UNRELATED BUSINESS INCOME ISSUES FOR FRATERNAL ORGANIZATIONS

Barbara Schwartz Bromberg

INTRODUCTION

The Internal Revenue Service has just announced that audits conducted over the past year and a half or  so as part of an IRS compliance project aimed at tax exempt social clubs exempt under Code Section 501 (c) (7) have been completed and the results should be available by late spring of this year. It was further stated that the Exempt Organizations Division of the IRS is analyzing the data obtained from the audits of 500 social clubs in this category which were conducted with the aid of a new software system. The focus of this audit program was the failure of these organizations to report investment income as unrelated  business income on Form 990-T, as required under Code Section 512 (a) (3). A matching program had previously discovered approximately 1,400 such organizations with investment income reported on their Forms 990 but which had not filed Forms 990-T. Against this background, it seems timely to review one of the most frequently discussed areas which I encounter in my practice – just what are the unrelated business income (UBI) rules for fraternal organizations and how should a fraternal organization meet its reporting and taxpaying obligations concerning UBI.

COMMON TYPES OF UBI IN FRATERNAL ORGANIZATIONS

INVESTMENT INCOME

As referenced in the above-mentioned IRS study, the most common type of UBI generated by fraternal organizations is passive investment income. This definition includes dividends, interest, rent, capital gains, royalties and other types of investment income. Because the rule that this type of income is taxable to a fraternal organization (and other social clubs) as UBI differs from the fact that such income is generally considered nontaxable income for other types of exempt organizations, such as Code Section 501 (c) (3) charitable organizations, there is much confusion over this rule. It is therefore each fraternal organization’s responsibility to be aware of this rule and to make sure that its tax returns properly reflect this requirement as it is not unknown for some tax return preparers to be unaware of this. Many fraternal organizations choose to use the set aside procedure to avoid taxation ₀₁₁ this type of income, in whole or in part. Please consult earlier columns in Fraternal Law for details as to the set aside procedures. Suffice it to say, for purposes of this article, that use of the set aside procedure means that the funds so set aside are dedicated to charitable, educational, leadership and similar purposes. Each organization has to make a decision about whether or not to use a set aside based on its overall cash flow and the program needs of the organization. An organization can elect to use the set aside procedure for part of its investment income and make a new election every year.

It should be noted that one type of income which is often wrongly included as investment income is interest generated by loan payments from affiliate house corporations to their related fraternity on local chapter housing loans. The IRS indicated its view in a technical advice memorandum several years ago that this so-called interest is in reality member income and therefore is not treated as UBI to a fraternal organization.

AFFINITY CARD INCOME

A frequently asked question is whether affinity card income and similar income such as telephone card income is considered a royalty which may be set aside as described above, or must be reported as UBI from the sale of a membership list. Prior to the latest round of developments in the Sierra Club case¹ and other subsequent decisions, some observers believed that such income was taxable as UBI to fraternal organizations. However, although the matter has not been finally decided and the IRS has not officially indicated that it has given up this particular fight, with this background, many fraternal organizations feel that affinity card and similar income is royalty income subject to the set aside rules (this would also mean that if a Code Section 501(3) charitable organization has such income, it would be excludable from UBI as a royalty). If a fraternal organization takes this position, it should separately and clearly disclose that income as affinity card income on its tax returns so that the statute of limitations will start to run with regard to this issue.

DEBT-FINANCED INCOME

Another fairly common type of UBI in fraternal organizations is investment income which has been debt financed. In general, under Code Section 514, if an organization receives income from an investment which it acquired or improved with  a mortgage,  and  such property is not directly related to the exercise of its exempt function, then such income becomes taxable. Moreover, it is the IRS’ longstanding position that this type of income may  not  be set aside and is therefore taxable as UBI. For example, in general, if a fraternal organization holds mortgaged real estate and receives rentals on that real estate, those rentals would be taxable as UBI under the debt financed income rules, and could not be set aside.

NON-MEMBER INCOME

Another type of UBI frequently encountered with respect to fraternal organizations is active nonmember income of various types..   For     example,  a fraternal organization may engage in fund raising to the general public. If the funds raised in these endeavors arc used for charitable purposes, then they may be set aside, but if they are used for the organization’s own social and fraternal purposes, then such proceeds are taxable as UBI. Another type of nonmember income generated by fraternal organizations arises from renting chapter house rooms to nonmembers or serving meals to nonmembers. These types of income arc also considered UBI for fraternal organizations.

It is very important when analyzing a fraternal organization’s nonmember income to bear in mind the important distinction between UBI and the 15%–35% gross receipts test. If fund raising proceeds used for the organization’s fraternal purposes or proceeds of offering meals or housing to nonmembers exceed 15% of gross receipts, there is a possibility that the organization could lose its tax exempt status even though it had paid tax on the profits as UBI. A similar rule applies to passive income or fund raising proceeds used for charity, but in those cases the ceiling percentage is 35% when added to all other types of nonmember income. This rule, like the investment income rules described above, is a special rule peculiar to Code Section 501 (c) (7) organizations, and is the subject of much misunderstanding. The important point to bear in mind here is, it is not “just a matter of paying tax,” but could affect the organization’s tax exempt status.

TRUE BUSINESS INCOME

Finally, it is important to note that fraternal organizations, just like the other types of exempt organizations, are subject to the normal UBI rules in that if they engage in a business regularly carried on, they arc required to pay taxes on the net profits. The Service views most types of insurance activity, active marketing of merchandise and travel tours, among other ventures, as falling within this rule. Here again, there is a special rule for fraternal organizations in that if they engage in what is deemed a “nontraditional” activity for college fraternities and sororities, they may be subject to losing their tax exempt status in its entirety, whether or not they have paid tax on the proceeds or whether or not the activity in question is even profitable.

REPORTING REQUIREMENTS.

Once the organization has determined what types of income it has that might be subject to UBI, it is important to note the reporting requirements with respect thereto. Another easily misunderstood point in this area is that UBI is reported on a gross basis so that if the organization has over $1,000 (the de minimis exclusion amount) of gross UBI, this must be reported on a Form 990-T for the organization’s fiscal year. Such tax return is due on the fifteenth day of the fifth month following the close of the organization’s fiscal year, unless extended, and there is a separate extension form required for this return. Furthermore, Form 990-T must be filed if this threshold is met even if the organization’s gross receipts are low enough so that it is not required to file a Form 990, and even if its only UBI is investment income which is set aside. Certain deductions are allowed in the computation of UBI, and the rates imposed on this income are the same for a fraternal organization which is incorporated as a normal business corporation.

There is also a portion of Form 990 (Part VII) where a fraternal organization is required to report and describe an analysis of its income producing activities as generating UBI, income excluded under Code Section 512,513, or 514, or related or exempt function income.

CONCLUSION

As one would expect, the IRS has always taken a great interest in UBI matters in the exempt organizations field, and as is indicated by the current study, such matters continue to be of prime interest. In order to plan properly in this area, each fraternal organization should conduct a review of all of its income-producing activities to determine whether they fall into one of the UBI categories, and if so, whether the set aside procedure is available or desirable in such organization’s particular situation. If such a careful review is made with the input of the organization’s counsel and CPA, the organization can properly meet its responsibilities to the IRS, and at the same time, minimize its tax obligations and maximize cash available for serving both its fraternal and educational missions to its members.