Can a Non Profit Earn Interest Income?

Non-profit organizations often seek ways to ensure their financial stability and expand their mission-driven activities. Non-profits are generally permitted to earn interest on their assets, which can be a valuable component of their overall financial health. This capability allows organizations to build reserves, support ongoing operations, and fund future initiatives, contributing to long-term sustainability.

Allowable Interest-Earning Investments

Non-profit organizations typically utilize various financial instruments to earn passive interest income. These investments are characterized by their non-operational nature, meaning they do not involve active trade or business activities. Common examples include:
Traditional savings accounts, which offer a secure way to hold funds while accruing interest.
Money market accounts, which provide a slightly higher interest rate than standard savings accounts, offering liquidity with competitive returns.
Certificates of Deposit (CDs), where funds are deposited for a fixed period at a set interest rate, generally yielding higher returns than savings or money market accounts in exchange for less liquidity.
Certain types of bonds, such as government bonds or highly-rated corporate bonds, which pay regular interest to the bondholder.
These investment vehicles are widely used because they typically generate income without requiring significant management or involvement in commercial operations.

Protecting Tax-Exempt Status

Earning passive interest income generally does not jeopardize a non-profit organization’s tax-exempt status under IRS regulations. The Internal Revenue Service (IRS) recognizes that tax-exempt organizations, such as those classified under Section 501(c)(3) of the Internal Revenue Code, need to manage their assets to support their charitable, educational, or religious purposes. Passive income derived from investments, including interest, is typically considered “exempt function income” when it is used to further the organization’s mission. The distinction lies in the nature of the income generation. Income from passive sources, like interest, is generally viewed as distinct from income generated by an active trade or business. As long as the interest income is truly passive and not derived from an activity that constitutes an unrelated trade or business, it typically remains exempt from federal income tax. This framework allows non-profits to prudently manage their financial resources without risking their tax-exempt standing.

When Interest Becomes Unrelated Business Income

While passive interest income is generally not taxed for non-profits, specific circumstances can transform it into Unrelated Business Taxable Income (UBTI). UBTI refers to income from a trade or business regularly carried on by a tax-exempt organization that is not substantially related to its exempt purpose. The primary goal of UBTI rules is to prevent non-profits from having an unfair advantage over for-profit businesses.

One common scenario where interest income may be classified as UBTI involves debt-financed property. If a non-profit acquires income-producing property with borrowed funds, a portion of the income, including interest, generated from that property can be subject to UBTI. For instance, if an organization purchases a rental property using a mortgage, the rental income and any associated interest income may be treated as UBTI in proportion to the outstanding acquisition indebtedness. The IRS applies a proportional method, meaning the percentage of income subject to tax corresponds to the debt-financed percentage of the property. If 75% of a property was financed by debt, then 75% of the income from that property could be taxable as UBTI. This rule applies even if the property’s income is used to support the non-profit’s exempt purpose; the key is the debt financing of the asset itself.

Another instance where interest income could become UBTI is if the non-profit is actively engaged in a lending business, rather than merely holding investments. If the organization’s activities involve regularly making loans for profit as a primary function, the interest earned from these loans may be deemed income from an unrelated trade or business. This differs significantly from simply holding interest-bearing bank accounts or bonds. The IRS evaluates whether the activity is conducted with the intention of generating income from the sale of goods or the performance of services, and if it is regularly carried on in a manner similar to a commercial enterprise. If the lending activity meets these criteria, the interest income would be subject to UBTI. However, most passive investment income, such as interest from conventional bank accounts or publicly traded securities, is typically excluded from UBTI calculation unless generated from debt-financed assets or an active, unrelated trade or business.

Reporting Requirements

Non-profit organizations are required to report their financial activities to the Internal Revenue Service annually. The specific form depends on the organization’s size and type. Most tax-exempt organizations file a form from the 990 series, including:
Form 990 for organizations with gross receipts of $200,000 or more, or total assets of $500,000 or more.
Form 990-EZ or Form 990-N for smaller organizations.
Form 990-PF for private foundations, regardless of financial size.
These forms provide transparency regarding the organization’s mission, programs, and financial health.

If a non-profit organization generates gross unrelated business income of $1,000 or more during the tax year, it must file Form 990-T, Exempt Organization Business Income Tax Return. This form is specifically used to report and calculate federal income tax on UBTI. The organization must report each unrelated trade or business activity separately on Schedule A of Form 990-T. Accurate and timely filing of these forms is essential for maintaining tax-exempt status and complying with federal regulations.