Nonprofits are generally exempt from federal income taxes, but that exemption doesn’t cover all types of income. When a nonprofit earns money from a business activity that isn’t directly related to its core mission, it may be subject to the Unrelated Business Income Tax (UBIT).
For many nonprofit leaders, UBIT can be a confusing area of tax law. What counts as unrelated business income? How much tax is owed? And how can your organization stay compliant without risking its tax-exempt status? These are common questions—and understanding the answers is key to avoiding penalties and protecting your nonprofit’s financial health.
What is Unrelated Business Income Tax (UBIT)?
Unrelated Business Income Tax (UBIT) is a federal tax imposed on the income generated from activities that are not directly related to a nonprofit’s core mission. This tax was created to ensure that nonprofit organizations that engage in business activities unrelated to their primary purpose do so on a level playing field with for-profit businesses, which are taxed on all their income.
Criteria for UBIT
For income to be taxed under UBIT, it must meet three specific criteria:
- It is a trade or business: The activity must be conducted in a manner similar to comparable commercial activities.
- It is regularly carried on: The activity is performed with a frequency and continuity similar to equivalent for-profit activities.
- It is not substantially related to furthering the organization’s exempt purpose: The activity does not contribute importantly to accomplishing the nonprofit’s mission, other than through the production of funds.
Common Examples of UBIT
Here are a few examples where a nonprofit might find itself dealing with UBIT:
- A university owns a bookstore that sells merchandise to students and the general public.
- A charity runs a parking lot all year round where the majority of spaces are rented to the general public.
- A nonprofit arts organization sells advertising space in its event programs to unrelated businesses.
Why UBIT Matters for Nonprofits
Understanding and managing UBIT is essential for several reasons:
- Compliance with Tax Laws: Properly handling UBIT ensures compliance with IRS regulations, avoiding potential penalties and legal issues.
- Financial Health: By managing UBIT properly, nonprofits can make informed decisions about which activities to pursue and avoid those that might lead to disproportionate tax liabilities.
- Mission Focus: Understanding which activities trigger UBIT helps organizations focus on their primary exempt purposes and manage unrelated business activities appropriately.
Managing UBIT: Strategies for Nonprofits
1. Identify Unrelated Business Activities
The first step in managing UBIT is identifying which activities might generate unrelated business income. This involves a detailed review of all revenue-generating activities to assess their connection to the nonprofit’s mission.
2. Use of Subsidiaries
One common strategy to manage UBIT liability is to use a taxable subsidiary to conduct unrelated business activities. This can help shield the nonprofit from direct tax liabilities, as the subsidiary will be responsible for paying corporate income taxes on its earnings.
3. Maintaining Good Records
Accurate and detailed record-keeping is essential for managing UBIT. This includes maintaining separate accounts for unrelated business activities and documenting how income and expenses are related to those activities.
4. Seeking Professional Advice
Due to the complexities associated with UBIT, consulting with a knowledgeable accountant or tax advisor is advisable. This is particularly important when starting a new activity that might generate unrelated business income or when revising the organization’s business structure.
5. Planning for Tax Obligations
Nonprofits should plan for potential UBIT obligations in their annual budgets. This includes estimating potential tax liabilities and setting aside funds to cover these taxes.
Contact MKS&H Today!
If your nonprofit organization is grappling with the complexities of Unrelated Business Income Tax, or if you’re seeking ways to optimize your tax strategies while staying compliant, we’re here to help.
At MKS&H, our dedicated team of tax professionals specializes in nonprofit accounting and tax services, offering specific advice and support to ensure your organization thrives. Contact us today to learn how we can assist you in managing your tax obligations efficiently and effectively.
About MKS&H: McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick. MKS&H helps owners and organizational leaders become more successful by putting complex financial data into truly meaningful context. But deeper than dollars and data, our focus is on developing an understanding of you, your culture and your business goals. This approach enables our clients to achieve their greatest potential.
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