Q: We are a small 501(c)(3) public charity that helps children develop reading and math skills. For Federal income tax compliance, we only file the e-postcard. We also publish an annual calendar and bi-monthly newsletter about our activities and other newsworthy information relevant to our exempt purpose. In these publications, we’re selling advertising space to our sponsors and neighborhood businesses. Our accountant says that we may need to pay Unrelated Business Income tax or at least file a Form 990-T to report the advertising income. Since we don’t charge tuition for our programs, and this sponsorship revenue helps us buy books and materials for the children, isn’t this revenue related to our exempt purposes?
A: Advertising usually generates unrelated business income (UBI). This is because advertising usually meets all three UBI tests: It is (1) regularly carried on, (2) it is a trade or business, and (3) it is substantially unrelated to the organization’s exempt purpose, aside from the need to generate income. That said, there can be exceptions and exclusions.
For this writing, let’s assume you have determined that your advertising activities meet the first two basic UBI tests mentioned above: It is (1) regularly carried on, and (2) it is a trade or business. Let’s assume it’s also carried on to produce revenue, is conducted with the same frequency and continuity, and is pursued in a manner similar to commercial nonexempt businesses.
Now, let’s explore the rare circumstances wherein an advertising activity can be related to the exempt purpose. To be so related, the revenue-generating activity must contribute importantly to accomplishing the organization’s exempt purpose, other than the organization’s need for acquiring funds to further its exempt purpose.
For example, even though the substantive content of your calendar and newsletters, such as articles, news, and events; may be related to helping children with reading and math, the advertisements are extremely unlikely to significantly further this purpose.
Some Exceptions and Exclusions
Even though the advertisements are part of the publication, which as a whole may be related to the exempt purpose, the advertising must be evaluated separately. If your school has students sell ads as part of its school newspaper publishing curriculum, it is possible that advertising sales could contribute importantly to furthering the exempt purpose of the school.
Is it possible to exclude the income because it is not advertising? To answer this question, we must determine what constitutes advertising. Advertising is any message that promotes or markets a business, service, or product. Advertising includes qualitative or comparative language, price, value or savings information, an endorsement, or an inducement to buy or use the sponsor’s services or products.
With that definition in mind, which published messages do not count as advertising? Mere acknowledgments do not count as advertising. An acknowledgment identifies the sponsor rather than promotes the sponsor’s products or services. The bare recognition of the sponsor may include sponsor logos and slogans, so long as they do not contain comparative or qualitative descriptions or promote the product or service.
Acknowledgments may also include sponsor locations and telephone numbers, value-neutral descriptions of a sponsor’s products or services, sponsor brand or trade names, and product service listings.
Website links can also count as sponsorships, as long as the link leads to the sponsor’s homepage, or to an information page, and not to a page that is a “checkout” page for purchasing goods or services from the advertiser on your organization’s website.
There is still one other exclusion: If all of your organization’s advertising sales are conducted by volunteers, it is possible the advertising revenue would be exempt from unrelated business income tax under a statutory provision.
How to Report the Unrelated Business Income
A Form 990-T must be filed if it’s determined that (1) the advertising is an unrelated business that does not fit an exclusion, and (2) it generates $1,000 or more of gross income in a tax year. If there is net profit, a tax must be paid. Advertising is entered on Schedule J of the 990-T.
This sounds fairly onerous, however, there is some good news: You may deduct all of the direct and appropriate indirect expenses associated with advertising income to offset the gross revenue. This may result in a net loss.
However, if there is still profit after applying the expenses associated with the advertising, you may also allocate any net circulation losses associated with the publication as an expense to further reduce advertising income, but not below zero.
The circulation expenses may bring the net income down to zero, but are not permitted to generate a loss. Thus, if the publication as a whole is running a loss, the advertising will not result in taxable income.
Speak with your tax advisor and provide her with all the facts. She should be able to advise you regarding what is classified as advertising versus acknowledgment, and what might qualify as an exclusion or exception to unrelated business income. If the advertising is taxable, she should be able to tell you how to minimize the tax with proper allocation of expenses.
Laura McKay, CPA is a manager and key member of the Jones & Roth Nonprofit Team and Assurance Services Department. She has extensive experience working with both nonprofit and commercial businesses and manages many of the firm’s largest and most complex audit engagements. Laura is highly involved in the development and instruction of firm-wide continuing education and the firm’s Form 990 Task Force.