — and Trigger Tax Obligations– May 02, 2019 by Cathleen Lorenz

When an exempt organization such as a 501(c)(3) generates income unrelated to the core purpose of the organization — whether knowingly or unknowingly — the not-for-profit may face unexpected taxes on that income.
 
Below are six areas that could generate unrelated business income and leave not-for-profits subject to the Unrelated Business Income Tax (UBIT).

1. Commercial Enterprises                                                

Income is considered unrelated business income from a commercial enterprise if it comes from an enterprise that is both regularly carried on and substantially unrelated to the organization’s exempt purpose. Income is NOT considered unrelated business income if the commercial enterprise:

  • Is used for the convenience of members, students, patients, employees;
  • Uses volunteer labor; or
  • Is used to sell donated merchandise.

There are exceptions to the types of income that will be taxed, even in an activity that meets the commercial requirements — among them are interest, dividends, rental income from real property (unless the property is acquired with debt, as noted below), royalties, qualified corporate sponsorships and the sale of capital assets.

2. Employee Parking Expenses

Employee parking expenses paid by a not-for-profit to a third party are also considered unrelated business income. If the organization owns the parking lot employees use, IRS Notice 2018-99 can be used to calculate the amount of unrelated business income.

3. Debt-Financed Income

If funds are borrowed to purchase assets that will produce income, such as rental real estate or securities purchased on margin, then the income from these activities may be taxable. Taxability involves a calculation that divides the average acquisition indebtedness by the average adjusted basis and multiplies by gross income.

4. Income from an S Corporation Investment or Partnership

Income from an S Corporation investment is always considered unrelated business income. Income from an investment in a partnership whose operations are substantially unrelated to the organization’s exempt purpose is also unrelated business income.

5. Income from Controlled Organizations

Income from controlled organizations also may be subject to UBIT. The not-for-profit, as the controlling organization, must “look through” the controlled organization and pick up any unrelated business income that was passed through to it without payment of tax.

6. Advertising Income

Advertising income can be considered unrelated business income if the advertiser expects a substantial benefit from the activity. Advertising is subject to the exceptions noted for commercial enterprises. Therefore, if it is not regularly carried on, is conducted by volunteer labor or is substantially related to the exempt purpose of the organization, then it most likely will not be taxable.

Reporting Your Unrelated Business Income

There are a few important notes regarding unrelated business income and the Tax Cuts and Jobs Act of 2017. Namely, if the organization needs to file a 990-T to report unrelated business income, then the following changes apply for tax years beginning after December 31, 2017:

  • The new corporate rate is 21% and is levied on each activity separately, so losses on one activity may no longer be offset against another. 
  • There is now a limit (up to 80%) on net operating losses that can be netted against income. 
  • Net operating losses can no longer be carried back but can be carried forward indefinitely.

It’s important for not-for-profits to understand the nature of their activities and related entities so there isn’t a surprise at tax time. Start by reviewing the areas above and then have a conversation with your tax team if you feel your organization may be generating unrelated business income.
 
Please contact a member of your service team, or contact Cathy Lorenz at clorenz@cohencpa.com for further discussion.
 
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.