Unrelated Business Income- What to be Aware of as a 501(c)(3) Organization
As a nonprofit corporation operating under §501(c)(3) of the internal revenue code, maintaining tax-exempt status is a priority. However, a corporation may generate income from activities that are taxable. For example, a church may operate a theater for educational purposes used during “Sunday school” for children. This activity is furthering the church’s exempt purpose. If the church decides to open the theater to the public every Monday to show popular movies, however, and charge admission, the church is generating revenue that is unrelated to its exempt purpose. The circumstance described here is known as unrelated business income.
Unrelated business income (UBI) arises when income comes from a trade or business that is regularly carried on and is an activity that is not substantially related to accomplishing the organization’s exempt purpose. The terms “trade or business” generally refer to any activity carried on for the production of income from selling goods or performing services. As long as a nonprofit corporation runs a trade or business that furthers its exempt purposes, the income generated would not be considered UBI. Sometimes, even activities that are similar to those that are related to an exempt purpose may generate UBI. To illustrate this idea, imagine a nonprofit organization that helps to rescue marine animals publishes a newsletter to inform the public on volunteer opportunities. The purpose of this newsletter directly correlates to the nonprofit’s exempt purposes. However, the nonprofit also chooses to sell space in the newsletter to unrelated advertisers. The income generated from the companies that are taking up space in the newsletter to advertise baked goods is completely unrelated to rescuing marine animals, thus the income is considered UBI.
In order to be considered a “regularly carried on” activity, the activity in question must demonstrate frequency and continuity. As a 501(c)(3) corporation, consider whether the activity is conducted in a way that a non-exempt organization would run a similar business. If the answer is yes, the activity is regularly carried on.
If a regularly occurring, income producing activity is not closely related to the nonprofit’s exempt purposes, any income it produces will be considered UBI. Consider the source of the income rather than the destination of the income. Even though an organization uses income from a particular activity to further its charitable purposes, that does not make the activity substantially related to its exempt purposes. Referring to the newsletter example, the nonprofit marine rescue corporation may use the revenue generated from the baked-good selling for-profit to clean up the harbor. While cleaning up the harbor does further the nonprofit’s exempt purposes, the selling of baked goods does not. This means that anything sold by a nonprofit, even for the purpose of raising funds, could be generating UBI.
There are three principles to determine whether the activity in question is significantly related to the organization’s exempt purpose:
- Selling products of exempt functions. Selling products that result from the performance of exempt functions is typically not an unrelated trade or business if the product is sold in substantially the same state it was when the exempt functions were completed.
- Dual use of assets or facilities. Some assets or facilities may be used for both exempt and commercial functions. The use of an asset or facility does not, alone, make the commercial activities an unrelated trade or business.
- Exploitations of exempt functions. Exempt activities may create goodwill that can be exploited in a commercial way. If this occurs, the fact that the income depends on an exempt function does not automatically mean the activity is related to the exempt function; the income could be considered UBI.
There are a few exceptions to the general rules of UBI. One exception is the distribution of low-cost articles. Nonprofit organizations may include incidental items like stamps when soliciting donations through the mail. The recipient is allowed to keep the stamps and is encouraged to donate to the nonprofit. The distribution of low-cost articles is not an activity which falls under the term “unrelated trade or business”. However, to be considered low-cost, the item must cost no more than $9.70.
Another exception relates to “convention or trade show activity”. To qualify under this exception, a convention must promote and stimulate interest in the products and services of a particular organization or industry. The purpose may also be to educate attendees on issues of the industry.
To qualify for the sponsorship exception, payments must be made to an exempt organization by an individual or company when the individual or company does not receive any substantial benefit, other than the use or acknowledgement of the contributor’s name, logo, or product line in connection with the organization’s activities.
Finally, bingo games may fall under an exception to UBI. The bingo exception applies to games that are only the traditional type of bingo where all wagers are placed, all winners are determined, and all prizes are awarded in the presence of all people playing the game. The game must be legal under state and local law and played in a jurisdiction where bingo games are not regularly conducted by for-profit businesses.
The Internal Revenue Code also mentions some exclusions to the rules of UBI, which include royalties, rental income, and gains and losses from the sale of property. However, if property is held for sale in the course of a regular trade or business, that income may not be excluded.
UBI can be offset by expenses related to production of the income just like other income tax. The Internal Revenue Code mentions some deductions that are allowed, including charitable contributions that are made to other qualified charitable organizations.
It is important to note that when UBI equals or exceeds $1,000, an organization must file Form 990-T. Furthermore, if a nonprofits total anticipated tax for the year equals or exceeds $500, the nonprofit must pay a quarterly estimated tax using Form 990-W.