This article originally was published on Aug. 2, 2016. 

By Zachary S. Kester, JD, LLM, CFRM and Kylie Schreiber, at Charitable Allies

As charitable organizations seek to increase streams of revenue — to provide more services, support more staff or help ensure long-term sustainability — many dabble in sources of business revenue to supplement the financial bottom line. For example, an organization with a pool may wish to rent the pool and locker room access to local schools to use for their interscholastic or intramural swimming teams.

Business activities are fairly common among charitable organizations, in fact according to the National Center for Charitable Statistics, nearly 70 percent of the $1.4 trillion of nonprofit income was earned. The activities themselves are not inherently wrong or impermissible for charities. They only become an issue if they are unrelated to the charitable purposes of the organization and represent a substantial percentage of the total revenue and activities of the organization. Unrelated business income tax (UBIT) can apply to income from those types of unrelated business activities.

In fact, ‘business’ activities are often related to the charitable nature of the nonprofit (i.e., sales of counseling or therapeutic services, or selling donated goods). Yet, many regularly carried-on-business activities do not qualify as related (i.e., receiving debt-financed rental income or selling advertisements in a newsletter) even if the income produced is used to further the tax-exempt purposes.

When nonprofit business activities start to grow, regardless of whether they are ‘related’ to the charitable purposes of the organization, best practices often involve driving those activities through a subsidiary legal entity such as an LLC, a supporting organization, or a traditional business corporation.

Called a ‘blocker’ corporation, it is a traditional business c-corporation that is wholly owned by a charity but whose activities are not attributed to the charity. This is true even if the charity exercises substantial influence or control over the blocker corporation’s activities. Through a blocker corporation, not only is the charity protected from liability related to the business activity, but also the charity may engage in substantial revenue-generating activities that would otherwise be considered UBIT.

Understanding UBIT

In deciding whether or not to conduct business activities through a blocker corporation, it is important to first understand UBIT and its purpose. UBIT was created to ensure that tax-exempt organizations did not start competing with for-profit entities by providing goods and services beyond the scope of their tax-exemption and not pay taxes.

What can trigger the UBIT is complicated and, as usual, comes with a host of exceptions.

Unrelated business taxable income (UBTI) is defined by the IRS as “the gross income derived by any organization from any unrelated trade or business regularly carried on by it.” An “unrelated business” is “any trade or business the conduct of which is not substantially related to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption.”

In order for income to be classified as UBTI, the business activity must (1) be derived from the operation of a trade or a business, (2) be regularly carried on, and (3) not be substantially related to the tax-exempt purpose of the organization. If a business activity meets those criteria, then that income must be reported on the Form 990-T, if it is over $1,000. At that point, the income will be subject to standard corporate tax rates, and if such income is more than insubstantial, it can threaten a charity’s tax-exempt status.

The UBTI and UBIT determinations vary on a case-by-case basis because of many exceptions, exclusion and modifications to the law, many of which do not make much sense.

Examples of business activities not subject to UBIT include:

• Passive income, such as dividend and interest income, royalties and rents from real estate property
• Any activity in which 85 percent or more of the work is performed by unpaid volunteers is exempt from UBIT, such as a thrift store
• Sales of donated items

Examples of common sources of taxable income include:

• Sales from advertisements in a newsletter or on a website
• Rental income from debt-financed property (i.e. renting out property acquired from a loan for big events like weddings or fundraising concerts for a discounted fee)
• Investments like hedge funds and private equity funds that function as partnerships (unless a blocker corporation is used)
• Fees earned for providing administrative or clerical services to another organization

Use of a blocker corporation

All these are the types of business activities that might be better off and more successful if spun into a blocker corporation. And the blocker corporation transfers income to the charity in the form of passive, non-taxable income.

Recall that through a blocker corporation, not only is the charity protected from liability related to the business activity, but the charity may engage in substantial revenue-generating activities that would otherwise be considered UBIT.

Suppose there is a charity that promotes health and wellness in a community and operates an animal shelter also has an associated vet clinic that charges for veterinarian services. Vet services, being unrelated to human health and wellness, may trigger UBIT. However, having the vet services provided by a blocker corporation allows those services to continue being offered and the income used to support other health and wellness and animal shelter programs without triggering UBIT.

