Once an organization has qualified for tax-exempt status, it might feel like the time to rejoice over never having to pay federal income tax. As in most things, the Internal Revenue Code is not quite as simple as that. The Unrelated Business Income Tax (UBIT) applies to otherwise tax-exempt organizations on their unrelated business income (UBI). Knowing more about UBIT and which activities may trigger it can help exempt organizations avoid a surprising tax bill.
Who is subject to UBIT
UBIT applies to most organizations exempt from tax under IRC Sec. 501(c), including: charities, religious organizations, and scientific organizations. Individual retirement accounts (such as traditional IRAs, Roth IRAs, and simplified employee pensions), medical savings accounts, Coverdell savings accounts, and others are also subject to UBIT.
What is UBI?
Unrelated business income (UBI) is income from a trade or business regularly carried on by the exempt organization where the business activities do not substantially relate to the purpose for which the organization was granted tax-exempt status. Here, a trade or business could be anything where an exempt organization generates income from selling goods or services with the intention of making a profit from those sales.
Whether or not the business activity substantially relates to the exempt purpose of the organization is where the “unrelated” part of “unrelated business income” comes into play. Determining if an activity is an unrelated trade or business depends on whether the activity contributes importantly to the organization’s exempt purposes. This determination must be made based on the facts of each organization’s circumstances. To make matters even more complicated, even if a business activity is carried on as part of similar activities that may be related to the exempt purposes of the organization, the activity will still be considered a trade or business. For example, if an exempt organization publishes a magazine as part of its exempt purpose and sells advertisements in that magazine, the sale of advertisements could be considered UBI while the publishing of the magazine would not be considered UBI and could remain exempt.
Activities excluded from UBI
Some activities, even though they otherwise fit the definition of an unrelated trade or business, are not taxed by the IRS as UBI. What follows are some, but not all, of the activities that may be excluded from the UBI calculation.
- A trade or business which is for the convenience of the exempt organization’s members, students, patients, officers, or employees. Under this exclusion, something like a hospital’s cafeteria would not be considered UBI and would not be subject to UBIT.
- Selling donated merchandise.
- A trade or business where all the work is performed by volunteers.
What to do if you have UBI?
For exempt organizations unaccustomed to facing tax bills come year-end, the unrelated business income tax can present an unwelcome surprise. This makes it important to carefully consider whether an exempt organization’s activities may be considered as an unrelated trade or business in the eyes of the IRS. When an exempt organization expects its UBIT to be $500 or more in a year, the organization must make quarterly estimated tax payments to avoid facing late payment penalties.
If you are questioning whether an activity for your organization’s purpose is truly exempt or whether it might be subject to UBIT, please do not hesitate to contact your L&B professional at (858) 558-9200.