Most organizations exempt from tax under Internal Revenue Code (“IRC”) Section 501(a), including charitable, religious, scientific, and other organizations described in IRC Section 501(c), may be subject to tax on unrelated business income (UBIT), depending on the nature of the activities producing that income. It is important for an organization to distinguish between its tax-exempt purpose and its business activities.
Identifying Unrelated Business Activities
Generally, income derived from a trade or business regularly conducted by an exempt organization that is not substantially related to its exempt purpose or function, except that the organization may use the profits to support its mission, is considered unrelated business income. All three of the following components must apply for the activity to be considered unrelated business activity:
- Trade or business – This includes any activity conducted for the production of income, including selling goods and/or performing services, with the intent of generating a profit.
- Regularly conducted – Activities are considered regularly conducted if they show frequency and continuity that would be comparable to the activities of a nonexempt provider. For example, an annual bake sale conducted by volunteers of an organization would not be considered a regular trade or business. However, if the same organization maintained an ongoing bake shop with customary business hours and permanent employees this would be considered a regular trade or business.
- Not substantially related to the organization’s exempt purpose or function – The business activity isn’t substantially related to the organization’s exempt purpose if it doesn’t contribute significantly to accomplishing that purpose. It doesn’t matter that the profits generated provide support for the exempt purpose.
Determining if your organization has unrelated business activities may require careful analysis of all income sources, particularly those sources that are not substantially tied to your core mission. Certain activities that are comparable to other commercial enterprises such as food concessions, book stores and parking lot services are activities that are commonly considered unrelated activities and subject to UBIT. Some activities are not so clear-cut, and there are many activities specifically excluded from the definition of unrelated trade or business. These include activities such as bingo games (if legal where played), those intended for the convenience of members, convention or trade show activity and qualified sponsorship payments.
Some Sources of Income Are Excluded
All dividends, interest, annuities, payments with respect to securities loans, income from national principal contracts, and other income from an exempt organization's ordinary and routine investments that the IRS determines are substantially similar to these types of income, are excluded in computing unrelated business taxable income. Most royalties are also excluded.
Reporting the Unrelated Activity and Calculating the Tax
If you determine that you have activities that are subject to UBIT, these activities are reported on Form 990-T. It is important to understand the rules and methods of accounting for all expenses that are eligible to offset unrelated activity income. Direct expenses related to the activity such as cost of sales, payroll, rent, etc., should be identified. In addition, indirect and allocable expenses should be calculated. For example, if certain staff members spend a portion of their time on unrelated business activities, their salary and benefits should be calculated and allocated to the activity. Similarly, occupancy and overhead costs should be calculated and allocated.
Other Things to Consider
We have only touched on some of the more common activities. There are many other activities that may require specific treatment, exclusions and exceptions. Research and/or consultation may be needed in certain circumstances.
Organizations can jeopardize their tax-exempt status if the IRS determines that the percentage of their income from business activities unrelated to their specific exempt purposes is excessive. However, the IRS has not defined what percentage of unrelated business income is considered too large. The facts and circumstances of each situation would be considered.
Some organizations with sizable unrelated business activities create separate for-profit entities as subsidiaries for the specific purpose of separating unrelated trade or business activities from the mission-related activities of the tax exempt organization.
It is important that tax exempt organizations consider the nature and extent of all their business activities. Failure to do so could lead to the loss of tax–exempt status.