What Revenue Is Excluded From Tax Under Sections 512-514?

While organizations are granted tax-exempt status based on their charitable or other nonprofit missions, this exemption does not cover all income-generating activities. The Internal Revenue Service can levy the Unrelated Business Income Tax (UBIT) on revenue it deems unrelated to an organization’s primary purpose. This tax was established to prevent tax-exempt entities from having an unfair competitive advantage over for-profit companies. The Internal Revenue Code details the framework for UBIT, establishing which income is taxable but also providing for specific exclusions and modifications that shield certain revenue.

Defining Unrelated Business Income

For income to be classified as Unrelated Business Income (UBI) and be taxable, it must meet three criteria from Section 513 of the Internal Revenue Code. If an activity fails to meet even one of these conditions, the income is not considered UBI.

The first criterion is that the activity must constitute a “trade or business,” which is broadly defined as any activity carried on for the production of income from selling goods or performing services. For example, if a university’s law school owned a commercial pasta company, the income from selling pasta would be considered a trade or business.

The second condition is that the trade or business must be “regularly carried on.” This determination is based on the frequency and continuity of the income-producing activities, comparing them to a for-profit competitor. An annual fundraiser would likely not be considered regularly carried on, whereas a gift shop open to the public year-round would be.

The final requirement is that the activity must not be “substantially related” to the organization’s exempt purpose. This means the activity itself does not contribute importantly to achieving the nonprofit’s goals, aside from the production of income. For instance, a museum operating a public parking lot is generating revenue not substantially related to its mission. Conversely, if that same museum sells prints of its collection, that activity is substantially related because it furthers its purpose of art education.

Activities Not Considered Unrelated Trades or Businesses

Even if an activity meets the definition of an unrelated business, the tax code provides specific statutory exceptions. These exceptions focus on how the activity is conducted, carving out certain operations from being classified as an unrelated trade or business. If an activity falls into one of these categories, its income is not subject to UBIT.

An exception applies to activities where “substantially all” of the work is performed by unpaid volunteers. This allows nonprofits to use volunteer labor for fundraising without tax consequences. The IRS generally considers “substantially all” to mean 85% or more of the labor. For example, income from a church bake sale handled by uncompensated members is not UBI.

Another exception is for businesses operated by an organization for the convenience of its members, students, patients, or employees. This rule permits organizations like hospitals or universities to provide necessary services to their constituents without the income being taxed. A hospital cafeteria that serves patients, staff, and visitors is a common example.

The tax code also excludes the business of selling merchandise that has been received by the organization as gifts or contributions. This is the foundation of the thrift store model. When a nonprofit sells donated goods to the public, the revenue is not UBI because the inventory was acquired through charitable contribution.

Modifications Excluding Specific Income Types

Beyond exceptions for activities, Section 512 of the Internal Revenue Code provides “modifications” that exclude specific types of income from UBI. These exclusions apply to passive investment income, which is not derived from the active conduct of a business. This income is statutorily removed from the taxable amount.

The most common types of excluded income are dividends and interest. When a tax-exempt organization holds stocks or bonds in its portfolio, the dividends and interest earned are not taxable as UBI. This exclusion extends to annuities and payments received for securities lending, as earning investment income is a standard practice for managing assets, not a commercial enterprise.

Royalties are another category of excluded income. A royalty is a payment for the right to use an intangible asset, such as a patent, copyright, or trademark. For example, if a university licenses a patent for a new technology to a commercial company, the royalty payments it receives are excluded from UBI.

Rent from real property is also generally excluded from UBI. If a nonprofit owns a building and leases office space, the rental income is not taxed. This exclusion also applies to rents from personal property leased with the real property, as long as the rent for the personal property is an incidental part of the total. However, this exclusion is subject to limitations if the property was financed with debt.

An exception to these passive income exclusions arises when the income is from a controlled organization. If a tax-exempt organization controls more than 50% of a subsidiary, the interest, rents, and royalties received from that subsidiary can be pulled back into UBI. The amount of income treated as UBI is determined by the proportion of the subsidiary’s own income that is unrelated to the parent’s exempt purpose. This rule prevents organizations from using subsidiaries to transform active business income into passive payments.

The Debt-Financed Income Rule

The debt-financed income rule in Section 514 of the Internal Revenue Code can cause otherwise exempt passive income, such as rent or dividends, to become taxable as UBI. The rule is triggered when an organization acquires property using debt and that property is not used for its exempt purpose. The principle is that a nonprofit should not use borrowed money to acquire income-producing assets and enjoy a tax-free return on that investment.

“Debt-financed property” is defined as any property held to produce income and for which there is “acquisition indebtedness” at any point during the tax year. Acquisition indebtedness is the unpaid amount of debt incurred to buy or improve the property. This includes the original mortgage and any debt incurred before or after the acquisition that would not have been incurred but for the acquisition.

The calculation of taxable income under this rule is based on a specific formula. The percentage of the gross income from the property included in UBI is determined by the ratio of the average acquisition indebtedness to the property’s average adjusted basis. The same percentage is then applied to the deductions allowed for the property.

To illustrate, consider an organization that buys an apartment building for $1 million, using $400,000 of its own funds and a $600,000 mortgage. The debt-to-basis percentage is 60% ($600,000 debt / $1,000,000 basis). If the building generates $100,000 in gross rental income, $60,000 would be treated as gross income from an unrelated business. The organization could then deduct 60% of its allowable expenses, such as mortgage interest and operating costs.