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Taxation of Unrelated Business Income

Income derived from activities unrelated to a tax-exempt organization’s purposes is taxed as if earned by a comparable for-profit entity. This is called Unrelated Business Income Tax (UBIT). Generally, such income is subject to tax at the regular corporate rates. In computing unrelated business income taxes, most recognized business deductions are available to exempt organizations.

Unrelated Business Income

Unrelated business income is defined as income derived from 1) a trade or business, 2) which is regularly carried on, and 3) which is not substantially related to the performance of tax-exempt functions, i.e., it does not contribute importantly to the achievement of tax-exempt purposes. The fact that income was produced for use in furthering exempt purposes does not qualify the income as related; the income itself must be derived in the course of furthering an exempt purpose. For unrelated business income taxes to be incurred, all three elements must be present.

Trade or Business

A trade or business, as defined by the Internal Revenue Code (the “Code”), is widely encompassing. It includes any activity carried on for the production of income from the sale of goods or the performance of services. Characterization as a trade or business depends on the level of active participation by the exempt organization in generating revenue.

Regularly Carried On

Business activities of exempt organizations will be deemed to be regularly carried based on frequency and continuity, and are pursued in a manner generally similar to comparable commercial activities of nonexempt organizations. When activities are consistently promoted and carried on by the organization, they meet the requirement of regularity. Even activities conducted intermittently or sporadically throughout the year may not be treated as regularly carried on. For instance, an occasional dance, or a hospital auxiliary’s operation of a food stand for two weeks at a state fair is not considered regularly carried on. The sale of advertising in a book published only once per year may be deemed to be an activity regularly carried on. The IRS ruled that since an exempt organization contracted with a commercial firm for the solicitation of advertising sales on a year round basis, the frequency of actual publication was not determinative.

Substantially Related

Generally, income derived by an exempt organization is not taxed if the income-generating activity contributes importantly to the tax exempt purposes of the organization. Certain activities which even indirectly further exempt purposes may satisfy the “important contribution” requirement. Merchandise sales (stationary, clothing, and accessories) by a conservation organization are related activities because the products, containing the logo of the organization or other environmental reference, stimulate interest in wildlife preservation. Likewise, related activities include the operation of a lawyer referral service by a bar association, the provision of group insurance for member agencies by a social welfare organization, and the sale of educational products by a higher education institution.

In contrast, activities that were ruled not to contribute importantly to exempt purposes include the provision of veterinary services for a fee by an animal cruelty prevention society, the sale of uniforms by a labor union, the provision of language translation services by an international trade promotion association, the management of health plans by a business league, and liquor sales by a veterans organization.

  1. Fragmentation. The fragmentation rule must be used for purposes of calculating gross unrelated income. The IRS fragments a tax-exempt organization’s operation, run as an integrated whole, into component parts. The Code states, an activity does not lose identity as a trade of business merely because it carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of the organization.
  2. Retail Sales – Educational Organizations. Bookstore, pharmacy or convenience store sales that further the intellectual life of the campus community and specifically students, are related activity sales. Exempt items include books, computers, food, cosmetics, clothing, novelty items, supplies, candy etc.
  3. Advertising. In perhaps the most widely cited application of the fragmentation rule, the sale of a monthly journal by medical organizations is considered to be related activity, but the sale of advertising within such periodicals is unrelated. The Supreme Court has held that such advertising is taxable even though it may have been educational or informational. For such advertising to be considered related activity, it must contribute to the accomplishment of an exempt purpose, as in the case of a university newspaper the purpose of which is to train students in journalism.
  4. Hospitals (Pharmacy sales). Similarly, the sale of pharmaceuticals by the pharmacy of an exempt hospital to patients of the hospital is related activity, though sale to the general public generates unrelated business income.
Exclusions from Unrelated Business Income

Passive income, including interest, dividends, rents from real property, revenue from property sales, and royalty payments, is generally excluded from unrelated business income. If passive income is generated through controlled subsidiaries or through the use of borrowed funds, this exclusion may not apply and must be evaluated further.

