Unrelated business income (UBI) can involve significant labor in accounting and documentation efforts, but the payoffs can be rewarding. The route to the payoffs must be followed carefully to keep on the right side of the IRS, whose scrutiny of UBI continues to intensify.

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The State of the Not-for-Profit Sector in 2015
Understand what the IRS is looking at
Over the past 18 months, the IRS has become very active with
audit activity at not-for-profits, something not unexpected in
the current economic and political environment. A primary
focus has been UBI. Based on studies, examinations and sample
returns, the IRS and Congress have publicly expressed concern
that tax-exempt organizations are not properly identifying
income that meets the three-part UBI test; when they do report
the UBI, organizations aren’t properly allocating the expenses
to offset it.
UBI can present in many ways, but the streams we see most
frequently scrutinized by the IRS are:
• Rental activities (e.g., personal property requiring services
or utilizing debt-financed space)
• Limited partnership investments
• Advertising
• Sales of unrelated items (e.g., logo items or certain museum
gift shop items)
• Service agreements characterized as royalties or licenses,
but requiring a certain level of active involvement of the
organization
• Special events that occur too frequently
• For associations, the provision of particular services to
members (more akin to a fee-for-service transaction) or
multilevel membership classifications
Dan Romano, Partner, Not-for-Profit and Higher Education Practices, Tax Services
Mary Torretta, Senior Manager, Not-for-Profit and Higher Education Practices,
Tax Services
Unrelated business income (UBI) can involve significant labor
in accounting and documentation efforts, but the payoffs can be
rewarding. The route to the payoffs must be followed carefully
to keep on the right side of the IRS, whose scrutiny of UBI
continues to intensify.
Nonprofit organizations that are tax-exempt under §501(c) of
the Internal Revenue Code (the Code) are not liable for income
tax on revenue generated from activities related to the exempt
purpose. But they are still liable for tax due from UBI at regular
corporate (or trust, if applicable) income tax rates.
As you pursue UBI, ready your organization for an IRS audit
by preparing a revenue analysis, following these framework
recommendations:
Become familiar with the three-part test
Generally, a revenue stream will constitute taxable UBI if these
three factors are all present:
1. The income is earned from a trade or business.
2. The trade or business is regularly carried on by the
organization.
3. The conduct of the trade or business is not substantially
related to the organization’s performance of its tax-exempt
function.
Strategic ways to pursue unrelated business income

2. 15
Keep documentation up-to-date
When the IRS initiates an audit, the agent mails a request for
specific information about your organization’s activities. The
requests begin innocuously with trial balance accounts, detail
of underlying amounts reported on Form 990 and the like.
Then the requests become more focused, asking for contracts
generating particular revenue, documentation supporting
the reasons behind undertaking an activity, and details of the
expenses offsetting each revenue stream.
From a practical perspective, it is often difficult to gather
this information because the audit occurs years after the fact.
Because of this, it is prudent to document your support as you
prepare your returns.
Examples: If you are renting out conference space, you should
document the identity of lessors and how the lease furthers
your organization’s exempt purposes. If the lessor has a
different tax-exempt purpose (or is a taxable person/entity), you
might document that it was a space-only rental agreement with
no debt, thereby meeting one of the exceptions to UBI.
If you are selling items in a gift shop, document the relationship
between the items and a particular exhibit or your mission in
general. If the shop is run by volunteers, document that their
level of effort exceeds 85% of the overall effort.
Parse your revenue streams
When evaluating a revenue stream, proceed methodically.
In addition to the three-part test, the Code contains specific
modifications and exclusions for activities such as passive
investment income, royalties, sale of donated goods and
activities conducted primarily by volunteers. Verify and
document the exceptions.
When allocating expenses to unrelated business activities,
identify only those expenses directly related to carrying on the
trade or business. Take these two steps:
1. Identify the truly direct expenses. These are expenses such
as salaries paid to staff that conduct an unrelated activity and
all out-of-pocket expenses incurred for that activity (e.g.,
meal cost for an event).
2. Determine if there are indirect expenses related to the
UBI activity. Indirect expenses are not as easily identified
and almost always involve an allocation. The process of
determining the value of indirect expenses is not as simple
or arbitrary as determining the percentage of UBI over total
revenue and multiplying that by your overhead. This is a
common mistake. Make the allocation based on employee
time incurred, space used, etc. The denominator in the ratio
is usually of particular concern. For example, if an expense
such as utilities is incurred in carrying on an unrelated
activity, be careful to allocate it based on unrelated time over
available time, e.g., if a room is used for UBI for 30 days
and related for 170 days, the allocation is 30 over 365, not 30
over 200. The IRS often finds issue with this common error.

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The State of the Not-for-Profit Sector in 2015
An organization cannot offset UBI by deducting expenses
incurred from a related-purpose activity partially funded by the
unrelated business activity. For example, if providing services
at a conference generates UBI and those services help fund
athletic programs, you cannot deduct athletic expenses against
the conference services revenue. In addition, expenses incurred
regardless of whether the organization conducted the unrelated
activity are often disallowed as a deduction against UBI.
Watch out for UBI loss activities
Supported by past court rulings, the IRS has adopted a facts
and circumstances test to determine if an activity constitutes
a trade or business. Some facts the IRS will consider in this
determination are:
• Three successive years of activity without a profit
• Variable and fixed expenses routinely exceeding income
from the activity
• Continuing losses without adjusting the price or
discontinuing the activity
• Activity directed toward a single recipient with no effort to
solicit additional sales or customers
• Informal operations, e.g., no business plan, no contract,
temporary or intermittent provision of services
If these factors are present and the activities generate a net
operating loss deduction for future years, the organization may
have to justify the stream as UBI to be able to take advantage
of those losses. Keep the Code’s exploitation rules in mind for
UBI activities that incur losses. The IRS has asserted, and courts
have agreed, that an activity that continually loses money is
not considered a “trade or business” because there is no “profit
motive.” The IRS disallows the losses to offset other profitable
UBI activities of the organization.
UBI can be a good thing
Although some organizations are averse to having “taxable”
income, we think it should be embraced as a source of
additional income activities that, though taxable, can still create
funds to further mission. To find these potential business
activities, review current activities to see if any can be expanded
or modified, even if they serve a slightly unrelated purpose.
Look at facilities to see if you can rent any that are not already
fully utilized. Remember to report the income, and carefully
determine and document the expenses directly and indirectly
related to the activity so you can file a Form 990-T and pay tax
on the net income.
Be creative and make a profit. There is nothing wrong with
some UBI — just pursue it with caution.