Unrelated Business Income Overview

Transcription

1 Unrelated Business Income Overview Trainer: Michael J. Peterson, CPA, Manager 1

2 Materials/Disclaimer Please note that these materials are incomplete without the accompanying oral comments by the trainer(s). These materials are informational and educational in nature and represent the speakers' own views. These materials are for the purchasing agency s use only and not for distribution outside of the agency or publishing on a public website. 2

3 IRS Circular 230 Disclosure Any tax advice included in this communication, including attachments, is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. 3

4 Purposes and Goals Purposes Obtain an understanding of unrelated business income Obtain an understanding of distinctions between different types of income Obtain an understanding of income tax implications of unrelated business income activities Goals Recognize tax implications to organizations of income generating activities that are beyond an organization's exempt purposes Identify tax ramifications in considering potential income generating activities Understand strategies that can reduce or eliminate potential unrelated business income 4

5 Agenda Unrelated Business Income (UBI) Defined Exclusions to and Exceptions from UBI Debt Financed Income Special Considerations Calculating Tax How much is too much? State and Local Tax implications 5

6 What is Unrelated Business Income? 6

7 What is Unrelated Business Income? History: Prior to 1950, income earned from a business was tax free, as long as it was used for exempt activities The destination of income approach. In 1951, Congress established Unrelated Business Income Tax (UBIT) to attempt to eliminate the unfair competition that charitable businesses represented. 7

8 What is Unrelated Business Income? The question is: Not: How is the money earned? What are the net funds used for? 8

9 What is Unrelated Business Income? Unrelated business income (UBI) is the income from a trade or business that is regularly carried on and that is not substantially related to the performance by the organization of its exempt function or purpose, except that the organization uses the profits derived from this activity. 9

10 Trade or Business Any activity carried on for the production of income from selling goods or performing services (profit motive) An activity does not lose its identity or character because it is carried on within a larger group of similar activities which may or may not be related to the organization s exempt purposes 10

11 Regularly Carried On Activities show a frequency and continuity and Activities are pursued in a manner similar to comparable commercial activities of nonexempt businesses 11

12 Regularly Carried On For example Example A CAP agency expands its weatherization services to the general community and charges for the service A CAP agency s operation of a stand at the state fair for two weeks out of the year Operating a parking lot every Friday night of the year UBI? YES NO YES The IRS considers time spent preparing for an activity 12

13 Not Substantially Related A business activity is not substantially related to an organization s exempt purpose if it does not contribute importantly to accomplishing that purpose The fact that revenues earned in an activity are used in carrying out the organization s exempt purpose does not have bearing on the determination of whether the activity is substantially related How the income is earned and not the destination of the income is what matters 13

14 Not Substantially Related Consider the size and extent of the activities involved in relation to the nature and extent of the exempt function which they are designed to serve For example, a museum operates a restaurant to serve hungry guests and employees. The restaurant is open three hours before the museum opens in the morning and is open for several hours in the evening after the museum is closed. The restaurant advertises its breakfast and dinner service in the newspaper and on the radio. 14

15 Not Substantially Related Selling products resulting from the performance of the exempt function is not unrelated. However, selling products that are used or exploited in further business activity beyond what is reasonably necessary to dispose of them, as is, is unrelated. 15

16 Not Substantially Related Where facilities are used for both unrelated and related purposes (fragmentation), look to the particular activities conducted in the facility Exempt activities creating goodwill or other intangibles that can be exploited in a commercial way may result in income that is not substantially related 16

17 Other Factors Is there a causal relationship between the revenue generating activity and the mission? For example, tuition in exchange for educational programs and rent in exchange for low income housing Disposition of articles that are byproduct of taxexempt function You can charge fees for tax-exempt function activities The size and extent of the activity can become too large Look at context of activity 17

18 What Is Not Considered Unrelated Business Income? Contributions Income from activities for which the organization exists Other types of income are considered exclusions or modifications Must be careful with exclusions because, like much of life, there are exceptions to the exceptions (exclusions) Activity doesn t lose its character as a trade or business because it is carried on within a larger aggregate of similar activities which may or may not be related to an organization s exempt purposes 18

19 Exclusions to and Exceptions From UBI Tax 19

20 Exclusions To and Exceptions From UBI Tax Common Income Dividends, interest, payments with respect to securities loans, annuities, and certain other types of investment income are excluded from unrelated business taxable income unless income is debt financed. Special rules also apply in the case of certain types of income derived from controlled organizations. 20

