Unrelated business income (UBI) is something every nonprofit owner needs to know about. By default, income in a nonprofit is tax free. However, you may owe tax on certain income that is unrelated to your charitable purpose. That’s unrelated business income.
IRS Definition of Unrelated Business Income
The IRS defines unrelated business income as “income from a trade or business, regularly carried on, that is not substantially related to the charitable, educational, or other purpose that is the basis of the organization’s exemption.” For a deeper definition, check out Publication 598.
Let’s break this down. To qualify, the income needs to meet the following elements:
- From a trade or business;
- Regularly carried on; and
- Not substantially related to the charitable purpose.
We’re going to break those elements down below. If the income fails in any one of these elements, it is not unrelated business income. You never want your income to be UBI, so keep these elements in mind when you’re running your organization.
If you see the term “Unrelated Business Taxable Income” or “UBTI,” that’s just the gross income that comes from the Unrelated Business Income minus the expenses related to that income.
Trade or Business
The IRS defines “trade or business” as “any activity conducted for the production of income from selling goods or performing services.” For example, if you sell shirts as a fundraiser, this would be a trade or business.
However, just because something fits into one of these elements does not mean it fits all of them. Looking at our shirts example, it’s only unrelated business income if it is also regularly carried on and not substantially related to your cause.
Regularly Carried On
I dislike this element because it feels incredibly subjective. To be “regularly carried on,” the activities must be at a frequency and continuity, and are pursued in a manner similar to comparable commercial activities of nonexempt organizations.” That’s kind of a mouthful. The example the IRS gives in Publication 598 is about a hospital operating a one off sandwich shop versus a year-round commercial parking lot. The sandwich shop wouldn’t be regular because it’s doesn’t compete with similar nonexempt facilities. However, the year-round parking lot would be regular under this element.
Not Substantially Related
Finally, the business activity isn’t exempt if it doesn’t contribute substantially to accomplishing that exempt purpose. However, raising of funds does not count as a contribution to the exempt purpose.
This element requires a case by case analysis. The IRS states “In determining whether activities contribute importantly to the accomplishment of an exempt purpose, the size and extent of the activities involved must be considered in relation to the nature and extent of the exempt function that they intend to serve.”
Selling of products of exempt functions
Generally, products that are produced through the exempt activities are not considered unrelated business income. For example, you wouldn’t owe tax when you sell old horseshoes from an educational horse farm. However, this only counts if the organization doesn’t substantially modify the horseshoes before selling.
Dual use of assets or facilities
If an organization uses an asset for exempt and commercial purposes, that doesn’t make it related business income on its own. You still need to run a separate analysis for the associated income.
For example, if you rent out your organization’s space on weekends, that income might be unrelated business income if it meets the above elements.
Exploitation of exempt functions
The IRS makes a point to talk about what happens when organizations take commercial advantage of intangible assets of the organization. Unless the commercial exploitation contributes importantly to the exempt purpose, the IRS would classify that exploitation as unrelated.
For example, if a nonprofit uses Facebook to provide educational materials and then uses their Facebook to sell a product using that same following, there’s a strong likelihood that exploitation would generate unrelated business income taxation.
In IRS Publication 598, the IRS provides pages of examples for you to peruse at your leisure. They cover a wide range of common scenarios to help you better understand UBI.
Excluded Trade or Business Activities
The IRS specifically excludes certain activities from UBI.
One of the main excluded activities is very specific gambling activities. Normally, gambling would be unrelated business income. However, bingo and certain other games are excluded from UBI if they meet the proper criteria. We’ll cover this and other exclusions in more depth in later articles.
Here’s some of the other excluded trade or business activities. However, keep in mind each of these comes with their own criteria and exemptions.
- Convenience of members
- Convention or trade show activity
- Distribution of low-cost articles
- Employee association sales
- Exchange or rental of member lists
- Hospital services
- Utility pole rentals
- Public entertainment activity
- Qualified sponsorship activities
- Selling donated merchandise
- Volunteer workforce
For more information on any of these, check out IRS Publication 598 and other related materials on IRS.gov. We’ll be covering some of these in future articles.