    1. Interest and Dividends. Most interest and dividends, including annuities and payments relating to loaned securities, are excluded from unrelated business income. Note however, that partnership income, including income derived by passive investors (i.e., limited partners), is treated as unrelated business income.
    2. Rent From Real Property. Income derived from the rental of real property is usually excluded from taxation. However, income derived from the rent of personal property is not excludable. In the case of a lease containing both real and personal property, if more than 50% of the rent is derived from personal property then none of the rental income is excludable. If the amount of rental income is dependent on a percentage of the lessee’s sales or profits, the rental income will not qualify for exclusion. Regulations reason that such division of profits connects the exempt organization with the active conduct of a business. Therefore, the rental payments can not be considered passive. Rental income may also be taxable if the lease involves the performance of services beyond those normally provided by a landlord. For instance, normal maintenance and repairs may be provided by the exempt organization/lessor. If additional cleaning, laundry, or other personal services are provided, the rental income will be construed as derived from a trade or business.
    3. The Sale of Property. Gains or losses from the sale or other disposition of property are generally not taxed as unrelated income. Under this provision, all income that would normally be considered capital gain income is excluded from taxation.
    4. Royalties. Royalty income is excluded from taxation. Excludable royalties include payments from the licensing of patents, trademarks, and mineral rights. In contrast to the rules regarding rental payments, receipts may still be considered royalty income when the payment is based on gross profits. In particular, revenues derived from a share of the gross profits of a gas producing property were ruled to be royalty payments. Exempt organizations have attempted to classify, as royalties, payments that are in fact fees for services. The IRS, ignores contractual language and looks to the true substance of such transactions. However, a venture that would otherwise produce taxable proceeds can be legitimately structured as a royalty arrangement. The royalty exclusion is commonly used by exempt organizations to exclude licensing fees from UBIT. The IRS generally agrees with this result, so long as the exempt organization plays a passive role in the licensing arrangement. However, where the exempt organization’s involvement is active, the IRS will not characterize the payment as a royalty, excluded from UBIT.
    5. Research Activities. There are three primary exclusions available for scientific research activities. First, income is not unrelated if “derived from research for (A) the United States, or any of its agencies or instrumentalities, or (B) any State or political subdivision thereof.” Second, income derived for research by colleges, universities, and hospitals is excluded. Third, income derived by exempt organizations which operate primarily for scientific research purposes and make the research results available to the public free of charge is untaxed. The term “research” does include fundamental and basic research which may include testing of pharmaceuticals for the development of new products. However, research does not include activities that are incidental to ordinary business operations, such as the testing or inspection of commercial products or materials.
    6. Volunteer Activities. Activities that would otherwise be unrelated are deemed to be related if “substantially all the work in carrying on such trade or business is performed for the organization without compensation. A museum program operated by volunteers 95% of the total time was deemed to be substantially operated by volunteers.
    7. Sales of Contributed Property. “The selling of merchandise, substantially all of which has been received by the organization as gifts or contributions” is not an unrelated trade or business. This exception is most commonly used by thrift shops which sell donated clothes and other items to the general public.
    8. Activities for Convenience of Members, Employees et al. A trade or business carried on by an exempt organization “primarily for the convenience of its members, students, patients, officers or employees” is not taxable. Thus, the operation by an art museum of a cafeteria and snack bar for use by its staff and visiting members of the public is considered a related activity, as is the operation of gift shop, and parking lot for the staff, patients, and visitors of a hospital. The operation of a dormitory, dining facility or laundry by a college for its students qualifies under this exclusion, but if operated primarily for the benefit of the public it is an unrelated business.
    9. Membership and Mailing Lists. The sale or exchange by 501(c)(3) organizations to other 501(c)(3) organizations of their membership or mailing lists is specifically excluded from taxation and may include affinity credit card mailing lists if no services are rendered by the exempt organization.
    10. Low Cost Items. Income derived from the sale of low cost articles such as t-shirts and coffee mugs, by 501(c)(3) organizations only, are excluded from taxation if their distribution is “incidental to the solicitation of charitable contributions. A low cost item is defined as any article costing the exempt organization (not the recipient) no more than $5, based on 1987 dollars and adjusted for inflation annually. If more than one item is distributed to a single recipient in a calendar year, then the aggregate of the items is treated as one article.
Computation and Payment of Unrelated Business Income Taxes

Unrelated business taxable income is the gross income derived from an unrelated trade or business less deductions which are directly connected to the carrying on of such trade or business. Unrelated taxable income is subject to the regular corporate income tax rates. Exempt organizations must also make quarterly estimated tax payments under the same rules applicable to corporate income.

When an exempt organization derives income from two or more unrelated activities, unrelated taxable income is the aggregate of all unrelated income minus the aggregate of all allowable deductions

Where staff time is used to conduct both exempt and unrelated activities, deductions must be allocated between the uses on a reasonable basis. Similarly, the dual use of facilities must use a reasonable consistent basis for allocation of expenses such as utilities, depreciation and maintenance.

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“The I.R.S. examined 1.4 million individual income tax returns in 2010, about 1 percent of the total number filed. In 2018, the latest year with available data when Republicans started making these claims, audits decreased to 370,000, or about 0.2 percent… The budget office estimated increasing I.R.S. funding would return enforcement to its 2010 levels. Doing so would result in about 1.2 million more audits; of those, 583,000 would target people making less than $75,000.”

The New York Times, “Fact-Checking the Misleading Claim About 87,000 Tax Agents”, November 6, 2022

“…For example, you educate believers on national issues that are central to their belief in the Bible as the inerrant Word of God. Specifically, you educate Christians on what the bible says in areas where they can be instrumental including the areas of sanctity of life, the definition of marriage, biblical justice, freedom of speech, defense, and borders and immigration, U.S. and Israel relations. The bible teachings are typically affiliated with the Republican party and candidates. This disqualifies you from exemption under IRC Section 501(c)(3).”

Stephen A. Martin, IRS Director, Exempt Organizations, Rulings and Agreements

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