By Karen Dunn, JD, LLM
The Advisory Committee on Tax Exempt and Government Entities (ACT) released recommendations to the IRS last summer for specific changes to UBI reporting and additional guidance. In its report, the committee expounds on the lack of guidance from the IRS on the subject. The ACT points out that such lack of guidance contributes significantly to the reporting errors that the IRS found in their examinations of colleges and universities and proposes that the IRS publish a revenue ruling that provides comprehensive guidance on UBI issues.
Simply put, UBI is taxable income from trades or businesses that are unrelated to an organization’s exempt purpose. However, the rules can be quite complex. Many organizations do not fully understand the UBI rules. This leads to more noncompliance, audit risk, and payment of back taxes, interest, and penalties. Not only may UBI create a tax liability, it can also cause an organization to lose its exempt status if it becomes a substantial part of the organization’s overall activities.
The ACT report specifically asks for IRS guidance on internet and catalogue sales, website periodicals, hyperlinks to for-profit business websites, and allocations of expenses to unrelated activities, particularly expenses of dual use facilities or activities. Dual use facilities or activities are partly related to the exempt purpose and partly unrelated to the exempt purpose. For example, a museum may rent out its space for unrelated events such as weddings. Another example is a university facility, such as a gym, that is used both by students, faculty, and the general public.
A sample suggested ruling was included in the ACT report. The proposed ruling describes 23 situations illustrating the application of the UBI rules. For the most part, the ruling does not provide any new concepts or surprising analyses, but it nicely organizes the history and basic rules in one document. Many of the examples demonstrate that, in a dual use situation, the revenue coming from persons who are not part of the class of persons served in the organization’s exempt function will be unrelated business income. Using a golf course that is partly used by students and faculty and partly by the general public and alumni as an example, the ruling shows that only the fees from the general public and alumni were UBI.
Most of the illustrations focus on how the provision of significant services or personal property affects the taxability of an otherwise excluded activity, such as real estate rentals, licenses of intellectual property, or certain event sponsorships. Also, although all of the situations illustrated in the ruling involve a university, the examples in the ruling are quite applicable to other kinds of exempt organizations, such as museums, senior living communities, youth programs, hospitals, and others.
Here are some highlights of the proposed ruling:
- Substantial services may result in unrelated business income in these dual use examples:
- Facility rental. Generally, income from rental of real estate is excluded from UBI. However, if substantial services are included in the rental agreement, the entire rental income will be UBI. One example in the proposed ruling is the provision of security services and operating concession stands to the lessee of event space.
- Hotel rentals and dormitory use. Generally, rental of such rooms is not considered rental of real estate because of the substantial services that are included and thus generates UBI. Often, this occurs in a dual use situation, such as when a school rents dormitories when school is out of session. The examples in the proposed ruling demonstrate that such rentals to the general public result in UBI, while such rentals to visitors or guests, such as parents of students or visiting faculty, do not result in UBI. Sometimes this is referred to as the convenience exception and can be applied to persons staying in the rooms who are visitors or guests of the organization, students, patients, residents, or other persons involved in the exempt activities of the organization. The room rental also can be directly related to the exempt purpose of the organization. The ruling illustrates this with the operation of a hotel as part of a degree program in hotel management. If the degree program is part of the exempt purpose of the organization, this activity will not result in UBI provided it is not operated on a scale significantly larger than needed for such exempt purpose.
- Catering and food services. Food service can be another type of dual use activity. If an outside company provides all the services and the organization only rents the meeting room, then the provision of these services does not taint the rental exception for the rent revenue. However, if the services are provided directly by the organization and are substantial, then the rental of the meeting room that includes these services will result in UBI.
- Exclusive provider arrangements. The proposed ruling describes exclusive provider arrangements as substantial return benefits that pull sponsorship revenue into UBI. If the arrangement includes substantial services, such as promotional appearances or marketing a product, it does not meet the qualified sponsorship exception and thus income received will not be an excluded royalty but rather UBI.
- Technology transfer. The proposed ruling makes clear that technology license agreements should separately state the amount of royalties from the licensing of software, which should be excluded from UBI, from the fees for services provided, which would be UBI.
- Youth camps. Operation of youth camps may or may not be related to an organization’s exempt purpose. However, if the youth camp is not a related activity and is operated by a third party for-profit entity using the exempt organization’s facilities or personnel, it should be viewed as a dual use activity similar to the activities discussed above and income from the youth camp would be UBI.
- The rental of personal property may result in unrelated business income in these examples:
- Facility rental and dual use property. The facility and dual use property illustrations also demonstrate that if more than 50 percent of the rental is for personal property, the entire rental income will be UBI. If the personal property portion is between 10% and 50%, then only the revenue from the personal property should be UBI.
- Cell tower rentals. The crux of the cell tower examples show that if the tower is considered real property by state law or the organization only rents the real property and not the tower that sits on it, the rental activity fits the UBI exclusion for rental of real estate. Of course, the exceptions to the real property exclusion apply as with any rental of real property. If the cell tower is considered personal property, then the rental income of personal property will be considered UBI.
- Allocation of expenses in dual use situations:
- Website publications. The sample ruling makes clear that website publications should be treated the same as printed material. Thus the expenses directly connected with the unrelated advertising in the website publication may be deducted in computing unrelated business taxable income from the advertising portion of the dual use of the website.
- Youth camps. In the example above, an allocable portion of the expenses attributable to providing the facilities and personnel to the youth camp may be deducted in computing unrelated business taxable income.
- Other miscellaneous unrelated business income issues in the proposed ruling:
- Bookstore operations. The ruling states nothing new in these examples. Items sold are either related to the exempt purpose, are for the convenience of the persons served by the exempt function of the organization (such as students and faculty of a school), or are neither and thus result in UBI. If the store is operated by an outside business, the rent charged will be considered rental of real estate, provided none of the exceptions to the rental exclusion, some of which are discussed above, apply.
- Preparatory time. The proposed ruling follows a landmark case in determining that preparatory time should not be included in the consideration of whether an activity is regularly carried on. Whether the activity is regularly carried on is one of three criteria for taxability as UBI. In the example, the university spends two months selling advertising space in a brochure that is distributed at a five-day tournament. The time considered is only the five days and thus the advertising was not regularly carried on and not an unrelated business activity.
- Foreign blocker corporation. The ACT seeks more guidance on UBI from controlled foreign blocker corporations and presents one example in which they suggest that the income from such foreign blocker corporation would be excluded from UBI. The facts in the illustration are very simple and thus shed little light on how this should be treated in a more complex situation. However, the preamble to the illustration is informative on the subject.
The suggested revenue ruling is nice in that it consolidates many of the UBI rules in one guidance document and has many factual examples. However, the guidance is very basic, as are the examples. Although the author would like to see a ruling that has examples that go a bit beyond the basics, this proposed ruling demonstrates some of the most common situations that might occur in an organization and presents clear guidance on treatment of revenue in such situations that organizations can easily understand.
The proposed ruling may provide some basics that will help you identify some issues and know what questions to ask your tax advisor. However, the rules are much more complex than the ruling demonstrates, and there may be specific facts to your situation that could drastically change the result from what is presented in the illustrations. Therefore, if you are engaged in any situations that fall into any of these categories, please talk to your tax advisor.
© Clark Nuber PS, 2015. All Rights Reserved