What Is Unrelated Business Taxable Income for a Nonprofit?
Even tax-exempt organizations may owe taxes. This guide explains the framework for evaluating business income to maintain compliance and manage financial obligations.
Nonprofit organizations are granted tax-exempt status for work that serves their mission. However, this exemption does not cover all income. When a nonprofit earns income from an activity not directly linked to its core mission, that income may be classified as Unrelated Business Taxable Income (UBTI). UBTI was established to prevent tax-exempt organizations from having an unfair competitive advantage over for-profit businesses and is subject to federal income tax.
Identifying an Unrelated Trade or Business
The Internal Revenue Service (IRS) uses a three-part test to determine if an activity produces UBTI. For income to be taxable as UBTI, it must meet all three criteria; if it fails to meet even one, the income is not subject to this tax. The analysis focuses on the nature of the activity itself, not how the resulting funds are used.
The first part of the test is whether the activity is a “trade or business,” meaning it is carried on to produce income from selling goods or services. The primary motive must be to generate a profit. For example, a museum gift shop is considered a trade or business because its purpose is to sell goods for income.
The second criterion is that the trade or business must be “regularly carried on.” This focuses on the frequency and continuity of the activity compared to similar for-profit businesses. For instance, a hospital auxiliary operating a public parking lot every day meets this standard, while an infrequent, annual bake sale would not.
The final test is whether the activity is “not substantially related” to the organization’s exempt purpose. An activity is substantially related only if it contributes importantly to the nonprofit’s mission, beyond simply providing funds. A university selling textbooks to students is a related activity supporting its educational mission. However, if that same bookstore sold cars to the public, that income would be unrelated.
Activities Excluded from UBTI
Even if an activity meets the three-part test, Congress has created statutory exclusions that shield certain income from being taxed as UBTI. These exclusions recognize that some activities are passive in nature or are conducted in a way that aligns with the nonprofit’s function.
A primary category of exclusions covers passive income, such as dividends, interest, annuities, and royalties. For example, dividends from stock investments and interest from a savings account are excluded. Rent from real property is also excluded, though this can be nullified if the property has acquisition debt or if rent is tied to the tenant’s profits.
Other exclusions are based on how the activity is conducted. An exception applies to activities where substantially all work is performed by volunteers. Another is for activities carried on for the convenience of members, students, patients, or employees, such as a hospital gift shop. Income from selling merchandise that was donated to the organization is also not taxable.
Calculating and Preparing to Report UBTI
If a nonprofit has income from an unrelated business that is not excluded, it must calculate the taxable amount. The formula is the gross income from the activity minus the expenses that are “directly connected” with it. This calculation determines the net income from the business, which is the basis for the tax.
Allowable deductions are ordinary and necessary expenses with a primary relationship to the unrelated business. Examples include the cost of goods sold, salaries for employees in the unrelated business, and a portion of overhead expenses like rent or utilities that can be reasonably allocated to the activity.
After calculating net income, organizations can take a specific deduction of $1,000. If an organization’s total net income from all unrelated business activities is less than $1,000, it will not owe any tax. This deduction applies to the total UBTI, not to each separate activity.
These calculations are reported on Form 990-T, “Exempt Organization Business Income Tax Return.” A rule for this form is “siloing,” established by Internal Revenue Code Section 512. This requires a nonprofit to calculate the net income for each unrelated business activity separately, as losses from one business cannot offset profits from another.
Filing Form 990-T
An organization with $1,000 or more in gross income from an unrelated business must file Form 990-T. The deadline is the 15th day of the 5th month after the organization’s accounting period ends, which is May 15 for calendar-year filers. An automatic six-month filing extension can be requested.
Most organizations must file Form 990-T electronically through an IRS-approved provider. The small number of organizations eligible to file by paper can find the correct mailing address in the form’s official instructions.
If tax is owed, payment is due by the original filing deadline, even with an extension. Payments can be made through the Electronic Federal Tax Payment System (EFTPS). Organizations expecting a tax of $500 or more must also make estimated tax payments during the year.
The obligation to file Form 990-T is separate from the annual requirement to file an information return, like Form 990. Organizations should retain a copy of the filed return and the IRS confirmation of receipt for their records.