Most not-for-profits (NFPs) are founded to provide some public benefit. Tax-exempt status refers to the federal income tax exemption that is available for certain kinds of income under section 501(a) of the Internal Revenue Code (IRC). NFPs that have obtained tax-exempt status from the IRS are referred to as tax-exempt organizations or simply exempt organizations (EOs). The benefits of exempt status include exemption from federal income tax on income related to the organization’s exempt purpose and, for some entities, the eligibility to receive tax-deductible contributions from donors and supporters.
Federal law permits an NFP to engage in a certain amount of income-producing activity that is unrelated to the EO’s exempt purpose, which may be subject to unrelated business income taxes (UBIT). The income that is subject to federal taxes is referred to as unrelated business taxable income (UBTI).
Related vs. Unrelated Activities
To obtain and maintain tax-exempt status, an NFP must be organized and operated primarily for exempt purposes. However, federal tax law permits an NFP to engage in a certain amount of income-producing activity that is unrelated to its exempt purpose.
It is important to understand that an entity’s purpose is different than its activities. The entity’s purpose is the reason why the organization exists and its basis for qualification as a tax-exempt entity. Activities are the organization’s actions and undertakings.
Organizations Subject to UBIT
An NFP may be liable for federal income taxes if it generates certain types of income from business activities that are unrelated to the NFP’s tax-exempt purpose.
Some of an NFP’s activities are related to the entity’s exempt purpose, and some may be unrelated. The IRS is interested in how the unrelated income was earned, not in how it is used. Thus, income from unrelated business activities may be taxable even if the income derived from such activities is used to further the NFP's tax-exempt purpose.
Nearly all tax-exempt organizations are subject to the UBIT requirements. These include charitable entities such as religious and educational organizations and scientific and research institutions. The requirements also apply to social welfare organizations, advocacy groups, veterans’ organizations, trade and professional associations, labor organizations, employee benefit funds and fraternal organizations.
Organizations that are not generally subject to UBIT requirements include:
- corporations that have been organized under Acts of Congress and that are instrumentalities of the United States, and
- certain charitable trusts not subject to the tax on private foundations
Unrelated business income is:
- income from a trade or business which is regularly carried on and is not substantially related to the charitable, educational, or other purpose that is the basis of the organization's exemption.
Unrelated business income will result in UBIT unless an exception or exclusion is available.
It is helpful to understand that the law related to unrelated business income was implemented by Congress in 1950 to curb unfair competitive advantage of tax-exempt organizations over commercial for-profit entities. An NFP cannot qualify for tax exemption or can have its tax-exempt status revoked if it is, in reality, a commercial enterprises. This is a legal concept known as the commerciality doctrine.
For example, a tax-exempt NFP youth organization operates a miniature golf course that is open to the general public. The golf course, which is managed by salaried employees, is substantially similar to commercial courses. The admission fees charged are comparable to fees of commercial facilities and are designed to return a profit. The operation of the miniature golf course in a commercial manner does not contribute importantly to the accomplishment of the organization's exempt purpose and, therefore, is an unrelated business.
Consequences of Excessive UBI
NFPs can lose their tax-exempt status if the IRS determines that the percentage of their income that is from business activities unrelated to their specific exempt purposes is excessive. There is, however, no specific percentage of unrelated business income defined by the IRS as too large a percentage. The facts and circumstances of each unrelated business income situation would be considered.
Many NFPs depend on their tax-exempt status for funding purposes and could lose their funding if that status was revoked.
To learn more about UBIT, refer to this archived webcast from the AICPA's Not-for-Profit Section, in which industry experts will help you navigate the complexities of complying with UBIT rules. This archive is not eligible for CPE credit.