Qualified vs. Non-Qualified UBTI: What’s the Difference?

Unrelated Business Taxable Income (UBTI) is the income a tax-exempt organization earns from activities not substantially related to its exempt purpose. The federal government taxes this income to create a level playing field between tax-exempt organizations and for-profit companies engaged in similar commercial activities, preventing an unfair competitive advantage. For an activity to generate UBTI, it must meet three criteria: it must be a trade or business, be regularly carried on, and not be substantially related to the organization’s exempt mission.

The UBTI Siloing Framework

The Tax Cuts and Jobs Act of 2017 (TCJA) introduced a “siloing” framework for calculating UBTI under Internal Revenue Code (IRC) Section 512. Before this change, an organization could aggregate profits and losses from all its unrelated business activities. A loss from one venture, like a bookstore, could be used to offset a gain from another, such as a parking facility, resulting in a lower overall taxable income.

The siloing rule changed this by requiring that each unrelated trade or business be treated as a separate unit, or “silo.” An organization must compute the net income or loss for each business activity independently. The primary consequence is that a net loss from one silo can no longer be used to reduce the taxable income of a profitable silo.

This change requires organizations to methodically track and categorize their revenue-generating activities. The intent was to more accurately measure the profitability of each distinct business line, ensuring that each commercial enterprise is viewed on its own merits for tax purposes.

Identifying Separate Unrelated Trades or Businesses

The first step in applying the siloing rules is to determine what constitutes a “separate” trade or business. The Internal Revenue Service (IRS) directs organizations to use the North American Industry Classification System (NAICS) for this. Organizations identify each unrelated business activity and assign a 2-digit NAICS code that best describes its sector.

For example, a university’s public fitness center might fall under NAICS code 71 (Arts, Entertainment, and Recreation), while its advertising sales would be classified under NAICS code 54 (Professional, Scientific, and Technical Services). Each of these activities represents a distinct silo.

Organizations can change the 2-digit NAICS code for a business, but the change must be reported on Form 990-T for that year. Any Net Operating Losses (NOLs) from the original business activity silo do not transfer to the new silo.

Calculating Tax on Siloed UBTI

After classifying each activity, the organization calculates the UBTI for each silo individually by taking its gross income and subtracting only directly connected deductions. For instance, a museum’s gift shop would subtract the cost of goods sold, shop employee salaries, and a portion of allocated overhead.

If a silo results in a net loss, that loss is trapped and cannot offset income from a profitable silo. The treatment of Net Operating Losses (NOLs) also changed. A distinction is made between NOLs generated before January 1, 2018 (pre-2018 NOLs), and those generated after (post-2017 NOLs).

Pre-2018 NOLs can be deducted against the total UBTI from all profitable silos. Post-2017 NOLs are siloed and can only be carried forward to offset future income from that same specific silo. To determine the final tax liability, the organization sums the UBTI from all profitable silos, deducts any available pre-2018 NOLs, and applies the 21% federal corporate tax rate.

Special Rules for Specific Income Types

Certain income types have unique UBTI rules and are not always siloed based on NAICS codes. One example is income from debt-financed property. This occurs when a tax-exempt organization acquires property using debt and the property’s use is not substantially related to its exempt purpose. A portion of the income generated from this property, such as rent, is treated as UBTI based on the debt-to-basis percentage.

Another special category involves income from controlled entities. Passive income like interest, annuities, rents, and royalties is normally excluded from UBTI. This exclusion may not apply if the income is received from a controlled entity, defined as a subsidiary in which the parent organization owns more than 50% of the voting stock or value. If a controlled subsidiary makes a payment like rent or interest to its parent, that payment could be UBTI to the extent the subsidiary earned the money from unrelated business activities.

Regulations also provide flexibility for investment income, allowing an organization to aggregate UBTI from certain investments into a single “investment activities” silo. This includes income from debt-financed properties, qualifying S corporation interests, and qualifying partnership interests (QPIs). A partnership interest qualifies as a QPI if the organization meets either a “de minimis test” (holding no more than 2% of profit and capital interests) or a “participation test” (holding no more than 20% of the capital interest without significant control).

Reporting UBTI on Form 990-T

Calculated UBTI is reported to the IRS on Form 990-T, Exempt Organization Business Income Tax Return. An organization with more than one unrelated business must complete a separate Schedule A for each silo. This schedule details the calculation of gross income, deductions, and net income for a single business activity and corresponds to one of the NAICS-coded silos.

For instance, a nonprofit with three separate businesses will file three distinct Schedule A forms. The net income or loss from each schedule is carried to the main Form 990-T. On the primary form, the positive income figures from all profitable silos are aggregated to arrive at the total UBTI, which is then used to calculate the final tax liability.