What Is Unrelated Business Taxable Income?
Unrelated business taxable income (UBTI) is income earned by a tax-exempt entity that's not related to the tax-exempt purpose of the entity.
More precisely, the Internal Revenue Service (IRS) defines unrelated business taxable income for most organizations as "income from a trade or business, regularly carried on, that is not substantially related to the charitable, educational, or other purpose that is the basis of the organization's exemption."
- Unrelated business taxable income (UBTI) is income earned by a tax-exempt entity that's not related to the tax-exempt purpose of the entity.
- UBTI prevents or limits tax-exempt entities from engaging in activities that are unrelated to their primary purposes.
- It was established in 1950 to ensure that tax-exempt businesses competed fairly with taxable companies in profit-generating activities
- Most forms of passive income, such as dividends, interest income, and capital gains from the sale or exchange of capital assets, are not treated as UBTI.
- Organizations with taxable unrelated business income pay corporate or trust tax rates.
Understanding Unrelated Business Taxable Income
The Internal Revenue Code (IRC) Section 501 grants tax-exempt status to a variety of tax-exempt and mutually beneficial organizations. However, a tax-exempt entity, such as a nonprofit or educational organization, may be liable for tax if it engages in, and derives income from, unrelated business activities.
UBTI was introduced in 1950 to ensure that tax-exempt businesses competed fairly with taxable companies in profit-generating activities. UBTI also prevents or limits tax-exempt entities from engaging in businesses that are unrelated to their primary purposes.
Most forms of passive income, such as dividends, interest income, and capital gains from the sale or exchange of capital assets, are not treated as UBTI. For example, if an investor holds an Individual Retirement Account (IRA) that simply invests in traditional equities, mutual funds, and ETFs, the UBTI rules will most likely not apply.
However, if an investment—for example, a mutual fund—generates income that qualifies as UBTI, the fund may be subject to taxation. For example, income from a restaurant business that flows into an IRA is considered taxable. That's because the business activity doesn't relate to the tax-exempt purpose of providing a pension to the IRA holder.
Activities That Generate UBTI
An activity is considered unrelated business (and the income generated taxable) if it meets the following thresholds, as defined by the IRS:
It is a trade or business and produces income from selling goods or performing services.
It is regularly carried on, frequently and with continuity in a way that's similar to commercial activities of nonexempt organizations.
It is not substantially related to furthering the exempt purpose of the organization. Activities that generate income must play a major role in achieving an organization's tax-exempt purpose to be substantially related.
IRS Publication 598 provides more information about unrelated business activities and these three categories.
Some transactions that may be considered unrelated business activity include:
- Buying and selling a significant number of real estate properties in a year.
- Conducting operations in businesses—such as restaurants, convenience stores, lodging inns, gas stations—that generate active income and are operated through a pass-through entity, such as a limited liability company (LLC) or master limited partnership (MLP).
- Using margin for a stock purchase.
- Making multiple private loans in a single year.
Organizations must make estimated tax payments if they expect annual unrelated business income tax to be $500 or more. Estimated tax payments are normally due the 15th day of the 4th, 6th, 9th, and 12th months of the tax year and must total 100% of the organization’s total tax liability for that year.
The IRS excludes these activities from the definition of unrelated trade or business:
- Volunteer Labor: When substantially all the work is performed for the exempt organization for no payment. For example, volunteer-run bake sales would be excluded.
- Business for Convenience of Members: When a 501(c)(3) organization or a governmental college or university conducts business primarily for the convenience of its members, students, patients, officers, or employees. A school cafeteria would be excluded in this circumstance.
- Selling Donated Merchandise: When a business sells merchandise that the exempt organization received as gifts or contributions. For example, thrift shop operations of exempt organizations would normally be excluded
- Bingo: Certain bingo games are not considered to be unrelated trade or business.
Taxes on UBTI
Any exempt organization subject to the tax on unrelated business income is taxable at corporate rates (a federal rate of 21%) on gross income beyond $1,000. The same applies to exempt trusts except that income is taxed at trust rates (federal rates from 10% to 37%).
According to the IRS, the tax computed on the total UBTI can be reduced by any applicable tax credits, including general business credits (such as the investment credit) and the foreign tax credit. However, an exempt trust may not claim the deduction for a personal exemption that a trust normally can claim.
To pay their tax, exempt organizations must file IRS Form 990-T.
Certain income is excluded from the unrelated business taxable income that an exempt organization may have to pay taxes on:
- Certain other investment income
- Certain rental income
- Certain income from research activities
- Gains or losses from the disposition of property
IRS Publication 598 provides more information about income that's excluded from UBTI.
Do I Have to Pay Taxes on UBTI?
If your tax exempt organization earns unrelated business income over $1,000 that doesn't fall into the IRS's excluded categories, then, yes, you do.
What Is Excluded From Unrelated Business Taxable Income?
Income that's excluded includes dividends, interest, capital gains, royalties, and certain other investment income. For a complete list, please see IRS Publication 598.
What Happens If UBTI Tax Isn't Paid?
An exempt organization may be subject to interest and penalty charges if it fails to pay a tax when the tax is due, it underpays its tax liability, doesn't file a return, or files a late return.
The Bottom Line
Unrelated business taxable income (UBTI) is income earned by a tax-exempt entity that isn't related to the tax-exempt purpose of the entity.
An income-earning activity is considered to be unrelated if it involves a trade or business, is carried on regularly, and is not substantially related to helping the organization carry out its mission.
With some exceptions, organizations will owe federal and state corporate or trust taxes on annual gross unrelated business income over $1,000.