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How the Unrelated Business Income Tax Can Affect Nonprofits

How the unrelated business income tax can affect nonprofits by davis law group pc in chesapeake, virginia

How the Unrelated Business Income Tax Can Affect Nonprofits

April 18, 2024 Davis Law Group

Tax-exempt 501(c)(3) organizations must operate primarily to achieve religious, charitable, scientific, or educational purposes and may not carry on more than an insubstantial amount of commercial activity unrelated to its charitable purposes. Nonetheless, income generated from insubstantial trades or businesses may be subject to a federal unrelated business income tax (UBIT). Income from activity is subject to the UBIT if the activity (1) is a trade or business (2) that is regularly carried on and (3) is not substantially related to the charitable purpose of the organization.

An activity conducted with the intent to make a profit constitutes a trade or business. An activity is “regularly carried on” if it is done with a frequency and continuity comparable to the commercial activities of non-exempt organizations. The theory behind the UBIT is to prevent tax-exempt organizations from having an unfair advantage when competing with taxed organizations. When a 501(c)(3) operates an insubstantial trade or business to generate income, it would be unfair for that income to go untaxed when the activity does not achieve an exempt purpose.

Finally, an activity is not substantially related to the organization’s exempt purpose if it does not contribute importantly to accomplishing that purpose. It is the source of the funds that matters as opposed to how the funds are used. Just because the organization uses the profits generated from its side business to fund the organization’s exempt activities does not protect the income from being taxed.

Let’s look at an example.

Say a church sells Christmas trees during November and December each year to raise money for its missionary programs. This activity would be a “trade or business” because the church’s primary intent is to make a profit to fund one of its programs. Even though the activity is not carried on throughout the year, non-exempt organizations generally only sell Christmas trees during the holiday season. Therefore, the church is competing with taxed organizations because it carries on the trade with similar frequency and continuity. The activity is not substantially related to the organization’s exempt religious purpose because the main aim is to raise money. Even though the money will go toward funding the church’s missionary programs (which is clearly religious), it is the source of the funds—not the use of the funds—that matters. For the funds to be exempt from taxation, the church would need to show how the activity of selling Christmas trees contributes to accomplishing its religious purpose rather than how the money raised accomplishes its religious purpose. Here, the Christmas tree sales would be subject to the UBIT.

The IRS has specifically exempted some activities from the UBIT. Any trade or business substantially carried out by volunteers (uncompensated workers) will not be taxed. This exempts many fundraising activities from federal taxation. If, in the above example, the Christmas tree sales are done substantially by volunteers, then the generated income would be exempt from the UBIT. Additionally, any trade or business carried on primarily for the convenience of its members, officers, or employees will not be taxed. A great example of this is a school cafeteria.

Furthermore, a trade or business that mostly sells donated merchandise would not be taxed. Therefore, thrift shops operated by exempt organizations would likely be exempt from the UBIT. Tax-exempt groups also may provide low-cost articles to individuals when trying to solicit donations through the mail without being taxed on the cost of the articles or on the donations received. The IRS has also exempted income derived from normal investments from the UBIT.

The income subject to the UBIT is taxed at corporate rates. A tax-exempt organization must file Form 990-T to report all unrelated business income if it receives $1,000 or more in gross income from the business. This requirement is in addition to its obligation to file Form 990 each year. If the organization estimates that its tax will be $500 or more, the organization must make estimated quarterly tax payments using Form 990-W. These payments are generally due by the 15th day of the 4th, 6th, 9th, and 12th months of the organization’s tax year.

Tax-exempt organizations that carry on trades or businesses subject to the UBIT must ensure that their commercial activities do not become substantial. To maintain its exemption, a tax-exempt organization must pass the “operational test.” This test requires that a tax-exempt organization operate primarily to achieve an exempt purpose listed in § 501(c)(3), such as a religious, charitable, scientific, or educational purpose. If more than an insubstantial amount of the organization’s activities accomplish a different purpose, such as generating income (a commercial purpose), then the organization may be at risk of losing its tax-exempt status.

There is no exact point at which an activity becomes “substantial.” Rather, the IRS looks at various factors to determine whether a commercial activity is too substantial for a tax-exempt group to maintain its exemption. The IRS considers whether

    • the organization’s activities looks more like a business or a charitable organization,
    • the primary activity is characteristic of a trade or business,
    • the organization competes with commercial businesses,
    • the organization receives profits,
    • the organization advertises its business activities to the public,
    • the organization provides free or below-cost provision of goods and services,
    • the organization’s activities are performed by volunteers,
    • the organization relies on donated goods for its business activities, and
    • benefits from the organization are limited to customers.

Contact Davis Law Group

Determining whether an activity is subject to UBIT is complicated, and it is often best practice to engage an experienced charitable law attorney. If you have any questions about which of your organization’s activities might be subject to the UBIT or about preserving your tax-exempt status, make an appointment with our non-profit attorney today.