One of the most attractive aspects of a not-for-profit organization is the ability to operate and produce income which is not subject to taxation.  While this is generally the rule, there are situations where activities conducted by an organization can generate unrelated business taxable income.  This post focuses on the definition of unrelated business income tax (UBIT) and what activities may trigger UBIT.

In essence, UBIT is the gross income generated from activities:

1. Comprising the operation of a trade or business;
2. Which are regularly carried on; and
3. Are not substantially related to the performance of the organization’s exempt purpose or function.

The need of the organization to raise funds to support its mission does not meet the definition of “substantially related” in this case. Instead, you must look to criteria such as whether the activity has a substantially causal relationship to the organization’s exempt purpose and whether the size and extent of the activities are conducted on an appropriate scale in relation to the exempt function it serves. Unfortunately, these criteria are very subjective and depend on the facts and circumstances of each situation.  If, after analyzing the activity in question, it meets all three criteria above, then UBIT exists.

There are various exceptions and modifications to the UBIT rules which treat income otherwise subject to UBIT as non-taxable.  Any income generated from an unrelated trade or business is not considered UBIT if:

1. Substantially all the work is performed without compensation; or
2. The activity is carried on for the convenience of its members, students, etc. (e.g., museum cafeteria facilities); or
3. The activity is selling merchandise, substantially all items of which were received as contributions (e.g., thrift shops).

In addition, there are select items that have been specifically identified as not subject to UBIT.  Some of the more common items include:

1. Dividends and interest;
2. Royalties;
3. Real property rental income not subject to debt financing; and
4. Gains and losses from the sale, exchange or other disposition of property, excluding inventory.

While the goal of most organizations may be to avoid UBIT at all costs, keep in mind that unrelated business activities can be a productive way for an organization to support and/or expand its main operations depending on individual circumstances.

Each of the points identified above has its own set of nuances and exceptions which generally require further investigation depending on specific fact patterns.  For additional details or questions, contact Jeff Chiles at [email protected] or call him at 312.670.7444.