While almost all activities that nonprofit organizations work on are exempt from income tax, if an organization generates income from an activity unrelated to its charitable mission, this will result in the organization owing unrelated business income tax (UBIT). If $1,000 or more of income is generated, you are required to file a Form 990-T, even if you are not required to file the main Form 990; this includes churches and religious organizations. Additionally, if you expect to owe $500 or more of taxes, you must make quarterly payments on the estimated tax.
There are 3 criteria to determine if activity is an unrelated business, that would result in paying UBIT:
- It is a trade or business, carried on with the intent of making a profit.
- It is regularly carried on, even if it’s only seasonal and not year-round.
- It is not substantially related to furthering the exempt purpose of the organization.
The first 2 criteria are fairly self-explanatory, and the third is the most often to result in confusion. To be substantially related to the organization’s exempt purposes, it must contribute in a significant way to accomplishing the purposes for which the organization is tax-exempt. Using the income from the business to fund other parts of the organization doesn’t make it substantially related.
Articles from Nonprofit Quarterly and the Nonprofit Law Blog delve into deep detail and provide several examples of activities that may or may not be considered unrelated business income (UBI). For example, a university charging tuition is a business, and regularly carried on, but is related to the university’s exempt mission of providing education. Similarly, when a church’s congregants pay membership dues, this falls under the church’s religious function, its exempt purpose.
On the contrary, if a school raises funds by opening a clothing store, this doesn’t fall within the school’s exempt purposes and would be considered UBI. Despite the fact that the profits of the store help fund the school’s exempt purpose of educating students, the activity itself, selling clothing, is not part of the school’s exempt purpose.
Another factor to consider is whether the UBI is substantial. If it is insubstantial, the organization would pay UBIT to the IRS. If the income is substantial, in light of the rest of the organization’s activities, the organization runs a risk of losing its tax-exempt status. Since the source of your tax exemption is being primarily engaged in 501(c)(3) tax-exempt activities, this must drive what activities your organization focuses on.
There are a handful of exceptions under which unrelated, regularly carried on business activities do not result in UBIT. They include:
- Convenience exception – when the business is carried on for the convenience of the organization’s members, students, patients, officers, or employees; for example, a restaurant run by a hospital that primarily serves staff, patients, and visitors.
- Sale of donated property; for example, at thrift shops or bake sales.
- Work performed by unpaid volunteers
- Passive investments – e.g. dividends, royalties, interest, capital gains, income from renting out real estate
The IRS can also use the “fragmentation rule” when reviewing an organization’s activities for UBI. This looks at each source of revenue to determine which specific activities are, or are not, related to the organization’s exempt purpose. For example, if your organization publishes a periodical, proceeds from selling the periodical will likely be considered a related activity, but if you sell ads in the periodical, the advertising revenue is unrelated.
Similar to a Form 990, organizations that file a Form 990-T must make it available for public inspection. This includes the form itself, plus any schedules, attachments, and supporting documents relating to UBIT being imposed on the organization. The documentation must be available for 3 years, beginning on the last day for filing the return.