Unrelated Business Income Brandy Terwilliger, CPA Principal bterwilliger@manercpa.com Agenda Unrelated Business Income (UBI) Overview Common sources of UBI Expenses Resources Tax Reform 517.323.7500 1
The Law. 513 Unrelated trade or business (a) General Rule. The term unrelated trade or business means, in the case of any organization subject to the tax imposed by section 511, any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its charitable educational, or other purpose or function constituting the basis for its exemption under 501 (or, in the case of an organization described in section 511(a)(2)(B), to the exercise or performance of any purpose or function described in section 501(c)(3) Unrelated Business Income Overview Trade or business Unrelated to exempt purpose UBI Regularly carried on 517.323.7500 2
UBI Overview Trade or Business Profit Motive Loss activity that has evidence of a profit motive Questions to ask: History of NOLs Net position before depreciation & charitable contributions UBI Overview Regularly Carried On Frequency & continuity - not sporadic or infrequent Similar to commercial enterprises 517.323.7500 3
UBI Overview Unrelated to exempt purpose Does not contribute to the exempt purpose No substantial causal relationship to the achievement of the exempt purpose Size & extent of the activities Dual use property Exceptions & Exclusions Real Property Personal Property Services Interest Dividends Royalties Gain on sales But.. If there is debt involved in the acquisition or improvement of the property, there is potential UBI 517.323.7500 4
Exceptions & Exclusions Volunteers Thrift shop Research Exceptions & Exclusions Sponsorships Public Entertainment activities & trade shows Convenience Exception 517.323.7500 5
Potential UBI Sources Partnership Interest Trade or business income Debt financed income Income from securities purchased on margin Probably UBI Not UBI, passive income Potential UBI Sources S Corporation Income Always taxable Management services to unrelated organizations Advertising on periodicals/magazines Payments from controlled entities Interest, Royalties, Rent & Annuities 517.323.7500 6
Expenses The Regs. Except as otherwise provided in 1.512(a)-3, 1.512(a)-4, or paragraph (f) of this section, section 512(a)(1) defines "unrelated business taxable income" as the gross income derived from any unrelated trade or business regularly carried on, less those deductions allowed by chapter 1 of the Code which are directly connected with the carrying on of such trade or business, subject to certain modifications referred to in 1.512(b)-1. To be deductible in computing unrelated business taxable income, therefore, expenses, depreciation, and similar items not only must qualify as deductions allowed by chapter 1 of the Code, but also must be directly connected with the carrying on of unrelated trade or business. Except as provided in paragraph (d)(2) of this section, to be "directly connected with" the conduct of unrelated business for purposes of section 512, an item of deduction must have proximate and primary relationship to the carrying on of that business. In the case of an organization which derives gross income from the regular conduct of two or more unrelated business activities, unrelated business taxable income is the aggregate of gross income from all such unrelated business activities less the aggregate of the deductions allowed with respect to all such unrelated business activities. For the treatment of amounts of income or loss of common trust funds, see 1.584-2(c)(3). Direct Expenses Expenses attributable solely to unrelated business activities Expenses, depreciation and similar items attributable solely to the conduct of unrelated business activities are proximately and primarily related to that business activity, and therefore qualify for deduction to the extent that they meet the requirements of section 162, section 167 or other relevant provisions of the Code. Thus, for example, salaries of personnel employed full-time in carrying on unrelated business activities are directly connected with the conduct of that activity and are deductible in computing unrelated business taxable income if they otherwise qualify for deduction under the requirements of section 162. Similarly, depreciation of a building used entirely in the conduct of unrelated business activities would be an allowable deduction to the extent otherwise permitted by section 167. *Code Section 162 is trade or business expenses *Code Section 167 is Depreciation 517.323.7500 7
Dual Use Facility of Personnel 2 ways to calculate facility overhead Total days used for unrelated business activities/total days the facility is used for all purposes. See Rensselaer Polytechnic Institute (not binding circuit case) Total days used for unrelated business activities/total days available to use. IRS preferred method. Example: A tax exempt organization (XYZ) conducts exhibits/shows in their multi-purpose room. When the multi-purpose room is not needed for exempt function, XYZ will stage special events (concerts, movies, etc.) that are not related to the exempt function, and considered UBI. In the current year, XYZ conducted exempt function activities in the room for 150 days and unrelated activities for 75 days for a total of 225 days used. Gross UBI was $350,000. Direct expenses were as follows: Fees paid to performers $100,000 Movie rental Fees $25,000 Legal Fees $5,000 Salary of Special event coordinator $30,000 Allocable portion of ED s salary/benefits (she spends 10% of her time on special events) $15,000 Total Direct Expenses $175,000 Unrelated business income after direct expenses is $175,000 517.323.7500 8
