Unrelated Business Income Tax Overview
“Unrelated business income” is defined as gross income derived by an exempt organization, less certain deductions, from an activity which satisfies all of the following criteria:
- the activity is a trade or business;
- the trade or business is not substantially related to the organization’s exempt purpose; and
- the trade or business is regularly carried on.
Federal and state income tax is imposed on an exempt organization’s unrelated business income at the corporate tax rate; this tax is referred to as the “unrelated business income tax” (i.e., UBIT).
The treasury regulations indicate that “trade or business” means any activity which is carried on for the production of income. An activity does not lose its identity as a trade or business merely because it is carried on within a larger group of similar activities that may or may not be related to the exempt purpose of the organization (fragmentation rule.)
As a general rule, income received by an exempt organization from regularly carrying on a trade or business is not subject to UBIT if the business activity contributes importantly to the accomplishment of the organization’s exempt purposes other than a need for funds. This is known as the “substantially related test.”
Another general rule provides that UBIT is only imposed on income from a trade or business (including activities carried on through a partnership) if the business is frequent, continuous, and pursued in a manner similar to commercial businesses. This is known as the “regularly carried on test.”
Statue provides that UBIT is not imposed in connection with income from activities that meet the following exceptions:
- the volunteer work exception, in which substantially all the work is performed without compensation;
- the donated goods exception, in which the income is from the sale of merchandise substantially all of which was donated to the organization;
- the convenience exception, in which the trade or business is conducted by the organization primarily for the convenience of its students, faculty, patients, officers, or employees; the convenience exception can be challenged by the IRS if sales appear to be substantially beyond “the convenience” of students, faculty, patients, officers, employees;
In addition, specific additional exclusions from UBIT are provided for certain types of income. The excluded items primarily involve passive income sources and include royalties, dividends, interest, annuities, certain rents from real property, and capital gains. Passive income (except dividends) may still be subject to UBIT if received from a controlled organization, or if the income is received from debt-financed property.
Questions regarding the tax status of a particular revenue producing activity can be addressed to Kelly Peterson, Manager, Tax Services.