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Red Alert – Test Alert A – July 12 expiration
Red Alert – Test Alert A – July 12 expiration
As the new tax bill worked its way through Congress last fall, nonprofits across the country raised their voices high to share concerns about its disincentives for charitable donations — as well as the proposed repeal of the Johnson Amendment. Little was heard, though, about changes to the rules for unrelated business income tax (UBIT). It turns out that the final law, the Tax Cuts and Jobs Act (TCJA), includes several provisions that have the potential to boost your organization’s liability for the tax, regardless of whether you operate an unrelated business.
Why your UBI may grow
The most important change relates to how unrelated business income (UBI) is computed. The new law requires nonprofits to calculate UBI separately for each unrelated business, with the $1,000 deduction typically allowed applied to the aggregate UBI for all businesses.
Your UBI also can increase because net operating losses (NOLs) can only be claimed against future income from the specific business that generated the loss. Under previous law, you could use NOLs from one business to offset the income of another or to offset gains from alternative investments or pass-through entities, also considered UBI.
UBI also might grow due to a change in how certain fringe benefits are treated under the TCJA. In previous years, you could provide your employees qualified transportation benefits (including commuter transportation and transit passes), qualified parking fringe benefits and on-site athletic facilities free of income tax for both you and employees.
The TCJA, however, treats the payments for such benefits as UBI unless they are directly connected to an unrelated business (for example, parking benefits provided employees of an unrelated business). Congress made the change to create parity between nonprofits and taxable organizations. For-profit businesses lost a previous tax exemption for certain fringe benefits under the TCJA. The end result, though, is that nonprofits may owe UBIT even without operating any unrelated businesses.
It’s not all bad news. The new law also changes the corporate tax rate that nonprofits pay on UBI to 21% from a range of 15% to 35%. In some cases, a nonprofit’s UBIT liability might fall despite your higher UBI.
What you can do
Fortunately, you have some options to avoid the worst effects of these changes. For example, you may conduct an audit of your unrelated businesses. You might find that you have been over-reporting your UBI because you have not captured all the related business expenses.
Another option for nonprofits with multiple unrelated businesses is forming a single taxable corporate subsidiary to hold all of them, which would permit you to again offset their income and losses. Any restructuring will likely carry some implications, whether tax-related, financial or operational.
Changes to the UBIT rules have not received as much coverage as some of the other TCJA provisions, but they may impact your organization. Consult with your CPA to determine steps you can take to minimize the impact of tax reform on your bottom line.
Nonprofits have pursued corporate sponsorships for years, with good reason. Effectively executed, sponsorships can benefit both sponsor and organization. But if your nonprofit is not careful, a sponsorship can be deemed paid advertising and your organization could end up liable for unrelated business income tax (UBIT). Although the Internal Revenue Code includes an exception from UBIT for certain sponsorship arrangements, navigating the rules can prove tricky.
Generally, “qualified sponsorship payments” received by a nonprofit aren’t income from an unrelated trade or business. A qualified sponsorship payment is a payment of money, transfer of property, or performance of services with no expectation that the sponsor will receive any “substantial return benefit.” Benefits returned to the sponsor can include advertising; goods, facilities, services or other privileges; rights to use an intangible asset such as a trademark, logo or designation; or an exclusive provider arrangement.
To be considered “substantial” by the IRS, the aggregate fair market value (FMV) of all benefits provided to the sponsor during the year must exceed 2% of the amount of the sponsor’s payment to the nonprofit. If the total benefit exceeds 2% of the payment, the entire FMV of the benefits (not just the excess amount) is a substantial return benefit.
The regulations specify for purposes of the exception that a nonprofit’s “use or acknowledgment” (as opposed to promotion, marketing or endorsement) of a sponsor’s name, logo or product lines won’t constitute a substantial return benefit to the sponsor. Your organization’s use or acknowledgment can include:
You can include a sponsor’s product at the sponsored activity as long as there’s no agreement to provide the sponsor’s product exclusively. Mere display or distribution of a sponsor’s product at an event, whether for free or remuneration, isn’t considered an inducement to purchase, sell or use the product (that is, advertising). It won’t affect the determination of whether the qualified sponsorship payment applies.
Say that a nonprofit is holding an annual 10K race and is providing participants with drinks and prizes supplied free of charge by a sponsor. If the organization lists the sponsor’s name in promotional materials or includes it in the event name, those activities constitute permissible acknowledgment of the sponsorship. Therefore, the drinks and prizes are an exempt qualified sponsorship payment.
