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Q&A: Taxation of Unrelated Business Income

Legal Counsel for Philanthropy and the Nonprofit Sector

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Q&A: Taxation of Unrelated Business Income

  1. My organization provides vocational training for disabled adults. Like many nonprofits, we've become more "entrepreneurial," in part through training programs which include the sale of various products. I'm concerned about two issues. Do we have to pay taxes on our product sales? And can we lose our tax exempt standing by involving ourselves in these kinds of business operations?
  2. I work at a large health agency and am in charge of our monthly newsletter. Since we reach a large targeted audience (35,000 people), various companies have expressed interest in advertising in our publication. Can we do this? Or would accepting advertising money jeopardize our exempt status?

  1. My organization provides vocational training for disabled adults. Like many nonprofits, we've become more "entrepreneurial," in part through training programs which include the sale of various products. I'm concerned about two issues. Do we have to pay taxes on our product sales? And can we lose our tax exempt standing by involving ourselves in these kinds of business operations?

    There are still many misconceptions in the nonprofit world about such profit-related issues. The key point to remember is that as long as you are acting in furtherance of your tax exempt purposes, the Internal Revenue Code generally does not prohibit or restrict your income-generating activities. This is true regardless of how much you may resemble a for-profit business in carrying out your exempt purposes.

    Under the Internal Revenue Code, income derived by an organization from activities unrelated to its tax exempt purposes is taxed at prevailing corporate rates. Presumably, in your case, the production and sale of products by your clients is an integral part of the training programs. The product sales would therefore generate income which is related to your organizational purposes and not be subject to tax.

    What if your clients sell but do not actually produce the products? Much like the sale of cookies by the Girl Scouts, the income could still be considered related if the act of selling itself helps develop vocational abilities or individual potential.

    Even in situations where it may be difficult to show that income is related to your organization's purposes, one or more specific exclusions to the tax may apply. For example, if substantially all the work in selling the products is performed by volunteers, then the income is not taxable. Other exclusions that may apply in your case include the sale of contributed property (the thrift shop exception), services for the convenience of members, employees, and patrons (including gift shops, restaurants, and parking lots), and certain low cost items (tee shirts, knick-knacks).

    Only if you derive a "substantial" percent of your income from activities unrelated to your tax exempt purposes do you risk losing your exempt status. Neither the IRS nor case law have completely defined the term "substantial".

    As a general rule, if unrelated income regularly falls within the range of 15 percent to 30 percent of gross income, you may wish to consider establishing a for-profit subsidiary. Certainly, once unrelated income begins to exceed 50 percent, it becomes difficult to demonstrate to the IRS that the organization primarily furthers tax exempt purposes.

  2. I work at a large health agency and am in charge of our monthly newsletter. Since we reach a large targeted audience (35,000 people), various companies have expressed interest in advertising in our publication. Can we do this? Or would accepting advertising money jeopardize our exempt status?

    Welcome to the murky waters of unrelated business income taxation, otherwise known as UBIT. In all likelihood, your tax exempt status would not be jeopardized from this activity alone, but the income would constitute unrelated income and you would have to pay taxes on it. Taxes would be assessed as if you were a for-profit corporation, i.e., you would deduct expenses incurred in connection with the advertising and then pay taxes on the proceeds at the regular corporate rate. Such taxes, which are paid quarterly, are reported to the IRS in an attachment to your annual Form 990 called Form 990T.

    UBIT laws are somewhat complex and, with case rulings continually setting new precedents, somewhat confusing. The general rule is that a tax-exempt organization must pay taxes on income unrelated to its nonprofit purposes derived from a trade or business regularly carried on.

    In your case, newsletter advertising is considered unrelated to the provision of health care services. The sale of advertisements is of a sufficiently commercial nature as to constitute business activity (as opposed to, for example, revenues derived from investments or royalties). Lastly, as part of a monthly publication, such business would be considered to be regularly carried on.

    Caveat: If unrelated income comprises a "substantial" portion of your agency's income, you may risk loss of tax-exempt status. The term substantial has not been clearly defined (although in one case an organization with 75 percent of its revenues from unrelated sources did not lose its exempt status). Suffice it to say, if over 5 percent of your organization's revenue is unrelated or questionably related to your exempt purposes, your activities should be monitored by an accountant or lawyer familiar with UBIT laws.