Direct mail, sponsorships, fundraisers – these are just a few of the many ways nonprofits work to raise revenue to support their charitable or educational endeavors. But did you know that the IRS considers certain activities or types of revenue “unrelated business income”(UBI)? The presence or level of UBI on an organization’s books could jeopardize its tax-exempt status, so it’s important that nonprofit leaders understand this concept and how to stay in compliance.
What is unrelated business income?
The IRS classifies UBI as activities of a tax-exempt organization that are not substantially related to the performance of the group’s core mission. Net revenue generated by an unrelated business activity is subject to federal income tax.
Keep in mind that the IRS deploys the UBI rule not only to raise additional tax revenue, but also to eliminate a source of unfair competition with for-profit businesses.
It is safe to say that UBI is a grey area of taxation, with a great deal of subjectivity, modifications and exclusions. But in a general sense, there are a couple of tests that a revenue stream must pass in order to be considered UBI, such as:
- It has to be substantially unrelated to the mission or goals on which the organization’s tax-exempt status is based.
- It must have the general characteristics of a trade or business, which includes any activity carried on for the production of income.
- It is carried on in a frequent and continual manner. This includes prep time and also can have a seasonal frequency component.
Exceptions to unrelated business income
There are several key activities common to nonprofits that are exceptions to UBI.
- Convenience businesses: There must be a “substantial causal relationship” as the IRS would say, meaning that offering this product or service is a direct result of the organization’s mission to provide assistance or support to its members. Examples of a convenience business include vending machines, laundry facilities, cafeterias and coffee shops.
- Sale of gift items: The items sold must have been donated. For instance, sales at a thrift shop operated to benefit a tax-exempt organization would not be considered UBI, nor would vehicles donated as part of a fundraiser.
- Gambling activities: Bingo is an exception to UBI when it is not conducted on a commercial basis and it is permitted under state law. Other games of chance are also exempt from UBI if they are run by a volunteer and are not run on a regular basis.
- Fairs, expos or industry events: Entertainment activities at a fair or expo designed to educate attendees on a particular topic are not considered UBI, nor are those conducted to attract members of the public to the fair. Also excluded from UBI are industry promotional activities like trade shows, conventions or annual meetings, both the cost of attendance as well as rental of display space.
Why it pays to be mindful of unrelated business income
A good rule of thumb is if 25 percent of gross income is derived from unrelated sources, an organization could come under IRS scrutiny. IRS audits of tax-exempt organizations have been on the rise in recent years, and there is no sign that the trend is reversing.
If gross revenue from UBI is more than $1,000 in a given tax year, it must be reported to the IRS using Form 990-T. These filings are due the 15th day of the 5th month, with some exceptions. UBI is taxed at the federal corporate tax rate, but may be reduced by applicable tax credits. In addition to federal tax requirements, there could also be state tax consequences. Your RKL advisor can help determine if a revenue stream qualifies as UBI and help you prepare the necessary tax paperwork to stay in compliance. Contact us today to assess your level of UBI.
Contributed by Ruthann J. Woll, CPA, Principal in RKL’s Tax Services Group and member of the firm’s Not-for-Profit Industry Group. Ruthann has significant experience in tax planning and compliance and specializes in serving individual and not-for-profit clients.