Example (cont.): In addition, there are indirect expenses that XYZ incurred to operate the building and multi-purpose room for the entire year (including the days the facility was not in use) Salary and benefits of facility manager $72,000 Repairs and Maintenance $4,000 Depreciation $25,000 Utilities $8,000 Total Indirect Expenses $109,000 The total direct expenses of $175,000 are fully deductible because they are directly related, however only a portion of the indirect expenses are deductible from UBI. Example (cont.): Using the Rensselaer Method, indirect expense deduction would be calculated this way: 75 (days used in unrelated business activity) / 225 (total number of days facility was used).3333 x $109,000 = $36,333 Using the IRS method, indirect expense deduction would be calculated this way: 75 (days used in unrelated business activity) / 365 (total number of days in tax year).2055 x $109,000 = $22,400 The difference between the two represents the fixed expenses related to the portion of the year when the facility is not used at all. 517.323.7500 9
Indirect Expenses Any reasonable and consistent allocation methods can be used: Time sheets or other time-tracking method Days/hours of use of facility Square footage Gross income Any other reasonable method that makes sense and you can document Advertising Income from advertising in magazines, brochures, periodicals Expenses Direct Expenses Cost of color if advertising is the only item in color Salary of individual whose sole job is to get advertisements Readership Costs Expenses related to putting together the entire publication, periodical, etc. Take the dues paid to the organization and multiple by the portion of the dues related to payment for the periodicals, this is your circulation income. Readership costs in excess of circulation income is also a indirect expense. 517.323.7500 10
Limitations on Certain Deductions Related party transactions Uniform Capitalization Rules Meals & Entertainment Fines & Penalties Charitable deductions regardless if directly connected to the unrelated activity Depreciation Debt-financed- use straight line Section 179 allowed Bonus Depreciation allowed (check state filings) Resources IRS code section 511-514 www.stayexempt.irs.gov site created especially for 501(c)(3) organizations https://www.irs.gov/pub/irs-pdf/p598.pdf Publication 598 Tax on Unrelated Business Income of Exempt Organizations https://www.irs.gov/charities-non-profits/calendar-of-events https://www.irs.gov/charities-non-profits/subscribe-to-exempt-organization-update New releases New forms, guidance and other publications Upcoming IRS trainings 517.323.7500 11
Tax Reform Charitable donation deduction hopefully saved! Considering a repeal of the provision that prohibits all 501(c)(3) non-profit organizations from endorsing or opposing political candidates. Tax royalties for use of an organizations logo or name as UBI Separating unrelated activities Treat certain corporate sponsorships as taxable advertising revenue Excise taxes on higher end executive compensation Tax Reform Proposals that would diminish charitable giving Cap on deductible amount 2% floor before contributions deductible Proposals that would increase charitable giving Make charitable deduction an above the line item Permitting taxpayers to claim a charitable deduction after the close of the tax year but before the due date of the return. 517.323.7500 12
New Not-for-Profit Reporting Standard Mark Lockwitz, CPA Principal mlockwitz@manercpa.com 517.323.7500 13
1993 Financial Accounting Standards Board (FASB) released Statement of Financial Accounting Standards (FAS) No. 117, Financial Statements of Not-for-Profit Organizations 517.323.7500 14
FAS 117 The new standard s objective was to: Enhance relevance, understandability and comparability of financial statements issued Required basic statements Required classification of net assets Total standard was 70 pages in length August 18, 2016 FASB issued Accounting Standard Update (ASU) No. 2016-14, Presentation of Financial Statements of Not-for-Profit Entities First financial reporting update in 23 years New standard is 264 pages in length 517.323.7500 15
Why the change? FASB and its Not-for-Profit Advisory Committee: Existing model is good, but needs tweaking for more useful information for the user (donors, grantors, creditors, others) Project was initially much bigger (eventually broken into phases) Phase 1 What everyone could agree on Phase 2??? Effective Date Standard becomes effective for fiscal years beginning after 12/15/2017, which means: Fiscal year ends starting with 12/31/2018 517.323.7500 16
So what is changing? Net Asset classification Liquidity and availability of resource disclosures Expense reporting Investment return reporting Cash flow statement Net Asset Classification Current Presentation Unrestricted Temporarily Restricted Permanently Restricted New Presentation Without Donor Restrictions With Donor Restrictions Disclosures Amount, purpose and type of board designations Nature and amount of donor restrictions 517.323.7500 17
