Unrelated Business Income Tax (UBIT): Protecting Your Nonprofit Status

Unrelated Business Income Tax (UBIT) is an area of increasing confusion for many nonprofits. In particular, many charities aren’t sure how to ascertain whether or not a current or future revenue-generating activity might be subject to additional tax and/or throw their exempt status into question.

Many nonprofits seek to supplement their income with retail activities; while these may be connected to their charitable mission (such as a museum gift shop), interpreting whether or not a nonprofit must pay tax on these business activities is an area subject to some interpretation.

On the whole, generating income through a business activity is an appropriate method of helping your nonprofit carry out its exempt purposes. But in doing so, you must be able to fit certain IRS criteria.

What Exactly is Unrelated Business Income Tax (UBIT)?

As defined by the IRS, “for most organizations, unrelated business income is income from a trade or business, regularly carried on, that is not substantially related to the charitable, educational, or other purpose that is the basis of the organization’s exemption.”

While this may seem rather straightforward, what constitutes this “substantial” relationship is subject to a fair amount of interpretation. Frequently, the IRS has used the “commerciality doctrine” to assess nonprofit retail operations. In doing so, they place business activities that are unrelated to a nonprofit’s mission on the same tax basis as businesses with which they compete. In such cases, it’s possible a nonprofit’s tax exempt status may be jeopardized or revoked.

How Do I Determine UBIT for My Nonprofit?

In cases where the organization is still considered tax-exempt by the IRS, you’ll want to determine whether or not you’re subject to UBIT. According to the IRS’ website, an activity is an unrelated business (and subject to unrelated business income tax) if it meets all of the following three requirements:

  1. Is a trade or business: any activity carried on for the production of income from selling goods or performing services;
  2. Is regularly carried on: frequently or continually pursued and is comparable to commercial activities; and
  3. Is not substantially related to furthering the exempt purpose of the organization.

Additionally, the following types of income are specifically excluded from UBIT:

  1. Volunteer labor;
  2. Convenience of members (activities carried on for the convenience of its members, students, patients, officers, or employees i.e. a cafeteria);
  3. Selling donated merchandise; and
  4. Certain types of bingo.

You can learn more about the specifics of these excluded activities on the IRS’ website.

Using Your Judgment to Determine UBIT

If you’re considering starting a retail venture, or are unsure whether or not your current revenue-generating activities subject you to UBIT, your best route is to work with a nonprofit CPA . Because nonprofits need to use their own judgment to interpret the IRS rulings, this can get tricky and confusing.

As a general guideline, if the income is related to the performance of your exempt functions (i.e. your charitable mission) you should be in the clear. However, if the IRS determines that these activities are larger in scale than reasonably necessary to carry out your exempt functions, you have UBIT, making this income taxable.

In interpreting the UBIT guidelines, and to avoid these liabilities, you should ensure that your revenue-generating endeavor is:

  1. Substantially related to your exempt purpose; and
  2. Conducted on a scale that’s appropriate to your charitable mission.

If you’re still unsure how these guidelines affect your nonprofit, or would like assistance in determining UBIT status for a current or future revenue generating activity, contact ESP. We’d be happy to consult with you in better understanding how Unrelated Business Income Tax might effect your nonprofit.

Your Board Treasurer’s Role and Responsibilities

It’s no surprise that raising funds is paramount for nonprofit organizations, allowing them to provide the vital services they offer the community. Some nonprofits have staff available to assist and steer the accounting function while others rely solely on volunteer support. In either case, the role of the Board Treasurer is key in ensuring the financial integrity of the organization.

Why is the Treasurer’s Role Important?

Board Treasurers fulfill a volunteer role, and while they aren’t paid to perform this function, they should still have clear job responsibilities and functions, just as any other key member of your organization. Accounting policies and procedures should be formalized, and this is particularly important for nonprofits that essentially function as small businesses.

Smaller nonprofit organizations may have a more casual relationship with the treatment of money, and yet this can create problems such as questions about how money was spent, money getting lost or even theft. By systematizing the accounting function, and using your Board Treasurer to help provide oversight and enforcement, your nonprofit can avoid many problems that could damage your nonprofit’s viability and reputation.

What Should Your Treasurer Be Doing?

To help you understand the ins and outs of your Treasurer’s role and responsibilities, we’ve compiled the following list:

