When is income taxable?
Your 501(c)(3) organization generally is required to pay tax on income that isn’t related to its main purpose — even if that income keeps the not-for-profit afloat. This unrelated business income (UBI) is something to watch closely, because if your nonprofit is ever audited, the IRS will likely scrutinize your records to see whether you’ve accurately reported UBI.
If you haven’t reported UBI correctly, your organization may be responsible for back taxes, interest and penalties that can easily go into the thousands. And worse, if the IRS determines that your not-for-profit has significantly strayed from its mission because of UBI-generating activities, your tax-exempt status could be jeopardized. Fortunately, if you understand and follow the rules, you can avoid such scenarios.
How the IRS sees it
According to the IRS, an activity generally is an unrelated business and its income subject to UBI tax if the activity:
- Is a trade or business,
- Is regularly carried on, and
- Isn’t substantially related to furthering the organization’s exempt purpose.
Typically, all three situations must exist for the income to be considered UBI.
Activities that count
The types of activities that can generate UBI sometimes fall under the fundraising umbrella and include the following:
Sale of products unrelated to your purpose. Examples might include sales from a hospital gift shop or a zoo restaurant. To determine if the revenue is UBI, ask:
- Are you regularly — that is, frequently and continuously — selling the goods to make a profit?
- Would a for-profit organization want to carry on this kind of activity?
If you answer “yes” to these questions, you’ll likely need to report the income from the activity as UBI.
Sale of advertising space. Do you sell ad space in your organization’s journal, magazine or newsletter or on its website? Language that induces the reader to buy or use a product or service typically is considered advertising — for instance, a description of the product’s or service’s quality or a favorable comparison to a similar product or service. And the income from that activity is considered UBI. Conversely, a brief acknowledgment — listing, for instance, the supporter’s name and logo in a program — probably isn’t advertising, but rather is sponsorship and considered a donation.
Sale of unrelated services. In an online tutorial, the IRS uses the example of parking lots to explain this type of UBI. If an organization owns a parking lot and opens it regularly to the general public, the parking fee income is taxable. That’s because the activity — charging a fee for public parking — isn’t substantially related to the not-for-profit’s exempt purpose.
But, if only members and visitors use the parking lot while participating in the organization’s activities, the parking fee income isn’t taxable. The excellent tutorial can be found at http://www.stayexempt.org/VirtualWorkshop.aspx.
These are only some of the activities that can generate UBI. Income from certain investments, from selling membership lists and from gaming activities (see the sidebar “It’s all in the game”) also can produce UBI.
Exceptions to the rules
Keep in mind that there are many exceptions to the rules — for example, when your volunteers run the activity. According to the IRS, income from any trade or business where uncompensated volunteers perform 85% of the work is exempt from UBI tax.
A transaction’s structure also can exclude the resulting income from taxation. While being paid to directly promote products compatible with your mission probably will result in UBI, receiving royalties for licensing others to use your name or logo to promote such products may avoid it.
Other situations in which your nonprofit’s income may be exempt from tax include when the merchandise you sell is largely donated, such as in a book sale, or when gross income from the activity is less than $1,000. See IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations, for more exemptions.
These examples of activities that produce UBI are straightforward. But your not-for-profit may sponsor activities that seem to fall into a gray area, making them more difficult to evaluate. For instance, an exception that often applies to museum restaurants is when the nonprofit effectively documents that the operation is held for the “convenience of the members or attendees.” Additionally, fundraising activities often are exempt because they aren’t held regularly.
Your CPA can help you to analyze and quantify potential unrelated business activities and allocate expenses against this income. With proper planning, UBI often can be avoided and taxes reduced.