A tax-exempt organization prefers that all of its revenue generated be eligible for tax-exempt status. However, due to strict laws enacted by Congress, your organization is faced with restrictions that prevent certain types of revenue from being classified that way. As a result, revenue might come from an unrelated trade or business (IRC Section 513(a)) and therefore subject to unrelated business income tax (UBIT) if you regularly carry on the activity.
A common type of unrelated business income is advertising. If you sell advertising space in a periodical you publish, and that periodical also contains editorial material related to the accomplishment of your exempt purpose, the revenue generated from the periodical is considered revenue from an unrelated trade or business and subject to UBIT. This type of revenue is referred to as exploited exempt activity income, namely, income from a commercial activity that is part of an exempt activity, but which does not contribute importantly to the accomplishment of an exempt purpose.
You can offset this income with expenses directly related to the advertising portion of the periodical to arrive at net advertising income. Some examples of direct advertising expenses are commissions, travel, salaries, promotion, and overhead.
Because the advertising exploits the exempt function of the periodical, which is to educate your readers, the law gives you a possible break in computing UBIT. You can offset any net advertising income by a loss from the rest of the periodical. If your readership costs (the cost of the non-advertising content), exceed circulation income you can use the excess to reduce UBIT.
Your organization generates circulation income when it produces, distributes or circulates a periodical. Included in circulation income are the amounts from the sale or distribution of the readership content of a periodical, such as subscription revenue, allocable membership receipts (dues, fees, or other charges associated with membership), if the right to receive a periodical is associated with a membership or similar status in the organization and income from reprints or single copy sales (Reg. Section 1.512-1(f)). Membership receipts are those that would be included in circulation income if the periodicals were published for profit by a taxable organization and the members were an unrelated party dealing with the taxable organization at arm’s length.
The regulations provide three methods you can use to calculate the amount of membership receipts to allocate to circulation income. The first method is used if 20 percent or more of the total circulation consists of sales to nonmembers. If this method applies then the organization needs to include the subscription price charged to nonmembers as the allocable membership receipts.
The second method is uncommon, and applies if the first method does not apply and 20 percent or more of the members pay reduced dues because they do not receive the periodical. If this method applies then the amount of membership receipts to allocate is the reduction in dues for members not receiving the periodical.
The third method will apply if neither the first or second method applies and is by far the most common. In this case your dues income is multiplied by a fraction, which divides the total periodical costs by the sum of periodical costs and the cost of other exempt activities. Total periodical costs are the sum of the direct advertising costs and readership costs. For the denominator, the other remaining expenses related to your other exempt activities are added to the total periodical costs. The allocated dues are added to paid subscriptions and other periodical income to determine circulation income.
If a periodical’s direct advertising costs exceed its gross advertising income, the excess expenses can reduce other unrelated trade or business taxable income. However, if your periodical’s readership costs exceed circulation income by more than the net advertising income, you cannot use this excess to reduce other unrelated business income. As a result, net operating loss carrybacks and carryforwards will only result from direct advertising costs in excess of advertising income.
It is important to note that the net advertising income for each periodical must be calculated separately. However, in certain circumstances, you could choose to treat all or some of the periodicals on a consolidated basis. If you adopt this treatment it is binding and you must stay on a consolidated basis as long as your periodicals qualify.
There are exceptions to treating advertising activities as coming from an unrelated trade or business. If the advertiser, which is the person paying the organization for advertising space, does not expect to receive more than a "negligible commercial benefit," no unrelated business taxable income is recognized as the income is treated as a qualified sponsorship. For example, if you list the advertiser’s name and/or logo in your periodical with no additional qualitative data included, you will not have income from an unrelated trade or business.
Advertising income is also excluded from UBIT if the advertising activity is not regularly carried on as a trade or business, is substantially related to your organization’s exempt purpose, or is conducted primarily by volunteers.
Your organization reports its advertising activities on Form 990-T, Exempt Organization Business Income Tax Return. As noted earlier, you may report advertising on either a separate basis or consolidated basis. Both methods are shown separately on Schedule J of Form 990-T. After completing Schedule J, the net advertising income before applying the excess readership costs is included on page 1, Part I, line 11 of Form 990-T. The excess readership costs are then applied on page 1, Part II, line 27 of Form 990-T.
The Financial Accounting Standards Board (FASB) issued FASB Interpretation 48 (FIN 48), Accounting for Uncertainty in Income Taxes, on July 13, 2006. FIN 48 was created as an interpretation of FASB Statement No. 109 to provide that an individual tax position will have to meet to recognize the benefit of that position in an entity’s financial statements. FIN 48 requires organizations to compare the weight of tax authority that supports a tax position with the weight of tax authority that opposes the same tax position. If the IRS can successfully challenge the tax position and assess tax, then the tax position is uncertain.
If your organization conducts advertising activities related to a periodical it is taking a tax position that must be weighed in accordance with FIN 48. Therefore, it is critical that you take the proper steps in determining what portion of your advertising income is treated as an unrelated trade or business and subject to UBIT. In addition, your organization must be careful in allocating the direct advertising and readership costs associated with the periodical generating unrelated business income. Specially allocating direct advertising and readership costs also puts the organization in a tax position that is subject to being weighed in accordance with FIN 48.
If after weighing the tax position taken on advertising activities, you think the position can be challenged and tax can be assessed, you should disclose the tax position on your financial statements and Form 990, Return of Organization Exempt From Income Tax. It is important to note that the disclosure on Form 990 will apply for tax year 2008 going forward.
Despite the tax risks, advertising can be a significant revenue source for your organization. Carefully managing the calculations can minimize your UBIT exposure, but even paying tax is better than not having the revenue. NPT
Harvey Berger is a retired tax partner with Grant Thornton and currently serves as a consultant on nonprofit tax issues. His email is firstname.lastname@example.org. D. Greg Goller is Grant Thornton’s national partner-in-charge of Not-for-Profit Tax Services and is based in the Washington, D.C. area office. His email is email@example.com. William Winter is a senior associate in the not-for-profit tax practice in Grant Thornton’s Washington Area Office. His email is firstname.lastname@example.org