What Is Unrelated Business Taxable Income (UBTI)?

Unrelated Business Taxable Income, or UBTI, is the net profit a tax-exempt organization earns from an activity that is not substantially related to its charitable, educational, or other exempt purpose. The Internal Revenue Service (IRS) imposes a tax on this income to prevent nonprofits from having an unfair competitive advantage over for-profit businesses engaged in similar commercial activities. This tax applies to a wide range of organizations, including public charities, universities, and even certain retirement accounts like IRAs that hold investments in operating businesses.

Identifying Unrelated Business Income

The IRS applies a specific three-part test to determine if an organization’s revenue-generating activity constitutes unrelated business income. All three conditions must be met for the income to be subject to tax.

It is a trade or business

The first criterion is that the activity must be a “trade or business,” defined broadly by the IRS as any activity carried on to produce income from selling goods or performing services. This includes activities with characteristics of a commercial operation, like set prices and marketing, regardless of scale. The primary motive is profit generation, which distinguishes it from activities that might only generate incidental revenue.

It is regularly carried on

The second part of the test requires that the trade or business be “regularly carried on.” This analysis considers the frequency and continuity of the activity in comparison to how a for-profit business would conduct a similar venture. For example, operating a gift shop year-round or a parking lot every weekend would meet this standard.

Conversely, activities that are infrequent, such as an annual fundraising gala or a bake sale held only a few times a year, would likely not meet this test. The IRS looks at the actual time span over which the activities are conducted, not just the preparation time. For instance, the Girl Scouts’ annual cookie sales, which occur over a few weeks, are structured to avoid being classified as a regularly carried on business.

It is not substantially related to the organization’s exempt purpose

The final and often most complex criterion is that the activity must not be “substantially related” to the organization’s exempt purpose. This means the activity itself must contribute importantly to achieving the organization’s mission, beyond simply providing funds for its operations.

A clear example is a university bookstore. The sale of textbooks and course-required supplies is substantially related to the university’s educational mission. However, if that same bookstore began selling automobiles or operating a travel agency for the general public, that income would likely be unrelated. Similarly, a museum gift shop selling reproductions of its collection’s artwork is related, while selling common souvenirs or electronics is not.

Common Income Exclusions

Even if an income stream meets the three-part test for being an unrelated business, Congress has specifically excluded certain types of income from UBTI. These exclusions cover passive investment income, which is not considered active business competition.

One of the most significant exclusions is for dividends and interest. Income received from stock dividends and interest from savings accounts, bonds, or loans is almost always excluded from UBTI. This allows tax-exempt organizations to maintain investment portfolios without triggering tax consequences on the returns.

Royalties, which are payments for the right to use an intangible property right like a patent or copyright, are also generally excluded. For example, if a university licenses a patent it developed to a commercial company, the resulting royalty payments are not taxed as UBTI.

Certain rental income is another common exclusion. Rent from real property, such as land or buildings, is typically not UBTI. However, this exclusion can be nullified if substantial personal property is leased along with the real property, or if significant services are provided to the lessee, such as maid service in a hotel. Other exclusions include gains from the sale of property (if not held as inventory), income from research for a government agency, and income from an activity where substantially all work is performed by unpaid volunteers.

Calculating Unrelated Business Taxable Income

Once an organization determines it has gross income from an unrelated trade or business that is not excluded, it must calculate the final taxable amount. Unrelated Business Taxable Income is the net income after subtracting allowable expenses. Under a “silo” approach, UBTI must be calculated separately for each distinct trade or business, and a net loss from one unrelated business cannot be used to offset the net profit from another.

To calculate the net income for each business, the organization can deduct expenses that are “directly connected” with that specific activity. These are costs solely attributable to the unrelated business, such as the cost of goods sold, salaries of employees working exclusively in that business, and its direct marketing expenses.

For dual-use expenses that benefit both exempt functions and unrelated business activities, the organization must make a reasonable allocation. For example, if a university uses 10% of a building for its unrelated bookstore, it can deduct 10% of the building’s utilities, maintenance, and depreciation against the bookstore’s income. A specific deduction of $1,000 is also permitted against the organization’s total UBTI.

Tax Reporting Requirements

An organization with gross UBTI of $1,000 or more must report this income to the IRS using Form 990-T, “Exempt Organization Business Income Tax Return.” This form is separate from the annual information return, like Form 990, that most exempt organizations file.

Form 990-T is available on the IRS website, and most organizations must file it electronically. The deadline for filing is the 15th day of the 5th month after the end of the organization’s tax year. For organizations on a calendar year, this is May 15th.

The tax on UBTI is paid at the same rates that apply to for-profit corporations or trusts. If an organization expects its tax liability for the year to be $500 or more, it must make quarterly estimated tax payments. Failure to file or pay on time can result in penalties and interest charges.