UNDERSTANDING UBIT THROUGH COMMON ISSUES FACING MUSEUMS
THE TAXATION OF UNRELATED BUSINESS INCOME
Most readers probably have some familiarity with the basic premise of UBIT (Unrelated Business Income Taxation) rules. Simply put: If your organization derives revenues from 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 organization's tax-exempt functions.
This article focuses on three major exclusions to UBIT rules as they relate to revenues derived by museums and most nonprofit organizations. Taken together, these three exclusions often result in minimal or no tax on profits from most of the ancillary services a museum provides. Note, however, that UBIT rules are continually being refined and applied somewhat inconsistently across a broad spectrum of specific activities, and at times seem to involve almost microscopic hair splitting.
Exclusion #1: Museum Dining: Nontaxable As A Convenience to Visitors, Employees
Whether a museum has a fine restaurant, cafe, or vending machine, on-premise food sales to visitors and employees 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 workday. Food sales, like exhibit room benches and rest rooms, facilitate and enhance the museum experience. Thus, resulting revenues are not taxable. Revenue Ruling 74-399 (1974).
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 revisions created by UBIT regulation.
One case has imposed additional limits on this 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 to the public as such, the convenience exclusion did not apply. Note the fact that restaurant patrons did not have to pay museum admittance fees to access the restaurant was one factor weighed in the decision, but was not itself determinative.
To museums' benefit, the rule of "fragmentation" applies to all nonprofit organizations in calculating net income in a variety of settings. 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: Revenue from Hosting Events for Educational Purposes
Museums often host business and social functions in their facilities (for more information on the separate issue of reducing liability risk when serving liquor at museum functions please see the following outline). The UBIT issue is then whether an event is held primarily to produce income or for museum/educational purposes (in which case food and entertainment is incidental).
Suppose an outside company or group asks a museum to host and create an educational event, focusing on an exhibit, lecture, or tour, and food and other services are provided by the museum for a fee. Such an event contributes importantly to accomplishing the museum's purposes and therefore proceeds are not subject to tax. IRS Technical Advice Memorandum 97-02-003 (1996).
However, if the event is primarily focused around, for example, a corporate event, a cocktail and dinner dance, or an award ceremony, then the educational aspects are secondary to other business purposes, and proceeds are not "substantially related" to a museum purpose. Madden v. Commissioner, T.C. Memo 1997-395. That may be the case even if an exhibit opening or other educational component that is incidental to the event is included. As you can imagine, distinguishing between an secondary and primary purpose in this context easily becomes a very subjective challenge.
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 regularly carried on, but rather the passive receipt of revenues. Such so-called passive revenues, which most importantly include investment income as well as royalties from the licensing of intellectual property, have long been excluded from UBIT. Internal Revenue Code Section 512(b)(3). However, if a museum actively provides services, such as labor, food, catering, linens, etc., in addition to simply renting out its facility then the rental arrangement is subject to tax. IRS TAM 97-02-003.
As you can see, the factual variations and legal distinctions relating even to these three exclusions leave much room for ambiguity and many open questions. Hopefully this brief primer gives you a sense of general legal parameters for the most foreseeable UBIT situations museums encounter. Please don't hesitate to contact us if you have any questions or concerns about UBIT and tax liability.