Collectively, charitable nonprofits generate the vast majority of their income from fees for services. According to the National Center for Charitable Statistics, in 2013, public charities reported over $1.74 trillion in total revenues and $1.63 trillion in total expenses. Of the revenue:
- 21% came from contributions, gifts and government grants.
- 72% came from program service revenues, which include government fees and contracts.
- 7% came from "other" sources including dues, rental income, special event income, and gains or losses from goods sold.
Nonprofit earned income can be a product of either a related and unrelated business. Generally, a tax-exempt nonprofit does not pay taxes on income from its related businesses, but it may be subject to unrelated business income taxes (UBIT) on the net income from its unrelated businesses.
The General UBIT Test
The general test to determine whether an earned income activity is subject to UBIT is based on whether the activity meets all of the following requirements:
- It is a trade or business,
- It is regularly carried on, and
- It is not substantially related to furthering the exempt purpose of the organization.
The IRS describes the requirements as follows:
"Trade or Business" Defined
The term trade or business generally includes any activity carried on for the production of income [with a profit-motive] from selling goods or performing services. It is not limited to integrated aggregates of assets, activities, and goodwill that comprise businesses for purposes of certain other provisions of the Internal Revenue Code. Activities of producing or distributing goods or performing services from which gross income is derived do not lose their identity as trades or businesses merely because they are carried on within a larger framework of other activities that may, or may not, be related to the organization's exempt purposes.
"Regularly Carried On"
Business activities of an exempt organization ordinarily are considered regularly carried on if they show a frequency and continuity, and are pursued in a manner similar to, comparable commercial activities of nonexempt organizations.
To determine if a business activity is substantially related requires examining the relationship between the activities that generate income and the accomplishment of the organization's exempt purpose. Trade or business is related to exempt purposes, in the statutory sense, only when the conduct of the business activities has causal relationship to achieving exempt purposes (other than through the production of income). The causal relationship must be substantial. The activities that generate the income must contribute importantly to accomplishing the organization's exempt purposes to be substantially related.
Exceptions to the General Rule
There are a number of modifications, exclusions, and exceptions to the general definition of unrelated trade or business.
The following activities are specifically excluded from the definition:
Volunteer Labor: Any trade or business is excluded in which substantially all the work is performed for the organization without compensation. Some fundraising activities, such as volunteer operated bake sales, may meet this exception.
Convenience of Members: Any trade or business is excluded that is carried on by an organization described in section 501(c)(3) or by a governmental college or university primarily for the convenience of its members, students, patients, officers, or employees. A typical example of this is a school cafeteria.
Selling Donated Merchandise: Any trade or business is excluded that consists of selling merchandise, substantially all of which the organization received as gifts or contributions. Many thrift shop operations of exempt organizations would meet this exception.
Bingo: Certain bingo games are not unrelated trade or business.
Qualified sponsorship activities. Soliciting and receiving qualified sponsorship payments is not an unrelated trade or business, and the payments are not subject to unrelated business income tax. [A qualified sponsorship payment] is any payment made by a person engaged in a trade or business for which the person will receive no substantial benefit other than the use or acknowledgment of the business name, logo, or product lines in connection with the organization's activities. “Use or acknowledgment” does not include advertising the sponsor's products or services.
The following types of income (and deductions directly connected with the income) are generally excluded when figuring unrelated business taxable income:
Dividends, interest, annuities and other investment income. All dividends, interest, annuities, payments with respect to securities loans, income from notional principal contracts, and other income from an exempt organization's ordinary and routine investments that the IRS determines are substantially similar to these types of income are excluded in computing unrelated business taxable income.
Royalties. Royalties, including overriding royalties, are excluded in computing unrelated business taxable income. To be considered a royalty, a payment must relate to the use of a valuable right. Payments for trademarks, trade names, or copyrights are ordinarily considered royalties. Similarly, payments for the use of a professional athlete's name, photograph, likeness, or facsimile signature are ordinarily considered royalties. However, royalties do not include payments for personal services. Therefore, payments for personal appearances and interviews are not excluded as royalties and must be included in figuring unrelated business taxable income.
Rents. Rents from real property, including elevators and escalators, are excluded in computing unrelated business taxable income. Rents from personal property are not excluded. However, special rules apply to “mixed leases” of both real and personal property. … In a mixed lease, all of the rents are excluded if the rents attributable to the personal property are not more than 10% of the total rents under the lease, as determined when the personal property is first placed in service by the lessee. If the rents attributable to personal property are more than 10% but not more than 50% of the total rents, only the rents attributable to the real property are excluded. If the rents attributable to the personal property are more than 50% of the total rents, none of the rents are excludable.
Income from research. A tax-exempt organization may exclude income from research grants or contracts from unrelated business taxable income. However, the extent of the exclusion depends on the nature of the organization and the type of research.
These exclusions do not apply to unrelated debt-financed income or to certain rents, royalties, interest or annuities received from a controlled organization. An organization is controlled if the controlling organization owns (by vote or value) more than 50% of the stock, profits or capital interests, or other beneficial interests.
In general, the term “debt-financed property” means any property held to produce income (including gain from its disposition) for which there is an acquisition indebtedness at any time during the tax year (or during the 12-month period before the date of the property's disposal, if it was disposed of during the tax year). It includes rental real estate, tangible personal property, and corporate stock. Generally, investment income that would otherwise be excluded from an exempt organization's unrelated business taxable income must be included to the extent it is derived from debt-financed property. The amount of income included is proportionate to the debt on the property.