Form 990 Article Series 05: Unrelated Business Income: What is it and how do I identify it?
Originally published on June 20, 2017
Updated on July 31st, 2023
Certain nonprofit organizations are tax-exempt because of the “charitable” nature of their mission and activities. This does not mean however, that all income earned by a nonprofit is exempt from tax
In light of budget cuts and reduced grant funding, many nonprofit organizations are seeking alternative revenue sources that are outside their exempt purpose in an effort to raise additional funds. However, any income from an unrelated business is subject to tax. It is important for organizations to understand what constitutes unrelated business income so it can be identified and properly reported to the IRS.
The starting point for identifying unrelated business income comes from the definition of the term “unrelated business taxable income” as defined by IRS regulations. The basic definition of an unrelated trade or business is gross income from an activity in which all of the following conditions exist :
- It is income from a trade or business;
- Such trade or business is regularly carried on by the organization; and
- The conduct of such trade or business is not substantially related (other than through the production of funds) to the organization’s performance of its exempt functions.
The following three-prong test helps determine whether all three of these conditions are met; if so, the activity is taxable unless any exclusion applies (as discussed later). This is regardless of whether the income is used to further the exempt purpose of the organization. Note that if the gross income from the unrelated activity is $1,000 or more, the organization must file Form 990-T-Exempt Organization Business Income Tax Return.
Test 1: Determine if the activity is a trade or business.
To be considered a trade or business, the activity must be carried on with a profit motive from the sale of goods or the performance of services. The key factor used by both the IRS and courts is if the activity has a profit motive, or a desire for financial gain. Many factors come into play in determining whether an activity is engaged for a profit (e.g., the manner in which the activity is carried on, time and effort expended, success experienced in carrying on the activity, history or income or losses, etc.). The IRS and courts do not look at each factor individually; instead, they look at the activity as a whole and consider several factors and other relevant information that may help in making this determination.
Test 2: Determine if the trade or business is regularly carried on by the organization.
A trade or business will generally be considered to be regularly carried on if it has a frequency and continuity and is pursued in a manner comparable to similar activities performed by for-profit businesses. The idea is to place a nonprofit organization’s business activities on the same level as the endeavors of for-profit businesses with which they compete. Because this aspect can vary from organization to organization and from activity to activity, it is particularly important that the frequency with which each activity is conducted is determined separately.
An example the IRS provides is a hospital auxiliary’s operation of a sandwich stand for two weeks at a state fair. This would not be the regular conduct of a trade or business, as the stand would not compete with similar facilities that a nonexempt organization would ordinarily operate year-round. However, operating a commercial parking lot every Saturday, year-round, would be the regular conduct of a trade or business.
Test 3: Determining if the conduct of the trade or business is not substantially related to the purposes for which the exemption is granted.
The presence of this requirement necessitates an examination of the relationship between the business activities that generate the particular income in question (i.e., the activities of producing or distributing the goods or performing the services involved) and the accomplishment of the organization’s exempt purpose.
For an activity to be substantially related, it must have a substantial causal relationship to the achievement of an organization’s exempt purposes. Thus, for the income derived from the conduct of a trade or business to be substantially related, it must contribute importantly to the accomplishment of those purposes. It will not qualify as substantially related only because its income is needed to fund the organization’s program services.
The determination of whether activities contribute importantly to the accomplishment of any purpose for which an organization is granted exemption depends in each case upon the facts and circumstances involved. Some factors an organization should take into consideration when making this determination include:
- The size and scope of the activities involved in relationship to the nature and scope of the exempt function they intend to serve;
- The selling of products that result from the performance of exempt functions isn’t an unrelated trade or business if the product is sold in substantially the same state it is in when the exempt functions are completed; and,
- If an asset or facility necessary to the conduct of exempt functions is also used in commercial activities, its use for exempt functions doesn’t, by itself, make the commercial activities a related trade or business.
Once an organization has gone through these tests and determined that their particular activity meets the requirements of an unrelated trade or business, they should not just stop there. The IRS has allowed certain activities to be statutorily excluded from the unrelated business income rules.
One of the most common exclusions is when you have an activity in which substantially all of the work is performed by unpaid volunteers (often referred to as the volunteer labor exclusion). Although the phrase substantially all is not defined in the context of volunteer labor, the IRS has indicated that using 85% volunteer labor (as measured by number of hours worked) will qualify.
Another common activity that would be excluded from an unrelated trade or business is the sale of merchandise, substantially all of which has been received by the organization as a gift or contribution (e.g., thrift stores). Similar to the volunteer labor exclusion, the 85% threshold to define substantially allwould also apply in the context of donated merchandise.
Activities that are incidental to an organization’s exempt function are also excluded from classification of an unrelated trade or business. A common example of this would be income from distributing low cost articles that are incidental to soliciting charitable contributions. To be considered incidental, the distribution must be made without the express consent of the recipient and accompanied by a request for a donation and a statement that the recipient may keep the item distributed regardless of whether a contribution is made. In 2017, an article is considered low cost if the cost of the item is no more than $10.70.
In addition to these common exclusions, case law provides various other exclusions for specific activities. IRS Publication 598 also has examples of other excluded trade or business activities.
Certain activities are not the only exclusions the IRS has provided to nonprofits to be excluded from the definition of an unrelated trade or business. Certain specific types of income are excluded due to their passive nature:
- Interest, dividends and similar income
- Rental income from real property
- Gains and losses from the disposition of property
However, each of these types of excluded income has exceptions that can cause the income to be taxable. For example, the rental income from real property exclusion generally does not apply if the property being rented is debt-financed (i.e., the property is subject to a mortgage). It is these various exceptions that add to the complexity and make the determination of unrelated business income so complicated.
While the information discussed above may seem extensive, it is really just the tip of the iceberg. There are many nuances in the world of unrelated business income, and small changes in the facts and circumstances can alter the determination and taxability of the income. Changing even one factor in how the activity is conducted may cause the tax to apply or not to apply.
The organization’s ultimate goal should be to identify all possible sources of unrelated business income to avoid any surprises if audited by the IRS. By understanding the basics about unrelated business income and being proactive in the planning stages of an activity regarding the potential tax consequences, an organization will be prepared and informed from the start.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
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