Section 513: Defining Unrelated Business Income

Organizations that are tax-exempt under Section 501 of the Internal Revenue Code do not pay federal income tax on activities related to their mission. However, if a nonprofit earns income from an activity that resembles a commercial business and is not linked to its core purpose, that income may be taxed as unrelated business income. This tax ensures that nonprofits do not have an unfair competitive advantage over for-profit businesses. The Internal Revenue Service (IRS) provides guidelines to determine when an activity becomes a taxable venture.

The Three Criteria for Unrelated Business Activity

For income to be classified as unrelated business income, the activity must meet three specific conditions. The IRS applies this three-pronged test, and all conditions must be present for the income to be potentially taxable.

A Trade or Business

The first criterion is whether the activity constitutes a “trade or business,” which is any activity performed to generate income from selling goods or services. The primary element is the intent to produce a profit, even if the activity is not ultimately profitable. The IRS looks for commercial characteristics like advertising, standard business hours, and competition with for-profit companies. For example, a hospital pharmacy selling to patients is a related activity, but if that pharmacy also sells to the general public, that portion of its operation is a trade or business because it competes with commercial pharmacies.

Regularly Carried On

The second test is whether the business activity is “regularly carried on,” meaning it is conducted with a frequency and continuity similar to comparable commercial ventures. The analysis considers the typical business season for that type of enterprise. For instance, a one-time annual charity auction is not regularly carried on, but a nonprofit gift shop open to the public year-round would be. The comparison is against the normal timeframe and manner in which for-profit businesses conduct the same type of activity.

Not Substantially Related

The final criterion is whether the activity is “substantially related” to the organization’s exempt purpose. The activity must contribute importantly to the organization’s mission beyond simply providing funds; the activity itself must be part of achieving that mission. For example, a museum cafeteria for visitors is a related activity because it furthers the educational mission by allowing patrons to stay longer. However, if the museum operated an off-site restaurant for the public, the income would be unrelated as the restaurant’s operation does not have a substantial causal connection to the museum’s purpose of displaying art or history. The scale of an activity is also considered, as any portion conducted on a larger scale than necessary may be deemed unrelated.

Statutory Exclusions from Unrelated Business Income

Even if an activity meets all three criteria, the income may not be taxable. Congress has created several statutory exceptions that shield certain types of income from UBIT.

• Volunteer Workforce: An exclusion applies to a trade or business where “substantially all” of the work is performed by volunteers. The IRS interprets this as 85% or more of the total work hours being performed by uncompensated individuals.
• Convenience of Members: An activity conducted by an organization or a state college or university primarily for the convenience of its members, students, patients, or employees is excluded. This covers operations like a hospital cafeteria for patients or a university laundry service for students.
• Sale of Donated Merchandise: The sale of merchandise is not an unrelated business if substantially all of it was received by the organization as donations. This exclusion is the basis for most charitable thrift stores.
• Qualified Sponsorship Payments: A “qualified sponsorship payment” is not taxable. This applies when a sponsor receives no substantial return benefit beyond the use or acknowledgment of its name or logo. If the nonprofit provides endorsements or calls to action, the payment may be considered taxable advertising income.
• Certain Bingo Games: Specific bingo games are excluded if they are legal under state and local law and do not compete with for-profit bingo operations in the same jurisdiction.

Tax Implications and Reporting Requirements

If an organization has unrelated business income, it is subject to the Unrelated Business Income Tax (UBIT). This tax applies only to the net income from the specific unrelated activities, not the organization’s total revenue. The tax is calculated using either corporate or trust tax rates, depending on the nonprofit’s structure. Most incorporated nonprofits pay the flat 21% federal corporate income tax rate on their net UBI.

An organization must report its unrelated business income and pay any tax due if it has $1,000 or more in gross income from all unrelated business activities for the year. To do so, the organization must file Form 990-T, “Exempt Organization Business Income Tax Return,” which is separate from its annual information return.

The tax is calculated on net income, allowing an organization to deduct expenses that are “directly connected” with the unrelated business. For instance, a retail store can deduct the cost of goods sold, employee salaries, and rent from its gross sales. If an organization has multiple unrelated businesses, the net income or loss for each must be calculated separately.