Unrelated Business Income
Unrelated business income (UBI) refers to the gross income generated by a tax-exempt organization from an activity that constitutes a trade or business, is regularly carried on, and is not substantially related to the organization's exempt purpose. This concept falls under tax law, specifically designed to ensure fairness in competition between nonprofit entities and for-profit businesses. While many organizations are granted an exemption from federal income tax on their mission-related activities, income derived from activities that do not directly contribute to their charitable, educational, or other exempt functions may still be subject to taxation.
History and Origin
The concept of taxing unrelated business income emerged in the mid-20th century to address growing concerns about unfair competition. Prior to 1950, tax-exempt organizations could operate commercial businesses without paying income tax on the profits, provided those profits were used to further their exempt purposes. A notable example was the C.F. Mueller Co., a pasta manufacturing company owned by New York University School of Law, which paid no income taxes on its profits because they funded the law school's educational activities.25,
This situation led to competitive disadvantages for traditional, tax-paying businesses. In response, Congress enacted the Revenue Act of 1950, which introduced the unrelated business income tax (UBIT).24 The primary objective was to "level the playing field" by taxing income from commercial activities of exempt organizations as if earned by a comparable for-profit entity.23,22 The Tax Reform Act of 1969 further expanded the scope of UBIT to nearly all exempt organizations and included new rules for "unrelated debt-financed income," which pertains to income generated from property acquired with borrowed funds.21
Key Takeaways
- Unrelated business income (UBI) is derived from a trade or business that is regularly carried on and not substantially related to an organization's tax-exempt purpose.
- The UBIT was established to prevent unfair competition between tax-exempt organizations and for-profit businesses.
- Tax-exempt organizations with $1,000 or more of gross UBI in a tax year must generally file Form 990-T.20
- Certain types of income, such as most dividends, interest, royalties, and rents, are typically excluded from UBI unless derived from debt-financed property or a controlled subsidiary.19
- Expenses directly connected with the unrelated business activity are generally deductible when calculating UBI.18
Formula and Calculation
The calculation of unrelated business taxable income (UBTI) involves determining the gross income from the unrelated trade or business and then subtracting the deductions that are directly connected with carrying on that trade or business.
The general formula can be expressed as:
Where:
- Gross Unrelated Business Income represents the total revenue generated from the unrelated trade or business activity.
- Allowable Deductions Directly Connected refers to the expenses incurred solely for the purpose of generating the unrelated business income.
- Specific Deduction is a statutory deduction of $1,000 permitted in computing UBTI.17
The resulting net income (UBTI) is then generally taxed at corporate income tax rates.16
Interpreting the Unrelated Business Income
Interpreting unrelated business income requires a careful assessment of an organization's activities against three core criteria: whether the activity is a "trade or business," whether it is "regularly carried on," and whether it is "substantially related" to the organization's exempt purpose.15 An activity is considered a trade or business if it involves the sale of goods or services with an intent to profit. "Regularly carried on" implies frequency and continuity similar to commercial entities.14 The "substantially related" test is crucial; an activity is substantially related only if it contributes importantly to the accomplishment of the organization's exempt purpose, beyond merely providing funds. For example, a hospital gift shop serving patients and visitors might be considered related, while a general retail store open to the public might not.13
The presence of UBI signifies that a tax-exempt organization is engaging in commercial activities that fall outside its core mission as defined by its charitable organization status. Organizations must diligently identify and properly classify such income to maintain compliance with IRS regulations.
Hypothetical Example
Consider "Helping Paws," a tax-exempt animal rescue organization. Its primary exempt purpose is to rescue, rehabilitate, and rehome animals. To raise funds, Helping Paws decides to operate a weekly "Pawsome Pet Supplies" store in a rented commercial space, selling pet food, toys, and accessories to the general public. This store is open year-round, seven days a week, and employs paid staff, operating much like any other retail pet supply store.
In this scenario:
- Trade or Business: Selling pet supplies to the public is a commercial activity.
- Regularly Carried On: The store operates consistently throughout the year, similar to a for-profit retail business.
- Not Substantially Related: While the profits from the store support Helping Paws' mission, the direct selling of pet supplies is not integral to the rescue and rehabilitation of animals itself. It is a separate commercial endeavor.
Therefore, the net income generated by "Pawsome Pet Supplies" would likely be considered unrelated business income. Helping Paws would need to track the store's revenue and associated expenses, and if the gross income exceeds $1,000, report it on Form 990-T and pay UBIT.
