Understanding Unrelated Business Income Tax for Nonprofit Organizations

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Throughout the lifetime of a nonprofit organization, it will likely face varying degrees of donor fatigue, especially in smaller communities where multiple nonprofits are competing for the same donor attention and donor dollars. In an effort to diversify its funding, a nonprofit may choose to seek alternative revenue streams that are outside its core mission. In many cases, these alternative revenue streams may be considered Unrelated Trade or Business Income, which can result in exposure to Unrelated Business Income Tax. This activity is reported annually to the Internal Revenue Service on Form 990-T if gross receipts from such activity are $1,000 or greater.

A very common example of this type of funding is when a nonprofit accepts advertising revenue from businesses so that they can advertise their products or services in the nonprofit’s periodical. By definition, this type of advertising revenue is seen by the IRS as unrelated business income while the actual periodical sales revenue (if any) is generally considered exempt activity income. Direct costs incurred to produce the advertising is deducted from the advertising revenue in order to calculate the net unrelated business taxable income.

Another common example relates to rental income of personal and/or real property. While rental income and capital gains realized on the sale of the property (per Code Section 5152(b)(5)) are generally excluded from the definition of unrelated trade or business income, certain income received on debt-financed property is considered unrelated business income if not “substantially all” of the property is used to support the exempt purposes of the organization. Reg. Section 1.514(b)-1 states that property will be substantially related if 85% or more of the use of such property is devoted to the organization’s exempt purpose. Also, Code Section 514(b) defines debt-financed property as any property held to produce income with respect to which there is acquisition indebtedness at any time during the year. Acquisition indebtedness, then, is the unpaid amount of indebtedness incurred in acquiring or improving debt-financed property. Rental income that is directly related to the organization’s tax-exempt purpose is excluded from consideration of unrelated trade or business income. What all of this means is that if you have acquisition debt on your building and you rent out substantial space to those who are not directly associated with your organization’s mission, the resulting net income will likely be subject to unrelated business income tax.

Income from the sales of products or services that are unrelated to the organization’s mission and are regularly carried on (conducted on a routine basis) can be subject to 990-T filing. However, there are many exclusions to this general rule. For example, if all of the activity is performed by unpaid volunteers, if the sales are of donated merchandise, or if the activities are principally for the convenience of members or employees, such activity will not be considered unrelated trade or business income. Also, a one-time unrelated activity will generally not be subject to unrelated business income tax since it is not regularly carried on.