The ABCs of Nonprofit Compliance

1. The ABCs of Nonprofit Compliance Kathleen E. Gerber Thompson & Knight April 20, 2018

2. Obtaining Tax-Exempt Status under IRC Section 501(c)(3) - Overview • Organizational Requirements • Certification of Formation • Operational Requirements • Permissible activities • IRS Form 1023-EZ/Form 1023 Application • Exemption under Texas Law • Texas application for franchise and sales tax exemption

3. IRC Section 501(c)(3) • “Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.” • An IRC Section 501(c)(3) charity MUST apply for recognition of exemption on IRS Form 1023 or IRS Form 1023EZ.

4. Organizational Requirements • To satisfy the organizational requirement of IRC Section 501(c)(3), your Certificate of Formation must contain the following clauses: (i) a purposes clause limiting the organization to IRC Section 501(c)(3) purposes; (ii) a prohibition on private inurement; (iii) a limit on private benefit; (iv) a prohibition on political campaign activities; (v) a limit on lobbying activities; and (vi) a dissolution clause. • The instructions to IRS Form 1023 include sample language. https://www.irs.gov/pub/irs-pdf/i1023.pdf

5. Operational Requirements • While IRC Section 501(c)(3) states that an organization must be “operated exclusively” for one or more exempt purposes, the Treasury regulations clarify that an organization is treated as “operated exclusively” for IRC Section 501(c)(3)exempt purposes only if it engages “primarily” in activities which accomplish one or more such exempt purposes. • Accordingly, an organization can engage in some non-exempt activities (which, as further discussed below, may generate unrelated business taxable income (“UBTI”)) without jeopardizing its exemption.

6. Private Inurement and Private Benefit • IRC Section 501(3)(3) prohibits private inurement and limits private benefit. • Private inurement occurs when insiders receive a benefit from the nonprofit. Private inurement is absolutely prohibited. • Private benefit occurs when a private person receives a benefit from a nonprofit that is more than insubstantial. Accordingly, private benefit is limited rather than absolutely prohibited. The private person or persons are not limited to persons who are insiders. • Private benefit does not occur when a member of the charitable class that the nonprofit is organized and operated to serve receives a benefit in the course and scope of the nonprofit’s charitable purposes.

7. Lobbying Activities • An IRC Section 501(c)(3) public charity can engage in legislative lobbying as long as such activities are insubstantial. There is no clear guidance on what is “insubstantial.” • To avoid uncertainty, a charitable organization can make an election under IRC Section 501(h) to apply the expenditure test. • Under the expenditure test, the extent of an organization’s lobbying activity will not jeopardize its tax-exempt status if its expenditures related to such activity do not normally exceed a specified amount. The limit generally is based on the size of the organization.

8. Lobbying ActivitiesDirect v. Grassroots Lobbying • Lobbying activities are divided between (i) direct lobbying, and (ii) grassroots lobbying. Direct lobbying is any communication with a legislator that expresses a view about specific legislation. Grassroots lobbying is any communication with the public that expresses a view about specific legislation and includes a call to action. • A communication is any conversation (in person or by phone), letter, fax, or other mechanism to convey a message. A legislator is a member of a legislative body or his or her staff. Executive branch officials who participate in the formulation of legislation are also considered legislators (e.g., governors, mayors, or an agency secretary who helps write a bill). The public is anyone but a legislator or member of an organization. Communications to an organization’s own members are treated as direct lobbying. A member is someone who has given more than a small amount of time or money to the organization

9. Lobbying ActivitiesDirect v. Grassroots Lobbying • Specific legislation is any bill or resolution that has been introduced in a legislative body or a specific proposal to solve a problem, including budget appropriations, taxes, attempts to influence the confirmation of judicial and executive branch nominees. A proposal may qualify as specific legislation even if it has not yet been introduced, written down, or even fully fleshed out. • A call to action is a specific means of encouraging the communication’s recipient to take lobbying action. It must include one of the following actions: (i) telling the recipient to contact a legislator; (ii) providing information on how a recipient can contact his legislator, such as providing the phone number or address; (iii) providing a mechanism for enabling the recipient to contact his legislator, such as a postcard, petition, or email form; or (iv) identifying a legislator who will vote on the applicable legislation or a member of a legislative committee who will vote on the legislation, or the recipient’s legislator. • Ballot measure activity is considered direct lobbying and is not impermissible electoral activity.

10. Lobbying ActivitiesIRC Section 501(h) Limits The separate sliding scale for grassroots lobbying expenditures (i.e., efforts aimed at the public) is one-quarter of the above amounts.

