The IRS and state governments have continuing concerns about “unfair competition” between tax-exempt nonprofits and small businesses. They pay strict attention to a charitable nonprofit abusing its tax-exempt status to create an unfair advantage in the marketplace. One of the rules in place to prevent this is the Unrelated Business Income Tax, covered in more detail below.
What is Unrelated Business Income?
Charities have always earned income. Museums charge entrance fees, universities charge tuition, hospitals and clinics charge for services. There is no limit to the income that can be earned from mission-related activities.
Questions arise when the income is not directly related to the charitable purpose of the organization; this type of income is called Unrelated Business Income (UBI). Many nonprofits have some form of unrelated business income (for example, a raffle or an endowment), but not all UBI is subject to tax.
In general UBI refers to the gross income received; UBTI (unrelated business taxable income) refers to the amount of that income that is taxable.
What is UBIT?
UBIT is “Unrelated Business Income Tax”. It is frequently used to refer to unrelated business taxable income (UBTI); these are two sides of the same coin. UBTI is the income and UBIT is the tax that is levied based on the UBTI. UBTI is taxable at the corporate rates on that income.
Once a nonprofit organization reaches over $1,000 a year in gross profits from UBI, a separate Form 990-T income tax return must be filed with the IRS for each activity. Normal and necessary business activities are able to be deducted from the gross income to determine the taxable income amount.
If an organization anticipates its UBIT to be more than $500, it must file estimated tax payments.
What makes UBI taxable?
UBI is taxable income if the income is from a trade or business which is regularly carried on and is unrelated to the exempt purpose of the organization. Tax is only owed if the income meets all three of the requirements. (Note: There is no “de minimus” rule which exempts an activity merely because it is minor or included with other clearly exempt activities. The IRS has gone as far as to categorize items in a museum gift shop to divide which are related and which are not. )
A “Trade or business” is “any activity carried on for the production of income from the sale of goods or the provision of services” (Reg 1.513-1(b). There are exclusions from this definition; most applicably:
- Low-cost items given to encourage larger donations, such as cards, pens, or other branded items. To qualify, the items must meet a cost to benefit ratio that is annually indexed to inflation. (In 2024, the gift must cost less than $13.20 and the donation received must be more than $66.50.)
- Operations where the work is done substantially or solely by volunteers. (The IRS interprets ‘substantially all” as at least 85% of all activity to run the operation is done by volunteers.)
- Activities carried on for the “convenience” of members, customers, or employees. An example would be a hospital operating a pharmacy in a rural area where no commercial pharmacy is present for miles.
- Operations where substantially all of the merchandise is donated, such as typical thrift shops not using consignment practices.
- Qualified sponsorship activities where the sponsor will receive no substantial benefit other than the use or acknowledgment of the business name, logo, or product lines in connection with the organization’s activities. Advertising does not qualify here.
“Regularly carried on” is less clear than trade or business. Activities are regularly carried on if they “manifest a frequency and continuity, and are pursued in a manner generally similar to comparable commercial activities of nonexempt organizations.” (Reg. 1.513-1(c) Generally, once a year fundraisers are not regularly carried on. Holding a food booth for a week at the annual fair would not be regularly carried on, but operating a stand each week at the football game would be.
“Unrelated activity” is any activity that is not in alignment with the charitable purpose of the organization. This is the purpose that is listed in your exemption application and reported on the annual 990. The activity itself must be substantially related beyond just raising funds for the purpose. The use of the income does not matter for this purpose. For example, selling model tractors at the farm show is likely to be related; selling model RC cars would not be.
It is also important to note that the US Supreme Court will consider the manner in which the activity is operated in determining whether or not it is related to your purpose. The more the activity looks like a standard commercial venture, the more likely it is to be considered unrelated.
There are some other exclusions from UBIT that are important to note.
- Rental of land or building so long as the property is not subject to a mortgage or other indebtedness and there is not substantial personal property or personal services included.
- Dividends and interest income on money market funds, endowments, and other reserves.
- Royalty income from unrelated activities
Can a nonprofit organization make too much UBI?
Yes. There is no hard and fast line, but if the nonprofit has too much UBI (gross income, not net income) it could ultimately lose its nonprofit status. PANO recommends that once 10% of an organizations’ income is generated from UBI, a separate entity be created to carry out those activities.
What if my organization is a municipal library?
Check with your accountant and legal counsel. Some governmental instrumentalities are subject to UBIT (state-owned colleges and universities are specifically named) whereas others are not. It depends on the precise method of organization of the instrumentality.
In general, avoid unrelated business income until you are sure of your tax status..
Last updated July 2024
This information is provided to the best of our knowledge as of the date provided. Information is subject to change without notice. While authoritative, it is not guaranteed for accuracy or legalities. If there are questions, please reach out to your district consultant, who may encourage your library to ask a local solicitor/lawyer for further guidance.