21 Exclusions To and Exceptions From UBI Tax Royalties unless they are received from the use of debt financed property or Royalties paid by a controlled corporation (unless the royalties paid in 2006, 2007, 2008, 2009, 2010 and 2011 and subject to binding written contract in effect on August 17, 2006 or to a contract which is renewed under substantially similar terms to the contract in effect on August 17, 2006) This is an exception to the exception to the exception 21

22 Exclusions To and Exceptions From UBI Tax Rents from real property and personal property leased with such real property are generally excluded, if rents attributable to personal property are an incidental amount of the total rents received under the lease. 22

23 Exclusions To and Exceptions From UBI Tax Determining if rents attributable to personal property are incidental: Generally incidental if amounts attributable to personal property are less than 10% of total rent received If more than 10% but 50% or less unrelated income from only the amount attributed to the personal property Rents will not be excluded if more than 50% of total rents received are from personal property Rents not excluded if property is debt financed Rents based in whole or in part on income derived from the profits of the activity for which real property leased are not excluded Fixed percentage based on gross receipts or sales ok 23

24 Exclusions To and Exceptions From UBI Tax Rents from controlled corporations* are unrelated business income. Rents from real property where personal services are performed in connection with the rental and those services are beyond those which are customarily rendered in connection with the rental of rooms or space for occupancy Maid service in a hotel Personnel for operating equipment Custodial services are ok *more than 50% controlled 24

25 Exclusions To and Exceptions From UBI Tax Income from controlled organizations: Certain income from controlled organizations is subject to special rules. Generally, if an organization (the controlling organization ) receives a specified payment from another entity which it controls (the controlled entity ), the controlling organization must include such payment as an item of gross income in computing its unrelated business taxable income. Specified Payment means any interest, annuity, royalty or rent. 25

26 Exclusions To and Exceptions From UBI Tax Definition of control: Corporation more than 50% of the stock in the corporation Partnership more than 50% of the profits interests or capital interests in the partnership Other entities more than 50% of the beneficial interests in the entity Nonstock Corporation At least 50% of the directors of the entity are trustees, directors, agents, or employees of the controlling organization or the controlling organization has the power to remove at least 50% of the directors or trustees of the entity and appoint new directors or trustees. 26

27 Exclusions To and Exceptions From UBI Tax Other Exclusions Volunteer labor At least 85% of the labor force is unpaid (substantially all) Ok to have some paid staff and someone to supervise volunteers Determine using volunteer hours Donated items Known as thrift shop exception At least 85% of the merchandise sold is donated Distribution of low cost article incidental to charitable campaign Cost set annually using cost of living ($10.60 for 2016) 27

28 Exclusions To and Exceptions From UBI Tax Convenience Convenience of: members; students; patients; officers; or employees Must be for their convenience Qualified convention and trade shows Carried out by 501(c)(3),(4),(5) or (6) organization and conducted in conjunction with convention, meeting or show; purpose of sponsoring organization is promotion and designed to achieve purpose through character of exhibits 28

29 Exclusions To and Exceptions From UBI Tax Sales of investments (non-inventory property) provided they are not debt financed Certain mailing list rentals or exchanges Can exchange with another organization exempt under Section 501(c)(3) Beyond exchange with a charitable organization must consider whether royalty rules apply 29

30 Unrelated Debt Financed Income 30

31 Unrelated Debt Financed Income Existence of acquisition indebtedness converts otherwise non-taxable income into taxable income Does not apply to related income Property held to produce income for which acquisition debt was used to acquire Not just real property Exclusion if 85% or more of the property is used for exempt purposes Lease to another nonprofit advancing exempt purposes of leasing organization counts Determination of related usage based on time property used for exempt purposes and portion used for exempt purposes May have to allocate between related and unrelated usage Neighborhood land 31

32 Unrelated Debt Financed Income Related real estate owned by partnerships Are all partners in the partnership qualified partners? If not, certain rules apply in order for income to passthru as related 32

33 Unrelated Debt Financed Income Acquisition indebtedness includes the following: Unpaid portion of indebtedness incurred in acquiring and/or improving property Unpaid portion of indebtedness incurred before acquisition and/or improvement of the property if such indebtedness would not have been incurred without acquisition or improvement, and Unpaid portion of indebtedness incurred after acquisition and/or improvement of the property if such indebtedness would not have been incurred without acquisition or improvement and incurring debt reasonably foreseeable at time of acquisition and/or improvement 33

