Publication 598 |
2001 Tax Year |
Deductions
To qualify as allowable deductions in computing unrelated business
taxable income, the expenses, depreciation, and similar items
generally must be allowable income tax deductions that are
directly connected with carrying on an unrelated trade or
business. They cannot be directly connected with excluded
income.
For an exception to the "directly connected" requirement, see
Charitable contributions deduction, under
Modifications, later.
Directly Connected
To be directly connected with the conduct of an unrelated business,
deductions must have a proximate and primary relationship to carrying
on that business. For an exception, see Expenses attributable to
exploitation of exempt activities, later.
Expenses attributable solely to unrelated business.
Expenses, depreciation, and similar items attributable solely to
the conduct of an unrelated business are proximately and primarily
related to that business and qualify for deduction to the extent that
they are otherwise allowable income tax deductions.
For example, salaries of personnel employed full-time to carry on
the unrelated business and depreciation of a building used entirely in
the conduct of that business are deductible to the extent otherwise
allowable.
Expenses attributable to dual use of facilities or personnel.
When facilities or personnel are used both to carry on exempt
functions and to conduct an unrelated trade or business, expenses,
depreciation, and similar items attributable to the facilities or
personnel must be allocated between the two uses on a reasonable
basis. The part of an item allocated to the unrelated trade or
business is proximately and primarily related to that business, and is
allowable as a deduction in computing unrelated business taxable
income, if the expense is otherwise an allowable income tax deduction.
Example 1.
A school recognized as a tax-exempt organization contracts with an
individual to conduct a summer tennis camp. The school provides the
tennis courts, housing, and dining facilities. The contracted
individual hires the instructors, recruits campers, and provides
supervision. The income the school receives from this activity is from
a dual use of the facilities and personnel. The school, in computing
its unrelated business taxable income, may deduct an allocable part of
the expenses attributable to the facilities and personnel.
Example 2.
An exempt organization with gross income from an unrelated trade
or business pays its president $90,000 a year. The president devotes
approximately 10% of his time to the unrelated business. To figure the
organization's unrelated business taxable income, a deduction of
$9,000 ($90,000 × 10%) is allowed for the salary paid to its
president.
Expenses attributable to exploitation of exempt activities.
Generally, expenses, depreciation, and similar items attributable
to the conduct of an exempt activity are not deductible in
computing unrelated business taxable income from an unrelated trade or
business that exploits the exempt activity. (See Exploitation of
exempt functions under Not substantially related in
chapter 3.)
This is because they do not have a proximate and primary
relationship to the unrelated trade or business, and therefore, they
do not qualify as directly connected with that business.
Exception.
Expenses, depreciation, and similar items may be treated as
directly connected with the conduct of the unrelated business if all
the following statements are true.
- The unrelated business exploits the exempt activity.
- The unrelated business is a type normally carried on for
profit by taxable organizations.
- The exempt activity is a type normally conducted by taxable
organizations in carrying on that type of business.
The amount treated as directly connected is the smaller of:
- The excess of these expenses, depreciation, and similar
items over the income from, or attributable to, the exempt activity,
or
- The gross unrelated business income reduced by all other
expenses, depreciation, and other items that are actually directly
connected.
The application of these rules to an advertising activity that
exploits an exempt publishing activity is explained next.
Exploitation of Exempt Activity -- Advertising Sales
The sale of advertising in a periodical of an exempt organization
that contains editorial material related to the accomplishment of the
organization's exempt purpose is an unrelated business that exploits
an exempt activity, the circulation and readership of the periodical.
Therefore, in addition to direct advertising costs, exempt activity
costs (expenses, depreciation, and similar expenses attributable to
the production and distribution of the editorial or readership
content) can be treated as directly connected with the conduct of the
advertising activity. (See Expenses attributable to exploitation
of exempt activities under Directly Connected,
earlier.)
Figuring unrelated business taxable income (UBTI).
The UBTI of an advertising activity is the amount shown in the
following chart.
Table
The terms used in the chart are explained in the following
discussions.
Periodical Income
Gross advertising income.
This is all the income from the unrelated advertising activities of
an exempt organization periodical.
Circulation income.
This is all the income from the production, distribution, or
circulation of an exempt organization's periodical (other than gross
advertising income). It includes all amounts from the sale or
distribution of the readership content of the periodical, such as
income from subscriptions. It also includes allocable membership
receipts if the right to receive the periodical is associated with a
membership or similar status in the organization.
Allocable membership receipts.
This is the part of membership receipts (dues, fees, or other
charges associated with membership) equal to the amount that would
have been charged and paid for the periodical if:
- The periodical was published by a taxable
organization,
- The periodical was published for profit, and
- The member was an unrelated party dealing with the taxable
organization at arm's length.
The amount used to allocate membership receipts is the amount shown
in the following chart.
