A working knowledge of Unrelated Business Income Tax (UBIT) is increasingly important for nonprofit organizations. Recent years have seen significant changes to the laws that govern UBIT, first with the Tax Cuts and Jobs Act of 2017 and more recently through the CARES Act of 2020.
At the same time, the volatility of the past couple of years has prompted many nonprofits to begin the process of diversifying their revenue streams. Often, these new revenue streams are not directly related to the core mission of the nonprofit. Any profits these activities generate may be considered Unrelated Business Income (UBI) and are subject to UBIT.
As nonprofits continue to enter new businesses and diversify their revenue base, it’s incumbent on executives and board members to consider the broader tax implications, particularly those relating to UBIT. Proactively partnering with an experienced nonprofit accounting firm to develop a strategic approach is an investment that will reap dividends when it comes to tax filing season.
Generally, any profits derived from the mission-related activities of a nonprofit are tax-exempt. However, when a nonprofit regularly carries on a revenue-generating trade or business not substantially related to the mission of the nonprofit, this income is generally subject to UBIT.
There is a lot of nuance in determining which business activities of a nonprofit fall under this category, and as we’ll see, there are various categories of UBIT. However, the easiest way to think about it is this: is the business activity in competition with a traditional for-profit business?
Examples of business activities that satisfy this definition might include a museum that has a restaurant open to the general public, not just museum patrons, or a symphony hall that rents out event space for weddings each summer. Another example would be an independent school whose employees sell advertising in its publications. In each of these instances, the nonprofit is in direct competition with other, for-profit businesses. UBIT is in place to ensure nonprofits do not have an unfair advantage.
The trade or business must be regularly carried on to be subject to UBIT. Specifically, per the IRS, an activity is considered carried on if it shows a “frequency and continuity, and is pursued in a manner generally similar to comparable commercial activities of non-exempt entities”.
Paying UBIT is not inherently bad and does not affect the tax-exempt status of the nonprofit. If anything, being required to pay UBIT is a positive sign. In essence, it simply means that your nonprofit runs a sustainable, profitable business.
UBIT is split into a series of different silos. These can be thought of as separate business lines and nonprofits are required to report UBIT for each of these silos. Within each silo, there are a variety of intricacies that determine which revenue, and what proportion of associated costs, are included in the UBI calculation.
There are certain characteristics that apply to each of these silos, which we will explore below. In addition, there are specific exceptions for which certain organizations or fact patterns may qualify. However, it’s important to note that correctly navigating these nuances demands professional expertise from a specialized CPA firm.
Many museums, performance venues, botanical gardens, and similar tax-exempt organizations routinely rent out their space for events. Common examples include weddings or corporate events. In some instances, it may be possible to qualify for an exception or posit that the venue rental is related to the mission of the nonprofit organization in order to reduce UBIT.
Consider the example of a university renting out space to a movie studio to shoot a new film. Initially, it’s rational to think this is UBI. But perhaps the university has a film department and stipulates in the rental agreement that the filmmakers must give students the opportunity to observe the filmmaking process. In this instance, the income derived from the venue rental may not be subject to UBIT as it advances the university’s core mission: educating students.
The passage of the Tax Cuts and Job Act saw parking become taxable as UBIT for nonprofits for the first time. Overnight, this change saw many nonprofit organizations become liable for tens of thousands of dollars in tax on parking fees paid on behalf of employees and by guests.
However, in late 2019 this provision was retroactively revoked and nonprofits were permitted to amend their UBIT filings and claim a refund on tax paid on this income. If a nonprofit has yet to do this, it’s still possible to claim a refund – contact an accountant to learn more.
Many nonprofits work closely with corporate partners to raise funds that help further the mission of the nonprofit. This may include advertising partnerships on online platforms and print publications. To determine whether income from corporate partners is classified as UBI, it’s necessary to determine whether the income is derived from advertising or sponsorship.
In essence, advertising includes a call to action. For example, a piece of marketing collateral that states “Shop at Retailer X” is an advertisement. A piece of collateral that states “Brought to you by Retailer X” is a sponsorship. Advertising income is typically subject to UBIT, whereas sponsorship income tends not to be.
In addition, the organization should determine if an exception exists because volunteers sell the advertising. For example, if school yearbook advertisements are sold by students, the advertising income is not UBI.
Many nonprofit organizations have onsite catering facilities: common examples include a museum cafeteria, a cocktail bar at a theater, or a concession stand at a school sport event. Generally, these types of facilities are exempt from UBIT as they provide convenience to the members, students, patients, officers, or employees of the non-exempt organization.
However, there are complications to this convenience exception. If a museum restaurant has a door to the street where non-museum patrons can enter to dine without paying museum admission, they are in competition with local for-profit restaurants. In these instances, it’s typically the case that some portion of the income derived from the restaurant is classified as UBI.
