Unrelated business income (UBI) remains one of the most fact-intensive areas of federal tax compliance for all exempt-organizations, particularly healthcare organizations.
As health systems diversify revenue, expand ancillary services, and allocate capital into alternative investments, the line between related and unrelated activity may become blurred.
This article provides organizations with a comprehensive framework which analyzes the core components of UBI, common sources of UBI, alternative-investment risks, and practical planning considerations.
Three-Prong Test for Unrelated Business Income (UBI)
Treasury Regulation § 1.513-1 lays out a three-prong test to determine whether an activity constitutes unrelated business income, and all three tests must be satisfied before income is treated as UBI.
First, the activity must be a trade or business carried on to produce income.
The IRS gives substantially more weight to the objective factors surrounding an activity than to the organization’s stated intent in engaging in an activity. Treasury Regulation § 1.183-2 enumerates those objective factors including the manner of conducting the activity, expertise of the organization or its advisors, time and effort devoted to the activity, expectation of asset appreciation, and history of income or losses.
Second, the activity must be regularly carried on, measured against the frequency and continuity of commercial activities of non-exempt organizations.
Third, the activity must not be substantially related to the organization’s exempt purpose. Relatedness depends on whether the activity contributes importantly to the organization’s exempt purpose, considering the size and extent of the activity in question.
Each portion of the three-prong UBI test contains an extremely facts and circumstances based determination. Often, what constitutes UBI for one organization may not constitute UBI for another organization. Therefore, we have provided common sources of UBI for healthcare organizations in the following commentary.
Common Sources of Unrelated Business Income (UBI)
Non-Patient Laboratory Services
Non-patient laboratory testing has long been viewed by the IRS as a classic source of UBI for healthcare organizations.
When a hospital lab performs testing for outside parties such as independent physician practices, nursing homes, or employer clinics on commercial terms, the activity can resemble a for-profit reference lab, thus producing UBI.
Hospitals reporting reference lab activity as UBI should track gross revenues and direct expenses—supplies, labor, courier, billing, and equipment, from non-patient lab testing separately and overhead should be allocated reasonably.
Some exceptions do apply to this source of UBI; however, such exceptions require strong facts and documentation. Lab testing performed for the convenience of patients and employees may be reported more accurately as a related activity.
Additionally, where no other labs are available, the hospital may have a strong case that reference lab activity fulfills a community need and does not constitute UBI.
For more information related to non-patient laboratory services, click here.
Non-Patient Pharmacy Sales
Pharmaceutical sales to non-patients that are frequent and continuous may constitute a regularly carried on unrelated trade or business.
A hospital pharmacy filling prescriptions for neighborhood residents who are neither patients nor employees presents clear UBI risk, whereas a Meds-to-Beds program for discharged patients is far easier to defend as relating to patient care. UBI risk increases when the pharmacy functions like a retail drugstore with broad advertising, commercial hours, and competition with nearby stores.
If your organization is operating a pharmacy, be sure to track patient versus non-patient sales via point-of-sale systems or via electronic medical records.
For more information related to non-patient pharmacy sales, click here.
Outside Catering
Food service for patients, staff, and residents generally falls within the convenience exception or is treated as a related activity. Outside catering is different.
When a hospital regularly caters events for external groups such as weddings, civic banquets, corporate meetings, or fundraising dinners, the activity may generate UBI.
Key questions include who is served, whether the service is marketed externally, how frequent the activity is, and whether separate pricing and dedicated staff exist to operate outside catering. Outside catering should be tracked separately from cafeteria operations, with direct assignment of food, labor, transportation, and event costs.
Cell Tower and Antenna Leases
A distinction exists between rents from real property, often excluded from UBI, and rent from personal property or services, which are typically taxable UBI.
