Nonprofits Must Pay Taxes on Unrelated Business Income
Nonprofit organizations, e.g., charities, were historically not taxed. In 1950, however, an amendment to the Internal Revenue Code made taxable income earned from activities that did not further the tax-exempt purposes of such organizations.
Unrelated Business Income
Income earned from activities unrelated to the organization’s charitable purpose was termed “unrelated business income” (UBI) and such income became subject to an “Unrelated Business Income Tax” (UBIT). This tax is essentially the same as the corporate taxes that a company operated for profit would have to pay on similar activities. An activity is “unrelated” and thus subject to UBIT if three requirements are met:
- UBI is earned from a “trade or business,” defined as any activity carried on for the production of income from selling goods or performing services;
- The trade or business is regularly carried on, which means that there is a frequency and continuity, such that the activity is pursued in a way comparable to taxable organizations; and
- The trade or business is not “substantially related” to furtherance of the organization’s exempt purposes. In making such a determination, the Internal Revenue Service (IRS) considers whether the conduct of the activities that generate the income have a “causal relationship” to achieving the tax-exempt purposes of the organization, other than merely through the production of income. Simply funding the exempt activities is not enough.
Determining whether the three requirements have been met may be difficult; the third requirement in particular is often difficult to determine. For example, exempt museums often have a gift shop selling art reproductions and art books. One of the museum’s exempt purposes is likely furthering art appreciation within the community, so such sales may further that purpose and thus is not UBI. If, however, the shop also sells scientific books and souvenirs of the city where the museum is located, such sales arguably do not further the exempt purpose of the museum and such sales will be treated as UBI, and will be subject to UBIT.
Exceptions to UBIT Treatment
Under certain circumstances, unrelated business activities may not be subject to UBIT, including:
- If substantially all the work is performed by volunteers, without compensation. For example, a volunteer operated bake sale is not subject to UBIT.
- For certain organizations or public colleges and universities, activities carried on primarily for the benefit of the members, students, patients, officers, or employees are not considered UBI. Typical examples are school cafeterias or a laundry operated by a college to launder dormitory linens and student clothing, or the sale of work-related clothing and equipment at trade union job sites.
- Any activity or business, such as a “thrift shop” run by an exempt organization, where substantially all of the merchandise being sold has been acquired by gift or donation is exempt from treatment as UBI.
- Soliciting and receiving “qualified sponsorship payments” is not considered UBI, if they are payments, received by an exempt organization, where sponsors receive no substantial benefit, other than use of a business name, logo, or product lines in connection with exempt activities, i.e., a promise to use the donor’s name or logo acknowledging the donation during a fundraising or other event. The acknowledgment cannot constitute advertising sponsors’ products or services, which may make such donations UBI.
- Certain bingo games are not considered UBI if they meet the applicable definition of bingo, are legal where played, and are played in a jurisdiction where bingo games are not regularly carried on by for-profit organizations.
- An exempt hospital providing certain hospital services at or below cost to other exempt hospitals that have 100 or fewer patients.
- Qualified public entertainment activities, such as those traditionally conducted at an agricultural fair or exhibition, and qualified convention or trade show activities.
Exemptions and Deductions from UBIT Treatment of Income
UBI may be taxable, but a portion of such income may be exempt from UBIT, under certain circumstances and subject to exceptions, including:
- Dividends, interest, annuities, and other investment income.
- Rents from real property (but usually not from personal property).
- Income from research.
- Gains and losses from the sale, exchange, or other disposition of certain property.
In general, the organization may deduct from UBI the expenses, depreciation, and other commonly allowable income tax deductions, but only if they are solely and directly connected with carrying on the unrelated trade or business, i.e., they must have a proximate and primary relationship to carrying on the trade or business.
Only organizations with more than $1,000 in UBI are required to file a special UBIT tax return (in addition to regular tax returns for the organization). The IRS asserts that 38,040 organizations filed UBIT returns in 2004 with gross UBI of nearly $9.5 billion. After various deductions, however, the amount of taxable UBI was only just under $1.3 billion.
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