Even if an activity is considered to be taxable, there are a number of modifications to income and statutory exceptions that are available under the UBIT regulations.
These include the following:
- Passive income such as dividends, interest, annuities, and royalties where no active business participation and management is involved;
- Rents from real property (contingent with debt finance issue) and some personal property;
- Income from certain forms of research;
- Income generated from donated services or property;
- Income produced from sales made primarily for the convenience of the organization's members, students, and employees (including faculty and staff); and
- Special situations:
A royalty may be generally defined as a tax, duty or compensation paid to owners of a patent, copyright, mineral interest, or other property right for the use of it or the right to exploit it. The royalty exclusion includes overriding royalties, net profit royalties, and royalty income received from licenses by the university as the legal and beneficial owner of patents assigned to it by inventors. (IRC Section 512(b)(2); IRS Treasury Regulation 1.512(b)-1(b)).
A 1. Licensing Agreements
The IRC Section 512(b)(2) royalty exclusion is commonly used by exempt organizations to exclude licensing fees from UBIT. The IRS generally agrees with this result, so long as the exempt organization plays a passive role in the licensing arrangement. However, where the exempt organization's involvement is active, the IRS will not characterize the payment as a royalty, excluded from UBIT. One such situation is when the exempt organization is providing endorsements or services that are important to the success of the arrangement. In such cases, the IRS views the royalty payment as consideration for services performed and not a royalty. The IRS has recently begun to focus on this theory in deciding whether an exempt organization's licensing arrangement will be treated as a royalty.
A 2. Mailing Lists and Affinity Card
Based on recent court cases (Mississippi State University Alumni Association, Inc. v. Commissioner; Sierra Club v. Commissioner; Alumni Association of the University of Oregon, Inc. v. Commissioner), a rough set of guidelines now exists for exempt organizations to rely upon in structuring a viable affinity credit card program. (Tax Court Memos 1993-199, 1996-33, and 1996-34).
Mailing lists of potential card users should be made available on a selective basis, and minimal staff time and expenses should be allocated to maintenance and marketing of the list.
Organizations should avoid providing specific services (i.e., advertising, promotion, endorsements, etc.) other than reviewing the materials for quality control. The agreement should expressly provide that the organization will not provide specific services.
When services are provided, make sure they are "de minimis" or "courtesy" services.
If the arrangement necessitates the provision of substantial services, create a separate agreement for the service component and allocate a portion of the income to services. This will avoid "tainting" the entire amount of income thus avoiding the full amount to be considered UBI.
Prepare a separate mailing list agreement. If income from a mailing list is ultimately determined to be UBIT, then the intertwining of the mailing list with any other component of the licensing program may taint the entire transaction and cause all the income to be subject to UBIT. (IRS Letter Ruling 9029047).
By specifically terming the arrangement a "licensing agreement" and referring to the payments as "royalties", the exempt organization can avoid a certain amount of discrepancy.
Any expenses incurred by the exempt organization in connection with the production, preparation or mailing of solicitation materials should be reimbursed by the bank, financing institution, or other commercial entity, so as to minimize the risk that these activities are deemed to make up part of the consideration for the licensing payments. (Tax Court Memos 1993-199, 1996-33, and 1996-34).
The rules covering rents vary depending on whether they are derived from real or personal property or from a mixed lease of both real and personal property., and 1996-34).
B 1. Real Property
Rents from real property not debt financed are excluded from taxable income. (IRS Treasury Regulation 1.512(b)-1(c)(ii)(a)) provided:
- Property is not debt financed;
- Additional services are not rendered; and
- Are not dependent on a percentage of profits.
Amounts received by the university do not qualify as excludable rents if the university renders services for the convenience of the occupant. Services are considered rendered to the occupant if they are primarily for his or her convenience and are other than those usually rendered in connection with the rental of rooms or other space for occupancy only. (IRS Treasury Regulation 1.512(b)-1(c)(5)).
Rents dependent on profits or income derived by the university 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. (IRS Treasury Regulation 1.512(b)-1(c)(2)(iii)).
The code contains an exception to the debt-financed property rules for the acquisition of real estate by "qualified organizations", including educational institutions.
The term "acquisition indebtedness" does not include debt incurred by a qualified organization to purchase real property where the following conditions are present:
- The purchase price is a fixed amount;
- The amount of an indebtedness and the time for payment of such indebtedness is not dependent on revenue, income, or profits derived from the real property;
- The real property is not leased back to the seller or a party related to the seller; or
- If the real property is held by a partnership and one or more of the partners is not a qualified organization, then allocations to the partners must be qualified allocations or must not have as a principal purpose the avoidance of income tax. (IRC Section 514(c)(9)(c)(i)).
