A nonprofit will not ordinarily be taxed on its revenues. However, income from unrelated business income is subject to tax (UBIT). UBIT is based on gross income derived by any nonprofit from any unrelated business activity it regularly conducts less the expenses directly connected with the activity.
Income is subjected to UBIT if 1) it is income from a trade or business, 2) is regularly carried on by the organization, and 3) is not substantially related to the organization’s exempt function. Certain income is excluded by statute from being subject to UBIT, including interest, dividends, royalties, rental income, gains on disposal of property, and research income. Caution, income from property that is debt-financed is not excluded. Debt-financed means any property held to produce income where there is acquisition indebtedness. Acquisition indebtedness is any indebtedness incurred in acquiring or improving property.
Income from a trade or business includes any activity carried on with a profit motive from the sale of goods or services. An activity is likely to be considered a trade or business if a for-profit entity would want to, and could, conduct it.
In every case in which a nonprofit has unrelated business income, a determination must be made whether the activity is regularly carried on before it can be concluded that the income is subject to tax. Regard must be given to the frequency and continuity with which the activities that produced the income are conducted and the manner in which they are pursued. Internal Revenue Service regulations provide that where income producing activities are normally conducted by nonexempt commercial organizations on a year-round basis, the conduct of such activities by a nonprofit over a period of only a few weeks does not constitute the regular carrying on. However, business activities of a nonprofit will ordinarily be deemed to be regularly carried on if they are generally similar to comparable commercial activities of nonexempt organizations. Advertisements for a program book that is published and distributed at an annual concert to raise funds for a music organization is not regularly carried on. However, advertising for a concert program during an eight-month period for nonprofit symphony orchestra that publishes a weekly concert program is a business that is regularly carried on and should be subject to income tax.
Determining whether an activity is substantially related to the exempt function is another area that requires judgment. To be substantially related to an organization’s exempt purpose, there must be substantial causal relationship to the achievement of the exempt purpose. An activity cannot qualify as substantially related solely because its income is needed to fund the conduct of an exempt function. For example, a program that gets its funding from the profits of a year-round car wash activity would not meet the requirement of substantially related. Although the funds from the car wash activity provide critical support for the program service, it is highly unlikely that the car wash is otherwise related to the organization’s exempt purpose.
The nonprofit’s exempt purpose determines whether an activity is substantially related. For example, the sale of scientific books by an art museum has no causal relationship to the accomplishment of the art museum’s exempt purpose to enhance public appreciation of art. The fact that the book sales could be related to the educational purpose of some other exempt organization is irrelevant.
As nonprofits look for new sources of revenue to fund program operations, be aware of the criteria that might cause the income to subject to taxes. Activities where there is an exchange of money for a product or service will be considered a trade or business. The nonprofit should ensure that such activities are either not regularly carried on or substantially related to the organization’s exempt purpose. Otherwise, the business activity will be subject to income tax and the exempt organization will need to file Form 990T.