Hey Nonprofits – Listen Up! Did you know that a nonprofit can sometimes generate “taxable income” even AFTER it receives tax exempt status from the IRS

Sometimes tax-exempt nonprofits engage in fundraising and other income-producing options in order to supplement their contributions. This article provides an overview of the tax treatment of business activities of charities.

In General

A tax-exempt nonprofit is subject to the so-called “unrelated business income tax,” a tax imposed on certain business income notwithstanding the organization's tax-exempt status. The tax was enacted by Congress to address the issue of unfair competition by exempt organizations with their taxable competitors. As larger numbers of exempt organizations have entered the business arena, increased attention has been focused on the unrelated business income tax. It is now advisable to consider the potential impact of the tax on any fundraising or other income-producing activity engaged in by a tax-exempt nonprofit.

Bear in mind, that to qualify for exemption a tax-exempt nonprofit must engage primarily in activities that accomplish its exempt charitable purposes. A single nonexempt purpose or activity, such as an unrelated trade or business, if substantial in nature, will result in loss of exemption. For purposes of this initial examination of the unrelated business income tax, I will assume that the tax-exempt nonprofit's business endeavors will be confined within permissible levels.

Criteria for Taxation

Income from a business activity is not subject to the unrelated business income tax unless three basic criteria are satisfied. The first requirement is that the activity must constitute a trade or business. Broadly defined for purposes of the tax, a trade or business includes any activity that is carried on for the production of income from the sale of goods or the performance of services. The IRS has authority to divide what may appear to be a single trade or business into component parts, some of which may be treated as related activities and other of which may be treated as unrelated businesses. For example, if an exempt organization sells advertising space in its journal, the publication of the editorial content of the journal may be viewed as a related business while the sale of advertising will be treated as an unrelated business.

The second criterion for taxation is that the business activity must be regularly carried on by the exempt organization. An activity is regularly carried on only if it is conducted with a frequency and continuity similar to comparable commercial activities of nonexempt organizations and if the activity is pursued in a manner similar to such commercial activities.

Finally, the conduct of the activity must not be substantially related to the performance of the organization's exempt function. To escape taxation as a related business, the conduct of the business activity must contribute importantly to the accomplishment of the organization's exempt purposes, other than simply by the production of income.

Exceptions

Several types of business activities are excepted from the scope of the unrelated business income tax. The tax is not applicable to a business in which substantially all of the work in carrying on the business is performed by volunteers. A trade or business that is carried on by a tax-exempt nonprofit, or by a state college or university, primarily for the convenience of its members, students, patients, officers or employees is not subject to the tax. Income from the sale of donated merchandise is not covered by the tax. Other excepted activities include entertainment events at fairs, certain convention and trade shows, certain services provided to small hospitals at cost by other hospitals, bingo games, the distribution of low cost articles incident to the solicitation of charitable contributions, the exchange or rental of mailing lists, and certain sponsorship payments.

Imposition of the Tax

The unrelated business income tax is a tax on unrelated business taxable income. Unrelated business taxable income is equal to: (1) the gross income subject to the tax; (2) minus the deductions directly connected with the production of such income; and (3) computed with certain modifications. To be deductible in computing unrelated business taxable income, an expense must be both allowable under the general income tax provisions applicable to taxable organizations and directly connected with the conduct of the unrelated business. An item of deduction is directly connected with a business if the item has a proximate and primary relationship to the conduct of the business. Most of the modifications result in the exclusion of the unrelated business income tax. For example, dividends, interest, annuities, royalties, certain rents from real property, gains and losses from the sale of capital assets, and income from certain research activities are not subject to the tax.

The rate of tax depends on the legal form of the organization. The tax on exempt trusts is computed using the income tax rates applicable to taxable estates and trusts, and the tax on other exempt organizations is computed using the corporate rates. Organizations subject to the unrelated business income tax are also subject to the alternative minimum tax with respect to items of tax preference that enter into the computation of unrelated business taxable income.

Returns and Compliance

The unrelated business income tax is reported on Form 990-T. A return must be filed if gross income subject to the tax equals or exceeds $1,000. Quarterly estimated payment of the unrelated business income tax must be made. The Form 990-T must be made available for public inspection.

 Conclusion

The foregoing discussion provides a general idea of the scope of the unrelated business income tax, the exceptions to the tax, and the manner in which the tax is computed. You should carefully analyze the potential application of the tax to any specific fundraising options that you are seriously considering for your tax-exempt nonprofit.