Nonprofits Can’t Afford to Ignore Unrelated Business Income Tax

Despite what the name “nonprofit” suggests, they can, and should, earn a profit. While there are limits on how that profit is generated and how it can be used, profitability is necessary for sustainability.

While nonprofits can pursue revenue-generating activities, their leaders and professionals must understand that, like the term “nonprofit,” the designation “tax-exempt” is also misleading. Nonprofits aren’t exempt from all federal income taxes. When they engage in revenue-generating activities, they may be subject to the unrelated business income tax.

Nonprofit leaders and professionals can’t afford to overlook UBIT, which is subject to certain exemptions and exclusions and imposed at the corporate tax rate of 21%. Here’s what you need to know about what it is, why it matters, and how to promote compliance.

Defining UBIT

Nonprofits receive their tax-exempt status to fulfill a specific exempt purpose. For example, organizations can receive exemption under section 501(c)(3) if they fulfill a religious, charitable, scientific, or educational purpose, while a business league can receive exemption under section 501(c)(6) if its purpose is to promote the common business interests of its members.

When the organization generates income from an activity that’s substantially related to that purpose, the income is tax-exempt. But when the income is generated from an activity that isn’t substantially related to the exempt purpose, an organization may owe UBIT.

To be considered unrelated business income, the income must come from:

A trade or business. This is any activity that is carried out to produce an income, whether through selling goods or advertising space, providing services, or other commercial operations.

Activity regularly conducted by the nonprofit. The activity must be conducted with frequency and continuity like that of a for-profit business. For example, operating a food stand for two weeks at a local fair wouldn’t be considered “regularly conducted,” but running a commercial parking lot on weekends year-round would be.

Activity insubstantially related to the nonprofit’s purpose. If the income generating activity doesn’t “contribute importantly” to the nonprofit’s exempt purpose, then it isn’t substantially related. Determining whether an activity contributes importantly isn’t a straightforward answer; it depends on the specific facts and circumstances of each activity.

For example, if an art museum sells reproductions of artwork, that revenue wouldn’t be unrelated business income, because the sale of these items contributes importantly to the museum’s purpose by making art more widely available and increasing its appreciation. But if the museum also sells science books, then the revenue wouldn’t be unrelated business income, because it isn’t causally related to furthering the museum’s purpose, other than raising funds.

Overlooking UBIT requirements can have serious implications. Nonprofits run on tight budgets and unanticipated UBIT can lead to shortfalls. Nonprofits also can face:

Revocation of tax-exempt status. There’s no hard cap on the amount of unrelated business income an organization can have. But a nonprofit risks losing their tax-exempt status if these activities are more than an insubstantial part of its overall activities.

IRS penalties. Nonprofits with $1,000 or more in unrelated business income must file Form 990-T. Failure to do so can trigger a costly visit from the IRS.

Promoting Compliance

Tight budgets mean that many nonprofits think about compliance reactively. But being reactive isn’t an efficient use of already limited resources. Instead, nonprofits need to think about compliance proactively. Here are steps that you can take to promote compliance with UBIT requirements at your organization.

Understand the exempt purpose. UBIT isn’t one-size-fits-all. Whether income is taxable depends on your nonprofit’s exempt purpose, and that looks different for every organization.

Everyone involved in UBIT-related conversations and decisions should understand what the specific exempt purpose is. As a starting point, review the organization’s Application for Recognition of Exemption and Form 990 filings.

Plan ahead. UBIT must be considered during the budget process, not just at tax time. Evaluate each income-producing activity to determine whether it may trigger UBIT.

Factor any resulting tax liability into the budget to avoid unexpected shortfalls. Establishing clear procedures related to UBIT is important to promote continuing compliance.

Engage professionals. While nonprofit leaders should understand UBIT rules and how they apply to their organization, it’s also important to work with accountants and attorneys who specialize in advising nonprofits. Involve them throughout the year.

Keep detailed records. Nonprofits are required to keep accurate records of income and expenses, and UBIT is no exception. Because UBIT, along with any allowable deductions, is calculated separately for each different income-producing activity, records must clearly track and allocate the income and expenses of each activity.

Nonprofits shouldn’t shy away from unrelated business activities that support profitability simply out of fear of navigating IRS rules. By addressing UBIT proactively, you can pursue revenue-generating activities with confidence.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.
Author InformationAllie Levene is the founder of Levene Legal and an adjunct professor for Wake Forest University’s Master in Studies of Law program.

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