Even though an organization is recognized as tax exempt, it still may be liable for tax on its unrelated business taxable income. For most organizations, unrelated business income is income from a trade or business, regularly carried on, that is not substantially related to the charitable, educational, or other purpose that is the basis of the organization’s exemption.
For most organizations, an activity is an unrelated business (and subject to unrelated business income tax) if it meets three requirements:
1. The activity is a trade or business. The term trade or business generally includes any activity carried on for the production of income from selling goods or performing services. It is not limited to integrated aggregates of assets, activities, and goodwill that comprise businesses for purposes of certain other provisions of the Internal Revenue Code. Activities of producing or distributing goods or performing services from which gross income is derived do not lose their identity as trades or businesses merely because they are carried on within a larger framework of other activities that may, or may not, be related to the organization’s exempt purposes.
2. The activity is regularly carried on. Business activities of an exempt organization ordinarily are considered regularly carried on if they show a frequency and continuity, and are pursued in a manner similar to, comparable commercial activities of nonexempt organizations.
3. The activity is not substantially related to furthering the exempt purpose of the organization. To determine if a business activity is substantially related requires examining the relationship between the activities that generate income and the accomplishment of the organization’s exempt purpose. Trade or business is related to exempt purposes, in the statutory sense, only when the conduct of the business activities has causal relationship to achieving exempt purposes (other than through the production of income). The causal relationship must be substantial. The activities that generate the income must contribute importantly to accomplishing the organization’s exempt purposes to be substantially related.
The Internal Revenue Code contains a number of modifications, exclusions, and exceptions to unrelated business income. For example, dividends, interest, certain other investment income, royalties, certain rental income, certain income from research activities, and gains or losses from the disposition of property are excluded when computing unrelated business income. In addition, the following activities are specifically excluded from the definition of unrelated trade or business:
Volunteer Labor: Any trade or business is excluded in which substantially all the work is performed for the organization without compensation. Some fundraising activities, such as volunteer operated bake sales, may meet this exception.
Convenience of Members: Any trade or business is excluded that is carried on by an organization described in section 501(c)(3) or by a governmental college or university primarily for the convenience of its members, students, patients, officers, or employees. A typical example of this is a school cafeteria.
Selling Donated Merchandise: Any trade or business is excluded that consists of selling merchandise, substantially all of which the organization received as gifts or contributions. Many thrift shop operations of exempt organizations would meet this exception.
Bingo: Certain bingo games are not unrelated trade or business.
An exempt organization that has $1,000 or more gross income from an unrelated business must file Form 990-T, Exempt Organization Business Income Tax Return. For additional information, see the Form 990-T instructions. Section 512(a)(3) of the Internal Revenue Code provides for special unrelated business taxable income rules for organizations that are tax-exempt under section 501(c)(7), 501(c)(9), 501(c)(17), or 501(c)(20)*.
The unrelated business taxable income (UBTI) of organizations described in Internal Revenue Code sections 501(c)(7), 501(c)(9) and 501(c)(17) includes all gross income, less deductions directly connected with producing that income, but not including exempt function income. Also, the dividends received deductions for corporations are not allowed in computing UBTI, because they are not expenses incurred in producing income. Exempt function income is gross income from dues, fees, charges, or similar items paid by members for the purposes for which exempt status was granted to the organization. Exempt function income also includes income that is set aside for qualified purposes.
The investment income of these types of organizations generally is not taxed if it is set aside to be used for religious, charitable, scientific, literary, or educational purposes or for the prevention of cruelty to children or animals. In addition, for a section 501(c)(9), 501(c)(17), or 501(c)(20) organization, investment income is generally not taxed if it is set aside to provide for the payment of life, sick, accident, or other benefits. However, income on any amounts set aside that exceed the qualified asset account limit, figured under Code section 419A, is unrelated business income. Special rules apply to the treatment of existing reserves for post-retirement medical or life insurance benefits. Income derived from an unrelated trade or business may not be set aside and therefore cannot be exempt function income. In addition, any income set aside and later spent for purposes other than those specified must be included in unrelated business taxable income.
Any gain on the sale of property used directly in performing an exempt function by a section 501(c)(7), 501(c)(9), 501(c)(17), or 501(c)(20) organization that is used to purchase other property that is used directly in performing an exempt function is recognized only to the extent the sales price of the old property exceeds the cost of purchasing the new property. For nonrecognition of gain to apply, the purchase of the new property must be within one year before the date of sale of the old property or within three years after the date of sale. For these purposes, the term sale of property includes the property’s destruction in whole or in part, theft, seizure, requisition, or condemnation.