What Nonprofits Need to Know About Unrelated Business Income Taxes (UBIT)
Unrelated Business Income Taxes (UBIT)
UBIT in a Nutshell
Most NFPs are founded to provide some public benefit. Tax-exempt status refers to the federal income tax exemption that is available for certain kinds of income under section 501(a) of the Internal Revenue Code (IRC). NFPs that have obtained tax-exempt status from the IRS are referred to as tax-exempt organizations or simply exempt organizations (EOs). The benefits of exempt status include exemption from federal income tax on income related to the organization’s exempt purpose and, for some entities, the eligibility to receive tax-deductible contributions from donors and supporters.
Federal law permits an NFP to engage in a certain amount of income-producing activity that is unrelated to the EO’s exempt purpose, which may be subject to unrelated business income taxes (UBIT). The income that is subject to federal taxes is referred to as unrelated business taxable income (UBTI).
Related vs. Unrelated Activities
To obtain and maintain tax-exempt status, an NFP must be organized and operated primarily for exempt purposes. However, federal tax law permits an NFP to engage in a certain amount of income-producing activity that is unrelated to its exempt purpose.
It is important to understand that an entity’s purpose is different than its activities. The entity’s purpose is the reason why the organization exists and its basis for qualification as a tax-exempt entity. Activities are the organization’s actions and undertakings.
Organizations Subject to UBIT
An NFP may be liable for federal income taxes if it generates certain types of income from business activities that are unrelated to the NFP’s tax-exempt purpose.
Some of an NFP’s activities are related to the entity’s exempt purpose, and some may be unrelated. The IRS is interested in how the unrelated income was earned, not in how it is used. Thus, income from unrelated business activities may be taxable even if the income derived from such activities is used to further the NFP’s tax-exempt purpose.
Unrelated business income is income from a trade or business which is regularly carried on and is not substantially related to the charitable, educational, or other purpose that is the basis of the organization’s exemption. Unrelated business income will result in UBIT unless an exemption or exclusion is available.
Commerciality Doctrine
It is helpful to understand that the law related to unrelated business income was implemented by Congress in 1950 to curb unfair competitive advantage of tax-exempt organizations over commercial for-profit entities. An NFP cannot quality for tax exemption or can have its tax-exempt status revoked if it is, in reality, a commercial enterprise. This is a legal concept known as the commerciality doctrine.
Consequences of Excessive UBI
NFPs can lost their tax-exempt status if the IRS determines that the percentage of their income that is from business activities unrelated to their specific exempt purposes is excessive. There is, however, no specific percentage of unrelated business income defined by the IRS as too large a percentage. The facts and circumstances of each unrelated business income situation should be considered.
Many NFPs depend on their tax-exempt status for funding purposes and could lose their funding if that status was revoked.
Article credited to the AICPA.
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