S Corporation tax issues
S Corporation tax issues

Taxing Nonprofits: Changes in Unrelated Business Income

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When the Tax Cuts and Jobs Act (TCJA) was signed into law, most of the coverage revolved around changes in deductions and massive tax rate changes that affected almost every for-profit business and individual in America. Few noticed, at least initially, the changes made to the law affecting nonprofits. However, it turns out that seemingly small changes are having a huge impact; thousands of nonprofits that have never worried about taxation may now owe unrelated business income tax (UBIT) and must file Form 990-T, Exempt Organization Business Income Tax Return.

While several TCJA changes impact nonprofits, the following are receiving significant attention:

  1. Nonprofits with more than one unrelated trade or business activity can no longer net activities when computing taxable income. This means that nonprofits cannot use a loss in one unrelated trade or business activity to lower taxable income in another. While this will affect some larger nonprofits, it is the second change that is causing a stir in the nonprofit community and will be the focus of this article.
  2. Nonprofits are now required to pay tax on certain fringe benefits, including parking, given to employees. In a study by The Urban Institute in November 2018, 40 percent of responding nonprofits reported they provided transportation fringe benefits in some form to their employees. Under TCJA, these nonprofits may now need to file a 990-T and may well owe taxes for the first time.

Whether you specialize in nonprofit tax, sit on a board or only have a handful of clients, you’ll want to understand UBIT before and after these changes. In addition, the amount of tax your clients owe really depends on the nonprofit’s home state.

Upset About UBIT? Blame Pasta!

Before 1950, tax-exempt organizations could earn tax-free income on all activities, even commercial enterprises, as long as the funds raised were used for tax-exempt purposes. Enter C.F. Mueller Company, the pasta maker. In 1947, a group of alumni donated the company to New York University Law School. The company’s earnings were to be solely for the benefit of the school; in turn, the company stopped paying income tax, claiming it was now a tax-exempt organization. The IRS challenged the company in court, but it won, and because its profits were used to further the school’s tax-exempt purpose, no tax was owed.

For-profit entities cried foul, claiming this gave nonprofits the ability to compete directly with for-profit businesses with the unfair advantage of not being taxed on the income. In response, Congress enacted a law in 1950 to begin taxing nonprofits engaging in commercial activities unrelated to the organizations’ tax-exempt purpose. Since then, additional legislation was enacted and guidance issued to ensure nonprofit compliance.

The UBIT law applies to mostly any entity that is exempt from tax. In addition to organizations excluded under IRC Sec. 501(a) — charities, religious organizations, state and municipal colleges and universities, and scientific organizations — certain tax-favored vehicles, including pensions, IRAs, SEPs, 529 plans, medical savings accounts and Coverdell Savings Accounts, are also included.

The Traditional Part of UBIT: Unrelated Trade or Business Activity

As with most of tax law, UBIT rules are initially fairly straightforward. Activities considered taxable must meet three conditions:

  1. They are considered a “trade or business” activity.
  2. They are “regularly conducted.”
  3. They are not “substantially related” to an entity’s tax-exempt purpose.

All three conditions must be true, unless the organization is otherwise specifically exempt (more on that later). Make the argument that even one condition doesn’t apply, and you have avoided UBIT for that activity. Let’s drill down a bit into each of these.

Trade or business: If a product or service is sold with the intent to make a profit, then you typically have a trade or business for purposes of UBIT; however, this isn’t always the case. Selling t-shirts at an event? As long as the price is roughly the same as the cost, including overhead, it seems logical that a profit motive doesn’t exist. However, just because a specific for-profit activity is part of a larger tax-exempt activity does not make the activity tax-exempt. Selling ads in a periodical that contains articles related to an organization’s tax-exempt purpose does not make the ads tax-exempt.

Regularly conducted: Here, frequency and continuity of comparable commercial activities are examined. For example, one organization may sell sandwiches at a local state fair for two weeks a year; that’s certainly not what other vendors do that sell food at the same fair — they may sell year-round at other fairs. In this organization’s case, this makes the activity tax-exempt. The idea is to only tax activities that are in direct competition with for-profit entities.

Not substantially related: If the activity doesn’t contribute in an important way to the organization’s tax-exempt purpose, then it is not substantially related and may be subject to tax. Remember that merely providing funds to the organization is not enough. The activity must further the organization’s exempt purpose.

In IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations, there is a list of examples of activities that were determined to be (or not to be) unrelated trades or businesses, based on the facts and circumstances of the specific activity. Here are a few examples:

  • A charity whose purpose is to stimulate public interest in art also rents apartments and a dining hall to artist tenants. The rent and dining hall activity are considered unrelated trades or businesses, subject to UBIT, because the activity of housing and feeding artists does not contribute substantially to stimulate a public interest in art.
  • A charity whose purpose is to train artists via a residency program, and charges rent and dining hall fees, could consider the rent and dining fees substantially related to the charity’s tax-exempt purpose and the activities would not be unrelated trades or businesses subject to tax.
  • A tax-exempt museum operates a restaurant inside the museum that is open to staff and visitors, but not the general public. The purpose of the restaurant is to allow for visitors to spend more time in the museum and not have to leave in order to eat a meal. The restaurant can be considered an important part of the organization’s mission, so it is not subject to tax.
  • Suppose the same museum also operates a restaurant that is next to the museum, displays art on its walls and is open to the public. This restaurant is subject to tax because serving the general public is on a scale larger than is reasonably necessary to the museum’s mission, and the restaurant is directly competing with other restaurants on the same block. Some more aggressive clients may try to argue that having the restaurant next to the museum and displaying art at the restaurant may entice people to go to the museum and, therefore, it is part of the museum’s mission and not subject to tax. This argument is most likely a bridge too far! The fact that customers may take note of the art is ancillary to the main activity occurring, which is serving food. The activity doesn’t contribute importantly to the museum’s mission.

If you went through the three tests and it looks as if your clients’ activity may be subject to UBIT, don’t worry — all is not lost. The IRS provides a list of activities that are specifically excluded from UBIT in IRS Pub. 598.

Still Can’t Find the Exception You Want? Wait, There’s More!

In a separate section of the law, the IRS excludes certain income items from unrelated business taxable income (UBTI). Unlike the first set of exclusions, which focus on activities that, in many cases, are related at least tangentially to the organization’s mission, this additional list of exclusions is related to income:

  • Interest, dividends, annuities and other investment income; there are a couple of exceptions to this rule, the most common one being if you borrowed the funds that were invested and still owe a balance, then a pro rata portion of the income is not excluded.
  • Royalties.
  • Rents of real property, such as a building or land (the non-debt financed portion as with investment income above). Rental of personal property (e.g., equipment and furniture) is still considered an unrelated trade or business activity.
  • Research grants and contracts from federal, state and local governments are always excluded. Private grants can also be excluded, but only by colleges/universities and hospitals. A private grant to a nonprofit that is not a school or hospital may still be excluded if it can be shown that the research will benefit the general public.
  • Gains and losses from the sale, exchange or disposal of investments, as well as certain business assets. As with interest and dividends, if you borrowed money to buy the asset and still owe on it during the year preceding the sale, you will need to pay tax on the portion of the gain attributable to the outstanding loan balance.
  • Income from services provided under federal license. This is a carve-out for certain religious orders operating activities before May 27, 1959.
  • Member income of mutual or cooperative electric companies.