Note that contingent payments aren’t qualified sponsorship payments. If a sponsor’s payment is contingent on event attendance, broadcast ratings or other measures of public exposure to the sponsored activity, the payment falls outside the exception.
When a sponsorship comes with a substantial return benefit, only the part of the sponsor’s payment that exceeds the substantial return benefit is considered a qualified sponsorship payment. The remainder is unrelated business income.
Consider, for instance, a not-for-profit that receives a large payment from a sponsor to help fund an event. The organization recognizes the support by using the sponsor’s name and logo in promotional materials. It also hosts a dinner for the sponsor’s executives, and the FMV of the dinner exceeds 2% of the sponsor’s payment.
The use of the sponsor’s name and logo constitutes permissible acknowledgment of the sponsorship, but the dinner is a substantial return benefit. As a result, only that portion of the sponsorship payment that exceeds the dinner’s FMV is an exempt qualified sponsorship payment.
Application of the qualified sponsorship payment exception and the rules for unrelated business income are complicated. Your financial advisor can help reduce the risk of incurring UBIT.
The Internal Revenue Code provisions about unrelated business income distinguish between “exclusive sponsor” and “exclusive provider” arrangements. An arrangement that acknowledges a corporation as the exclusive sponsor of a nonprofit’s activity generally doesn’t by itself result in a substantial return benefit that could incur the unrelated business income tax (UBIT) for a nonprofit. Similarly, an arrangement that acknowledges a company as the exclusive sponsor representing a particular trade, business or industry won’t constitute a substantial return benefit on its own.
On the other hand, an arrangement with a sponsor that limits the sale, distribution, availability or use of competing products, services or facilities in connection with the nonprofit’s activity generally does result in a substantial return benefit. For example, if the organization agrees in exchange for a payment to allow only the sponsor’s products to be sold in connection with an activity, the sponsor has received a substantial return benefit.
Dividends, interest, rents, annuities and other investment income are generally excluded when calculating unrelated business income tax (UBIT). But tax law provides two exceptions where such income will indeed be deemed taxable. And with IRS scrutiny of unrelated business income intensifying these days, nonprofits need to know about these potential pitfalls.
When a nonprofit incurs debt to acquire an income-producing asset, the portion of the income or gain that’s debt-financed is generally taxable unrelated business income (UBI). Such assets are usually real estate — for example, an apartment building with income from rents not related to the nonprofit’s mission. But the assets also could be stocks, tangible personal property or other investments purchased with borrowed funds.
Income-producing property is debt-financed if, at any time during the tax year, it had outstanding “acquisition indebtedness” — debt incurred before, during or shortly after the acquisition (or improvement) of property if the indebtedness wouldn’t have been incurred but for the acquisition.
Certain property is exempt from this treatment:
Related to exempt purposes. If 85% or more of the use of the property is substantially related to a not-for-profit’s exempt purposes, it’s not excluded as debt-financed property. Related use can’t be solely to support the organization’s need for income or its use of the profits.
Used in an unrelated trade or business. To the extent that income from a property is treated as income from an unrelated trade or business, the property isn’t considered debt-financed, as the income is already UBI.
Used in certain excluded activities. Debt-financed property doesn’t include property used in a trade or business that’s excluded from the definition of “unrelated trade or business” either because it’s used in research activities or because the activity has a volunteer workforce, is conducted for the convenience of members, or consists of selling donated merchandise.
Covered by the neighborhood land rule. If a not-for-profit acquires real property intending to use it for exempt purposes within 10 years, the property won’t be treated as debt-financed property as long as it’s in the neighborhood of other property the organization uses for exempt purposes. The latter exception applies only if the intent to demolish any existing structures and use the land for exempt purposes within 10 years isn’t abandoned.
Interest, rents, annuities and other investment income aren’t excluded from UBI if they are received from a for-profit subsidiary or controlled nonprofit. The payment is included in the parent organization’s taxable UBI to the extent it reduces the subsidiary organization’s net taxable income or UBI.
The IRS generally considers a corporation to be “controlled” if the other organization owns more than 50% of the “beneficial interest” — either stock in a for-profit or voting board positions in a nonprofit. For example, if a for-profit leases space from an organization that owns more than 50% of its stock, the lease payments are valid deductions from taxable income. But when these lease payments are received by the controlling nonprofit, they aren’t excluded from UBI.
Failing to pay UBIT on debt-financed property or income from controlled organizations could have negative consequences, ranging from taxes, penalties and interest to, in extreme cases, the loss of tax-exempt status. Your CPA can help you stay on the right side of the UBIT law.