As a general rule, tax-exempt nonprofits are exempt from paying federal income taxes on their net revenues, but they may nevertheless owe taxes on income generated from unrelated business activities. The term “tax-exempt” thus can be misleading. When does a nonprofit become subject to income taxes? The answer depends on the type of organization, its specific activities, and a complicated framework of rules, exceptions, and more exceptions found in the Internal Revenue Code.
Of Bake Sales and Training Programs
Many nonprofits seek creative opportunities to raise funds (and they should!). For example, a church may provide occasional bake sales for special youth trips or other worthwhile activities. All well and good; the bake sales are sporadic, targeted only at regular attenders, and buyers may well be purchasing the baked goods predominantly to support the cause. Such sales thus do not compete regularly with any commercial bakeries.
But what if the church sells baked goods every day, through a nearby shop on a busy street, and with widespread advertising to garner increased sales revenue? In that case, the church is really operating a commercial business that is distinct from its religious mission. Even if the resulting net revenues are used directly to fund church activities, they will likely be taxable under the federal unrelated business income tax rules – a/k/a “UBIT.” (The resulting tax liability must be reported on IRS Form 990-T, if sales are more than $1000.)
Now consider a nonprofit organization that seeks to provide job training and skills for at-risk youth by selling baked goods. The nonprofit focuses on teaching youth how to work in a kitchen, develop customer relation skills, and operate a business. The baked goods are essentially a byproduct, since the program emphasizes development of entrepreneurial and interpersonal skills for charitable beneficiaries, over sales. This activity is thus not commercial in nature but instead is directly related to the nonprofit’s core mission of helping youth. For these reasons, the sales likely will not be taxable under UBIT rules.
Why is the resulting tax liability different for these two nonprofits?
The Three-Part UBIT Test
The answer depends on whether a nonprofit’s activity is (1) a trade or business, (2) regularly carried on, and (3) not substantially related to the organization's tax-exempt purpose. The key reason for UBIT liability is to avoid giving tax-exempt organizations an unequal competitive advantage over for-profit organizations that pay taxes on income generated from similar business activities. Given this underlying tax policy rationale, several exceptions may come into play.
1. Trade or Business
The first question to ask in a UBIT evaluation is: Is the activity generally considered a trade or business? The term “trade or business” is defined as “any activity which is carried on for the production of income from sale of goods or the performance of services.” In the examples above, both organizations’ regular sale of baked goods thus would satisfy this first prong, since selling baked goods is widely recognized as a trade or business (e.g., bakeries, grocery stores).
2. Regularly Carried On
Second, is the activity regularly carried on? Generally, when an exempt organization carries on a business activity with the same frequency and continuity as a for-profit, the activity is considered to be “regularly carried on.” In other words, the activity then directly competes with commercial enterprises. With this distinction in mind, occasional fundraiser sales will not be subject to UBIT since the activity fails to satisfy this prong. Many nonprofits thus easily avoid UBIT liability simply because they rarely conduct the particular business activity. Note, however, that a seasonal or annual business activity, such as Christmas tree sales in December, are still considered “regularly carried on” if they are conducted in a similar manner and time frame as commercial counterparts.
3. Not “Substantially Related”
Third, is the activity “substantially related” to an exempt purpose? Or, put another way, does the activity contribute importantly to the accomplishment of the organization’s exempt purposes? If not, then this UBIT element is satisfied. Note that the focus of the analysis is on the activity itself and not whether the money raised will be used to further the exempt purposes of the nonprofit. Consequently, the fact that an organization seeks to use sales revenues for its operational needs, however worthwhile, is legally insufficient to satisfy the “substantially related” test. This question must be answered by examining the organization’s business activities in conjunction with the charitable, educational, and/or religious purposes, as set forth in the organization’s articles of incorporation, bylaws, and program materials.
Using the above examples, the church’s regular sale of baked goods thus cannot be “substantially related” to its tax-exempt purpose, since its purpose is necessarily religious. On the other hand, since the second nonprofit’s purposes are focused on youth development rather than sales, its baked good sales activities may well be “substantially related” and therefore not subject to UBIT. Such conclusion should be borne out by additional favorable facts, such as significant emphasis on training and education, volunteer involvement, and other non-commercial elements.
Many nonprofits’ revenue-generating activities will not result in tax liability because one or more prongs of the above UBIT test are missing. It is thus extremely important to carefully evaluate such activities under this test, as a crucial initial matter. But even if a nonprofit’s activities satisfy the three-part UBIT test, they may nevertheless escape UBIT liability because of applicable tax law exceptions. The exceptions’ rationales are myriad. They essentially boil down to the fact that such activities are fundamentally non-commercial in nature, and therefore satisfy Congress’ intended goal of “leveling the playing field” between businesses and nonprofits through tax policy.
1. Passive Income – Rents, Royalties, Dividends
Perhaps most significantly, the Internal Revenue Code excludes passive income from UBIT liability. This includes rental income from real estate and other property, royalties received from licensing arrangements, and dividends. Additional wrinkles apply, however. For example, rental income will nonetheless be subject to UBIT liability if the underlying real estate or other asset is debt-financed, but an additional exception may apply if the real estate at issue constitutes only a small percentage of total property. As a further example, revenues from a cell tower lease may not be subject to UBIT, even if the underlying real estate is debt-financed, if the actual real estate used for the lease is physically quite small.
2. Volunteer Labor
Many nonprofit organizations can avoid UBIT liability on their fundraising activities by using substantially all volunteers for the necessary labor. This is a common UBIT exception for thrift store operations, where most workers are volunteers and only the manager is paid. Again, the tax policy regarding commercial activity comes into play: since volunteer-run activities generally do not compete with commercial businesses, no justification exists (or at least such justification would be lessened) for taxing the resulting revenues. Using the above church example, this UBIT exception will apply if church volunteers supply all the labor needed for the baked goods.
3. Selling Donated Merchandise
A closely related UBIT exception is for revenues resulting from sale of donated merchandise, such as clothing, books, and furniture. Again, or alternatively, this may be a good UBIT exception for thrift stores or other regular sales activities that are essentially non-commercial in nature. And likewise, in the above church example, this UBIT exception will apply if all baked goods sold are donated.
4. Convenience of Members and Others
A different type of UBIT exception applies to sales activities focused on convenience, but again for non-commercial types of operations. Typical examples include a hospital that operates a small gift shop primarily for patients and their families or a school that runs a cafeteria primarily for its students or teachers. Note, however, that to the extent such operations are aimed more broadly at the general public and are therefore more commercial in nature, UBIT liability may result.
Other State Tax Exemption Considerations
Along with UBIT considerations, nonprofits may need to evaluate other applicable tax aspects of their fundraising activities as follows. First, state income tax laws may apply as well as the federal UBIT laws. Second, nonprofits may be obligated to collect and remit state and local sales taxes, normally charged to purchasers (as in ordinary business retail sales). Similar but distinctly different rules apply here. For example, an annual fundraiser bake sale will likely be exempt from both UBIT, as not “regularly carried on,” and states sales tax liability, for essentially the same rationale – i.e., not commercial in nature. But the UBIT exceptions do not typically apply within the state sales tax arena, such as those listed above. Thus, certain sales activities may be excluded from UBIT but subject to state sales tax liability. In other words, be careful! Third, note too that a nonprofit’s state sales tax exemption letter is for its retail purchases, not its sales – so such exemption privilege does not bear directly on these other tax liability questions. Fourth, regularly carrying on a business or commercial activity on a nonprofit’s real property may adversely affect the organization’s property tax exemption under many state laws.