Exempt Organizations and UBIT - A Primer

Tests for the Determination of Unrelated Business Income

Introduction

           It is not uncommon for nonprofit, tax-exempt organizations to seek multiple sources of revenue to sustain their mission.  When seeking to establish different sources of revenue, nonprofit organizations must be keenly aware of whether or not any of their activities are substantially related to the organization’s exempt purpose and the difference that a degree of unrelatedness makes to the IRS. When any activity is considered unrelated to the organization’s exempt purpose, the revenue earned from that unrelated activity may be considered unrelated business income (UBI) by the IRS, consequently, the revenue will be taxable. Further, in certain circumstances, a nonprofit, tax-exempt organization may risk its exemption status.

           Unrelated income rules exist to prevent unfair competition between tax-exempt organizations and for-profit commercial enterprises.1 The unrelated income rules act to assure that a nonprofit, tax-exempt organization is organized and operated primarily for exempt purposes.2

The Three-Pronged Test for Unrelated Business Income

         The Internal Revenue Service (IRS) uses a three-pronged test to determine how a nonprofit, tax-exempt organization treats its income and whether the organization’s activities substantially further the exempt purpose of the organization.

·        The income must be from a trade or business - this refers to activities that produce income (usually from the sale of goods or services).

·        The trade or business must be regularly carried on. This means that the business activity operates continuously or frequently. Infrequent activities, such as an annual fundraiser, are not considered regularly carried on. Of note is that time spent preparing for an event should also be included in evaluating an activity and that outsourced events fall under the law of principal and agent. The activities of the “agent” could be attributable to the exempt organization, who would be the principal. Further, seasonal activities could be deemed to be regularly carried on if conducted on the same season every year.

·        The trade or business is not substantially related to the organization’s exempt purpose. If an activity does not contribute in a significant way to the organization’s exempt purpose, then the activity may be unrelated to the organization’s exempt purpose.3 The size and extent of activities matter and evaluations are very fact-specific, meaning there is no clear criteria (“it depends”).

There are some exceptions to unrelated business income which will be non-taxable.  For example, activities conducted by uncompensated volunteers or the sale of merchandise donated to the organization are non-taxable. Also, the sale of merchandise which has been received by the organization as a gift or contribution, is not an unrelated trade or business if the merchandise constitutes greater than 85% of all the merchandise being sold [IRC Sec. 513(a)(3)]. Exclusions to the unrelated business income rule are discussed further in this article.

If an activity results in UBI it may result in taxes payable to the IRS. However, this does not necessarily mean that the organization needs to discontinue the activity. Unrelated activities will generally only put an organization’s tax-exempt status at risk when they are significant in comparison to all the exempt activities conducted by the organization. 

Nonprofit, tax-exempt organizations must make it a priority to review their activities.  It is very important to be aware of activities that may be considered UBI and can result in a tax liability. Also, organizations should check their stated exempt purpose as described on its application for exemption (Form 1023).  A nonprofit, tax-exempt organization should not, at the end of the year, realize that they have unintentionally conducted unrelated taxable activities and have accumulated a tax liability for which they are unprepared.

The Fragmentation Rule

           The IRS, in the evaluation of an exempt organization’s unrelated business activities, can fragment an activity into its separate parts (unbundle) so that each fragment can be examined independently of the others.4 In this way, the IRS can determine if sales from an activity, for example, are related or unrelated for the purposes of UBI.

           An exempt organization cannot expect that simply because an unrelated activity resulted in a loss in a year, the activity will not be treated as an unrelated one. The opposite is also true, simply because an activity was very profitable will not result in it being treated as unrelated.5

               Caution should be exercised when an activity is conducted in a commercial manner, as would a for-profit enterprise, and the activity is clearly within the purpose of the exempt organization. Although statutory law does not authorize the IRS to conclude that simply because an activity is conducted in a commercial manner similar to that of for-profit enterprises, that it is unrelated; however, the IRS still may do so.6 This is an illustration of the administrative power of the IRS.

