It may not be common knowledge to the layman, but even organizations that have been granted tax-exempt status by the Internal Revenue Service (IRS) may need to pay income tax. If you’re an officer or board member for a nonprofit organization, or even an employee with responsibilities for the finance or accounting functions of the organization, you’re going to need to understand the basics about unrelated business income tax (UBIT). In the first article of our UBI series, we’re going to give you an overview of the IRS rules pertaining to UBIT.
Q: How does the IRS determine what income is subject to unrelated business income tax?
A: For most organizations, an activity is an unrelated business (and subject to unrelated business income tax) if it is:
- A trade or business
- Regularly carried on, and
- Not substantially related to furthering the exempt purpose of the organization.
As is often the case with our tax code, there are a number of modifications, exclusions, and exceptions to the general definition of unrelated business income. For example, dividends and interest and certain other types of investment income are excluded from the definition of an unrelated trade or business. There are many others unrelated to investments as well.
Q: What does the IRS consider a trade or business?
A: The IRS defines this broadly. Generally, any activity carried on for the production of income from selling goods or performing services meets the definition of a trade or business, even if the income generated from the activity is ultimately used to further the organization’s exempt purpose. It is the nature of the activity that matters, not how the money is used.
Q: What about “regularly carried on”? What does that mean?
A: Here’s the IRS’s take: “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.” There is no hard and fast rule for what frequency crosses the line into “regularly carried on”. For example, if your organization sells Christmas cards only once per year around the holidays, it may still be considered “regularly carried on” since that’s the norm. However, if you have an annual golf tournament and earn registration fees from that, it is unlikely to be considered regularly carried on because it could theoretically be done almost any time of the year, but you’ve chosen to do it only once.
Q: How do you determine if an activity is “substantially related” to your exempt purpose?
A: This is based on the specific facts and circumstances. There are just too many possibilities for the IRS to give specific guidance about this in the tax code. They do, however, give some broad guidance:
“[A] trade or business is related to exempt purposes, in the statutory sense, only when the conduct of the business activities has causal relationship to achieving exempt purposes (other than through the production of income). The causal relationship must be substantial. The activities that generate the income must contribute importantly to accomplishing the organization’s exempt purposes to be substantially related.”
You can see that one isn’t black and white. There have been IRS revenue rulings and court cases over the years that provide a little more information for some specific sets of circumstances. For example, merchandise sales by an exempt organization whose exempt purpose was to support wildlife conservation was considered “related” when the merchandise had wildlife designs on them because it generated interest in wildlife conservation. Conversely, selling pillows stuffed in the shape of a fish was not considered substantially related to the exempt purpose of an aquarium.
This certainly won’t get you all the way to a full understanding of UBI, but it should get you headed in the right direction. Keep an eye out for other articles in our UBI series in the future. In the mean time, if you want to take a deeper dive, please feel free to contact us
. We’d be glad to help.