When a not-for-profit (NFP) organization has a question about whether a certain type of income is taxable, the most common response is “it depends” as this determination is not always straightforward. The three criteria for income to be taxable are: (1) the income is from a trade or business, (2) it’s regularly carried on, and (3) the activity that produces the income is not substantially related to the organization’s exempt purpose. Let’s explore this in a little more depth.
The taxability determination can be complex because slight modifications to the circumstances may make all the difference. Here are a few examples of similar situations, but with different outcomes:
|Type of organization
|Related (not taxable)
|Sale of legal forms to members
|Sale of various items
|Forms are not monitored or updated
|Sale of art and books
|Sale of reproductions of art in the museum
|Sale of scientific books in a folk-art museum shop
|Sale of various handmade items
|Made by students at the school
|Made by others in the community
|Sale of books, supplies
|Sales of plants
One common example of taxable income is advertising income. Sponsorship income is not taxable because sponsorships, or a portion of them, are contributions. A sponsorship is an acknowledgement or identification of the sponsor, whereas advertising is promotional. It is not always easy to differentiate between these two classifications. With advance planning, you may find that an acknowledgement meets the donor’s needs without giving rise to taxable income.
The three criteria noted above should be the basis for determining most types of taxable income. There are also exceptions to the criteria which can make the determination of taxability more complicated.
A common example is an exempt organization’s rental income from real property which is generally not taxable unless the organization has debt on that property. But if the lease includes certain services and/or rental of personal property, the rental income may be taxable without regard to whether debt financing is present.
Another special rule applies when rental income is received from a controlled for-profit taxable subsidiary. The IRS designates the rental income as taxable to the not-for-profit owner in this situation due to the possible susceptibility of manipulation of taxable income. An exception applies to rental income if the rented property is at least 85% used for the not-for-profit organization’s tax-exempt purposes. In this case, the income is not taxable. Are you confused yet? Yeah, it can get complicated.
There are a couple of other common exceptions to the criteria to note. If the activity is conducted with substantially all volunteer labor, the income is not taxable. The term “substantially all” for this situation is not defined by the IRS. Another exception to the above criteria is if the income is produced from an unrelated activity that is conducted for the convenience of members (e.g., an art museum operates a cafeteria for its staff and patrons).
Taxable income may also arise as part of the income reported to the not-for-profit organization on Schedule K-1 forms when the organization invests in partnerships or LLC’s. It is important to have an awareness of this possibility as partnership investments may be managed by the organization’s investment advisor and be included as part of the investment statement, and taxable income on K-1’s may be overlooked if the investment and financial management personnel are unfamiliar with the taxable income potential.
These examples, common taxable income types, and exceptions to the general criteria are just a few of the areas that demonstrate how the determination of the taxability of income for an NFP can be complex. That complexity is why the answer to your question on this topic most likely will be “it depends” and requires a deeper understanding of the circumstances.
Reach out to your Baker Tilly Value Architect™ or contact us today to discuss your questions around unrelated taxable income.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.