The Nonprofit – Understanding Unrelated Business Income & How to Account For It

What Is Unrelated Business Income

Unrelated Business Income (UBI) is a topic that can cause confusion among nonprofit managers.  UBI is defined as income generated from an ongoing activity or activities of an organization, however, the activity(s) generating this income does not directly further the organization’s exempt purpose.  Although not illegal, if the income generated from UBI is not properly handled or accounted for, it can lead to penalties and/or revocation of an organization’s tax-exempt status.  It is important that nonprofits understand when an activity they are engaging in is unrelated to the charitable purpose of the organization.  

Examples of Unrelated Business Income

Giving clear examples may help in deciphering what may or may not be considered UBI, so I have taken some examples from Wikipedia to help provide some clarity:

Example 1

A university runs a pizza parlor that sells pizza to students and non-students alike. The university is a tax-exempt organization and its pizza parlor generates unrelated business income. While the tuition and fees generated by the university are tax exempt, its income from the pizza parlor is not tax-exempt because the pizza parlor is unrelated to the university’s education purpose.

Example 2

A counter-example is a social-service nonprofit that holds a one-time bake sale. While the sale is unrelated to their mission, it is tax-exempt because it is not regularly carried on. Business activities of an exempt organization ordinarily are considered regularly carried on if they show a frequency and continuity, and they are pursued in a manner similar to comparable commercial activities of nonexempt organizations.

Example 3

If a nonprofit organization receives income from providing services to outside entities and the performance of those services does not further the organization’s mission of the organization, the income may be unrelated business income.

Example 4

If a nonprofit organization sells advertising in print or on the organization’s website, the income is typically unrelated business income if the advertisements promote the advertiser’s business and not the nonprofit organization.

Example 5

If a nonprofit organization has ownership in an S corporation, the income from the S corporation is typically unrelated business income. Gain or loss from the sale of stock in the S corporation stock is also typically unrelated business income.

If the income from the examples above were generated as a one-time endeavor, or once in awhile and not on an ongoing basis, the income may not have to be classified as unrelated business income.  

How To Report Unrelated Business Income

Unrelated Business Income must be accounted for separately from a nonprofit’s income from tax-exempt activities.  The UBI activities are required to be reported on Form 990-T, and the net income is taxed at the corporate tax rate.   UBI is taxed even if the income generated from the activity is used exclusively to fund tax-exempt activities.  

Excessive Unrelated Business Income

The IRS vaguely asserts that “earning too much income generated from unrelated activities can jeopardize an organization’s 501(c)(3) tax-exempt status.”  The assumption is that if you fit into this category, your organization is operating for a commercial purpose rather than the tax-exempt purpose the organization was initially approved for.  

The question now becomes what does the IRS consider “too much income generated from unrelated activities?”  Unfortunately, the IRS has never provided an explicit dollar amount, percentage or any other guidance to assist nonprofits with this question.  If you ask your CPA or an Enrolled Agent this question, you are likely to get a different answer from each person.  I have heard “too much” can be anywhere in the range of 15 to 30% of gross revenue, but who is to say.

When the IRS does not provide explicit guidance to a question or a specific matter, court cases are a good place to go for additional research and guidance.  

Court of Appeals for the Second Circuit upheld the revocation of a 501(c)(3)’s tax-exempt status after the organization generated between 29 and 35 percent of its revenue from unrelated business activities in three consecutive years.  See Orange County Agric. Soc’y v. Comm’r, 893 F.2d 529 (2d Cir. 1990).  In another case, the U.S. Court of Claims held that a nonprofit association was not entitled to a tax exemption for the years in which the association generated nearly 60% of its income from unrelated business activities and its employees devoted roughly 50% of their time to such income-producing endeavors.  See Ind. Retail Hardware Ass’n, Inc. v. United States 366 F.2d (Ct. Cl. 1966).  The court explained that the amount of time devoted to and income generated from unrelated business activities showed that the activities had become substantial and were not merely incidental ways the association furthered its exempt purpose.  

Because the IRS has not established explicit rules in this area, they evaluate each issue on a case-by-case basis.

If your organization intends to engage in UBI activities, make sure to sit down with your accountant and come up with a plan of action that seems reasonable to the both of you.   Remember, losing federal tax-exempt status on the federal level may cause you to lose your state exempt status as well because many states grant tax-exempt status based on approval on the federal level.  

When Must An Organization Pay Income Tax On Unrelated Business Income?

An exempt organization must pay income tax on its unrelated business income if it generates revenue of $1,000 or more.  Taxable income is reported on form 990-T.  So in addition to filing the normal form 990, an organization must also file a separate form 990-T to report all taxable income.  Additionally, if an organization believes its tax liability will equal $500 or more, it must pay estimated tax.

Related Article