Tax-exempt organizations have a federal income tax exemption and are not required to pay tax on exempt function income. However, in the 1950s, Unrelated Business Taxable Income (UBTI) was enacted to eliminate unfair competition between tax-exempt organizations and for-profit entities. For most organizations, an activity is an unrelated business (and subject to unrelated business income tax) if it meets three requirements:
- It is a trade or business,
- It is regularly carried on, and
- It is not substantially related to furthering the exempt purpose of the organization.
The term trade or business generally includes any activity carried on for the production of income from selling goods or performing services. Activities of producing or distributing goods or performing services from which gross income is derived do not lose their identity as trades or businesses simply because they are carried on within a larger framework of other activities that may, or may not, be related to the organization’s exempt purposes.
Business activities of an exempt entity ordinarily are considered “regularly carried on” if they show a frequency and continuity and are pursued in a manner similar to comparable commercial activities of nonexempt organizations.
Determining whether a business activity is substantially related requires examining the relationship between the activities that generate income and the accomplishment of the organization’s exempt purpose. Trade or business is related to exempt purposes, in the statutory sense, only when the conduct of the business activities has a causal relationship to achieving exempt purposes other than through the production of income. The causal relationship must be substantial. The activities that generate the income must contribute importantly to accomplishing the organization’s exempt purposes to be substantially related.
There are several modifications, exclusions, and exceptions to the general definition of unrelated business income. For example, dividends, interest, certain other investment income, royalties, certain rental income, certain income from research activities, and gains or losses from the disposition of property are excluded when computing unrelated business income for 501(c)3 organizations. In addition, the following activities are specifically excluded from the definition of unrelated trade or business:
- Volunteer Labor: Any trade or business is excluded in which substantially all the work is performed for the organization without compensation. Some fundraising 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 section 501(c)(3) or by a governmental college or university primarily for the convenience of its members, students, patients, officers, or employees. A typical example of this is a school cafeteria.
- Selling Donated Merchandise: Any trade or business is excluded that consists of selling merchandise, substantially all of which the organization received as gifts or contributions. Many thrift shop operations of exempt organizations would meet this exception.
- Bingo: Certain bingo games are not unrelated trade or business.
Passive income derived from an asset subject to acquisition indebtedness will be generally treated as UBTI. Acquisition indebtedness is debt incurred in connection with the purchase of the property, whether the indebtedness is incurred before, after, or at the time of the acquisition. The general rule states that any liability that is reasonably foreseeable at the time of asset acquisition will be captured by the acquisition indebtedness rules.
Other organizations organized under separate code sections have different requirements for UBTI. For example, social clubs that are organized under code section 501(c)(7) are taxed on passive income like dividends, nonmember rents, and interest. There are special rules relating to set-asides for charitable and similar purposes, virtually negate the tax imposed.
When determining whether an activity is unrelated business income, each situation must be examined independently within the exempt function of the organization. If you have any questions, please reach out to your personal Sciarabba Walker contact or email us at firstname.lastname@example.org.
By Svetlana Svetlichnaya, CPA