Unrelated Business Income – Rules and Exceptions

At times the line between related exempt income and unrelated income can be narrow and gray. Because exempt organizations are not required to pay income taxes on “exempt earnings”, there are perceived advantages for developing diverse revenue streams that support the operations of the entity. However because these activities are competing with for-profit (tax paying) organizations, the IRS attempts to impose equality by assessing a tax on unrelated activities.

What is program related and what is unrelated? Here’s an example – A substance abuse center offers educational and counseling services to individuals based on need and income levels, helping them understand the signs of addiction. Because the center’s exempt purpose is rehabilitating individuals with addictions, this revenue stream is directly related to the exempt purpose. However, suppose the center operates a donut shop selling baked goods to the public. Is the donut shop related to the center’s exempt purpose? Probably not.

In order to qualify as unrelated income, the activity must meet all of the following characteristics:
1. Performance of a trade or business (profit motive in the selling of goods or services).
2. Regular activity (based on frequency and continuity, compared to commercial enterprises).
3. Not related to exempt purpose (does not significantly advance the exempt purpose of the organization).

If the activity meets all three requirements, there may be exceptions that eliminate the potential tax. These exceptions include:
1. Activity produced/conducted by unpaid volunteers.
2. Activity is for the convenience of the organization’s members, employees, students, patients, etc. (Example – a hospital’s parking garage available only to employees, patients and hospital visitors).
3. Merchandise sold, substantially received from public donations (Example – clothing thrift store selling merchandise donated by the community).

Most passive income (interest, dividends, royalties, rent) is exempt, however if the revenue is generated from property that is debt financed, the transaction must be analyzed and determined if it is excluded. Additional criteria impact passive income, so it is important to understand the requirements.

The exclusions and the “except fors” make UBIT complicated.
But rest assured, the IRS is looking for these types of activities.