34 Unrelated Debt Financed Income Property acquired subject to mortgage Outstanding mortgage balance treated as acquisition debt even if mortgage not assumed Exception for property acquired by gift, bequest or devise as long as the mortgage was placed on the property more than 5 years before the gift and the property was held by the donor for more than 5 years before the gift then the indebtedness is not acquisition debt for a period of 10 years after the date of the gift. This exception does not apply if in order to acquire the property the organization assumes and agrees to pay the indebtedness secured by the mortgage. Extensions, renewals, and refinancing treated as acquisition debt 34

35 Special Considerations 35

36 Common examples of UBIT include: Bookstore operations Museum shop Sales of pharmaceuticals Laboratory services Fitness centers Membership list sales Services provided with lease Yearbook advertising Magazine advertising Travel tour programs Business association s parking and bus services Non-income-eligible rents Debt financed rents 36

37 Advertising Advertising can be related in rare cases Advertising must contribute importantly to the organization s exempt purpose What is regularity of advertising activity? Periodical Multiple publications? Is it regularity of event or regularity of sales activity? Volunteers Royalties 37

38 Qualified Sponsorships Payments in connection with qualified convention and trade shows and income from sale of advertising or acknowledgement in exempt organization periodicals No expectation of substantial return benefit by person making payment Any benefit other than goods, services or other benefits with a fair market value of more than 2% of the payment and a use or acknowledgement of name, logo or product line of payor s trade or business Advertising, use of facilities, rights to use of intangible and exclusive provider arrangements considered Logo and non-qualitative slogans with no comparative description of products or services, locations value neutral descriptions and brand or product listings are not advertising 38

39 Exploited Exempt Activity Income Advertising Income from unrelated activity that exploits exempt activity Expenses attributable to the exempt activity may offset the income from the particular unrelated activity but may not create a loss With respect to advertising, generally advertising income may be offset by advertising expenses, however, if publication is a periodical and has a loss from circulation it may offset advertising income with the current year s circulation loss 39

40 Unrelated Business Income Tax Allocating Costs: Indirect costs or overhead may be allocated to unrelated income Reasonable and consistent methodology, includes Time Square footage Gross income Advertising lineage 40

41 Partnership Investments If partnership carries on unrelated trade or business resulting income is taxable Look at nature of partnership income Notify the partnership of your exempt status 41

42 Alternative Investments Not typical investments Not traditional stocks and bonds LLCs and LPs, most commonly invest in real estate, hedge funds, and private equity Structure is key consideration Where in the structure is there debt Foreign corporations commonly used to block unrelated income Alternative Investments generally open the door to many other filings/exposure including state exposure and foreign activity. 42

43 Other Considerations Joint ventures with for-profit entities Single member LLCs disregarded, however, income subject to unrelated business income tax rules S corporation income taxable regardless of how earned Rents, royalties, and interest from controlled corporations 43

44 Unrelated Business Income Tax Public disclosure, if IRC Section 501(c)(3) Similar to Form T required if $1,000 or more gross income from unrelated businesses Estimated taxes can be required based on tax liability. Corporate income tax rates for most organizations Organizations that are charitable trusts under state law are taxed as trusts 44

45 Unrelated Business Income Tax IRS Focus: Continued and repeated losses may result in IRS determination that activity is not a trade or business and use of loss to offset income from profitable unrelated business activities may be limited The IRS will be looking at organizations reporting unrelated income on Form 990 but have not filed Form 990-T and developing risk models to help identify organizations reporting significant gross receipts from unrelated activities but declaring no tax 45

46 How to Limit Unrelated Business Income Are articles of incorporation broad enough to provide for activities being considered related? Planning Could a particular activity be carried out by substantially all volunteers? Is debt appropriate? What activities should be conducted by a partnership or LLC? Whom should other partners or members be? 46

47 How Much is Too Much? Generally unrelated business activities must be less than a substantial portion of the organization s activities Charitable organizations must be organized for exclusively charitable purposes Generally no fixed percentage limitations, however, one court has said one third of revenue too high Others have said 20% or less Typically a facts and circumstances determination Consideration given to time and efforts What is size and extent of trade or business Consideration may be given to where organization applies its resources 47

48 State and Local Taxes Potential property tax implications Sales and use tax issues 48

49 Questions and Discussion 49

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