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As associations continue their efforts to decrease reliance on traditional sources of revenue such as dues and trade shows, they are expanding into entrepreneurial business endeavors. Some of these activities are related to their tax-exempt missions; others are not. This shift has placed associations — whether trade, business, or professional — in the forefront of unrelated business income taxation (UBIT). Bottom line: Real money is at stake. Your organization needs to consider UBIT implications every time it wants to move into a revenue-generating activity.

Of particular interest to associations pondering UBIT questions are advertising income, the treatment of both corporate sponsorships and travel tours, revenue from partnerships or other joint ventures, and business conducted via the Internet. Regarding the last item, the IRS has said that electronic business (e-commerce) is regarded by the agency the same as business conducted in other ways.

Thanks to complex tax rules, numerous gray areas, and perhaps inexperience with this area of financial management, association leaders often do not adequately evaluate a potential UBIT situation. A three-step process can help.

First, ascertain the purposes of your tax-exempt organization by reviewing the statement of purposes in its articles of organization, any explicit language in its bylaws or other documents (such as a mission statement), and the answer to Part III in its annual information return (Form 990).

Second, identify each of the organization's discrete program activities. Check whether the activity was referenced in the organization's application for recognition of tax exemption (Form 1023 or 1024), if one was filed. If it was portrayed as a program activity (related business) in that document, it will be more difficult for the Internal Revenue Service (IRS) to subsequently assert that the activity now is an unrelated business. Often, however, the activity was not mentioned in the application, usually because it came into existence after the determination letter was issued.

Third, evaluate the activity in question. Consider the rationale, if any, of why there is a nexus (a causal relationship) between the furtherance of exempt purposes and the conduct of the activity. If there is a nexus, is it substantial? If the answer is believed to be yes, the organization has at least a credible position in asserting that the activity is a related business. If the answer is no, the next elements to consider are whether the activity is a business to begin with (it usually is) and whether it is regularly carried on (it usually is). If the answer to both questions is yes, the activity is an unrelated business that would be subject to UBIT.

If that is the case, the next step is to determine whether the activity is the subject of a statutory exclusion (e.g., trade shows) and whether the income involved is the subject of an exclusion (e.g., royalty income). If an exclusion is not available, you should consider restructuring the activity to try to use one of these exceptions or exclusions.

Note that if an association does not conduct an activity on a regular basis, it will not have to pay UBIT. Otherwise, two exceptions exist for either an association or its related foundation: the volunteer labor exception and the donated goods exception. The volunteer labor exception says a business in which substantially all of the work in carrying on the business is performed without compensation is exempt. Unrelated business also does not include a business that involves selling merchandise in which substantially all items have been contributed to the organization.

If an exception such as these two is not available, you should pay close attention to maximizing the amount of deductible expenses that can be marshaled in computing UBIT.

The final step is to quantify the unrelated business in relation to the organization's other activities. If it is sufficiently large (amounting to, say, 15 to 20 percent or more of total income or staff time expended annually), you should consider placing the unrelated business in a for-profit subsidiary.

The Internal Revenue Code defines a "trade or business" as including "any activity that is carried on for the production of income from the sale of goods or the performance of services" (IRC § 513(c)). This is, of course, a sweeping definition. However, courts often add to or ignore this definition in deciding whether an activity is a business. For example, courts check on whether the exempt organization has a profit motive, whether the activity is competitive with for-profit endeavors, or whether the activity has the characteristics of a business as defined in other areas of the tax law, such as the business expense deduction rules (IRC § 162).

Frankly, nearly every undertaking of an exempt organization is a business. Each of an organization's programs, for example, is a business. Thus, federal tax laws view an exempt organization as a cluster of businesses. Each of these businesses is evaluated separately to determine whether it is related or unrelated, a process called "fragmentation."

One element the IRS examines during this fragmentation is the frequency and continuity with which the revenue-raising activity is conducted and the manner in which it is pursued. Officials are looking to answer the question, "Is the activity regularly carried on?"

A business activity of a tax-exempt organization is considered to be regularly carried on if it is pursued in a manner generally similar to comparable commercial activities of nonexempt organizations. If income-producing activities are of a kind normally undertaken by nonexempt commercial organizations only on a seasonal basis, the conduct of the activities by an exempt organization during a significant portion of the season ordinarily constitutes the regular conduct of a business. An example is the sale of holiday cards only during the holiday period.

