GUIDELINES FOR NONPROFIT ORGANIZATIONS: REGARDING UNRELATED BUSINESS INCOME TAX (UBIT)
by Patrick Sternal, J.D., LL.M.
Updated 9/1/08
Nonprofit organizations that have established their tax-exempt status with the IRS are not taxed on their proceeds from activities related to their exempt purposes. So, one might ask, why should a tax exempt organization ever worry about taxation on income? The exemption from taxation is not absolute: when a nonprofit organization carries on business that is not related to its exempt purpose, the income received may be subject to a special tax, called the Unrelated Business Income Tax, or “UBIT.”
There are three determinations that must be made in order for the income from an activity to be subject to UBIT. All three of the following questions must be answered “yes” in order for the UBIT to apply:
1. Is the activity a trade or business?
Trade or business activity generally includes any activity carried on to make income by selling goods or performing services. An activity may be considered a business if it is carried on in a commercial manner, with competing with similar for-profit business enterprises.
Example: A school selling books and supplies to students is carrying on business activity. Note, however, that the convenience exception will likely apply. (See below.)
Consider: What are the activities carried on by your organization which would be considered trade or business activity?
2. Is the activity regularly carried on?
An activity is regularly carried on if it is done frequently and continuously and is pursued in a manner similar to commercial activities of nonexempt organizations.
Example: A church operates a sandwich stand at a county fair for 3 weekends every year. This is not considered an activity regularly carried on. However, if the church operates a sandwich stand every weekend, it would likely be considered an activity regularly carried on.
Consider: Is X trade or business activity carried on by your organization on a regular basis?
3. Is the activity substantially related to the exempt purpose of the organization?
An activity is not related to the exempt purpose of the organization simply by virtue of the fact that it produces funds. The income must be derived in the course of pursuing the exempt purpose.
Example. A school for the performing arts charges admission for the student performances. The activity, however, is substantially related to the purpose of the school.
Consider: What is the exempt purpose of your organization? Is doing X income generating activity in furtherance of your exempt purpose?
Commerciality
Related to, but not quite the same as, the 3 basic tests for unrelated business income above is the notion of the “commerciality” of a particular activity. If a nonprofit organization carries on a trade or business in the same manner as, and competes in the same market with, commercial enterprises, this commerciality may establish to the IRS that the activity is not related to the exempt function of the organization.
Example. An organization, whose exempt purpose is to help deserving women in need of charitable assistance, operates a restaurant as one of its activities, serving meals to the general public in a manner which is commercial in nature. That is to say, the restaurant competes with other restaurants for customers, has profit-making pricing, advertises, and operates comparable hours as those of a commercial restaurant. The IRS considers the operation of such a business as nonexempt function subject to UBIT.
However, the IRS would consider the operation of a restaurant in a museum, which helped attract visitors and allowed both staff and visitors to remain on premises, to be a related business, because it is provided for the convenience of the visitors and staff.
Consequences of Having Unrelated Business Income
If the exempt organization receives income of more than $1000 from activity which meets these requirements, that income must be reported on Form 990-T and is subject to the Unrelated Business Income Tax, similar to the tax on corporate income.
If the unrelated business income becomes a substantial portion of the organization’s income, the IRS may revoke the exempt status of the organization. The determination of when the activity becomes substantial is based on all the facts and circumstances.
Consider: How much unrelated business income does my organization have? Is it a substantial portion? If so, you may consider speaking to an attorney or accountant about options for your organization.
There is still one more question that can be asked in determining whether there is UBIT:
4. Is there an exception?
Even if the activity of the organization meets all three of the above named criteria, there are several exceptions that apply in various situations.
Volunteer workforce - If the workforce doing the activity does so on a volunteer basis, the income will not be considered unrelated trade or business.
Example: A museum selling a cookbook that has been collected, assembled and sold by the volunteer staff is not unrelated business.
Convenience exception - If the activity is provided by an exempt organization for the convenience of the members, students, patients, officers, or employees.
Example: An exempt college takes in income from vending machines selling food and drinks located in campus residence halls. The income is not unrelated because the vending is provided for the convenience of the residents.
Sale of donated merchandise - Trade or business activity which consists of the sale of merchandise, substantially all of which has been donated to the organization as gifts or contributions, the activity will not be unrelated trade or business.
Example: A women’s shelter operates a thrift store selling donated used items. The income is not from an unrelated business, since the items have been donated to the shelter. Note that, if the thrift store were staffed by volunteers, the volunteer workforce exception may also make the income not unrelated.
Rule of Fragmentation.
An activity may be a trade of business even though it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which are related to the exempt purposes of the organization.
Example: A pharmacy attached to a charitable health clinic will not be subject to UBIT on the sales of medicine and other items to patients of the clinic, since such sales are related to the exempt purpose of the clinic; however, any sales made by the pharmacy to the public are separated out and subject to UBIT.
Sponsorship
Many nonprofit organizations accept contributions from corporate and commercial sponsors in exchange for displaying the business’s name or logo on their website or in other materials. Often the nonprofit will linked to the sponsor’s website. A tax-exempt organization should have a clear policy with regard to what is posted and linked on its website in order to avoid creating unrelated business income. As a rule, if the contributor receives no substantial benefit other than the placement of its logo, the activity is a qualified sponsorship and not producing of unrelated business income. However, an activity is not a qualified sponsorship if the person receives advertising in exchange. The contribution will then be seen as payment for advertising, and subject to UBIT.
Conclusion
Any nonprofit organization that takes in proceeds from business-like activities should review the activity as outlined above for possible UBIT liability and discuss it with their attorney, accountant or others who are responsible for filing tax returns and compliance with the laws and regulations governing tax-exempt entities.