What Is Commercial Activity Income for Tax Purposes?

Commercial activity income is revenue from selling goods or services in a business-like manner. Its specific tax consequences depend on the context. For a tax-exempt organization, it can refer to income subject to federal tax, while for a for-profit business, it may define the base for a state-level tax.

The way this income is taxed varies between federal and state jurisdictions and is applied differently to for-profit and nonprofit entities.

Defining a Commercial Activity for Tax Purposes

For tax purposes, an activity is considered commercial if it meets two criteria. The first is that the activity must be a “trade or business,” which is any activity carried on to produce income from selling goods or providing services.

The primary test is the intent to generate a profit, regardless of whether one is actually realized. An activity with a clear profit motive is considered a trade or business even if it loses money, which distinguishes it from a hobby. The focus is on the operational intent.

The second criterion is that the activity must be “regularly carried on.” This is based on the frequency and continuity of the activities compared to similar for-profit businesses. An activity conducted year-round, even if only one day a week, is considered regularly carried on.

A brief, intermittent activity, like a one-time bake sale, would not meet this standard. In contrast, a coffee shop operated by a group that is open to the public every weekday would be seen as regularly carried on. The purpose of this rule is to place exempt organization business activities on the same tax footing as the nonexempt businesses they compete with.

Application for Tax-Exempt Organizations

The concept of commercial activity income is relevant for tax-exempt organizations, such as those under Internal Revenue Code Section 501(c)(3). Although exempt from federal income tax, they can be subject to the Unrelated Business Income Tax (UBIT). The IRS uses a three-part test to determine if income is taxable: it must be a trade or business, be regularly carried on, and not be substantially related to the organization’s exempt purpose.

If an activity fails either of the first two tests—being a trade or business and being regularly carried on—it does not generate unrelated business income.

The most complex part of the analysis is determining if an activity is “substantially related” to the organization’s exempt mission. A related activity must contribute importantly to accomplishing the organization’s purpose in a way other than just producing income. For example, a university art museum selling prints of works from its collection is a related activity because it furthers the museum’s educational purpose.

Conversely, if that same museum began selling consumer electronics, that activity would be unrelated as it does not contribute to its educational purpose. Similarly, a hospital pharmacy that sells to the general public is conducting an unrelated trade or business. The IRS can use a “fragmentation rule” to separate a single business into related and unrelated components for tax purposes.

State-Level Gross Receipts Taxes

Separate from the federal UBIT, “commercial activity” is central to a state-level tax known as a Commercial Activity Tax (CAT). A CAT is a gross receipts tax imposed on a business’s total revenues without deductions for expenses like cost of goods sold or salaries. This tax applies to the privilege of doing business in the state and covers most business entities.

For a state to impose its CAT, the business must have a sufficient connection, or “nexus,” with that state. Nexus is established through a physical presence, like an office, or through “economic nexus,” where a business is subject to tax if its sales into the state exceed a specific threshold.

Once nexus is established, a business uses “sourcing” rules to determine which gross receipts are taxable in that state. For sales of tangible property, receipts are sourced to the location where the property is received by the purchaser. For services, receipts are sourced to the state where the benefit of the service is received.

These state-level taxes have high revenue thresholds, meaning many small businesses are not required to pay. This structure focuses the tax on larger enterprises with a significant commercial footprint.

Calculating and Reporting Taxable Income

The methods for calculating and reporting taxable income from commercial activities differ between the federal UBIT system and state-level gross receipts taxes.

For Tax-Exempt Organizations

For a tax-exempt organization, the taxable amount is the gross income from the unrelated business minus directly connected expenses, such as salaries and rent. After calculating this net income, the organization is permitted a specific deduction of $1,000, and only the excess amount is subject to tax. This tax is reported to the IRS on Form 990-T, the Exempt Organization Business Income Tax Return.

UBTI must be calculated separately for each business activity, which prevents an organization from using losses from one unrelated business to offset income from another. A separate Schedule A is filed for each distinct unrelated trade or business.

For State Gross Receipts Taxes

To calculate a state’s Commercial Activity Tax (CAT), the tax base is the business’s “taxable gross receipts,” which is the total amount from activities sourced to that state. Unlike income tax, deductions for business expenses are not allowed. However, states provide a list of statutory exclusions that can be subtracted from total receipts, such as interest, dividends, and receipts from the sale of certain capital assets.

The final tax liability is determined by applying the state’s tax rate to the taxable gross receipts that exceed a set threshold. The tax rates are a low percentage of gross receipts, but the exact calculation differs by state.