Adapted from material developed by Dale Zuehls CPA, JD, PhD (Zuehls, Legaspi & Company) for the California State University. Used with permission and updated 5/2012.
Those that are not familiar with the intricacies of tax law might assume that once a non-profit has been granted 501(c)(3) status by the IRS, all income received by that organization is not subject to income tax. Although typically this is the case for most types of income that the University receives, there is a specific exclusion under the law for what is called “Unrelated Business Income”.
Tax-exempt organizations such as the University of Miami are taxed on unrelated business income, which is income from any trade or business that is not substantially related to its tax exempt mission (education, research, and patient care).
In order for income to be considered unrelated business income, it must meet all three criteria outlined below. The income is:
However, even if the University receives income that meets the initial criteria to be classified as unrelated business income, there are additional tests to consider before the income is determined to be taxable.
Tax law contains several modifications that have the effect of exempting various kinds of income from the unrelated business income tax. These include income from dividends, interest, annuities, royalties, rents from real property, and certain forms of research.
The Internal Revenue Code excludes most types of passive income from the definition of unrelated business taxable income. IRC §512(b)(1) excludes all dividends and interest from tax. IRC §512(b)(2) excludes royalties when measured by gross or taxable income from tax provided that services are not provided by the University in exchange for the payment. IRC §512(b)(3) excludes certain types of rental income from tax as further discussed below.
Income generated by the rental of personal property (i.e. property other than real estate) is generally taxable unless the personal property is rented in conjunction with the rental of real property (see Mixed Leases in the section directly below). However, income generated from rental of personal property may not be subject to unrelated business income tax under the following circumstances:
Rental income from real estate is normally excludable from unrelated business income (Reg. §1.512(b)-1(c)(ii)(a)). However, amounts paid for the occupancy of space do not qualify as excludable rents if the owner of the property renders services for the convenience of the occupant.
Services are considered rendered to the occupant if they are primarily for his/her convenience and are other than those usually rendered in connection with the rental of rooms or other space for occupancy only (Reg. §1.512(b)-1(c)(5)). For example, the provision of maid, linen or food services constitute services rendered for the convenience of the occupant, whereas the furnishing of utilities, the cleaning of public areas (e.g. public entrances and exits, stairways, lobby) and collection of trash do not. The operation of a box office and concession stand has been treated as services for the lessee of an auditorium.
Rents dependent on profits or income derived from real property do not qualify for the exclusion unless they are based on a fixed percentage of gross receipts or sales. Rents based on a percentage of net profits are taxable (Reg. §1.512(b)-1 (c)(2)(iii)). The IRS has determined that the rental of parking spaces to the general public is not considered rent from real property, regardless of whether any services are being provided.
Where both real and personal property are rented, the rents from personal property are excluded if the rents attributable to the personal property are an “incidental” part of the total rents received under the lease. Determination of the excludable portion of rentals attributable to personal property is based on the following rules:
A royalty is defined as a tax, duty, or compensation paid to owners of a patent or copyright for the use or right to act under such patent or copyright. The royalty exclusion includes overriding royalties and royalty income received from licenses accorded the University as the legal and beneficial owner of patents assigned to it by inventors (IRC §512(b)(2) and Reg. §1.512(b)-1(b)).
However, where the royalty income is derived in part from the performance of services, the payment does not constitute royalty income (Rev. Rul. 73-193).
The sale of commercial advertising is taxable even though the advertising is published in an exempt organization’s periodical (e.g. a newsletter, magazine or scholarly journal) that contains editorial matter related to the exempt purpose of the organization (IRC 513(c)).
1. Related - Advertising published in a college newspaper as part of an instructional program or advertising which serves an “informational function,” as opposed to providing a means of stimulating demand for products, is considered related to the college’s exempt purpose.
However, consumer advertising may be regarded as related to the University’s exempt purpose if students are actively involved in the solicitation, sale and publication of the advertising under the supervision and instruction of the University.
For example, a campus newspaper operated by students publishes paid advertising. Although the services rendered to the advertisers are of a commercial character, the advertising business contributes importantly to the University’s educational program through the training and participation of the students involved (Reg. §1.513-1(d)(4)(iv) Example (5)).
2. Unrelated - The sale of general consumer advertising in an exempt organization’s journal is considered to be an exploitation of the organization’s exempt purpose. Such advertising is not substantially related to the accomplishment of the purpose that constitutes the basis for the organization’s exemption (Reg. §1.513-1(d)(4)(iv)).
Generally, contributions received by a charitable organization are not considered unrelated business income if the organization does not provide a valuable service or benefit to the donor. However, if an organization goes beyond mere acknowledgement of a contribution and extensively promotes the sponsor of a special event, such as a post-season tournament, bowl game, or fundraiser, the income may be subject to tax because a valuable benefit or service in the form of advertising is being provided in exchange for the contribution (Prop. Reg. §1.513-4).
1. Non-Taxable Acknowledgements. Sponsorship activities that merely acknowledge a corporate sponsorship payment by using the following means of sponsor identification are not considered taxable:
2. Taxable Advertising. Messages or other program materials broadcast or otherwise transmitted, published, displayed, or distributed in connection with a specific sponsored event to promote a company, service, facility, or product in exchange for a corporate sponsorship payment are considered taxable advertising. For example, the presence of the following factors would indicate that an exempt organization is engaged in advertising for a corporate sponsor:
In addition, if the amount of a sponsorship payment is contingent, by contract or otherwise, upon such factors as broadcast ratings or attendance at an event, the payment is considered advertising.
Generally, income from a joint venture will not be taxable if the undertaking contributes importantly to the University’s exempt purpose or if it is carried on for the convenience of University members. However, joint venture relationships have been scrutinized by the IRS to ensure that a tax-exempt organization is not serving the private purposes of the for-profit entity.
Even if an activity meets the definition of an unrelated trade or business, it may not be subject to tax if it meets one of the following criteria:
Convenience of University Members - Any unrelated activity conducted primarily for the convenience of University students, faculty, staff or patients is exempt from tax. The convenience exception applies only to members of the University. Any sales to nonmembers, e.g. the general public, are taxable unless the sales are not regularly carried on (Reg. §1.513-1(e)(2)).
The IRS has ruled that alumni should be treated the same as members of the general public since there is no stipulation in the IRC that alumni should be treated otherwise (PLR 8020010).
Volunteer Labor - Any activity in which substantially all the work of the trade or business (probably 85%) is performed without compensation is immune from tax. In assessing the contribution made by volunteers, such factors as the monetary value of the services rendered, the number of hours worked, the intrinsic importance of the volunteer work performed, and the degree of reliance placed upon volunteers should be considered (Reg. §1.513-1(e)(1)).
Donated Merchandise - Any unrelated activity involving the sale of merchandise, substantially all (probably 85%) of which was received as gifts or contributions, is exempt regardless of whether the labor to operate the activity is paid or volunteer (Reg. §1.513-1(e)(3)).