Even though an organization is recognized as tax-exempt, it still may be liable for tax on its unrelated business taxable income.
The unrelated business income tax (UBIT) is not a penalty imposed on tax-exempt organizations. It is a tax designed to level the playing field when it is perceived that tax-exempt organizations are competing with commercial businesses.
An exempt organization that has $1,000 or more gross income from an unrelated business must file Form 990-T, Exempt Organization Business Income Tax Return.
The tax is generally imposed on net income from the unrelated business activity at rates applicable to corporations, ranging from 15-35 percent. To calculate the net profit, the tax-exempt organization can reduce the gross income by expenses incurred in conducting the business activity.
Any tax due with Form 990-T is generally referred to as the unrelated business income tax. For most tax-exempt organizations, an activity is an unrelated business and subject to UBIT if it meets three requirements:
1. The activity constitutes a trade or business. Generally, a trade or business is any activity carried on for the production of income from selling goods or performing services. An activity will not be considered related simply because it is carried on within the framework of a larger exempt activity. For example, advertising revenue from an academic periodical will be considered unrelated even though the overall activity, the publication of the periodical, is related to the organization’s exempt purposes.
2. The activity is regularly carried on. Business activities of an exempt organization ordinarily are considered regularly carried on if they show a frequency and continuity and are pursued in a manner similar to comparable commercial activities of nonexempt organizations. Thus, an activity may be regularly carried on even if it is conducted seasonally, if that period is similar to the time frame for the activity when conducted by for-profit entities.
3. The activity is not substantially related to furthering the exempt purpose of the organization. A trade or business is related to the exempt purposes only when the conduct of the business activities has a causal relationship to achieving the exempt purposes, other than through the production of income. This causal relationship must be substantial. The activities that generate the income – not the use of that income – must contribute importantly to accomplishing the organization’s exempt purposes. A failure to meet these standards will lead to a conclusion that the activity is not substantially related.
Note that an unrelated business activity could be conducted directly by the tax-exempt organization or indirectly, such as by a partnership in which the tax-exempt organization is a partner. If the activity is conducted by a partnership, the exempt organization has unrelated business income equal to its share of the partnership’s business income that would be unrelated income if the tax-exempt organization conducted the activity directly.
The Internal Revenue Code contains a number of modifications, exclusions and exceptions to unrelated business income. For example, dividends, interest and certain other investment income are excluded when computing unrelated business income.
In addition, the following activities are specifically excluded from the definition of unrelated trade or business:
- Any trade or business in which substantially all the work is performed for the organization without compensation. Some fundraising activities, such as volunteer-operated bake sales, may meet this exception.
- Any trade or business that is carried on by an organization described in Section 501(c)(3) or by a governmental college or university primarily for the convenience of its members, students, patients, officers or employees. A typical example under this exception is a school or museum cafeteria.
- Any trade or business that consists of selling merchandise, substantially all of which the organization received as gifts or contributions. Many thrift shops operated by exempt organizations meet this exception.
- Certain bingo games.
The Internal Revenue Code provides special unrelated business taxable income rules for certain organizations such as a social club (501(c)(7)), a VEBA (501(c)(9)), a supplement unemployment benefit trust (501(c)(17)) or a group legal services organization (501(c)(20)).
The unrelated business taxable income of these organizations includes all gross income less the deductions directly connected with producing that income, but not including exempt function income.
Exempt function income is gross income from dues, fees, charges or similar items paid by members for the purposes for which exempt status was granted to the organization.
This definition can often result in the organization’s investment income being subjected to the UBIT. However, the investment income of these types of organizations generally is not taxed if it is set aside to be used for religious, charitable, scientific, literary or educational purposes or for the prevention of cruelty to children or animals.
In addition, for a Section 501(c)(9), 501(c)(17), or 501(c)(20) organization, investment income is generally not taxed if it is set aside to provide for the payment of life, medical, accident or other benefits.
In theory, the IRS could revoke an organization’s tax-exempt status if there is too much unrelated business income. This revocation would be based upon the conclusion that the exempt activities of the entity are no longer its principal activity. Unfortunately, the IRS has provided little in the way of useful guidance for determining what constitutes too much unrelated business activity.
This is the first in a series of articles exploring the world of unrelated business income. Subsequent articles will delve more deeply into some of the more common types of unrelated business income.