Associations and Unrelated Business Activities in Tough Economic Times

**Originally published in the February 2012 issue of the Midwest Society of Association Executives’  (MSAE) newsletter**

Associations have had to find ways in recent years to cut their budgets by reducing expenses and/or creating new sources of revenue.  New sources of revenue can often be generated from unrelated business activities, requiring the organization to comply with unrelated business income tax (UBIT) laws.  These laws can be complex, and often contradictory, so it is important to complete a UBIT analysis when your association has a new revenue source.  Filing Form 990-T, the Business Income Tax Return filed by exempt organizations, is required when gross receipts from unrelated business reach $1,000, so it doesn’t take much activity to reach the filing requirement.

What is an unrelated business? 

The IRS has three criteria which must be met for an activity to be subject to unrelated business income tax:  

• The activity must be a trade or business;
• It must be regularly carried on; and
• It must be unrelated to the exempt purposes of the organization. 

When an activity is determined to be an unrelated business activity, the association will allocate expenses to deduct from the unrelated income to determine taxable income that is subject to income tax at corporate income tax rates.  Determining what is a deductible expense is often more art than science; it is important to develop a reasonable methodology for determining these expenses, and to consistently apply this methodology.  Some typical allocations reflect percentages of employees’ time spent or office space used for the unrelated activity.

Exceptions to every rule

The Internal Revenue Code includes many statutory exclusions from UBIT, including investment income such as interest, dividends and royalties, sales by volunteer labor, sales of donated goods, qualified sponsorship income, and qualified trade show or convention income.  On the other hand, real estate rental income, which is normally considered to be excluded from UBIT, can become taxable if the property being rented is debt-financed.

A word about advertising

Many associations generate income from advertising in their member periodical publications. The rules for reporting this income and calculating deductible direct costs and readership costs are complex.  If the organization has multiple publications, an election can be made to report the publications separately or on a consolidated basis.   The net taxable results can differ significantly, depending on which method is used. 

Revenue from sponsorships and website or directory advertising can be taxable or not, depending on the facts and circumstances of the activity and the actual content presented.  Revenue from displaying a sponsor’s name and logo on your conference program isn’t generally considered to be unrelated business income.  However, when a sponsor receives a substantial economic benefit, such as an endorsement of its products or services by the association, or the content includes statements as to the quality of the sponsor’s products or services or a call to action, the revenue generated becomes taxable.   

The importance of contracts

Properly drafted written agreements can be structured to minimize the association’s exposure to UBIT by taking advantage of statutory exclusions.   As an example, an association’s royalty contract for affinity credit cards excludes this revenue from UBIT by statute, but it is important that the organization does not provide services as part of the agreement.  Providing services can taint the royalty agreement; however, if services are provided by the association, a separate agreement for these services would keep the royalty revenue passive and excluded from UBIT.  Only the service revenue would be subject to UBIT, and would be offset by related expenses to determine taxable income.

How much unrelated activity is too much?

An association’s tax-exempt status could be jeopardized if its unrelated business activities are more than an insubstantial part of its operations as a whole.  “Insubstantial” isn’t defined by law, but common sense (and case history) would indicate that less than 5 percent is ok, but more than 20 percent could be too much. 

Organizations often consider moving a growing unrelated activity into a separate for-profit subsidiary to protect the organization’s tax-exempt status.  Tax laws affecting tax-exempt organizations and their related for-profit entities and transactions between them can differ from general tax-exempt laws, including situations where normally tax-exempt sources of income become taxable when received from a related for-profit subsidiary.  For example, rent paid by the for-profit subsidiary to the tax-exempt organization is a tax deduction for the for-profit, so, it is taxable rental income for the exempt organization.

Conclusion

The decision by an association to pursue sources of revenue which are unrelated to its mission should be weighed carefully and executed with an understanding of the unrelated business income tax laws.  Legal or accounting assistance can be very helpful when you have a new source of revenue – for determining whether or not the income will be taxable, drafting written contracts, and setting up accounting systems to properly allocate expenses to the revenue.  Establishing and operating the unrelated activity in the proper manner can save you headaches and tax dollars, and provide resources for your association’s mission.

Linda M. Nelson, CPA is a Principal with Olsen Thielen & Co., Ltd., in St. Paul, MN.  She has 28+ years of public accounting experience, most of those with exempt organizations.  She can be reached at 651-621-8624 or lnelson@otcpas.com.