Armanino Blog

Nonprofit Tax Issues Part 1: UBI and Excess Benefits

by Kelly Gillette
April 07, 2017
Sometimes it can seem like more work not to pay taxes. Tax-exempt organizations are subject to a multitude of rules to ensure they are not taking advantage of their “free pass” on income tax, and complying with these regulations can be complicated.

In this two-part series, we review areas where nonprofit leadership might overlook important details that can land their organizations in hot water with the IRS. First up is a look at the ins and outs of unrelated business income (UBI) and excess benefits.

Unrelated Business Income
The IRS is a stickler about a nonprofit’s exempt purpose and is likely to hit you with the unrelated business income tax (UBIT) if you stray too far from it.

According to the IRS, UBI is generated by a trade or business that is regularly carried on and not substantially related to the exempt purpose. An exempt organization with $1,000 or more of gross income from an unrelated business must file Form 990-T and pay estimated tax if it expects its tax to be $500 or more.

Common examples of ventures that can trigger UBI might include running a restaurant or gift shop or other commercial venture. However, if these activities are substantially related to the nonprofit’s exempt purpose—for example, merchandise sales of art history books from a museum gift shop—they would be safe from UBIT.

The IRS also provides some exceptions and exclusions, including:
  • Rental of a facility or other real property, such as for an event
  • Intermittent activities, such as a once-a-year book sale
  • Income generated from donated items, such as items sold in a homeless shelter’s thrift store
  • Activities that are for the convenience of members, such as a cafeteria in a museum, hospital or school
Even these exclusions have nuances, however. For example, renting a facility for an event is generally excluded, but renting non-real property (such as tables and chairs) would be considered UBI.

Another area where an organization can get into trouble is in the grey area between a sponsorship, which does not trigger UBIT, and advertising, which does. A qualified sponsorship payment is any payment made by a person engaged in a trade or business for which the person will not receive or expect to receive a substantial benefit other than the use or acknowledgment of the business name, logo or product lines. That sponsorship is considered to be an ad if it includes any of these characteristics:
  • Qualitative or comparative language, price information, or other indications of savings or value
  • Endorsements
  • Inducements to purchase, sell or use the products or services
The IRS is serious about holding nonprofits to their exempt purpose—and taxing them if they cross the line. If your organization is considering a new venture, talk to your professional tax advisor to find out if it could trigger UBI, and whether there are simple steps you can take to avoid that scenario.

Excess Benefit Transactions
Nonprofits must report (on Schedule L) certain financial transactions or arrangements between the organization and a “disqualified” person—defined as any person with substantial influence over the affairs of the organization currently or within the past five years. Certain related parties may also be included, such as family members and businesses where control by a disqualified person is more than 35%. Excess benefit transactions are those in which the disqualified person receives an economic benefit that exceeds the value of the consideration received by the organization.

If the IRS deems a transaction to be excessive, it can levy a first-tier excise tax on the disqualified person equal to 25% of the excess benefit from each transaction. If the excess benefit is not corrected within the taxable period, a second-tier excise tax equal to 200% of the excess benefit is imposed on the transaction. An additional tax of 10% of the excess benefit is imposed on any officer, director or trustee who participated in the excess benefit transaction.

Executive compensation is one of the most common types of excess benefit transactions. The key to avoiding that scenario is to document that the compensation is comparable to that at organizations that are similar in size and composition. The person receiving the compensation and any board members who have a conflict of interest should also recuse themselves from the compensation discussion.

Another common area that can stray into “excess” territory is the purchase or lease of property to or from the organization. While disqualified persons are not prohibited from engaging in these transactions, they do need to show that the price for the property is consistent with fair market value. Coloring within the lines in this area typically is a matter of obtaining an independent third-party appraisal.

To continue fulfilling your charitable mission, your nonprofit must stay alert to the actions that can trigger costly excise taxes or even jeopardize your tax-exempt status. In our next article, we’ll touch on two more areas that many nonprofits should be aware of: political and foreign activities.

For guidance on how to comply with the rules around UBI and excess benefits, contact your local Armanino nonprofit expert.

April 07, 2017

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