Unrelated business income can be a real problem for a nonprofit if you’re not careful. Nonprofit organizations benefit greatly from their tax-exempt status with the IRS.
But that can be threatened if the income you generate starts to make you look more like a commercial business than a charity.
We’ll guide you through it all in this post and help you stay in good shape when it comes to your taxes!
What is Earned Income for Nonprofits?
Before we can talk about unrelated business income, we need to first define what the IRS considers “earned income.”
In the regular “for profit” business world, earned income is any revenue you receive in exchange for providing some sort of goods or services. It could be a widget of some sort, something you do that others pay you for, or even the produce or livestock a farmer/rancher provides.
Nonprofits can also have earned income, even though we think of them as generally being funded by donations. In fact, many nonprofits make most of their money from earned income. In an article on “Earned Income for Nonprofits”, nonprofithub.com makes the excellent point that “you can finance your nonprofit, not just fundraise for it” (italics added for emphasis).
A great example of a nonprofit making most of its money from earned income is the Girl Scouts. Their cookies are delicious, and they sell millions of them every year. The revenue from those sales is what funds their organization and community projects throughout the rest of the year. There are probably a decent number of individuals and organizations that make donations in order to receive their own tax deductions, but the majority of their funding comes from earned income.
Whenever a nonprofit makes money from something other than direct monetary donations, the IRS sees that as earned income just as it would any other business. Therefore, it can be taxable.
The Society for Nonprofits points out that there are several pros and cons related to nonprofits who operate using earned income. Here are a few worth keeping in mind.
Pros:
- You can use the money however you want. (Many donations come with specific requirements for how you can spend them.)
- Your organization can be more “self-sufficient” and still operate when donations are low.
- It allows you to be even more visible in your community.
Cons:
- Doing what it takes to create an actual business plan within your nonprofit can be time-consuming and could possibly distract from your overall mission.
- You’ll need to be business-minded as well as “nonprofit-minded”, and so will the rest of your team.
- Other businesses in your community may begin to feel like you are competing with them, creating a negative view of your organization.
- If the IRS believes that too much of your revenue is coming through earned income, they may begin to question your tax-exempt status.
We went even deeper into this topic in another post recently titled “How Much Profit Can A Nonprofit Make? (Or When Tax-Exempt Isn’t Really).” If you’re a nonprofit looking to support your mission through earned income, you’ll want to read that as well.
What Is Unrelated Business Income?
Unrelated business income is revenue that comes from activities outside the main scope of a nonprofit’s stated mission and activities. The taxes related to this are referred to as UBIT (Unrelated Business Income Tax).
The IRS considers revenue to be “unrelated business income” if it meets these three criteria:
- It is a trade or a business, which they define as “any activity carried on for the production of income from selling goods or performing services.”
- It is regularly carried on with “frequency and continuity” similar to nonexempt businesses.
- It is not substantially related to “furthering the exempt purpose of the organization.”
Examples of Unrelated Business Income for Nonprofits
Some examples of unrelated business income (UBI) would include scenarios like these:
- Your charity has become very well-known and popular within your community, so you decide to start selling merchandise with your nonprofit’s logo. People are eager to be associated with your organization, so they buy lots of items. Since selling t-shirts, hats, mugs, etc. isn’t the primary purpose of your nonprofit, this revenue is UBI.
- You decide to rent out your facility to private parties and events when it is not in use by your organization. This rental income is UBI.
- You have lots of snacks and soft drinks on hand for your volunteers to enjoy while they serve on community projects you organize. Realizing that you could make extra money by selling some of these items to nonmembers, you open a sidewalk snack shop outside your headquarters. This revenue is considered UBI.
- Your nonprofit owns a large amount of land that you use for summer camps and retreats for area churches and businesses. You decide to cut down some of the timber and sell it. Any money you make from that would be UBI.
The possibilities are endless. However, the main thing to keep in mind is that you need to pay attention to where all of your money is coming from and maintain good records.
Unrelated Business Income Tax Exemptions and Exclusions
There are a few exceptions to UBIT rules to keep in mind as well. The IRS lists these exemptions and exclusions on their site as examples.
- Volunteer labor – If most of the work is performed by noncompensated volunteers, the revenue generated from their activity is not considered UBI. For instance, money raised from a bake sale where volunteers create the items and sell them to the public on your behalf would fall under this category.
- Convenience of Members – Business activity performed by a nonprofit that primarily benefits its members, students, patients, employees, or officers is exempted. An on-campus university coffee shop would be an example of this.
- Selling Donated Items – If a nonprofit operates a thrift store or auctions off high-value donated items, that income would not be seen as UBI.
- Some Games of Chance – A weekly bingo game that is a fundraiser isn’t considered UBI. However, as we mentioned before in this post, offering multiple games of chance ever night in a way that looks more like a casino is going to make the IRS question your nonprofit intentions.
Making Nonprofit Tax Filing Easy
As you can tell, there are a lot of things to keep in mind when it comes to operating a nonprofit and taxes. Trying to stay on top of it all can get overwhelming to the point that you aren’t able to focus on your mission the way you want to.
Our tax experts have over 40 years of experience working with nonprofits of all types and sizes. We can help you protect your nonprofit status and stay in good standing with your tax filings. Schedule a call today to learn more!
