Unrelated business income tax (UBIT) is a tax on certain types of income earned by nonprofits. Essentially, most nonprofits must be chartered with a particular tax-exempt purpose that the IRS agrees to. Unrelated business income is any income that a nonprofit earns from activities NOT related to that tax-exempt purpose. Unrelated business income is taxed at the normal corporate tax rate.
Example 1:
Smart Kids is chartered as an educational nonprofit with the tax-exempt purpose of providing tutoring to kids in elementary school. The organization offers the tutoring at cost, but they also sell coffee to the public at the front of their building.
Since coffee sales have nothing to do with tutoring, the IRS will likely deem the income from the coffee sales to be “unrelated business income” which is subject to the unrelated business income tax. However, the income from selling tutoring services is still not taxed.
Example 2:
First Christian Church operates as a 501(c)(3) nonprofit. The church bought its property using a mortgage and rents out the space for events during the middle of the week in order to help cover the cost of the mortgage. That rental income is unrelated business income subject to UBIT.
Sponsorships: A Tricky Topic for UBIT
One of the most common ways that nonprofits inadvertently generate unrelated business income is from sponsorships. If a local business sponsors an event hosted by a nonprofit, the nonprofit is allowed to acknowledge the business’s contribution, thank them, and display the company’s logo. However, if the nonprofit crosses the line into “advertising” the sponsor’s business, then the sponsor’s donation suddenly becomes unrelated business income subject to tax.
The line between “sponsorship” and “advertising” is fuzzy. However, as a rule of thumb, the line is crossed when the nonprofit starts using “qualitative or comparative descriptions” when describing a sponsor’s business or products.
For example, if First State Bank sponsors a nonprofit youth sports event by providing a $10,000 gift, then it’s okay for the nonprofit to announce during the game:
“We want to send out a special thank you to First State Bank for helping to make this all happen. We are so grateful for their support.”
That’s fine. That’s still a sponsorship. However, suppose the announcement instead was:
“We want to thank First State Bank for sponsoring today’s event. With hassle-free checking accounts and the best customer service in the county, First State Bank has what you need.”
Now we’ve crossed the line into advertising because “hassle-free” and “best” are qualitative and comparative descriptions. Now the $10,000 donation becomes unrelated business income subject to tax at the corporate tax rate.
One issue that commonly comes up around sponsorships is whether or not a nonprofit can use a sponsor’s slogan if that slogan is itself somewhat boastful. For example: “First State Bank: Simple, Anxiety-Free Banking”.
The general rule for such slogans is to avoid using them UNLESS the slogan is a well-established part of the sponsor’s identity. For example, “Like a good neighbor, State Farm is there” is a very well established part of State Farm’s identity and has been in use for a long time, so it would be fine for a nonprofit to use that slogan.
In general, the IRS provides the “qualified sponsorship” safe harbor for nonprofits who want to guarantee that they don’t accidentally convert untaxed donations into taxable unrelated business income.
Special Rules for UBIT
In general, if a nonprofit generates income, there must be a substantial causal relationship to the achievement of the nonprofit’s exempt purpose(s), OTHER than the production of income, in order for that income to avoid being taxed. However, there are exceptions to that:
- Passive income from interest, dividends, annuities, or royalties are NOT subject to UBIT.
- Rental income from un-financed property is generally NOT subject to UBIT.
- Rental income from financed property generally IS subject to UBIT.
- If a nonprofit club provides goods or services (on a small scale) for the convenience of its members, that income generally will NOT be subject to UBIT.
- Income from selling services which are performed mostly by volunteers are generally NOT subject to UBIT.
- Income from the sale of goods donated to a nonprofit is generally NOT subject to UBIT.
Which Nonprofits Are Subject to UBIT?
It’s estimated that there are between 1.5 million and 2 million nonprofit organizations in the U.S., including churches, schools, charities, private foundations, political organizations, social clubs, and business associations. Most nonprofits ARE subject to UBIT on any unrelated business income. However, nonprofit corporations organized under Acts of Congress and which are now instrumentalities of the U.S. government (e.g. Federal Reserve Banks) are NOT subject to UBIT.
References
[1] IRS: Unrelated Business Income Tax
[2] IRC 511 – Imposition of tax on unrelated business income of charitable organizations
[3] IRC 512 – Unrelated business taxable income