Navigating Unrelated Business Income
by Mafer Freeman, CPA
Nonprofit organizations are tax-exempt entities, right? Well, generally speaking, yes. However, some organizations may be subject to certain state taxes (more on that in a future article) and federal income taxes on unrelated business income (UBI).
Since no one gets ecstatic about paying a tax bill, it is important to be aware of UBI and potential tax consequences for your organization.
An unrelated activity is one that does not relate to the Organization’s mission, even if the cash generated by it is used to further the organization's exempt purposes.
UBI is defined as income from an unrelated trade or business activity that is regularly carried on and not substantially related to the organization's exempt purpose. Okay. What does this mean?
Breaking down UBI
To be taxable, the income from an unrelated activity must meet three tests (drumroll!):
- Trade or Business: the activity involves the provision of goods or services held out to the general public with a profit motive. When evaluating this first test, ask yourself the following questions:
- Have business-like procedures been adopted?
- Is considerable time and effort devoted?
- Are professional experts consulted or hired?
- Is the end- goal to maximize profit?
- Are the goods or services available to the general public? Or only available to members (such as members of a church)?
- Regularly carried on: the activity is frequent and continues in a manner comparable to similar commercial activities of a nonexempt organization.
The key here is that the number of times the activity occurs should not be considered exclusively. For example, a nonprofit’s Valentine’s Day flower sales may be a regularly carried on activity, even though it does not occur consistently throughout the year, if other for-profit organizations also sell Valentine’s Day flowers only during the holiday season.
- Not substantially related: The activity does not further the exempt purpose of the organization.
To put this into context, a homeless shelter would be taxed on starting up a coffee shop managed by shelter staff. However, a homeless shelter who starts a coffee shop and staffs it primarily with recovering homeless individuals as part of a program to reintegrate them into society would further the exempt purpose of the organization.
Remember, tax rules are complex and come with exclusions. Here are some examples to paint a clearer picture.
UBI Activities Commonly Subject to Tax
- A cafeteria, coffee shop or gift shop used primarily by the general public.
- Operating a commercial parking lot every Saturday of the year.
- Renting facilities to the general public for public functions.
- Selling advertisements in your Organization’s professional periodical.
- Renting out an office in the building it owns, and the building is financed by a mortgage.
Unrelated Activities Generally Excluded From UBI Tax
- Dividends, interest, royalties
- Rental income from real property not financed by debt
- Certain gains on the sale of property and equipment (except for inventory)
- Activities conducted substantially by volunteers
- Activities conducted for the convenience of members, students, patients, officers, or employees
- Oh, and Bingo! (WAHOO!)
You Have Identified Potential UBI – Now What?
Taxable activities aren’t necessarily a bad thing and generally don’t jeopardize your tax-exempt status. So, don’t panic, but be proactive. The first step is getting your CPA on the phone to come up with a game plan:
- Don’t miss filing requirements: If an exempt organization generates gross UBI of $1,000 or more, in addition to receiving an extension for time to file the Form 990, it is also required to file or receive an additional extension for time to file Form 990-T (Exempt Organization Business Income Tax Return) by the 15th day of the fifth month after fiscal year end.
- Calculate your tax liability: If unrelated business taxable income is over $1,000, the Organization will have a tax payment. Getting your CPA involved early in the process can help you plan ahead, estimate the tax impact and determine whether carrying a UBI activity makes sense for your Organization.
Above all, don’t fret! Testing for the presence of unrelated business income is not black and white. There are no clear principles or hard-and-fast rules. Give us a call, we are here for you!
Call us at (360) 734-4280 or fill out the form below and we'll contact you to discuss your specific situation.
Mafer Freeman, CPA
Mafer Freeman joined LG in 2016 and serves on the firm’s nonprofit team today. Her expertise is multi-faceted, including tax and financial statements.