Unrelated Business Income Tax Primer for Nonprofits
What do all the following scenarios have in common? A nonprofit youth camp leases its facilities during the off season for weekend business conventions; a homeless shelter forms a joint venture with private investors to raise money for the construction of a new facility; a church sells Christmas trees at twice their cost to raise money for a mission trip; a church leases its parking lot to a local university during the school year. All of these nonprofit entities have the potential to generate business income that is unrelated to their tax-exempt purpose, which in turn generates a tax, which is otherwise known by the IRS as the “Unrelated Business Income Tax” or “UBIT.” If not properly handled, UBIT that is not properly reported and paid can trigger liability and penalties from the IRS, possibly even endangering the tax-exempt status of the entity, particularly if the income generated is substantial. The IRS has stepped up enforcement of the regulations involving UBIT over the past years, making this nuanced area an important topic for each nonprofit to review in order to protect its ministry.
- The Rationale
UBIT is a tax levied by the IRS in an attempt to prevent exempt organizations from gaining an unfair advantage when competing with for-profit enterprises. Unrelated business income is not in itself illegal; the IRS may simply tax the income that an exempt organization earns from activities unrelated to that organization’s exempt purpose. The rationale is that an organization’s charitable purpose is what entitles the organization to its tax exemption in the first place; any income-producing activities beyond that purpose tend to resemble commercial enterprises that compete directly or indirectly with for-profit businesses.
- The Rule
There is a presumption that activities carried out by nonprofits, and any income or profit they generate, is related to their exempt purpose. The requirement to pay UBIT on income only applies when all three of the following elements are met:
a) the income is from a trade or business;
b) the trade or business is regularly carried on; and
c) the income is not substantially related to the exempt purpose of the entity.
Before going into each of these elements below, a general rule of thumb is that if the entity’s primary purpose in engaging in the activity in question is making a profit, and the activity the entity is engaging in is very similar or comparable to what a commercial, for-profit entity would do, it is likely that UBIT comes into play.
Hypothetical A: An exempt organization, formed with the purpose to increase public awareness and understanding of environmental issues, operates a bookstore.They sell books that educate the reader about the environment. Income from these will not likely be subject to UBIT. They also sell gift cards, calendars, and other memorabilia bearing the name of the organization which are not about environmental issues in some direct way; the consumer price is marked up from the price the bookstore paid to obtain them. Income from these items is likely subject to UBIT because the sale of these items does not primarily advance the organization’s exempt purpose. If, however, the calendars and gift cards had pictures of endangered animals along with an explanatory paragraph, they may be primarily educational and escape UBIT.
- Element 1: “Trade or Business”
It is generally rather easy for an activity to be a “trade or business.” Any activity that is unrelated to the exempt purposes and is conducted to produce income from the sale of goods or performance of services with a reasonable expectation of a profit, can qualify as a trade or business for purposes of UBIT. Courts look at the entire “facts and circumstances” test of the overall activity. This means that an activity can be a trade or business while not producing any actual profit. It also means that while an activity cannot hide its nature in a larger group of activities, some of which may be not for profit and may be related to the exempt purposes, a single activity does not need to be part of a larger business scheme to qualify as a “trade or business.” For example, even though advertising is typically part of a larger, unified publishing business scheme, advertising itself can be a “trade or business” for purposes of UBIT on its own.
On the other hand, a “trade or business” does not include every single income-producing activity, especially if the income is related to the exempt purposes of the entity (see third element). For example, investment activities or securities lending transactions do not constitute a trade or business for purposes of UBIT event hough these activities produce a profit. Similarly, conducting an activity without intent to make a profit in a demonstrable way can avoid the classification as a trade or business. For example, a federal court in Montana held that because an exempt organization did not reinvest the profits of its greeting card business back into the business, it had no competitive advantage in the market and therefore wasn’t operating a trade or business for purposes of UBIT.
Charging a fee for offering exempt services would also likely not be a trade or business, since such activity would be substantially related to the exempt purposes (See third element below). For example, UBIT would likely not apply to charging tuition or lab fees at a nonprofit educational institution.
- Element 2: “Regularly Carried On”
According to IRS regulations and court interpretations, this element is only met when the exempt organization carries out “extensive business activities over a substantial period of time.” A trade or business is normally considered “regularly carried on” if the organization engages in it in a manner similar to comparable commercial activities undertaken by profit entities.
Under that rationale, running business activities only once a year, or for a week or less once a year, would most likely not qualify as “regularly carried on.” For example, a church that holds an annual charity dance, or runs a hot-dog stand at annual week-long state fair could likely avoid UBIT on the income from those activities.
In contract, activities that are held weekly, monthly, or even bi-annually are much more likely to qualify as “regularly carried on.” These types of activities are particularly in danger of UBIT if the planning and execution of the activity represents an on going effort by the organization. For example, if an exempt entity sells marketing in its annual yearbook by making weekly phone call campaigns, that may qualify as “regularly carried on,” even though the advertising is only published once a year.
Under this element, one factor courts look at is how the activity compares to similar, for-profit activities. For example, UBIT can usually be avoided if a nonprofit entity sends out low-cost items that are incidental to soliciting charitable contributions in a way that does not compete with for-profit entities. On the other hand, even seasonal activities can qualify as UBIT if they are carried on in a manner that is competitive with comparable commercial/taxable activities. For example, the IRS assessed UBIT against a nonprofit organization for income it received from the sale of bumper stickers, buttons, t-shirts, and related items, partly because they were sold in direct competition with commercial vendors at seasonal sporting events. The items all carried athletic logos of the teams, players or events, but nothing identified the items with the nonprofit.Commercial vendors sold the same or similar items at the same sports events.The IRS considered this activity“regularly carried on” despite its seasonal aspects, and noted that the nonprofit pursued the activity in a very competitive manner.
