Here's a one-question quiz many leaders of non-profit organizations will flunk: 'Once the IRS recognizes your group's tax-exempt status, do you ever have to pay income taxes?' I suspect that nine out of 10 leaders would say 'No.' And they would be wrong.

A non-profit organization is granted tax-exempt status because of the specific particular activities in which it engages. Historically, the idea was that charitable institutions provided services that the government would otherwise have to provide (such as education or caring for the destitute) and were entitled to special treatment because they lessened the burden on government. The concept has been greatly expanded over the years, which is a good thing for the arts because they have scarcely been (or are now, for that matter) regarded as a function of government in the United States. The Internal Revenue Code now defines charitable organizations as those 'organized and operated exclusively for charitable, religious, educational, literary, scientific, or testing for public safety purposes, or to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals.'

And that is only one class of tax-exempt organizations, those to which contributions are tax-deductible. The Code lists 28 other classes of tax-exempt entities, which include groups as diverse as labor unions, political parties, credit unions, condominium associations, farmers' cooperatives, the Elks and the National Football League.

What they all have in common is that their exemption from income taxes is limited to income related to their exempt function. Other types of income are subject to the unrelated business income tax.

Being Active

'Unrelated business income' has been a surprisingly hard term for Congress and the Internal Revenue Service (IRS) to define. To be sure, some of the difficulty is self-inflicted by Congress trying to please certain pressure groups, and by the IRS's tendency to define by specific example instead of concept. But, in many cases, the line between related and unrelated income is subtle.

Generally, unrelated business income comes from the active, regular conduct of a trade or business that is not substantially related to the organization's exempt purpose. Almost every word in that sentence is subject to interpretation, and federal courts at every level have done so.

Merely providing funds to support an organization's ongoing good deeds does not make an activity 'related.' So if the Art Institute of Chicago were to profitably operate a Burger King in Waxahachie, Texas, they have taxable unrelated business income. That's pretty obvious. But, of course, the Art Institute doesn't operate a Burger King; if you want to buy a hamburger from them, you must go to the restaurant they operate at the museum itself. And that restaurant does not generate unrelated business income, for the IRS has ruled that museum dining rooms, cafeterias, etc., do not create unrelated business income because they help to attract visitors and enable them to give more time and attention to the museum's exhibits.

A similar logic extends to the gift and bookshop operated by a museum, or'dare I say it?'a theatre. Sales of reproductions of works in the museum, or published plays presented by that theatre, are related; sales of sunscreen or the 'Harry Potter' books are not.

Being Passive

Passive income is automatically excluded from unrelated business income: dividends, interest, sale of assets, rents and royalties. All of these require some activity, of course'someone must invest the money, sign the leases and so forth. Because organizations often want assurance that their good name won't be sullied, they may put restrictions on these arrangements that tiptoe close to, or across the line, of active involvement. When renting your mailing list, for example, how much control can you have over the content of the material mailed by the renter? When a church sells vacant land and restricts how it is to be developed, are they in the real estate business? The courts have handled hundreds of these situations, leaving a messy, muddy and inconsistent body of case law.

One type of passive income is, nevertheless, unrelated business income: rents from debt-financed property. A typical situation might involve a theatre that buys a two-story building. They perform upstairs and rent the downstairs to a store to help pay the mortgage. Until the mortgage is paid off, that rent is welcome but unrelated business income.

A Non-Taxing Experience

Most arts organizations with unrelated business income pay little or no unrelated business income tax. Just as a regular corporation or self-employed person would, they pay tax only on the profits. In addition to the direct expenses (such as the cost of the books you sell and the bag you put it in), organizations can deduct an allocated share of occupancy costs, personnel (including management) and other overhead. Rarely is any taxable income left. This is not to say that the unrelated activity should be discontinued. That would not decrease most of the allocable overhead costs. So long as the activity covers its incremental costs and contributes something towards the overhead, it is probably worthwhile.

What trips up many organizations, however, is the need to file an unrelated business income tax return in addition to their regular exempt organization return. Again, the situation is like a regular corporation or self-employed person. Profit or loss, you must file a return if you have more than a minimal amount of potentially taxable revenues. And the penalties for non-filing can be painful.

 

Are there money or tax questions you would like to see discussed in this column? Let me know, at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or call 773/525-1778 (888/525-1778 toll-free outside the Chicago area) or e-mail greg@gregmermel.com.

Greg Mermel is a certified public accountant whose clients in the arts range from individual performers to major theatre companies and suppliers. He also sometimes produces theatre.