But We’re a Non-profit! We Don’t Pay Income Taxes!

Really? Your organization might not be paying income taxes, but should it be?

As a 501(c)(3) nonprofit organization you might think that the IRS exemption grants you all kinds of rights – the right to receive tax deductible donations, the right to not be liable for FUTA on wages, the right to exemption from paying sales tax, the right to lobby a bit, and the right to do all kinds of good and wonderful things as written in the nonprofits’ mission statement. And you’re right. The organization does have those rights.

But, if your organization generates revenue related to advertisements on the website or in periodicals, or, if T-shirts and baseball caps are sold solely to raise funds, or, if there is a mortgage on the building and unused space is rented out, or, there is a Jobs Posting board where a referral fee is collected, or if investments in certain partnerships are held, your organization may have UBIT!!!

What is UBIT you ask? UBIT is unrelated business income tax that is tax paid by a nonprofit who is carrying on for-profit related activities. It’s not that you can’t perform the activities mentioned above, it’s just that the organization has to pay income tax on the profits of those activities, just like a regular corporation.

You see, the IRS not only cares how the money is spent, but also, where it came from. So, just because someone can give to the organization, should you accept it? Not necessarily.

The administrative burden and internal controls should be considered before pursuing certain revenue streams. If someone wants to contribute a toxic dump site, is it worth accepting and dealing with the nightmare of cleanup? Same with UBI – is it worth it?

Most often, yes. The revenue is offset by related expenses, taxes are paid, a few more pages get added to the annual tax return, and the nonprofit has more money in their pocket at the end of the day to spend on their mission-related goals. It seems reasonable, so, you move forward with the activity.

You set up codes and track the activity separately in the accounting records, the organization registers with the IRS and state authorities to make estimated tax payments on the anticipated profit, the tax accountant is already aware of this project and issues an annual engagement letter to include the Federal Form 990-T and the applicable state filing (D-20, VA500, MD500, etc.), the forms are prepared and then filed along with the Form 990.

That wasn’t so bad now, was it?

But what could you have done to avoid being assessed UBIT? Ah yes, there exists a few little ‘loopholes’, i.e. conditions under which the income is not considered UBI, which an organization can plan for, and that make sense.

If there is an educational component related to the item, an organization can sell items such as T-shirts and baseball caps without creating UBI. For example, a tag explaining how the cotton used to make the t-shirts was cultivated by the people of protected lands; or, the animals depicted on the t-shirts are those endangered and protected by the NPO. However, items with just the NPOs’ logo = UBI.

It’s okay for a NPO to buy a building, hold a mortgage and rent out excess space. But, if services are provided to the lessee, such as catering, the lease is tainted and is then subject to UBIT. Instead of renting that space to an unrelated mission-oriented organization, such as Starbucks, rent it to C3 organizations with a similar mission…unless of course you are the National Coffee Growers Association.

It’s okay for a NPO to have investments. In fact, if a NPO has excess cash on hand, it only makes sense to strategically invest and maximize earnings. However, certain investment partnerships, e.g., private equity funds, hedge funds, venture capital, publicly traded partnerships, and other alternative investment structures, can trigger UBIT based on the nature of the investments. If you look at the latest Form K-1 received, search specifically for the code ‘V’ in box #20 which will tell you if any UBI was earned that year. The best way to avoid UBIT on investment revenue is to select non-UBI producing investments, although, keep in mind that if you pay tax, that is a great indicator that you earned revenue. The cost vs. benefit must be weighed.

It’s okay to recognize sponsors in periodicals and on the website. You can also have advertisements for which the revenues and expenses would need to be tracked and reported as UBI. However, if you want to avoid UBI, do what is necessary to ensure that the item meets the description of a ‘sponsor recognition’. Keep away from ads you would see in a magazine stand type magazine – those with a call to action….’Buy our product’ or comparative language …… ‘We’re the best in the industry’. Those kinds of ads = UBI. Sponsorships on the other hand might be solely a congratulatory-type statement….” Congratulations to the winners of the ABC organization 2023 Scholarships. May you have the courage to pursue your dreams”. Or, as an alternative, just show the sponsor logo with a link to the sponsor site.

And, it should be mentioned, that it's okay to generate UBI of less than $1,000 as the IRS provides a specific exclusion. In this case, no Form 990-T is required to be filed.
Do you see the differences in the approach?

One little sidenote. The IRS has recently come down a bit harder on nonprofits compared to for-profits. Through 2017, the NPO could put all UBI revenue in one bucket and offset that revenue by all the UBI expenses – and the same for for-profit companies. So, if one activity was profitable, but another not, they offset, and income tax was imposed on the net profit. Effective 2018, with the passage of the Tax and Cuts and Jobs Act of 2018, the IRS implemented the use of “silos”.

Under these new regulations, basically, each activity has its own silo, and the net operating losses carry forward along with the income tax is imposed on all profitable silos. No longer can you offset profitable UBI activities with loss UBI activities…...although for-profit corporations still can.

So, do the math, calculate the taxes, talk to a tax expert before engaging in the activity, figure out how to make it work, and ‘have the courage to pursue your dreams’.