Editors’ note: This article was originally published as a feature on NPQ’s website, on September 15, 2011.
If there is one thing that people know about taxes, it is that tax-exempt organizations don’t pay federal income tax. That seems simple enough. After all, if they had to pay tax, they wouldn’t be “tax-exempt,” right? Well, not always. While it is true that under most circumstances tax-exempt organizations are not subject to a corporate level income tax (as their taxable entity counterparts are required to pay), there are times that they will be subject to income tax—in this context known as the Unrelated Business Income Tax, or “UBIT” for short.
Much to the dismay of business owners, corporations and trusts pay income tax at the corporate/trust level. To ensure that tax-exempt organizations aren’t given an unfair advantage over their corporate/trust counterparts, Congress added the UBIT rules to force exempts to pay their fair share when engaged in commercial activity outside the scope of their exempt purposes.
The laws surrounding UBIT are complex. This article is not meant to cover all scenarios but is intended to provide an overview and alert readers to potential UBIT issues. Competent tax counsel is recommended for further detailed questions. In addition, the IRS’s Publication 598, which describes the UBIT regulations, is a handy resource.
When Will an Organization Pay UBIT?
UBIT rules require a tax-exempt organization to pay income tax when the organization regularly carries on a trade or business that is not substantially related to the organization’s exempt purposes. Let’s discuss each of these elements separately.
To be subject to UBIT, first, the organization has to carry on a trade or business. This is pretty self-explanatory, but to be clear: trade or business will usually involve the sale of goods or services in exchange for money or something else of value for the purpose of making a profit.
Second, the trade or business must be regularly carried on. This means it takes place frequently or on a continual basis similar to the way the activity would be carried on by a for-profit business. (Even a seasonal ?business can be considered regularly carried on, regardless of the large gaps of time between sales.)
Third, the trade or business must not be substantially related to the organization’s exempt purposes. In other words, the activity must not contribute importantly to accomplishing the organization’s exempt purposes. What are its exempt purposes? This gets a bit more complex, so let’s take a step back and review some background.
At the time of formation, nonprofits file a certificate (or articles) of incorporation with the secretary of state in the state of incorporation (trusts execute a trust document). The founders of the organization choose from a short list of permissible purposes in which a nonprofit is permitted to engage, and include the purposes in the certificate. Whereas a for-profit business is generally incorporated with the ability to conduct all lawful activity, nonprofits may only carry on certain activities, and in exchange they receive certain benefits when they are recognized by the IRS as tax-exempt. Depending on the kind of organization, the benefits may include the ability to receive tax-deductible contributions, income tax exemption, a property tax exemption, and preferred U.S. postal rates, among others.
The most common exempt purposes for charities and houses of worship are religious, charitable, educational, and scientific. While the tax regulations defining the activities that fall within each of these purposes are lengthy, suffice it to say that a church’s activities will fall within religious, charitable, and perhaps even educational purposes, and such purposes should have been listed in the church’s formation documents. And while an exempt school’s main purpose is educational, some of its activities will also fall within the charitable category. Finally, the activities of most charities will fall within the charitable category, but if they provide some educational element, such as educating communities regarding issues of concern to the broader public, those activities would be listed as educational. The nonprofit, in short, may only engage in activities that contribute importantly to those exempt purposes it is authorized to conduct—and it becomes authorized by including them in its certificate.
As an illustration, the charging of tuition by an exempt school is, no doubt, a regularly carried on business. But the charging of tuition is related to its exempt purpose, since parents are paying for the education of their children—education being the name of the game. The rule is that when a business activity is related to the exempt purpose, it may be carried on even substantially, with the organization never having to pay UBIT. Similarly, in the case of a church charging its congregants membership fees and dues, this is a regularly carried on business but it is related to its exempt purpose—admission for the purpose of prayer, which falls squarely within a church’s religious function. From these examples we see an interesting point: there is no prohibition for a nonprofit to make money, so long as it does so by carrying on an activity related to its exempt purposes. Of course, the organization is restricted with regard to what it may do with that money; generally, it may only use the money to pay reasonable compensation and necessary expenses. It is subject to the restrictions on private inurement and excess benefit transactions.
In determining whether an activity ?is related, we look to the activity itself and not to where the profit from the activity may go. So, if an activity itself does not contribute to the organization’s exempt purposes, the act of applying the proceeds to fund the organization’s exempt purposes does not make the activity related.
For example, what if, in an attempt to raise funds, the school started a retail clothing business located across the street, where it sold clothing to the general public at market value? The retail sale of clothing does not fall within any of the school’s exempt purposes, and so it is unrelated regularly carried on business activity. As noted above, it will be unrelated regardless of the fact that the proceeds go to benefit the school’s core function of educating students.
Once we have a regularly carried on trade or business that is unrelated, the next question to ask is whether it is substantial or insubstantial compared to all else that, to stay with the above example, the school does. If it were insubstantial, the school would be required to pay UBIT to the Internal Revenue Service. This is a tax at the current tax rate for the net profits the organization earns by running the unrelated business.