For this purpose, the total periodical costs are the sum of the
direct advertising costs and the readership costs, explained under
Periodical Costs, later. The cost of other exempt
activities means the total expenses incurred by the organization in
connection with its other exempt activities, not offset by any income
earned by the organization from those activities.
Table
Example 1.
U is an exempt scientific organization with 10,000 members who pay
annual dues of $15. One of U's activities is publishing a monthly
periodical distributed to all of its members. U also distributes 5,000
additional copies of its periodical to nonmembers, who subscribe for
$10 a year. Since the nonmember circulation of U's periodical
represents one-third (more than 20%) of its total circulation, the
subscription price charged to nonmembers is used to determine the part
of U's membership receipts allocable to the periodical. Thus, U's
allocable membership receipts are $100,000 ($10 times 10,000 members),
and U's total circulation income for the periodical is $150,000
($100,000 from members plus $50,000 from sales to nonmembers).
Example 2.
Assume the same facts except that U sells only 500 copies of its
periodical to nonmembers, at a price of $10 a year. Assume also that
U's members may elect not to receive the periodical, in which case
their dues are reduced from $15 a year to $6 a year, and that only
3,000 members elect to receive the periodical and pay the full dues of
$15 a year. U's stated subscription price of $9 to members
consistently results in an excess of total income (including gross
advertising income) attributable to the periodical over total costs of
the periodical. Since the 500 copies of the periodical distributed to
nonmembers represent only 14% of the 3,500 copies distributed, the $10
subscription price charged to nonmembers is not used to determine the
part of membership receipts allocable to the periodical. Instead,
since 70% of the members elect not to receive the periodical and pay
$9 less per year in dues, the $9 price is used to determine the
subscription price charged to members. Thus, the allocable membership
receipts will be $9 a member, or $27,000 ($9 times 3,000 copies). U's
total circulation income is $32,000 ($27,000 plus the $5,000 from
nonmember subscriptions).
Periodical Costs
Direct advertising costs.
These are expenses, depreciation, and similar items of deduction
directly connected with selling and publishing advertising in the
periodical.
Examples of allowable deductions under this classification include
agency commissions and other direct selling costs, such as
transportation and travel expenses, office salaries, promotion and
research expenses, and office overhead directly connected with the
sale of advertising lineage in the periodical. Also included are other
deductions commonly classified as advertising costs under standard
account classifications, such as artwork and copy preparation,
telephone, telegraph, postage, and similar costs directly connected
with advertising.
In addition, direct advertising costs include the part of
mechanical and distribution costs attributable to advertising lineage.
For this purpose, the general account classifications of items
includable in mechanical and distribution costs ordinarily employed in
business-paper and consumer-publication accounting provide a guide for
the computation. Accordingly, the mechanical and distribution costs
include the part of the costs and other expenses of composition, press
work, binding, mailing (including paper and wrappers used for
mailing), and bulk postage attributable to the advertising lineage of
the publication.
In the absence of specific and detailed records, the part of
mechanical and distribution costs attributable to the periodical's
advertising lineage can be based on the ratio of advertising lineage
to total lineage in the periodical, if this allocation is reasonable.
Readership costs.
These are all expenses, depreciation, and similar items that are
directly connected with the production and distribution of the
readership content of the periodical.
Costs partly attributable to other activities.
Deductions properly attributable to exempt activities other than
publishing the periodical may not be allocated to the periodical. When
expenses are attributable both to the periodical and to the
organization's other activities, an allocation must be made on a
reasonable basis. The method of allocation will vary with the nature
of the item, but once adopted, should be used consistently.
Allocations based on dollar receipts from various exempt activities
generally are not reasonable since receipts usually do not accurately
reflect the costs associated with specific activities that an exempt
organization conducts.
Consolidated Periodicals
If an exempt organization publishes more than one periodical to
produce income, it may treat all of them (but not less than all) as
one in determining unrelated business taxable income from selling
advertising. It treats the gross income from all the periodicals, and
the deductions directly connected with them, on a consolidated basis.
Consolidated treatment, once adopted, must be followed consistently
and is binding. This treatment can be changed only with the consent of
the Internal Revenue Service.
An exempt organization's periodical is published to produce income
if:
- The periodical generates gross advertising income to the
organization equal to at least 25% of its readership costs, and
- Publishing the periodical is an activity engaged in for
profit.
Whether the publication of a periodical is an activity engaged in
for profit can be determined only by all the facts and circumstances
in each case. The facts and circumstances must show that the
organization carries on the activity for economic profit, although
there may not be a profit in a particular year. For example, if an
organization begins publishing a new periodical whose total costs
exceed total income in the start-up years because of lack of
advertising sales, that does not mean that the organization did not
have as its objective an economic profit. The organization may
establish that it had this objective by showing it can reasonably
expect advertising sales to increase, so that total income will exceed
costs within a reasonable time.
Example.
Y, an exempt trade association, publishes three periodicals that it
distributes to its members: a weekly newsletter, a monthly magazine,
and a quarterly journal. Both the monthly magazine and the quarterly
journal contain advertising that accounts for gross advertising income
equal to more than 25% of their respective readership costs.
