Should You Be Concerned About Unrelated Business Income Tax?
If an organization is approved for an exemption under IRC Section 501(c)3 it’s exempt from federal and state income taxes. This recognition by the IRS can lead to additional exemptions for real estate, sales and even some utility taxes, depending on the laws in your state.
Beware, though, of exceptions to your exempt status, such as unrelated business income. When a nonprofit organization conducts profit-making activities unrelated to the organization’s core mission, those funds become subject to Unrelated Business Income Tax (UBIT).
Three tests to determine whether a “business” activity is subject to UBIT include:
- The activity is not substantially related to the organization’s tax-exempt status — meaning it doesn’t further the organization’s mission;
- The activity is considered a trade or business in its own right; and
- The activity is conducted regularly.
Here are some general guidelines to consider:
- Investment income (interest, dividends, royalties, gains/losses from sales of property, etc.) is excluded. However, income from controlled pass-through entities may not be. Also, if the property that generates this investment income is debt financed, then it becomes partially taxable.
- Activities specifically operated for the benefit of members, students, patients, officers or employees (e.g., a cafeteria) are exempt.
- Retail operations selling donated merchandise (such as a thrift store raising money for the organization) are exempt.
- The sale of membership lists for an affinity program would be unrelated business income, as would products manufactured by the organization, unless the process is instrumental to the mission of the entity.
- Bingo games are considered a related trade or business.
- Activities operated with substantially all volunteer labor are exempt from this provision if they’re considered fundraising operations.
- Leases of property are generally exempt income unless services are included in the lease, such as janitorial, utilities, security, etc. Thus, a triple net lease would be exempt, but a full service one wouldn’t.
(Warning: A nonprofit organization’s unrelated, profitable activities are permitted but they cannot consume a substantial amount of resources to accomplish them. Suppose your organization operates a bookstore that contributes a major source of income for the operations of your charity. If the store requires the majority of the organization’s overhead to operate it, the appearance is that you’re running a bookstore instead of a charity, even though all of the proceeds support your mission. The IRS could determine that the tax-exempt purpose has been abandoned and revoke the 501(c)3 status.)
If you discover you earned $1,000 or more in gross UBI, use Form 990-T to report it to the IRS. Reporting this income doesn’t necessarily mean it’s taxable. All related expenses, including indirect ones, are deductible from the UBI in determining the taxable income.
If you need more details about what’s potentially taxable and what’s exempt, IRS Publication 598 is a great resource.