 Computing Taxes for Unrelated Business Income

           The computation of taxes on unrelated business income of charitable, exempt organizations is described in the IRC Code Section 511, which states,

           ‘There is hereby imposed for each taxable year on the unrelated business taxable income (as defined in section 512) of every organization described in paragraph (2) a tax computed as provided in section 11.”

           Per the IRS, an exempt organization that has $1,000 or more of gross income from an unrelated business must file Form 990-T PDF. An organization must pay an estimated tax if it expects its tax for the year to be $500 or more.7

The Main Types of Income Exempted from the Unrelated Business Income Tax

           The unrelated business income tax rules do have several exceptions. The main activities producing income for exempt organizations that are specifically excluded from the definition of unrelated trade or business include the following:

• Volunteer Labor: Any trade or business is excluded in which substantially all the work is performed for the organization without compensation. Some fundraising activities, such as volunteer operated bake sales, may meet this exception.
• Convenience of Members: Any trade or business is excluded that is carried on by an organization described in section 501(c)(3) or by a governmental college or university primarily for the convenience of its members, students, patients, officers, or employees. A typical example of this is a school cafeteria.
• Selling Donated Merchandise: Any trade or business is excluded that consists of selling merchandise, substantially all of which the organization received as gifts or contributions. Many thrift shop operations of exempt organizations would meet this exception.
• Bingo: Certain bingo games are not unrelated trade or business.8  U.S. Code § 513(3)(f)(2) – Bingo Game Defined – is helpful in understanding specifically what activities acceptable which are defined as part of a “Bingo Game.”  You can find the statutory reference here. There is also additional discussion of bingo in the section below referencing gaming related issues.
• Qualified Public Entertainment Activities: Activities qualifying as public entertainment include any entertainment or recreational activity traditionally conducted at fairs or expositions promoting agricultural and educational purposes.9  First of all, U.S. Code § 513 states that only a “qualifying organization” may consider public entertainment activities as activities which are qualified business activities.  The term “qualified organization” means an organization which regularly conducts, as one of its substantial exempt purposes, an agricultural and educational fair or exposition and the organization is a tax-exempt charitable, social welfare, or labor organization.10 To better understand convention and trade show activities reference should be made to U.S. Code § 513 (A).(B), and (C).11

Effectively Managing UBI and the Use of the Internet

The World Wide Web has opened tremendous opportunities for charitable, exempt organizations to obtain the revenue necessary to sustain its purpose.  It is through the internet that cash is often involved since noncash contributions are usually not made through a website. 

However, the ease of placing your exempt organization in full view of a world-wide audience and obtaining their contributions does not change the rules related to unrelated business income as taxable income.  Our earlier discussion of the “fragmentation rule” applied by the IRS to “unbundled” activities often involves internet activities. The fragmentation rule allows the IRS to better understand each thread of a revenue-generating operation, particularly each participant and activity involved in an internet-based revenue generating operation, and how each thread and its participants and activities fits into the IRS’s definition of unrelated business income. Even though the IRS has yet to clarify exactly how it will treat internet-based activities, it has consistently stated that it will remain consistent with its position with respect to advertising and merchandising in the off-line world.”12

           What we do know now, is that activities such as the following may raise questions concerning UBIT:

·        Hosting advertising or sponsorship statements on an exempt organization’s own website, including links to sponsors' and advertisers' websites

·        Various merchandising transactions.

·        Transactions involving mailing lists.

·        Endorsement of companies' products or services.

·        For trade associations, the operation of virtual trade shows.13

An exempt organization must take the time to review 26 U.S. Code § 513 - Unrelated trade or business, (i)(2)(A) and (B) which provides a framework for distinguishing between advertising and corporate sponsorship transactions. 

