Organizations that operate and carry on activities in order to derive income to support their cause and mission, and have been deemed a tax exempt organization by the IRS, are not subject to corporate income tax.
However, when a tax exempt organization produces income from an activity that is outside the boundaries of its tax exempt purpose, the income may be subject to the unrelated business income tax. This is known as unrelated business income, and this income is taxed the same as a for-profit entity’s income at regular corporate tax rates. In addition, most business deductions available to for-profit entities are allowed to be taken by tax exempt entities. It is important to further note that if unrelated business income becomes a “substantial” portion of a tax exempt entity’s overall income, a loss of tax exempt status of the organization may result.
Professionals at GBQ are here to help break this down. The IRS has defined unrelated business income as income meeting each of the following characteristics:
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Trade or Business
Trade or business income is defined as income produced from the sale of goods or the performance of services. An exempt organization’s fundraising activities do not fall under the umbrella of trade or business income.
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Regularly Carried On
Per IRS Publication 598, the IRS deems activities to be regularly carried on “if they show a frequency and continuity, and are pursued in a manner similar to comparable commercial activities of nonexempt organizations.” This can be a grey area when it comes to evaluating a tax exempt organization’s activities as the IRS does not provide threshold guidelines of what constitutes an activity as being regularly carried on. However, case rulings can be helpful in determining whether an activity is regularly carried on or not. For example, IRS Private Letter Ruling 7905129 deemed the one-time sale of billing programs developed by an exempt health care provider an activity that is not considered regularly carried on. On the other hand, IRS Private Letter Ruling 8203134 treats the distribution of Christmas cards by an exempt organization to be unrelated business income due to the fact that this activity is comparable to commercial activities of a taxable organization.
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Unrelated to Exempt Purpose
For income to be considered a related activity, it must be derived to contribute importantly to the tax exempt entity’s purpose of the organization. Again, case rulings can be used as a guide to determine if an activity is related, or if it’s an unrelated income-producing activity. In IRS Private Letter Ruling 8107006, sales of stationary, clothing and accessories by a conservation organization containing the organization’s logo and other environmental messages, are considered related business income. This is due to the fact that these goods promote the interest in wildlife preservation which coincides with the organization’s mission.
The Tax Cuts and Jobs Act (TCJA) was passed by Congress in late 2017. The most significant change related to unrelated business income (UBI) is that UBI must now be calculated separately for each unrelated trade or business. Losses from one unrelated trade or business activity can no longer offset income from another. Along these lines, net operating losses generated in 2018 or later can only be claimed against income generated from the same specific business that generated the loss. Pre-2018 losses are subject to the rules prior to TCJA.
Certain forms of income are usually considered excludable from the unrelated business income tax. This includes interest, dividends, royalties, rental income from real property, gains and losses from the sale of property and research income.
A thorough analysis of a tax exempt organization’s income producing activities is important to abide by the unrelated business income tax rules and ensure that revocation of tax exempt status is not at risk due to its unrelated business income activities. Please consult with your GBQ advisors for help with determining the proper classification and treatment of your organization’s income producing activities.
Article originally written October, 2017, by:
Ashley Channel, CPA
Senior Manager, Tax & Business Advisory Services
Article updated April, 2023, by:
Christy Zimmerman, CPA
Director, Tax & Business Advisory Services
