Understanding Unrelated Business Income Tax
Unrelated business income tax, or UBIT, is a tax on income earned by a nonprofit that is unrelated to its tax-exempt purpose. Many organizations may not be familiar with the rules around UBIT or understand that not all income earned is tax-exempt by a nonprofit. In either case, understanding the rules around UBIT is critical as an organization can be subject to back taxes and penalties if an audit shows they have not been paying taxes on unrelated business income.
What is the history of UBIT?
The concept of unrelated business income tax has been around since the 1950s; however, enforcement and collection of UBIT has increased in recent years.
UBIT was created to address concerns that nonprofit entities were engaging in unfair competition for activities unrelated to their exempt purpose. Specifically, the concerns focused on nonprofits having an edge over competing organizations by offering lower rates on the same goods or services because those activities were tax exempt. UBIT collects taxes on income-generating activities that are not substantially related to the organization’s tax-exempt mission.
Any unrelated business activity that generates more than $1,000 annually of gross income is subject to UBIT. The organization must take care to account for any income-generating activities and report them annually on a Form 990-T. As with for-profit businesses, the organization can deduct related expenses from the total income for those activities reported to the IRS.
How is UBIT assessed?
Three factors determine whether nonprofit income qualifies as unrelated business income and is subject to taxation. All three factors must be met for the tax to apply, but there are many nuances to how UBIT can be triggered. We recommend working with a qualified advisor to determine when UBIT applies.
1. Is the income derived from a trade or business?
UBIT is generally assessed on any activities that produce income, such as the sale of goods or providing services. One common example that may trigger UBIT for many nonprofits is the sale of merchandise. A merchandise sale often generates more than $1,000 in gross income and is very seldom substantially related to the organization’s tax-exempt mission.
There are some exceptions for awareness organizations when a specific symbol is directly related to raising awareness, such as the pink ribbon for breast cancer. If an organization is selling merchandise that was donated, as in the case of a thrift shop, then it likely is substantially related to the exempt purpose of the organization.
2. Is the trade or business regularly carried on?
UBIT does not likely apply to one-time sales or events, but rather to services or goods that are offered on a regular basis. Even where an event was held on a seasonal basis, the IRS determined that it qualified as “regularly carried on” because it occurred each summer and the income from the event was subject to UBIT.
3. Is the trade or business not substantially related to the exempt purpose of the nonprofit?
Income derived from activities not substantially related to the tax-exempt purpose of an organization may subject the organization to UBIT. For example, a tax-exempt school operated a ski facility for use in its physical education program and for recreational use by students. They also generated income from members of the public using the slope and ski lift fees, which was deemed UBIT. See Rev. Rul. 78-98, 1978-1 C.B. 167.
In another case, a nonprofit operated a retail grocery store that was staffed by participants in their therapeutic program for adolescents. The income from the grocery store was substantially related and was not subject to taxation. See Rev. Rul. 76-94, 1976-1 C.B. 171.
This is an area, however, that is often nuanced. Each situation requires a detailed examination of its relationship to the nonprofit’s exempt purpose to determine if the factors are met for UBIT.
“Partnerships between for-profit businesses and nonprofit organizations have become a popular fundraising strategy in recent years.”
UBIT and cause marketing/advertising
Partnerships between for-profit businesses and nonprofit organizations have become a popular fundraising strategy in recent years. For example, a school fundraiser at XYZ Pizza Place where someone mentions the school’s name when they place their order, and a percentage of sales are donated to the school.
These partnerships often fall under the category of cause marketing, but nonprofits should be cautious of any marketing that appears to endorse a for-profit company’s products or services. Careful examination of the agreement between the nonprofit and for-profit entities can help determine if the marketing activities will qualify as a sponsorship or advertising and whether UBIT may apply.
Unrelated business income tax is a topic that every nonprofit leader and board member needs to understand. As with many tax guidelines, there can be gray areas where UBIT does or does not apply. The three factors to determine UBIT and its application to your trade or business activity are highly nuanced. Be sure to consult your attorney, accountant, or other qualified professional in determining whether nonprofit income is subject to UBIT.
