For nonprofit organizations heavily involved in fundraising and charitable activities, recognizing unrelated business income (UBI) and reporting it accordingly is critically important to maintaining tax-exempt status. In a previous post, we defined UBI and outlined the key exceptions. Now, we’ll take a look at two of the most common types of UBI and how to calculate them.
Income from Debt-Financed Property
Debt-finance property is defined by the IRS as “any property which is held to produce income and with respect to which there is acquisition indebtedness at any time during the taxable year.” The same exceptions to general UBI also apply here, meaning property that derives its income from volunteer, convenience, donation, research or mission-driven activities is not considered debt-financed.
The amount included in UBI is proportionate to the debt associated with the property, and is calculated by this formula:
Gross receipts x Average Acquisition Indebtedness ÷ Average Adjusted Basis = Taxable Amount
“Average Acquisition Indebtedness” is the average amount of principal indebtedness on the property during the portion of the year the property is held. “Average Adjusted Basis” is the average of the adjusted basis of the debt-financed property on the first and last day of the year. Keep in mind, a proportionate amount of expenses associated with the rental may be claimed.
Here is a fictional example to demonstrate how the taxable amount of debt-financed income is calculated. Let’s say a not-for-profit organization owns a building, half of which is rented to a clothing store, which is unrelated to the nonprofit’s mission. The not-for-profit has debt of $100,000 on the property. The adjusted basis of the property is $200,000 and the rental income from the store is $20,000. Using the formula above, we calculate: $20,000 x ($100,000 $200,000) = $10,000 taxable income. Since it is over the $1,000 IRS threshold, this amount must be reported as UBI using Form 990-T.
Income from Controlled Entities
Normally, passive income is exempt from UBI. According to the IRS, however, interest, annuities, rents or royalties received from a controlled organization may constitute UBI. Dividends received from controlled entities are not considered UBI. The threshold for determining control is “more than 50 percent,” which means the tax-exempt organization owns more than 50 percent of the stock, profits or capital interest. Here are two examples to illustrate this concept:
- Example #1: A §501(c)(3) educational organization licenses the right to use its name and logo to a taxable subsidiary that produces a television show. The subsidiary pays the organization $100,000 annually in royalties. The subsidiary had taxable income for the year of $900,000. The $100,000 royalty is considered UBI and must be reported as such.
- Example #2: A not-for-profit organization owns a for-profit corporation to which it loans money. The for-profit corporation takes a deduction for interest expense on the loan, but the interest income to the not-for-profit is subject to UBI.
As with all taxation issues, specific circumstances and situations can impact the categorization or calculation of income as UBI. RKL’s Not-for-Profit Industry Group is here to help nonprofit leaders and financial executives determine UBI and file the necessary paperwork to preserve tax-exempt status. Contact one of our local offices today for assistance.
Contributed by Ruthann J. Woll, CPA, Principal in RKL’s Tax Services Group and member of the firm’s Not-for-Profit Industry Group. Ruthann has significant experience in tax planning and compliance and specializes in serving individual and not-for-profit clients.