Nonprofit Law Resource Library
Taxation of Unrelated Business Income
Candlelight, A Glass of Wine, and UBIT: A Food and Facilities Primer
This article, by Jeffrey Hurwit, originally appeared in the New England Museum Association News.
Most readers probably have some familiarity with the basic premise of the UBIT (Unrelated Business Income Taxation) rules. Simply put: If your museum makes money on activities unrelated to its tax-exempt purposes, the profit is taxed at for-profit business rates. More technically, unrelated business income is net income derived from a trade or business regularly carried on which does not contribute importantly to the accomplishment of the museum's tax-exempt functions.
This article focuses on the three major exclusions to UBIT relating to museum food service. These exclusions likely mean that most of your food and facilities profits are not taxable. However, the UBIT rules are continually being refined and at times seem to involve almost microscopic hair splitting.
Exclusion #1: Vending Machines to Four-Star Meals: Nontaxable As A Convenience to Visitors, Employees
Whether snackbar, cafe, or fine restaurant, whether Snickers or creme brulee, on-premise food sales to employees and visitors contribute to accomplishing tax-exempt purposes because they 1) allow visitors to devote more time to the museum's educational exhibits, and 2) enhance efficient museum operation by enabling staff to remain on-site throughout the day. Food sales, like water coolers, restrooms, and exhibit room benches, facilitate and enhance the museum experience. Thus, resulting revenues are not taxable. Revenue Ruling 74-399 (1974).
At least that's the legal conclusion. For now. Usually.
But as an example of how small facts make big legal differences, if a dining facility is accessible not only through the museum but also through a door directly to the street, then it has been held by the IRS not to be primarily for visitor convenience but for general public use, and therefore taxable. Ibid. Thus we now have museum architectural design created by UBIT regulation.
A recent case has imposed additional limits on the convenience exclusion. In IRS Technical Advice Memorandum 97-20-002 (1996), a museum opened an upscale restaurant larger than needed for visitors and staff. The IRS determined that since it was designed partly as a public restaurant and was advertised regularly in magazines, the convenience exclusion did not apply. Note the fact that restaurant patrons did not have to pay museum admittance fees was one factor weighed in the decision, but was not itself determinative.
To museums' benefit, the rule of "fragmentation" applies in calculating net income. Museums may "fragment" restaurant sales (by separately recording sales to museum visitors and to the general public), and pay taxes only on sales to the general public.
Exclusion #2: Outside Museum Facility Use for Educational Purposes
Increasingly, museums use their facilities for outside business and social affairs. The legal issue is then whether an event is held primarily for business purposes or museum/educational purposes (in which case food/entertainment is incidental).
Suppose an outside sponsor asks a museum to create an educational program for its participants, focusing on an exhibit, lecture or tour, and incidentally food and other services are provided. Such an event contributes to accomplishing the museum's purposes and is therefore not subject to tax. IRS Technical Advice Memorandum 97-02-003 (1996).
However, if the event is primarily focused around, for example, a cocktail and dinner dance, a business meeting, or an awards ceremony, then the educational aspects are secondary to other business purposes, and it is not "substantially related". Madden v. Commissioner, T.C. Memo 1997-395. That may be the case even if an exhibit opening, tour or other educational component is included in the event.
Exclusion #3: Passive Rental of Museum Facilities
The rental of real property, including function facilities, is not considered the "active conduct of a trade or business", but rather the "passive" receipt of revenues. So-called passive revenues, such as endowment investment income, have long been excluded from UBIT. Internal Revenue Code Section 512(b)(3). However, if a museum provides services, such as labor, food, catering, linens, etc., in addition to simply renting out a facility then the rental arrangement is subject to tax. IRS TAM 97-02003.
As you can see, the factual variations and legal distinctions relating even to these three exclusions leave many open questions. Hopefully, this brief primer gives you a sense of the legal parameters for the majority of UBIT situations you will encounter.