Net Asset Presentation Net assets: Without donor restrictions: Undesignated $ 80,000 Designated by the Board 5,000 85,000 With donor restrictions: Time restricted only 6,000 Purpose restricted 15,000 Perpetual in nature 74,000 95,000 Total net assets $ 180,000 Net assets: Without donor restrictions $ 85,000 With donor restrictions 95,000 $ 180,000 Presentation style on the statement of financial position can be in detail or summarized. Statement of Activities Without Donor With Donor Restrictions Restrictions Total Revenues and other support: Contributions $ 8,000 $ 5,000 $ 13,000 Grants 12,000 12,000 Investment return, net 3,000 12,000 15,000 Net assets released from restrictions 12,000 (12,000) Total revenues and other support 35,000 5,000 40,000 Expenses: Program A 10,000 10,000 Program B 12,000 12,000 Management and general 5,000 5,000 Fundraising 2,000 2,000 Total expenses 29,000 29,000 Change in net assets 6,000 5,000 11,000 Net assets at beginnig of year 79,000 90,000 169,000 Net assets at end of year $ 85,000 $ 95,000 $ 180,000 517.323.7500 18
Net Asset Disclosure Requirements Composition of net assets with donor restrictions Qualitative or quantitative information regarding board designations Presentation should emphasize how and when net assets will be used Net Asset Disclosure Requirements Net assets with donor restrictions are restricted for the following purposes: Subject to the passage of time: For years ending after December 31, 20XX $ 6,000 Subject to expenditure for specified purpose: Program A activities 11,000 Program B activities 4,000 15,000 Subject to the Organization's spending policy and appropriation: Investment in perpetuity (including amounts above original gift amount of $50,000), which, once appropriated, is expendable to support: Program A activities 22,000 Program B activities 44,000 Any activities of the Organization 8,000 74,000 Total net assets with donor restrictions $ 95,000 517.323.7500 19
Net Asset Disclosure Requirements Net assets without donor restrictions: Undesignated $ 80,000 Quasi endowment 3,000 Operating reserve 2,000 Total net assets without donor restrictions $ 85,000 OR The Board of Directors of the Organization has several standing board policies that affect the presentation of board designations of net assets. Bequests without donor restrictions are designated for long term investment (quasi endowment), which totaled $3,000 at December 31, 20XX. Additionally, the Board of Directors has established an operating reserve with the objective of setting funds aside to be drawn upon in the event of need. The operating reserve balance totaled $2,000 at December 31, 20XX. Underwater Endowments Current reporting practice show underwater activity as unrestricted New reporting practice show underwater activity in the fund where the endowment is located 517.323.7500 20
New Endowment Disclosure Requirements The Board s interpretation of the ability to spend from underwater endowment funds The Board s policy and actions taken concerning appropriation from underwater endowment funds For each year presented: The fair value of the underwater endowment funds The original endowment gift amount The amount of deficiencies of the underwater endowment New Endowment Disclosure Example From time to time, the fair value of assets associated with the individual donor-restricted endowment funds may fall below the level that the donor or UPMIFA requires the Organization to retain as a fund of perpetual duration. The Organization has a policy that permits spending from underwater endowment funds depending on the degree to which the fund is underwater, unless otherwise precluded by donor intent or relevant laws and regulations. As of December 31, 20XX, various donor-restricted endowment funds had aggregated original values totaling $18,000, current fair values totaling $14,000, and deficiencies totaling $4,000. These deficiencies resulted from unfavorable market fluctuations that occurred shortly after the investment of new contributions for donor-restricted endowment funds and continued appropriation for certain programs that was deemed prudent by the Board of Directors. 517.323.7500 21
New Liquidity Disclosures Qualitative information that communicates how an NFP manages its liquid resources available to meet cash needs for general expenditures within 1 year of the balance sheet date. Quantitative information that communicates the availability of financial assets at the balance sheet date to meet the needs for general expenditures within 1 year of the balance sheet date. New Quantitative Disclosure Example SAMPLE STATEMENT OF FINANCIAL POSITION Cash $ 15,000 $ 15,000 Investments 82,000 82,000 Receivables 26,000 26,000 Inventory and prepaids 20,000 Total current assets 143,000 123,000 PP&E 97,000 Total assets $ 240,000 $ 123,000 Considered Financial Assets Total current liabilities $ 35,000 Total long term liabilities 25,000 Total liabilities 60,000 Net assets without donor restrictions 85,000 Net assets with donor restrictions 95,000 Total net assets 180,000 Total liabilities and net assets $ 240,000 517.323.7500 22