           Each of the following activities includes a form of corporate sponsorship:

·        Banner advertisements. Consistent with the treatment of hard-copy advertising, income from banner advertisements that, like other advertisements, include (1) comparative or qualitative language, (2) price, savings or value information, (3) an endorsement, or (4) an inducement almost certainly will be deemed to be UBI.14

·        Corporate sponsorships. Corporate sponsorships in any form that include no substantial benefits other than the use or acknowledgment of the sponsor's name, logo, or product lines, will be excluded from UBI under Section 513(i).15

·        Links. Links may be automatically created by browser software used to navigate the Internet or by some word processing software and allow a viewer to jump from the nonprofit's website.  The presence of a link to a corporate sponsor on a nonprofit's website has been analogized to listing a telephone number, which is permitted under the corporate sponsorship rules, and goes directly to another web page such as that of a sponsoring corporation.16 

There are other activities in which the IRS has stated that it will remain consistent to, including treatment of advertising and merchandising and their presence on the internet. To better manage these types of internet issues, further information is worthwhile.

·        Merchandising. Merchandising refers to the participation by an exempt organization, at some level, in the income from the sale of actual merchandise.

o   Individual merchant affiliation. Certain retailers (such as Amazon.com) offer percentage referral fees to participating exempt organizations that send purchasers (usually through links) from their website to that of the retailer. The purchaser in such a transaction is probably not able to claim a Section 170(c)(2) deduction, as he or she in theory is purchasing an item and receiving full value.17

o   On-line "charity malls." Some commercial websites that act as intermediaries between on-line buyers, retailers, and exempt organizations provide on-line purchasers with the option to donate a percentage of their purchase price back to charity. If the on-line purchasers initiate the contribution and the exempt organization is not involved in sales that are unrelated to its exempt purposes, these monies should be treated by the charity as donations rather than UBI.18 

o   Virtual storefronts. The IRS's approach to traditional sales activity of exempt organizations, such as museum gift shops, also will apply to the sale of merchandise from a website address that presents itself as an internet store, or "virtual storefront." Generally, the IRS will look to the primary purpose of such sales, reviewing the nature, scope, and motivation for the sales activities in question. Under the fragmentation rule of Section 513(c), each item of merchandise would be evaluated separately as to whether its sale merely generates revenue or instead furthers the organization's exempt purposes.19 

o   On-line auction activities. Typically, charities that conduct annual fundraising auctions do not pay UBIT on the amounts that donors pay for items. This is in part because the auctions are not "regularly carried on," one of the requirements for UBIT, and also because in many cases the goods that are being auctioned are all donated, one of the exceptions to UBIT.20

o   Endorsements. Endorsements by exempt organizations must be carefully reviewed both for their potential for affecting the organization's credibility, and for the possibility that they may result in the revocation of exempt status due to a determination that the organization was being operated for private benefit. Cases resulting in such revocation have been based on an exclusive relationship between the exempt organization and the business or other private entity.

·        Potential Problems Involving Membership, Professional and Trade Associations. Many of these organizations have comprehensive websites with materials for the general public as well as materials that are restricted to members only. Many of these members only sections provide access to research services, continuing education opportunities, employment listings, membership directories, links to various organization benefit programs, legislative alerts, publications, etc. Organizations and web designers must be aware that the traditional rules with respect to prohibitions on providing services, treatment of advertising income, sales activity, as well as lobbying restrictions still apply to website activities.21

The IRS’s treatment of internet-based operations and activities by exempt organizations continues to evolve. Continuous research, review of relevant literature, and professional seminars will serve to better understand the perplexing field of IRS treatment of exempt organization with respect to UBI and the internet. However, this is an area in which expert assistance is necessary in order to avoid an unintentional activity that damages the ability of an exempt organization to effectively conduct its public benefit activities.

