Throughout my time working with not-for-profit organizations, I've realized that unrelated business income tax is a topic that is often misunderstood. My clients frequently look to diversify their revenue streams which is why it’s critical that not-for-profit organizations understand what will qualify as unrelated business income and trigger possible taxes.
Understanding UBIT: The Basics
Unrelated business income (UBI) is defined by the IRS as income from a trade or business that is regularly carried on and not substantially related to a not-for-profit organization’s exempt purpose. Even if the income is used to fund mission-driven programs, it may still be taxable if the activity itself doesn’t directly further your organization’s charitable goals.
A trade or business includes any activity that is conducted for the production of income from selling goods or performing services with the intent of making a profit. For the income to be considered regularly carried on, the activity must occur frequently or consistently.
To be clear, UBI is not inherently negative. The IRS allows tax-exempt organizations to engage in some unrelated business activities, provided they report the income appropriately and pay the associated taxes. However, excessive unrelated activity can raise red flags and, in extreme cases, threaten your organization’s exempt status if the activity becomes the organization’s primary activity.
Organizations are required to file a form 990-T and report the income if the sum of the organization’s gross income from all unrelated business is $1,000 or more. This return is required to be filed by the 15th day of the 5th month after the end of the organization’s tax year (for example, May 15 for a December 31 year-end or November 15 for a June 30 year-end).
Common Triggers of UBIT
There are six common UBIT triggers that organizations should be on the lookout for. We often see several of these among our not-for-profit clients.
1. Advertising and Sponsorship Revenue
Income from commercial advertising is typically considered UBI. The advertising income isn’t excluded from UBI just because it appears in a publication that relates to your organization’s exempt purpose.
While corporate sponsorships may be exempt if structured properly, the line between sponsorship and advertising can be thin. The IRS notes that qualified sponsorship payments are excluded from UBI if there is no arrangement or expectation that the sponsor will receive any substantial return benefit other than the use or acknowledgement of the name or logo of the sponsor’s trade or business in connection with the activities of the organization that receives the payment. This use or acknowledgement should not be advertising the sponsor’s products or services. Careful documentation and legal review are essential.
2. Rental Income from Debt-Financed Property
If your organization rents out property that is subject to acquisition debt, the rental income may be partially or fully taxable under UBIT rules. Examples of this would include museums or performance venues renting out their space for wedding or corporate events. See the exclusions from UBI section below for specific instances where the rent would not be considered UBI.
3. On-Site Restaurants
If on-site restaurants are operated only for the convenience of your organization’s members, such as a cafeteria within a museum (see specific exclusions from UBI section below), the income would be excluded from UBI. However, restaurants that are open to the public will generate income that is classified as UBI.
4. Retail Operations and Gift Shops
Operating a gift shop or selling merchandise unrelated to your organization’s mission—such as branded apparel or general consumer goods—can generate UBI. The key determinant is whether the activity is substantially related to the exempt purpose.
5. Alternative Investments
As organizations continue to diversify their investments, it’s important to be aware that alternative investments such as partnerships, joint ventures, or limited liability companies may trigger UBI. Closely analyze any Schedule K-1 forms you receive for possible UBI and provide them to your organization’s tax preparer.
6. Parking Lots
Direct operations of parking lots that can be used by the general public will generate UBI. Similar to restaurants though, if the parking lot is necessary for the normal conduct of your organization and private for your members, the income would be excluded from UBI.
Specific Exclusions from UBI
There are several types of income that are specifically excluded from being unrelated business income.
- Investment Income – Dividends, interest, and other income from a not-for-profit organization’s ordinary and routine investments are excluded. This exclusion does not apply to 501(c)(7) organizations.
- Royalties – Payments that relate to the use of a valuable right are excluded.
- Rents – Rents from real property are excluded.
The exclusion does not apply if the income is derived from debt-financed property with the amount of income included being proportionate to the debt on the property. If substantially all (85% or more) of the use of any property is substantially related to your organization’s exempt purposes, the property isn’t treated as debt-financed property.
Special rules apply to mixed leases of real and personal property:- All of the rents are excluded if the rents attributable to the personal property aren’t more than 10% of the total rents under the lease.
- None of the rents are excluded if the rents attributable to the personal property are more than 50%.
- If the rents attributable to the personal property are between 10% and 50%, only the rents attributable to the real property are excluded.
- Income from Research – Organizations that are operated primarily to conduct fundamental research with the results available to the public can exclude all income from research.
- Gains and Losses from Disposition of Property – Other than the gains or losses from the sale of inventory or property held primarily for sale to customers, this income is excluded from UBI.
- Convenience of Members – Sales of goods and services that are provided exclusively for the convenience of a not-for-profit organization’s members are excluded.
- Volunteer Labor – Activities where substantially all of the work is completed by individuals without any compensation would be excluded from UBI.
- Donated Merchandise – UBI would not include any trade or business where the organization is selling merchandise which was substantially all donated.
Understanding the Impact of UBI on Your Not-for-Profit Organization
By understanding the triggers of UBIT and proactively managing risk, not-for-profits can continue to grow and diversify revenue streams while preserving the tax-exempt status that underpins their mission.
If you have any questions or would like to discuss the impact of UBI on your organization, please reach out to Katie Galaska, Director, Not-for-Profit Industry Group.