– Profitable activities may trigger unrelated business income tax.
Tax-exempt organizations must be operated primarily for their stated exempt purpose, but the IRS allows them to carry on certain unrelated business activities without jeopardizing their exempt status. If these ventures are not related to a nonprofit’s core mission, however, the organization may have to pay unrelated business income tax (UBIT) on the net income.
Even organizations exempt from filing Form 990, such as churches, could still be subject to UBIT if an income-generating activity is deemed to be unrelated to their purpose.
Some not-for-profits have opted to simply steer clear of activities that might be considered unrelated out of appearance concerns or fear they might endanger their exempt status. Others have taken the stance that because they may incur tax liability, it’s best to avoid having unrelated business income altogether.
But when carried out properly, unrelated activities pose little risk for not-for-profits. Even if UBIT is owed – and often it isn’t because taxes are paid only on the net income after expenses – your organization still has the potential to retain substantial income for your effort.
Rather than routinely avoiding ventures that might incur income tax, raise your awareness of the rules in this are so you can effectively comply if you conduct an income-generating activity.
Take the “Unrelated” Test
According to the IRS, an activity is unrelated and potentially subject to tax if it’s:
- A trade or business,
- Regularly carried on, and
- Not “substantially related” to an organization’s exempt purpose.
A trade or business is defined as selling goods or performing services to produce income. It’s considered to be regularly carried on if it’s frequent, continuous and pursued in a manner comparable to the commercial activities of a nonexempt organization.
For instance, an annual money-making event wouldn’t meet the definition, but an activity that tkes place one or two days a week during the year probably would.
To determine if an activity is substantially related, the IRS looks at whether there is a clear relationship between the activity and the organization’s ability to achieve its exempt purpose.
Understand Unrelated Activities, Exclusions
Many types of income-producing activities may be unrelated, depending on the circumstances. For example, income derived from the rental or sale of most debt-financed property, rental income from parking lots, and regular revenue from advertising are usually considered unrelated income.
Sponsorships aren’t included in advertising because they are treated as contributions rather than income. The IRS has loosened the rules on sponsorships to allow qualitative or comparative descriptions if they are part of the organization’s slogan or corporate message – for instance, “the region’s best.”
In addition to the general rules for unrelated activities, there are numerous activities and situations that are excluded from UBIT, including:
- Activities substantially performed by uncompensated volunteers,
- Most passive income such as royalties, dividends and interest,
- Gains from sale of property (unless it’s debt-financed),
- The sale of donated merchandise (for example, goods given to a thrift shop),
- Real property rental income (unless it’s debt-financed),
- Income from bingo in states where it isn’t carried on by for-profits,
- Income from the rental or exchange of mailing lists with other exempt organizations or with for-profits, as long as no other services are provided,
- Income from trade shows and conventions,
- Activities carried on primarily for the convenience or benefit of members, students, patients or employees (such as a school cafeteria), and
- Qualified sponsorship payments.
Organizations with annual gross income of less than $1,000 from unrelated business activities are excluded from UBIT.
Follow the Tax Rules
As is the case with most tax matters, the rules pertaining to unrelated business income contain numerous exceptions and stipulations. For instance, if you expect to owe $500 or more in UBIT, you organization must make quarterly estimated tax payments.
Unrelated activities, whether excluded from UBIT or not, may consume too many resources. When this occurs, the IRS may see the unrelated business activities as your organization’s primary focus and revoke your exempt status.
In complex financial situations such as these, you should see professional advice before starting a for-profit venture or filing Form 990-T, the income tax return for exempt organizations.
Assess Your Objectives
It’s not inherently bad for your not-for-profit to conduct unrelated business activities. You can develop a much needed income source, which can also complement and further your mission.
But, as with any business matter, your decision to engage in profit-making should be carefully evaluated in the context of your organization’s needs and goals.