Review of Unrelated Business Taxable Income
While 501(c)(3) organizations are generally recognized as tax-exempt, they may have to pay tax on income derived from certain revenue-generating activities (as opposed to income from donations) known as unrelated business taxable income (UBTI). Income may be considered UBTI if it (1) is from a trade or business, (2) that is regularly carried on, and (3) it is not substantially related to the charitable, educational, or other exempt purpose that is the basis of the organization’s tax-exempt status. See our previous blog for more details on these three factors and how nonprofits report and pay taxes on UBTI.
What are the Exceptions and Exclusions to UBTI?
Federal law permits no more than an insubstantial amount of a nonprofit’s activity to be devoted to unrelated business activity. Engaging in too much unrelated business activity could result in revocation of a nonprofit’s tax-exempt status. Thus, it is important to know the numerous modifications, exclusions, and exceptions from UBTI, including:
- Dividends, interest, and certain other investment income: Dividends, interest, annuities, and other passive income similarly derived from a nonprofit’s ordinary and routine investments are generally excluded from UBTI.
- Royalties: To qualify as a royalty excluded from UBTI, a payment must relate to the use of a valuable right. For example, payments for trademarks, trade names, copyrights, and mineral rights are ordinarily considered royalties. Royalties do not include payments for personal services, such as payments for personal appearances or interviews by a celebrity. Some key exceptions to the royalties exclusion include debt-financed income and royalties received by a controlling organization from its controlled subsidiary.
- Rental income from real property (with some exceptions): While rental income from real property is generally excluded from UBTI, there are exceptions. , These include, but are not limited to, rents based on income or profits derived from leased property and payments for renting space when personal services are also rendered to the occupant (e.g., custodial services or coordination of special events). Also note that income derived from renting personal property is not excluded from UBTI.
- Gains or losses from the sale or other disposition of property: This exclusion from UBTI does not include the sale, exchange, or other disposition of (a) stock in trade or other property of a kind that would properly be includible in inventory if on hand at the close of the tax year, or (b) property held primarily for sale to customers in the ordinary course of a trade or business.
- Income from research activities: The extent of the exclusion depends on the nature of the organization and the type of research. The three primary exclusions from UBTI for research activities are for (1) research for the United States, any of its agencies or instrumentalities, or a state or any of its political subdivisions, (2) income derived for research by colleges, universities, and hospitals, and (3) income derived from research performed by organizations that operate primarily for fundamental scientific research (as distinguished from applied research) purposes and make the research results available to the public for free.
- Income generated by a trade or business in which volunteers perform substantially all the work or that consists of selling donated merchandise: For example, bake sales or thrift shops.
- Activity conducted for convenience of members: Income derived by a trade or business conducted for the convenience of members, students, patients, officers, or employees of a nonprofit is not UBTI. For example, a cafeteria on a college campus.
Be Aware of State Tax Laws Regarding UBTI
Although some states do not tax UBTI, most states do. How a nonprofit must compute UBTI for state income tax purposes will vary from state to state. While most states that tax UBTI conform in whole or in part to the federal definition of UBTI, many of those states have state-specific modifications.
Further, nonprofits must also determine the amount of UBTI attributable to the states in which it operates. Again, those rules vary from state to state.
While the rules governing Unrelated Business Taxable Income are complicated, The Law Firm for Non-Profits is well-versed in their nuances and here to help you navigate them.