Business owners, corporations and trusts pay income tax. And when tax-exempt organizations engage in commercial activity that's outside the scope of their exempt purposes, they may find themselves with unrelated business taxable income (UBTI).
The government wants tax from an otherwise tax-exempt organization that regularly carries on a trade or conducts business not substantially related to its tax-exempt purposes. Consider the following scenarios:
- The trade or business will usually involve the sale of goods or services in exchange for money or something else of value for the purpose of making a profit.
- The trade or business must be conducted regularly — and this applies to a seasonal business with large gaps of time between sales.
- The trade or business is not substantially related to the NPO's tax-exempt purposes. That is, it doesn't contribute to accomplishing your organization's exempt purposes.
As a rule of thumb, the income generated from unrelated activity should not exceed 20 percent of overall net income.
NPOs engage in charitable, educational, scientific and religious activities contributing to their tax-exempt purposes, while being restricted in what they do with the money, paying reasonable compensation and necessary expenses.
Suppose a school started to sell clothing to raise funds and ended up with a retail clothing business. Selling clothing doesn't fall within the school's exempt purpose — it's an unrelated, regularly conducted business activity, even though the proceeds benefit the school's core function of educating students.
The business is insubstantial compared to all else the school does: It's required to pay tax to the IRS. Should that business really take off and becomes substantial, then the school would risk losing its tax-exempt status.
Exceptions include the following:
- The business is performed primarily for the convenience of your NPO's members, students, patients, officers or employees.
- The sale of donated property, including used cars.
- Work performed by unpaid volunteers.
- Income derived from passive investments such as dividends, royalties, interest, and capital gains.
- Income derived from an annual dance or similar fundraising event for charity.
If your NPO meets certain standards for gross income from an unrelated business, it must pay the tax and file the appropriate form. The rules surrounding UBTI are complex. It's always wise to seek advice from your RINA representative.