Neighborhood Transformation
Neighborhood Transformation

"Unrelated Business Income" and
501(c)(3) Exempt Status

Section 501(c)(3) organizations can have two kinds of business income:
  • related business income, which is not taxed, and

  • unrelated business 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 incorporation.

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 not included.

  • 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).
Analyzing proposed 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 classification.
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 debts.

  • The partnership 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.