The Tax Consequences of Fee-for-Service (Part 2 of 2): The Unrelated Business Income Tax

In the first part of this two-part series, we discussed the growing commercialization of the non-profit sector, and examined how and when heavy reliance on “fee-for-service” revenue may be inconsistent with an organization’s “tax-exempt purpose” under section 501(c)(3) of the Internal Revenue Code (the “Code”). In this second part, we will look at the basic rules for determining whether fee-for-service activity triggers unrelated business income tax (“UBIT”).

Even if a fee-for-service activity is consistent with an organization’s tax-exempt purpose, the organization may be subject to taxes on the revenue under the UBIT rules. The UBIT rules (found in sections 511-514 of the Code) were passed in 1950 in response to fears that non-profits were using their tax-exemption to unfairly compete with for-profit businesses. Congress sought to level the playing field by imposing a tax (at regular corporate tax rates) on revenue generated by a tax-exempt organization that is not related to the organization’s tax-exempt purpose.

UBIT applies to the gross income derived from any unrelated trade or business, regularly carried on by the organization, minus the deductions directly connected with the carrying on of such trade or business. In other words, to trigger UBIT the activity must be (1) unrelated; (2) a trade or business; and (3) regularly carried on.

A. Related vs. Unrelated

An “unrelated” activity is one that does not directly further a tax-exempt purpose, notwithstanding the use of the funds generated from the activity. This requires an examination of the nature of the activity itself – the fact that the funds are used for charitable purposes does not make the activity related for purposes of the UBIT rules. For example, consider an educational organization whose purpose is to teach music to inner city children. If the organization decides to hold a charity car wash to raise money to buy instruments, the car wash is unrelated to its tax-exempt purpose. A car wash does not further a child’s music education. On the other hand, an organization whose purpose is to help mentally-disabled individuals find employment may have a related activity if it sets up a car wash as a way of putting mentally-disabled individuals to work. In this case, a car wash may be a means of directly achieving the organization’s goals.

B. Trade or Business

An unrelated activity is not necessarily subject to UBIT. It won’t trigger UBIT unless it is also a “trade or business” and “regularly carried on.” A “trade or business” requires (1) a profit motive and (2) extensive business activities over a substantial period of time. “Profit motive” means entering into an activity with the “dominant hope and intent of realizing a profit.” United States v. American Bar Endowment, 477 U.S. 105 (1986). The fact that an activity consistently generates more money than it loses is considered very strong evidence of a profit motive, so organizations rarely escape UBIT on these grounds. However, some profit-making activities, such as investments and other forms of passive income, are not sufficiently extensive to constitute a “trade or business” (the Code also has special statutory exclusions for certain types of passive income, such as dividends, interest, and royalties).

C. Regularly Carried On

An activity that is not “regularly carried on” is not subject to UBIT, even if it is an unrelated activity that constitutes a trade or business. An activity is considered “regularly carried on” if it manifests a frequency and continuity similar to comparable commercial activities of non-exempt organizations. For example, a car wash held once per year would generally not be considered regularly carried on, because commercial car washes are typically run year-round. A one-time or occasional sale of property is typically excluded from UBIT on these grounds. Similarly, annual special events are often excluded from UBIT, but be careful of preparation time: six months of preparation for a one-day annual event can potentially make the activity “regularly carried on” (but not necessarily an unrelated activity or a trade or business).

D. Special UBIT Rules

Notwithstanding the general UBIT analysis discussed above, the Code has numerous special rules that must be carefully considered. It is beyond the scope of this article to address all of these special rules in depth, but note that advertising revenue and income from unrelated debt-financed property (for example, a building that is mortgaged and rented out for unrelated purposes) are typically subject to UBIT. On the other hand, the Code has provisions generally excluding from UBIT royalty income, rental income from real property (provided the unrelated debt-financed property rules don’t apply), dividends, interest, capital gains, income from the sale of merchandise gifted to the organization, and income from businesses conducted by volunteers. It is important to research whether any of these or other special UBIT rules apply before launching a fee-for-service activity, and if necessary, structure such arrangements properly to take advantage of any favorable Code provisions.

When computing the tax on unrelated business income, organizations should also be sure to deduct the expenses directly connected with the carrying on of the trade or business. Some expenses, such as overhead and staff time, are partly allocable to exempt activities and partly allocable to unrelated business activities. In this case, organizations should work with their accountants to find reasonable methods of allocating such expenses (such as by having staff members keep track of their activities with time sheets), and stick to these methods consistently.

Lastly, note that unrelated business activities may result in extra tax filing requirements. Any organization with $1,000 or more of gross unrelated business revenue must file Form 990-T, which breaks down all items of unrelated revenue and expenses in detail. This applies even to very small organizations that file the Form 990-N electronic postcard rather than the full Form 990 or 990-EZ.