Effective Management of Gaming Related Issues

           To begin with, there is no formal federal law concerning gaming and unrelated business income, other than for bingo.22  This should express the extent to which the regulatory waters may be murky and the IRS is the only navigator. For example, Form 990 defines gaming as follows:

Includes (but isn't limited to): bingo, pull tabs/instant bingo (including satellite and progressive or event bingo), Texas Hold-Em Poker, 21, and other card games involving betting, raffles, scratch-offs, charitable gaming tickets, break-opens, hard cards, banded tickets, jar tickets, pickle cards, Lucky Seven cards, Nevada Club tickets, casino nights/Las Vegas nights (other than events not regularly carried on in which participants can play casino-style games but the only prizes or auction items provided to participants are noncash items that were donated to the organization, which events are fundraising events), and coin-operated gambling devices. Coin-operated gambling devices include slot machines, electronic video slot or line games, video poker, video blackjack, video keno, video bingo, video pull tab games, etc.23

An interesting twist to the issue of gaming is how the IRS is consistent in its treatment of gaming as a fundraising activity or as a fundraising event. Note the definition of “fundraising activities” in Form 990:

Activities undertaken to induce potential donors to contribute money, securities, services, materials, facilities, other assets, or time. They include publicizing and conducting fundraising campaigns; maintaining donor mailing lists; conducting fundraising events, preparing and distributing fundraising manuals, instructions, and other materials; professional fundraising services; and conducting other activities involved with soliciting contributions from individuals, foundations, governments, and others. Fundraising activities don't include gaming, the conduct of any trade or business that is regularly carried on, or activities substantially related to the accomplishment of the organization's exempt purpose (other than by raising funds).

           Also, consider the IRS definition of “fundraising events” in Form 990:

Include dinners and dances, door-to-door sales of merchandise, concerts, carnivals, sports events, auctions, casino nights (in which participants can play casino-style games but the only prizes or auction items provided to participants are noncash items that were donated to the organization), and similar events not regularly carried on that are conducted for the primary purpose of raising funds. Fundraising events don't include the following:

1. The conduct of a trade or business that is regularly carried on;

2. Activities substantially related to the accomplishment of the organization's exempt purposes (other than by raising funds);

 3. Solicitation campaigns that generate only contributions, which may involve gifts of goods or services from the organization of only nominal value, or sweepstakes, lotteries, or raffles in which the names of contributors or other respondents are entered in a drawing for prizes of only nominal value; and

4. Gaming.

 Nevertheless, among the most popular activities available to an exempt organization to raise revenue are related to “gaming.” Let us review gaming activities which are popular and within the safe zone for exempt organizations. Perhaps why the IRS considers gaming activities not to be fundraising activities or events, nevertheless, games such as bingo, or an activity such as a raffle, share the characteristic of raising revenue.  

·        Bingo. Fortunately, bingo is not only the most popular gaming activity available to exempt organizations, but it also has statutory reference and explanation. Consequently, managing issues related to bingo are easier (relatively speaking) than other gaming activities. U.S. Code § 513(3)(f)(2) – Bingo Game Defined, is the controlling source of authority for bingo games. To avoid having the conduct of games such as bingo classified as an unrelated trade or business, an exempt organization should operate the games with unpaid volunteers or conduct the games, so they qualify as bingo under IRC Secs. 513(a)(1) and (2).

·        Raffles.  In Texas, several laws oversee fundraising, including raffles.  As learned in the reading of Hopkin’s, “starting and managing a nonprofit organization,” pages 213 to 229 (see Reference # 1), IRS regulations are meant to protect the public and the rights of other not-for-profit organizations. So do Texas laws.  Texas laws affecting charity, tax-exempt organizations are clear, if not more restrictive than federal law. That is why before embarking on a fundraising project, getting well acquainted with any applicable laws regarding raffles is advisable.   

According to the Texas Charitable Raffle Enabling Act, qualified organizations in Texas are allowed to hold as many as two raffles per calendar year. There are certain restrictions surrounding these events, however  

o   only one at a time and are not permitted to advertise it statewide or through paid advertisements  

o   no one can be compensated for running the raffle, and 

o   organizations do not have to register their raffle with the state. 

Texas defines a raffle as 

o   “the award of one or more prizes by chance at a single occasion among a single pool or group of persons who have paid or promised a thing of value for a ticket that represents a chance to win a prize.”  

