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Thursday, March 26, 2015

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Earned Income and the Arts: UBTI


Funding is a perennial challenge for arts and cultural nonprofits. Yet many have tapped into their inherent creativity to develop some decidedly inventive revenue streams. These include:

  • Facility rentals for events
  • Program ads
  • Food and beverage sales
  • Gift shop sales
  • Artifact or exhibit rental fees
  • Licensing

If your organization is doing this, there’s good news: You’re earning income that is not dependent on the vagaries of state and federal funding—or the whims of donors. The bad news is that this “earned income,” if not properly managed, can trigger a host of complicated tax issues and penalties—even revocation of your organization’s tax-exempt status.

Understanding Earned Income
Earned income is different from program service revenues (such as ticket sales, admissions, and subscriptions). It is income that you, the nonprofit, actually earn. You make something and sell it for a profit. Or you provide a service. For example, you rent out your facility for an evening or provide a behind-the-scenes tour for a fee.

The problem occurs when the earned income comes from a source that is not substantially related to your organization’s tax-exempt purpose. The IRS calls this Unrelated Business Taxable Income (UBTI). More specifically, the feds define UBTI as “income derived from any trade or business, regularly carried on, that is not substantially related to the furtherance of the exempt purpose of the organization.”

Related … or Unrelated?
Unfortunately, the lines are not always clear when it comes to determining UBTI.

Example: A small community theater takes seriously its mission to enrich the cultural life of residents and visitors through performances, productions and education of all aspects of contemporary and classic theater. During its theatrical season, the theater sells tickets at $20 each for its productions. This is certainly a regularly scheduled, on-going activity, and is directly related to the theater’s exempt purpose. Therefore, the revenue generated from ticket sales is not considered UBTI. The theater also publishes a 56-page Playbill for each of its productions. It sells advertising space to businesses in the community and generates substantial revenue.

Verdict: The IRS generally holds that selling space in a periodical or program beyond what is considered “sponsorship identification” triggers UBTI.

Example: A mid-size art museum does a brisk business selling reproductions of its artwork in a museum gift shop. This is clearly related to its mission of promoting the understanding, appreciation, and enjoyment of the arts for the broad public. However, the gift shop also carries a substantial line of scientific books, toys and novelties.

Verdict: This case illustrates the concept of "fragmentation." For purposes of calculating UBTI, the “fragmentation rule” allows the IRS to examine the sale of each type of item separately and determine if such sales are related or unrelated for the purposes of UBTI. 

The IRS is likely to determine that the sale of the scientific books, toys and novelties is not a substantial part of the museum’s exempt purpose.

When Success Becomes too Much
To be clear, there is nothing wrong with a tax-exempt museum, theater or cultural attraction earning Unrelated Business Taxable Income. Just be aware that UBTI does trigger the following issues:

  • Taxes. If your organization generates UBTI in excess of $1,000, you must report it on Form 990-T and pay tax on that income.
  • Tax-exemption. UBTI must remain an insubstantial part of your organization’s total revenue. Generally, when such income makes up about 25-30% of all income, organizations are advised to begin discussions with tax professionals about forming another company to conduct the activity which generates this income.

Is it Time for Subsidiary?
Some organizations with a successful, unrelated business that generates substantial revenue choose to put that business in a separate, for-profit corporation operated as a subsidiary. Under this scenario, the for-profit subsidiary operates the unrelated business, pays taxes on the net income and contributes all or some of the remaining net income to the charitable organization.

If you’re wondering if your organization’s activities are straying into UBTI territory, contact Armanino for help making that determination.

 

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