Unrelated business income tax

What Is Unrelated Business Income Tax?

Unrelated business income tax (UBIT) is a federal tax levied on income generated by tax-exempt organizations from business activities that are not substantially related to their exempt purpose. This taxation falls under the broader financial category of Taxation. The primary goal of UBIT is to prevent tax-exempt organizations, such as nonprofits and educational institutions, from gaining an unfair competitive advantage over for-profit businesses by operating commercial enterprises without incurring federal income tax. An activity is generally subject to unrelated business income tax if it constitutes a trade or business, is regularly carried on, and is not substantially related to the organization's exempt function.

History and Origin

The concept of unrelated business income tax emerged from concerns in the mid-20th century regarding potential unfair competition between tax-exempt entities and taxable businesses. Before 1950, a tax-exempt organization could earn tax-free income from any commercial activity, even if unrelated to its mission, as long as the profits were used for its exempt purpose. A notable instance that highlighted this issue was the case of C.F. Mueller Company, a pasta manufacturer, which was donated to New York University Law School in 1947. The company ceased paying income taxes, asserting its newfound charitable status³⁶.

This scenario, where a commercial enterprise could operate tax-free simply by being owned by a charitable organizations, prompted Congress to act. The Revenue Act of 1950 introduced the unrelated business income tax, shifting the focus of tax exemption from the use of income to its source. From then on, income would be considered tax-exempt based on whether the activity generating it was substantially related to the organization's exempt purpose, rather than merely how the profits were ultimately utilized³⁵. The IRS enacted UBIT to "even the playing field" and promote fair business practices³⁴.

Key Takeaways

• Unrelated business income tax (UBIT) applies to income from trade or business activities conducted by tax-exempt organizations that are not substantially related to their exempt purpose.
• The three criteria for UBIT applicability are: the activity is a trade or business, it is regularly carried on, and it is not substantially related to the organization's exempt function.
• UBIT was established by Congress in 1950 to prevent unfair competition between tax-exempt and taxable entities³², ³³.
• Certain types of passive income, like dividends, interest, and royalties, are generally excluded from UBIT.
• Tax-exempt organizations with gross unrelated business income of $1,000 or more in a fiscal year must file IRS Form 990-T³¹.

Formula and Calculation

The unrelated business income tax is calculated on the organization's unrelated business taxable income (UBTI) at standard corporate or trust tax rates, depending on the organization's structure³⁰.

The general formula for UBIT is:

Where:

• Gross Unrelated Business Income represents the gross income derived from any unrelated trade or business activity that meets the three UBIT criteria²⁹.
• Allowable Deductions are expenses directly connected with carrying on the unrelated trade or business²⁸. These can include operating expenses and other costs attributable to that specific activity²⁷.
• Applicable Tax Rate is the corporate tax rate or trust tax rate, depending on whether the organization is structured as a corporation or a trust for tax purposes²⁶.

Organizations generally must have more than $1,000 in gross unrelated business income annually to be subject to UBIT filing requirements²⁴, ²⁵.

Interpreting the Unrelated Business Income Tax

Interpreting the unrelated business income tax requires a careful assessment of an organization's business activities against the IRS's criteria. The core principle is whether an activity contributes importantly to the accomplishment of the organization's exempt purpose, beyond merely generating income. For instance, a university operating a bookstore that sells textbooks to students would likely not generate UBIT, as this activity supports its educational mission²³. However, if that same university also runs a public pizza parlor with paid employees that is open to the general public, the income from the pizza parlor would likely be subject to UBIT because it is not substantially related to the university's educational purpose²².

The determination often hinges on whether the activity is conducted with the frequency and continuity of a commercial enterprise and whether it directly supports the exempt mission, rather than simply providing a source of revenue. The Internal Revenue Service provides guidance, but the nuances can be complex, often requiring detailed analysis of the specific facts and circumstances.

Hypothetical Example

Consider a tax-exempt art museum that normally generates income from admissions, gift shop sales of art-related items, and grants—all activities related to its exempt educational purpose.

Suppose the museum decides to rent out its grand hall for corporate holiday parties every weekend throughout December. The rental income from these parties is substantial.

1. Trade or Business: Renting out the hall for events, particularly with accompanying services like catering referrals, constitutes a trade or business activity aimed at producing income.
2. Regularly Carried On: Even though it's only in December, if the museum actively markets the hall rentals, has dedicated staff for bookings, and carries out these rentals with the frequency and continuity similar to a commercial event venue during that season, it would likely be considered "regularly carried on".
   ²¹3. Not Substantially Related: While the income might support the museum's mission, renting out the hall for private corporate parties is not, in itself, an activity that directly promotes art education or appreciation.

In this scenario, the income derived from the corporate holiday parties would likely be classified as unrelated business income, and after accounting for direct deductions related to these rentals, the resulting taxable income would be subject to unrelated business income tax.

