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Nonprofit Unrelated Business Income

There are few topics that generate more confusion to nonprofit managers than unrelated business income (UBI).  It is also one the areas than can cause the most problems for your organization.  It can cost you money…even your tax exempt status if not properly handled.  In this issue of our newsletter, we will shed some needed light on the subject.

The technical definition of UBI is: Income from a trade or business that is regularly carried on by an exempt organization and that is not substantially related to the performance by the organization of its exempt purpose or function, except that the organization uses the profits derived from this activity. Clear?  Not really.  A better way to say it is:  money generated from any on-going activity of your organization when the activity itself does not directly further the organization’s exempt purpose.  Examples are helpful:

Example #1 A community performing arts organization charges admission to its quarterly productions.  The stated purpose of the organization is to promote the performing arts to the community and to teach performance art to the participants.  The organization conducts quarterly plays and recitals for the public, charging $10 per attendee.  The activity is considered a regularly scheduled, on-going activity.  It is also directly related to the purpose of the organization.  Therefore, the revenue generated from ticket sales is NOT considered UBI.

Example #2 – A church owns a vacant, corner lot next door to its facility.  After studying traffic patterns and demographics, the leadership determines this to be a great location for a convenience store and gas station.  It then proceeds to build one and open for business.  The store provides a much needed cash infusion to supplement the various charitable programs the church conducts.  This activity is considered a regularly scheduled, on-going activity.  It is NOT directly related to the purpose of the church and IS considered UBI.

What are the problems with UBI?  Well, the good news is that it is not illegal.  The bad news is that it is taxable…and complicated to deal with.  It can even lead to penalties or tax-exemption revocation if improperly handled.  When a nonprofit generates UBI, the law requires the activity to be financially accounted for separately from the regular, tax-exempt activities.  The nonprofit is required to report the activity on federal Form 990-T and pay corporate taxes on the net profits…even if all the net profits are used to fund tax-exempt activities.  Sounds unfair?  Well, consider this:  If a nonprofit were allowed to generate revenue tax-free from an activity usually conducted by a for-profit business, then the nonprofit has an unfair competitive advantage.  In the case of the church in example #2, the church could jeopardize its local real estate tax exemption as a result of the UBI generating activity…even if properly handled for federal tax purposes!

Our advice: Avoid UBI if you can.  If your organization determines it simply cannot turn down an opportunity to make a pile of money from unrelated activity, know what you’re getting into.  Also know that federal law generally limits UBI to 30% of total organizational income in order to maintain tax exempt status.

For more information, see IRS Publication 598.

If you wish to start up a 501c3 organization, click here.

Greg McRay is the founder and CEO of The Foundation Group. He is registered with the IRS as an Enrolled Agent and specializes in 501(c)(3) and other tax exemption issues.

This Post Has 3 Comments

  1. Hi Greg, thanks for the great post! I’d like to see you discuss some of the gray areas. Like when the dance company sells shoes at intermission. I know that many museums make a fortune from their gift shops, but I bet they claim it to be tax-exempt. Nonprofits NEED this additional revenue desperately – I don’t want them to shy away from cause-related profits. Thanks!

    1. A “gray area” article is a great idea, Gail. The devil is in the details. With the museum gift shop example, if the items sold can pass the test of furthering the exempt purpose, they can usually get away with not claiming it as UBI. But many is the organization that rides the line as closely as possible…and even crosses it.

  2. Greg, this is a great explanation UBI, with enlightening examples. UBI should only be avoided if it is not a well thought out strategy. I am currently researching nonprofits and social enterprises that create handmade gift items as part of a funding and/or job training strategy. There are quite a few mental health organizations, as well as other types of organizations that do this. Perhaps the answer is to create a separate business entity to handle the administration and finances of the program.

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