23.3 Allowable UBI Deductions
Institutions of the University System of Georgia (USG) are tax-exempt as instrumentalities of the State of Georgia under Section 115 of the Internal Revenue Code. Similarly, institution foundations are exempt under Section 501 (c)(3) of the Internal Revenue Code.
As tax-exempt entities, USG institutions and foundations are exempt from federal income tax for activities that further their educational purpose. However, they are not exempt from income tax imposed on activities that are substantially unrelated to exempt purposes, called “Unrelated Business Income” or UBI, even though these activities may bring in funds to support exempt operations.
This section provides users with guidelines for identifying and reporting activities that are not exempt from income taxation and reporting on IRS Form 990-T. It also presents a working definition of UBI, lists activities to report as UBI – taxable, and describes principal exemptions from UBI reporting.
Unrelated Business Income (UBI) is gross income from a trade or business regularly carried on by a college or university, which is not substantially related to the performance of its exempt purpose or function, except that the institution uses the profits derived from this activity.
Note: The mere fact that an activity generates a source of funds that is used to carry out a mission-related activity does not mean the activity per se is related to the mission. The IRS places particular emphasis on the size and extent of the activity. If an activity is conducted on a scale larger than reasonably necessary to carry out the exempt purpose, it is more likely to be treated as unrelated business income. Refer to IRS Publication 598, Chapter 3, for more details: http://www.irs.gov/pub/irs-pdf/p598.pdf.
23.2.1 Reportable, Non-Exempt Activities
In general, any commercial-type activity operated by an institution will be subject to Federal income tax if it is:
- A trade or business;
- Regularly carried on; and,
- Not substantially related to the institution’s exempt purposes of teaching and instruction, research, or public service.
To be “reportable,” the unrelated business income activity must generate more than $1,000 in income per tax year.
23.2.2 Determining Whether UBI Applies
Commonly reportable unrelated business income activities for institutions are listed below. If an institution still questions whether UBI applies to an activity, they should contact their tax advisor or legal counsel.
To qualify as a deduction in computing net unrelated business taxable income, an expense must be:
- An allowable deduction for income tax purposes; and,
- Directly or indirectly connected with fulfillment of the unrelated business activity.
Deductible expenses fall into two broad categories: direct and indirect costs.
Generally speaking, activities cannot be considered taxable unless they are deemed to be a “trade or business” as defined in IRC Section 162. Among other things, a trade or business has to include competitive promotional efforts, and exhibit the intent to generate a profit. If the intent is simply to recover costs, the activity may lack a profit motive and be exempt from UBI treatment.
Note: For more information on the definition of trade or business, refer to: http://www.law.cornell.edu/uscode/26/usc_sec_26_00000162—-000-.html.
IRS regulations also consider the frequency and continuity of the activity when evaluating UBI applicability. If an activity occurs infrequently or for a short period of time during the year, it may fail to meet the IRS definition for “regularly carried on.”
Even if an activity meets all criteria for treatment as unrelated business income, one or more of the following conditions may qualify the activity for exemption under IRS guidelines:
Community Need Exemption: Activities fulfill an unmet medical need in the community, such as non-patient specimen testing or services provided to another tax-exempt hospital.
Convenience Exemption: Activities are performed for the convenience of the institution’s students, faculty, staff or patients, and/or the activities relate to sales where the product has a useful life of less than one (1) year.
Donation Exemption: Eighty-five per cent (85%) or more of the income is related to donated merchandise, property or services, even if the labor to operate the activity is paid or volunteered.
Editorial Exemption: Publications include editorial content related to the accomplishment of the institution’s exempt purposes.
Educational Function Exemption: Activities are important to the overall educational function of the institution, such as a performing arts theater, symphony, etc.
Other Miscellaneous Exemptions:
- Activities relate to “expendable” sales; and,
- Activities relate to sales in an area near other commercial facilities selling similar products.
Passive Participation Exemption: Passive income such as dividends, interest, annuities, royalties, licensing agreements, etc., without any active business participation or management.
Student Participation Exemption: Activities include substantial student participation, which directly supports the institution’s educational program(s).
Volunteer Exemption: Eighty-five per cent (85%) or more of the work related to an activity is performed by volunteers.
23.3.1 Direct Costs
Examples of “allowable direct deductions” include:
- Salaries, wages, and employee benefit costs when the effort devoted and the benefit derived are directly identifiable with a specific UBI-applicable activity
- Supplies and other general expenditures including travel, telephone and technology charges, etc.
- Equipment purchases
- For self-sustaining operations, equipment, depreciation, operations and maintenance of plant, and institution general administrative support charges
- Interest paid to third parties during building construction, maintenance, and remodeling prior to occupancy/capitalization
23.3.2 Direct Cost Allocations
When personnel, facilities, supplies, equipment, and other institution assets are used to conduct both exempt and non-exempt activities, the institution must allocate the costs between the two uses on a reasonable basis. In most instances, allocations based on the percent of time devoted to each activity will fulfill the reasonableness test.
