In order to qualify for tax-exempt status, charitable organizations must comply with very stringent rules related to the activities they are allowed to carry out. In general, these rules require that a charitable organization’s activities be directly related to the organization’s tax-exempt purpose. However, in most instances, a charitable organization is allowed to invest in or engage in a trade or business that is considered unrelated to the exempt purpose. So long as the charitable organization follows the rules, and pays the tax, they will continue to maintain their exempt status. This article addresses what activities are considered an unrelated trade or business under these rules, and how a charitable organization can comply with the reporting requirements related to these activities.
Definition of Unrelated Trade or Business
An unrelated trade or business is generally defined as an activity that is regularly carried on and unrelated to a charitable organization’s exempt purpose. This determination is made by looking at the actual activity – not what the organization does with the revenue generated from the activity. While this definition may seem straight forward, many activities would appear to be unrelated, but qualify for an exception. And many activities perhaps should be considered related, but are not.
For instance, some income from investment activities – interest, dividends, capital gains, and rental income – would appear to be unrelated to an organization’s exempt purpose, but these items of income are specifically excluded from the definition of an unrelated trade or business for most charitable organizations. In contrast, revenue generated from advertising in a newsletter that a charitable organization publishes in furtherance of their exempt purpose is generally considered unrelated to the organization’s exempt purpose because it is commercial in nature.
Determining whether an activity is an unrelated trade or business depends on the facts and circumstances of any given situation, and therefore the best guidance available comes from court cases, revenue rulings, and other guidance that the Internal Revenue Service provides. Here are some examples of activities that are unrelated and therefore subject to tax:
- The leasing activity of an exempt organization is considered an unrelated trade or business where the building that is being leased is subject to a mortgage, but only the rental income that relates to the mortgaged portion is subject to tax since it is financed by debt and not eligible for exclusion.
- The sale of scientific books and city souvenir items by an art museum is unrelated to the art museum’s exempt purpose because these items have no causal relationship to art or artistic endeavors.
- Income from pet boarding fees and grooming services for the general public that is received by an organization that advocates for the prevention of cruelty to animals is considered unrelated to the organization’s exempt purpose because the activities do not contribute to the purpose of preventing cruelty to animals.
On the other hand, these activities were found to be related to a charitable organization’s exempt purpose:
- A museum’s operation of eating facilities, which help attract visitors and allow them to spend more time viewing the museum’s exhibits, is related to the museum’s exempt purpose because it contributes to the museum’s accomplishment of its exempt purpose.
- A gift shop operated by an exempt hospital is substantially related to the hospital’s exempt purpose because it allows visitors to make purchases for patients and employees.
- The operation of a furniture shop by an exempt halfway house that provides full-time employment for the residents is related to the exempt purpose because it aids the residents in their transition from treatment to a normal and productive life.
Reporting Unrelated Trade or Business Income
Once a charitable organization determines that an activity is an unrelated trade or business, the organization must then account for the revenue and expenses related to that activity and then determine whether it is required to file Form 990-T to report the net income. A Form 990-T is required if gross income exceeds $1,000 during the tax year. If the organization is not required to file, it may still benefit from filing if there are losses that may carry forward to offset income in future years.
If an organization has more than one unrelated trade or business, these activities will generally need to be accounted for and reported separately, and tax must be calculated separately on each activity. This separate treatment is a relatively new reporting requirement, imposed by the Tax Cuts and Jobs Act (TCJA) of 2017. The Treasury Department recently issued regulations providing some relief to this requirement, and allowing organizations to aggregate some investment income received from partnerships and other entities that the organization may invest in.
Form 990-T is due on the 15th day of the fifth month after the end of the organization’s tax year. An organization that has a year-end of December 31st will therefore need to file Form 990-T by May 15th of the following year. The organization may also apply for a six-month extension to a filing 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). Late payment and late filing penalties may apply if the organization misses these deadlines.
The rules governing unrelated trades and businesses that are carried out by charitable organizations are complicated. Having an experienced nonprofit specialist is critical to ensuring that an organization is in compliance with these rules and is not potentially subjecting the organization to unnecessary penalties. If you operate or are involved in the operation of, a charitable organization, we encourage you to reach out to the HBK Non-Profit Solutions Group to assist you in understanding and complying with the unrelated trade or business rules.