11. Form 1023-EZStreamlined Application for Recognition of Exemption Under IRC Section 501(c)(3) • On July 1, 2014, the IRS simplified the process for a charitable organization to apply for tax-exempt status under IRC Section 501(c)(3) through the IRS Form 1023-EZ. • The IRS Form 1023-EZ is must simpler than the IRS Form 1023. The IRS Form 1023-EZ filing fee is also less expensive. • Charitable organizations should proceed with caution when using the IRS Form 1023-EZ. • Some donors may be hesitant to donate to an exempt charitable organization that obtained exempt status through the IRS Form 1023-EZ. • The IRS stated in Rev. Proc. 2014-40 that “a determination letter issued to an organization that submitted a Form 1023-EZ may not be relied upon if it was based on any inaccurate information submitted by the organization”.

12. State ExemptionTexas Application for Franchise and Sales Tax Exemption • Exempt charitable organizations are eligible for exemption from Texas franchise tax and sales tax on the items they purchase for use in carrying out their exempt purposes. A qualifying charitable organization must apply for the Texas state tax exemption. • To apply for franchise and sales tax exemptions, the exempt charitable organization must complete and submit Form AP-204, Texas Application for Exemption, to the Comptroller’s office. A copy of the IRS issued exemption determination letter must be attached to the Form AP-204.

13. Public Charity v. Private Foundation Classification • IRC Section 501(c)(3) organizations are further classified under IRC Section 509(a) as: (i) public charities; or (ii) private foundations. • Categories of public charities include: (i) churches or conventions or associations of churches; (ii) schools, colleges, and universities; (iii) hospitals and medical research organizations that carry out research in conjunction with a hospital; (iv) Governmental units; (v) charitable organizations meeting one of two public support tests; and (vi) agricultural research organizations engaged in continuous and active research in conjunction with a land grant college or university.

14. Public Support TestIRC Section 509(a)(1) v. 509(a)(2) • An organization can satisfy either test. • The tests apply on an aggregate five year basis including the current year and the immediately preceding four years. • The tests do not have to be met during the first five years that the organization is recognized as tax-exempt under IRC Section 501(c)(3) as long as the charity has a good faith belief that they will meet the test in the sixth year. • An IRC Section 509(a)(3) “supporting organization” of a public charity does not need to meet the public support test.

15. Public Support TestIRC Section 509(a)(1) - 1/3 variation • IRC Section 509(a)(1) – the 1/3 test - must receive at least 1/3 of financial support from contributions and membership fees from the general public, government, or other charitable organizations. • Gifts from donors other than government grants or publicly funded public charities are subject to a 2% limitation – these donations only count toward the 1/3 public support to the extent the donation does not exceed 2% of the organization's overall support. The purpose of the rule is to ensure that the charity is truly being supported by a wide range of donors. • Program-related revenues such as ticket sales and services revenue are not included in the numerator or denominator.

16. Public Support TestIRC Section 509(a)(1) - 10% & Facts and Circumstances Variation • An organization that fails to meet the 1/3 test may still qualify as a publicly supported public charity under IRC Section 509(a)(1) if: • It receives at least 10% of its financial support from contributions from the general public, government, or other charitable organizations; AND • Based on all the facts and circumstances the organization was organized to attract public support. • Good factors: (i) closeness to 1/3 support; (ii) a representative governing body (i.e. unrelated directors); (iii) availability of public facilities or services & public participation in programs; and (iv) a robust fundraising program.

17. Public Support TestIRC Section 509(a)(2) • Must receive at least 1/3 of financial support from contributions from the general public, government, or other charitable organizations, membership fees, and gross receipts from admissions, sales of merchandise, performance of services or furnishing of facilities in an activity that is not an unrelated trade or business; and • Must not receive more than 1/3 of financial support from investment income. • ALL amounts received from “disqualified persons” as defined in IRC Section 4946 are excluded from the numerator of the public support test. Gross receipts from admissions, sales, etc. from any person in excess of the greater of $5,000 or 1% are excluded from the numerator.

18. Annual IRS Filing • Most IRC Section 501(c)(3) organizations are required to file an annual return. The type of annual return largely depends on the organization’s financial activity. The return is due on the 15th day of the 5th month of the following year. • Form 990-N (e-postcard): gross receipts less than or equal to $50,000. • Form 990-EZ: gross receipts less than $200,000, and total assets less than $500,000. • Form 990: gross receipts greater than or equal to $200,000, or total assets greater than or equal to $500,000.

