Navigating Unrelated Business Income Taxes for Nonprofits

Navigating Unrelated Business Income Taxes for Nonprofits can be a daunting task, but understanding the basics can help you avoid costly mistakes.

The IRS defines an unrelated business income (UBI) as income from a trade or business that is regularly carried on by a nonprofit organization and is not substantially related to its exempt purpose.

A key factor in determining UBI is whether the business activity is a trade or business, which is defined as an activity involving the exchange of property, services, or both.

The IRS provides a list of activities that are generally considered to be unrelated businesses, including the operation of a golf course, a hotel, or a hospital.

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Income from a trade or business, regularly carried on, that is not substantially related to the charitable, educational, or other purpose that is the basis of the organization's exemption, is considered taxable.

If your tax-exempt organization earns unrelated business income of $500 or more, then you do have to pay taxes on that income.

Unrelated business income tax is a tax on all income earned from an unrelated business activity, minus tax deductions as a result of producing that income.

To determine if an activity is unrelated business, consider the following: Is it a trade or business? Is it regularly carried on? And is it not substantially related to furthering the exempt purpose of the organization?

An activity is considered a trade or business if it's carried on to produce income from selling goods or performing services. For example, an art museum operating a gift shop that sells goods for a profit is in a trade or business.

If the activity is performed frequently and continuously, and operated in a manner similar to comparable commercial activities of nonexempt organizations, it is considered regularly carried on. For example, if the museum operates the gift shop every weekend, year-round, this activity is regularly carried on.

The sale of goods that do not contribute importantly to accomplishing the organization's exempt purposes is not substantially related to furthering the exempt purpose of the organization. For example, t-shirt sales have no relationship to art and do not contribute importantly to accomplishing the museum's exempt educational purposes.

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Unrelated Business Income Taxes (UBTI) are a reality for many tax-exempt organizations. The IRS defines UBTI as income from a trade or business that's not substantially related to the charitable, educational, or other purpose that's the basis of the organization's exemption.

For tax-exempt entities, UBTI was introduced in 1950 to ensure fair competition with taxable companies in profit-generating activities. It also prevents or limits tax-exempt entities from engaging in unrelated business activities.

Most forms of passive income, such as dividends, interest income, and capital gains from the sale or exchange of capital assets, are not treated as UBTI. This means that income from an IRA that invests in traditional equities, mutual funds, and ETFs is unlikely to be subject to UBTI rules.

However, if an investment generates income that qualifies as UBTI, the fund may be subject to taxation. For example, income from a restaurant business that flows into an IRA is considered taxable because the business activity doesn't relate to the tax-exempt purpose of providing a pension to the IRA holder.

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Any exempt organization subject to the tax on unrelated business income is taxable at corporate rates (a federal rate of 21%) on gross income beyond $1,000. Exempt trusts are taxed at trust rates (federal rates from 10% to 37%).

Exempt organizations must file IRS Form 990-T to pay the tax on UBTI. If an organization earns unrelated business income of $500 or more that doesn't fall into the IRS's excluded categories, it must pay taxes on that income.

Here's a summary of the tax rates for UBTI:

Exempt organizations must make estimated tax payments if they expect their tax for the year to be $500 or more. These payments are generally due the 15th day of the 4th, 6th, 9th, and 12th months of the tax year and must total 100% of the organization's total tax liability for that year.

Volunteer labor is excluded from unrelated business income, including activities like volunteer-run bake sales.

Certain types of income are also excluded, such as dividends, interest, royalties, and rental income from real property.

The IRS considers income from the sale of donated merchandise to be exempt from unrelated business income taxes.

Businesses conducted primarily for the convenience of members, students, patients, or employees are also excluded.

Here are some examples of excluded income:

Additionally, income derived from the work of unpaid volunteers and income from trade shows and conventions is excluded.

The "Convenience Exception" is another exemption, provided for the convenience of students, patients, or employees.

Some common UBIT exemptions include:

You'll need to pay taxes on your unrelated business income (UBI) if it exceeds $1,000. This tax is computed at corporate rates, which is a flat rate of 21% of your taxable income.