Retail stores such as museum gift shops and school campus stores are perhaps one of the most complex business activities when it comes to distinguishing tax-exempt income from UBI.
There are two major exceptions that apply to gift shops. One is the convenience exception. Generally, sales of items such as food and drink that provide convenience to patrons and guests are considered exempt. Secondly, income derived from the sale of products related to the mission of the nonprofit may also be exempt. Examples of these products might include replicas of the artwork displayed in a museum. However, the rules for this are complex, and deciding whether revenue from smaller products like magnets, key chains, pens, and coffee mugs qualifies as UBI should be done on a case-by-case basis.
Nonprofit organizations with gift shops should work with their accounting firm to categorize individual products as exempt or non-exempt and then invest in financial systems that can allocate income in accordance with these rules.
When nonprofits make investments into alternative assets, some portion of the returns from these investments may be recognized as UBI. In some cases, nonprofits may be required to submit foreign disclosure filings.
To ensure a complete and accurate tax filing and understand any potential UBIT related to alternative investments, it’s critical that nonprofit organizations provide their tax preparer with all Schedule K-1 forms.
With the potential for so many different forms of UBIT, accurately calculating UBIT is a complex task best left to tax professionals. Nonprofit organizations are required to file Form 990-T and separately report each business silo that is declaring UBI.
For each silo, the nonprofit must specify the unrelated revenue and any expenses associated with it. Expenses can include direct costs, such as equipment rental for a venue rental business, and indirect costs.
Calculating indirect costs is more complex. Indirect costs could include depreciation and some portion of administrative costs such as payroll. Generally, a percentage of the overall administrative costs will be allocated to the unrelated business activity. There are no hard and fast rules to determine this percentage: the IRS states tax filers may use any reasonable method to do so.
After these expenses have been allocated, nonprofits may find that their business has barely broken even, or may even be generating a loss. These losses can be carried over into future years to reduce income from the silo generating the loss. Alternatively, if the business is profitable, then the business will pay UBIT. That’s not a bad thing: a profitable business means the nonprofit has more money to invest in advancing its mission.
Once the UBI has been calculated for the various business areas, it must be reported to the IRS and taxed, unless the UBI is less than $1,000 annually. For most mature nonprofits, that’s not the case. Established nonprofits often declare UBI of several hundred thousand dollars, underscoring the importance of working with an accounting firm that knows how to accurately report UBIT.
An IRS Form 990 is the tax return filed by organizations exempt from income tax. The form includes a revenue schedule where the nonprofit must break out its revenue into distinct categories. One of these categories is UBI. Organizations should confirm their 990 revenue disclosures and their Form 990-T filings are in agreement.
The nonprofit must provide more detail on UBI in IRS Form 990-T. This form has evolved in recent years but is currently structured to enable separate reporting for each business silo. For each silo, the nonprofit must report the NAICS code, revenue, expenses, and net income or loss.
UBIT filing requirements are complex and changes in recent years have only exacerbated the difficulties nonprofits face in filing accurate returns. However, there are some common errors that nonprofits tend to commit. By educating themselves on these mistakes, nonprofit executives and board members can take steps to ensure an accurate filing.
The most common mistake nonprofits make when it comes to their UBIT filing requirements is simply not considering UBIT requirements. If a nonprofit fails to specify whether they have UBI or not, the IRS may investigate, discover that UBIT should have been paid, and calculate these taxes on behalf of the nonprofit. While nonprofits can argue against this, doing so is expensive and time-consuming, requiring significant professional support from attorneys and CPA firms.
Additionally, calculating UBIT without fully understanding the tax code can lead to errors in UBI calculations. This area of the tax code contains a lot of nuance and it’s likely that the majority of established nonprofit organizations would benefit from a strategic partnership with a CPA practice specialized in nonprofit accounting. This can lead to significant savings which can then be invested into advancing the core mission of the nonprofit.
Failing to take a proactive approach to UBIT filing requirements is another common mistake. It’s much more efficient to establish the facts and define the tax strategy of a new business line before it is operational. This is especially true in the post-pandemic era when many nonprofits are diversifying their revenue base by looking at alternative revenue sources which may be subject to UBIT.
Effectively structuring a nonprofit business to deliver long-term success demands expertise. The tax code is complex and it’s important for nonprofits to have a strategic partner they can trust to optimize their financial infrastructure.
At Smith and Howard, we are proud to offer a range of tax and assurance services to nonprofits. Our highly-trained team closely follows the latest developments around UBIT and is proud to serve as long-term strategic advisors to a number of leading cultural institutions around the nation.
To learn more about Smith and Howard’s nonprofit accounting services, contact us today.
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