19. Auto-revocation of IRC Section 501(c)(3) Status • If an exempt charitable organization fails to satisfy its annual filing requirement (i.e., Form 990-N, Form 990-EZ, or Form 990) for three years, there is an automatic revocation of the charitable organization’s exempt status under IRC Section 6033(j). • Note that the Form 990-N e-postcard filing was created at the same time, in 2008, as the automatic revocation under IRC Section 6033(j).

20. Governance BasicsFormation • Texas nonprofit corporations are governed by the Texas business Organizations Code (“BOC”). • A Certificate of Formation must be filed with the Texas Secretary of State to form a Texas nonprofit corporation. • A Texas nonprofit corporation is not required to include the word “Incorporated” or “Inc.” in its name. • A Texas nonprofit corporation must maintain a current registered office and registered agent for service of process.

21. Governance BasicsMinimum Officers and Directors • A Texas nonprofit corporation must have at least two officers, a president and a secretary. Other officer positions are optional and one person can hold two or more offices except the offices of president and secretary. • A Texas nonprofit corporation must have at least three board members. Board vacancies must be filled as provided in the Certificate of Formation or Bylaws. Otherwise, a majority of the remaining directors appoints replacements. Term limits are not required but may be included in the Certificate of Formation or Bylaws.

22. Governance BasicsQuorum Requirements • A quorum of the Board of Directors must be present to conduct business. A quorum is the number of directors (not less than three) required to conduct business. The Certificate of Formation or Bylaws should indicate the number of directors required for a quorum. • If the Certificate of Formation or Bylaws do not define a quorum, the BOC provides that a quorum is three directors or a majority of the number of directors listed in the Certificate of Formation, whichever is greater. • For nonprofit corporations with voting members, a quorum is 10% of eligible voting members unless otherwise provided in the Certificate of Formation or Bylaws.

23. Governance BasicsProxy Voting • Director proxy voting is not allowed unless authorized in the Certificate or Formation or Bylaws. • A proxy must be in writing. It may be revoked unless it states otherwise or is irrevocable by law. • A director proxy expires within three months, unless a shorter period is stated in the proxy. • For a Texas nonprofit corporation with voting members, a member proxy expires in eleven months, unless a shorter period is stated in the proxy.

24. Electronic Communications Meetings • Under Texas law, remote electronic meetings are permissible if: • The meetings are not restricted by the Certificate of Formation or bylaws; • Each member entitled to participate in the meeting consents beforehand to the electronic communication; • All persons can communicate concurrently with one another; • The notice for the meeting lists the type of communication system to be used; • Reasonable methods are taken to identify every person at the meeting; and • A record is kept of any vote or action taken.

25. Consent of the Board of Directors to Take Action • Under Texas law, the Board of Directors generally cannot take action without a meeting unless there is a unanimous written signed consent. • If consent is not unanimous, the Board of Directors can only take action if the following take place: • The Certificate of Formation permits lack of unanimity; • The same number of directors agree to the action as necessary to take action at a meeting at which all directors are present and voting; • The Board of Directors gives prompt notice to all directors who did not consent in writing; and • The Board of Directors delivers the written consent in person or by certified mail, return receipt requested within 60 days and addresses the consent to the president or primary managing office.

26. Board Responsibilities • The Board of Directors manages the affairs of a Texas nonprofit corporation. • Directors, officers, and committee members must perform their duties as a director, officer, or committee member (1) in good faith, (2) with ordinary care, and (3) in the best interest of the nonprofit corporation. • A director acts in the best interest of the nonprofit if the director reasonably believes that the action will benefit the nonprofit corporation. The director should have a proper motive and sufficient information. • A director owes a duty of obedience to the terms of the governing documents, a duty of care, and a duty of loyalty.

27. Compensation and Loans to Directors • Directors cannot be compensated for their service as a Board member and they cannot claim a charitable deduction for the value of their donated services to the nonprofit corporation. • However, directors can be reimbursed for their reasonable out-of-pocket expenses incurred on behalf of the nonprofit corporation in accordance with an expense reimbursement policy. • If a director provides some other goods or services to the nonprofit corporation in addition to serving on the Board, the nonprofit corporation may compensate the director by following the conflict of interest provisions discussed below.

