Q & A: What is unrelated business for purposes of UBIT?

Definition.  In a nutshell, UBIT, or the unrelated business income tax, applies when an exempt organization's activity meets the following three criteria:

It is a

• trade or business
• regularly carried on
• that is not substantially related to the organization's exempt purpose or function.

If a transaction is subject to UBIT, the organization must pay tax on the profits at the corporate income tax rate.  If the IRS determines that your organization is engaged in a substantial amount of unrelated business, it may determine that your organization has a substantial non-exempt purpose. 

Which would be bad, because that would lead the IRS to revoke your exemption.

Strategy.  If your organization has to pay UBIT, don't panic--it won't kill you so long as it is isn't too much in relation to all of your activities.  Still, one way to make sure it doesn't get too much is to find ways to make sure the ways you generate income from the sale of goods or services don't count as UBI ("unrelated business income"). 

How do you do that?

Three primary ways:

(1)  Be prepared to persuade the IRS that the activity does not fit within the definition of unrelated business income--for example, that it is NOT regularly carried on or that it IS substantially related to your exempt purposes and functions.

(2)  Spin off the taxable activities into a separate for-profit corporation.  Sure, it will have to pay taxes, but they generally won't be attributed back to the exempt organization.

(3)  Be prepared to persuade the IRS that the activity falls within one of the specific exceptions to UBIT.

What are some of the main exceptions?

• Volunteer labor (Examples: Cookies sold by girl scouts; a commercial farm run by unpaid monks; a store run by unpaid staff)
  
• Convenience of members, patients, students, officers or employees (Examples: laundry service for students; museum restaurant; hospital pharmacy sales to patients)
  
• Donated goods (Examples: thrift shops)
  
• Passive investment income (Examples:  dividends; interest; rent, so long as it does not include the provision of disqualifying services)
  
• Capital gains (provided not from sales in the ordinary course of business)
  
• Royalties (rights to broadcast the Oscars!)
  
• Low cost items distributed incidental to charitable fundraising solicitations

Key principles to remember:

• The fragmentation rule: the IRS can break transactions down into related and unrelated elements (for example, a museum gift shop's obligation to pay UBIT will be determined on an item-by-item basis, and an organization may have to pay UBIT on ads in a related publication)
  
• Qualified sponsorships:  These essentially passive ads (names, logos, mention of sponsorship) provide a way to have ads that aren't subject to UBIT