By Elizabeth Schultz-Horbus & Jarman J. Smith on August 26, 2019
Many nonprofit organizations are recognized by the federal government as being tax-exempt; therefore, taxes are generally one of their lowest business concerns. However, even tax-exempt organizations may be liable for tax on any activities that generate unrelated business income. According to the Internal Revenue Service (IRS), unrelated business income is any income realized from a trade or business regularly carried on by an organization, which is not substantially related to furthering the purpose of the organization’s tax exemption. A trade or business is substantially related to an organization’s exempt purpose only where the conduct of the business has a significant causal relationship to the achievement of the exempt purpose and contributes importantly to that purpose. Therefore, any nonprofit organization that engages in a trade or business that does not contribute importantly to the exercise or performance of its exempt function is subject to a tax on the resulting unrelated business income. Because nonprofit organizations pay a corporate tax rate of up to 37% on unrelated business income, it is important for these organizations to fully understand this tax code and associated implications to avoid any undesirable tax liability.
To determine whether activities are substantially related to furthering the purpose of an organization’s tax-exempt status, the size and extent of the activities involved must be considered in relation to the nature of the organization’s exempt function. Thus, even income realized from activities that are in part related to an organization’s exempt status but that are conducted on a larger scale than is reasonably necessary to further the purpose of the exemption is taxable as unrelated business income. Furthermore, a tax-exempt organization may use its assets or facilities in a commercial enterprise that is separate from its tax-exempt function or purpose; however, the income realized from the additional use of any asset or facility is also unrelated business taxable income. Ultimately, income derived from any activity that does not contribute importantly to the accomplishment of an organization’s exempt purpose is income from an unrelated business activity which is subject to taxation.
A tax-exempt, nonprofit organization that generates $1,000 or more of gross income from an unrelated business activity must report the unrelated business income to the IRS, and any organization that expects its tax liability for the year to be $500 or more must pay an estimated tax. Although any activity which generates income and is not substantially related to an organization’s tax-exempt status constitutes an unrelated business or trade. Common examples of such activities include:
- Receiving income from advertising and corporate sponsorships;
- Buying and selling a significant number of real estate properties within a given year;
- Making multiple private loans within a given year;
- Conducting operations in businesses such as restaurants, convenience stores, lodging inns, gas stations, or other operations that generate income through pass-through entities such as LLCs;
- Purchasing stocks on margin;
- Providing commercial-type insurance that conflicts with tax-exempt status; and
- Providing any good or service that goes beyond what is reasonably necessary to accomplish a tax-exempt function or purpose.
- Contact your qualified legal counsel to help monitor and separate your organization’s unrelated business income to reduce taxes and protect your tax-exempt status. Adequate legal counsel can determine whether any modifications, exclusions, or exceptions to the general definition of unrelated business income apply to the activities of your organization.
- Consult with a tax attorney to determine if offsetting unrelated business income with the net operating losses from the corresponding business is feasible. However, it is important to note that net operating losses from one business or trade cannot be used to reduce the taxable income of another business or trade. If your organization operates multiple unrelated businesses, you should consider housing these businesses in a single taxable corporate subsidiary. This will allow you to offset the businesses’ income and expenses against each other; however, such restructuring may have additional legal and tax implications.
- Track and record any unrelated business income and expenses generated by your organization. Unrelated business income should be calculated separately for each unrelated trade or business and then totaled to determine the sum of those amounts.
- Avoid unrelated business income taxation altogether by ensuring that your organization only engages in business activities that are substantially related to your specific tax-exempt purpose.
Every nonprofit organization should have procedures in place that regulate and monitor all business activities to effectively determine whether they have any unrelated business income. Moreover, any organization engaged in unrelated business activities should have adequate methods for tracking and recording the resulting income and expenses. Brouse McDowell can help identify activities that generate unrelated business income, reduce tax liability associated with this income, and protect your organization’s tax-exempt status. Please contact our Corporate Group for more information.
This blog is intended to provide information generally and to identify general legal requirements. It is not intended as a form of, or as a substitute for legal advice. Such advice should always come from in-house or retained counsel. Moreover, if this Blog in any way seems to contradict advice of counsel, counsel's opinion should control over anything written herein. No attorney client relationship is created or implied by this Blog. © 2022 Brouse McDowell. All rights reserved.