Many tax-exempt organizations assume that their tax-exempt status eliminates the potential for tax on all forms of income they may generate. Exempt organizations beware. Activities you are involved in may be identified by the Internal Revenue Service as unrelated business taxable income (UBTI) which is subject to tax.
The primary objective of UBTI is to eliminate the potential of unfair competition that exempt organizations might enjoy because they are tax exempt. Unrelated business taxable income is defined as gross income derived from an unrelated trade or business which is regularly carried on by the organization, less deductions. To establish UBTI, all three of the following characteristics must exist: (1) The income is derived from a trade or business activity; (2) The activity is regularly carried on; and (3) The activity is substantially unrelated to the organization’s exempt purpose. While these tests may be fairly basic on the surface, they actually can be quite complicated, depending on the facts and circumstances involved.
Generally, an activity will be considered a trade or business activity if it is carried on for the production of income from the sale of goods or the performance of services. This definition is so broad that by itself would result in most exempt organizations being taxed on sources of income other than donations received. Fortunately, all three of the characteristics must exist before UBTI will apply.
In determining if an activity is regularly carried on, the exempt organization’s activity should be compared to a comparable activity performed by a non-exempt commercial organization. For example, if a commercial organization operates an activity on a seasonal basis, and an exempt organization carries on the activity on the same seasonal basis, it would be considered regularly carried on. One time activities are normally not considered regularly carried on and therefore, would not create UBTI.
The most difficult characteristic to evaluate is typically the substantially related test. In order for an activity to be substantially related, a relationship must exist between the activity and the accomplishment of the entity’s exempt purpose. In other words, the trade or business activity must importantly contribute to the organization’s exempt purpose (other than the need to raise funds). The use of an asset in an exempt function does not prevent it from being considered UBTI, and therefore subject to tax. It is the activity, not the asset or facility, which is evaluated.
As with many Internal Revenue Code sections, there are typically exclusions or exceptions to the above rules. In addition to statutory exceptions for such items as interest income, dividend income, etc., you may be able to avoid UBTI on activities where the work is performed by volunteers, on activities that are for the convenience of the organization’s members and on activities where income is produced from the sale of items donated to the organization. As a caution, there are exceptions to the exceptions.
While an organization may be surprised to learn they have unrelated business taxable income and therefore owe tax, it may not be a bad thing. The cost of raising the charitable dollar and the competition for such dollars continues to increase. With the appropriate allocation of expenses to income, the entity can minimize the tax that might be due. In addition, there is still net income generated to the organization even after the payment of tax. A careful evaluation of all activities of any exempt organization is a must. In addition to surprise tax liabilities, excessive amounts of UBTI could threaten an organization’s exempt status.
Thank you to Gina Ross at Mayer Hoffman McCann, L.C. for assisting with this article. Mayer Hoffman McCann is Kansas City’s largest independent, locally owned accounting firm.
Denise E Farris, Esq.
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Farris Law Firm, LLC
20355 Nall Avenue, Stilwell, KS 66085
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