Unrelated Business Income Tax

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The commerciality doctrine was created along with the operational test to address concerns over not-for-profits competing at an unfair tax advantage with for-profit businesses. But even business activities related to your exempt purpose could fall prey to the commerciality doctrine, resulting in the potential loss of your organization’s exempt status.

Several Factors Considered
The operational test generally requires that a not-for-profit be both organized and operating exclusively to accomplish its exempt purpose. It also requires that no more than an “insubstantial part” of its activities further a nonexempt purpose. Your organization can operate a business as a substantial part of its activities as long as the business furthers your exempt purpose.

But under the commerciality doctrine, courts have ruled that some organizations’ otherwise exempt activities are substantially the same as those of commercial entities. They consider several factors when evaluating commerciality, including:

  • Whether an organization has set prices to maximize profits,
  • The degree to which it provides below-cost services,
  • Whether it accumulates unreasonable reserves,
  • The use of commercial promotional methods such as advertising,
  • Whether the business is staffed by volunteers or paid employees,
  • Whether it sells to the general public, and
  • The extent to which the not-for-profit relies on charitable donations. (They should be a significant percentage of total support.)

No single factor is decisive for courts or the IRS.

Possible UBIT Issues
There’s another risk for not-for-profits operating a business. You could pass muster under the commerciality doctrine but end up liable for unrelated business income tax (UBIT).

Revenue that a not-for-profit generates from a regularly conducted trade or business that isn’t substantially related to furthering the organization’s tax-exempt purpose may be subject to UBIT. Much depends on how significant the business activities are to your organization as a whole. There are also several exceptions.

Seek Advice First
If you’re thinking about launching a new business to drum up additional revenues, consult your advisors first. They can help reduce the risk that your organization will run into potential exemption or UBIT issues.

Jen:  This is the PKF Texas Entrepreneur’s Playbook.  I’m Jen Lemanski, this week’s guest host, and I’m back again with Annjeanette Yglesias, one of our tax managers on our not for profit team.  Welcome back to the Playbook Annjeanette.

Annjeanette:  Thanks, Jen, it’s nice to be here.

Jen:  Well now I’ve heard you talk about unrelated business income tax; what is it?  What do nonprofits need to know about it?

Annjeanette:  Well, first of all, that’s a mouthful so we call it UBI.  UBI is an income tax that is imposed on certain tax-exempt organizations that participate in certain activities that are unrelated to their exempt purpose.

Jen:  So what would qualify for that UBI?

Annjeanette:  UBI is income from a trader business that is regularly carried on and that is not substantially related to the organization’s exempt purpose.

Jen:  So what would a leadership team look for?  How would they know that they need to do something about it?

Annjeanette:  I think the most important thing about UBI to remember is that it hinges heavily on the organization’s exempt purpose.  So I think in most cases the organization should talk to their CPA, just kind of make sure that an activity that they’re thinking about engaging in would qualify under UBI or not because tax could be imposed.

Jen:  What’s an example of something that would qualify under the UBI?

Annjeanette:  Actually it’s case by case.  I think the most important part of UBI to remember is that since it hinges heavily on the organization’s exempt purpose that you have to consider the facts and circumstances of each case.  So for example, one activity that is not considered UBI to one organization might be considered UBI to another organization.

Jen:  So that’s why they need to get you involved so that you can help go through that case by case and you can assist them with that.

Annjeanette:  Exactly.

Jen:  Perfect.  Well thank you so much for being here, I really appreciate it and we’ll get you back to talk about some more stuff impacting on profits.  How does that sound?

Annjeanette:  That sounds great.

Jen:  Perfect.  To learn more about how we can help not for profits visit PKFTexas.com/notforProfit/.  This had been another Thought Leader production brought to you by PKF Texas The Entrepreneur’s Playbook.