One of the scariest moments for any organization is an IRS examination, particularly when the IRS is questioning whether the organization has strayed outside of its exempt purpose. The worst-case scenario is that the entity will lose its tax exemption and be forced to close. However, in many cases, the IRS will impose a tax on those activities that it deems to be outside of the entity’s tax-exempt purpose. This is referred to as the unrelated business income tax (UBIT).
The IRS Code defines UBIT as the tax on gross income derived by the organization from an unrelated trade or business that is carried out by the organization on a regular basis. For example, a university is a tax-exempt organization under the Internal Revenue Code. However, when it engages in a business such as running a restaurant or parlor, the income from these businesses is unrelated to the tax-exempt educational purpose of the university. Thus, the income from the unrelated business of the university will be taxed.
The Three-Factor Test
Most exempt organizations are given their status under Section 501(a) of the U.S. Internal Revenue Code. When they engage in unrelated business, they become subject to UBIT. A tax-exempt organization may determine if an activity it engages in will be subject to UBIT through a three-factor test.
1. Business Motivation
The first factor is that a business generates income from its activity, and the activity is motivated by profit. For example, a non-profit organization operates a business that generates income, which is then used to supplement the revenues of the organization for its programs and activities directly related to its exempt purpose. The business here is profit-motivated precisely because it is used to increase the revenues of the exempt organization.
2. Business Continuance and Frequency
The second factor is that the trade or business should be carried out regularly. Continuance and frequency are important factors, which relate to an activity
being done on a regular basis. An activity that is done only once a week or once a month does not qualify as being regularly carried out. The regularity of business requires some degree of permanence. Even an activity that has a certain time span such as selling products may not qualify as being regularly carried out. The concept of regularity distinguishes a trade or business from a fundraising event, such as an annual dinner, bake sale or an auction.
The Code requires that the business activity of an exempt organization be given the same treatment as organizations that are conducted for profit.
3. Relatedness to the Exempt Purpose of the Non-Profit Organization
Third, the trade or business is not substantially related to the exempt purpose of the non-profit organization. The Code states that an organization’s activity is not substantially related to its exempt purpose if the activity does not contribute importantly to the accomplishments and goals of the exempt purpose. For example, accommodating advertisements in a school publication would generally not be related to the exempt purpose of an organization.
Other Things to Consider
Beyond the three-factor test, another important factor for determining if an activity is subject to UBIT is the fragmentation rule. This rule requires the exempt organization to identify whether an activity that is otherwise exempt has income that is generated from unrelated sources. For example, the services that a membership club provides to its members are considered exempt. However, when the same services are provided to nonmembers, the income generated from such services are considered unrelated and are therefore subject to UBIT.
Under the Code, there are income-generating activities that are not considered trade or business subject to UBIT. These include, among others, activities that generate dividends, interest, capital gains, and royalties from the passive activities of an exempt organization, activities wherein all or substantially all of the work in carrying out the business is performed by volunteers who do not receive compensation, activities that are carried out by the organization mainly for the convenience of its members, employees or officers, and activities that involve the sale of merchandise received by the organization as contributions or gifts.
The existence of the UBIT is merely another business risk not for profit organizations need to be aware of and manage.
It’s far better to be proactive and perform an analysis of an organization’s fundraising activities to determine if any may be considered unrelated business then to passively wait for the IRS to come knocking. If the organization is involved in unrelated business activities, a form 990-T must be filed annually to report such activities to the IRS and pay the appropriate tax.
The unrelated business income tax is a complex area and requires the assistance of a CPA in order to properly analyze and evaluate.