Tax-exempt organizations typically rely on grants and donations to support their missions, but many nonprofit organizations explore alternative sources of revenue to maintain financial stability. For example, a school may rent out additional space in its building or sell advertisements in its bulletin, newspaper, or podcast. While some organizations generate income from activities that do not align with their mission, it may be crucial to prioritize earning funds to further execute the organization’s purpose. However, if an organization is not careful, this added income can potentially jeopardize the organization’s tax-exempt status.
Generating income from activities unrelated to the
organization’s purpose may be considered unrelated business income (“UBI”), and
the income derived from it may be subject to an income tax referred to as
unrelated business income tax (“UBIT”). The Internal Revenue Service (“IRS”)
defines an activity as UBI if it is “(1) income from a trade or business, (2)
regularly carried on, (3) that is not substantially related to the charitable,
educational, or other purpose that is the basis of the organization’s
exemption.”[1] The
primary purpose of UBIT is to eliminate unfair competition by placing the
unrelated business activities of certain tax-exempt organizations in the same
tax position as non-exempt businesses.[2]
Determining if an Activity Is Unrelated Business Income
UBIT applies to nearly every tax-exempt organization except
public elementary and secondary schools,[3] some
governmental entities defined in Section 115 of the Internal Revenue Code,[4] or
other governmental “integral part[s] of a State.”[5] In determining if your organization’s
activity may fall within UBI, the board should ask three questions:
1. Is the Activity Considered a Trade or Business?
The first prong of establishing whether an activity falls
under UBI is whether it is carried out to produce income from the sale of goods
or the performance of services. In simplest terms, this means the tax-exempt
organization would behave like a for-profit business, even if the organization
has engaged in an activity that ultimately produces a loss.
2. Is the Activity Regularly Conducted as Compared to a Similar For-Profit Corporation?
Frequency and continuity are the main factors when
determining if an activity is “regularly carried on” compared to a for-profit
business. For example, selling advertisements in an annual gala pamphlet would
likely not fall under UBI, but selling advertisements in a weekly newsletter or
on a website likely would.
3. Is the Activity Substantially Related to the Organization’s Mission?
Demonstrating whether an activity is substantially related
to one’s tax-exempt organization is a fact-specific inquiry, which can be
difficult. A substantial causal relationship must exist between the activity
and the organization’s tax-exempt purposes. For instance, if a fine arts
organization’s purpose is to promote art exhibits and cultural events, but the
nonprofit also leases studio apartments and operates a dining hall for tenants,
those activities could trigger UBIT because they do not relate to the purpose.[6]
However, the fragmentation rule gives organizations some flexibility because nonprofits can separate unrelated parts of an activity from the related parts, and only the unrelated portion is taxed.[7] A museum gift store is an example—a museum selling an art print is substantially related to its mission, but a city souvenir mug is not.[8] The museum must pay UBIT for the mug sale but not the print sale.
Exceptions to Unrelated Business Income
Furthermore, UBI has many exclusions, but boards should be
aware of three crucial exclusions:[9]
1. The Use of Volunteer Labor
The IRS excludes UBI when volunteers substantially perform
all the work without compensation. If an exempt orphanage opened a retail store
where unpaid volunteers substantially performed all the work carrying on the
business, it would not be considered UBI.[10]
2. An Activity for Convenience
Another exclusion is if the activity is conducted by a
tax-exempt organization for the convenience of its members, students, patients,
officers, or employees. For example, a college operating a laundry to launder
dormitory linens and students’ clothing would not be considered UBI.[11]
3. Selling of Donated Merchandise
Lastly, the IRS does not consider selling merchandise a nonprofit receives as a gift or contribution as UBI. Many thrift stores fall under this category, with Goodwill being a real-world example. Goodwill’s purpose is to provide employment services and opportunities to those with employment barriers,[12] but the sale of donated goods perpetuates that goal.
Guidelines for Unrelated Business Income
Once an organization identifies that it may have UBI and is
subject to UBIT, the board should adhere to the following guidelines:
1. Separating Books
First, separate the books for any unrelated business
activities. Organizations must maintain accurate records of their activities
and finances to calculate and report their UBI and pay UBIT. The tax reporting
process is complex, and streamlining the practice lessens the potential for
noncompliance. Establishing and maintaining effective control over finances is
vital, and precisely documenting the records helps ensure that transactions are
properly authorized and recorded.
2. Limiting UBI
Some UBI is okay and is often encouraged. However, the IRS
has no bright-line test to determine what percentage is too much, and experts
differ in opinion about what percentage is too much and estimate between 10% to
20%.[13] To
avoid eclipsing a for-profit business, experts recommend that UBI earns an
insubstantial amount compared to the tax-exempt revenue. Keeping the number
relatively low is a priority.
3. Filing a 990-T
If a tax-exempt organization has over $1,000 of gross income
from UBI, it must submit a 990-T in addition to the 990, 990-EZ, or 990-PF.[14]
Filing a 990-T helps a tax-exempt organization calculate what the organization
owes to the IRS based on the organization’s UBI and pay the tax.
Conclusion
The organizations subject to UBIT must be cautious about UBI
because following the guidelines or paying UBIT can prevent the revocation of
tax-exempt status, an audit, or tax liability. Nonprofit organizations should
prioritize understanding UBI and UBIT to ensure compliance with federal tax
regulations.
[2] § 26 C.F.R. § 1.513-1
[3] § 26 C.F.R. § 1.511–2.
[4] § 26 U.S.C.A. § 115.
[5] State of Mich.
v. United States, 40 F.3d 817, 829 (6th Cir. 1994).
[7] § 26 C.F.R. § 1.513-1
[9] https://www.irs.gov/charities-non-profits/charitable-organizations/unrelated-business-income-tax-exceptions-and-exclusions