By way of background, to qualify for tax-exemption, tax-exempt organizations must be organized and operated primarily for tax-exempt purposes. Tax-exempt organizations are permitted to engage in a limited amount of business activity unrelated to its exempt purposes; however, such activities generate unrelated business income (â€œUBIâ€). UBI is subject to tax at corporate income tax rates. Taxable UBI exists when the following three factors are present: i) the income is from a trade or business; ii) the trade or business is regularly carried on; and iii) the conduct of the trade or business is not substantially related to the organization's exempt purposes.
Trade or Business. The definition of the term â€œtrade or businessâ€ refers to any activity that is carried on for the production of income, from the sale of goods, or from the performance of services. The IRS generally considers a trade or business to be any venture motivated by the desire to earn a profit. Thus, the definition of â€œtrade or businessâ€ for purposes of determining whether unrelated business income tax (â€œUBITâ€) applies is very broad and covers many activities that a tax-exempt organization may conduct.
Regularly Carried On. The term â€œregularly carried onâ€ refers to the frequency and continuity of the business activity as well as the manner in which it's conducted. Even when the activity is not conducted year round, it may be deemed regularly carried on if for-profits conduct comparable activities with the same frequency and continuity. For example, if the activity would normally be conducted by the for-profit only seasonally, then seasonal activity by the tax-exempt organization is deemed to be regularly carried on. In contrast, a one-time sale of property is typically not considered to be regularly carried on and therefore does not generate UBI.
Substantially Related. The third factor is that the activity not be â€œsubstantially relatedâ€ to the tax-exempt organization's exempt purpose. In determining whether the activity is substantially related, the regulations provide that the business activity must contribute importantly to the accomplishment of the organization's exempt purpose. This depends upon the facts and circumstances in each case.
Fragmentation Rule. The IRS applies the â€œfragmentation ruleâ€ when examining whether an activity is related to an organization's exempt purpose. This requires an analysis of each segment of the tax-exempt organization's revenue generating activities to determine whether each separately distinguishable activity is related or unrelated to the organization's exempt purpose. For example, the sale of a promotional ad in an exempt organization's publication may constitute the unrelated sale of advertising even though the proceeds will further the exempt organization's mission.
Exceptions.Â There are several exceptions to UBI treatment. The most popular exceptions are as follows:
- Volunteer Labor – Any trade or business is excluded in which substantially all the work is performed for the organization without compensation. Some fund-raising activities, such as volunteer operated bake sales, may meet this exception.
- Convenience of Members – Any trade or business is excluded that is carried on by an organization described in 501(c)(3) primarily for the convenience of its members, students, patients, officers, or employees. A typical example of this would be a hospital or school cafeteria.
- Selling Donated Merchandise – Any trade or business is excluded that consists of selling donated merchandise. Many thrift shop operations run by tax-exempt organizations meet this exception.
Modifications. Even where income is considered UBI based on the three factor test outlined above, there are several modifications that are made in calculating UBI that may reduce or eliminate UBIT liability. These most common modifications include the following:
- Passive Income â€“ Income derived from dividends, interest, annuities, royalties, rents, and the like is generally exempt from UBI. However, the exemption is lost where the asset generating the passive income is â€œdebt financed.â€
- Charitable Deduction â€“ A charitable deduction of up to 10 percent of the organization's UBI is permitted; however, the contribution must go to another tax-exempt organization.
- Net Operating Losses â€“ A net operating loss deduction is permitted. The net operating loss deduction is the total of the net operating loss carryovers and carrybacks that can be deducted in the tax year. To be deductible, a net operating loss must have been incurred in an unrelated trade or business activity.
- Specific Deduction â€“ A $1,000 deduction is available but is not allowed in the calculation of net operating losses. Only one specific deduction may be taken, regardless of the number of unrelated businesses conducted.
Threats to Exempt Status.Â Even if you end up having to pay some tax on it, having more income is always a good thing. The primary challenge for tax-exempt organizations is ensuring its unrelated business income is maintained within a relatively â€œsafeâ€ rangeÂ of its overall exempt activity. It is acceptable for a tax-exempt organization to operate an unrelated business so long as operating the unrelated business is not its primary purpose. Unfortunately, there is no crisp test for determining when this threshold has been crossed. In determining whether the unrelated business has morphed into the organization's primary purpose, all of the circumstances must be considered including the size and extent of the organization's exempt purpose activities. When in doubt, most organizations elect to protect their tax-status by forming a separate taxable subsidiary to conduct the unrelated activity.
Ellis Carter is a nonprofit lawyer licensed to practice in Washington and Arizona. Ellis advises tax-exempt clients on federal tax matters nationwide.