While most nonprofits are operated primarily to be tax exempt, it doesn’t mean they won’t pay business income tax. When nonprofits generate income on unrelated activities, this can result in that income being taxed as unrelated business income (UBI) and the final result is income tax. To be considered under UBI, activities must generally meet three rules; they must:
- Be a trade or business, which the IRS defines as any activity that is carried on for the production of income from sale of goods or the performance of services.
- Be regularly carried on.
- Not be substantially related to the organization’s exempt purposes.
It is important for nonprofit organizations to be mindful of the following tax laws in the current economy where IRS scrutiny of UBI is escalating. In this article, we will elaborate on two areas where such income will be deemed taxable; debt-financed property and income from controlled organizations.
1. Debt-Financed Property
The term, debt-financed property, means any property (e.g. rental real estate, tangible personal property and corporate stock) held to produce income, and with respect to which there is an acquisition indebtedness at any time during the taxable year.
Oftentimes, a not-for-profit organization will procure debt to obtain an income-producing asset. A prime example of this is real estate, such as an apartment building, where income from rent may not be related to the organization’s mission. Generally rents from real property are excluded from UBI, however, if the property is acquired with a mortgage, it is considered debt-financed. Alternatively, investment income from stocks and bonds is usually excluded from UBI, except where the portfolio has a margin loan against it.
There are several exceptions to the debt-financed property rules, which includes property that is:
- related to certain exempt purposes
- used in an unrelated trade or business
- related to research activities
- used in thrift shops
- used by a related organization
- used for exempt purposes
Making the determination if income is related, excluded or unrelated can be very tricky and requires research of regulations and case law.
2. Income from Controlled Organizations
The IRS identifies a corporation as controlled if another entity has the power to remove and replace (or to appoint, elect, or approve or veto the appointment or election of) a majority of the nonprofit organization’s directors and trustees, or a majority of the members who have the power to elect a majority of the nonprofit organization’s directors or trustees.
- The nonprofit may be controlled, or control another entity including another exempt organization, corporation or partnership.
- A nonprofit controls a stock corporation if they own more than 50% of the stock (by voting power or value) of the corporation.
- A nonprofit controls a partnership or limited liability company if they own more than 50% of the profits interests or capital interests in the partnership (including a limited liability company treated as a partnership or disregarded entity for federal tax purposes, regardless of the designation under state law of the ownership interests as stock, membership interests, or otherwise).
Investment income, such as interest, rents and annuities, are not excluded from UBI if they are received from a controlled nonprofit. For example, lease payments received by the controlling nonprofit organization are not excluded from UBI.
There are serious penalties for nonprofits who fail to pay UBIT on debt-financed property or income from controlled organizations. To avoid these penalties, ensure you are in compliance. To learn how Mercadien can help your nonprofit, contact me at email@example.com or 609-689-9700.