Earned Income Strategies (Part 3 of 5): Passive Income Activity (Let Money Work for the Cause)

The next option for earning income that every nonprofit should know about is income exempt from unrelated business income tax. While there are quite a few exceptions, the key exception that we will talk about in this post is passive income: income derived from dividends, rental income, royalties, or capital gains.

            Generally, all income that a nonprofit receives in the form of dividends from its investment in a for-profit corporation will be tax exempt.  This is also true for royalties from intellectual property licensed out by the nonprofit and rental income for property leased out by the nonprofit. The key to each one of these examples is that the income must be passive (i.e. the nonprofit must not have active involvement in the generation of such income).

  • Dividends: Most income derived from dividends is exempt from unrelated business income tax. This also includes annuities. However, this exception does not include income derived from a partnership, even those derived by passive partners.
    • Royalties: Under this exemption, royalty payments include fees from patent licenses, copyrights, other intellectual property, and other income that would traditionally be considered royalty payments. The IRS will look to the nature of the deal rather than the nominal classification in order to determine if a payment is a royalty. Fees for service, even if classified as a royalty, will not be exempt.
    • Capital Gains: Most income derived from the sale of property (income that represents capital gains) is exempt from unrelated business income tax. However, this exemption does not include the sale of property in the normal course of the nonprofits trade or business.
    • Rental Payments: While rental income for real property is exempt from unrelated business income tax, rental income from personal property is not. Regarding income representing the rental of both real and personal property, none of the rental income is exempt if more than 50% of the income comes from the rental of personal property. Rental payments dependent on the successor of the lessee are also no exempt, as well as rental payments made when the nonprofit must perform services beyond what is generally expected of a landlord.

The passive income exception to UBIT is a key consideration that every tax-exempt organization should think carefully about. A strong investment portfolio could be a game changer for even the smallest of nonprofits. A strong base of investment income could create a base of revenue reserves for organizations to channel to their exempt purposes and continue operations even in scarce circumstances.

The above article is for general information purposes only and should not be relied upon as specific legal advice.  This article, or using the contactapex@apexlg.com form, does not in any way form an attorney-client relationship.  If you have any questions or would like to learn more, please contact Jacob Ferrari at jacob@apexlg.com.

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