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Exempt Organizations

Exempt Organizations
April 2011

Tax exempt organizations that file Form 990-T (“Exempt Organization Business Income Tax Return”) to report unrelated business income must make those returns available for public inspection in a manner similar to the Form 990. This is consistent with the overall approach taken by the IRS to make the activities of tax exempt organizations transparent and subject to broader public scrutiny.

The Form 990-T filed by other organizations may provide additional insight into the types of revenue-generating activities in which those organizations are engaged. Organizations that are exploring ways to raise additional revenue may learn what other organizations are doing to enhance their bottom lines or offset costs.

The Internal Revenue Code §501(c)(3) exemption from income tax extends to income that is related to an organization’s exempt purpose. Income that is not related to an exempt purpose is taxed at regular corporate rates—this is the unrelated business income tax (“UBIT”). UBIT is not a penalty; it is a mechanism to create a level playing field between taxable entities and tax exempt organizations that conduct similar activities.

Over time, organizations may broaden their view of the types of activities that fulfill their original mission. An activity may be considered by the board as program-related and within the scope of an organization’s mission but still be considered an unrelated activity by the IRS. Alternatively, organizations may make a deliberate decision to engage in an unrelated activity that generates revenue and provides additional resources to meet their exempt mission. Many organizations engage in activities that generate unrelated business income in order to support their other exempt activities. The tax, if any, simply represents another cost associated with an unrelated activity.

The unrelated business income tax starts with a general rule that subjects income to tax, followed by exceptions and modifications which exclude many types of income from tax. Thus, interest from bank accounts, dividends from investments, real property rents, and capital gains would constitute unrelated business income under the general rule, but are excluded from tax under certain modification provisions. Form 990, Part VIII, is formatted in a fashion which illustrates this concept, where Column (D) reflects the modifications and exclusions.

Three-pronged definition. An unrelated business income activity is an activity that meets all of the following three requirements:

  • The activity is unrelated to the exempt purposes of the organization
  • The activity is a trade or business activity
  • The activity is regularly carried on

If any one of these requirements is missing, the activity is not subject to unrelated business income tax. Thus, annual fundraising galas or golf tournaments are not subject to UBI because they are not “regularly carried on.”

Modifications and exclusions. As mentioned above, certain types of revenue that would otherwise fall within the three-pronged definition of unrelated business income are excluded by statute from tax. Some of the more familiar include:

  • Interest, dividends, real property rents, royalties
  • Revenue from activities conducted for the convenience of students, patients, employees
  • Activities in which substantially all merchandise that is sold has been donated
  • Activities in which substantially all work is performed by volunteers

The cost of engaging in an unrelated business activity. An organization that engages in an unrelated business income activity must report such income on Form 990-T (if gross revenue from that activity exceeds $1,000). Direct and indirect costs related to the activity may be used to offset the income. The net revenue is subject to tax at regular corporate rates.

Generating revenue used for programs does not necessarily insulate an activity from UBIT. The fact that all of the revenue from a particular activity is used for program services does not automatically mean that the activity is a related activity. It is the nature of the revenue-generating activity that must be evaluated. Thus, a museum gift shop may sell items that relate to items on exhibit at the museum, but also sell certain items that are wholly unrelated to the exhibits or to the museum’s educational mission (e.g., certain items that are primarily utilitarian). Although all of the gift shop revenue is used to support museum programs and exhibits, the sale of each item must be evaluated separately to determine whether the income is related to the exempt purpose of the museum.

Unrelated business income, good or bad? As long as activities that give rise to unrelated business income are not the primary activities of an organization, engaging in such activities will not jeopardize exempt status. They may generate some tax liability which should be considered as part of the cost of engaging in such activity. The more difficult question may be how activities (whether or not they generate unrelated business income) fit into the overall mission and objectives of the organization. Some organizations will avoid activities that generate UBIT. Other organizations may be willing to engage in unrelated business activities that arguably fulfill a broader view of the organization’s mission than that on which tax exemption was based. Still others may be comfortable in engaging in activities that are unrelated but generate revenues that can be used to bolster programs or offset operating costs.

Should you have any questions regarding the foregoing, please contact John Kikuchi at (925) 944-7666 or by email.

The information contained in this newsletter is general in nature and does not constitute tax advice or opinion. Applicability to specific situations should be determined through consultation with your tax advisor.

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