While most non-profits enjoy tax exempt status, it is important to note that the Internal Revenue Service ( IRS) can tax certain portions of the organization’s income through the Unrelated Business Income Tax (UBIT). For most organizations, unrelated business income is income from a trade or business activity realized by a tax-exempt organization that is not substantially related to the non-profit purpose for which the organization enjoys tax-exempt status.
If a tax-exempt organization has $1,000 or more of gross income from an unrelated business, it must report the income to the IRS and state tax authorities and pay both federal and state income taxes on it. The income is taxed at the corporate income tax rate.
Unrelated business income is reported on a form 990-T. If the organization expects its tax for the year to amount to $500 or more, it must pay estimated quarterly withholdings.
A non-profit runs the risk of losing its tax-exempt, nonprofit status if it earns too much unrelated business income. If a nonprofit is generating more than 50% of its total gross revenue from unrelated business activities, it should be concerned about losing its nonprofit status and should probably seek out the advice of an experienced tax lawyer to analyze it situation..
The nonprofit organizations to whom the UBIT would apply are as follows:
- Charitable organizations: Organizations that exist for religious, charitable, scientific, testing for public safety, literary, educational, or other specified purposes and that meet certain other requirements as detailed in Internal Revenue Code (IRC) Section 501(c)(3);
- Churches and religious organizations: Churches and religious organizations may be exempt from federal income tax under IRC Section 501(c)(3).
- Private foundations: Private foundations typically have only one major source of funding; the funding source is usually a gift from a single family or corporation. Their primary activity is usually making grants to other charitable organizations and to individuals. They usually do not directly operate charitable programs themselves.
- Political organizations: A political organization subject to IRC Section 527 is a political party, committee, association, fund or other organization that has been organized and is operated primarily for the purpose of taking contributions or making expenditures, or both, for a nonprofit, political function.
- Other nonprofits: Other nonprofit organizations that meet specified requirements may qualify for exemption as something other than 501(c)(3) organizations. Some examples would be social welfare organizations, civic leagues, social clubs, labor organizations and business leagues.
What Is the UBIT test?
Under the UBIT rule, a nonprofit is obligated to pay taxes on income it realizes from “trade or business activity,” which is “regularly carried on” and is “unrelated” to its purpose or mission as a nonprofit organization. The definitions of these various elements are technical, and are constantly battled over in the courts.
The term “trade or business” generally includes any activity whose goal is generating income, usually by selling goods or performing services. Activities whose goal is the production or distribution of goods or the provision of services to generate income do not lose their identity as trades or businesses because they are done by an organization that is otherwise engaged in nonprofit activities.
The business activities of a nonprofit ordinarily are considered to be “regularly carried on” if they are frequent and continuous, and are carried on in a way that is similar to the comparable commercial activities of for-profit organizations.
In order to decide if a business activity is “substantially related” requires analyzing the relationship between the income generating activities and the accomplishment of the organization’s nonprofit purpose. A trade or business is connected to nonprofit purposes only if the business activities have a causal relationship to achieving nonprofit purposes.
If the purpose of the trade or business is only to produce income, it is not “substantially related” to the nonprofit purpose of the organization. The causal relationship is required to be “substantial”. The activities that generate the income must contribute importantly to accomplishing the organization’s nonprofit goals if it is going to be considered “substantially related”.
Of course, as with every rule, there are exceptions. The IRC contains a number of exceptions to the unrelated business income tax rule. For example, income from the following sources are excluded when an organization computes its unrelated business income:
- Dividends from stocks;
- Interest on investments;
- Certain other investment income;
- Certain rental income;
- Certain income from research activities; and
- Gains or losses from the disposition of property.
Furthermore, the following activities are definitively excluded from the definition of unrelated trade or business:
- Volunteer labor: Income from a trade or business is not taxable if substantially all the work is performed for the organization by volunteer workers for no compensation. So, for example, bake sales for fundraising staffed by volunteers may meet this exception;
- Convenience of members: Income is not taxed if it is realized from a trade or business that is carried on by an organization described in IRC section 501(c)(3) or by a governmental college or university primarily for the convenience of its members, students, patients, officers, or employees. A school or nonprofit hospital cafeteria is an example of this type of activity;
- Selling donated merchandise: Income from a trade or business is not taxed if realized from selling merchandise, substantially all of which the organization receives as gifts or contributions. Many thrift shop operations of exempt organizations would come within this exception;
- Bingo games: Revenue from certain bingo games are not considered to be income from an unrelated trade or business.
What Are Common Examples of UBIT?
One activity the IRS has repeatedly found to be a source of unrelated business income is advertising. Many nonprofits have journals or other publications from which they realize income in the form of advertising revenue. The IRS often considers this income unrelated to the nonprofit’s purpose.
Another activity that the IRS may consider unrelated business income is the exchange of mailing lists for money in the form of licensing arrangements. If a nonprofit actively markets its mailing lists to other businesses, the IRS may consider such activity unrelated to the nonprofit’s purpose and may tax income realized from the activity.
How Can a Lawyer Help Me with My UBIT Problem?
If you are unsure whether your non-profit organization is generating income subject to taxation under UBIT, you should contact an experienced tax lawyer. There are many technical definitions involved in this exemption from taxation. A tax lawyer can analyze your situation and help you determine your exact tax liability. If your nonprofit organization is grossing a great deal of income from unrelated business activities, it could jeopardize the nonprofit status of the organization. In order to avoid this outcome, you need the help of a tax lawyer.
You are most likely to have successful communications with the IRS if you are represented by an experienced tax lawyer.