UBIT Guidelines: Does My non-profit Organization Need to Pay Taxes?

Most exempt organizations that are exempt under Section 501(a) of the Internal Revenue Code (“Code”) could be subject to unrelated business income tax (“UBIT”). The Code defines UBIT as gross income “derived by any organization from any unrelated trade or business regularly carried on by it, less the deductions allowed.

In other words, unrelated business income is the profit from any trade or business activity that is performed on a regular basis by an exempt entity that is not specifically related to the exempt purpose of the organization.
If an exempt organization engages in a one-time profitable, unrelated activity, it is not liable for UBIT because it occurred one time. The Treasury Regulations (“Regulations) add and clarify that the trade or business be “regularly carried on” to be taxed as UBIT income.

The Three-Factor Test
An organization can determine whether an activity will be considered UBIT income in the following three-factor test:

  1. The income is generated by a “trade or business” andwhether the activity has a profit motive. An example would be a non-profit organization that operates an activity that generates a profit to supplement the revenues needed to provide funding for programs directly related to its exempt function. Another activity example would be a business that is run in a similar manner as a for-profit business.
  2. The trade or business is regularly carried on. Frequency and continuance are factors that relate to an activity being “regularly carried on.” An activity that is done as infrequently as once a week, once a month, or once a quarter could be considered to be regular. Even an activity that has a normal time span of once a year may be considered regular, such as. the sale of calendars. Regulations require that exempt organization’s activities be given the same treatment as the for-profit business with which they compete.
  3. The trade or business is not substantially related to the non-profit organization’s exempt purpose. The Regulations state that an activity is not “substantially related” to an organization’s exempt purpose unless the activity “contributes importantly” to the accomplishments of the exempt purpose. For example, selling advertising in a publication generally, would not be considered related to an organization’s exempt purpose.

The Fragmentation Rule
Another important factor beyond the three-factor test would be the Fragmentation Rule (Rule). The Rule requires the organization to determine whether an otherwise exempt activity has activity receipts that are generated from sources unrelated to the exempt organization’s purpose.

For example, in an exempt membership club, services provided to club members are generally considered exempt. However, when the club also provides these same services to nonmembers, the receipts from these services are considered unrelated. Another example is in a museum gift shop, the sales of merchandise that are reproductions of artwork in their collections is exempt. However, the sale of general souvenirs would be considered unrelated.

Types of Income Not Subject to UBIT
Some income-generating activities are not a trade or business as a matter of law or regulation.  Specific types of income that are not subject to UBIT are:
  1. Income from activities that generate interest, dividends, royalties, and capital gains from passive activities for certain exempt organizations.
  2. Income from a business in which substantially all of the labor in carrying on the business is done by volunteers without compensation.
  3. A business which is carried on by the organization primarily for the convenience of its members, students, patients, officers or employees.
  4. Income generated by selling merchandise, substantially all of which has been received by the organization as gifts or contributions.
  5. Exchange or rental of membership lists between organizations eligible to receive charitable contributions as contrasted to sales of member list to commercial entities.
  6. Income generated by bingo or other games of chance. Certain restrictions apply to these activities and are subject to state or local regulations.
  7. Rental income can be exempt as long as there is no “acquisition indebtedness” associated with the assets producing such income (debt-financed income) and is generally for the lease or rent of real property and the rent or lease is not contingent on the lessor’s profit or income.
  8. Qualified sponsorship revenue is an exempt activity if the sponsor does not expect to receive substantial return benefits other than the use of acknowledgment of the name or logo or product lines of the sponsor’s trade or business In connection with the exempt organization’s activities.

All Exempt Organizations Could be Subject to UBIT
Not only can the UBIT income activity lead to owing federal income tax and require the annual filing of Form 990T, but it can also lead to jeopardizing an organization’s exemption. As a rule of thumb, an exempt organization should limit its unrelated gross revenue to no more than 25-30% of its total revenue

A non-profit advisor who is well-versed in non-profit operations and issues will be able to help you determine whether your organization could be subjected to the unrelated business income tax and whether your non-profit is conducting income-generating activities.

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