One of the great advantages of being a nonprofit organization (NPO) is that the organization avoids paying income taxes in many situations. However, tax can apply at certain times in the form of unrelated business income tax (UBIT). If you are not familiar with the UBIT regulations, the time to evaluate your NPO’s activities is now!
An important concept to understand is that the evaluation of applying UBIT is focused on how the income is earned, not how it is ultimately used. Therefore, the idea that the income is being used solely to support your mission is not a legitimate way to avoid paying UBIT.
In general, UBIT applies when all three of the following criteria are met:
- The income is from a trade or business. Generally, this means an activity conducted for the production of income with the intent to profit.
- The trade or business is regularly conducted.
- The trade or business is not substantially related to the performance of the NPO’s exempt function or purpose. It is noteworthy that ‘substantially related’ isn’t clearly defined by the IRS and an evaluation will need to be performed to arrive at a supportable conclusion.
As is the case with many laws and regulations, exceptions to rules and less common situational elements always apply. Further research or consultation with your CPA will be essential to ensure compliance. Several common exceptions to the three criteria above are:
- The activity is carried out by substantially all volunteer labor.
- The activity is for the convenience of an organization’s members.
- The goods sold were donated merchandise.
- The operation of certain bingo games are allowed under certain circumstances.
Other forms of income are specifically excluded as being passive, such as interest and dividends, royalties, rental income from real property that is not debt-financed, and gains on the sale of investment assets. Again, there are also exceptions to these exclusions.
Some income streams that are more common to nonprofit organizations that are subject to UBIT are debt-financed rental income, income received for placing advertisements in publications or at special events, income from partnerships or S-corporations, and administrative or business services provided to others. Many other activities must be considered as well.
Recently, the IRS released new regulations concerning UBIT. Under the old rules, organizations could take the gross income of all unrelated trades or businesses and offset it with allowable deductions from all unrelated trades or businesses, whereas the new rules require organizations to ‘silo’ the revenue and expenses for each trade or business separately. This new methodology will directly affect the amount of any UBIT that may be due each year.
We encourage you to evaluate your NPO’s activities and evaluate whether any may be subject to UBIT, even if the activity may seem insignificant. Yeo & Yeo’s Nonprofit Services Group would be happy to help you reach a conclusion regarding compliance with UBIT regulations.