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How to Avoid Unrelated Business Income Tax

Tax-exempt organizations are corporations that are normally exempt from federal and state income tax. Even with this exemption, these organizations can be subject to another type of tax – unrelated business income (UBI). UBI is reported on the Form 990-T and is taxed at the corporate rate of 21%. The IRS defines UBI as any income that is:

  1. from a trade or business;
  2. regularly carried on; and
  3. not substantially related to the charitable, educational, or other purpose that is the basis of the organization’s exemption.

Although tax law changes under the 2017 Tax Cuts and Jobs Act increased the list of activities that qualify as UBI, most tax-exempt organizations can take precautionary steps to limit or avoid the unrelated business income tax (UBIT).

Conduct Activities Substantially Related to Tax-Exempt Purpose

According to Reg 1.513(d)(2), an activity that generates business income must “contribute importantly” to the organization’s tax-exempt purpose. The activity must also bear a substantial causal relationship to achieving that purpose.

Several Revenue Rulings have clarified how the IRS determines which activities are substantially related to an organization’s exempt purpose. Rev Rul. 73-105 , for example, determined that the sale of scientific books and city souvenirs by a museum of folk art constitutes unrelated trade or business even though other items sold in the museum shop are related to its exempt function. The ruling stated,

“scientific books and souvenir items relating to the city where the museum is located have no causal relationship to art or to artistic endeavor and, therefore, the sale of these items does not contribute importantly to the accomplishments of the subject organization’s exempt educational purpose which, as an art museum, is to enhance the public’s understanding and appreciation of art.”

Evaluate Income from Debt-Financed Property

IRC Section 514 expands unrelated business income to include unrelated debt-financed income from investment property in proportion to the debt acquired in purchasing it. Property purchased with borrowed money (acquisition indebtedness) and held to produce investment income is referred to as debt-financed property. Examples of debt-financed property include rental property financed with a mortgage, margin-financed securities, and interest in an investment partnership that generates income with debt-financed property.

Note, if substantially all of a property’s use is directly related to the exercise or performance (rather than merely the funding) of an organization’s exempt purpose, it is not debt-financed property. The phrase substantially all is defined in Reg. 1.514(b)-1(b)(1)(ii) as 85% or more of the use of the property, calculated based on the facts and circumstances.

Be Cautious of Advertising Income

Advertising income is not considered UBI if it is not regularly carried on, it is substantially related to the organization’s tax-exempt purpose, or it is conducted substantially by volunteers. Tax-exempt organizations should carefully evaluate income from periodicals, links to external websites, corporate sponsorship activities, and other advertising activities to determine if it is exempt from UBI.

Certain types of corporate sponsorships called Qualified Sponsorship Payments (QSPs) are also not subject to UBI. A QSP is a payment by a sponsor engaged in a trade or business to an exempt organization without an arrangement or expectation that the sponsor will receive any substantial return benefit. Let us say that a university accepts a multiyear payment from a beverage company in exchange for exclusive privileges to sell their product on campus. This type of exclusive provider arrangement is considered a substantial benefit that does not meet the definition of a QSP. The multiyear payment would generate UBI.

Assess Income from Pass-through Entities

An organization’s ownership of a partnership interest may generate UBI if the partnership’s activity is an unrelated business activity with respect to the organization or if the partnership has debt-financed property. Tax-exempt entities with multiple partnership interests will have to review the interim guidance under the new tax law to determine whether to aggregate or silo income from each partnership investment on the Form 990-T.

UBI is normally disclosed on Box 20W of a Partnership’s Form K-1. The following types of income from a partnership are excluded from the definition of UBI:

  1. Interest, dividends, and similar income
  2. Royalties
  3. Rental income
  4. Gains and losses from the disposition of property; and
  5. Research income

These exclusions do not apply to income received from an S corporation. A qualified tax-exempt entity (other than an employee stock ownership plan) must treat its entire share of S corporation income as UBI.

Other types of UBI include nonpassive rental income, providing certain management and administrative services to other exempt organizations, and qualified parking transportation fringe benefits. For any UBI incurred, an exempt organization that has $1,000 or more of gross income from an unrelated business must file Form 990-T. An organization must pay estimated tax if it expects its tax for the year to be $500 or more.

For more information on how to avoid the unrelated business income tax, please contact Chérie Williams at or at 844.4WINDES (844.494.6337).
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