There is a common misconception that non-profit organizations are exempt from all federal income taxes. However, if an organization engages in certain activities that are unrelated to its exempt purpose, as discussed below, it may be subject to tax on its unrelated business taxable income (UBTI). The following provides an introduction.
What organizations are subject to tax on unrelated business taxable income?
Organizations exempt under Internal Revenue Code (IRC) § 501(a) may be subject to unrelated business income tax. This includes organizations described in IRC § 401(a) and 501(c), including subsection 501(c)(3) organizations.
What is unrelated business taxable income?
UBTI is defined by the Internal Revenue Code as income with the following three characteristics:
1. The income produced is from a trade or business.
According to Treasury Regulation 1.513-1(b), a trade or business generally includes any activity that is carried on for the production of income. An activity does not lose its identity as a trade or business merely because it is carried on within a larger group of similar activities that may, or may not, be related to the exempt purposes of the organization. For example, the sale of pharmaceutical supplies to the general public does not lose its identity as a trade or business merely because the pharmacy also furnishes supplies to the hospital in accordance with its exempt purpose.
2. The trade or business is regularly carried on.
According to Treasury Regulation 1.513-1(c), an activity will be considered to be regularly carried on if it is conducted with frequency and continuity and pursued in a manner comparable to commercial activities of nonexempt organizations. The more regularly or frequently the income producing activities are performed in the organization’s fiscal year, the greater the likelihood that they will be considered “regularly carried on.” The similarity of conduct with commercial organizations pursuing the same interests is the key to the differentiation between intermittent activities that are “regular” and those that are not. For example, operating a stand for 2 weeks at a state fair would not be a regular conduct of business, but operating a commercial parking lot one day per week year round would be considered regularly carried on.
3. The conduct of the trade or business is not substantially related to the organization’s performance of its tax-exempt functions.
According to Treasury Regulation 1.513-1(d), if the trade or business which produces the income is not substantially related to the organization’s exempt purpose (other than through the production of funds), it will be considered to have produced unrelated business income. To be considered substantially related and therefore not considered unrelated business income, the activity must contribute importantly to the accomplishment of the organization’s exempt purpose, which is determined on a case by case basis depending on the facts and circumstances involved. The size and extent of activities must also be considered in the determination. Where income is realized from activities related to the performance of its exempt function, but the scale of the business performed is on a larger scale than is reasonably necessary for the performance of its exempt function, the portion of the activities in excess could be considered UBTI.
Is there any other guidance?
The courts have developed guidelines in their case-by-case determination of UBTI called the “commerciality” doctrine. The doctrine states that revenue cannot be exempt function income if the activity is conducted in a commercial manner. Some examples of this include the existence of direct competition with for-profit businesses pursuing the sale of the same products or services, prices being set using formulas comparable to those used by for-profits (which generally include a profit element), the use of advertising and promotional materials to enhance sales, the exempt organization’s operating hours being similar to those of competing for-profit entities, the use of paid staff instead of volunteers, and charitable contributions were not solicited.
Are there any exceptions?
The Internal Revenue Code provides the following exceptions to organizations that would otherwise be subject to tax on UBTI.
1. Volunteer Exception:
The volunteer exception holds that any trade or business in which substantially (at least 85%) all of the work necessary to carry it out is performed without compensation (i.e. by volunteers), the trade or business will not be considered to produce UBTI.
2. Thrift Store Exception:
The thrift store exception holds that any trade or business that consists of selling merchandise, substantially all (again, greater than 85%) of which has been received by the organization as gifts or contributions, does not produce UBTI.
3. Convenience Exception:
If the activity is carried on primarily for the convenience of its members, students, patients, officers, or employees at their usual place of employment, it will not be considered to produce UBTI.
What is the consequence of having UBTI?
If an organization has gross income of $1,000 or more from a regularly conducted unrelated trade or business it may be required to file IRS Form 990-T. The tax rates for unrelated business taxable income start at 15% and can be as high as 39% depending on income levels. If you have any questions, please do not hesitate to contact the team at Howe, Riley & Howe.
The information presented is only of a general nature, may omit many details and special rules, is current only as of its published date, and accordingly cannot be regarded as legal or tax advice. Any tax advice contained in this communication is not intended or written to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties.