Does My Organization Have Unrelated Business Taxable Income?

Robert Lyons, CPA, MST
Published Date:
Aug 1, 2016

Unrelated business taxable income (UBTI) is a relatively simple concept: It represents activities conducted by an organization that are both (1) commercial and (2) not in furtherance of the organization’s exempt purpose. UBTI is based on the idea that when a nonprofit participates in commercial activities or exploits its exempt purpose, it would be competing at an unfair advantage with for-profit entities because, as a nonprofit, it generally does not pay taxes on its income. UBTI treatment, then, attempts to level the playing field between nonprofits and commercial ventures when they conduct the same activity by placing the nonprofit on a comparable basis with its commercial counterpart.

 Note that if a nonprofit has a substantial amount of unrelated business activities, it could also jeopardize its tax-exempt status. As long as the activities are either related to the organization’s exempt purpose or fall within one of the modifications found in IRC section 512(b), the income will not be taxable for federal purposes. There are, however, exceptions: Several states, such as California, tax income earned in the state if the organization was not treated as a nonprofit for state purposes.

IRC section 512(a)(1) defines UBTI as “the gross income derived by any organization from any unrelated trade or business regularly carried on by it, less deductions allowed . . . which are directly connected with the trade or business.” While the definition sounds straightforward, its details are anything but simple. There are three components in the definition that must be evaluated in determining whether the organization has UBTI: whether the activity comprises (1) a trade or business (2) that is regularly carried on and (3) that is unrelated to the organization’s exempt purpose. If any one of these three components is missing, the organization does not have UBTI.

“Trade or business” generally includes any activity conducted by the organization for the production of income from selling goods or performing services. Whether an activity reaches the level of trade or business depends, in part, on the level of active participation and the appearance of “business operations” by the organization generating the revenue. The key characteristic of a trade or business is “profit motive”—the activity does not lose its identity merely because it produces a loss. It also does not lose its identity merely because it is conducted within a large group of similar activities that might or might not be related to the organization’s exempt purpose. See, for example, Carolina Farm & Power Equipment Dealers Association, Inc. v. United States and Louisiana Credit Union League vs. United States.

The I.R.S., on audit, uses a nine-factor test found in Treasury Regulations section 1.183-2(b), including

-- the manner in which the taxpayer carried on the activity
-- the expertise of the taxpayer or the taxpayer’s advisers
-- the time and effort expended by the taxpayer in carrying on the activity
-- the expectation that the assets used in the activity may appreciate in value
-- the success of the taxpayer in carrying on other similar or dissimilar activities
-- the taxpayer’s history of income or loss with respect to the activity
-- the amount of occasional profits, if any, which are earned
-- the financial status of the taxpayer; and
-- elements of personal pleasure or recreation.

The second component for inclusion in UBTI is that the activity must be “regularly carried on.” Of the three elements, this is the hardest to quantify because it could more appropriately be described as a concept rather than as a specific definition. It might also be the requirement that is hardest to meet.

Evaluating this component means considering the frequency and continuity with which the organization pursues the activity that in turn produces the income. The concept of “regularly carried on” is examined within the framework of one year. For example, say an activity has been conducted one week a year for the past 10 years. To determine whether it is regularly carried on, the I.R.S. will focus on the number of times the activity is conducted within a given year, rather than the frequency over a number of years. Therefore, an activity carried on one week a year for 10 years is not considered regularly carried on. 

In Technical Advice Memorandum 8734005, a charitable organization selling real estate received advice as to whether the sale would be considered “casual” and therefore maintain favorable tax treatment. In this case, a 501(c)(3) organization proposed to sell part of its 60-acre property—which it had held for over 80 years—because the organization no longer used the property for its exempt purpose. It attempted to have the property rezoned to allow for commercial development but was unsuccessful. Then, it unsuccessfully tried to sell the entire parcel to one buyer. This was followed by hiring an engineer to subdivide the property into 36 lots, including all the curbs, gutters, sidewalks, drainage, and water systems necessary under county laws to sell the property. The lots were purchased in five blocks by five different parties.

In its analysis, the IRS stressed that the organization had unsuccessfully tried to sell off the property in a single block; that it only made the minimal improvements required by local law; that it had hired a real estate developer to market the property rather than attempt to do so itself; and that it took over five years to sell off the five blocks of property. The IRS determined that the organization’s activity did not reach a level of anything other than an incidental attempt to sell.