Exempt trusts are taxed at trust rates, ranging from 10% to 37%, on their unrelated business income. The tax computation can be reduced by applicable tax credits, such as general business credits and foreign tax credits.

To pay the tax, you'll need to file IRS Form 990-T. This form is due by the 15th day of the 5th month after the end of your tax year.

If you expect your tax liability to be $500 or more, you'll need to make estimated tax payments. These payments are due on the 15th day of the 4th, 6th, 9th, and 12th months of your tax year and must total 100% of your total tax liability for that year.

Here's a summary of the tax rates and payment due dates:

Keep in mind that the tax rates and payment due dates may vary depending on your tax year and type of organization. It's essential to consult the IRS guidelines and consult with a tax professional if you're unsure about your specific situation.

Income from investments in certain pass-through entities, such as partnerships, can generate UBTI.

Selling goods or services that are unrelated to an organization's mission can also generate UBTI, according to the IRS.

Testing or other commercial activities on behalf of a private company can be considered an unrelated business activity, making the income taxable.

Here are some examples of UBTI generating activities:

If your tax-exempt organization earns income from activities that aren't directly related to its exempt purpose, you may have to pay taxes on that income. This is known as unrelated business income tax, or UBTI.

Some activities that generate UBTI include buying and selling a significant number of real estate properties in a year, conducting operations in businesses like restaurants or convenience stores, and using margin for a stock purchase. These activities are considered trades or businesses that produce income from selling goods or performing services.

Using margin for a stock purchase is a key example of an activity that can generate UBTI. This is because it involves selling goods or performing services, and is regularly carried on in a way that's similar to commercial activities of nonexempt organizations.

Conducting operations in businesses like restaurants or convenience stores can also generate UBTI. These businesses generate active income and are often operated through a pass-through entity like an LLC or MLP.

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Making multiple private loans in a year can also be considered an unrelated business activity, which can generate UBTI. This is because it involves selling goods or performing services, and is regularly carried on in a way that's similar to commercial activities of nonexempt organizations.

Here are some examples of activities that may be considered unrelated business activities:

Organizations must make estimated tax payments if they expect annual unrelated business income tax to be $500 or more.

Advertising can be a source of unrelated business income (UBTI) for nonprofit organizations. If a nonprofit sells advertisements that promote the advertiser's business, not the organization's, the income is considered UBTI.

Advertising in a nonprofit's publication, such as a newsletter or magazine, is taxable even if the publication contains editorial matter related to the organization's exempt purpose. This is because the sale of commercial advertising is considered taxable under IRC 513(c).

However, if the advertising serves an "informational function" or is part of an instructional program, it may be considered related to the organization's exempt purpose. For example, a campus newspaper operated by students publishing paid advertising may be considered related to the University's educational program if students are involved in the solicitation, sale, and publication of the advertising.

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Here are some key factors to consider when determining if advertising is taxable:

Some examples of non-taxable acknowledgements of corporate sponsorship payments include:

Rental is a common activity that can generate UBTI, but there are some exceptions. Income from the rental of real property is taxable unless it's rented in conjunction with the rental of personal property, also known as a mixed lease.

Rental income from personal property is generally taxable, but there are some exceptions. For instance, if the rental is not regularly carried on, it might be exempt from UBTI. Alternatively, if the rental is substantially related to the University's exempt purposes, it's also exempt.

Some rentals are exempt from UBTI, such as those primarily for the convenience of students, faculty, or staff. Rental income from personal property rented for substantially below market rates may also be exempt.

Here's a summary of the exceptions to rental income being taxable:

Joint ventures can be a complex issue for tax-exempt organizations, as they require careful consideration to avoid generating unrelated business taxable income (UBTI).

Income from a joint venture will not be taxable if the undertaking contributes importantly to the University's exempt purpose.

However, joint ventures have been scrutinized by the IRS to ensure that a tax-exempt organization is not serving the private purposes of the for-profit entity.

Tax-exempt organizations must ensure that any joint venture relationship is legitimate and not used to benefit the for-profit partner.

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