Tax-exempt organizations operate with the primary purpose of advancing charitable, educational, religious, or scientific objectives. The Internal Revenue Code grants them exemption from federal income tax based on their fulfillment of these public-benefit purposes. However, when an exempt organization engages in business activities unrelated to its core mission, the income generated from such activities may be classified as unrelated business income (UBI) and subject to taxation.
IRS Publication 598 outlines the definition of UBI, the process for determining whether income is taxable, and the potential consequences of engaging in repeated UBI. Organizations that fail to properly account for and manage UBI may face tax liabilities, penalties, and, in extreme cases, the loss of their tax-exempt status.
Defining Unrelated Business Income
According to IRS regulations, unrelated business income is derived from commercial activity that meets three primary criteria:
- The activity constitutes a trade or business. The IRS defines a trade or business as any activity conducted with the intent to generate income through the sale of goods or services. The key factor is whether the organization is operating the activity with the intent to generate a profit, rather than simply engaging in occasional or incidental transactions.
- The business activity is regularly carried on. If an organization engages in a revenue-generating activity with the same frequency and method as a commercial enterprise, it is considered “regularly carried on.” A one-time fundraising event may not be classified as UBI, but an ongoing business operation conducted throughout the year likely would be.
- The business activity is not substantially related to the organization’s exempt purpose. An activity is considered substantially related only if it contributes directly to the fulfillment of the organization’s exempt purpose beyond simply generating revenue. The fact that the income is used to fund the organization’s mission does not, in itself, make the activity exempt from UBI classification.
For example, if a nonprofit hospital operates a pharmacy that sells prescription medications to its patients as part of their treatment, the income generated is related to the organization’s exempt purpose and is not considered UBI. However, if the same hospital runs a general retail pharmacy open to the public, the sales from that business would likely be classified as UBI, as they do not directly advance the organization’s healthcare mission.
Exemptions and Exceptions to UBI Classification
Not all business activities conducted by a tax-exempt organization result in UBI. Several exceptions exist that exclude certain types of income from being classified as unrelated business income:
- Volunteer Labor Exception: If substantially all of the work in carrying out a business activity is performed by unpaid volunteers, the income from that activity is not considered UBI. A nonprofit bookstore staffed primarily by volunteers, for instance, would likely qualify for this exception.
- Convenience Exception: If the activity is conducted primarily for the convenience of an organization’s members, students, employees, or patients, the income generated is not UBI. This exception frequently applies to hospital cafeterias that serve staff and patients or university bookstores that primarily cater to students.
- Sale of Donated Goods: Income from the sale of merchandise that has been donated to the organization is not considered UBI. Many thrift stores operated by charitable organizations qualify under this exception.
Additionally, certain types of passive income are generally excluded from UBI classification:
- Dividends and Interest: Passive investment income, including earnings from stocks, bonds, and bank accounts, is typically not considered UBI.
- Royalties: Payments received for the use of intangible assets, such as trademarks, copyrights, or patents, are generally not considered UBI, provided the organization does not provide significant services in connection with the income.
- Rental Income from Real Property: Rent received from the leasing of real property is usually exempt from UBI, though exceptions apply if the property is financed with debt (resulting in unrelated debt-financed income) or if the organization provides substantial services to tenants.
Reporting and Taxation of UBI
Tax-exempt organizations that generate gross unrelated business income of $1,000 or more in a fiscal year are required to file Form 990-T, Exempt Organization Business Income Tax Return. This return must be filed in addition to the organization’s standard Form 990, Return of Organization Exempt from Income Tax.
UBI is subject to federal income tax at the corporate rate or, for trusts, at trust tax rates. Organizations with significant UBI may also be required to make estimated tax payments throughout the year.
Taxable UBI is calculated by subtracting directly related expenses, allowable deductions, and net operating losses from total unrelated business gross income. Organizations must maintain clear records separating revenue and expenses related to unrelated business activities from those associated with exempt-function operations.
Consequences of Repeated UBI Activity
While tax-exempt organizations are permitted to engage in some level of unrelated business activity, excessive reliance on UBI can have serious consequences. The IRS evaluates whether an organization is primarily operating for exempt purposes or if it has shifted its focus toward commercial activities.
Key risks associated with repeated UBI include:
- Loss of Tax-Exempt Status: If the IRS determines that an organization’s unrelated business activities have become its primary function, the organization may lose its tax-exempt status. This means all income—not just UBI—would become subject to corporate income tax, and the organization could also lose access to tax-deductible charitable contributions.
- IRS Audits and Penalties: Organizations that fail to properly report UBI or that misclassify revenue streams may be subject to IRS audits. Failure to file Form 990-T when required can result in penalties, interest charges, and potential legal consequences.
- Financial and Operational Impact: Engaging in excessive unrelated business activities can create administrative burdens, divert resources from the organization’s exempt mission, and alter its public perception. Donors and stakeholders may question the organization’s priorities if its business operations begin to overshadow its charitable work.
Strategic Considerations for Managing UBI
To minimize the risks associated with UBI while exploring revenue-generating opportunities, organizations should:
- Regularly Review Business Activities: Conduct periodic assessments to determine whether business activities align with the organization’s exempt purpose and whether income is properly classified.
- Structure Commercial Activities Carefully: Organizations engaged in substantial unrelated business activities may consider creating a separate taxable / for-profit subsidiary to conduct these operations, thereby protecting the exempt organization from potential tax liabilities.
- Maintain Clear Financial Records: Keep separate accounting records for unrelated business activities to ensure accurate tax reporting and compliance with IRS regulations.
- Seek Professional Tax Guidance: Given the complexity of UBI regulations, organizations should consult with tax professionals or legal counsel to ensure compliance and avoid unintended tax consequences.
Navigating unrelated business income requires a thoughtful balance between financial sustainability and mission integrity. Tax-exempt organizations that approach revenue generation with strategic oversight can expand their funding opportunities while remaining aligned with their exempt purpose. By staying informed, making intentional decisions about business activities, and adapting to regulatory requirements, organizations can create long-term stability without compromising their nonprofit status.
