If certain IRS requirements are met, a nonprofit organization is exempt from federal income tax. But that doesn't mean it's completely off the hook.
Your nonprofit may still be liable for unrelated business income tax. Here's how you determine your organization's exposure.
One Time vs. Year Round
Unrelated business income is defined by the IRS as, "gross income derived by any organization from any unrelated trade or business regularly carried on by it, less the deductions allowed." In other words, if your nonprofit earns a profit from a regular business activity that isn't substantially related to your entity's tax-exempt purpose, it's subject to UBIT.
Take, for example, a tax-exempt educational institution that engages in a one-time sale of t-shirts and hoodies with the school's name. It likely won't be assessed UBIT, even if the clothing sale isn't directly related to its charitable mission. However, if the school sells branded apparel all year round, it probably will be liable for tax on the profits.
The IRS has issued a comprehensive set of UBIT regulations that it applies on a case-by-case basis. Notably, for a trade or business activity to be related to a nonprofit's tax-exempt purpose, it must have a causal relationship and "contribute importantly" to the organization's objective.
The IRS may use a three-part test to determine whether a not-for-profit organization has UBI and is liable for the tax:
- Production of income: Is the organization carrying on a trade or business to produce income from the sale of goods or services? If it doesn't turn a profit, the examination proceeds to part two.
- Regular activities: It must be determined whether the activities are regularly carried out. The IRS will examine the operations and compare them to similar activities by for-profit businesses. Occasional fundraising events may be excluded even if they occur on an annual basis.
- Relation to tax-exempt purpose: The IRS will determine if the activities are substantially related to the organization's tax-exempt purpose. This involves a subjective analysis of particular activities that can be difficult to assess. The IRS may divide activities into "related" and "unrelated" buckets.
Certain items may be exempt from UBIT even if they would trigger tax consequences under the three-part test. These include investment income and capital gains, royalties, rent and income from religious services. Furthermore, the following activities aren't classified as a "trade or business" and thus won't generate UBIT:
- Income from activities where unpaid volunteers conduct substantially all the work,
- Rental of mailing lists provided by one tax-exempt organization to another,
- Distributions of low-cost items with fundraising solicitations,
- Sales of donated merchandise, and
- Bingo income.
With so many exceptions, which activities actually produce UBI?
Advertising: In most cases, advertising income — such as income from ads in publications and on websites — is treated as taxable income unrelated to an organization's tax-exempt purpose. The tax calculations are complex, so leave them to financial professionals.
Consulting: The IRS usually considers consulting services to be taxable, especially if they're customized for a single client. However, broad-based educational efforts may be exempt from UBIT if they're related to an organization's tax-exempt function.
Community benefits: Many nonprofits gear activities toward community improvement. The IRS will examine if public benefits outweigh private interests. It's critical that an organization establishes an underlying purpose for such activities.
Membership requirements: Organizations may charge membership dues for access to certain benefits such as advertising in publications. Typically, this is treated as taxable income.
Logo merchandise: Nonprofits may sell items with logos, including clothing, to the public. However, the burden is on the organization to demonstrate that the activity is substantially related to its tax-exempt mission. Otherwise, profits are subject to UBIT.
Job listings: If an organization provides job listings in exchange for fees, the income often is considered UBI.
In some cases, a nonprofit may partner with a for-profit entity to raise money for charitable purposes. Typically, if the organization assumes a passive role, the income is exempt from UBIT. But tax may result if the organization is active.
If payments for an activity are split (as is the case with some royalty arrangements), qualified sponsorship payments are excluded from taxable income as long as no substantial return benefits are allowed to the sponsor. However, use or acknowledgment of the sponsor's name or logo is allowed.
Similarly, there's a tax exemption for certain activities related to trade shows or conventions, such as exhibit space rentals. Several recent private rulings have exempted nonprofits from UBIT when they've entered into a joint venture with for-profit entities for trade shows or conventions.
When it comes to UBIT, the stakes are high. Nonprofits that don't follow the rules potentially face fines and loss of their tax-exempt status. Contact our nonprofit team to identify any potential UBIT exposure.