The third component in determining the existence of UBTI is whether the trade or business activity is substantially related to the organization’s exempt purpose. This relationship does not include the organization’s need for income to carry on its exempt purpose. UBTI is based on how the income is earned—and not how it is used.

Whether an activity is related can depend on the size and the extent of the activity. In making a determination as to whether an activity contributes importantly to accomplishing an exempt purpose, its size and extent must be taken into consideration in relationship to the organization’s exempt purpose.

IRS Letter Ruling 200225044 gives insight to training programs and how they might be related to the organization’s exempt purpose. Training programs that have been determined to be related to the organization’s mission—and, as such, do not generate UBTI—exhibit a combination of the following characteristics:

-- Clients are the primary employees, except for individuals providing the training.
-- All the work performed is done by the clients and their supervisors.
-- The program is transitional for the purpose of gaining job skills.
-- The training program clients can work in the program’s employment only for a limited period of time.
-- All net profits are applied to the organization and its mission.
-- The clients will learn new occupational skills.

The aforementioned example is specific to training programs where a service is being provided. The activity is clearly a trade or business and regularly carried on—so that the only element in question is whether the program supports the mission of the organization. Eliminating the need for money, the relationship—in most cases—rests on whether the activity carries on the expressed mission of the organization.

IRC section 512 defines UBTI as gross income derived from unrelated business activities less deductions directly connected with the activity. Treasury Regulations section 1.512(a)-1(a) states that an item of expense is directly connected with an unrelated trade or business if it has a “proximate and primary relationship” to the conduct of that trade or business, referring to the relationship in terms of (1) expenses attributable to unrelated business activities alone and (2) those attributable to the dual use of facilities or personnel. Under normal circumstances, there is little ambiguity about expenses related solely to either a related or unrelated activity. On occasion, however, the situation becomes considerably more complicated. 

For example, the issue becomes difficult when we can take an item of expense and allocate it to multiple activities. This is particularly true in the case of real estate that is being used on a dual basis. One of the best-known cases in this area is Rensselaer Polytechnic Institute v. Commissioner, 732 F. 2d 1058, 53 AFTR2d 89-1167 (CA-2, 1984), aff’g 79 TC 967 (E.D. Ill., 1982), which implicated the dual use of facilities and the allocation of associated expenses. The court found in favor of the school as to the methodology used in the allocation for the use of facilities. The Service has recently said it would challenge the concept again—and attempt to force through IRC revisions to support its allocation methodology. 

IRC section 512(b) provides for a series of “modifications,” whereby various forms of income—which are normally taxed—will be exempt. Whether a particular type of income falls within one of the modifications is based on the facts and circumstances of each situation. In reviewing the major sources of modifications, organizations need to keep in mind a number of exceptions to the exceptions—particularly IRC section 514, which deals with debt-financed income.

This article was designed to review the basic requirements for determining UBTI. The IRS has expressed on a number of occasions an increased interest in unrelated activities of an organization. The primary challenge is to look through the organization’s need for money when determining whether an organization has UBTI. In most cases where UBTI is not being reported, there is no Form 990-T being filed—and as such, the statute of limitations is not running, leaving the organization subject to a long-term exposure for taxes.

lyonsRobert Lyons, CPA, MST, is the managing tax director within the nonprofit and government Group at Marks Paneth LLP.  Mr. Lyons brings to his role the skills he has developed during more than 30 years of providing tax and consulting services to his clients in the nonprofit, higher education, and public sector niches.  His experience includes handling substantial exempt organization tax issues.  Mr. Lyons has testified in front of the House and Ways Committee in Washington D.C. establishing the current treatment of affinity royalty arrangements.  He has also been involved in special projects related to unrelated business income for exempt organizations, including but not limited to state filing issues, including settlements, foreign filing requirements for off-shore activities and use of exempt bond proceeds.  

Views expressed in articles published in Tax Stringer are the authors' only and are not to be attributed to the publication, its editors, the NYSSCPA or FAE, or their directors, officers, or employees, unless expressly so stated. Articles contain information believed by the authors to be accurate, but the publisher, editors and authors are not engaged in redering legal, accounting or other professional services. If specific professional advice or assistance is required, the services of a competent professional should be sought.