Practical Applications

Unrelated business income tax applies across a wide spectrum of tax-exempt entities, including universities, hospitals, and various nonprofit organizations. For instance, a university's revenue from a campus bookstore selling general merchandise to the public, advertising in its publications, or operating a commercial golf course may be subject to UBIT, as these activities are typically not considered substantially related to its educational mission. ¹⁹, ²⁰Similarly, a hospital that runs a commercial parking garage for the general public, rather than solely for patients and staff, might incur UBIT on that revenue.
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The IRS frequently scrutinizes these areas. A 2013 IRS report on colleges and universities, for example, found widespread underreporting of unrelated business income, with issues commonly arising from fitness centers, sports camps, advertising, and facility rentals. ¹⁶, ¹⁷Organizations need to carefully identify and categorize all income-generating ventures to ensure compliance with UBIT regulations. ¹⁵Resources such as IRS Publication 598 provide detailed guidance on these applications.
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Limitations and Criticisms

Despite its intent to level the playing field, unrelated business income tax faces complexities and criticisms. One significant limitation arises in defining what constitutes "substantially related" to an exempt purpose, leading to ambiguities and disputes between tax-exempt organizations and the IRS. ¹³For example, determining whether a university's fitness center or sports camp primarily serves an educational purpose or acts as a commercial venture can be challenging.
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Another common issue involves the allocation of expenses between exempt and unrelated activities. Organizations sometimes struggle with properly attributing indirect costs, such as shared administrative salaries or facility depreciation, which can lead to miscalculations of tax liability. ¹¹The IRS has cited issues with organizations improperly claiming expenses or misclassifying unrelated activities as related, leading to adjustments and disallowance of losses. ¹⁰The complexity of UBIT rules can also inadvertently incentivize tax avoidance strategies, as organizations seek to structure activities to fall outside the UBIT scope or qualify for exceptions. ⁹Some argue that the rules can be burdensome for smaller nonprofits with limited resources for complex tax compliance.

Unrelated Business Income Tax vs. Pass-through Income

Unrelated business income tax (UBIT) and pass-through income refer to distinct concepts in taxation, though both involve how income is treated for tax purposes.

UBIT specifically targets income earned by tax-exempt organizations from activities that are not integral to their exempt mission. The tax is applied at the organizational level, usually at corporate tax rates, on the net income from these unrelated commercial ventures. The purpose of UBIT is to ensure fairness in competition between tax-exempt entities and for-profit businesses.

In contrast, pass-through income refers to income generated by certain business structures, such as partnerships, S corporations, or sole proprietorships, where the income "passes through" directly to the owners or shareholders without being taxed at the entity level. The income is then reported on the owners' personal tax returns and taxed at their individual income tax rates. The entity itself does not pay corporate income tax.

The confusion sometimes arises because tax-exempt organizations can be partners in pass-through entities. If a tax-exempt organization receives income from an investment in a pass-through entity that conducts an unrelated trade or business, that income can be subject to UBIT at the exempt organization level, even though it was "passed through" from the underlying entity. ⁸This means that while the entity itself avoids corporate tax, the tax-exempt investor might still owe UBIT on their share of the income if it originates from an unrelated business activity.

FAQs

What types of organizations are subject to unrelated business income tax?

Most tax-exempt organizations under Section 501(c) of the Tax code are potentially subject to UBIT. This includes public charities, private foundations, universities with large endowment funds, hospitals, and other nonprofit entities. Even certain retirement accounts like IRAs can be subject to UBIT if they derive income from an unrelated trade or business.
⁷

What income is generally excluded from UBIT?

The IRS provides several exclusions from unrelated business income. Common exclusions include passive income such as dividends, interest, annuities, and royalties, provided there is no active business participation involved. ⁶Rent from real property is typically excluded, unless the property is debt-financed or significant services are provided. Income from activities where substantially all the work is performed by volunteers, income from the sale of donated goods, and certain income from trade shows and conventions are also usually exempt.
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What happens if an organization fails to pay UBIT?

If a tax-exempt organization fails to correctly identify and pay unrelated business income tax, it can be subject to back taxes, penalties, and interest. ⁴Repeated non-compliance or significant underreporting could also jeopardize the organization's tax-exempt status, leading to more severe consequences. Proper reporting requires filing Form 990-T if gross unrelated business income exceeds $1,000 in a year.
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Is all income generated by a nonprofit tax-exempt?

No, not all income generated by a nonprofit is automatically tax-exempt. While income derived from activities substantially related to the organization's exempt purpose is generally tax-free, income from activities that constitute an unrelated trade or business is subject to the unrelated business income tax. The key is the nature of the income-generating activity, not solely how the income is ultimately used.
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Does UBIT apply to investment income?

Generally, passive investment income such as dividends, interest, and capital gains is excluded from UBIT. However, there are exceptions. For example, if an exempt organization incurs debt to acquire income-producing property (debt-financed property), a portion of the income generated by that property may be subject to UBIT. ¹Similarly, income from an active trade or business conducted through a partnership, even if it's an investment, might trigger UBIT.