For a variety of reasons, your nonprofit entity may need a short-term or long-term loan. Whether it is a line of credit to fund short-term needs or term debt to fund the acquisition of a fixed asset, there could be tax consequences to your actions.
The IRS has acknowledged that nonprofit entities have borrowing needs. But it has also decreed that certain types of borrowing can force your hand into having Unrelated Business Income (UBI) that is taxable at the prevailing corporate tax rates. Most states have followed suit, requiring you to pay a UBI tax there as well.
The IRS Form 990
Unrelated Business Income requires a separate federal form called the 990-T. This reflects income that is unrelated to your exempt purpose, and which comes from a trade or business that is regularly carried on. This includes advertising revenue and “debt-financed” income.
If the source of the income is debt-financed, most times the IRS considers the income received to be Unrelated Business Income (though there are exceptions). For a Form 990 charitable organization, that means having to pay the corporate tax rate on this income versus otherwise paying no taxes at all. A Form 990-PF private foundation would be taxed at corporate rates, rather than being taxed as net investment income at a 1 percent or 2 percent tax rate. To both, it means adding a layer of state taxation as well.
Specifically, the IRS has said that temporary borrowing for administrative convenience does not create UBI, so lines of credit to fund grants for other nonprofits does not create UBI. But margin debt converts the related investment income into UBI.
When you have rental income from property with acquisition indebtedness, debt-financed rental income related to the organization’s mission is not UBI. But when debt-financed rental income is unrelated to the organization’s mission, it is UBI.
Finally, when you sell real estate and personal property, it may be considered Unrelated Business Income if the property (or a portion of it) is debt-financed.
It may be a challenge for you to understand IRS terms and all their intricacies. We’d be happy to discuss the implications of debt-financed income and any other not-for-profit and private foundation issues with you to ensure that you are in compliance with the IRS.