28. Conflicts of Interest and Insider Transactions • Financial transactions between an exempt charitable organization and a director are prohibited under Texas law unless the following requirements are met: • Material facts disclosed. The material facts about the director’s interests are disclosed to the Board of Directors, and the contract or transaction is specifically approved in good faith and with ordinary care by vote of the disinterested members; or • Fairness. The transaction is fair to the corporation at the time it is authorized. • Interested directors may be included in determining the presence of a quorum at a meeting of the Board, or committee of the Board, that approves the transaction. However, they cannot vote on the transaction.

29. Conflicts of Interest and Insider Transactions • Under Texas law, an exempt charitable organization must carefully document transactions with a director. • Meeting Minutes • The exempt charitable organization should carefully document in writing any transaction with an interested director in the minutes of a meeting at which the transaction is considered. • The exempt charitable organization must disclose and document contracts between the exempt charitable organization and a director. A contract between the exempt charitable organization and an office or director is valid if the material facts of the relationship and the contract have been disclosed and specified approval procedures are followed.

30. Excess Benefit TransactionsIRC Section 4958 • If an excess benefit transaction occurs, the IRS can levy taxes on both the disqualified person who received the excess benefit and the exempt charitable organization’s managers that approved the excess benefit transaction. • 25% excise tax on the excess benefit on the disqualified person who received the excess benefit; • An additional 200% excise tax of the excess benefit if the violation is not corrected within the taxable period; • 10% excise tax of the excess benefit on the organization manager who knowingly participated in the transaction (up to $10,000). • An excess benefit transaction is defined as any transaction in which an economic benefit is provided by an exempt charitable organization to or for the use of any disqualified person. The value of the economic benefit exceeds the value of consideration (including the performances of services) received for providing the benefit under Treas. Reg. Section 53.4958-4(a)(1).

31. Excess Benefit TransactionsIRC Section 4958 • A disqualified person is a person in a position to exercise substantial influence over the affairs of the exempt charitable organization at any time during a five-year period ending on the date of the excess benefit transaction under Treas. Reg. Section 53.4958-3(a)(1) (the “lookback period”). • To determine who is a disqualified person, there is a factual inquiry that looks at the actual powers and responsibilities of the person including the voting powers, power to implement decisions of the governing body, financial management, etc. Directors and officers are automatically considered to be disqualified persons.

32. Excess Benefit TransactionsIRC Section 4958 • Compensation is a difficult area to navigate as it relates to excess benefit transactions. Treasury Regulations create a rebuttable presumption that payments under a compensation arrangement are reasonable if certain requirements are met. • To gain the rebuttable presumption: • The compensation arrangement must be approved in advance by an authorized body of the exempt charitable organization the members of which do not have a conflict of interest; • The authorized body must obtain and rely upon appropriate data when making its determination; and • The authorized body must contemporaneously document the basis for the determination.

33. Excess Benefit TransactionsIRC Section 4958 • Exempt charitable organizations should educate their officers and directors about excess benefit transactions and should implement procedures for compliance. • Before the exempt charitable organization enters into an agreement or compensation arrangement with a disqualified person, it follow the procedures necessary to obtain the rebuttable presumption. Note, the rebuttable presumption technically only applies to compensation for services arrangements, but these procedures are “best practices” and recommended for all insider transactions.

34. Conflict of Interest Policy • Exempt charitable organizations are frequently subject to public scrutiny when they appear to have inappropriately benefitted their officers, directors or trustees. A conflict of interest can occur when individuals’ obligations to further an exempt charitable organization’s purpose is at odds with those individuals’ financial interests. • While not required, we recommend that exempt charitable organizations implement a conflict of interest policy to establish procedures that will offer protection against charges of impropriety involving officers, directors, or trustees. This is also recommended by the IRS.

35. Tax-Deductibility of Donations to IRC Section 501(c)(3) Charitable Organizations • Contributions to IRC Section 501(c)(3) charitable organizations generally are tax-deductible under IRC Section 170 for taxpayers who itemize their deductions. The new tax bill increased the standard deduction to $12,000 and $24,000 for individuals and married couples, respectively. • The charitable contribution deduction is limited to varying percentages of adjusted gross income (“AGI”). • 50% AGI limitation – for contributions to public charities, operating private foundations, and certain other private foundations making qualifying distributions by March 15th equal to 100% of the contributions received in the prior year (except cash contributions to these organizations made between 2018 and 2025 are limited to 60% of AGI.) • 30% AGI limitation – for contributions to private foundations. • Contributions of capital gain property are subject to further limitation: a contribution to a 50% limit organization is subject to a 30% AGI limit and a contribution to a 30% limit organization is subject to a 20% AGI limit.

