The Fundamentals of the Unrelated Business Income Tax (UBIT)
Business or “fee-for-service” revenue can be an important source of unrestricted funds for a well-rounded nonprofit organization. However, many organizations are hesitant to engage in commercial activities due to worries about the unrelated business income tax (“UBIT”). A basic understanding of UBIT fundamentals can alleviate these fears and help organizations to make better, more confident decisions about their business activities.
The UBIT rules (found in Sections 511 through 514 of the Internal Revenue Code) were enacted in 1950 in response to concerns that nonprofits were using their tax-exemption to unfairly compete with for-profit businesses. Congress sought to level the playing field by imposing a tax (at regular corporate income tax rates) on revenue generated by a tax-exempt organization that is not related to the organization’s tax-exempt purpose.
In general, UBIT applies to “unrelated business taxable income,” which is defined under Section 512 of the Internal Revenue Code as “gross income derived by any organization from any unrelated trade or business … regularly carried on by it, less the deductions allowed by this chapter which are directly connected with the carrying on of such trade or business,” except as modified by one of the many special UBIT rules and exclusions.
In other words, the starting point for any UBIT analysis is an assessment whether the activity at issue is:
“Unrelated” to the organization’s exempt purpose.
A “trade or business”; and
“Regularly carried on.”
Let’s examine each of these elements more closely.
Related vs. Unrelated
As detailed in Section 1.513-1(d)(2) the Treasury Regulations, an activity is “related” if it has a substantial causal relationship to the achievement of the organization’s “exempt purposes” – the mission and core activities upon which the organization’s tax-exempt status is based – other than through the production of income.
Importantly, as discussed in Q&A #68, how the funds from the activity are used (for example, whether a 501(c)(3) organization uses its business revenue to support a clearly charitable program) is irrelevant to the analysis of whether an activity is “related” or “unrelated” for UBIT purposes. Using the funds generated by the business to support an organization’s mission is not by itself sufficient to avoid UBIT. Rather, this inquiry requires an examination of the nature of the activity itself.
For example, consider an educational organization whose purpose is to teach music to inner city children that decides to hold a charity car wash to raise money to buy musical instruments. This activity would probably be considered unrelated to the organization’s tax-exempt purpose, because a car wash does not directly further a child’s music education aside from the money it generates.
On the other hand, an organization whose mission is to provide vocational training may have a related activity if it starts a car wash business as a way of helping individuals develop job skills. In this case, the car wash itself may be a means of directly achieving the organization’s mission goals.
A similar example is found in Revenue Ruling 73-128, in which an organization established a merchandise business as part of a training program to provide job skills to people from an economically depressed community. In this ruling, the IRS noted that the scale of the business was no larger than necessary to accomplish the organization’s charitable purpose, and on this basis concluded that the activity was “related” and did not trigger UBIT.
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Trade or Business
An unrelated activity is not necessarily subject to UBIT. It won’t trigger UBIT unless it is also a “trade or business” and “regularly carried on.” A “trade or business” must have a profit motive and a certain level of active day-to-day involvement and effort.
Having a “profit motive” means entering into an activity with the “dominant hope and intent of realizing a profit.” See United States v. American Bar Endowment, 477 U.S. 105 (1986). The fact that an activity consistently generates more money than it loses is considered very strong evidence of a profit motive, so organizations rarely escape UBIT on these grounds.
On the issue of active effort, some courts have held that a “trade or business” must involve “extensive business activities over a substantial period of time.” See American Academy of Family Physicians v. United States , 91 F.3d 1155 (8th Cir. 1996). Thus, some profit-generating activities, such as investments and other forms of passive income, are not subject to UBIT because they don’t involve a sufficient level of active day-to-day involvement from the organization. And, as mentioned below, there are also special statutory exclusions under the Internal Revenue Code for most types of investment investment income such as dividends, interest, capital gains, and passive income such as royalties.
Regularly Carried On
An activity that is not “regularly carried on” is not subject to UBIT, even if it is an unrelated activity that constitutes a trade or business. To be considered “regularly carried on,” business activities must “manifest a frequency and continuity, and are pursued in a manner, generally similar to comparable commercial activities of nonexempt organizations.” See Section 1.513-1(c)(1) of the Treasury Regulations.
For example, a car wash held once per year would normally not be considered regularly carried on, because commercial car washes are typically run year-round. A one-time or occasional sale of property is also typically excluded from UBIT on these grounds.
Similarly, annual fundraising events do not typically trigger UBIT because most once-per-year events are too sporadic to be considered “regularly carried on.” However, as discussed in Q&A #145, in certain cases the time and effort required to organize and promote an annual event over the course of the year can potentially suggest that the event is “regularly carried on.”
Special Rules
The Internal Revenue Code also has numerous special rules that sometimes override the basic UBIT analysis described above. It is beyond the scope of this article to address all of these special rules in depth, but be aware that certain categories of revenue are excluded from UBIT, while other categories are normally subject to UBIT.
For example, the following are some types of revenue and activities that are generally not subject to UBIT:
Dividends, interest and capital gains (these exclusions encompass most ordinary investment activities of a nonprofit organization).
Royalties (i.e., payments for the use of a valuable right such as the organization’s name, copyrighted materials, or other intellectual or intangible property).
Rental of real property (subject to certain restrictions related to how rental fees are structured and the extent to which goods or services are included in the arrangement).
Businesses in which substantially all the activities are conducted by volunteers (see Q&A #124 for more information about this exception)
Qualified sponsorship payments under Section 513(i) of the Internal Revenue Code (see Q&A 67 for more information about this exception)
Sale of merchandise received by the organization as gifts.
Conversely, these types of revenue do generally trigger UBIT, notwithstanding the other rules:
Advertising revenue (for example, revenue from banner ads on an organization’s website or ads placed in an organization’s journal or newsletter, even if the website or publication is otherwise in furtherance of exempt purposes).
Unrelated debt-financed property (for example, a building that is mortgaged and rented out for unrelated purposes).
Interest, annuity, royalty, rent, and other passive income received from certain subsidiaries (“controlled entities”) to the extent the payment reduces the tax liability of the entity.
An organization’s share of revenue from a partnership or other flow-through business entity (such as a limited liability company) generated by activities that would constitute an unrelated business if the organization engaged in the business directly.
When computing the tax on unrelated business income, organizations may deduct the expenses directly connected with the carrying on of the trade or business. However, pursuant to “silo” rules under Section 512(a)(6) of the Internal Revenue Code and Section 1.512(a)-6 of the Treasury Regulations, organizations with more than one unrelated trade or business must apply these deductions separately for each business. In other words, the losses from one business activity cannot reduce taxable income from another business activity.
Some expenses, such as overhead and staff time, are partly allocable to exempt activities and partly allocable to unrelated business activities. In this case, organizations should work with their accountants to find reasonable methods of allocating such expenses (such as by having staff members keep track of their activities with time sheets) and stick to these methods consistently.
And be aware having unrelated business taxable income likely means additional tax returns need to be filed, including the Form 990-T and state corporate tax returns.
Planning Tip – If your organization has business revenue that triggers unrelated business income tax (“UBIT”), make sure to plan for quarterly estimated tax payments to be paid under federal and state law throughout the tax year. Waiting until the Form 990 and Form 990-T are filed to remit taxes owed from unrelated business activities can subject an organization to penalties and interest in addition to the taxes.
While the above rules can seem intimidating, it is important not to lose perspective on the big picture. The possibility of reporting and paying UBIT should not discourage an organization from pursuing a profitable activity that provides needed funds that support the organization’s mission and enhances its financial health and sustainability.
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