Note: IRS guidelines require institutions to use 24 hours per day, 365 days per year as the basis for allocation direct costs, not the actual number of days used.
23.3.3 Indirect Costs
Examples of “allowable indirect deductions” include:
- Building usage
- Equipment usage
- Operations and maintenance costs
- General institutional administrative costs
- Departmental administrative costs
23.3.4 Indirect Cost Allocations
Indirect costs will be allocated to unrelated business income activities, in accordance with OMB Circular A-21, Principles for Determining Costs Applicable to Grants, Contracts and Other Agreements with Educational Institutions. Refer to http://www.whitehouse.gov/omb for more details.
23.4.1 Special Considerations
The following types of activities receive special IRS consideration when determining whether the activity is excluded from UBI reporting and taxation:
Acknowledgements: Incidental recognition of sponsorship with no qualitative or comparative basis may not subject to UBI treatment.
Advertisements: Ads in newsletters, magazines, journals, websites, or sports programs may be taxable even if the activity is carried on within a larger complex of other endeavors substantially related to an institution’s exempt purpose. Advertisements that serve an “informational function,” as opposed to serving as a means for stimulating demand for a product, may not be taxable.
Artistic, Entertainment, and Theatrical Events: IRS guidelines focus on the contracts negotiated with performance artists to determine whether they were consummated for related educational purposes. If the event is not distinguishable from those efforts of a commercial promoter and arena, the proceeds from ticket sales, advertisements, etc. may qualify for treatment as UBI.
Bookstores: IRS guidelines typically separate bookstore sales into three major categories when determining UBI applicability:
- Educational materials (exempt);
- Non-educational, convenience products low in cost and in current demand (exempt); and,
- Other merchandise that does not further the institution’s exempt purposes (not exempt).
Child Care Centers: IRS guidelines focus on whether the service is available to general public.
Computer Sales to Faculty, Staff, and Students: IRS guidelines focus on whether the program leads to the enhanced computer literacy of the institution’s faculty, staff, and students.
Dormitory Rentals and Food Service Charges for Conferences: IRS guidelines focus on whether the program is clearly linked to the institution’s educational mission and whether institution personnel participate in or benefit from the program.
Food Service Agreements: IRS guidelines focus on whether the financial agreement includes commissions, building (real property) rents, and/or equipment (personal property) rents. Personal property payments may be subject to UBI treatment, unless the IRS determines the payments are an “incidental” part of the total amount received under the agreement. The following rules apply to personal property/equipment payments:
- 10% or less (“incidental” and exempt);
- 11-50% - taxable in proportion to the percent of personal property payments to total payments (not exempt); and,
- 51% or more (not exempt – 100% taxable).
Leased Parking Spaces/Lots: IRS guidelines focus on whether the parking revenues are generated from the general public for non-institution events. In some instances, leases of parking spaces or lots to the general public qualify for treatment as rental real estate. Real estate leases are not subject to UBI treatment, if additional services are not offered.
Long Distance Carrier Commissions: IRS guidelines may dictate treatment as UBI, even if students purchase the services directly and the institution conducts no marketing or promotion of the service.
Mailing Lists and Affinity Cards: IRS guidelines focus on the whether the specific services provided under the agreement are deemed to be de minimis, or “courtesy services.”
Recreational and Athletic Facility Memberships: IRS guidelines treat usage by students, faculty, and staff as a convenience not subject to UBI. However, usage by alumni, guests, and/or spouses and children of students, faculty, and staff generates unrelated business income, subject to UBI treatment.
Rents: IRS guidelines focus on whether the rents are derived from real or personal property, or from a mixed lease of both real and personal property.
Research: IRS guidelines focus on the type of research performed by the institution when evaluating whether income is taxable:
- Performed for any level of government;
- Performed by a college, university, or hospital “for any person” as defined in IRC Section 512(b)(8) http://www.law.cornell.edu/uscode/26/usc_sec_26_00000512—-000-.html;
- Performed for any person for purposes of carrying out “fundamental research,” as distinguished from “applied research,” the results of which are freely made available to the public; or,
- Performed as a part of clinical trials or FDA drug testing protocol, where the institution can demonstrate the program contributes to the training of students or to patient care.
Research By-Products: IRS guidelines focus on the state of the product sold. If the product is manufactured or processed after completing the research phase, income from its sale may be treated as unrelated.
Special Circumstance Activities: IRS guidelines recognize special circumstances in which an unrelated activity may be recognized as “serving an exempt purpose.” The IRS makes this determination on a case-by-case basis.
Net UBI reported by the institution is subject to normal applicable corporate income tax rates. Any tax liability owed by the institution for UBI activities must be funded by revenues from the UBI activities, individually or collectively. UBI tax liabilities should not be paid from current unrestricted or restricted operating funds.
In most instances, UBI activities should be recorded in Auxiliary funds. UBI-applicable activity should not be recorded in the following funds: