The University is federally income tax exempt as an integral part of the State of Arizona when engaging in activities directly related to the exempt purposes of state colleges and universities. These purposes include those that are charitable, scientific, testing for public safety, literary, educational, to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals. However, the University is not exempt from income tax imposed on activities which are substantially unrelated to those exempt purposes, even though these activities may bring in funds to support the University’s exempt operations. Activities with income determined to be unrelated business income (UBI) are subject to unrelated business income tax (UBIT).
Internal income is not subject to UBIT. The remainder of this page is intended to assist departments who are considering external income producing activity. This guidance should allow users to identify activity that requires completion of a UBIT Questionnaire, as outlined here and in Policy 20.10 Unrelated Business Income Tax, to initiate documentation of a determination of exposure to UBI or lack thereof.
Any activity generating external income and passing the Three-Prong Test below requires the completion of the UBIT Questionnaire. The questionnaire can be filled out by an individual overseeing the activity, such as the Principal Investigator (PI) or activity coordinator. Send completed forms to Tax Services at FNSV-Tax-Services@arizona.edu.
The following materials are based on Internal Revenue Code (IRC), the Code of Federal Regulations, and IRS Publications and rulings.
Definition of UBI & the Three-Prong Test
UBI is income from a trade or business that is regularly carried on by an organization and that is not substantially related to the performance of the organization’s exempt purposes, except that the organization uses the profits derived to further those purposes. It is the activity itself, not the use of income that must be examined. To determine whether a particular activity that the University engages in will generate UBI, the following three elements must all be present. If any of these elements does not pertain to the activity, the activity is not generating UBI. These elements are often referred to as the Three-Prong Test.
- The activity must be operated like a trade or business.
- The trade or business activity must be regularly carried on.
- The conduct of the trade or business is substantially unrelated to exempt purposes.
1. Trade or Business
The term trade or business generally includes any activity carried on for the production of income from the sale of goods or the performance of services. An activity does not lose its identity as a trade or business merely because it is carried on within a larger group of similar activities that may or may not be related to the exempt purpose of the organization.
Profit motive is one of the more important factors for determining if an activity qualifies as a trade or business. Considerations for profit motive include:
- A trade or business must exhibit intent to profit from the activity.
- Where an activity carried on for profit is an unrelated trade or business, not part of the trade or business is excluded merely because it does not result in profit.
- Sustained, significant, and repeated losses generated by unrelated activities may not be considered trades or businesses due to a lack of profit motive.
- If charging substantially below the cost of its goods or services, an activity is not a trade or business for lack of profit motive.
- If business is conducted in a competitive manner, it is considered strong evidence of a profit motive (Reg. 1.513-(b)).
2. Regularly Carried On
Business activities are considered regularly carried on if they show frequency, continuity, and are pursued in a manner similar to the comparable commercial activities of nonexempt organizations.
An activity should not be considered regularly carried on if it takes place:
- On an infrequent basis,
- For a short period of time during the year, or
- Without competitive and promotional efforts.
Activities over a period of only a few weeks are not regular for an exempt organization if the same kind of activities are normally conducted by a nonexempt organization on a year-round basis. Intermittent, casual, or sporadic activities are generally not considered regular. However, year-round activities are regular even if they are conducted only one day a week. Furthermore, seasonal activities may be considered regularly carried on even though they are conducted only for a short period each year (Reg. 1.513-1(c)(2)).
3. Substantially Unrelated
A business activity is not substantially related to an organization’s exempt purpose if it does not contribute importantly to accomplishing that purpose (other than through the production of funds). Whether an activity contributes importantly depends in each case on the facts involved (Reg. 1.513-1(d)(2)).
In determining whether activities contribute importantly to the accomplishment of an exempt purpose, the size and extent of the activity involved must be considered. If an activity is conducted on a scale larger than reasonably necessary to carry out the exempt purpose, the part of the activity that is more than needed to accomplish the exempt purpose is considered unrelated (Reg. 1.513-1(d)(3)).
Use for both exempt and commercial purposes will not necessarily exempt the income derived from commercial use unless the business activity contributes importantly to the accomplishment of exempt purposes (Reg. 1.513-1(d)(4)(iii)).
Exclusions, Modifications, and Exceptions from UBI
Even if an activity passes the Three-Prong Test defining UBI and requires the completion of a UBIT Questionnaire, the guidelines below outline statutory exclusions, modifications, and exceptions that can be applied to potentially exclude an activity’s income from UBIT.
Exclusions and Modifications from Unrelated Trade or Business
Generally, UBI is taxable, but certain items of unrelated business income and related deductions are excluded from UBI treatment, many of which surround types of passive income.
IRC allows for specific exclusions related to the following types of activities:
Any trade or business in which substantially (85% or more) all of the work is performed without compensation is not unrelated trade or business. In assessing contributions made by volunteers, the IRS considers factors such as the monetary value of the respective services rendered, the number of hours worked, the intrinsic importance of the volunteer work performed, and the degree of reliance placed upon volunteers (Reg. 1.513-(e)(1)).
