What You Need to Know About Unrelated Business Taxable Income (UBTI)

If you are a tax-exempt entity, such as a nonprofit organization, an educational institution, or a retirement account, you may wonder if you have to pay taxes on income earned from activities not related to your exempt purpose. The answer is yes. You may have to pay taxes on unrelated business taxable income (UBTI). 

However, it’s not always easy to know what constitutes an unrelated activity. Here you will learn more about UBTI, how the IRS calculates it, and what you can do to mitigate or avoid this tax.

What Is UBTI?

The best explanation comes from the Internal Revenue Service (IRS), who are the arbiters and collectors of the tax. According to the IRS, UBTI, introduced in the Revenue Act of 1950, is income from a trade or business that is not substantially related to the charitable, educational, or other purpose that forms the basis of the organization’s exemption.

UBTI aims to prevent tax-exempt entities from engaging in unfair competition with taxable businesses. Additionally, the tax seeks to help keep tax-exempt entities from straying from their mission.

Generally, any UBTI over $1,000 will become subject to the same tax rate as for-profit corporations. Nevertheless, determining if an activity will generate UBTI isn’t always easy. The IRS also lists how they make those determinations. It’s important to understand the determinations, as many organizations engage in commercial activities to generate income.

In many organizations, an activity can fall into the unrelated business category and generate UBTI if it meets all three conditions:

  1. It involves a trade or business.
  2. It carries out the activity regularly.
  3. It does not have a significant connection to advancing the exempt purpose of the organization.

Nonetheless, there exist several adjustments, exclusions, and exemptions that modify the general definition of unrelated business income.

How Is It Calculated?

Unrelated business taxable income is calculated by adding up the gross income from all unrelated trades or businesses over $1,000, minus the deductions directly connected to those activities. However, some exemptions exist, such as:

  • Most forms of passive income.
  • Certain types of income are derived from activities substantially related to the exempt purpose of the organization (i.e., tuition fees, membership dues, research grants, charitable contributions).
  • Certain expenses are indirectly related to unrelated trade or business (i.e., administrative overhead, depreciation, taxes).

You can carry forward or backward certain losses incurred from unrelated trade or business to offset UBTI in other years through net operating loss (NOL). Finally, the tax rate for unrelated business taxable income is the same as the corporate tax rate, which is currently 21%.

How Does UBTI Affect Your Tax-Exempt Status?

It does not affect your tax-exempt status if you pay the appropriate taxes on it. Organizations with taxable unrelated business income must file Form 990-T and pay corporate or trust tax rates on their UBTI.

Nonprofit organizations must file Form 990-T, Exempt Organization Business Income Tax Return, to report unrelated business taxable income and calculate the associated tax liability. Filing requirements and deadlines may vary based on the organization’s annual gross income.

However, you risk your tax-exempt status if:

  • Your organization’s primary purpose becomes conducting an unrelated trade or business.
  • Your unrelated trade or business substantially interferes with your exempt purpose.
  • Your unrelated business or trade activities significantly infringe on the activities of a for-profit business.

Monitor your UBTI activities and ensure they are incidental and subordinate to your exempt purpose.

Examples of Activities That May Generate UBTI

Some common examples of activities that may generate unrelated business taxable income for tax-exempt entities include:

  • Advertising income from publications or websites that are not substantially related to the organization’s exempt purpose.
  • Income from gaming activities, such as bingo, raffles, lotteries, or casino nights not conducted for charitable purposes.
  • Income from debt-financed rental properties or leased with personal property.
  • Income from partnerships or other pass-through entities that engage in unrelated trades or businesses.
  • Income from unrelated business activities conducted by a subsidiary or a controlled organization.

Many activities can lead to UBTI, so always do your research.

How Can You Avoid or Minimize It?

You can avoid or minimize UBTI in several ways:

  • Keep unrelated business activities to an absolute minimum.
  • Always keep your exempt purpose at the forefront of all endeavors.
  • Take advantage of income sources not included as UBTI.
  • Set up separate, taxable entities to handle unrelated business ventures.
  • Use tax-exempt bonds or equity financing instead of debt financing for rental properties and investments.
  • Consult with a tax professional or a financial advisor who can help you plan and manage your UBTI activities and compliance.

Use due diligence. If an activity seems likely to generate UBTI, then give it careful consideration before moving forward with it. You may find it’s not worth the risk. Alternatively, you may find it will work out. The point is, you need to weigh your options carefully.

You can manage Unrelated Business Taxable Income (UBTI) and ensure it doesn’t interfere with the mission of your organization. Carefully managing your activities and investments can go a long way toward ensuring that UBTI isn’t something that will negatively impact your organization.

Beyond other considerations, always keep in mind that tax laws and regulations can change. Stay informed about UBTI, and you’ll stay ahead of any potential problems concerning it.

Learn what unrelated business taxable income is, how the IRS calculates it, and what you can do to mitigate or avoid UBTI.