Today, many independent schools have some form of Unrelated Business Income (UBI), which can trigger tax liabilities. Independent schools typically operate under tax-exempt 501(c)(3) status, meaning they do not pay federal income taxes on income related to their exempt purpose.
Schools are, however, required to pay Unrelated Business Income Tax (UBIT) on income derived from certain activities not related to the organization’s exempt purpose. As schools have continued to diversify their revenue streams in recent years, increasing numbers of educational institutions are generating income that is considered UBI.
Complicating the matter further is the fact that many schools have dual purpose activities: activities that provide benefits both for students/faculty and the general public. Understanding how to appropriately characterize and allocate the income from these activities is an important matter for independent schools.
In this overview, we share examples of activities that commonly result in UBIT exposure for independent schools. We will also explore the importance of taking a proactive approach to determining UBIT exposure and highlight the role an experienced independent school accounting firm plays in helping your school understand its tax reporting obligations.
Independent schools generate revenue in a wide variety of ways. Much of this income, such as tuition fees, is tax-exempt since it is directly related to the school’s mission. However, when a school engages in an activity not substantially related to its mission, this income may be considered UBI.
This definition is broken into three distinct components. If an activity meets each of these requirements, it is considered UBI:
Below, we explore several common scenarios of activities carried out by independent schools that routinely meet these three criteria, therefore resulting in the existence of UBI and the creation of UBIT exposure.
Many of these activities are dual activities. While some portion of the activity is in service of the school’s mission (such as the existence of sports facilities for student use), others are not in service of the nonprofit’s tax-exempt mission, instead benefiting the general public. It is this portion of the activity that may trigger UBIT exposure.
Many independent schools have well-developed sports facilities: gyms, sports fields, swimming pools, tennis courts, and so on. It’s common for independent schools to open these facilities on a regular basis to the general public outside of school hours. Assuming the school charges the general public a fee to access these facilities, this income may be considered UBI.
Schools located near major events venues such as sports stadiums and performing arts centers may rent their parking lots for use as overflow parking outside school hours. Provided these activities meet the three-pronged UBI test, the income may be considered UBI.
Generally, the rental of real property is not considered UBI, however, there are some notable exemptions. If the school provides personal property such as sports equipment, or substantial services such as janitorial services alongside the rental, some portion of the rental income may be considered UBI.
Income from a debt-financed rental property is also considered UBI unless the school can demonstrate that at least 85% of the property’s use was for exempt purposes. In most instances, this is achievable, since students likely use these facilities daily during term time.
Schools often rent their sports fields out for summer camps. If the school provided personal services to the summer camp, such as field maintenance and locker room services, or provided the camp with sports equipment, a portion of the income may be characterized as UBIT. Some schools rent their facilities to film crews – another rental activity that may result in UBI.
Schools may also rent equipment to the general public, particularly outside of term times. Common examples might include scientific and sports equipment. Income from these rental activities is classed as the rental of personal property and is subject to UBIT.
If a school operates a bookstore that is open to both the general public and the student body, it’s necessary to separate the income from the general public and the income from students. The income produced from selling textbooks to students is tax-exempt, however, in most cases, revenue generated from the sale of merchandise to the general public is not exempt.
Another common form of UBIT exposure comes through advertising. Many schools sell advertising space in their yearbooks, athletic programs, or on digital platforms. It’s common to contract with a third party to manage advertising sales on the school’s behalf, and in many instances, this income is classed as UBIT.
It’s important to note that income from sponsorships is exempt, but income from advertisements with a clear call to action is not exempt.
Since so many of the activities outlined above are dual purpose, it can be difficult for schools to determine which of their activities, and what proportion of income from an activity, should be considered UBI. Schools should work with a trusted accounting partner that has significant experience advising schools on their UBIT exposure.
Failing to correctly track UBI and pay the associated taxes can have significant consequences. Schools may be required to pay back taxes and assessed interest and penalties. In other instances, the IRS may challenge a school’s expense allocation on their Form 990, which could lead to Net Operating Losses (NOLs) being disallowed and additional penalties being assessed.
It’s important to note that having a UBIT liability is no bad thing: it simply means that your organization generated additional revenue to invest in its mission. Organizations only pay UBIT if they make a profit on unrelated business activities. However, schools should be mindful of the balance between unrelated income and exempt income. Producing too much UBI could lead to your school losing its tax-exempt status.
Given these factors, schools must take a proactive approach to determining whether new activities may result in UBIT exposure. This allows leaders to structure activities in a tax-efficient manner and incorporate their organization’s potential tax liability into the rates associated with unrelated business activities.
Accurately determining an independent school’s potential UBIT liability is a relatively complex matter that demands the support of experienced nonprofit tax and accounting experts.
At Smith + Howard, our nonprofit accounting practice works with a range of independent schools across the country. Our professionals have advised many schools on these issues and bring deep expertise to every engagement.
If you need assistance determining your independent school’s UBIT exposure, contact a Smith + Howard advisor today.
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