While nonprofits exempt under Section 501(c)(3) are typically exempt from paying income tax, there are exceptions to the rule. Generating unrelated business income could in fact cause an otherwise exempt organization to owe unrelated business income tax (UBIT). According to the commerciality doctrine, used by both the IRS and tax courts, if it looks like a commercial enterprise, and acts like a commercial enterprise, it is in fact a commercial enterprise and profits should be taxed.
Unrelated Business Income
A nonprofit may have unrelated business income if it is making a profit from activities that are unrelated to its charitable cause. This could include income received from advertising placed in an organization’s publication, from the use of an organization’s parking lot, or from the leasing of machinery or equipment.
More specifically, to be taxed, unrelated business income must meet all three of the following criteria. The income must:
- Be a trade or business activity carried on for the production of income from selling goods or providing services (the purpose of the activity is to make money);
- Be regularly carried on (it happens more than once a year); AND
- Be unrelated to the exempt purpose of the organization (an activity is not considered exempt simply because it raises money for the organization’s exempt purpose).
If all three apply, then your nonprofit’s activities may be producing taxable income and may, therefore, be responsible for paying UBIT.
However, there are exceptions. Generally, the following types of income will not trigger UBIT:
- Interest, dividends, annuities and income from notional principal contracts (unless from an S Corporation)
- Rental income from real property and royalty income
- Gains and losses on disposal of property held for an exempt purpose (unless inventory, debt-financed or S Corporation stock)
- Fundamental research income where results are freely available to the general public
Similarly, certain activities also are excluded and will not trigger UBIT, such as those that:
- Are conducted using volunteer labor
- Are conducted for members’ convenience
- Involve selling donated merchandise
- Qualify as public entertainment, convention or trade show activities
- Are games of chance (operated with volunteer labor)
- Are specific types of bingo games
Potential Tax Consequences
If it is determined that the income is taxable, then gross income of $1,000 or more must be reported on Form 990-T. Directly related expenses (with some exceptions) can be deducted from total income. A portion of indirect expenses from dual-use facilities and employees can be allocated as well. Be sure to keep records to substantiate all amounts and allocation methods used.
Under the Tax Cuts and Jobs Act, for tax years beginning after December 31, 2017, unrelated business income must now be calculated separately for each unrelated trade or business. This means that organizations can no longer combine losses from separate businesses to achieve an overall net operating loss (NOL). Previous year NOLs will still be able to be used without regard to which business created them. Losses arising in 2018 and later years can be carried forward to offset income from the same activity only.
Other allowable deductions include an NOL deduction (limited to taxable income), a $1,000 specific deduction that reduces the tax owed and a charitable contribution deduction (limited to 10% of income).
After deductions are taken, any resulting income tax may be minimal and worth the extra effort of producing the income in the first place. But there is one important caveat to keep in mind — excessive commercial activity or too much unrelated business activity can jeopardize the organization’s tax-exempt status. There is no fixed percentage to help determine how much is “too much.” So, if income will be generated from a particular activity, a best practice may be to consider spinning that enterprise off into a separate for-profit entity to avoid endangering the critical tax-exempt status of the organization as a whole.
Consider regularly reviewing your nonprofit’s activities to help ensure you are aware of any potential liability brought on by unrelated income and protecting your organization’s tax-exempt status.
Please contact a member of your service team, or contact Marie Brilmyer at firstname.lastname@example.org for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.