Three different scenarios come into play when analyzing cell tower activity:
- a carrier installing equipment on a hospital roof is likely real property rent
- a carrier utilizing capacity on a hospital-owned tower is more similar to a rent of personal property
- a lease of space bundled with substantial services such as maintenance, power, or monitoring make the exclusion uncertain and must be determined based on facts and circumstances
Organizations should regularly review all agreements with carriers when analyzing UBI from cell tower and antenna leases as the contract language is often the central factor in determining whether the activity is taxable.
For more information, click here to view a PLR related to cell tower and antenna leases.
Specified Payments from Controlled Entities
IRC § 512(b)(13) treats certain payments from taxable controlled subsidiaries as UBI. These “specified payments” include rent, interest, royalties, and annuities.
When an exempt parent owns more than 50% of a controlled, taxable subsidiary, IRC § 512(b)(13) closes an expenses loophole where the controlled, taxable subsidiary could pay its exempt parent for rent or interest while using those expenses to decrease taxable income. However, IRC § 512(b)(13) ensures that such payments are treated as taxable UBI for the exempt, parent organization.
The IRC § 512(b)(13) rules can easily be overlooked in complex organization structures. Organizations should confirm control, identify specified intercompany payments, review agreements annually, and coordinate between tax and accounting teams often to avoid under-reporting UBI.
Joint Ventures
Hospitals frequently enter joint venture (“JV”) arrangements for ambulatory surgery centers, imaging, specialty clinics, urgent care, and staffing.
A Schedule K-1 from a JV partnership may report passthrough UBI to the exempt partner, but organizations should not assume that passthrough UBI is truly correct without understanding the underlying activity in the JV partnership.
Factors that support characterizing the income as related include meaningful governance and control by the exempt entity, active charity care policies, and services directed to hospital patients and community health needs. However, a venture with little hospital control and limited charity care presents stronger UBI concerns.
Furthermore, joint ventures that provide services back to the hospital system itself in staffing or cost-sharing LLCs often do not generate UBI. Organizations should review the joint venture agreement—not solely the K-1—and must understand how the UBI amount was calculated before the Form 990-T is finalized.
Alternative Investments
Alternative investments such as private equity, venture capital, hedge fund, oil and gas investments are perhaps the single most common source of UBI for exempt organizations and health systems.
These investments generate pass-through UBI via Schedule K-1 reporting and can cause many organizations who would otherwise only file an annual Form 990 to become exposed to UBI risks the moment alternative investments are added to their portfolio.
Analyzing pass-through UBI from alternative investments can be extremely complex and alternative investments present many challenges to organizations such as:
- Special UBI siloing rules under Treasury Regulation § 1.512(a)-6
- Unrelated business income allocable to various states that may generate multiple state tax filings, in addition to Form 990-T filings
- Foreign tax filing exposure such as Form 926, Form 8865, Form 5471, and Form 8858
Organizations seeking to expand their portfolio to include alternative investments must be prepared for additional tax complexity as the challenges presented by investment in alternatives are truly a cost that the organization must bear.
Unrelated Business Income (UBI) Planning Considerations
UBI outcomes improve when identification, documentation, and cross-functional coordination are treated as strategic organizational efforts rather than year-end tax exercises.
Organizations should constantly manage their UBI exposure and accomplish the following:
- Annually review each revenue stream and document UBI positions for each stream
- Analyze subscription documents before investing in an alternative to fully understand the capital requirements and tax compliance requirements
- Ensure that tax, legal, finance, and accounting teams are aligned to assess UBI reporting—especially when entering joint venture arrangements and initiating intercompany transactions
- Organizations uncertain about where to begin should complete a systematic review of revenue streams relative to the three-prong UBI test to formally document each UBI position and identify unreported UBI exposure.
Contact Us
Experts from Blue & Co. can assist with identifying, analyzing, and reporting unrelated business income as well as completing formal UBI consultations.
Reach out to your local Blue & Co. advisor or contact one of our experts listed below if your organization needs more information about unrelated business income.
Kim Scifres, CPA, Principal
kscifres@blueandco.com
502-992-3511
Luke Lamb, CPA, Senior Manager
llamb@blueandco.com
502-461-8543
