During these financially challenging times, the creativity of nonprofit organizations is challenged in their efforts to raise adequate revenue to sustain operations. But new activities, however well-intentioned, can lead to tax trouble. Your nonprofit risks exposure to the unrelated business income tax (UBIT) if it operates outside its usual charitable scope. Here's how to avoid unwanted tax exposure.
Regular and Unrelated
For tax-exempt organizations, unrelated business income is generally defined as the profits generated by regular trade or business activities that aren't related to the organization's tax-exempt function. For example, if an animal welfare charity starts selling protective face masks to the public, the gain it realizes from such sales may trigger UBIT for this year.
Note that UBIT doesn't usually apply to one-time unrelated activities. Say your nonprofit makes a single sale of property;it won't owe UBIT on the profit because your organization isn't conducting the activity on a frequent and continuous basis.
A trade or business activity must have a causal relationship to be considered related to a nonprofit's tax-exempt function and it must contribute "importantly" to the nonprofit's purpose. What does this mean? The IRS decides on a case-by-case basis. But when assessing an activity for possible UBIT exposure, consider the size and nature of the activity relative to the size of your nonprofit's tax-exempt function.
Certain activities are excluded from the definition of an unrelated trade or business. For example, those:
Dividend and interest income, royalties and rents from real estate property are also generally excluded. There are a few situations where this type of income could be classified as unrelated business income.
If your nonprofit has unrelated business income, you may be able to claim certain deductions that are directly connected to an activity. This includes normal expenses such as depreciation and wages. Expenses related to both the tax-exempt function of your organization and the unrelated business must be allocated between the two functions.
The UBIT your organization owes is based on standard corporate tax rates. Currently, corporations are taxed at a flat rate of 21%. Unfortunately, unlike regular corporations, tax-exempt organizations are required to separate or break out each separate unrelated business activity into individual “silos”. Losses from one unrelated activity cannot offset the profits from another unrelated activity. In April of 2020, the IRS issued proposed regulations to assist tax-exempt organizations in applying this new law. In addition, nonprofits can claim many of the tax credits available to for-profit entities, including the general business and foreign tax credits.
Certain activities are more likely to trigger UBIT — for example, revenue from advertisements in a printed publication you produce. However, there are exceptions if the advertising activity is significantly related to your organization's exempt purpose or if it is conducted mainly by volunteers. Taxable gross advertising revenue is reduced by direct advertising costs and any readership costs in excess of circulation income. Gross advertising revenue is simply any amount received from advertising activities that are unrelated to your nonprofit's tax-exempt purpose.
Income generated from debt-financed property can also expose your organization to UBIT. However, if substantially all property is used to support your tax-exempt purpose, the income is excluded from tax. IRS regulations have established the "substantially all" test is met if at least 85% of the use of the property is devoted to a nonprofit's mission.
If your organization has gross unrelated business income (before any deductions) of at least $1,000, it must file Form 990-T and any related schedules with the IRS. Charities that are exempt from filing Form 990 — including certain churches — are still required to file Form 990-T if they have gross unrelated business income above the $1,000 threshold. Also, if your nonprofit expects to owe $500 or more in UBIT, you must make estimated tax payments and file Form 990-W.
No IRS Allowances … Yet
Most nonprofits aren't in the "business" of being profitable. But if you're facing a severe budget shortfall due to current social and financial circumstances, you may be more aggressive in pursuing profitable initiatives. The IRS hasn't made any special COVID-19 allowances for nonprofits that owe UBIT — although it could in the future. For now, assume you should watch your step and try to pursue mostly mission-related activities.
For additional guidance related to UBIT taxes, or taxes for nonprofit and governmental entities in general, contact Bryan Pautsch at firstname.lastname@example.org or 800.887.0437.