Convenience of Members
Any activity carried on primarily for the convenience of University members such as students, patients, officers, or employees is not unrelated trade or business. Any sales to nonmembers, e.g., the general public, are unrelated and taxable, unless the sales are not regularly carried on (Reg. 1.513-1(e)(2)).
The IRS has ruled that alumni should be treated the same as members of the general public (PLR 8020010).
Selling Donated Merchandise
A trade or business that consists of selling merchandise, substantially all (85% or more) of which the University received as gifts or contributions, is not an unrelated trade or business (Reg. 1.513-1(e)(3)).
Certain Investment Income
- Interest from bank accounts,
- Payments with respect to securities loans, and
- Any other incomes from routine investments, including notional principal contracts, which the IRS determines are largely similar to these types of income.
A royalty is a payment related to the use of a valuable right, including trademarks, trade names, and copyrights, etc. The royalty exclusion includes overriding royalties, net profits royalties and royalty income received from licenses by the University as the legal and beneficial owner of patents assigned to it by inventors (IRC 512(b)(2) and Reg. 1.512(b)-1(b)).
However, where the royalty income is derived in part from the performance of services, the payment will not constitute a royalty (Rev. Rul. 73-193).
These rent modifications generally do not apply to income derived from debt-financed property.
Generally, rents from real property are excluded (Reg. 1.512(b)-1(c)(2)(ii)(a)).
Certain Personal Property
Rents from personal property are excluded only if there is a mixed lease and the rents attributable to the personal property are an incidental part of the total rents received under the lease. The following rules apply to personal property rents:
- 10% or less is considered incidental and not subject to tax.
- 11-50% is considered taxable in proportion to the percentage of personal property rents to the total rents.
- 51% or more is considered 100% taxable (Reg. 1.512(b)-1(c)(2)(ii)(b)).
Certain Rendering of Services
Amounts paid for the occupancy of space do not qualify as excludable rents if the owner of the property renders services for the convenience of the occupant. Services are considered rendered to the occupant if they are primarily for his or her convenience and are other than those usually rendered in connection with the rental of rooms or other space of occupancy only. For example, the supplying of maid or linen services constitutes such services whereas the furnishing of heat and light, cleaning of public entrances, exits, stairways, or lobbies does not (Reg. 1.512(b)-1(c)(5)).
Certain Percentage of Profits
Rents dependent on profits or income derived by the University from real property do not qualify for the exclusion unless they are based on a fixed percentage of gross receipts or sales. Rents based on a percentage of net profits are taxable (Reg. 1.512-(b)-1(c)(2)(iii)).
Certain Gains or Losses from the Sale of Property
Gains and losses from the disposition of property, other than inventory or property held primarily for sales to customers, is excludable from UBI. This modification generally does not apply to income derived from debt-financed property.
Certain Research Income
Income from certain research grants or contracts may be exempt from UBI treatment depending on the type of research. The following types of research are exempt:
- Research performed for any level of government (IRC 512(b)(7).
- Research performed by a college, university, or hospital for any person (IRC 512(b)(8)).
- Research performed for any person in the case of an organization operated primarily for the purpose of carrying on fundamental research (as distinguished from applied), the result of which are freely made available to the general public (IRC 512(b)(9)).
However, the regulations further limit these exclusions by providing that research for this purpose does not include activities ordinarily carried on as an incident to industrial operations, such as ordinary testing or inspection of products (Reg. 1.512(b)-1(f)(4)).
The IRS has defined ordinary testing as those activities where “a standard procedure is used, no intellectual questions are posed, the work is routine and repetitive, and the procedure is merely a matter of quality control" (GCM 39196).
The IRS also rules that a project is ordinary testing if the work is performed to satisfy a federal or state regulation requiring such an evaluation before a product may be marketed (Rev. Rul. 68-373, 1968-2 C.B. 206).
Exceptions to Debt-Financed Property
Property Related to Exempt Purpose
If substantially all (85% or more) of the use of any property is substantially related to an organization’s exempt purpose, the property is not treated as debt-financed property. The extent to which a property is used for a particular purpose is determined by:
- A comparison of time the property is used for exempt purpose with the total time the property is used, or
- A comparison of the part of the property that is used for exempt purposes with the part used for all purposes, or
- Both comparisons.
Acquisition of Real Estate by Qualified Organizations
IRC also contains an exception to the debt-financed property rules for the acquisition of real estate by qualified organizations, including educational institutions. The term acquisition indebtedness does not include debt incurred by the University to purchase real property where the following conditions are present:
- The purchase price is a fixed amount,
- The amount of indebtedness and the time for payment of such indebtedness are not dependent on revenue, income, or profits derived from the real property,
- The real property is not leased back to the seller or a party related to the seller, and
- If the real property is held by a partnership and one or more of the partners is not a qualified organization, then allocations to the partners much be qualified allocations or must not have as a principal purpose the avoidance of income tax (IRC 514 (c)(9)).
Please view Policy 20.10 Unrelated Business Income Tax for additional information regarding UBIT and departmental reporting requirements if UBI is identified.