Bar News - February 18, 2011
Tax Law: Analyzing an Exempt Organization: Issues in Unrelated Business Taxable Income
By: Jared Yeaton
Exempt organizations often engage in activities that are either taxable by statute (such as the rental of certain debt-financed property), or are taxable because the activities conducted constitute a regularly carried-on trade or business that is substantially unrelated to the organization’s exempt purpose. Unfortunately, because of a general lack of knowledge about unrelated business activities and unrelated business income tax (UBIT), often exempt organizations either don’t report those activities correctly on their tax returns or, in some cases, don’t even realize that there is a taxability issue at all. This can be very damaging to an organization, at the very least creating a liability for unpaid UBIT, plus penalties and interest, or even worse, jeopardizing an organization’s tax exempt status.
As the recently redesigned Form 990 shows, in which questions about UBIT activities are on Page 1, Part I of the form, the Internal Revenue Service is looking at UBIT issues closely. The primary objective behind the imposition of UBIT is that it eliminates unfair competition against for-profit organizations by placing exempt organizations on the same tax basis in those activities in which they could compete against for-profits and aren’t related to the exempt organization’s exempt mission. 1 When analyzing an exempt organization’s activities for purposes of UBIT, the fact that net income is used to further other exempt functions is irrelevant, it is how the income is earned that is material.
Most exempt organizations are subject to a tax on income from any unrelated business.2 Form 990-T is used to report and pay the tax.3 An unrelated business is any trade or business, regularly carried on by the organization, that isn’t substantially related to the performance of the organization’s exempt purpose, function or mission.4 In order for an activity to be included in the calculation of unrelated business taxable income (UBTI), it must be a trade or business. The term “trade or business” has the same meaning that it has for the purpose of determining whether a particular expense is a deductible trade or business expense under IRC § 162.5 Being a trade or business presumes that the activity is being carried on for the production of income, whether or not profits result.6 In other words, there must be a profit motive.
A profit motive is important because if an organization is using the losses of one unrelated business activity to offset the income from another profitable activity, and the Internal Revenue Service determines that the loss activity lacks a profit motive (and is therefore not a trade or business) the organization will be liable for UBIT generated by the remaining, profitable activity. The determination of profit motive is based on a facts and circumstances analysis, and if the same activity has consistently generated losses of a significant period of time, and no demonstrable and reasonable efforts have been taken by the organization to correct that pattern, it is highly likely that that loss-generating activity will be deemed not to be a trade or business.
In order for an activity to be an unrelated business, it also must be regularly carried on by the organization. In determining whether a business is regularly carried on, the controlling factors are the frequency and continuity of the income producing activities, the manner in which they are conducted, and whether they are similar to comparable commercial activities of non-exempt organizations.7 Continuity doesn’t necessarily require an unbroken chain of activity but rather a connection by which similar activities have been conducted in the past and how they are expected to be continued in the future.
For example, the solicitation of advertising for a business league's industry-wide membership directory published every two years or three years was sufficiently long-lasting to make it regularly carried on. The directory was published in a regular cycle, which indicated a regular frequency and continuity of the activity, and the activity was performed almost daily over six or seven months.8 On the other hand, six-to-seven months of activity does not necessarily result in a regularly carried-on business. Thus, an exempt hospital's provision of food services to an exempt nursing home for a period of six-to-seven months until the nursing home decided how it was going to run its kitchen, was not a trade or business that could give rise to a loss allowable in computing the hospital's unrelated business income.9
In addition to the “trade or business” and “regularly carried-on” requirements necessary for classification as an unrelated business activity, the income-generating activity must not be substantially related to the performance by the exempt organization of its exempt purpose. For purposes of demonstrating whether the conduct of the trade or business producing the income isn't substantially related (other than through the production of funds) to the purposes for which exemption was granted to the organization, an analysis must be made of the relationship between the business activities that generate the income, and the accomplishment of the organization's exempt purposes.10
For the conduct of a trade or business to be substantially related to the exempt purposes, the production or distribution of the goods or the performance of the services from which the income is derived must contribute importantly to the accomplishment of the exempt purposes.11 In determining whether activities contribute importantly to the accomplishment of an exempt purpose, the size and extent of the activities involved must be considered in relation to the nature and extent of the exempt function they are serving. Thus, if an organization derives income from activities that are related to the performance of its exempt functions, but are conducted on a scale larger than is reasonably necessary to perform them, the income attributable to that excessive portion of the activities is unrelated business income.12
In summary, when an exempt organization or its advisor looks at the activities carried on, it is important to determine: (1) whether an activity is a trade or business, (2) whether it is regularly carried on, and (3) whether it is substantially related to the exempt purpose of the organization or not. If the answer to all three questions is “yes,” then it is very likely that there is unrelated business taxable income and it needs to be analyzed carefully and reported accordingly.
1 IRC Reg. § 1.513-1(b).
2 IRC § 511(a), IRC § 512(a), IRC § 512(b)(12); IRC Reg. § 1.511-2(a)(1).
3 IRC Reg. § 1.6012-2(e), IRC Reg. § 1.6012-3(a)(5).
4 IRC § 513(a), IRC § 513(c); IRC Reg. § 1.513-1.
5 IRC Reg. § 1.513-1(b).
6 IRC § 513(c).
7 IRC Reg. § 1.513-1(c)(1).
8 IRS Letter Ruling 9302035.
9 IRS Letter Ruling 9719002.
10 IRC Reg. § 1.513-1(d)(1).
11 IRC Reg. § 1.513-1(d)(2).
12 URC Reg. § 1.513-1(d)(3).
Jared Yeaton is Senior Tax Supervisor at Nathan Wechsler & Co. He has been a member of the NH Bar since 2007.