Non-profit organizations in the United States do not pay income tax on their “income.” However, when a non-profit ventures into certain business activities, it will owe income tax on this income, termed “unrelated business taxable income (UBTI).” This is only fair, as the non-profit is now competing with profit-making organizations that must pay tax on its income. UBTI levels the playing field.
What is Unrelated Business Taxable Income?
The IRS defines unrelated business taxable income as “gross income derived from any unrelated trade or business regularly conducted by the exempt organization, less the deductions directly connected with carrying on the trade or business.” Let’s unpack this definition and see how it applies in particular cases.
It must be a trade or business regularly carried on. An annual craft fair or yard sale is not a business and is not being regularly carried on. A church that operates a restaurant, open to the public with regular business hours has a trade or business. A non-profit that owns some stock or bonds and gets regular dividends and interest on these investments does not have UBTI, as passive income is not operating a business.
It must be unrelated to the exempt purpose of the non-profit. This is interpreted in a fairly broad manner. A church operating a bookstore for the convenience of its members does not have UBTI. Moving the bookstore to a location that has outside access to the store and keeps regular business hours is now serving the public, outside of their exempt purpose and may have UBTI. A church daycare center does not create UBTI, as it is furthering the education purpose of the church.
If the activity is conducted substantially with volunteer services, it is not generally UBTI. For example, Habitat for Humanity Chapters often operate a Restore, in which furniture, construction items, and similar merchandise is sold. However, a Restore is staffed primarily with volunteers, so this would not be UBTI. In a related vein, if the sale of merchandise is primarily the sale of donated goods, the income is not UBTI. For example the Salvation Army operates stores that are stocked primarily with goods that are donated by others.
To be exempt, the activity must be primarily for the convenience of clients, patients, faculty, staff, students or visitors. A church serving a Wednesday night meal to its member does not have UBTI, as this is a service being provided to help member attend the Wednesday night services. A college operation of a laundry, food service, bookstores, and vending machines are not considered UBTI as the purpose is for the convenience of students, faculty, and staff.
If the income is from the rental of real property, several issues arise. First, the organization may not provide significant services in relation to the rental or it becomes UBTI. Second, if the property is financed, the rental is termed “debt-financed income,” and would be UBTI. There are exceptions to this rule, however. Third, there must be a distinction between rental of real property and leasing space. For example a church located in a downtown location may rent parking space to downtown merchants and visitors during the week. This is UBTI. Also, short-term rentals, such as a boarding house or hotel-type operation would be UBTI.
Renting space to another non-profit is not UBTI. For example, a church has some excess office space, so they rent it to another non-profit organization. This is not UBTI, even if significant services are provided.
I Think I have UBTI. Now What?
Relax, this disease is not fatal. If you do have unrelated business taxable income, you should file Form 990-T as a part of the organization’s Form 990 filing. A church with UBTI would just file the Form 990-T. The tax rules applicable to business apply in this case. The organization can deduct direct costs of obtaining the income from the gross proceeds. For example, salaries paid to those working in a bookstore would be deductible items. The organization can also allocate indirect costs to the activity. This would include a portion of utilities, maintenance, and similar items. Finally, if the net unrelated income is under $1,000, there is no tax due as there is a specific exemption of $1,000.
If the UBTI exceeds $1,000, the organization is subject to income tax on the amount of UBTI that exceeds $1,000. This amount will be taxed at regular corporate rates. The return is due the 15th day of the fourth month after the close of the year. For most, this would be May 15.
This discussion of UBTI is by no means comprehensive. It is a complex topic, with numerous exceptions and nuances in the law. You should consult a qualified tax advisor to guide you in making the determination.