United States: When Is Income Taxable?

Last Updated: December 19 2014
Article by Kenneth L. Tornheim

Your 501(c)(3) organization generally is required to pay tax on income that is not directly related to its exempt purpose — even if that income is critical to the financial support of the organization. This unrelated business income (UBI) is something to watch closely, because if your not-for-profit is ever audited, the IRS will likely scrutinize your records to see whether you have accurately reported UBI.

If you have not reported UBI correctly, your organization may be responsible for back taxes, interest and penalties. And worse, if the IRS determines that your organization 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:

  1. Is a trade or business;
  2. Is regularly carried on; and
  3. Is not 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:

  1. 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-profitorganization want to carry on this kind of activity?

If you answer "yes" to these questions, you will likely need to report the income from the activity as UBI.

  1. Sale of Advertising Space — Do you sellad 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 quality of a product or service or a favorable comparison to a similar product or service would be considered advertising income. Further, the income generated from the sale of that product or service that is being advertised would need to be considered UBI. Conversely, a brief acknowledgment listing the supporter's name and logo in a program probably is not advertising; that income would be considered sponsorship revenue, which is considered a donation.
  2. 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 is because the activity of charging a fee for public parking is not substantially related to the not-for-profit's exempt purpose. But, if the use of the parking lot is limited to only members and visitors while participating in the organization's activities, the parking fee income is not taxable. The tutorial can be found at the StayExempt website.

These are only some of the activities that can generate UBI. UBI can also be generated from income from certain investments, selling membership lists and from gaming activities.

Exceptions to the Rules

Keep in mind that there are many exceptions to the rules. The following represent a few examples of those exceptions:

  • According to the IRS, income from any trade or business where uncompensated volunteers perform 85% of the work or more is exempt from UBI tax.
  • While receiving compensation to directly promote products compatible with your mission may result in UBI, receiving royalties for licensing others to use your name or logo to promote such products may avoid it.
  • Income may be exempt from tax when the merchandise you sell is largely donated, such as in a book sale.
  • Income may also be exempt 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.

Getting Advice

The above examples of activities that produce UBI are straightforward. However, your organization may sponsor activities that fall into a gray area, making them more difficult to evaluate. For instance, an exception that often applies to museum restaurants is when the not-for-profit effectively documents that the operation is held for the "convenience of the members or attendees." Additionally, fundraising activities often are exempt because they are not held regularly.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Kenneth L. Tornheim
 
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