36. Contemporaneous Written Acknowledgment • A donor is disallowed an otherwise allowable IRC Section 170 charitable deduction for a charitable contribution of $250.00 or more if the donor fails to substantiate the contribution by a contemporaneous written acknowledgment from the donee organization meeting the requirements of IRC Section 170(f)(8). • The contemporaneous written acknowledgment include: • the amount or cash and a description (but not value) of any property other than cash contributed; • a statement regarding whether the donee organization provided any goods or services in consideration (in whole or in part) for the contribution; and • a description and good faith estimate of the value of any such goods or service provided by the donee organization as consideration for the contribution.

37. Goods and services/donated property • A donee organization is considered to be providing goods or services in consideration for the donor’s payment if, at the time the donor makes the payment to the donee organization, the donor receives or expects to receive goods or services in exchange for that payment. • The amount of the charitable contribution for purposes of IRC Section 170 is reduced by the value of any goods or services provided by the donee organization as consideration for the contribution. For example, in Sklar v. Commissioner, 282 F.3d 610, the Ninth Circuit Court of Appeals noted in dicta that the purchase, for $75.00, of an item worth $5.00 at a charity auction is treated as a payment of $5.00 for goods and a $70.00 charitable contribution. • Special rules may apply regarding how the donor must substantiate the value of donated property (e.g., a professional appraisal), and report the gift on the donor’s tax return (e.g., IRS Form 8283).  

38. Additional Requirement for CertainQuid Pro Quo Gifts • IRC Section 6115 imposes an additional requirement on the charity when the charitable organization receives a payment in excess of $75.00 which is in part a charitable contribution and in part consideration for goods or services provided by the organization. • Specifically, the charity must provide the donor with a written statement informing the donor that the amount of the contribution that is deductible for federal income tax purposes is limited to the excess of the amount of any money and the value of any property other than money contributed by the donor over the value of the goods or services provided by the donee organization in exchange for the contribution. • The charity must also include a good faith estimate of the value of such goods or services.

39. Additional Requirement for CertainQuid Pro Quo Gifts • Unlike the substantiation requirements under IRC Section 170(f)(8), where the obligation to meet the requirements is imposed on the donor, the obligation to meet the disclosure requirements under IRC Section 6115 is imposed upon the charity. • IRC Section 6714 imposes a penalty on the charity in the amount of $10.00 for each contribution with respect to which the organization fails to make the required IRC Section 6115 disclosure, with the total penalty imposed with respect to a particular fundraising event or mailing campaign capped at $5,000.00.

40. Timing of the Contribution • Delivery date rule: a gift delivered to a charity in the form of a check is treated as being made on the delivery date. Accordingly, if donor delivers a check on December 31, 2018, the gift will be treated as completed in 2018 as long as it is ultimately paid in due course even if the charity does not deposit the check until 2019. The delivery rule also applies to checks delivered via private delivery services (e.g., FedEx/UPS). • Mailbox rule: The Treasury Regulations provide for a “mailbox,” rather than a “postmark,” rule for determining the deductibility of contributions mailed to a charity. If the donor mails a check (via the U.S. Postal Service only) payable to a charity on or prior to December 31, 2018, and maintains an adequate record of such mailing, a charitable deduction may be taken for the 2018 tax year unless the check is not ultimately paid in due course.

41. TUPMIFA • The Texas Uniform Prudent Management of Institutional Funds Act, as codified in Chapter 163 of the Texas Property Code (“TUPMIFA”), sets forth rules governing the investment and expenditure of charitable funds by charitable organizations, charitable trusts and governmental agencies. • Under the standards set forth in TUPMIFA, each person responsible for managing and investing the charitable funds of an institution must make investment decisions in good faith and with the care that an ordinarily prudent person in a like position would exercise under similar circumstances. • TUPMIFA is based on the Uniform Prudent Management of Institutional Funds Act (“UPMIFA”), as promulgated by the National Conference of Commissioners of Uniform State Laws. A version of UPMIFA has been adopted to date by every state in the United States except for the Commonwealth of Pennsylvania.

42. TUPMIFAInvestment Standards • TUPMIFA provides that the following factors, if relevant, must be considered when managing and investing charitable funds: •  (1) general economic conditions; (2) the possible effect of inflation or deflation; (3) the expected tax consequences, if any, of investment decisions or strategies; (4) the role that each investment or course of actions plays within the overall investment portfolio; (5) the expected total return from income and the appreciation of investments; (6) other resources of the charity; (7) the needs of the charity to make distributions and to preserve capital; and (8) an asset’s special relationship or special value, if any, to the charitable purposes of the institution.

