UBI Activity Loophole for Schools

April 18, 2017

Schools often rent their facilities to a third party when they’re not in use or have excess space. They usually do this as a community service; for instance, renting the facility to a daycare provider or a summer school, or to produce additional income. School business managers and CFOs should know that this type of activity typically has to be treated as Unrelated Business Income (UBI), and may be subject to tax. However, it warrants a closer look, as the rules are not “typical” and many exceptions exist.

Schools are not taxed on income generated from their mission or programs. However, the same rules do not apply when schools use their facilities for unrelated activities. The tax code contains numerous rules that designate what an unrelated income stream is and assist in determining if it is taxable. Unrelated activities are those that fit a three-pronged definition: the school is conducting a trade or business for the production of income from selling goods or services; the trade or business is regularly carried on; and, the activity is not substantially related to the organization’s exempt purpose. When schools lease or share space, and collect rental income, they should make sure that their accounting team is aware of the intricacies in the tax code as the facts and circumstances warrant.

In the event that a school rents out any part of a debt-financed property, the rules should be evaluated to determine if it is a taxable activity. There are exceptions to the acquisition indebtedness portion of the definition of a taxable activity for certain qualified organizations. A school described in section 170(b)(1)(a)(ii) is a qualified organization under one of the exception rules, which negates the acquisition indebtedness portion of the general rule. If applied properly, a school is not subject to unrelated business tax on such income.

Generally, when UBI rules are applied, revenue can easily be categorized as such. However, when all the exceptions are carefully considered, there are often rules that exist to negate certain revenues from being considered UBI – the trick is finding it. A nonprofit school, if organized under the correct section of the tax law, qualifies for this exception under the definition of acquisition indebtedness so that rental income on a debt-financed property is actually not subject to the UBI rules.

For more information or questions, please contact Aronson’s Kathy Cuddapah at 301.231.6200.