Did you know that sometimes nonprofits must pay income tax? It’s true. Just because you have a tax-exempt status, it does not mean that you’re, well, tax exempt! The IRS incorporated into the tax codes something called Unrelated Business Income (UBI) and it’s especially for nonprofit organizations.
Frequently, nonprofits have revenue that the IRS considers unrelated to their tax-exempt purpose, and it is that income that is taxable.
According to the IRS, Unrelated Business Income Tax (UBIT) must be paid on income that:
- Is a trade or business;
- Is regularly carried on;
- Is not substantially related to furthering the exempt purpose of the organization.
What does this mean?
A Trade or Business
Let’s start at the beginning with the definition of a trade or business. The IRS says a trade or business is any activity carried out to produce income from selling goods or services. That’s very broad and not always easily recognizable. For example, let’s consider a fictitious museum – the Metropolitan Museum of Adding Machines.
The museum may have a theater it uses to show educational movies about subjects represented within the museum. If tickets are sold, any revenue generated would NOT be subject to UBIT.
If, however, that same movie theater is also used to show the latest Hollywood blockbusters, ticket revenue WOULD be taxable.
In this example, the museum would end the year with both taxable and nontaxable revenues from selling movie tickets.
Regularly Carried On
Next, the IRS says that the trade or business, as just defined, must be regularly carried on. Regularly carried on means that the unrelated trade or business would be conducted with the frequency and continuity seen in a comparable for-profit business. Using the museum example, if the Hollywood blockbusters were shown one time per year as a fundraising event, the revenues generated would not necessarily be subject to UBIT.
Not Substantially Related to the Organization’s Exempt Purpose
Finally, the trade or business activity must not be substantially related to the organization’s exempt purpose. Using the museum example again, showing Hollywood blockbusters is not at all related to its tax-exempt purpose. Consequently, it is subject to UBIT.
On the other hand, consider a nonprofit that charged for a paper shredding service. The organization’s exempt mission was to help individuals with special needs live independent lives. Because individuals with special needs performed the shredding service, the service was consistent with the organization’s mission and the revenues from the shredding service were exempt from UBIT.
What About Investment Income?
Some revenue streams are specifically exempt from UBIT. Income from investment interest, dividends and gains falls into this category, as does rental revenues, in certain situations.
Conversely, income from advertising and corporate sponsorships that include “substantial benefit” for the sponsor is generally not exempt; therefore, it is subject to UBIT.
If you think you have a lot of income subject to UBIT, don’t panic…yet!
Like a for-profit business, the IRS allows tax exempt organizations to take deductions against UBI before determining the tax owed.
Back at the museum, they probably have employees who sell movie tickets, run the projector, and clean up the theater after the show is over. Maybe they show educational movies 5 out of 7 days a week and Hollywood blockbusters 2 out of 7 days a week.
In this example, the museum can take all its costs for salaries, benefits, cleanup, projection, lighting, etc. and allocate 2/7 against UBI to minimize it and reduce the related tax bill.
UBI also requires a separate tax return, so don’t forget to deduct the tax preparation costs related to this particular return.
You’re not alone. UBI is a very complex topic, and it illustrates nonprofits can be subject to income taxes even if all of the income earned is used for mission-related purposes. UBI is triggered not by the use of the funds, but by the activity that generated the income or loss. Good recordkeeping will help to ensure that UBI is properly identified and, more importantly, ensure expenses incurred to generate that income are properly deducted so the related taxes paid can be minimized.