43. TUPMIFAInvestment Standards • Under TUPMIFA, an institution must diversify the investments of an institutional fund unless special circumstances exist in which the purposes of the fund are better served without diversification. • Within a reasonable time after receiving property, an institution must decide whether to retain or dispose of the property in order to balance out the portfolio and maintain compliance with the charitable purposes of the institution. Decisions about a particular asset must be made in the context of the investment portfolio as a whole and as part of an overall investment strategy. • TUPMIFA authorizes the delegation of management and investment decisions to external agents to the extent that such delegation is prudent under the circumstances.

44. TUPMIFADonor Imposed Gift Restrictions • Under TUPMIFA, a charitable organization generally must honor a donor imposed restriction on the use of donated funds. • When a charitable organization accepts gifts with donor imposed use restrictions, it should engage in appropriate internal accounting methods to track the use of such restricted gifts accordingly. • Donor imposed gift restrictions typically are set forth in a written “gift instrument” (broadly defined as including “a record or records, including an institutional solicitation, under which property is granted to, transferred to, or held by an institution as an institutional fund”). • If the Board of Directors determines that the donor imposed restriction with respect to a particular gift would not further the organization’s charitable purposes or would be unduly burdensome, the Board may choose to decline to accept such gift. • TUPMIFA authorizes the delegation of management and investment decisions to external agents to the extent that such delegation is prudent under the circumstances.

45. TUPMIFAChanging Donor Imposed Gift Restrictions • In order to release or modify a donor imposed gift restriction, a charitable organization generally must: • (i) obtain the donor’s consent in writing; or • (ii) obtain an order from a court releasing or modifying the restriction upon demonstrating that the restriction has become impracticable or wasteful, impairs the management or investment of the fund, or that the modification will further the purposes of the fund in light of circumstances not anticipated by the donor when the gift was made.

46. TUPMIFAChanging Donor Imposed Gift Restrictions • However, if the funds subject to the restriction have a value of less than $25,000.00 and more than 20 years have passed since the donation was made, a charitable organization may release or modify such restriction upon 60 days prior written notice to the Texas Attorney General if the organization determines that the restriction is unlawful, impracticable, impossible to achieve or wasteful. • If the Board of Directors determines that the donor imposed restriction with respect to a particular gift would not further the organization’s charitable purposes or would be unduly burdensome, the Board may choose to decline to accept such gift.

47. Unrelated Business Taxable Income • When an exempt charitable organization earns income through an activity that is unrelated to their exempt purpose, such as an activity that is commercial in nature, and the activity is “regularly carried on,” the revenue from the activity may be unrelated business taxable income (“UBTI”). • An unrelated trade or business is a (1) trade or business, (2) that is regularly carried on, and (3) is not substantially related to the organization’s tax-exempt purposes. • An exempt charitable organization that has $1,000 or more of gross income from an unrelated business must file IRS Form 990-T.

48. Unrelated Business Taxable Income • Exceptions to UBTI: • Passive Investments. Income derived from passive investments (i.e., dividends, royalties, interest and capital gains) is not subject to UBTI. • Work Performed by Unpaid Volunteers. Work performed by unpaid volunteers is not considered an unrelated trade or business; however, labor must be a material factor. • Sales of Donated Property. The sales of donated property does not generate UBTI. This is generally called the “thrift store” exception.

49. Debt-financed income • Even when income generally would be excluded from the definition of UBTI pursuant to one of the exceptions under Section 512(b) for passive income, such income will nevertheless be treated as UBTI if it was derived from debt-financed property. • Debt-financed property generally is defined as any property held to produce income and with respect to which there is acquisition indebtedness at any time during the taxable year (or, if the property is disposed of during the taxable year, with respect to which there was acquisition indebtedness at any time during the twelve month period preceding the disposition date).

50. Debt-financed income • Acquisition indebtedness generally is debt incurred to acquire or improve the property. The portion of income derived from debt-financed property that is treated as UBTI under these rules generally is based on the portion of the exempt organization’s investment in the property attributable to the debt. • However, even if property is subject to acquisition indebtedness, it will not be treated as debt-financed property to the extent the property is substantially related to the performance of the exempt organization’s exempt purposes or its use is substantially related to the organization’s exempt purposes. • Special rules apply to property acquired by an exempt organization by bequest/devise or gift.