Many nonprofits run business enterprises to supplement their charitable giving income and to help create additional income to cover administrative costs. That business activity can be related to the organization's mission or it can be unrelated.
At some point, however, if the unrelated business activity becomes very successful, the nonprofit might be taking in a substantial income from it.
In this case, the organization needs to understand the income tax implications of doing so, including the possibility of putting the entity's nonprofit status at risk.
The Meaning of Unrelated Income
Nonprofits must understand the difference between related and unrelated business income. The first simply means that the revenue supports the mission of the organization.
For instance, a symphony orchestra sells tickets to its performances. Those performances are mission-related. On the other hand, if a nonprofit decides to sell balloons at market rates to the general public, this income would not likely be mission-related.
Whether income is related or unrelated is complex, with many exemptions and nuances. For instance, if a volunteer workforce sold those balloons, the income might be considered mission-related.
Similarly, income from an ice cream shop run by a nonprofit that employs the physically challenged youngsters that the nonprofit exists to serve would likely fall into the mission-related category.
If income turns out to be unrelated to the nonprofit's mission, then the question becomes how much of that income is acceptable before triggering a tax bill or other issues with the IRS.
Many large nonprofits such as universities and medical centers create many sources of income, some related and some not. Figuring out whether they owe taxes on any of that income requires the expertise of a team of tax attorneys.
For small nonprofits, the questions should be much easier, but charities should think through the related vs. unrelated issue well before they start any business activity.
In a nutshell, nonprofits can make up to $1,000 of unrelated income before they have to pay taxes on it. Anything more will require the nonprofit to pay both state and federal corporate income taxes. A nonprofit can jeopardize its exempt status by earning too much income that is unrelated to its mission. But clearly defining what qualifies as unrelated income is where things get tricky.
The Legal Perspective
Emily Chan, an attorney who specializes in nonprofit issues, offered her opinion on the murky topic of how much unrelated income is too much, summarized here:
Nonprofit organizations are generally limited in the number of unrelated business activities they can conduct. But the Internal Revenue Service (IRS) has not been specific about how much permissible earned income can be generated by unrelated sources.
Although no fixed percentage limitation exists, there are two main reasons why unrelated business income raises concern for public charities and most other exempt organizations under Internal Revenue Code section 501(c).
- First, unrelated business income is taxable at the corporate tax rate (i.e., subject to the unrelated business income tax known as UBIT).
- Second, an exempt organization cannot engage in more than an insubstantial amount of unrelated business activity without risk of losing its tax-exempt status.
An "unrelated business" is defined by the IRS as a trade or business that is regularly carried on, and not for the most part related to the exempt purpose of the organization.
A related business means that the income-generating activity supports the organization's exempt purposes , and does not just produce income.
Whether or not the activity produces income is not the most essential fact. But what does matter is if that activity supports the organization's mission.
The analysis of related vs. unrelated business activities can become quite complicated. For instance, individual items sold in a museum gift shop could be classified either way.
There are also exceptions to the rule under Internal Revenue Code section 513(a) for certain activities.
These exceptions include:
- Activities run by volunteers.
- Activities carried on for the convenience of its members, students, patients, officers, or employees.
- Selling of donated merchandise. (Passive income, such as interest, dividends, rents, and royalties, is also generally excluded from unrelated business income.)
Serious issues would likely exist under the unrelated business income rules for an organization with over 50% of its total gross income produced from unrelated business activity, as that would be more than insubstantial.
However, regulations are imprecise about where to draw the line below that 50% mark.
Without a fixed percentage limitation from the IRS, legal advisers often use various rules of thumb, although 20% is common.
Organizations should seek appropriate counsel or expertise when engaging in business activities.
If the activities do not meet the definition of an unrelated business or fall under an exception or exclusion, the organization may have much more flexibility in how it engages in such activities without triggering any penalties.
This communication was not written or intended to be used. It may not be used, by any taxpayer to avoid any tax-related penalty under the Internal Revenue Code.