How Does “Unrelated Business Taxable Income” Relate to Nonprofits?

What is unrelated business taxable income (UBTI)?

Although tax-exempt organizations (referred to herein as a “nonprofit”) are generally exempt from federal income tax, they may have to pay income tax on net income derived from business activity that is unrelated to their tax-exempt purpose, called “unrelated business taxable income” (UBTI). This type of tax is designed to level the playing field when nonprofits engage in activities that may compete with commercial business endeavors. If an organization engages in too much unrelated business activity, it risks losing its tax-exempt status. No substantial part of a nonprofit’s activity may be devoted to carrying out an unrelated business.

What are the criteria for an activity to be considered UBTI?

Not all of a nonprofit’s revenue is subject to taxation. The following three-part test is used to determine if income is UBTI.

1. Income is from a trade or business. While nonprofits often have a variety of income sources, including donations, a trade or business includes any activity carried on for the production of income from the sale of goods or the performance of services.
2. The trade or business is regularly carried on. This means that the trade or business must be an ongoing activity that has the frequency and continuity of comparable commercial activities. Such activity must be a regular occurrence, although it need not be year-round (e.g., seasonal activities can also be regularly carried on).
3. The trade or business is not substantially related to the nonprofit’s exempt purpose. In order for the trade or business activity to be related to a nonprofit’s exempt purpose, it must contribute importantly to achieving that purpose, other than simply through the production of income.

If all three parts of the test are met, the net income derived from the activity will likely constitute UBTI, unless it falls within one of the exceptions or exclusions. It is important to note that it is the nature of the activity generating the income that triggers the tax, not the purpose the income is used for. Simply put, even if all of the income generated by the unrelated business activity is used to support the organization’s exempt purposes, it may nonetheless be UBTI.

Are there exceptions or exclusions from UBTI? 

Yes. Even if all three parts of the UBTI test are satisfied, there are numerous modifications, exclusions, and exceptions from UBTI, including, but not limited to:

1. Dividends, interest, and certain other investment income;
2. Most royalties;
3. Rental income from real property (with some exceptions);
4. Income generated by volunteers or donated merchandise.

 How do nonprofits report and pay taxes on UBTI?

A nonprofit that has $1,000 or more of gross income from UBTI must file IRS Form 990-T (in addition to its annual information return, the Form 990, 990-EZ, or 990-PF) and pay tax on its net income at the corporate income tax rate. Moreover, a nonprofit must pay estimated taxes if it expects its tax for the year to be $500 or more.

How do nonprofits minimize income tax liability generated from UBTI?

As noted above, only net taxable income over $1,000 for any given tax year must be reported. Nonprofits that generate UBTI in excess of $1,000 may avail themselves of the tax deductions available to for-profit businesses, including deducting ordinary and necessary business expenses from the activity generating UBTI. In addition, the IRS allows nonprofits to carry forward net operating losses, if the activity continues into multiple tax years.

Another strategy to minimize tax liability may be to restructure the activity so that it falls within one of the carveouts to UBTI. Our next blog post will discuss the various exceptions and exclusions in greater detail.