In order to avoid paying federal (and often state) income tax on revenue generated by a nonprofit organization, the organization generally must affirmatively apply for tax-exempt status. The type of tax-exempt organization generally controls how much revenue can avoid tax under IRS tax rules. For example, an Internal Revenue Code (IRC) section 501(c)(3) organization may be exempt as a private foundation, but must pay income tax on net investment income, whereas a public charity is not subject to the net investment income tax. In total, there are 29 different tax-exempt organization types under IRC section 501(a), with 25 different categories found under section 501(c). Each organization type has different levels of tax-exempt status, but all may be subject to the unrelated business income tax.
Unrelated Business Income Definition
The unrelated business income tax (UBIT) is a tax assessed on income that is generated by an unrelated trade or business. To fall under the unrelated business income rules, an activity must meet three requirements:
- The activity must be considered a trade or business,
- The activity must be regularly carried on, and
- The activity must be substantially unrelated to the organization’s exempt purpose.
Trade or Business: The IRS does not specifically define a trade or business. Instead, it looks at multiple factors to determine whether an activity rises to the level of a trade or business. An activity is generally found to be a trade or business if it is carried out in a business-like manner, and there is an expectation that the activity will generate a profit.
Regularly Carried On: To determine whether an activity is regularly carried on, the IRS will focus on the type of activity and the regularity required of that activity. For example, if an organization operates a store that is open every day with set hours, it would generally be found to be regularly carried on. In contrast, if an organization put on a one-time sale event at a local store to generate revenue, the “regularly carried on” condition would likely not be met.
Substantially Unrelated: When determining whether an activity is related to an organization’s exempt purpose, the organization must analyze the activity being performed, not what is ultimately done with the revenue generated by the activity. This analysis is very fact-specific, and may be challenging to determine. For example, an organization whose exempt purpose is the furtherance of the arts within a community may argue that putting on an arts festival annually is related to their exempt purpose. However, if an organization whose exempt purpose is to protect wildlife puts on an annual arts festival to raise funds, it becomes harder to link the art festival to the protection of wildlife.
Not all unrelated business activities will fall under the UBIT rules. For example, some income from investment activities—interest, dividends, capital gains, rental income—may be unrelated to the organization’s exempt purpose, but are specifically excluded from the definition of unrelated business income for public charities and certain other organizations. In contrast, advertising revenue generated from a publication put out by an organization would generally fall under the UBIT rules due to its commercial nature.
Unrelated Business Income Tax Reporting
Once a charitable organization makes the determination that an activity falls within the unrelated business income rules, the organization must separately account for the revenue and expenses related to that activity. If the gross income from the activity exceeds $1,000, the organization must file a Form 990-T to report the revenue and expenses and calculate any unrelated business income tax that might be owed. Each activity must be separately reported, with its own tax calculation. If an organization invests in publicly traded partnerships or makes other investments that report unrelated business income, the income from these investing activities might qualify to be aggregated for reporting and tax calculation purposes.
Form 990-T is due on the fifteenth day of the fifth month after the end of the organization’s tax year. An organization that has a year-end of December 31will therefore need to file Form 990-T by May 15 of the following year. The organization may also apply for a six-month filing extension by submitting a request on Form 8868 on or before the original due date. Note that this extension is separate from an extension to file the organization’s Form 990, 990-EZ, 990-N, or 990-PF. In addition, any taxes that may be owed must be paid by the original due date of the return. Payments are made electronically using the Electronic Federal Tax Payment System (EFTPS), and late payment and late filing penalties may apply if the organization misses these deadlines.
Conclusion
Tax-exempt organizations should be cautions when engaging in activities that may not be substantially related to their exempt purpose. Where an organization has a significant amount of revenue from unrelated business activities, the organization might owe a significant amount in tax, or could even jeopardize its tax-exempt status. Having an experienced nonprofit accounting specialist is critical to ensuring that an organization is in compliance with the unrelated business income tax rules.
As seen in NJCPA Focus, December 2024 issue.
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