Pub. 3402: Tax on Unrelated Business Income

Tax-exempt organizations operate under a general shield from federal income tax, but this protection is not absolute. Certain activities can generate income that is taxable, known as Unrelated Business Income (UBI), which is subject to the Unrelated Business Income Tax (UBIT). The purpose of this tax is to ensure that tax-exempt entities do not have an unfair competitive advantage over for-profit businesses. The Internal Revenue Service provides detailed guidance in Publication 598, “Tax on Unrelated Business Income of Exempt Organizations.”

Defining Unrelated Business Income

For income to be classified as UBI, the IRS requires that it meet three criteria. If an activity fails to meet even one of these conditions, the income it generates is not subject to UBIT. The analysis requires a close look at the nature of the activity itself.

The first test is whether the activity constitutes a trade or business, which includes almost any activity carried on to produce income from selling goods or performing services. This definition focuses on the intent to profit, not whether a profit is actually made. The IRS aligns this with the definition used under Internal Revenue Code Section 162.

An activity must also be “regularly carried on.” This test examines the frequency and continuity of the income-producing activities in comparison to how a similar for-profit business would operate. For example, a university operating a public parking lot year-round would meet this standard, while a student group’s car wash held one weekend a year or an annual fundraising dinner would not.

The final criterion is that the trade or business is “not substantially related” to the organization’s exempt purpose. The activity itself must contribute importantly to achieving the organization’s mission, aside from the need for funds. For instance, a museum that sells prints of its collection in a gift shop is conducting a related activity. If that same museum were to operate a gas station, the income would be unrelated because it does not contribute to its artistic or educational purpose.

Exclusions from Unrelated Business Income

The Internal Revenue Code excludes certain categories of passive income and other revenue sources from UBIT, even if the activity meets the three-part test. These exclusions recognize that nonprofits often hold investments to support their operations. Common exclusions include:

• Dividends, interest, annuities, and payments with respect to securities loans. This allows a nonprofit to maintain an endowment or investment portfolio without triggering UBIT on the returns.
• Royalties, which are payments received for the right to use intangible property such as patents, copyrights, and trademarks.
• Rents from real property, such as land and buildings. However, this exclusion does not apply if the nonprofit provides substantial personal services to the lessee, or if the rent amount is based on a percentage of the lessee’s net income.
• Gains or losses from the sale, exchange, or other disposition of property. This exclusion does not apply to property held as inventory or stock in trade for sale to customers in the ordinary course of business.

Exceptions to Unrelated Business Income Rules

Beyond specific income exclusions, the tax code also provides several broad exceptions for certain types of activities. These exceptions can shield an entire trade or business from UBIT based on how it is conducted.

• Any trade or business where substantially all the work is performed for the organization without compensation. This is known as the “volunteer labor” exception and is generally met if at least 85% of the work is done by volunteers.
• Activities conducted by a 501(c)(3) organization or a government college or university primarily for the convenience of its members, students, patients, officers, or employees. A hospital cafeteria or a university laundry service for students would fall under this exception.
• The sale of merchandise that was received by the organization as a gift or contribution. This is the basis for the tax-exempt status of most thrift stores operated by charitable organizations.
• Qualified sponsorship payments for which the sponsor does not receive any substantial return benefit other than the use or acknowledgment of its name, logo, or product lines. If the nonprofit provides advertising services in return, the payment may be treated as taxable income.

Calculating and Reporting the Tax

An organization with UBI must calculate and pay the associated tax, which is figured at corporate tax rates. To calculate the taxable income, an organization can deduct expenses that are “directly connected with” the carrying on of the unrelated trade or business. Expenses attributable to both exempt and unrelated activities must be allocated on a reasonable basis.

The tax is reported on Form 990-T, “Exempt Organization Business Income Tax Return.” This form must be filed by any exempt organization with a gross income of $1,000 or more from an unrelated business. The filing of Form 990-T is a separate requirement from an organization’s annual information return, like Form 990, and is due by the 15th day of the 5th month after the end of the tax year.

If an organization expects its UBIT for the year to be $500 or more, it must make quarterly estimated tax payments. These payments are due on the 15th day of the 4th, 6th, 9th, and 12th months of the tax year. Failure to make these payments on time can result in penalties.