  • Steward finances with ethical standards. Treasurers, with the help of a nonprofit CPA expert, should set up and oversee controls regarding receipt of cash, incoming checks, authorization of invoices, signing of checks, and cash deposits.
  • Utilize the annual budget to evaluate and plan. Every nonprofit should be operating with an annual operating budget. This process begins with having managers and executives estimate their expenses, in addition to plans for funding those expenses through income and fundraising. Treasurers should also assist in reviewing the prior year’s budget, ensuring that income and expense estimates appear to be achievable.
  • Ensure appropriate licenses and permits. Due to the benefits of having 501(c)(3) status, your nonprofit is subject to special permits and licenses, in addition to those that are required for certain activities such as holding a special event. These laws vary from state to state and your Treasurer should facilitate checking on these requirements beforehand.
  • Supervise financial filings. Your Treasurer is ultimately responsible for ensuring that your filings, particularly form 990, are submitted in an accurate and timely manner. Keep a calendar of when filings are due, and consult with a nonprofit CPA as needed. Your Treasurer should also be sure your nonprofit is registered with the appropriate charitable solicitation agencies; the Unified Registration Statement (URS) offers a summary of state requirements.
  • Track volunteer time. Many nonprofits leverage substantial time contributions from volunteers, but fail to track it. Ensuring that you know who has volunteered, when, where and for how long can help protect your organization and its volunteers from liability. Additionally volunteer time can be an important line item to monetize in your budget and underscore when applying for financial support, such as grants.
  • Recognize donations. Your Treasurer should help set up systems and oversee the written confirmation and recognition of donations. Thank you letters should be sent promptly and comply with IRS requirements for reporting, particularly for donor tax records. You can send this information via email; be sure to list any single contribution of $250+ and in cases that aren’t cash, describe the property without a value.
  • Prepare timely financial reports. Reviewing your current finances against your budget is vital in understanding your ability to carry out your plans. Yet often nonprofits struggle in understanding what kinds of reports to generate and how to use this information for planning purposes. Working with an expert like a nonprofit CPA, your Treasurer can ensure template reports are created and reviewed at each Board meeting. Additionally, as you grow you should consider commercial accounting software such as Quickbooks, in addition to cloud-based options (see below).
  • Recruit his/her replacement. Being prepared for your next Treasurer to assume responsibility requires some planning as well as recruitment. Your current Treasurer should be involved in seeking his or her replacement, and ensuring s/he has been properly trained.

What Cloud-Based Options are Available?

Cloud-based accounting software is the new frontier in accounting, and can be particularly helpful for nonprofits as they work in tandem with their Treasurer. Such software solutions include:

  • Quickbooks Online
  • Xero
  • Intacct

For more information on how you should be working with your Treasurer, or to implement cloud-based accounting options for your nonprofit, contact ESP. We’d be happy to discuss solutions for your organization.

‘The Overhead Myth’ and Nonprofit Accounting

While many people may think that the primary role of accounting in the nonprofit arena is focused on balance sheets and fiscal oversight, recent conversations are shedding light on another important role accounting can play. As Dan Pallotta discusses in his recent TED Talk, The Way We Think About Charity is Dead Wrong, the intricate tie between fundraising, expenses and accounting factors greatly into how donors and grantors view nonprofit budgets.

Isn’t Less Nonprofit Overhead Better?

In specific, recent conversations have been sparked regarding nonprofit oversight and overhead expenses. Many groups have joined forces to challenge the long-held notion that “less overhead = better charity.” In truth, as Pallotta discusses, this mentality pushes nonprofit organizations to offer salaries, benefits and administrative accommodations that are well below what executives would receive in the corporate world. As a result, it’s nearly impossible for savvy professionals to want to work in the nonprofit sector, which ultimately results in brain drain.

What Can Accounting Do?

Accountants can play a pivotal role in moving the needle toward a more equal playing field in the way we track and report nonprofit expenses. Rather than downplaying costs associated with operating successful nonprofits, the accounting function can and should paint a more realistic picture. The more informed donors are about how much it actually costs to run a successful nonprofit, the more we can raise the bar and support nonprofits in operating on more than a shoestring budget.

 What Work is Already Being Done?

As part of this ongoing conversation, three of the nation’s leading philanthropic information sources – GuideStar, Charity Navigator, and BBB Wise Giving Alliance – wrote an open letter to America’s donors, tasking them to rethink the concept of overhead expenses. In it, they ask donors to “pay attention to other factors of nonprofit performance: transparency, governance, leadership, and results.” The letter goes on to discuss the “Nonprofit Starvation Cycle” which drains nonprofit organizations of access to the quality leadership and resources they need to truly excel.

They also make the case for nonprofits to actually spend more money on overhead, arguing that “overhead costs include important investments charities make to improve their work: investments in training, planning, evaluation, and internal systems— as well as their efforts to raise money so they can operate their programs. These expenses allow a charity to sustain itself (the way a family has to pay the electric bill) or to improve itself (the way a family might invest in college tuition).” As a result they’ve started a website and a movement titled “The Overhead Myth” to help raise awareness and debunk this common misperception about nonprofit administrative expenses.

How Can I Help?

In a recent news release written by Guidestar, the company’s President and CEO, Jacob Harold, provides a number of ways constituents and nonprofits alike can support this cause. We’ve included those below in addition to others:

  • Visit OverheadMyth.com and download the open letter. This letter is being made available for open use and nonprofits can include it on their website, in donor solicitation communications, as well as marketing materials.
  • Share your nonprofit data via Guidestar.org. Guidestar’s website provides an open channel for donors to access information about nonprofit financials. The more donors see and understand what it takes for a nonprofit to function successfully, the better we’ll be able to raise the bar for overhead expenses.
  • Watch Dan Pallotta’s TED Talk, The Way We Think About Charity is Dead Wrong, and share with your friends and colleagues via your social networks. Pallotta’s talk helps make the case for rethinking nonprofit expenses, the charity lifecycle and the role of accounting.
  • Donors can also help spread the word using The Overhead Myth’s communications and social media toolkit, which provides sample tweets, Facebook and Google+ posts, and newsletter emails and articles.

For more information on how your nonprofit can improve its accounting reporting functions to help turn the tides of “The Overhead Myth,” contact ESP. We’d be happy to consult with you regarding your nonprofits reports and overhead.