The IRS also is evaluating whether an activity is "substantially related" to the organization's exempt purposes. A business is related to tax-exempt purposes of an organization only when the conduct of the business activity has a causal relationship to the achievement of an exempt purpose. It is substantially related only if the causal relationship is a substantial one. In one recent example, an organization's consignment shop was held to be substantially related, but a small restaurant for visitors, while considered related, was found to be not substantially related.

There are, however, subtests in this regard.

1. The "size and extent" test. In determining whether an activity contributes importantly to the accomplishment of a tax-exempt purpose, the size and extent of the activity must be considered in relation to the nature and extent of the exempt function that it purportedly serves. An activity may be generally related to exempt purposes but conducted on a scale that is larger than reasonably necessary for the performance of exempt functions. In this situation, the gross income attributable to the portion of the activity that is in excess of the needs associated with exempt functions constitutes gross income from the conduct of an unrelated business.
   
   
2. The "same state" rule. Ordinarily, gross income from the sale of items that result from the performance of tax-exempt functions does not constitute gross income from the conduct of an unrelated business if the item is sold in substantially the same state it is in on completion of the exempt functions. Conversely, if an item resulting from an exempt function is used or exploited in further business endeavors beyond that reasonably appropriate or necessary for disposition in the state it is in upon completion of exempt functions, the gross income derived from these endeavors is from the conduct of unrelated business. An association of those who fish commercially can sell fish to a wholesaler without tax, but a tax is likely if the sold fish is cooked.
   
   
3. The "dual use" rule. An asset or facility of a tax-exempt organization that is necessary to the conduct of exempt functions also may be used for nonexempt purposes. In these dual-use instances, the mere fact of the use of the asset or facility in an exempt function does not, by itself, make the income from the nonexempt endeavor gross income from a related business. The test is whether those revenue-producing activities contribute importantly to accomplishing exempt purposes.
   
   
4. The exploitation rule. Activities carried on by a tax-exempt organization in the performance of exempt functions may generate goodwill or other intangibles that can be exploited in commercial endeavors. Where an exempt organization exploits this type of intangible in commercial activities, the fact that the resultant income depended in part on the conduct of an exempt function of the organization does not make it gross income from a related business. The most common example of this is commercial advertising in an exempt-function publication.

The principal exclusions are for dividends, interest, annuities, royalties, rents, and capital gain. Let's review how these terms are defined by the IRS for UBIT purposes. A "royalty" is a payment for the use of a valuable right, such as a name or logo. A royalty is not taxable to a tax-exempt organization as long as the organization provides only incidental services in connection with payment of the money. A good example of this might be an affinity credit card program in which the association is a completely passive sponsor, permitting only the use of the organization's logo and name and ensuring that the organization does not get involved in marketing.

A frequent question about UBIT is whether income from rent — say, renting part of your headquarters building — is always excluded. The answer is no. If the organization is in the business of renting property, the exclusion generally is not available. The same is true regarding income from rentals of personal property.

What about capital gains? Yes, such income is always excluded — if it is truly capital gain. However, if, for example, a tax-exempt organization is found to be a dealer in the property involved, the resulting income is ordinary income, not capital gain.

In addition, be aware that unrelated debt-financed income, which is income derived from property that the exempt organization has borrowed money to acquire, may be taxable even if the income is in one of the otherwise excludable forms.

Another frequent question is how income from a controlled organization is treated. ("Control" can be as low as 51 percent ownership or board overlap.) Income from a controlled organization may be subject to UBIT if the payment reduces the net unrelated income of the controlled entity. This is the case even if the income is in one of the otherwise excludable forms (other than dividends).

In the past few years, the IRS has made it clear that the association community should expect increasing attention on the UBIT front. The agency's "Implementing Guidelines," issued for the government's fiscal year 2002, focused on six segments of the tax-exempt organizations community. One of these segments is business leagues (501(c)6 organizations). The IRS also has said that part of the analysis will be looking at associations' unrelated business activities, nonexempt activities, private inurement, and fundraising. The bottom line again? Put UBIT implications on your financial and programmatic radar screens or risk an unpleasant, even threatening surprise when tax season arrives.

Author Link: Author of 15 books and a specialist in legal issues of nonprofits, Bruce R. Hopkins is a lawyer with Polsinelli, Shalton & Welte, PC in Kansas City, Missouri. He can be reached at (816) 360-4371.

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