Most not-for-profit leaders understand a principal truth of their tax-exempt status: The IRS generally considers any revenue they take in that’s not related to their mission to be unrelated business income (UBI), and that income is subject to tax. Not-for-profits that don’t pay tax on that income face the possibility of back taxes, penalties and interest — and, in extreme cases, the loss of their tax-exempt status.
When it comes to investment income, your organization must comply with some rather complex rules. The following provides information to help you identify UBI and stay on the right side of the law.
Debt-financed income is generally taxable
While dividends, interest, rents, annuities and other investment income are generally excluded when calculating UBI, that’s not the case for income from debt-financed property.
The income produced from a property that is debt-financed will be taxable UBI in the same percentage as the debt is to the full acquisition cost. So 75% of any income or gain from a property with a loan for 75% of its cost will be taxable UBI. Such assets are typically real estate — for example, an office building with income from rents unrelated to the not-for-profit’s mission. But the assets also could be stocks, 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.
Some types of debt-financed property aren’t considered debt-financed property when calculating UBI. One type is property 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 won’t be considered debt-financed property. And, thus, income from the property won’t be taxable. Simply using the income to support the organization’s programs doesn’t make the property related to the exempt purpose. The property must actually be used in providing program services.
For the purposes of the UBI rules, debt-financed property also doesn’t include property used in certain excluded activities. This is property used in a trade or business that’s excluded from the definition of “unrelated trade or business.” That’s either because it’s used in research activities or because the activity has a volunteer workforce, is conducted for the convenience of members, or operates to sell donated merchandise.
Real property covered by the neighborhood land rule also isn’t considered debt-financed property for UBI purposes. The not-for-profit must acquire the real estate intending to use it for exempt purposes within 10 years and the property must usually be connected to other property the organization uses for exempt purposes. This favorable treatment will no longer apply, however, if the not-for-profit abandons its intent to use the land for exempt purposes.
Payments from subsidiaries may be taxable
Another situation where dividends, interest, rents, annuities and other investment income may be taxable is when that income is paid directly from a not-for-profit’s “controlled” organization, whether a for-profit or not-for-profit. Such payments are included in the parent organization’s taxable UBI to the extent they reduce the subsidiary organization’s net taxable income or UBI.
The IRS generally considers an organization 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 not-for-profit. For instance, 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 not-for-profit, they are included in UBI.
The IRS has increased its scrutiny of UBI in recent years. If you have any uncertainties about which investment income at your organization counts as UBI, talk to your CPA.
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