Starting a 501(c)(3) nonprofit organization is one thing, but maintaining its tax-exempt status requires a thorough understanding of financial aspects and accounting.
It’s a common misconception that nonprofits don’t pay federal taxes on their income, but that’s not entirely true. The Internal Revenue Service (IRS) clarifies that any income unrelated to a nonprofit’s declared charitable purpose is taxable. As indicated by the name, such income falls under the category of unrelated business taxable income or UBTI.
There are many nuances to UBTI, such as exemptions, what incomes are considered under this category, and more. This guide will help you better understand UBTI and save your nonprofits from legal hassles.
Table of contents
Examples of unrelated business income
Pros and cons of unrelated business income for nonprofits
What are the exceptions to UBTI?
How much unrelated business income can a nonprofit have?
Taxation of UBTI for nonprofits
Organizations subject to the tax
What types of income are exempt from UBTI?
What is UBTI?
UBTI is the income that a tax-exempt organization, like a charity or nonprofit, earns from activities that don’t align with its primary purpose.
The IRS Publication 598 explains that UBTI comes from a regular business activity unrelated to the organization’s charitable, educational, or other purpose.
The aim is to prevent nonprofits, churches, or other organizations from using their tax-exempt status to earn profits by selling products and services. The tax is applicable even if the organization uses the earned profits for the betterment of the community.
This does not mean the IRS restricts you from earning unrelated business income. You can generate funds from diverse trade or business, but you must correctly fill out appropriate forms and annual reports to maintain your tax-exempt status.
Here’s how to file your financial reports and comply with the necessary regulations:
- If you earn $1,000 or more from an unrelated business, you need to file IRS Form 990-T and pay the taxes.
- If your nonprofit expects to pay $500 or more in tax for the year, you must pay quarterly estimated taxes. Check the IRS Form 990-W to find out how much tax to pay.
Note that Form 990-T and Form 990-W are separate from your organization’s annual return. You must file the following forms depending on your organization’s size:
- Form 990: For large organizations with gross receipts over $200,000 or total assets exceeding $500,000.
- Form 990-EZ: For mid-sized organizations with gross receipts under $200,000 and assets under $500,000.
- Form 990-N Electronic Notice (e-Postcard): Small organizations with gross receipts of $50,000 or less.
- Form 990-PF: This form is exclusive to all private foundations.
IRS UBTI requirements
To qualify as unrelated business taxable income, the earnings must meet the following criteria:
- Trade or business: The activity must involve a trade or business that sells goods or services.
- Regularly carried out: The activity can’t be a one-off event; it must be conducted over a period and with continuity similar to that of a for-profit business.
- Not substantially related: This activity must be significantly unrelated to the organization's primary purpose, which is the basis for its tax-exempt status.
Examples of unrelated business income
Example 1: Fundraising events that align with your mission
Suppose you started an animal rescue organization with a mission to rescue, rehabilitate, and find homes for abandoned and abused animals.
Your nonprofit organization wants to support these purposes and hosts quarterly fundraising events, for which an admission fee of $15 per attendee is charged. These events include pet adoption charges, educational seminars on animal care, and pet-friendly community activities.
Your nonprofit organizes quarterly fundraising events with a 60-day ticket sales window.
Let's examine this activity through the lens of UBTI criteria. While selling tickets is a regular business activity, it directly supports your organization's mission of animal rescue and education.
Since these events align closely with your nonprofit's charitable purpose, the income generated is unlikely to be subject to UBTI. This demonstrates how activities that further your organization's goals typically don't trigger unrelated business income tax.
Example 2: Unrelated community events triggering UBTI
Suppose the same animal rescue organization starts supporting its operations with other types of fundraising events. These events include a general community fair featuring food trucks, art vendors, and live music performances.
While your organization promotes its mission at these events, the primary income-generating activities—the food trucks and live music— are unrelated to its core purpose. Tickets sold for these events are available at the same price of $15, and the events are organized regularly.
All the conditions are the same, but the activities are carried out regularly and are different—they do not directly support your organization’s mission of rescuing and rehabilitating animals or educating the public about animal welfare.
This means the income generated from these ticket sales will come under the unrelated business income tax.
Benefits and challenges of unrelated business income for nonprofits
What are the exceptions to UBTI?
Passive income
Passive income covers dividends, interest, annuities, royalties, rents from real property, and capital gains from property. Under UBTI, all these sources of income are tax-free.
Volunteer run activities
If most of the funds raised are from activities or events run by unpaid volunteers, the revenue from such activities might not be considered UBTI. Note that the paid staff must not be substantially involved in the activity.