Similarly, the total income attributable to each periodical has
exceeded the total deductions attributable to each periodical for
substantially all the years they have been published. The newsletter
carries no advertising and its annual subscription price is not
intended to cover the cost of publication. The newsletter is a service
that Y distributes to all of its members in an effort to keep them
informed of changes occurring in the business world. It is not engaged
in for profit.
Under these circumstances, Y may consolidate the income and
deductions from the monthly and quarterly journals in computing its
unrelated business taxable income. It may not consolidate the income
and deductions from the newsletter with the income and deductions of
its other periodicals, since the newsletter is not published for the
production of income.
Modifications
Net operating loss deduction.
The net operating loss deduction (as provided in section 172) is
allowed in computing unrelated business taxable income. However, the
net operating loss for any tax year, the carrybacks and carryovers of
net operating losses, and the net operating loss deduction are
determined without taking into account any amount of income or
deduction that has been specifically excluded in computing unrelated
business taxable income. For example, a loss from an unrelated trade
or business is not diminished because dividend income was received.
If this were not done, organizations would, in effect, be taxed on
their exempt income, since unrelated business losses then would be
offset by dividends, interest, and other excluded income. This would
reduce the loss that could be applied against unrelated business
income of prior or future tax years. Therefore, to preserve the
immunity of exempt income, all net operating loss computations are
limited to those items of income and deductions that affect the
unrelated business taxable income.
In line with this concept, a net operating loss carryback or
carryover is allowed only from a tax year for which the organization
is subject to tax on unrelated business income.
For example, if an organization just became subject to the tax last
year, its net operating loss for that year is not a carryback to a
prior year when it had no unrelated business taxable income, nor is
its net operating loss carryover to succeeding years reduced by the
related income of those prior years.
However, in determining the span of years for which a net operating
loss may be carried back or forward, the tax years for which the
organization is not subject to the tax on unrelated business income
are counted. For example, if an organization was subject to the tax
for 1996 and had a net operating loss for that year, the last tax year
to which any part of that loss may be carried over is 2011, regardless
of whether the organization was subject to the unrelated business
income tax in any of the intervening years.
Charitable contributions deduction.
An exempt organization is allowed to deduct its charitable
contributions in computing its unrelated business taxable income
whether or not the contributions are directly connected with the
unrelated business.
To be deductible, the contribution must be paid to another
qualified organization. For example, an exempt university that
operates an unrelated business may deduct a contribution made to
another university for educational work, but may not claim a deduction
for contributions of amounts spent for carrying out its own
educational program.
For purposes of the deduction, a distribution by a trust made under
the trust instrument to a beneficiary, which itself is a qualified
organization, is treated the same as a contribution.
Deduction limits.
An exempt organization that is subject to the unrelated business
income tax at corporate rates is allowed a deduction for charitable
contributions up to 10% of its unrelated business taxable income
computed without regard to the deduction for contributions.
An exempt trust that is subject to the unrelated business income
tax at trust rates generally is allowed a deduction for charitable
contributions in the same amounts as allowed for individuals. However,
the limit on the deduction is determined in relation to the trust's
unrelated business taxable income computed without regard to the
deduction, rather than in relation to adjusted gross income.
Contributions in excess of the limits just described may be carried
over to the next 5 tax years. A contribution carryover is not allowed,
however, to the extent that it increases a net operating loss
carryover.
Specific deduction.
In computing unrelated business taxable income, a specific
deduction of $1,000 is allowed. However, the specific deduction is not
allowed in computing a net operating loss or the net operating loss
deduction.
Generally, the deduction is limited to $1,000 regardless of the
number of unrelated businesses in which the organization is engaged.
Exception.
An exception is provided in the case of a diocese, province of a
religious order, or a convention or association of churches that may
claim a specific deduction for each parish, individual church,
district, or other local unit. In these cases, the specific deduction
for each local unit is limited to the lower of:
- $1,000, or
- Gross income derived from an unrelated trade or business
regularly carried on by the local unit.
This exception applies only to parishes, districts, or other local
units that are not separate legal entities, but are components of a
larger entity (diocese, province, convention, or association) filing
Form 990-T. The parent organization must file a return reporting
the unrelated business gross income and related deductions of all
units that are not separate legal entities. The local units cannot
file separate returns. However, each local unit that is separately
incorporated must file its own return and cannot include, or be
included with, any other entity. See Title-holding corporations
in chapter 1
for a discussion of the only situation in which more than
one legal entity may be included on the same Form 990-T.
Example.
X is an association of churches and is divided into local units A,
B, C, and D. Last year, A, B, C, and D derived gross income of,
respectively, $1,200, $800, $1,500, and $700 from unrelated businesses
that they regularly conduct. X may claim a specific deduction of
$1,000 with respect to A, $800 with respect to B, $1,000 with respect
to C, and $700 with respect to D.
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