A 501(c)(3) nonprofit is not taxed on revenue that comes from an activity that is substantially related to the organization’s charitable, educational, religious, scientific, or other tax-exempt purpose that is the basis for the organization’s tax-exemption.
But, some activities that the nonprofit undertakes may subject it to tax. If a nonprofit conducts an unrelated trade or business to generate income, the nonprofit may be subject to the unrelated business income tax (UBIT). It does not matter that that income may be used to support the organization’s charitable efforts.
That is, if a nonprofit, tax-exempt organization regularly carries on a trade or business that is not substantially related to its tax-exempt purpose (except that it provides funds to carry out that purpose) the organization is subject to tax on its income from that unrelated trade or business.
The goal of UBIT is to eliminate unfair competition in the marketplace between for-profit and tax-exempt organizations. This is done by taxing a nonprofit’s unrelated business activities in the same way that a for-profit company would be taxed.
Definition of Unrelated Business Taxable Income Tax
Unrelated Business Income (UBI) represents the type of income that is taxable. You may also see this referred to as unrelated business taxable income (UBTI).
Unrelated Business Income Tax (UBIT) is the actual tax that is owed based on the income received within the tax-exempt account or entity. It is the tax imposed on the unrelated business income generated by tax-exempt organizations.
UBI (or UBTI) is the gross income derived by a nonprofit organization from any unrelated trade or business regularly carried on, less any allowable deductions, and computed within IRS guidelines. See IRC Section 513, 512(b). (Note – There are certain modifications from passive or investment income and there are many exceptions that you should discuss with your legal counsel.)
How do I determine my nonprofit organization is subject to UBIT?
Unrelated Business Income consists of income generated by the organization from activities that are not related to the exempt mission of the entity. Income from an activity is considered unrelated if all three of the conditions listed below are met:
- Trade or Business
- Regularly carried on
- Not substantially related to the organization’s tax exempt purpose
All three prongs must be met for UBI to exist. It is a facts-and-circumstances test.
Even if the three prongs of the UBIT test are satisfied, there are numerous specific exceptions from UBI that may apply.
(1) The activity is conducted as a trade or business
What is a trade or business?
The Internal Revenue Code Section 513 offers guidance about what is considered a trade or business for UBIT rules. Generally, an activity is considered to be conducted as a trade or business if its primary purpose is to generate a profit from the sale of goods or service. The existence of a profit motive and the competition factor with for-profit businesses are considered an important factors in determining whether the activity is a trade or business for UBIT purposes.
- Is there a profit motive?
- Is there a competition factor?
- Does the activity look like those done by for-profit businesses?
- Is there an unfair competitive advantage if the organization doesn’t pay taxes on the activity?
(2) Regularly carried on
What does it mean to be regularly carried on?
UBIT applies only to activities that are regularly carried on, as opposed to activities that are sporadic or infrequent.
An activity is considered regularly carried on if it is conducted with a frequency comparable to the conduct of a similar activity in the private sector.
- How frequent and continuous is the activity?
- How is the activity conducted (compared with a for-profit’s similar business activity)?
(3) Not substantially related to the organization’s exempt purposes.
How do we determine the exempt purpose?
The exempt purposes set forth in Internal Revenue Code Section 501(c)(3) are charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and the prevention of cruelty to children or animals.
Look at what the nonprofit organization is organized and operated to do. For what purposes did the IRS grant it 501(c)(3) status? What is the purpose that the organization shared on its application for 501(c)(3) status (IRS Form 1023)? What does the nonprofit state on its annual IRS Form 990? What purpose is listed on the nonprofit’s state formation documents? What is the purpose stated in the organization’s public documents?
For example, a school’s exempt purpose may be education and research. So an activity whose purpose is not substantially related to education or research likely would be characterized as unrelated. It is irrelevant that the proceeds from an activity will be used to fund education or research. The determining factor is the nature of the activity itself (unless there are certain exceptions).
How is an activity characterized as not being substantially related to its exempt purpose?
To see if the activity is substantially related or not substantially related to the nonprofit’s purpose, you must examine the relationship between the business activity and how it meets the organization’s exempt purpose. Generally, this is a facts and circumstances test and we must look at the size and extent of all activities.
It is important to note that some courts have applied the commercially doctrine that focuses on whether an activity is conducted in a competitive, commercial manner — even if the activity is a related business.
- What are the nonprofit’s tax-exempt purposes?
- How does the activity contribute significantly to to the accomplishment of one of the nonprofit’s tax-exempt purposes?
- Is the activity being conducted to generate income? Is the focus of the activity the maximization of profit?
- Has the activity become too commercial?
- Are the fees charged comparable to what a for-profit company could charge?
- Does the the organization operate its facilities through its own staff and does it provide substantial services in providing the activity?
Exceptions and Special Rules
The tax code has many exceptions and rules that are too extensive to include here. Please reach out to your legal counsel to discuss the specifics.
In general, some exceptions include
- Volunteer exception
- Convenience exception
- Thrift store exception
- Certain investment income exception
Note that there are special rules for
- Qualified conventions and trade shows
- Some types of hospital work
- Certain types of gaming activities (bingo)
- Distribution of low-cost articles incidental to soliciting charitable contributions.
- Membership list sales or rentals
- Revenue from controlled organizations
- Certain types of sponsorship payments – qualified sponsorship income
Determining whether or not the income from an activity is taxable can be difficult. Please contact our office and discuss your situation.
IRS: What is UBIT?
IRS Publication: Publication 598 Tax on Unrelated Business Income of Exempt Organizations