"Unrelated Business Income" and
501(c)(3) Exempt Status Section 501(c)(3) organizations can have two kinds of business income:
income, which is not taxed, and
income, which is subject to tax at regular corporate rates [gross
business income less deductible business expenses].
Generally, having unrelated
business income will not affect your organization's tax exempt status
unless the business activity is at such a significant level that the
IRS can question whether the organization is running or a charity. The
issue is not how you spend the profits from a particular activity. The
issue is the nature of the activity itself. Does the activity
itself contribute importantly to the achievement of your organization's
charitable objectives as specified in your organization's articles of
What is an "unrelated trade or business"?
CLICK HERE to go to the IRS website for a detailed definition the term.
An "unrelated trade or
business" is an activity that does not contribute importantly to the
achievement of the exempt organization's charitable objectives (as such
purposes are stated in the articles of incorporation and as approved by
the IRS when exempt status was granted).
If the goal of the
activity is merely to make money (rather that achieving some charitable
goal) the IRS will consider the activity to be "unrelated"
The test is not how you
spend the profits, it is the nature of the activity itself. An
organization must be able to show that the activity is merely an
instrument to achieve a charitable purpose and not an end in itself.
Three elements needed to
qualify as an "unrelated trade or business".
The key to understanding "unrelated trade or business" is
the concept of unfair competition. Congress did not want exempt
organization unfairly competing with taxable business. If an activity
in not "regularly" carried on, there is no unfair competition. Under the unrelated trade or business income tax provisions of IRS Code the following three requirements must be met for income to be subject to tax as unrelated business taxable income:
the activity must be
a "trade or business". - The definition is the same one definition
used in that part of the Code dealing with the deductability of
expenses for a "trade or business"
The activity is not
substantially related to the organization's exempt purpose -
remember, the test is whether the activity itself furthers your exempt
purpose and not what you do with the money.
The activity must be
"regularly carried on". - The IRS regulations look to the requency
and continuity of the activity. i.e., one time, short term events are
Exception: With certain exceptions, rents from real property are excluded in
calculating unrelated business taxable income. This exclusion does not apply, however, to income derived from debt-financed property (that is, money was borrowed to purchase the property there is a mortgage).
activities by an exempt organization
Every proposed new
activity of a should be analyzed to determine if it is an "unrelated
trade or business.
If it is an "unrelated
trade or business" tax will be owed on the net income
If the unrelated
activity is "substantial", the IRS could take away the group's exempt
How does an "unrelated trade
or business" affect exempt status?
An organization can
carry on "incidental" non-charitable activities without losing its
tax-exempt status. - If, however, the "unrelated" activity becomes
"substantial", exempt status can lost. The IRS will look closely at
organizations that operates in a manner that makes charity appear to be
only a secondary purpose. An activity is "substantial if the size and
scope of the business activity becomes is relatively large in relation
to the exempt organization's other activities.
What is the tax on"unrelated
trade or business income"?
Regardless of whether
the activity is incidental or subtantial, a tax must be paid on the net
income from all "unrelated trade or businesses".
How best to engage in
"substantial" unrelated activities
If the "unrelated"
activity is "substantial" consideration should be given to "spinning
off" the business activity into a separate for-profit subsidiary,
Can a charitable
organizations enter into partnership arrangements?
Partnership or joint
venture arrangements with for-profit entities will be closely
scrutinized by the IRS. The IRS often views such arrangements as giving
private interests the benefit of charitable assets, particularly if the
charitable organization is to be the sole general partner. This is
because a general partner can be held liable for all of a partnership's
arrangement should be structured to minimize financial risk to the
charitable organization, e.g., by having a co-general partner which has
adequate financial resources. This is an evolving area because the IRS
is beginning to recognize that certain types of partnership
arrangements are appropriate for charitable organizations. However, in
some cases it may be advisable for a charitable organization to use a
subsidiary corporation as a vehicle for a partnership arrangement
rather than entering into a direct relationship with a for-profit
entity or private investors. This would protect the charitable
organization's assets from the claims of partnership creditors.