Understanding Unrelated Business Taxable Income (UBTI)
Unrelated business taxable income (UBTI) refers to income earned by a tax-exempt entity that is not connected to its tax-exempt purpose. According to the IRS, UBTI is “income from a trade or business, regularly conducted, that is not significantly related to the charitable, educational, or other purpose which underlies the organization’s exemption.”
Key Takeaways
- UBTI is generated from activities by tax-exempt entities unrelated to their primary tax-exempt purpose.
- This income prevents tax-exempt organizations from having an unfair competitive advantage over taxable firms in profit-oriented activities.
- UBTI was instituted in 1950 to level the playing field between tax-exempt and taxable businesses.
- Generally, passive income types such as dividends, interest income, and capital gains are not considered UBTI.
- Taxes on UBTI follow corporate or trust tax rates.
Digging Deeper into Unrelated Business Taxable Income
What Qualifies as UBTI?
The IRS defines three criteria an activity must meet to be called unrelated business income and therefore taxable:
- Trade or Business: The activity generates income through the sale of goods or performance of services.
- Regularly Carried On: The activity mirrors the commercial endeavors of non-exempt organizations.
- Not Substantially Related: The activity must not considerably aid in advancing the organization’s tax-exempt purposes, like charity or education.
Examples of Transactions Generating UBTI
Certain transactions are typically defined as unrelated business activities capable of generating taxable income:
- Frequent buying and selling of real estate properties.
- Operating restaurants, convenience stores, inns, or gas stations through pass-through entities such as LLCs or master limited partnerships (MLPs).
- Purchasing stocks using margin.
- Engaging in repetitive private lending activities.
Organizations anticipating owing tax on unrelated business income must make estimated tax payments if their annual tax exceeds $500. Estimated payments are typically due on the 15th day of the 4th, 6th, 9th, and 12th months of the year and should total 100% of that year’s tax liability.
Exemplar Activities that Do Not Generate UBTI
The IRS identifies specific activities as unrelated business that do not qualify as taxable:
- Volunteer Labor: Activities performed predominantly by volunteers. For example, a bake sale organized and run entirely by volunteers.
- Business for Members’ Convenience: Services primarily for members, students, patients, or employees of a 501(c) organization or state college. A typical example is a school cafeteria.
- Donated Merchandise: Selling goods obtained as donations, like a thrift store run by a charity organization.
- Bingo: Certain types of bingo games are exceptions.
Taxes on UBTI
Any tax-exempt organization subject to unrelated business income tax must pay the tax at corporate rates (federal 21%) if their gross UBTI exceeds $1,000. Trusts follow trust tax rates, ranging from 10% to 37%.
Taxed exempt organizations can use tax credits applicable to reduce total UBTI tax, including general business credits and foreign tax credits; however, tax deductions for individual exemptions that trusts typically can claim do not apply.
To process the tax, organizations must file IRS Form 990-T.
Excluded Types of Income
Specific incomes are categories exempted from unrelated business taxable income:
- Dividends
- Interest
- Certain other investment earnings
- Royalties
- Specific rental income
- Income from certain research activities
- Gains or losses from property sale
Responsibilities and Penalties for Non-Compliance
If your nonprofit earns over $500 in unrelated business income and does not fall into excluded sections, taxes must be paid.
Failing to pay due taxes can result in significant penalties and interest charges. It is crucial to ensure proper filing and timely payments to avoid such consequences.
Conclusion
Unrelated Business Taxable Income (UBTI) impacts tax-exempt organizations that earn income through non-primary activities. This ensures a fair competitive environment between tax-exempt and taxable entities. Adhering to IRS regulations and understanding what constitutes UBTI is crucial for maintaining tax-exempt status and avoiding unnecessary penalties.
Related Terms: Passive Income, Exempt Organizations, Corporate Tax Rates, Trust Tax Rates.
References
- Internal Revenue Service. “Unrelated Business Income Tax”.
- U.S. Government Publishing Office. “Title 26, Internal Revenue Code, Section 501”.
- Internal Revenue Service. “A History of the Tax-exempt Sector: An SOI Perspective”. Page 107.
- Internal Revenue Service. “Publication 598, Tax on Unrelated Business Income of Exempt Organization”.
- Internal Revenue Service. “Unrelated Business Income Defined”.
- Internal Revenue Service. “Unrelated Business Income Tax Exceptions and Exclusions”.
- American Bar Association. “Unrelated Business Income Tax (UBIT): A Comprehensive Overview for Nonprofits”.
- Internal Revenue Service. “2023 Form 1041-ES”. Pages 2, 5.
- Internal Revenue Service. “Annual Exempt Organization Return: Penalties for Failure to File”.
