Q&A #68 – What does it mean for a business activity to be “unrelated” for UBIT purposes?

Question: I am the Executive Director of a 501(c)(3) arts organization that has a video production studio that we use primarily to teach students. We would like to generate additional revenue from our excess studio capacity by having our staff do commercial video production for local businesses. Would this activity result in unrelated business income tax, and can we avoid tax by using the revenue solely to fund our educational programs?

Answer: In general, an activity triggers unrelated business income tax (UBIT) if it is: (1) “unrelated” to the organization’s tax-exempt purpose; (2) a “trade or business”; and (3) “regularly carried on.” In this case, it appears the key issue is whether the activity is “unrelated.” It is a common misconception that using the revenue from a business activity solely for programs in furtherance of the mission is sufficient to make the activity “related” and thereby avoid UBIT. How an organization uses the funds is irrelevant for UBIT purposes, and a business is not considered “related” unless the activity itself has a substantial causal relationship to the achievement of the organization’s tax-exempt purpose.

This distinction is made clear in Section 1.513-1(d)(2) the Treasury Regulations:

“[A] Trade or business is related to exempt purposes, in the relevant sense, only where the conduct of the business activities has causal relationship to the achievement of exempt purposes (other than through the production of income); and it is substantially related … only if the causal relationship is a substantial one” (emphasis added).

A good example of a business activity that is considered “related” is found in Revenue Ruling 73-128. This ruling involved a 501(c)(3) organization formed for the purpose of providing education and vocational training to individuals from an economically depressed community who were unemployed or under-employed due to insufficient job skills. The organization focused its job training program around the manufacture of a line of toy products, which it sold through regular commercial channels. In this case, the business activity itself served as the means by which the organization carried out its job training program, and the scale of the business was no larger than necessary to accomplish the organization’s charitable purpose. On this basis, the IRS concluded that the activity was “related” and did not trigger UBIT.

In your case, the organization’s staff would be carrying out the business activity, and the activity itself (commercial video production for local businesses) most likely does not further the organization’s tax-exempt purpose, notwithstanding the fact that having additional funds will help the organization pursue its mission. The result might be different if the business was carried out by the students with staff oversight as a way to teach them video production methods. But based on your description of the facts, it is likely that this commercial business enterprise would be considered “unrelated.”

Planning Tip – Remember that unrelated business taxable income can be offset by the deductions directly connected with the carrying on of such trade or business (and note that pursuant to the “silo” rules enacted in late 2020, these deductions are calculated separately with respect to each unrelated trade or business, if the organization has more than one). It is important to consult an accounting professional to make sure you are properly recording, documenting, and allocating your business expenses in order to be in compliance and maximize expense deductions.

The notion that an organization’s use of the funds generated by a business activity is irrelevant for UBIT purposes seems counterintuitive and is difficult for many people to grasp. However, a primary goal of the UBIT rules is to avoid giving tax-exempt organizations (which generally do not pay tax) an unfair advantage over for-profit businesses (which must pay tax on business income). Whether or not you agree with this policy goal, Congress has determined that allowing tax-exempt organizations to avoid UBIT merely by using the funds from unrelated businesses in furtherance of their mission would make it too easy to subvert the purpose of the UBIT rules.

If you have a question you would like to submit to SE4N, send it to us using the contact form and we will consider answering it in a future post. Please do not send confidential information.