The IRS defines a “Raffle” as  

o   “In general, a raffle is considered a form of lottery. As such, a raffle generally refers to a method for the distribution of prizes among persons who have paid for a chance to win such prizes, usually determined by the numbers, or symbols, on tickets drawn.”  Greater clarification is available in the IRS Notice 1340, Tax-Exempt Organizations and Raffle Prizes - Reporting Requirements and Federal Income Tax Withholding, available here.

Texas law allows a qualified organization to  

o   distribute any prizes except money.  

o   If the organization offers a prize, it cannot be worth more than $50,000, or $250,000 if it is a house.  

o   If prizes were donated to the organization, there is no limit to their permitted value. Even though the proceeds from a Texas lottery ticket could exceed $50,000, it is permitted to offer lottery tickets as a prize. 

So, it looks like, in Texas, a noncash prize is the best option.   

How does the IRS view taxation of noncash prizes by a nonprofit organization?   

o  “Noncash Prizes: For noncash prizes, the winner must pay the organization 25% of the fair market value of the prize minus the amount of the wager.”  Form W-2G  

In short, even though the IRS includes bingo as a gaming activity but not as a fundraising activity or event, understanding and complying with IRC Secs. 513(a)(1) and (2) is the safest route (and do not get distracted by how the IRS has an apparent double definition of “bingo”).

Summary

           The challenge of avoiding taxation of unrelated income is best met by avoiding unrelated income to begin with. Whichever the issue related to unrelated business income and taxable income is, a founder or board of directors cannot afford to not to invest the time and cost (in obtaining expert counsel) to effectively manage operations and activities that may be treated as unrelated business income.   In fundraising, IRS regulations and Texas law appear to provide a method of fundraising, a raffle – which can be productive, avoid taxation, and consequently, not put at risk the tax-exempt status of the organization.  But whether it is bingo or a raffle or any other activity of an exempt organization, the lesson is that the IRS has a mind of it own, which cannot be read or even predicted. 

This article provides a brief and incomplete educational overview of a complex topic and is not intended to provide legal advice. Always consult experienced legal, tax, and accounting professionals in specific situations.

References

1.     Bruce R. Hopkins, “starting and managing a nonprofit organization,” 7th Edition, Wiley Press, Hoboken, New Jersey, 2017, p. 214.

2.     Ibid., p.214.

3.     Ibid., pgs. 215 -218.

4.     Ibid., p. 216.

5.     Ibid., p. 216.

6.     Ibid., p. 217.

7.     Review the application of taxes to UBI’s at the IRS website located here.

8.     Review the specific excluded activities from unrelated trade or business here.

9.     26 U.S. Code § 513 - Unrelated trade or business.

10. Ibid., Hopkins, p. 220.

11. A review of U.S. Code § 513 (A).(B), and (C) is available here.

12. Ibid., Hopkins, pgs. 224 -225.

13. “Making Use of the Internet—Issues for Tax-Exempt Organizations,” Alice M. Anderson and Robert A. Wexler, Journal of Taxation, Volume 92/Issue 5, May 2000. Also recommended for reference is 26 U.S. Code § 513 - Unrelated trade or business, which can be found here.

14. Ibid., Anderson and Wexler.

15. Ibid.

16. Ibid.

17. Ibid.

18. Ibid.

19. Ibid.

20. Ibid.

21. “Tax Exempt Organizations and World Wide Web Fundraising and Advertising on the Internet,” Cheryl Chasin, Susan Ruth and Robert Harper, Alder and Calvin P.C., 2017.

22. Ibid., Hopkins, 226.

23. Instructions for Form 990 Return of Organization Exempt From Income Tax, Definitions, p. 64, available here.

24. OCCUPATIONS CODE, TITLE 13. SPORTS, AMUSEMENTS, AND ENTERTAINMENT, SUBTITLE A. GAMING, CHAPTER 2002. CHARITABLE RAFFLES, available here.