Another factor the courts may look to under this element is whether or not the nonprofit entity can show that its goal or motive is not making a profit. For example, the Fourth Circuit has reasoned that if an activity is not substantially related to its exempt purposes, is “conducted in a competitive profit seeking manner, and regularly earns significant profits,” the nonprofit must prove that making a profit is not its motive. In the case it considered, the Fourth Circuit found that the nonprofit entity could not meet that burden of proof because it decided not to use its profits to offer members lower insurance rates, which would have allowed it to fulfill its “nonprofit, ostensible [sp] charitable purpose.”
Under this element, if your nonprofit is participating in a quasi-regular endeavor to make money that is regularly carried on and is competing with a similar, for-profit entity’s business, be very careful to have enough evidence to show that simply turning a profit is not your primary motivation. Your business endeavor should clearly show—both to the public and to the IRS, if needed—your entity’s charitable purpose in how it is run, how often it is run, where it is promoted, and how the income is used.
- Element 3: “Substantially Related to an Exempt Purpose.”
At the heart of UBIT analysis is the questions of whether or not an activity—even if it qualifies as a business that is regularly carried on—can be exempt from UBIT by being “substantially related to an exempt purpose.”
A business activity can meet this element if it contributes to accomplishing the entity’s exempt purpose. Typically there must be a significant causal relationship between the activity and the achievement of the purpose, and not merely a relationship where all the income generally goes to support the work of the nonprofit. The IRS generally looks for a specific and direct relationship between the activity’s income and the exempt purpose, and they may compare the size and extent of the business activity in proportion to the size and extent of the exempt purpose. For example, UBIT may be applied to the excess income from an activity that is conducted more frequently or more extensively that is reasonably needed to meet the exempt purpose.
Hypothetical: Your church has a bookstall on Sunday mornings for members and visitors, allowing them to purchase books from the church. The bookstall makes a profit, but it is directly tied to your exempt purpose because it contains books that your pastor recommends and it is targeted to members and visitors to help spread the gospel. The bookstall starts to do very well among the members, so the church expands the bookstall to an online store, marketing to the community at large, and begins carrying non-religious books that are popular outside the church membership. The excess income from the bookstall expansion would likely be UBIT.
In applying this rule, the IRS typically draws a very fine line, based on all the facts and circumstances of a case. For example, in one case, the sales of certain children’s items in a giftshop operated by an art museum were exempt fromUBIT because they were directly related to the museum’s educational purpose. The exempt items were limited to kaleidoscopes, painting set, and items “designed to develop fine art skills and a child’s awareness of his or her artistic ability.” Income from other items in the same gift shop, however, were not exempt because they only developed a child’s general knowledge and were not expressly educational in nature.
Based on various IRS rulings, it is safe to assume that UBIT could be assessed for the following types of income (though these examples are not exhaustive, nor can they be cited as binding precedent):
Pet boarding and grooming services for the general public by an exempt organization, operated to prevent cruelty to animals;
- Weekly bingo games by a social welfare organization;
- Sale of blood by a tax-exempt blood bank to commercial laboratories;
- Sale of appliances to senior citizens by a tax-exempt senior citizens center;
- Performance of language translation services by a tax-exempt trade association promoting international trade relations;
- Operation of a commuting program by a tax-exempt labor union;
- Distribution of business directories to new residents in a community;
- Sale of work uniforms by a tax-exempt union;
- Tours conducted by a nonprofit, unless they do not have a substantial recreational or social purpose but are strongly educationally oriented (i.e. reports, daily lectures, etc.).
On the other hand, it is safe to assume that UBIT may not be assessed for the following types of income (though, again, these examples are not exhaustive, nor can they be cited as binding precedent):
- Operation of dining room cafeteria and snack bar by a tax-exempt art museum for its staff and employees;
- Sponsorship of championship tournaments by a tax-exempt sport-promoting organization;
- Operation of beauty and barbershop by a tax-exempt senior citizens center;
- Sale of greeting cards and art reproductions by tax-exempt museum;
- Operation of a lawyer referral service by at ax-exempt bar association;
- Provision of veterinarian services by a tax-exempt humane society;
- Sale of computer software by a tax-exempt organization for med to publish and promulgate new scientific technology;
- Sale of posters and other promotional items carrying the tax-exempt organization’s program message;
- Sale of life insurance on the lives of donors by a tax-exempt charitable organization;
- Sale of art reproductions by a tax-exempt art museum.
Even if your entity conducts an activity that falls into the examples cited in either of these lists, contact an attorney knowledgeable in this area to confirm whether you are or are not liable to pay UBIT.
Another “fact and circumstance” that the IRS examines under this prong is whether the business activity of a tax-exempt entity fits into the exempt purposes of its parent entity. This analysis can be helpful for a church that runs a ministry through an affiliated school or daycare, a nonprofit soup kitchen or children’s ministry, or an integrated auxiliary corporation.
WANT TO READ MORE? The full-length article provides 7-8 more pages dealing with various exemptions and practical applications of the rules governing UBIT to your organization. Learn how you can structure your organization’s activities in a way that does not jeopardize its tax-exempt status but still allows for creativity in raising funds and marketing your purpose. If you would like further advice, please email the author or call the office at 703-771-4671 to purchase the full article and discuss how we can help address your specific concerns.
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