Public charities and other nonprofits count on being exempt from federal income taxes. However, even after the IRS has formally recognized a nonprofit’s tax exemption, the organization could have a tax liability if it has “unrelated business income.” The purpose of the tax on unrelated business income is to prevent tax-exempt nonprofits from gaining an unfair competitive advantage over commercial businesses that are conducting similar enterprises.
When the Tax Can Apply
The tax is triggered when a nonprofit generates income from a trade or business activity that it regularly carries on, and the activity is not substantially related to the purpose that forms the basis for the organization’s tax exemption. The tax can apply even if the organization uses the profits from the activity to further its mission.
Income-producing activities that should be carefully scrutinized for unrelated business income potential include:
n Sales of souvenirs, prepackaged foods, tee shirts, or other merchandise (but see When the Tax Doesn’t Apply for exceptions)
n Joint ventures with for-profit partners
n Sales of commercial advertising
n Travel tours
Where the potential for unrelated business income exists, it may be possible to sidestep a tax problem by structuring an arrangement differently, altering a product lineup, or making other changes to bring the activity within the scope of the organization’s mission.
When the Tax Doesn’t Apply
As in most areas, the tax law contains exceptions that allow certain activities to escape the reach of the unrelated business income tax. Among them:
n Volunteer efforts in which substantially all of the work is conducted by volunteers
n Selling donated merchandise
n Hospital gift shops operated for the convenience of employees, patients, and visitors
n Agricultural fair and exposition entertainment and recreational activities
n Certain trade shows
Nonprofits are constantly looking for new ways to keep their missions alive by expanding their revenues. Understanding the unrelated business income rules and how the tax can be avoided will help ensure that the IRS does not share in those revenues.