Nonprofit organizations exist to serve their communities, drive positive change, and make a lasting impact. For example, the American Red Cross, which provides disaster relief and emergency assistance while operating under tax-exempt status. Its mission-driven work is supported by various funding sources. Still, if it were to run a commercial business unrelated to its humanitarian efforts, it could be subject to Unrelated Business Income Tax (UBIT). With tax-exempt status, these organizations can focus their resources on their mission without worrying about federal income taxes. However, not all revenue streams fall under this exemption. If a nonprofit earns income from activities unrelated to its core mission, it may be subject to UBIT.
Understanding UBIT is crucial for nonprofits to avoid unexpected tax liabilities and ensure financial sustainability. For instance, in 2018, a well-known university was required to pay millions in UBIT after the IRS determined that some of its revenue-generating activities, such as rental income from commercial properties, did not align with its educational mission. This case underscores the importance of carefully assessing income sources and ensuring compliance with IRS regulations. In this article, we’ll break down what UBIT is, what qualifies as taxable income, key exemptions, and how nonprofits can stay compliant.
What Is Unrelated Business Income Tax (UBIT)?
UBIT is a tax imposed on income generated from business activities that do not align with a nonprofit’s primary mission. The IRS enforces UBIT to prevent tax-exempt organizations from having an unfair advantage over for-profit businesses while ensuring nonprofits remain focused on their charitable purposes.
What Qualifies as Unrelated Business Income (UBI)?
Not all income a nonprofit earns is taxable under UBIT. For an activity to be subject to this tax, it must meet three key criteria:
- Trade or Business – The nonprofit is engaged in an activity intended to generate revenue by selling goods or services.
- Regularly Carried On – The activity is conducted frequently and consistently, similar to a for-profit business.
- Not Substantially Related to the Organization’s Mission – The business activity does not directly contribute to the nonprofit’s primary mission.
For example, if a nonprofit animal shelter sells pet food to the public as a major revenue source, this income may be subject to UBIT because it is unrelated to its core mission of rescuing animals.
Exceptions and Exclusions from UBIT
Thankfully, not all revenue that meets the above criteria is taxable. These exceptions exist to support nonprofits in maintaining their financial stability while focusing on their missions. Historically, lawmakers recognized that certain revenue sources, such as donations and volunteer-driven activities, should not be taxed, as they align with the spirit of nonprofit work. Over time, policies were developed to ensure that essential fundraising efforts and passive income sources remained untaxed, allowing nonprofits to continue serving their communities effectively. The IRS provides several exceptions, including:
- Investment Income – Dividends, interest, royalties, and gains from the sale of stocks or real estate are exempt from UBIT.
- Volunteer-Operated Activities – If most of the work in an activity is performed by volunteers without compensation, the income is not subject to UBIT. For example, revenue from a charity auction run entirely by volunteers may be exempt.
- Convenience of Members – If a nonprofit operates a business primarily for its members, students, patients, or employees, it is exempt. A school cafeteria that primarily serves students and staff is a good example.
- Sales of Donated Goods – Revenue from selling donated items, such as in nonprofit thrift stores, is exempt because the goods were received as contributions.
- Qualified Bingo Games – Certain bingo games that comply with state and federal regulations are not considered unrelated business income.
Filing and Payment Requirements
If a nonprofit earns $1,000 or more in unrelated business taxable income (UBTI) in a fiscal year, it must file IRS Form 990-T to report the income and pay applicable taxes. The IRS allows a $1,000 deduction when calculating UBIT liability.
Form 990-T is due at the same time as the nonprofit’s Form 990. If a nonprofit expects to owe $500 or more in UBIT after adjustments, it must make estimated tax payments throughout the year to avoid penalties. While Form 990-T is publicly available, certain supporting documents that do not pertain to UBIT calculations remain confidential.
Conclusion
Understanding and managing UBIT is essential for nonprofits that engage in revenue-generating activities. By staying compliant with IRS regulations and strategically planning revenue streams, nonprofits can minimize tax liabilities and focus on their mission.
For expert guidance on UBIT compliance and financial strategies, HWA Alliance of CPA Firms, Inc. is here to help. Our team can assist your nonprofit in identifying potential UBIT risks, maximizing available exemptions, and developing a strategic approach to maintain financial strength while adhering to tax laws. Contact us today to ensure your nonprofit remains financially stable and compliant.
