5 Activities Causing Taxable Income for Independent Schools

Independent, nonprofit schools don’t pay income tax—well, most of the time. 

When a nonprofit earns income from a source that’s not connected to its exempt purpose, it may be subject to the unrelated business income tax (UBIT). 

As independent schools diversify their income outside of tuition and donations, they might find themselves generating income that’s unrelated to their exempt purposes of education and research. Independent school leaders should be aware of the activities that may result in federal and state tax bills. 

What is the Unrelated Business Income Tax (UBIT)? 

The UBIT is a 21% federal income tax that applies to a nonprofit’s income from a source that’s not tied to its exempt purpose. Most states also impose a UBIT. 

When an independent school has UBIT, it must file Form 990-T, Exempt Organization Business Income Tax Return, to report and pay any taxes owed. Only unrelated business income is subject to the tax; tuition and donor revenue remain exempt from income taxes.  

UBIT isn’t a penalty. In many cases, profit generated from an unrelated business activity outweighs the tax burden associated with it. However, it is important to evaluate the sources of revenue to confirm a particular revenue stream hasn’t unintentionally triggered a tax liability.  

What Activities Result in Unrelated Business Taxable Income for Independent Schools? 

Here’s a rundown of the most common UBIT-producing activities for independent schools. 

1. Joint Venture Investments 

In a bid to secure long-term growth in your independent school’s endowment, investment advisors sometimes recommend so-called alternative investments, such as private equity, hedge funds, or real estate. While these investments may provide potentially large upsides, some may result in a surprise tax bill. 

Potentially taxable alternative investments involve your school being named a limited partner in an entity, such as a joint venture or a partnership, that your investment advisor expects to provide a meaningful return.  

Be aware that your school’s share of the entity’s annual profits—even if they’re not distributed to you that year—are taxable income. Tax and compliance considerations can get even more complicated if the entity is based in a foreign country. Often, these investments will result in your school receiving a Schedule K-1 that lists your share of the investment’s income and losses. 

Joint venture investments are just one example of alternative investments that may result in UBIT for an independent school. When discussing investment options, make sure to ask about their tax implications, which can put a damper on your anticipated returns. 

2. Debt-Financed Real Estate Property Rentals 

Many independent schools rent out unused rooms or buildings on campus to boost non-tuition, non-donation revenue. Rental income generally isn’t taxable to a nonprofit school; however, a quirk in the tax law makes rental income taxable when the rental space has underlying debt, such as a construction loan or commercial mortgage. Put another way, if the real estate is debt-financed, then the rental of the space typically triggers the UBIT. 

There are some exceptions. For example, if at least 85% of the space’s use is school-related, then any rental income you receive in the remaining 15% is generally exempt from the UBIT. 

3. Personal Property Rentals 

In the tax space, personal property generally means property that isn’t real estate. When your school rents personal property—whether it’s debt-financed or not—the income is subject to the UBIT. 

The personal property category is vast, including: 

• Parking lots 

• Vehicles 

• Computers 

• School equipment 

• Theater sets 

Of course, there are some exceptions. Personal property rented incidentally with real property—say that you rent out a building that with computer equipment—isn’t subject to the UBIT, so long as it meets certain requirements. Talk to your tax advisor to understand the tax implications of renting out personal property. 

4. Advertising 

Be careful about how you sell space in yearbooks or on a placard. Certain sponsorship and advertising income is taxable, depending on the situation’s specific facts and circumstances. 

In general, income from naming opportunities is exempt from income taxes when the space communicates only the name of the person who or company that paid for it and potentially some contact information.  

However, an advertisement is subject to the UBIT when it communicates your independent school’s endorsement of the purchasing person or company. Unlike a mere disclosure of sponsorship, a call to action (“Check out this local restaurant!”) is typically grounds for an endorsement. 

Things get even more complicated when you’re selling space on a webpage. You might accidentally trigger the UBIT by including links to a person’s or companies for-sale product. To avoid UBIT, a tax-exempt entity should ensure that links published on their website related to a sponsor do not take a user directly to a webpage where a product or service is explicitly sold. A sponsor’s “about” page may be a suitable place to send web traffic. 

When soliciting sponsorships or advertisements, you’ll want to be clear that you aren’t offering an endorsement of the paying people or companies, and this isn’t an opportunity for people or companies to sell their products; rather, you’re offering the opportunity to put a person or company’s name in a specific place. It’s a good idea to run any solicitation language by your nonprofit tax advisor before sharing it. 

5. Earned Income 

Some independent schools are opening side businesses that are unrelated to their exempt purposes as a way to raise non-tuition, non-donor revenue. Those side businesses can sometimes trigger the UBIT. 

For example, schools can encounter UBIT when it offers services to other organizations, such as back-house support for administrative duties, bookkeeping, or other consultation services for other tax-exempt entities. 

We also have school stores—the kinds that sell t-shirts, sweatshirts, and notebooks advertising the school’s name. Much of the time, school stores are exempt from income taxes because they exist only to further the school’s mission and generally don’t compete with for-profit businesses. 

However, school stores enter murky territory when they begin to sell products in competition with other businesses, such as computers and cell phones. It’s reasonable to assume that a student’s first computer purchase is to help them succeed in school, but what happens if they buy a second? The income from the second computer could be construed as taxable.  

As you can see, determining the taxability of a school’s side business can get confusing pretty quickly. Before opening an unrelated business to boost school revenue, talk to your tax advisor to understand the tax implications. 

Smith + Howard: Your Go-To Independent School Tax Advisor 

Proper planning and proactive discussions with an experienced tax advisor can help school leaders structure and understand the tax impact, if any, of a new revenue stream. 

With decades of experience serving independent schools nationwide, Smith + Howard advisors help scores of schools navigate UBIT and other complex nonprofit tax rules and regulations. 

Reach out to a Smith + Howard advisor to learn more about services we can provide to your independent school.