One benefit of being designated a nonprofit organization is being exempt from paying income taxes. Many nonprofits that have approved tax-exempt status from the Internal Revenue Service (IRS) are exempt from federal income taxes. They may also be exempt from income tax obligations by the state, including property and sales taxes. Donations to tax-exempt organizations may also be tax-deductible for donors. The most common designation tax-exempt entities receive is 501(c)3 organizations.
While the status of tax exemptions seems simple, some organizations are liable for paying taxes on income received from certain activities. Unrelated Business Income Tax (UBIT) is a common tax issue nonprofits face.
Continue reading to learn how UBIT may impact your organization.
What is UBIT?
Unrelated business income tax (UBIT) is tax paid on revenue generated by commercial activities that are outside the scope of your non-profit’s purpose, as stated in the original tax-exemption application. Whether or not reported activities are taxable is an important indicator and often becomes the focus of external financial audits. To determine if income is considered UBIT and subject to income taxes, a three-prong test is used.
The first prong in the UBIT test determines if the organization is a trade or business that operates in a commercial manner, meaning it carries out activities for the purpose of generating income from selling goods and/or services.
The second factor in deciding whether revenue is considered unrelated business income is specifying whether the activities in question are regularly carried out. The IRS examines the manner in which these activities are conducted, excluding fundraising activities and other occasional or sporadic events, and compares them to similar for-profit businesses.
The third prong is the most complex and determines whether the questionable activities are related to the nonprofit’s exempt purpose. Often, the IRS fragments activities into unrelated and related categories to ensure tax is applicable to those activities determined unrelated.
Examples of unrelated activities
If any revenue collected by the organization is considered UBIT, that income is subject to federal income taxes. Some common activities that are found to be unrelated business and generate income subject to taxes include the following:
- Rental income – Revenue generated from renting debt-financed properties, including real estate, tangible personal property, and corporate stock.
- Job listings – Income from the sale of job listings is considered unrelated.
- Commercial advertising – Selling advertising in a magazine or online platform is declared by the IRS to generate income that is considered unrelated.
- Sale of merchandise – Clothing or merchandise that contains a logo is considered unrelated.
- Administrative services – Income from providing generic management services that are available from commercial sources is eligible for UBIT.
Some activities can be carried out by nonprofit organizations and remain exempt from federal and state taxes, once they have passed the three-prong UBIT analysis.
- Corporate sponsorships – Qualified sponsorship payments are made by any person engaged in a trade or business with no expectation that they will receive any return benefit and are exempt from UBIT.
- Passive Income – Investment income and gains from dispositions of property are not unrelated.
- Royalties – Payments received for the use of a valuable intangible property right are excluded from UBIT consideration.
- Volunteers – If the work for conducting an activity is done by only volunteers, the activity is not considered an unrelated business.
- Sale of donated goods – Income generated from selling goods that the organization received as gifts or contributions is not subject to UBIT.
- Convenience – If an activity is carried out for the convenience of the organization’s members, officers, staff, or students it is excluded from UBIT considerations.
How to report unrelated business income?
Once income or revenues are determined to be unrelated business income, they must be reported to the IRS. A nonprofit entity with more than $1,000 of unrelated business income must file a separate Form 990-T in addition to Form 990, the annual information return. IF an organization expects that its tax liability will be greater than $500, payment of estimated tax is required.
What can you do?
Understanding whether revenue from organized activities generates a tax liability is essential to proper financial planning. Organizations that ignore UBIT considerations stand to face an unexpected debt to the IRS as well as the pain of prior-year reporting and applicable fines and fees.
Knowledge and proper planning can help organizations prepare for UBIT obligations and in some cases avoid UBIT altogether. Some activities can be strategically restructured so that most of the labor is performed by unpaid volunteers. Contractual agreements can also be restructured so that profit-splitting proceeds become royalties.
Nonprofit organizations can work with an expert accounting advisor, like those at JFW Accounting Services, to understand which of their activities, if any, require UBIT. Working with JFW can also prepare organizations to plan for future obligations and avoid unnecessary tax debts. Protect your organization today by contacting JFW.
Jo-Anne Williams Barnes, is a Certified Public Accountant (CPA) and Chartered Global Management Accountant (CGMA) holding a Master’s of Science in Accounting (MSA) and a Master’s in Business Administration (MBA). Additionally, she holds a Bachelor of Science (BS) in Accounting from the University of Baltimore and is a seasoned accounting professional with several years of experience in the field of managing financial records for non-profits, small, medium, and large businesses. Jo-Anne is a certified Sage Intacct Accounting and Implementation Specialist, a certified QuickBooks ProAdvisor, an AICPA Not-for-Profit Certificate II holder, and Standard for Excellence Licensed Consultant. Additionally, Jo-Anne is a member of American Institute of Certified Public Accountant (AICPA), Maryland Association of Certified Public Accountants (MACPA), and Greater Washington Society of Certified Public Accountants (GWSCPA) where she continues to keep abreast on the latest industry trends and changes.