Reporting Unrelated Business Income
EXECUTIVE SUMMARY * Increased congressional and IRS scrutiny of exempt organizations includes looking at unrelated business income (UBI). * UBI is taxed to prevent unfair competition between tax-exempt and taxable organizations. It can be generated either directly or indirectly. Determining expenses directly connected to UBI can be a challenge. * Although the current IRS Compliance Questionnaire targets colleges and universities, all exempt organizations should be aware of the issues regarding UBI and address them accordingly. * Careful preparation of Form 990-T and review of UBI practices are crucial steps in preparing for the possibility that the IRS could contact your organization regarding UBI. ********** [ILLUSTRATION OMITTED] With the United States officially in a recession, state and federal funding sources on which charitable organizations rely are drying up. In addition to funding cuts, charities are struggling with across-the-board expense increases while trying to serve a broader charitable population. Colleges and universities are seeing a marked increase in requests for financial aid, while hospitals are challenged by having to provide more charity care. These financial struggles have led many organizations to seek alternative revenue sources that are outside their charitable mission and, therefore, are taxable. Despite charitable organizations' struggles, questions have been raised as to the appropriateness of granting these organizations tax-exempt status. In certain instances, the media have portrayed charitable organizations as entities with ballooning endowments that fail to carry out the charitable mission for which they receive tax exemption. In response, Congress and the IRS have begun to question not only the types of organizations that deserve tax exemption, but also whether those charitable organizations that currently have tax-exempt status are appropriately paying tax on income from their noncharitable activities. In October, the IRS released a college and university Compliance Questionnaire focused on compensation, endowment and the classification of activities as tax-exempt or taxable. Regarding the questionnaire, Sen. Charles Grassley, R-Iowa, the Senate Finance Committee ranking Republican, stated, "Colleges and universities should be much more transparent about their activities, just as tax-exempt hospitals are being asked to do.... They need to show they're making good use of the tax exemption and other federal subsidies they receive." While colleges and universities are the target of this IRS compliance check, all tax-exempt organizations should be aware of this initiative and be ready if the IRS asks questions about their activities. This article will focus on tax-exempt organizations' classification of revenue as "unrelated business income" (UBI). Is IT UBI? Revenue from activities that are related to a tax-exempt organization's charitable purpose is not considered UBI and, consequently, not taxed. However, revenue generated by a tax-exempt organization from activities outside its charitable mission generally is taxable as UBI. Tax-exempt organizations can generate UBI directly, by performing the activity themselves, or indirectly through partnership investments. Congress added UBI tax provisions to the Internal Revenue Code in 1950 in an attempt to eliminate "unfair competition" between for-profit businesses and tax-exempt organizations conducting similar activities. If not subject to tax on net income derived from business ventures unrelated to its exempt purpose or functions, an exempt organization would have a financial advantage over a for-profit entity carrying on a competing enterprise. The UBI rules generally impose an income tax at corporate rates (or at trust rates for exempt organizations that are created as trusts) on an exempt organization's net income derived from unrelated business activities. …