The possible classification of compensation received from privatization contracts as taxable should not dictate acceptance or denial of the contracts, but it should be an important consideration. A recent example of terminology used in a contract provided rent based on "cash net receipts" which was not well defined. If net cash receipts are defined as gross sales less applicable state and local sales taxes, no taxation of the contract occurs. On the other hand, if net cash receipts are defined as gross sales less any operating expenses, the compensation received is subject to the unrelated business income tax.
Oftentimes, the only action necessary is the clarification of a few contract terms to allow the compensation received to be non-taxable. Whether or not compensation is taxable to the university generally has no effect on the vendor, and they may be willing to alter terms of the contract slightly to help the university to avoid taxation.
B 2. Personal Property
Rents from personal property are excluded only if there is a mixed lease and the rents attributable to the personal property are an "incidental" part of the total rents received under the lease. The following rules apply to personal property rents:
- 10% or less is considered incidental and not subject to tax;
- 11-50% is considered taxable in proportion to the percent of personal property rents to the total rents; and
- 51% or more is considered 100% taxable. (IRS Treasury Regulation 1.512(b)-1(c)(ii)(b)).
Income from certain research grants or contracts may be exempt from the unrelated business income tax depending on the type of research. The following types of research are exempt:
- Research performed for any level of government (IRC Section 512(b)(7));
- Research performed by a college, university, or hospital "for any person" (IRC Section 512(b)(8)); and
- Research performed for any person in the case of an organization operated primarily for purposes of carrying on "fundamental" research (as distinguished from "applied"), the results of which are freely made available to the general public (IRC Section 512(b)(9)).
The regulations further limit these exclusions by providing that research does not include activities of a type ordinarily carried on as an incident to commercial or industrial operations. Ordinary testing and inspection of products or materials is not exempt. (IRS Treasury Regulation 1.512(b)-1(f)(4)).
C 1. Sale of By-Products
The sale of products resulting from research activities may or may not be exempt from UBIT. If the product is sold in substantially the same state it is in on completion of the research, the sale does not constitute unrelated business income. However, if further manufacture or processing of the product occurs, the gross income is considered unrelated. (IRS Treasury Regulation 1.513-1(d)(4)).
An example of their distinction is as follows. An experimental dairy herd maintained for scientific purposes by a research organization produces milk and cream in the ordinary course of operation of the project. The sale of the milk and cream would not be gross income from conduct of unrelated trade or business. On the other hand, if the research organization were to utilize the milk and cream in the further manufacture of food items such as ice cream, pastries, etc., the gross income from the sale of such products would be from the conduct of unrelated trade or business unless:
- The manufacturing activities themselves contribute importantly to the accomplishment of the exempt purpose of the organization (i.e. education of students); or
- The research produces more raw milk than can be sold as milk in its normal period of shelf life. This causes further processing to be done of the excess raw milk to obtain products that have a longer shelf life to avoid spoilage.
D. Donated Services or Property
D 1. Volunteer Labor
Any activity in which substantially all (approximately 85%) of the work of the trade or business is performed without compensation is exempt from tax. In assessing the contribution made by volunteers, the IRS considers such factors as the monetary value of the respective services rendered, the number of hours worked, the intrinsic importance of the volunteer work performed, and the degree of reliance placed upon volunteers. (IRS Treasury Regulation 1.513-1(e)(1)).
D 2. Donated Merchandise
Any unrelated activity engaged in the selling of merchandise, substantially all (approximately 85%) of which was received as gifts or contributions is exempt regardless of whether the labor to operate the activity is paid or volunteered. (IRS Treasury Regulation 1.513-1(e)(3)).
E. Convenience of University Students, Faculty, and Staff
Sales of otherwise taxable items may be exempt from tax under the "convenience" exception if sold to students, faculty, and staff (members). The convenience exception is applicable only to members of the university/agency. Any sales to non-members (e.g., the general public) are taxable unless the sales are not "regular". (IRS Treasury Regulation 1.513-1(e)(2)). The IRS auditors will contend that merely by making sales "more convenient" than purchasing from a taxable entity does not fall within the scope of the exception. The IRS position is that the convenience exception does not apply to items with useful lives of more than one year. The convenience exception normally applies to the operation of on-campus vending machines, the sale of sundry items by campus bookstores, and the laundering of dormitory linens and student clothing. (IRS Treasury Regulation 1.513-1(e)(3)).
F. Special Circumstances
There are special circumstances in which an unrelated activity may be recognized as serving an exempt purpose. The IRS will decide whether such unique circumstances exist on a case-by-case basis. The following are examples of unique circumstances (IRS Revenue Ruling 85-110, 1985-2 CB 166):
- Services or facilities otherwise unavailable in the community that fulfill an important community or medical need; and
- Services, facilities, or equipment which are technically advance or unique.