Got UBIT Activities? Don’t Fret: Deduct Costs

Once you’ve decided that your clients have income that may be subject to tax, it’s time to begin looking for expenses related to that income. Just as with for-profit businesses, nonprofits are allowed to deduct expenses of an activity from the income generated before computing the tax. This happens directly on Form 990-T, but keep these points in mind:

  • Any expense directly attributable to the income can be deducted. This may include cost of goods sold, payroll for employees, supplies, depreciation and other costs.
  • Some expenses, usually payroll and facility costs, are used for exempt activity as well as the activity subject to UBIT. In these cases, you may prorate a portion of these dual-use costs to lower UBIT. For example, consider a tax-exempt science center that sells tickets to a laser light show set to Pink Floyd music in its planetarium on weekends. A portion of the staff time, as well as the cost to maintain the planetarium, utilities, insurance and depreciation, can be deducted.
  • Selling ads in a periodical. There are specific rules for allocating some of the costs of the periodical against the advertising. See Pub. 598 for details.

Once all the costs have been deducted, the IRS allows three more deductions or modifications:

  1. Net operating losses: Any losses from a specific activity in a tax year beginning after 2017 can be carried forward and used to offset current-year income up to 80 percent of UBTI, but only for that specific activity. For tax years beginning Jan. 1, 2018, activities must be considered separately.
  2. Contributions to other charities: Just like for-profit businesses, nonprofits are allowed to deduct charitable contributions to a maximum limit of 10 percent of UBTI.
  3. Specific deduction of $1,000 per return: Note this is one $1,000 deduction per return, not per activity.

The New Part of UBIT: Taxing Certain Employee Fringe Benefits

Among the changes to the 2018 Form 990-T is one tiny line (Part III, Line 34) in the final computation of taxable income that says to add in “Amounts Paid for Disallowed Fringe.” TCJA limited, and in some cases eliminated, the deductibility of two fringe benefits paid or given to employees that were previously deductible:

  1. Qualified transportation: Van pools and transit passes (bus and train).
  2. Qualified parking: Parking that is at or near the employee’s place of work through a third party, or an employee-owned or leased facility.

Of particular concern are nonprofits leasing office space that includes free parking. In these cases, parking isn’t actually free, but part of the monthly rent being paid and should be factored into the evaluation of nondeductible fringe. In addition, TCJA limited, and in some cases eliminated, deductions for certain employee-related transportation and parking costs, whether incurred by the employer or the employee.

What Does This Mean for Nonprofits?

Qualified transportation assistance and parking, paid or provided, will generally be taxed to someone: either the nonprofit or the employee. The nonprofit can simply add the amounts to the employees’ wages and deduct them as wages, which means the employee pays the tax. If the employee elects to reduce their wages by these amounts pursuant to a compensation reduction agreement, the employee gets out of the tax, but the employer then must include these amounts on Form 990-T and pay tax on them.

Taxing Parking Costs: Help on the Way

Although some nonprofit employers provide transportation assistance to employees, a much larger number provide some sort of parking. This fact, coupled with the idea that even parking included with leased office space may still trigger a tax, has caused great uproar throughout the nonprofit community. In response, the IRS issued some guidance with Notice 2018-99 at the end of 2018. To minimize the tax on parking, keep the following in mind:

  • Payment made to a third party for parking spots: The IRS already requires employees to pay tax, as wages, on parking in excess of a monthly parking exclusion indexed for inflation – $265 in 2019. Therefore, any amounts paid in excess of $265 in 2019 per employee are not subject to UBIT and are, instead, wages.
  • Employer-owned or leased facility that includes parking: Parking costs are excluded from UBIT if no parking is reserved for employees, partners or independent contractors of the taxpayer, the parking lot is a shared lot open to the general public, and less than 50 percent of the spots are used by employees, partners or independent contractors (during normal business hours on a typical business day).

Note that reserved employee spots or sections will still be subject to UBIT. In addition, the amount of fringe incurred and included in UBTI is based on the actual cost to the employer and not the fair market value.

What’s Next?

Honestly, no one knows. With an election year upon us and other matters before Congress, it may be awhile before we see any further changes to UBIT.

Paying taxes is rarely fun. The more we can do to save our clients from UBIT, the more dollars they will have to further their missions — and that is better for everyone.

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