Suppose you host a games tournament organized and run by volunteers. This involves selling tickets, but because it is volunteer-run, the proceeds may be considered unrelated business income.
Convenience service
Income from activities providing convenience and benefits to the nonprofit’s members, students, employees, or officers falls under this tax-exemption category.
For example, an on-campus university cafeteria that offers services to its students and staff would not be subject to UBTI.
Selling donated items or sponsorships
High-value donated items sold through a nonprofit thrift store or auction also get tax-exemption under UBTI. A sponsorship that does not involve substantial return benefits and only involves acknowledgment of the sponsor is not a UBTI.
Some gaming activities
Revenue earned from bingo game fundraisers does not fall under UBTI. Note that offering multiple games of chance every night, like a casino, could trigger an IRS audit.
When organizing such activities, read the regulations and comply with IRS UBTI rules.
Convention and trade show income
Convention and trade shows can be exempt from UBTI under specific conditions.
The IRS guidelines state that nonprofit organizations may qualify for an exemption if the trade show activities are secondary to their exempt purposes. The event must relate to the nonprofit’s main goals, encourage interest, educate people on industry developments, etc.
The nonprofit should avoid holding the trade show primarily for profit.
How much unrelated business income can a nonprofit have?
Your nonprofit must pay the required taxes on any income from unrelated activities of $1000 or more. Beyond this, there is no specific revenue limit that nonprofits must adhere to.
Remember that the scope of unrelated business activities must be a manageable portion of your organization's overall engagements.
The IRS allows tax-exempt nonprofits to generate unrelated business income to support their mission and purpose. This does not mean nonprofits can engage in business activities under their tax-exempt status.
You must follow the IRS requirements, and if the percentage of unrelated income your nonprofit generates is too high, you may risk losing your tax-exempt status.
The IRS considers each organization’s unique scenarios when it comes to their unrelated business income. They check the nonprofit’s financial reports and apply the "commensurate test" to understand the scope of activities.
The key factors considered for the test include:
- Total unrelated business income
- Expenses for charitable activities
- Fundraising costs
- Administrative expenses
- Accumulation of funds
Taxation of UBTI for nonprofits
Calculation of UBTI
Nonprofits can determine their UBTI tax liability by subtracting expenses directly connected to the unrelated business income from the gross income generated from the activity.
UBTI = Gross income − deductions allowed
Here, gross income is the total income derived from unrelated business activities.
Deductions include all expenses incurred that are directly connected to generating unrelated business income.
UBTI tax rates for nonprofits
Nonprofits pay tax on UBTI under the corporate tax rate structure set by the IRS. It applies a flat 21% tax rate for most nonprofit organizations.
Remember that the state laws for nonprofits regarding UBTI vary, so check with your state's tax authority. This will help you understand any additional requirements or exemptions under the state laws.
Organizations subject to the tax
The IRS considers almost every charitable tax-exempt organization to be subject to unrelated business income tax. The most common nonprofit organizations that incur tax under unrelated trade or business are:
- Religious
- Educational
- Scientific
- Labor organizations under IRC section 501(c)(5)
- Employee benefit funds
- Research
- Social welfare under IRC section 501(c)(4)
- Advocacy groups
- Veterans’ organizations under IRC section 501(c)(19)
- Trade and professional associations
- Fraternal organizations under section 501(c)(8) or Section 501(c)(10)
What types of income are exempt from UBTI?
Most tax-exempt organizations must follow the UBTI requirements, though some special scenarios fall under exceptions to taxable unrelated business income, such as:
- Dividends
- Interest
- Income for volunteer labor
- Royalties
- Specific rental income
- Income from research activities, with some exceptions
- Gains or losses from property
- Income from some gaming activities like bingo
Determining if the above categories apply to your nonprofit revenue can seem complicated. Each case may have specific exemptions or conditions. Nonprofits must check the IRS Form 990-T instructions for more specific details regarding the exempted income sources.
Concluding thoughts on UBTI
Understanding the unrelated business income tax can help your nonprofit maintain its tax-exemption status under the Internal Revenue Code (IRC).
Proper reporting helps your nonprofit follow regulations and avoid penalties. It further enhances transparency in how your nonprofit organization strategically plans finances. This makes your nonprofit look more trustworthy to the public and the donors.
To simplify your financial management and fundraising efforts, use Zeffy's 100% free fundraising software for nonprofits.
Our user-friendly solution helps you track revenue-generating activities and streamline your donation process. With a centralized dashboard, you can clearly view your nonprofit's revenue, helping you manage UBTI and other financial aspects more effectively.