New Quantitative Disclosure Example The following reflects the Organizations financial assets as of December 31, 20XX, reduced by amounts not available for general use because of contractual or donor imposed restrictions within one year of the statement of financial position date. Amounts not available include amounts set aside for long term investing in the quasi endowment that could be drawn upon if the Board of Directors approves that action. However, amounts already appropriated from either the donor restricted endowment or quasi endowment for general expenditures within one year of the statement of financial position date have not been subtracted as unavailable. Financial assets, at year end $ 123,000 Less: Contractual or donor imposed restrictions: (95,000) Less: Quasi endowment fund (3,000) Less: Amounts set aside for liquidity reserve (2,000) Financial assets available to meet cash needs for general expenditures within one year $ 23,000 New Qualitative Disclosure Example The Board periodically designates a portion of any operating surplus to its liquidity reserve, which was $2,000 as of December 31, 20XX. There is a fund established by the Board that may be drawn upon in the event of financial distress or an immediate liquidity need resulting from events outside the typical life cycle of converting financial assets to cash or settling financial liabilities. In the event of an unanticipated liquidity need, the Organization also could draw upon $100,000 of available lines of credit (further discussed in Note XX) or the quasi-endowment fund. 517.323.7500 23
Impact of Changes All NFPs are required to present the liquidity and availability disclosures NFPs with weak financial condition will be evident Changes For Reporting Expenses Summarized reporting showing totals for programs, M&G and fundraising will no longer be enough Disclosure to describe the method utilized to allocate costs between program and support is now required 517.323.7500 24
Functional Expense Presentation Can be presented in: Statement of activities Statement of functional expenses (most common) Footnotes Cannot be reported as a supplementary schedule Example of Presentation Program Program Total Total Total A B Programs M&G Fundraising Supporting Expenses Salaries and benefits $ 4,000 $ 7,000 $ 11,000 $ 4,000 $ 1,000 $ 5,000 $ 16,000 Grants to other organizations 2,000 1,000 3,000 3,000 Supplies and travel 1,000 1,000 2,000 200 300 500 2,500 Services and professional fees 100 1,500 1,600 200 450 650 2,250 Office and occupancy 1,100 500 1,600 300 100 400 2,000 Depreciation 1,500 800 2,300 200 100 300 2,600 Interest 300 200 500 100 50 150 650 Total expenses $ 10,000 $ 12,000 $ 22,000 $ 5,000 $ 2,000 $ 7,000 $ 29,000 517.323.7500 25
Allocation Method Disclosure Example The financial statements report certain categories of expenses that are attributable to one or more program or supporting functions of the Organization. Those expenses include depreciation and amortization, the president s office, communications department, and information technology department. Depreciation is allocated based on square footage, the president s office is allocated based on estimates of time and effort, certain costs of the communication department are allocated based on estimates of time and effort, and the information technology department is allocated based on estimates of time and costs of specific technology utilized. Supporting Activities Defined as: Management and general activities Fundraising activities Membership development activities Include activities such as soliciting for prospective members and membership dues, membership relations and similar activities 517.323.7500 26
Management and General Activities Refocused effort to define what is included: Oversight Business management General recordkeeping and payroll Budgeting Financing, including unallocated interest costs Management and General Activities Refocused effort to define what is included: Soliciting funds other than contributions and membership dues Administering government, foundation, and similar customer-sponsored contracts, including billing and collecting fees and grant and contract financial reporting Informing the public of the NFPs stewardship and contributed funds Making announcements concerning appointments 517.323.7500 27
Management and General Activities Refocused effort to define what is included: Producing and disseminating the annual report Employee benefits management and oversight (human resources) All other management and administration except for the direct conduct of program services, fundraising activities, or membership development activities Reporting Investment Return Investment return is no longer required to be separated as: Investment income (interest, dividends, etc.) Unrealized and realized gains and losses Interest expense Investment return, net is the minimum required disclosure No longer necessary to break-out activity in investment or endowment disclosures 517.323.7500 28
The BIG Change to the Statement of Cash Flows You do not have to change a thing. Most organizations report using the indirect method. For NFPs using (or required) to use the direct method: No longer required to present the additional indirect method (reconciliation) Transition Guidance In year of adoption comparative reporting required All provisions apply in year of adoption Organization has option to omit some comparative requirements: Functional expense reporting Disclosures about liquidity Remember - fiscal year ends starting with 12/31/2018 517.323.7500 29
Brandy Terwilliger, CPA bterwilliger@manercpa.com 517.886.9544 Mark Lockwitz, CPA mlockwitz@manercpa.com 517.886.9603 517.323.7500 30