Unrelated business income tax (“UBIT”) is one of my favorite little avenues in the nonprofit world. Maybe it’s because it comes with an interesting, entrepreneurial backstory.
Way back in 1946, the majority shareholder of the C.F. Mueller Company (“Mueller Macaroni”) died. A business broker by the name of H.T. Sorg had a great idea. He put together a deal whereby the New York University School of Law financed the purchase of Mueller Macaroni and used the profits from the sale of macaroni and other delicious products to fund the law school, a nonprofit. This didn’t sit right with the IRS, and they assessed a tax.
At the time, nonprofits could earn tax free income from commercial enterprises as long as the income was used for a tax exempt purpose. Initially, Mueller Macaroni won in tax court, but for profit companies weren’t having it. They argued unfair competition.
In 1950, the tax court began taxing nonprofits engaging in commercial activities unrelated to the organizations’ tax-exempt purpose. Since then, additional legislation has been enacted and additional guidance has been issued from time to time in order to ensure nonprofit compliance, including in the Tax Cuts and Jobs Act of 2017. If you’d like to deep dive into the history of tax exemption and UBIT here you go!
If you’re here for the quick and dirty version, let’s get to it.
Who Does UBIT/UBTI Apply To?
The UBIT law applies to entities that you traditionally think of as being exempt from tax like charities, religious organizations, state and municipal colleges and universities.
It also applies to certain tax-favored vehicles you may not have thought of including pensions, IRAs, SEPs, 529 plans, medical savings accounts and Coverdell Savings Accounts.
Unrelated business taxable income (“UBTI”) is the income generated by a tax-exempt entity, such as an IRA, when it invests in a trade or business unrelated to its tax exempt purpose and/or uses debt to generate income. The term UBIT stands for unrelated business income tax, or the tax itself.
What is Unrelated Business Income?
Unrelated business income is gross income in excess of $1000 earned by any tax exempt entity from a regularly conducted trade or business that is unrelated to it’s exempt purpose. Gross income is made up of gross receipts in excess of the cost of the goods sold.
It seems simple, but there are a lot of defined terms here. In order for income to be considered UBIT, all of these conditions must exist.
Regularly conducted
In order to determine if an activity is regularly conducted, we look to the frequency of the activity and we compare it to for profit businesses conducting the same activity. Remember, the crux of the UBIT rules came from an attempt to prevent unfair competition to for profit entities. Selling pizza at basketball tournaments, for example, is unlikely to be construed as competition for a local pizza shop.
Trade or business
The term “trade or business” generally includes any activity conducted for the production of income from selling goods or performing services. The activity must be conducted with intent to make a profit to constitute a trade or business.
An activity is still a trade or business even if it is conducted within a larger group of similar activities that may or may not be related to the exempt purposes of the organization.
For example, the regular sale of pharmaceutical supplies to the general public by a hospital pharmacy doesn’t lose its identity as a trade or business, even though the pharmacy also furnishes supplies to the hospital and patients of the hospital in accordance with its exempt purpose.
That being said, there are a list of activities that are specifically exempt. Have you ever wondered why churches love Bingo? It has a carved out exemption from being considered a gaming activity and therefore not an unrelated trade or business.
In order to qualify for this exclusion, the bingo game must meet the following requirements.
1. It meets the legal definition of bingo;
2. It is legal where it is played; and
3. It is played in a jurisdiction where bingo games aren’t regularly conducted by for-profit organizations.
Other exemptions from UBIT include qualified corporate sponsorship payments, royalties, and convention and trade show income.
For more details on specifically exempt activities, take a look at IRS Publication 598 linked below.
Unrelated to its exempt purpose
The activity is not substantially related to the nonprofit entities exempt purpose. While it may seem like raising funds is always related to an organization’s exempt purpose, that is not the case. IRS Publication 598 is full of examples of what is and is not considered a business related to an organizations exempt purpose, here’s just one of those examples. This comes straight of of the IRS publication, the emphasis is mine in the interest of clarity.
“An art museum that exhibits modern art sells greeting cards that display printed reproductions of selected works from other art collections. Each card is imprinted with the name of the artist, the title or subject matter of the work, the date or period of its creation, if known, and the museum's name. The cards contain appropriate greetings and are personalized on request. The organization sells the cards in the shop it operates in the museum and sells them at quantity discounts to retail stores. The museum also sells greeting cards by mail order through a catalog that is advertised in magazines and other publications throughout the year. As a result, a large number of cards are sold at a significant profit. The museum is exempt as an educational organization on the basis of its ownership, maintenance, and exhibition for public viewing of works of art. The sale of greeting cards with printed reproductions of artworks contributes importantly to the achievement of the museum's exempt educational purposes by enhancing public awareness, interest, and appreciation of art. The cards may encourage more people to visit the museum itself to share in its educational programs. The fact that the cards are promoted and sold in a commercial manner at a profit and in competition with commercial greeting card publishers doesn’t alter the fact that the activity is related to the museum's exempt purpose. Therefore, these sales activities aren’t an unrelated trade or business.”
If You Have UBIT or UBTI
Report It!
UBIT and UBTI are reported on IRS Form 990-T, Exempt Organization Business Income Tax Return.
Deduct
UBIT is imposed at the 21% flat federal corporate income tax rate. Just like taxation of for profit corporations, deductions are permitted for expenses that are “directly connected” with the carrying on of the unrelated trade or business.
Net operating losses are allowed to be carried forward and backward (with certain limitation). Since the passage of the Tax Cuts and Jobs Act of 2017 losses from one unrelated business activity are not able to offset gains in another.
Profits and losses are not aggregated by nonprofit entity, rather they are determined per activity.
While paying UBIT is not the end of the world, there may be situations in which paying a tax in order to indirectly further an organization’s mission may make sense, you don’t want to find yourself inadvertently subject to an unexpected tax.
The rules around UBIT are important ones for nonprofit leaders to have a thorough understanding of as they strategically plan for the best use of their organizations funds.