Guest Post by: Jeff Fucito, Aleisa Howell and Mary Jo Alexander, Mauldin & Jenkins, LLC.
The Internal Revenue Service anticipates that exempt organizations will engage in activities that may be in competition with private business endeavors; but to be non taxable, the activities must be substantially related to the purpose for which the organization has an exemption status. Section 513(c) states “the term ‘trade or business ‘includes any activity which is carried on for the production of income from the sale of goods or from the performance of services.” In order to determine whether a particular activity that an institution engages in will generate taxable income, the following three criteria must all be present.
Substantially Unrelated to the Exempt Purpose
The first criteria in determining whether an activity is taxable is to determine whether the activity is “substantially unrelated” to the exempt purpose of the organization. The exempt purposes of educational institutions include (a) teaching and instruction, (b) research, and (c) public service. Particular emphasis is placed on the size and extent of the activity. If an activity is conducted on a scale larger than reasonably necessary to carry out the exempt purpose, it is more likely to be treated as unrelated. Use for both exempt and commercial purposes will not necessarily exempt the income derived from commercial use unless the business activity “contributes importantly” to the accomplishment of exempt purposes.
Trade or Business
Activities cannot be considered taxable unless they are deemed to be a “trade or business” as defined in IRC Section 162. Among other things, a trade or business has to exhibit intent to profit from the activity (real economic profit). If the intent is to merely recover costs and indeed no realized profit exists, the activity lacks a profit motive and is not subject to taxation. In addition there must be a regularity of activities and income production that would be different than the level of activity found in a hobby-like activity.
Regularly Carried On
The IRS Treasury Regulations consider the frequency and continuity of the activity and the manner in which it is pursued to determine if the activity is regularly carried on. Thus, the unrelated business income tax (UBIT) applies only to a business activity which is regularly carried on as distinguished from commercial transactions which are sporadic or infrequent.
An activity should not be considered as regularly carried on if it is:
1. on a very infrequent basis;
2. for a short period of time during the year; or
3. without competitive and promotional efforts.
Activities over a period of only a few weeks are not “regular” for an exempt organization if the activities are of a kind normally conducted by a nonexempt business on a year-round basis. Intermittent, casual or sporadic activities are generally not regular. However, year round activities are regular even if they are conducted only one day a week. Further, seasonal activities may be regularly carried on even though they are conducted only for a short period each year.
Exclusions from UBIT
Even if an activity is considered to be taxable based on the above three criteria, there are a number of modifications to income and statutory exceptions that are available under the UBIT regulations. These include the following:
• passive income such as dividends, interest, annuities, and royalties where no active business participation and management is involved;
• rents from real property (contingent with debt finance issue) and some personal property;
• income from certain forms of research;
• income generated from donated services or property;
• income produced from sales made primarily for the convenience of the organization’s members, students, and employees (including faculty and staff); and
• special situations.
Mailing Lists and Affinity Cards
Mailing lists of potential card users should be made available on a selective basis, and minimal staff time and expenses should be allocated to maintenance and marketing of the list. Organizations should avoid providing specific services (i.e., advertising, promotion, endorsements, etc.) other than reviewing the materials for quality control. The agreement should expressly provide that the organization will not provide specific services. When services are provided, make sure they are “de minimis” or “courtesy” services.
Rents from real property not debt financed are excluded from taxable income provided:
• Property is not debt financed;
• Additional services are not rendered; and
• Are not dependent on a percentage of profits.
Rents from personal property are excluded only if there is a mixed lease and the rents attributable to the personal property are an “incidental” part of the total rents received under the lease. The following rules apply to personal property rents:
• 10% or less is considered incidental and not subject to tax;
• 11-50% is considered taxable in proportion to the percent of personal property rents to the total rents; and
• 51% or more is considered 100% taxable.
The sale of advertising may be taxable even if the activity is carried on within a larger complex of other endeavors that are substantially related to an organization’s exempt purpose such as the publication of a newsletter, magazine, scholarly journal, or website, or the sale of advertising in sports programs. Related advertising (acknowledgments) are incidental recognitions of sponsorship. This form of advertising is not subject to UBIT.
Other Areas For Consideration Include:
• Bookstore, Museum Gift Shop, and other Merchandise Operations
• Food Service Agreements
• Artistic, Entertainment and Theatrical Events
• Alumni Usage
• Computer Sales to Faculty/Staff/Students
• Leased Parking Spaces/Lots
• Recreational and Athletic Facility Membership Fees
• Summer Dormitory Rentals and Food Service for Conferences
• Ordinary Income from Flow-Thru Entities (K-1’s)
• Joint Ventures
The Need for a Consultation
A consultation with our professionals can assist your institution throughout the process.
Mary Jo Alexander, Tax Manager, Not-For-Profit Educational Practice