A non-profit organization is generally exempt from federal income tax on the income generated from activities related to its charitable, educational or other purpose that is the basis for its exemption. In order to be tax-exempt the non-profit organization must have applied for and obtained tax-exempt status from the IRS.
But income from other activities carried on by the organization that are not directly related to its exempt purpose may be subject to tax. The tax-exempt status does not necessarily apply to all activities carried on by the non-profit organization. In order to be tax-exempt, the activities must be related to the exempt purpose. As pointed out by Hurwit & Associates, the tax on unrelated business income is intended to prevent unfair competition between exempt and taxable organizations.
According to the IRS, an activity is subject to the unrelated business income tax if the activity is a trade or business, it is carried on regularly, and it is not substantially related to the exempt purpose of the organization except that it provides funds to carry out that purpose.
An activity is considered not substantially related if it does not contribute importantly to accomplishing the exempt purpose. This depends on the facts involved in each case. One of the factors involved in making this determination is the scale of the activity. The portion of an activity that is more than necessary to accomplish the exempt purpose could be considered unrelated business income.
Another principle in determining whether income is related to the exempt purpose is how sales of products are made. If products from exempt activities are sold in substantially the same state, the income from the sale would be considered related to the exempt function and would not be taxable. But if products are further elaborated and used or sold in a business activity that goes beyond the exempt purpose, the income could be considered unrelated business income subject to tax.
The dual use of the facilities of an exempt organization could also give rise to unrelated business income. The IRS in its Publication 598 points out the example of a museum that has a theater auditorium. If the auditorium is open to the public as a motion picture theater when the museum is closed, the income generated by that activity could be considered unrelated business income.
Various other specific examples are provided in IRS Publication 598 that can help to determine whether the income generated by an activity would be considered exempt or unrelated business income.
According to the IRS, certain activities are specifically excluded from the definition of an unrelated business. These include any business in which substantially all the work is performed by a volunteer workforce; a business conducted primarily for the convenience of the exempt organization’s members, students, patients, officers or employees; qualified sponsorship activities; selling merchandise that was received as gifts or contributions; bingo games; the distribution of low cost articles to solicit charitable contributions; public entertainment activities at fairs or expositions that promote agriculture or education; and convention or trade show activities.
Also, certain types of income are excluded from unrelated business income. These include interest, dividends, and other investment income; royalties; rents from real property; and gains or losses on the sale or disposition of property.
If a tax-exempt organization has a total of $1,000 or more of gross unrelated business income in a year, it must file Form 990-T, Exempt Organization Business Income Tax Return. This is in addition to the obligation to file Form 990 or 990-EZ as applicable for the non-profit organization, or Form 990-PF for a private foundation. And, if a tax-exempt organization expects to owe $500 or more for the year in tax on unrelated business income, it should pay estimated tax. Unrelated business income is taxable at corporate rates for non-profit exempt organizations and at trust rates for exempt trusts.
Form 990-T, Exempt Organization Business Income Tax Return
Publication 557, Tax-Exempt Status for Your Organization
Publication 598, Tax on Unrelated Business Income of Exempt Organizations
Taxation of Unrelated Business Income, Hurwit & Associates
Unrelated Business Income Tax, IRS