Practical Applications
Unrelated business income provisions have significant practical applications for a wide array of tax-exempt entities, including educational institutions, hospitals, religious organizations, and private foundations. Organizations must carefully review all income-generating activities to determine if they meet the UBI criteria.
Common activities that can generate UBI include:
- Advertising income from periodicals or websites.
- Rental income from facilities not primarily used for exempt purposes, especially if the property is debt-financed.12,11
- Sales of merchandise that are not substantially related to the organization's exempt purpose (e.g., a university bookstore selling general apparel beyond school spirit items).10
- Commercial ventures such as operating a public fitness center, catering services, or parking lots if they primarily serve non-members or the general public rather than exempt beneficiaries.
The Internal Revenue Service (IRS) actively monitors compliance with UBIT rules. For instance, an IRS compliance project found that many colleges and universities had underreported their UBI, highlighting the need for vigilance in identifying and accounting for such income.9 Organizations must properly allocate expenses between their exempt activities and unrelated business activities to accurately determine their UBTI.
Limitations and Criticisms
Despite its intent to ensure fair competition, the unrelated business income tax has faced criticisms. One major critique is the complexity and ambiguity in applying the "substantially related" test, leading to confusion and inconsistent interpretations across different organizations and activities.8 The line between what constitutes a related versus an unrelated activity can be blurry, making compliance challenging.
Another point of contention has been the effectiveness of UBIT in truly leveling the competitive playing field. Some argue that the tax does not fully eliminate the competitive advantage enjoyed by tax-exempt entities due to other benefits, such as access to volunteer labor, tax-deductible donations, or favorable borrowing rates for their endowment.7 There have also been concerns about new "basketing" rules introduced by recent tax legislation, which require organizations to calculate UBIT separately for each unrelated business activity rather than aggregating gains and losses, potentially increasing tax liability and administrative burden.6 This can prevent an organization from offsetting losses from one unrelated business with gains from another, leading to a higher overall tax burden.
Unrelated Business Income vs. Taxable Income
The distinction between unrelated business income (UBI) and taxable income is crucial, particularly for tax-exempt organizations. Taxable income is a broad term referring to any income subject to taxation by a government, generally applicable to for-profit individuals and corporations. For a regular business, virtually all investment income, sales revenue, and other gains contribute to its overall taxable income, which is then subject to corporate tax rates.
In contrast, UBI is a specific subset of income that applies only to otherwise tax-exempt organizations. The defining characteristic of UBI is that it stems from activities not substantially related to the organization's core exempt purpose, even if the profits ultimately support that purpose. Most income generated by a qualified tax-exempt organization from its mission-related activities (e.g., tuition for a university, donations to a charity) is exempt from taxation and thus not considered taxable income in the same way as for a for-profit entity. However, income from an unrelated trade or business, no matter how the profits are used, falls into the UBI category and becomes subject to taxation, effectively being treated as taxable income within that specific context for the exempt organization.
FAQs
What types of organizations are subject to unrelated business income tax (UBIT)?
Most tax-exempt organizations, including charities, educational institutions, hospitals, and certain trusts, can be subject to UBIT if they generate income from activities that are an unrelated trade or business, regularly carried on, and not substantially related to their exempt purpose.5
Are all business activities of a nonprofit considered unrelated business income?
No, not all business activities of a nonprofit generate UBI. Only those activities that meet the three-part test (trade or business, regularly carried on, and not substantially related to the exempt purpose) are considered UBI. Many income-generating activities, such as those that contribute importantly to the organization's mission or are primarily for the convenience of its members, are typically excluded.4
Is income from investments considered unrelated business income?
Generally, passive investment income like dividends, interest, annuities, and most rents and capital gains from property sales are excluded from UBI. However, there are exceptions. If investment income is derived from "debt-financed property" (property acquired with borrowed funds), or from a controlled subsidiary, it may be subject to UBIT.3
What is Form 990-T used for?
Form 990-T, Exempt Organization Business Income Tax Return, is the IRS form that tax-exempt organizations use to report and pay tax on their unrelated business income if their gross UBI is $1,000 or more.2 It is filed in addition to the organization's regular annual information return, such as Form 990.
Can an organization reduce its unrelated business income tax liability?
Organizations can reduce their UBIT liability by claiming direct deductions associated with the unrelated business activity. Additionally, some income streams have statutory exclusions from UBI. Careful planning and ensuring activities align with the exempt purpose can also minimize UBI exposure.1