As tax-exempt organizations seek to diversify their sources of revenue, many engage in business activities that may be unrelated to their missions in the spirit of “social enterprise.” It is not inherently problematic for charities to engage in social enterprise activities. However, there can be negative impacts if those activities are unrelated to the organization’s tax-exempt purposes and represent a substantial percentage of the organization’s total revenue and activities.
What is UBIT?
The tax law defines unrelated business income as income derived from
1) a trade or business;
2) that is regularly carried on; and
3) is not substantially related to the performance of the organization’s tax-exempt functions.
For income to be taxable, all three elements must be present.
UBIT is a complex topic that has many exceptions and exclusions. In essence, the IRS taxes an exempt organization’s earned income at for-profit rates when it collects the revenue from activities that are unrelated to its tax-exempt purpose. If the unrelated income does not qualify for any of the UBIT exceptions or exclusions and exceeds $1,000, it will be subject to standard corporate/trust tax rates.
Tax-exempt organizations report unrelated business income on Form 990-T. If the unrelated business income or the activities associated with it are more than insubstantial, they can jeopardize the organization’s tax-exempt status. Conducting the business activity in a properly organized and operated UBIT blocker corporation safeguards the organization’s tax exemption.
Examples of income that is not subject to UBIT:
- Passive income, such as dividends, interest, royalties, and rents
- Income earned from annual fundraising activities such as golf tournaments
- Sales of donated items, such as in a thrift store
- Activity performed by unpaid volunteers
- Sales of goods for the convenience of members/patrons, e.g., hospital cafe/gift shop
Examples of income that is subject to UBIT:
- Rental income from debt-financed property (e.g., renting property subject to a mortgage)
- Income for providing services unrelated to accomplishing the organization’s tax-exempt purposes
- Advertising sales such as in a periodical or on a website
- Investment income from hedge funds and private equity funds the IRS taxes as partnerships
- Selling purchased items using more than 15% paid staff.
What is a UBIT blocker corporation?
A “UBIT blocker” is a for-profit corporation that is wholly owned by a tax-exempt organization but whose activities are not attributable to its tax-exempt parent. A corporation would not be useful for purposes of blocking UBIT unless it is organized as a c-corporation for tax purposes. C-corporation tax status is available to corporations or LLCs that make an election to be treated like a corporation for tax purposes.
A corporation or LLC taxed as an s-corporation or partnership will not block UBIT from being attributed to its owner because they are pass-through entities. In contrast, a c-corporation is taxed at the entity level, making distributions in the form of dividends to its owner. Dividends, unlike other forms of income, are not subject to UBIT, even when they are received from a controlled corporation.
Relationship between the organization and UBIT blocker corporation
The tax-exempt parent can exercise substantial influence over the UBIT blocker corporation so long as it does not control its day-to-day affairs. If the tax-exempt parent is excessively involved in the UBIT blocker corporation’s day-to-day activities, the UBIT blocker corporation’s unrelated business income may be attributed to the charity.
The IRS has developed a two-part test to determine whether to treat a subsidiary as separate from its owner. First, the subsidiary must have a bona fide purpose. Second, the subsidiary must not be an “instrumentality” of the parent. The parent can exercise control of the subsidiary through stock ownership or its right to appoint and remove the board of directors.
However, it must avoid day-to-day involvement in its subsidiary’s affairs. The satisfaction of this test requires that the subsidiary and the parent have an appropriate structure in place to ensure that the two corporations will be managed as separate companies.
A properly organized and operated UBIT blocker corporation makes it possible for tax-exempt organizations to capitalize on business opportunities, even if those business opportunities might otherwise threaten their tax-exempt status.
Ellis Carter is a nonprofit lawyer with Caritas Law Group, P.C., licensed to practice in Washington and Arizona. Ellis advises nonprofit and socially responsible businesses on corporate, tax, and fundraising regulations nationwide. Ellis also advises donors with regard to major gifts. To schedule a consultation with Ellis, call 602-456-0071 or email us through our contact form.