Examples of Unrelated Business Income and Excessive UBI
By Gorham S. (Rory) Clark. Esq.
A. Examples of Activities Generating Unrelated Business Income
(i) No matter how related a publication is to the tax exempt purposes for which an organization was founded, the income generated from advertising in the publication will be subject to UBIT. The foregoing rule notwithstanding, the Supreme Court has indicated that if an advertisement is educational in nature, it may not be subject to UBIT.
(ii) The IRS has found that when a publication is only produced annually, the advertising “business" is not regularly carried on and thus may be spared from the burdens of UBIT.
(iii) Net advertising income is taxed as UBTI.
a. Net advertising income is determined by deducting direct advertising costs from gross advertising revenue. If the exempt organization has a loss in the non-advertising aspect of the publication, the association is permitted to deduct this loss from the net advertising gain until the net advertising income is reduced to zero.
(iv) Third-Party Production
a. An organization may avoid the implications of UBIT in their entirety with respect to its advertising income if a third party manages the publication process. Under this arrangement, the exempt organization would typically license its name and the publication rights to the material in exchange for royalty payments, which are exempt from UBIT.
b. In order to qualify, the organization must completely relinquish editorial control and advertising control before the payments will be considered royalty payments.
2. Insurance Activities
(i) The IRS has taken the position that income generated by trade associations in connection with insurance benefits provided to its members is income subject to UBIT. While prior case law tended to disagree with this position, more recent case decisions agree with the IRS that income generated from insurance programs for the organization’s members is a business engaged in for a profit motive, regularly carried on, and is not substantially related to the exempt purpose of the organization.
3. Trade Show Income
(i) Income generated by an organization exempted under 501(c)(3), (4), (5) or (6) will not be subject to UBTI if the trade show activity is structured as a qualified convention.
4. Rent From Debt Financed Property
(i) Generally, rent is not included in UBTI under §512(b)(3), but if an exempt organization receives rental income from debt financed property, the rental income will be subject to UBTI.
(ii)§§ 512(b)(4) and 514(b) provide an exception to the general rule that rent is excludable from UBTI by setting out the rule that income generated from debt financed property is included in UBTI to the extent such property is debt financed. §514(b) defines debt-financed property as any property that is held by the exempt organization for the purpose of producing income on which there is acquisition indebtedness.
a. Rent will NOT be included in UBTI if 85% of more of the property is used for the organization’s exempt purpose, even if there is acquisition indebtedness on the property.
B. Excessive UBTI
As noted above, if activities generate UBTI that is deemed excessive the organization will lose its tax-exempt status. This is because the unrelated business activities of the organization will have gone beyond those merely incidental to the organization’s tax-exempt purpose. The income generating activities, which by definition are unrelated to any exempt purpose, will be deemed an additional, “substantial" non-exempt purpose. As explained above, the presence of a single non-exempt purpose if substantial in nature, will destroy the exemption regardless of the number or importance of truly exempt purposes.
The courts provide no bright-line test as to what constitutes “excessive" UBTI. In one case the IRS revoked an organization’s exemption where UBTI was 30% of the taxpayer’s total revenue. In another case, an exempt status was revoked where UBT was approximately 30% of its total revenue. Other cases have turned on higher, or lower, percentages of total revenue. In 2002, the IRS issued a private letter ruling that summarized the case law in this area stating that generally the courts have denied exemptions to organizations where their UBTI “generated income in excess of approximately 25% of the organization’s total annual income." While private letter rulings from the IRS do not constitute precedent, and cannot be relied upon by anyone other than the addressee of the letter ruling, they can be useful in gauging, at least generally, how an issue may be approached by the IRS. Thus, generally speaking, organizations with UBTI that is less than 25% of their total income are less likely to be found to have excessive UBTI, and the lower the percentage of income attributable to UBTI, the better.