What is UBI and when is it taxable?
While nonprofits are exempt from tax for activities that are in furtherance of their mission, they are not exempt from tax for all activities. A 21% tax on unrelated business income (“UBI”) occurs when an organization participates in an activity or activities that meet the following requirements:
- Income from a trade or business
- Regularly carried on
- Not substantially related to the charitable, education, or other purpose that is the basis of the organization’s exemption
There are a number of income items specifically excluded from UBI, including:
- Royalty income
- Qualified convention and trade show income
- Certain capital gains
- Sale of donated goods
- Qualified corporate sponsorship income
- Renting mailing lists to another charitable organization
- Certain non-debt-financed rental income from real property
- Certain research income
While some of the above are fairly straightforward, let’s take a closer look at royalty income and qualified corporate sponsorship, as these are two areas that typically cause some confusion.
Passive royalty income is excluded from UBI. Royalty was defined in Sierra Club v. Commissioner as “Payments received for the right to use intangible property rights and that such definition does not include payments for services.” Evidence of royalty relationship usually includes payment related to use of a valuable right. Additionally, an organization’s activities are generally limited to those necessary to protect its reputation, such as the limited use of name and logo to approved circumstances and the right to review use of name and logo for quality and style.
Sometimes a nonprofit organization enters in to an agreement that states it is a royalty agreement, but it is actually another kind of agreement, most often a service agreement. These types of agreements would be subject to UBI. Evidence of other (usually service) relationships include the following:
- Existence of a quid pro quo transaction
- Marketing services (promoting the product/service) and/or administrative services (helping to administer the program)
- Significant activities or rights, such as approval of editorial content and preparing articles in a periodical
Basic Rule: The less an organization does, the more likely income is to be characterized as royalty income.
There are also dual purpose relationships which combine a royalty component with a service component. If the service component is minimal, this is likely not an issue and can all be treated as tax-free royalties. However, if the service component is significant, the IRS will likely determine that none of the income is royalty income. If the determination is left up to the courts, they typically look at the totality of the relationship to determine what the nonprofit is actually getting paid for on a fair market basis (i.e. what is the value of the exclusive name/logo license versus the value of the services being provided?).
If a nonprofit is going to enter into a dual purpose agreement the IRS would prefer two separate agreements instead of a dual purpose agreement. However, this can be avoided if three requirements are met:
- The agreement clearly identifies and bifurcates the royalty and service components and payments in the agreement,
- The agreement is not entitled “Service Agreement,” and
- The agreement is reasonable
Qualified Corporate Sponsorship Payments
Qualified corporate sponsorship payments are not subject to UBI, but it can be difficult to determine if a payment is a qualified corporation sponsorship or an advertisement, which is subject to UBI. In order to alleviate some of the confusion, the IRS issued safe harbor rules.
Safe Harbor Rules
Under the safe harbor rules, a payment will be considered a qualified corporate sponsorship if there is no arrangement or expectation that the payor will receive a substantial benefit (valued at 2% or less of the sponsorship payment), other than the use or acknowledgement of the name or logo of the payor’s trade or business in connection with the nonprofit’s activities. The safe harbor is applicable to a broad range of temporary and permanent activities, including websites, but excluding:
- Trade show and convention activities (covered by another UBI exception)
- Contingent payments
- Advertisements or acknowledgement in a periodical (i.e. magazines, newsletters), but mere acknowledgement in periodicals may not trigger UBI
To get to the heart of the third point, it is important to understand the difference between an acknowledgement and advertising. An acknowledgement can include the following:
- Name or logo,
- Description of services or product lines, as long as use is not qualitative or comparative: but slogans which establish part of identity are permitted,
- Contact information, email address, telephone number, website, including hyperlink from the nonprofit’s website to the sponsor’s website if it is the main landing page and not a products or services purchase page, and
- Product displays, visual depictions, product samples.
An advertisement, which would be subject to UBI, is defined as containing the following:
- Qualitative or comparative language, price information, indications of savings or value, endorsements, inducements to purchase, sell or use.
If you have any questions about UBI activities related to your nonprofit organization, please contact me.