By using blocker corporations, charitable organizations maintain their tax-exempt status and can still increase revenue without paying UBIT. If a nonprofit is already conducting business but is not expanding due to unease about paying UBIT and the risk of losing its tax-exempt status, a blocker corporation may be the answer.

However, it is important that the nonprofit organization does not “control” the blocker corporation. “Control” means the nonprofit organization owns more than 50 percent of the stock, capital, or beneficial interests in the blocker entity. There is some indication that “control” by the nonprofit organization might mean owning at least 80 percent of the stock, capital, or beneficial interests in the blocker entity, but there is a conflict of the law and would require obtaining counsel exceptionally qualified in the creation of blocker corporations to determine. Therefore, to be safe nonprofit organizations should own no more than 50 percent of the blocker organization in whatever form that ownership interest may be. In the end, remaining under these ownership limits allows what would otherwise be UBTI to pass to the nonprofit organization without being taxed.

The primary activities of charities are, and should remain, pursuing charitable ends. If a business opportunity develops to help add to the bottom line, it may be worth exploring how that income can be converted into passive income for the charity, especially if the charity has already developed an expertise in a given area through which the larger community would benefit.

Pursuing or continuing business activities does not necessarily run the grave risks that it is often believed to have. Besides blocker corporations, there are other ways of avoiding UBIT, including having volunteers (not paid by the organization) do the work or even restructuring the activity so that it more closely relates to the charitable purpose.

Blocker corporations offer just one way for organizations to get where they want to go with a larger budget to do so. Performing business activities does not have to be intimidating and can be done in compliance with all regulations.

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Attorney Zac Kester provides generalist and strategic nonprofit legal and consulting services. He holds a Master of Laws, a post-law school advanced degree, in which he studied the unique needs of tax-exempt nonprofit organizations. His legal and consulting career has focused on nonprofit organizations.

With highly experienced legal and training personnel, Charitable Allies provides all manner of legal and educational services for boards, officers, management and staff of myriad charities throughout the sector. From basic one-time questions about a single matter to training for boards and officers to complex reorganization or merger of activities, Charitable Allies is your go-to cost-effective provider of legal services to nonprofit organizations.

Contact Zac Kester, executive director, at 317-333-6065 or zkester@charitableallies.org with any questions.

Substantiation

• AccountingWeb. UBIT: When a Nonprofit Is Profitable. Meredith Pratt, CPA. Jan 7th 2013. Tax-Exempt Entities: UBIT and Debt-Financed Income, Rack & Olansen, A Professional Law Corporation
• Hinckley Allen – Nonprofit Update. Katie A. Ahern. Five Things Nonprofits Should Know About: Unrelated Business Taxable Income (“UBTI”). February 13, 2014.
• Mosher & Wagenmaker, LLC. A Basic Study of Unrelated Business Income Under IRC §512.
• IRC section 512(a)(1).
• IRC section 513.
• IRC section 513(a)(1).
• IRC section 513(a)(2).
• IRC section 513(a)(3).
• IRC section 512(b)(4).
• IRC section 512(b)(13).
• IRC section 514(b)(1)(A).
• 26 C.F.R. § 1.512(b)–1(L).
• Jacobson Jarvis & CO, PLLC. What Not-for-Profits Need to Know About Tax Compliance.
• Mosher & Wagenmaker, LLC. A Basic Study of Unrelated Business Income Under IRC §512.
• The Nonprofit Times. Tax Strategies for Hedge Funds, Private Equity Funds. Karen Andersen, CPA.
  McGuire Woods. IRS Advisory Committee Releases Recommendations on UBTI Compliance. August 21, 2014
• Rack & Olansen. A Professional Law Corporation. Tax-Exempt Entities: UBIT and Debt-Financed Income
• Emily Chan, Profitabe Side of Nonprofits – Part I: Earned Income, http://www.nonprofitlawblog.com/the-profitable-side-of-nonprofits-part-i-earned-income/